The Union cabinet’s recent decision to allow oil marketing companies (OMCs) to increase diesel prices gradually is a welcome step although somewhat overdue. It still does not imply full deregulation of fuel prices, and increments will be gradual, around 50 paise per litre each month. It is, however, a meaningful market signal regarding the government’s intention to move towards market-based fuel pricing. For the first time, we have a systematic mechanism for phased price increases rather than ad-hoc price hikes and subsequent reactive rollbacks of the past few years.

Petrol prices were freed in 2011 and are now almost 50% higher than diesel prices. Diesel price increase is a much more emotive issue because it is used in agriculture and industry, and the potential inflationary effect of price hikes on the broader economy. The transportation sector accounts for 60-65% of diesel consumption in India, as diesel-fuelled commercial transportation accounts for over 70% of goods transported in India. In the short run, the move will be criticized by opposition parties, but in the medium term such a move was unavoidable.

OMCs were losing 13-15 per litre of diesel sold at the pump in January 2012. This figure came down somewhat after the last price rise of 5 per litre in September. The diesel subsidy cost the public exchequer over 80,000 crore in 2011-12, and is likely to be over 1 trillion for the current fiscal. Subsidies on kerosene sold under the public distribution system and cooking gas further increase the gap. The latest decision should help gradually narrow the subsidy Bill and its consequent impact on deficits, balance of payments and exchange rate pressures.

Reduction of fuel subsidies can benefit the economy in several other ways. Firstly, such a move is essential for addressing distortions in consumption patterns. An example is the recent disproportionate spurt in demand for diesel automobiles, whose sales accounted for almost 50% of new cars sold in past six-eight months. Typical annual driving distances of Indian motorists are relatively low. Diesel would not be the fuel of choice, were it not for the subsidized price.

Secondly, pricing of fuel at or above its true economic cost will promote its efficient use. For example, at prevailing prices diesel was often displacing fuel oil in industrial use. Diesel is a higher quality and value added product compared with fuel oil, and its use in industrial applications is not warranted. Significant volumes of diesel are currently used in power generation by domestic and commercial consumers. Such bulk users will start paying full market prices of over 60 per litre, forcing some rationalization of diesel for power generation.

Finally, removal of subsidies should enhance competition in the fuel marketing sector. With pricing subsidies available only to state-owned OMCs, private fuel retailers have stayed away from this sector. Compared with even other emerging markets, fuel retailing in India is 15-20 years behind in terms of maturity. If fuels are priced according to market forces over time, we can expect more participants to enter, leading to greater competition and choice, higher standards of customer service and more differentiated retail formats, all of which should ultimately benefit the end consumer.

The greater challenge before the government is how to address the burgeoning demand for liquid fuels and the growing import dependence for crude oil. India imports 75% of its crude requirements and with domestic production not growing, the dependence on imported crude will increase to over 80% in the next four-five years.

Market-based fuel pricing should help in tempering the increase in demand, and channel fuel towards the most efficient use. According to the Petroleum Planning and Analysis Cell of the ministry of petroleum, in May-July 2012, diesel consumption rose by 12-13% over the corresponding period in the previous year. After the price increase in September, the monthly reported growth figure has come down to 5-7%.

However, reduction and eventual elimination of diesel subsidy will in itself not address the fuel sufficiency and import dependence challenge. The country needs to diversify the basket of transportation fuels beyond diesel and petrol. Alternatives such as compressed natural gas (CNG) and biofuels are yet to be fully leveraged. Outside of regions such as Delhi, Mumbai and Gujarat, CNG is not a viable option.

Efficient use of available liquid fuel resources presents another opportunity. Demand for personal mobility will continue to increase with economic growth, higher disposable incomes and increasing social aspirations. However, tardy development of urban infrastructure and limited public transport options further contribute to a disproportionate growth in fuel demand. Enforcing stricter fuel efficiency norms for vehicles and introducing transparent fuel efficiency rating schemes should help. Encouraging investments in fuel efficiency technologies, wider consumer education and awareness campaigns on the benefits of fuel conservation are all essential steps. In the long term, adoption of alternative technologies such as hybrid/electric mobility and hydrogen will be essential. The recent launch of the National Mission for Electric Mobility by the Prime Minister is a step in this direction.

The above interventions pose significant implementation challenges. Coordination across multiple government agencies, the need for close cooperation between government, industry and civil society, strong political will and ensuring gradual change in consumer behaviour are essential. The diesel price increase is thus a welcome initial step—one hopes that the country will stay the course.

Suvojoy Sengupta and Ashish Rajvanshi are, respectively, managing director and principal in energy practice at Booz & Company, India.

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