Losses from coal block allocation

The government has offered two key defences in the controversy over coal block allocations. Let us examine why these defences are on shaky ground.

add_main_imageFirst, Kapil Sibal argued last week that unlike Coal India, which can sell the commodity in the open market, the private companies that were allotted the blocks cannot do so.

Sibal went on to argue that any numbers attributing losses from the sale of coal blocks are therefore incorrect. To unravel the fallacy in this argument, consider a private caterer that has contracted to supply mid-day meals to government schools at a certain fixed price. To enable the caterer to supply these meals, let us say the government allots some fertile land for free and prohibits the caterer from selling in the open market the rice produced from the plot. NextMAds

Then, along the lines of the argument put forward by Sibal, attributing any losses to the disposal of the fertile land for free is incorrect since the rice can only be used for producing the mid-day meals, for which the price is already fixed.

The fallacy lies in mixing the price contracted for the output (steel/electricity) with the prices that need to be paid for the input (coal). Continuing with our example, if the fertile land had not been allocated to the caterer, he would have had to procure rice in the open market at the prevailing market prices.

Getting the raw material for free showers a windfall gain on the caterer. Similarly, coal is an input for producing electricity/steel. The private firm that was allocated the coal block agreed to supply electricity/steel at a fixed pre-contracted price. However, to produce the electricity/steel, the private firm would have had to buy coal in the open market if the coal blocks were not allocated.

Up until 2003, the price of coal was steady in the range of $25-30 a tonne. However, after 2004, coal prices started increasing due to an increase in the demand from China. Coal prices soared to $60 in 2004 and then zoomed to $180 by July 2008. The price has now settled at about $100-105 a tonne. Therefore, if the private firm that received the coal block allocations had to procure coal in the open market, it would have had to pay these high market prices. Allocating the coal blocks for free meant that the private firm instead got the key raw material for free.

Based on the opportunity cost of having to acquire coal in the open market, the value of the coal block equals the present value of the purchase price for all future coal required for producing steel/electricity.

In fact, a market-based estimate for the opportunity cost of coal was revealed from the auction of coal blocks in Madhya Pradesh. In November 2008, the Madhya Pradesh State Mining Corp. auctioned six mines. The winning bids in these auctions ranged from 700-2,100 per tonne while the Comptroller Auditor General (CAG) estimates employed 295 per tonne. sixthMAds

Moreover, the coal blocks auctioned in MP were the relatively unprofitable underground mines. CAG estimates had excluded the underground mines and had only included the relatively profitable open-cast and hybrid mines. Therefore, using the fundamental principles of valuation, the loss numbers arrived at by CAG are conservative and based on the correct principle of opportunity cost.

A second argument given by the government is: “If coal blocks were not auctioned since 1993 onwards, why auction post-2004?” Again, economic reasoning explains why coal blocks should have been auctioned post-2004.

If one looks at the long-term trend in coal prices, up to July 2003, prices were in the range of $25-30 a tonne when the cost of production was around $30. No wonder then Coal India was making huge losses. After all, the cost of production exceeded the revenue from producing the same. Given the transaction costs of conducting an auction, distributing coal blocks free was therefore economically optimal till 2003.

However, as mentioned above, the price of coal doubled to $60 in 2004 and kept rising till 2008 with the current price being above $100-105 a tonne.

Thus, after 2004, the revenue per tonne has been several multiples of the production cost of coal per tonne even allowing for some cost escalation due to inflation. Therefore, the coal blocks have become enormously profitable since 2004. As a result, to not auction the coal blocks to the highest bidder resulted in significant loss of revenue to the government.

In fact, economic theory highlights that auctions ensure that the asset is acquired by the most efficient bidder. Thus, allocating the asset to the most efficient bidder and revenue generation for the exchequer are the two main reasons for auctioning of all natural resources. Therefore, purely based on economic considerations, all the coal block allocations since 2004 must be scrapped and auctioned off to the most efficient bidder.

Krishnamurthy Subramanian is an assistant professor of finance, Indian School of

Business, Hyderabad. Comments are welcome at theirview@livemint.com