When it comes to fuel pricing, politics trumps sound economics and any policy recommendation ought to recognize this fact of life. In the present regime, oil companies are given subsidies for “under-recoveries" in respect of fuels for which price is administered, namely diesel, kerosene and liquefied petroleum gas. There is no subsidy for unregulated fuels such as petrol and aviation turbine fuel. The principle by which under-recovery is fixed is that an oil retailer should get the same profit as a world-class firm operating in an unregulated market. The difference between the import parity price and the administered price in each fuel is deemed to be the under-recovery per unit in that fuel (when the difference is negative the under-recovery is zero). The subsidy is in the form of government grants and discounts from crude oil companies. The oil marketing companies are also asked to absorb a part of the under-recovery.

Illustration by Jayachandran/Mint

The data on the difference between the import parity price of diesel and the administratively fixed price shows a steep upward trend over the past few years. As expected, the resultant subsidy burden has also been increasing, and will continue to do so. While not suggesting that diesel deregulation is feasible in today’s scenario, the following steps are “doable", and imperative.

• Redefining under-recovery: At present, under-recovery is defined as the difference between the import parity price of a petro-product, such as diesel, at the refinery gate and its realized price, which is fixed by the government at a level lower than the import parity price. Keeping in mind that India is a net exporter of petroleum products, the appropriate cost price for the oil retailer is the export parity price, which is lower than the import parity price on account of the duties levied. Therefore, it is the export parity price, or in other words the freight-on-board price, which should be taken into account. Doing this will reduce the subsidy burden.

• Promoting real equity: The beneficiaries of the low diesel price include many undeserving individuals. The 11 progressive increases in the price of petrol since June 2010 have seen a mass migration of automobiles, including sports utility vehicles, to diesel-based options. Subsidized diesel is channelized for power generation in shopping malls, and commercial and residential complexes. The government should impose a higher tax on large diesel generators and personal diesel-driven automobiles. It is also important for the government to expedite coal and power sector reforms to bridge the bourgeoning demand-supply gap in the power sector.

• Eliminate double subsidies: The government is engaged in the curious act of subsidizing both diesel and renewable energy sources. In the telecom sector, firms receive up to Rs1,000 crore of diesel subsidy a year, and also are in line to receive a large subsidy to incentivize them to switch over to solar energy. Were the diesel subsidy removed, the solar subsidy required would be much lower, and the government would save a large amount of money.

• Controlling cartels: The existence of cartels in the transport sector increases the downstream burden of diesel price hikes on consumers. It is observed that truck rentals and general cargo freight rates shoot up far more than the weighted impact of diesel price hikes on the cost of transportation of goods. This may indicate the presence of market power in transportation. The government should take necessary steps to counter this and thus pave the way for eventual deregulation of diesel.

• Controlling demand: There should be focus on shifting freight traffic to railways using electric traction. This will significantly reduce diesel consumption and reduction of the dependence on diesel would further create conditions for diesel deregulation.

By holding the diesel price even as world prices soar, the United Progressive Alliance is sowing the wind. Unless doable measures are taken up to reduce the fiscal burden, the government of 2014, whether it is that of Rahul Gandhi or that of a leader currently in the opposition, will reap the whirlwind.

Sajal Ghosh and Rohit Prasad are, respectively, assistant professor and associate professor at MDI Gurgaon.

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