If reviving economic growth is a priority, then fixing the power sector—specifically the production and pricing of coal—deserves immediate attention. There is nothing clandestine about the political economy of coal to anyone who has been following news. Appreciating the gravity of the situation, the government has put the issue on the front burner. A coal regulator has been announced with responsibilities of a referee-cum-whistle-blower. While this is a welcome step, the issues of coal pricing and methods of block allocation are yet to be addressed.

Typically, India has met its coal needs through domestic production. However, unable to keep pace with rising demand, imports have risen over the last few years. Given the business-as-usual approach, the gap is only expected to increase over the years.

Though the problem at hand is identifiable, there are a myriad of issues preventing a solution. First, there are many parties with not necessarily aligned incentives—Coal India Ltd (CIL), its minority shareholders, the coal ministry, the power ministry, the Central Electricity Authority, iron and steel lobbies, private coal mine owners, private power plant owners, local micro entities, and now a regulator. Second, CIL has already signed fuel-supply agreements with several plants, which it is not in a position to honour with the current level of production. Third, imported coal is considerably more expensive than domestic coal. So, should we have two prices or one? Fourth, even if private entities mine coal, any surplus has to be sold back to CIL at a predetermined price. This has stoked a large black market. Finally, how should coal blocks be allocated?

The price of coal should be determined by the marginal source of supply, that is, if you were to go and buy an extra unit of coal in the market, where would you get it from and how much would you pay? This marginal supply, today and in the foreseeable future, will come from abroad. If domestic buyers don’t face imported price or some other notion of market prices, the government will subsidize power generation at the source.

If the government sets a “pooled price" using an ad hoc formula, which is different from the actual price of coal, it will not only artificially regiment choices of coal purchasers, but will also create uncertainty on what will happen if global prices fluctuate.

Conducting localized auctions in regional spot markets to discover the right price of coal is the best possible mechanism. Alas, these are sophisticated mechanisms we must endeavour towards, but are not immediately feasible.

Until we can set up the auction infrastructure, the third pricing option of having a single import parity price for domestic coal is the best way forward. It fits the criterion of determining price through the marginal source of supply. It will also aid in streamlining logistics as coastal plants will prefer international coal and inland ones domestic, instead of seeking geographically inefficient linkages.

The flip side of this proposal, of course, is that it will increase input costs of power plants, forcing them to suffer losses, or raise the price of electricity. But this problem can be overcome with a simple transfer—having an import-parity price will generate a substantial windfall for CIL (given domestic prices are much lower than import prices), which can then be transferred to power companies as compensation for higher coal prices. The quantum of transfer can be determined using a transparent metric based on the promises CIL has previously made.

The second big design issue is that of allocating coal blocks to private companies and individuals, who can potentially mine coal quickly and efficiently. The controversy plaguing the sector right now has its seeds in three postulates, which should have been followed properly: the blocks should be given out in a transparent way, there has to be an incentive to mine immediately and not sit on it or to sell it to a third party, and the price/royalty structure should be flexible enough to accommodate global volatility in coal and energy prices.

The ideal methodology, both for transparency and price discovery, is auctioning of coal blocks. And unlike coal, auctioning coal blocks is logistically easier. To incentivize firms not to squat over allocated mines, an upfront payment is essential. But upfront payments assume that a good estimate of the long-term value of the mine is available. This is problematic because it requires fairly precise estimates of the volume of coal underground and prophetic vision of energy prices. The most natural way to overcome this design inadequacy is by introducing an element of revenue/profit sharing. But going all out on revenue sharing will not push immediate mining and also put excessive monitoring burden on the government.

Understanding the merits of both forms of payment, an auction where pricing is based on a mix of upfront payment and revenue sharing is a better option. A fixed upfront fee can be charged and the private entities will bid to give the government the highest revenue share. The marriage of the two will help promote both the objectives of fast-tracking mining and providing some cushion against volatile global prices.

It is imperative that we understand the beast before we attack it. Simple pricing and allocation mechanisms are a prerequisite for a well functioning market that a regulator can then regulate.

Pranjul Bhandari and Rohit Lamba are economists. Bhandari is headed to Harvard University as a Mason fellow. Lamba is a research scholar in economics at Princeton University.