Pet Subsidies

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Petroleum SubsidiesA Case Against Subsidies


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Contents

Objective

Literature Review

Introduction/Theoretical Framework Analysis

Results

Conclusion Way Forward


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Objective of the Study

The objective of this project is to study:

what fuel subsidies are, how do they impact economies and the issuesfacing them!

This project also aims to take India as a case study and looks at the pricingof petroleum products as it has evolved over time, and the ramificationsof the pricing regimes on various stakeholders

It helps to calculate how the under recoveries are made and the extent ofsuch under recoveries and concludes by suggesting a way forward


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Literature Review Pricing is one of the most effective instrument in influencing the consumption and

production of a commodity

Pricing can also affect the technological development and innovation Subsidies and pricing are closely linked

The key to efficient energy pricing (including the provision of subsidies) lies in beingable to track the supply chain of energy and the consumption pattern exhibited byvarious consumer groups

Several studies examine the macroeconomic costs of energy subsidies in developing

countries. On the benefit side, the World Bank finds that in general quantity-basedutility subsidies tend to be regressive because their use increases with income(Komives et al., 2005)

Many case studies in various developing countries examine the income benefits or theprogressivity of household fuel subsidies (Dube, 2003; Gangopadyaya et al., 2005;Hosier and Kipondya, 1993; Kebede, 2006; Komives et al., 2005; Morris et al., 2006;Olivia and John, 2008; Pitt, 1985)

Piketty and Qian, 2009 discuss that these subsidies are often justified as instrumentsof redistribution in many developing countries, in part because of the lack of broad-based institutions that enable direct cash transfers

A recent study of the implications of distribution of fuel subsidies in developingcountries by Granado, Coady, and Gillingham (2010) shows that the benefits of fuelsubsidies accrue mainly to higher income households, with the richest 20% receiving

six times more in subsidies than the poorest 20%.


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Theoretical Framework


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What is Subsidy!?

The dictionary defines subsidy as a sum of money granted by the government ora public body to assist an industry or business

A subsidy can be interpreted as a reverse flow (transfer) from the government tothe public or an income/consumption supplement for individuals

Subsidies may be proportional, lump sum or progressive, just like indirect taxescan be

Subsidies should be assessed by their relative efficacy, sector efficiency, and cost-effectiveness

Subsidy can have three different interpretation- The first term as used by alayman, that is that of explicit budgetary subsidies. The second is the conceptused in National Accounts and this implies the converse of indirect taxes. Thethird is the concept used to refer to unrecovered costs of providing non-publicgoods


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Fuel subsidies are inefficient and a fiscally expensive approach to protecting the

poor from rising international fuel prices. However, eliminating fuel subsidies can

still have a sizeable adverse impact on poor households

Petroleum Products pricing is influenced by every major government in almost all

the countries, either directly or indirectly

Pass-through defined as the absolute change in domestic prices as a proportion

of the change in international prices- has varied a great deal in this period

For gasoline and diesel respectively, around two-thirds and one-half of countries

could not fully pass through international price increases during the period of2008-09

Petroleum product tax revenues decreased in 73 countries, with the decrease

exceeding 1% of GDP in 41 countries. Subsidies increased in 27 countries, with the

increase in subsidies exceeding 1% of GDP in 22 countries

tax-inclusive subsidies increased from $406 billion to nearly $1,000 billion overthis period, equivalent to 1.3% of global GDP- Emerging economies accounted for

over half of these subsidies

Thus, fuel subsidy reform could make a significant contribution to

fiscal consolidation efforts in these countries!!


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0

10000

20000

30000

40000

50000

60000

70000

2006/07 2007/08 2008/09 2009/10 2010/11

CONSUMPTION ('000 MT)

LPG

MS

SKO

HSD

7,042 5,766 8,700 8,072 8,32915,888

5,84310,191

13,61417810

31203

49480

2,617 4,2508,324 6,583

2,909 4,939

18,654

29,198

40,871

49670 50930

69300

2005/06 2006/07 2007/08 2008/09 2009/10 2010/11

IMPORTS ('000MT)

LPG PETROL KEROSENE DIESEL

53 112 99 109 131 1542,417

3,615 4,2585440

9771

13578

121 150 137 77 46 33

8,504

11,369

14,308 14720

1845120335

2005/06 2006/07 2007/08 2008/09 2009/10 2010/11

EXPORTS ('000MT)

LPG PETROL KEROSENE DIESEL

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

2005/06 2006/07 2007/08 2008/09 2009/10 2010/11

PRODUCTION('000MT)

LPG

PETROL

KEROSENE

DIESEL

Indian Petroleum Industry at a Glance


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Impact of the current pricing policyOn the Economy The government compensates the OMCs in two waysby issuing oil bonds and by

providing budgetary subsidies

the budgetary subsidies are only about 3% of the total under-recoveries

The oil bonds constitute a significant portion of the total under-recoveries

These are issued with a maturity period of 57 years and are treated as an off-budget

expense and have a direct and immediate fiscal impact on the economy

In 2008/09, the fiscal deficit for the country stood at 6.62% of the GDP (with inclusion

of the oil bonds) that grew to 8.06% (Reserve Bank of India 2010) as a result of high

rises in crude oil price in 2008-09

In February 2009, the international ratings agency

Standard & Poors (S&P) downgraded Indias long

term sovereign credit rating from stable to

negative. This was done on account of worsening

government budget deficit

2683 2699 2820 2877

40000

49387

77123

103292

0

20000

40000

60000

80000

100000

120000

2005/06 2006/07 2007/08 2008/09

Budget Subsidi

Under Recoveri

Linear (Under

Recoveries)


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On the Oil Industry

The national oil companiesboth upstream and downstreamare affected by the

pricing policy.

From 2005/06 to 2008/09, the under-recoveries have risen significantly. Within a

period of three years, these have increased from `400 billion (2005/06) to

`1032.92 billion (2008/09), growing annually at a rate of around 37%

The oil bonds provided by the government are an inefficient mechanism of

financing the oil companies as these are issued for medium to long term, and are

only partly tradable the oil companies find it difficult to generate funds for working capital from these

securities, and have increasingly been facing a short-term liquidity crunch

the net profits of these companies have been fluctuating, and have even been

negative in some quarters (three quarters of 2005/06)

the profitability of oil marketing over the years has declined substantially The burden on exploration and production (E&P) companies increased from `140

billion in 2005/06 to `320 billion in 2008/09

The OMCs in the face of rising international prices have been facing massive

under recoveries


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On the Consumers the penetration of these fuels remains limited, and so does the efficiency of their

use

As per the NSSO data (63rd round), almost 85% of rural households continue todepend on traditional fuels such as firewood, chips, and dung cakes as a source

of cooking fuel. The penetration of LPG was limited to 9.1% of rural households

since these traditional fuels have to be collected, it imposes an added burden on

the women and girls of the householdswith the latter often having to forego

attending school

In the urban areas, on the other hand, almost 62% of households have access toLPG, thus implying that a large chunk of the total subsidies is being wrongly

targeted

Subsidized kerosene is used by almost 40% of rural households for lighting

purposes. However, kerosene is an inefficient fuel for lighting

Also since it is easily available, it is increasingly being used for adulterating diesel.According to a study conducted by the National Council for Applied Economic

Research (NCAER), almost 40% of the kerosene consumed is siphoned off,

highlighting the severity of the issue (NCAER 2005)


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Analysis

We will first calculate the cost of producing and marketing petrol and

diesel in India

We shall then calculate the implicit subsidy that the government provides

these OMCs

We will also see how the government realizes the major chunk of revenue

from these figures

We shall then deduce are results and findings, based on which theconclusion is derived


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The Various Components that go into deriving these costs

Various Components involved in

determining the cost of producing

and marketing a Fuel Include:

Cost of Production of fuel

Marketing Costs

Marketing Margins

Return on working Capital

Stock lossDLAF (Domestic logistic

adjustment factor)

Interest on working capital

Terminalling charges

Sales Tax levied by the state

governmentExcise duty levied by the

Central Government on basic

price

Customs Duty Levied by central

government

Dealers commission on sale of

fuel

Various Components used in

calculation of cost of fuel

Amount of Crude oil produced

in India

Amount of crude imported

Value of Crude imported in

India

Total fuel supplied to refineries

in India

Total fuel (MS/HSD) produced in

India

Total Price incurred in

producing and importing crude

oil

Cost of production of Fuel


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Cost of producing Crude in India =Production ofCrude in India X Cost of producing 1MT of Crude

Total Cost Incurred = Cost of producing Crude In India + Cost incurred in

importing Crude in India

Cost of Producing MS/HSD = Total MS/HSD produced X Total Cost incurred

Total Crude Supplied to Refineries

Total Crude Supplied to Refineries = Production of Crude in India + Crude imported

in India

Cost of Producing MS/HSD per litre= Cost of producing MS/HSDTotal MS/HSD produced


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We will start with the cost calculation of petrol and then will calculate the cost of

diesel.

Let us consider the case of petrol or MS( Motor Spirit): (All the data are from the financial year 2009-10 and all the figures are in INR)

Amount of crude imported: 159.259 million MT (1)

Cost incurred: 375378 Crores (2)

Production of crude by India: 33.691 million MT (3)

Total amount of crude supplied to the refinery (1+3): 192.95 million MT (4)

Cost analysis of production of crude (offshore and onshore) (Prices in Rs/MT)

T3: Various price components of petrol or MS, 2009-10Figures taken from table T6 Weighted Average Crude Oil prices

Total price of producing 1 MT of crude: 31454/MT (5)

Total price of producing crude in India (3x5): 105971.67 crores (6)

Total price incurred (2+6): 481349.67 crores

Basic price Royalty Cess Sales Tax

25530 2633 2500 791


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Total MS produced: 22.537million MT

Total MS produced (in KL): 22537/0.750= 30.049333 million KL

Price of producing 1 KL of MS: 56222.73928 /30049.333

= 18.71/Litre

Other costs involved in the sale of MS:

Marketing Costs

Marketing Margins


Stock loss

DLAF (Domestic logistic adjustment factor)

Interest on working capital Terminalling charges

These costs accumulate to around a total of: Rs. 5/Litre

Total price of MS/litre without duties and taxes: Rs.23.71/Litre

Sales tax on MS(average of 4 Metros [25.25% of basic price]) : Rs. 4.72/Litre

Customs Duty (7.5% of Basic Price+Rs. 7.35/Litre): Rs.8.75/Litre Excise Duty: Rs.13.35/litre

Dealers margin in Delhi for MS: Rs.1.125/Litre

Retail price at which MS is available: Rs. 51.662/Litre


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We will start with the cost calculation of petrol and then will calculate the cost of

diesel.

Let us consider the case of petrol or MS( Motor Spirit):

(All the data are from the financial year 2009-10 and all the figures are in INR)

Amount of crude imported: 159.259 million MT (1)

Cost incurred: 375378 Crores (2)

Production of crude by India: 33.691 million MT (3)

Total amount of crude supplied to the refinery (1+3): 192.95 million MT (4)

Cost analysis of production of crude (offshore and onshore) (Prices in Rs/MT)

Total price of producing 1 MT of crude: 31454/MT (5)

Total price of producing crude in India (3x5): 105971.67 crores (6)

Total price incurred (2+6): 481349.67 crores (7)

Total HSD produced: 73.281 million MT

Total HSD produced (in KL): 73281/0.830=88290.361 million KL

Basic price Royalty Cess Sales Tax

25530 2633 2500 791


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Price of producing 1 KL of HSD: 1828130.877 /88290.361

=20.705/Litre

Other costs involved in the sale of HSD:

Marketing Costs

Marketing Margins


Stock loss

DLAF (Domestic logistic adjustment factor)

Interest on working capital

Terminalling charges

These costs accumulate to around a total of: Rs. 6/Litre

Total price of HSD/litre without duties and taxes: Rs. 26.705Litre

Sales Tax(average of the 4 metros [19.23% of basic price]): Rs. 3.98/litre

Customs Duty(2.5% of basic price + Rs. 3.6/litre): Rs. 4.12/Litre

Excise Duty: Rs. 4.22/Litre

Dealers margin in Delhi for HSD: Rs. 0.673/Litre

Retail price at which HSD is available: Rs.39.65/Litre


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Results and Findings

Based on the calculations done, we find that the cost of production and

marketing petrol is : Rs. 51.662/Litre

Now the retail selling price in Delhi during that period was Rs. 47.93/litre

The implicit subsidy, in the case of petrol is :

Based on above, we get the implicit subsidy as Rs. 3.732/Litre

Major chunk of the price of fuel comes from the sales tax and

excise/custom duties levied by the state and central governments

Implicit Subsidy on petrol= Cost of production and marketing petrol-Retail

Selling Price of Petrol


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In that case the indirect revenue of the government

(accounting for the implicit subsidy) is given by

Based on the above, we get the revenue earned by the government perlitre of fuel as:

Duties+Taxes levied on Petrol (Rs./Litre)= 26.82

Implicit Subsidy= Rs. 3.732/Litre

Revenue Earned= Rs. 23.09/Litre

Percentage of taxes and duties of the retail selling price of petrol : 54 %

Revenue earned by government= (Duties+Taxes levied on fuel)-implict subsidy

on the fuel


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Similarly we derive the same calculations for diesel, to obtain the implicit

subsidy on diesel and the revenue earned in case of diesel

Cost of producing and marketing diesel : Rs.39.65/Litre

Retail Selling price of Diesel: Rs. 34.45/Litre

Based on the above we get the implicit subsidy as : Rs 5.206/Litre

Based on the above we get the revenue as Rs. 7.11/Litre

The taxes and duties form 37% of the retail selling price of Diesel

Revenue earned by government= (Duties+Taxes levied on fuel)-implict subsidy

on the fuel

Implicit Subsidy on diesel= Cost of production and marketing Diesel-Retail

Selling Price of Diesel


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Impact of Subsidies on Government and OMCs

The indirect subsidy on petroleum products has been given by the government,

the amount of subsidy keeps changing. This subsidy cost is shared by OMCs and

government both. The government pays for 52% of the share to OMCs in terms ofoil bonds and the rest has to be paid by the OMCs, which passes its burden to the

upstream oil companies

Petrol:

Total MS produced : 22.537 million MT

Implicit Subsidy/litre = Rs. 3.73

Total cost incurred in subsidy = Rs. 3.73 * 22.537 million MT = Rs. 8406.4 crores

Now,

Governments share = Rs. 0.52 * 8406.4 = Rs. 4371 crores

OMCs share = Rs. 0.48 * 8406.4 = Rs. 4035.72 crores

Similarly for Diesel,Total HSD produced : 73.281 million MT

Implicit Subsidy/Litre= Rs. 5.20

Total Cost incurred in subsidy= 5.20* 73.281 million MT= Rs. 38106.12 Crores

Government Share= 0.52* 38106.12= Rs. 19815.18 Crores

OMCs share= .48* 38106.12= Rs. 18290.93 Crores


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Conclusion We find that the current pricing scheme bears heavy impact on the fiscal burden of the

government and on the oil marketing companies as they suffer huge under recoveries

Indias fiscal deficit (across all levels of government and including off-budget components)had more-than-doubled in nominal terms from 5.7% of GDP in FY 2007-08 to 11.4% in FY2008-09 during the volatile period. Total state and central government debt is estimated at82% of GDP.

The prices of petrol are now market determined, which was done owing to large underrecoveries faced by the OMCs in the volatile period of 2007-2009

The tax regime in the case of pricing fuel needs to be rationalized as well. Governmentsrealize large revenues on petrol and diesel, and let OMCs bear major chunk of the losses.Thus tax/duty structure needs to be rationalized. Like in the case of Goa, where the govt hadcut down on state taxes, to bring down the price per litre by Rs. 10

Owing to the large disparity between the prices of petrol and diesel in the country, thenumber of diesel cars sold in India has increased over the past few years. Industry data shows

that while sales of petrol cars and other vehicles dipped by 15% between April 2011 andFebruary 2012, the demand for diesel vehicles went up by 35% during the same period.

the growing preference for diesel cars is already showing its environment impact withnitrogen oxide levels - a major diesel pollutant. These diesel cars emit 7.5 times more toxicparticulate matter than comparable petrol cars. This means, one diesel car is equal to adding7.5 petrol cars to the car fleet in terms of PM emissions and three petrol cars in terms of NOxemissions

W F d


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Way ForwardReforming fuel pricing regimes

Between FY 2004-05 and FY 2008-09, the GoI pumped over USD 60 billion intoOMCs to absorb product under-recoveries and to ensure OMCs were capable ofcontinued rapid investment in capacity.

massive expenditure by the GoI to fund the system of unofficial productsubsidies is entirely unsustainable.

The best approach to petroleum pricing is to implement a fully liberalized regime,

accompanied by appropriate regulation to ensure competition As an interim measure, however, governments can adopt automatic pricing

mechanisms with smoothing mechanisms incorporated

In the case of diesel, The burden of diesel price increase on agriculture depends onwhere it is used. In 2008-09, 12 % of total diesel went to agriculture (i.e., totractors, thrashers, tillers, harvesters, pumpsets etc.). The cost of diesel in

agriculture would be accounted for by the Government while fixing the MinimumSupport Price (MSP) for major crops. Therefore, any increase in the cost of dieselwill be reflected in the price and will not adversely affect farmers

Higher diesel price will induce them to use less diesel which may reduce over-useof ground water prevalent in many parts of the country. Of course, higher dieselprice resulting in higher MSP will increase subsidy for PDS, but it would be much

less than the reduction in under-recovery on diesel.


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In the case of increasing diesel car sales and its impact on the pollution

level, below are listed some of the measures that the government can go for:

Discourage big cars and SUVs by linking taxation to the actual fuel consumption of thevehicles. More fuel a vehicle consumes the more tax should it pay. It is more scientific

and effective to link the tax policy to actual fuel consumption.

Remove price incentive for diesel cars. Either equalise fuel taxes and prices or imposeeffectively high additional taxes on diesel cars to neutralize the current fuel priceadvantage that the cars enjoy. Kirit Parikh Committee has already recommendedadditional taxes on diesel cars to neutralize the benefit of fuel price difference

Introduce clean diesel technology and fuel on a nation-wide basis: India needs to setthe timeline for the uniform introduction of clean diesel with sulphur content less than10 ppm and mandate use of advanced particulate traps to near eliminate toxicparticulates

Need post 2010-emissions standards roadmap to reduce the pollution impact ofmotorization: At this moment there is no roadmap for uniform introduction of Euro IV

and Euro V emissions standards across the country. The stepped approach ofintroducing tighter standards only in 13 cities benefits less than the quarter of urbanpopulation whereas the CPCB data shows that pollution levels are high across manysmall and big cities.

Fuel economy standards must not worsen the trade-off between fuel efficiency ofdiesel cars and their toxic emissions. Fuel economy standards currently in the making

must have built-in safeguards against dieselization of car fleet.

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