The Hindu Business Line : Energy policy: Band aids for bullet wounds

The country's current energy policy is having worryingconsequences: OMCs, forced to sell below cost, are goingbankrupt, companies that could develop alternativeshave to compete with artificially low fuel prices, andconsumers don't make the behaviouraladjustments that would lower the demand for oil,argue SHANMUGANATHAN N. and RAM VENKATACHALAM.

Oil security in my opinion is a grossly exaggerated fear. We are concerned about the high price of $70 per barrel. On the other hand, there is a huge amount of potential oil substitutes available in the world.

Kirit Parikh, Member, Energy, Planning Commission, (Nov 2006)

...no supply constraints (of crude oil) right now and demand has not escalated out of control.

Rather, trading on exchanges like the New York Mercantile Exchange or NYMEX is contributing enormously to high prices. We should halt trading of crude oil in commodity exchanges.

M. S. Srinivasan, Petroleum Secretary, (Nov 2007)

The above statements are just samples that reflect the ignorance of our policy- makers on fundamental energy issues and the role of markets in determining prices. As explained in an earlier article ("Cheap at $100/barrel", Business Line, January 4, 2008), what one thinks of as high prices today is going to look ridiculously cheap a couple of years down the line. Instead of trying to understand the fundamental drivers and develop real solutions, the country's bureaucrats continue to insist on treating the symptoms.

No wonder there is a disaster staring at our oil marketing companies that are projected to suffer a revenue loss of close to Rs 130,000 crore this fiscal. And this when the crude oil price is just $100. The political incentives to maintain subsidies at higher prices (say, $150-160 that are quite likely to be seen later this year) are going to be substantially higher and, consequently, the losses will be that much greater.

LACK OF ACCOUNTABILITY?

Now that oil prices have consistently stayed above $100 for the last few months, perhaps the Planning Commission members need to point out where these potential `oil substitutes' are hiding. In all probability, they may be referring to the unconventional sources, such as tar sands and oil shale, in which case, they should read the article "Of Tar Sands and Sand Castles" (Business Line, August 16, 2006) before making another statement on the subject of energy.

For sure, even in the most professionally run organisations, people make mistakes. But there is usually a market feed-back loop that exists in these situations that helps organisations quickly correct their mistakes and move ahead. Companies that fail to recognise this feed-back mechanism end up going bankrupt.

It is this market incentive that forces companies to improve all the time - and it is precisely the absence of this market feedback mechanism that allows our bureaucrats to keep bungling with fundamental issues till we face a major crisis. Quite perversely, bigger the mistakes, the higher become their power with their ability to distribute the freebies (in this case, Oil Bonds) amongst the affected parties.

To make it clear, providing market freedom is not going to bring down oil prices, but it would just enable the markets as a whole to develop solutions for the problem of energy security.

Just consider the disastrous consequences of current policy: OMCs are going bankrupt because they have to sell below cost price, companies that could potentially develop alternatives have to compete with a fuel price that is held artificially low, and consumers are shielded from making the behavioural adjustments that would help lower the demand for oil.

This policy today hurts the energy companies (OMCs as well as alternative energy companies) in both the short and long term. And in preventing market solutions to the problem of energy from emerging, the consumers are being hurt as well, in the long run. But does it at least benefit the consumers in the short run? Apparently, yes, because they are paying a lower price for oil and this might allow for a lower level of inflation. But just think of a situation wherein the Government creates bonds for producers of every item in the CPI list (that is, Food Bonds, Cloth Bonds, Rent Bonds, etc.) thereby maintaining "price stability".

Even assuming that shortages/ black markets do not develop as a market reaction to the above steps, does it mean that there will be zero inflation? While the CPI might well indicate zero inflation, consumers will soon realise that the prices of items not in the CPI list would go through the roof as the excess credit starts to flow into these non-CPI items.

Inflation is, and will always remain, a monetary phenomenon, and maintaining artificially low prices for a certain segment of goods/services will do nothing to alter the overall consumer inflation. What the current steps proposed will allow is for the Government to pretend that it cares about inflation.

A MARKET FUNCTION!

So, what would the contours of an "Integrated Energy Policy" look like? The answer is two-fold: First, there are several basic mistakes in the country's current policy such as proposing natural gas to develop electricity (Matt Simmons, author of Twilight in the Desert says using natural gas to generate electricity is like burning a Da Vinci painting for the heat value) and the lack of a coherent plan to develop alternatives.

But, more importantly, nobody should really be writing an "Integrated Energy Policy" in the first place. It is for the markets and the companies that are operating in this space to decide what the appropriate solution(s) should be.

The Government's role, if any, should be to facilitate the execution of these plans rather than decide on the feasibility or appropriateness of the plan itself.

For instance, if a certain plan envisages setting up a power station by using coal as a feed-stock, the Government could help this company buy a coal-mine in Australia or Africa through the efforts of its External Affairs Ministry.

Nobody should really be framing an `Integrated Energy Policy'. It is for the markets and the companies that are operating in this space to decide what the appropriate solution (s) should be. The Government's role, if any, should be to facilitate the execution of these plans rather than decide on the feasibility or appropriateness of the plan.

That's about all the role of Government ought to be. It should not be to create a plan that micro-manages the details of activities that are essentially market functions, including proposing how much power should be generated in the next five years.

(The authors are Directors at Benchmark Advisory Services. They can be contacted at ram.venkat@benchmarkconsulting.in and shan.sundaram@benchmarkconsulting.in . Previous articles of this series can be accessed at http://kinghubbert.blogspot.com)

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