Address fundamental flaws in fuel pricing

The furore caused by the sharp increase in petrol and diesel prices, since ‘dynamic’ daily pricing was introduced in June, has put the Government on the defensive. Oil minister Dharmendra Pradhan, forced to explain last week, said that prices of these fuels in India had increased due to a sharp rise in their international prices.

Not everyone was convinced. When the price of crude oil has halved since mid-2014, critics ask, why does petrol and diesel today cost almost the same as in mid-2014. They point out that when the crude oil rout was underway, the governments, central and State, instead of passing on the benefit to consumers, chose to pocket most of the gains through regular hikes in excise duty and VAT (value added tax).

And now, despite rise in prices, the Government is holding on to these high taxes instead of cutting them and giving relief to consumers. Taxes now are indeed high (more than 100 per cent of the base cost of petrol and diesel). Some critics also insinuate that the too-little-to-be-observed price changes under the daily pricing mechanism are being used as a cover to give effect to sharp hikes cumulatively.

While high taxes are indeed a problem, we cannot forget some fundamental issues arising from the pricing policies adopted by the oil companies.

First, the pricing mechanism. While the daily frequency of price change is fine, the methodology of the pricing mechanism is not. In India, the prices of petrol and diesel are not determined by the actual costs incurred by refiners on crude oil sourcing, refining and marketing and allowing for profits.

Rather, a formula — trade parity price (TPP) — is the starting point for pricing these products. The TPP is determined based on prices for these products prevailing in the international market assuming that 80 per cent of the petrol and diesel is imported and 20 per cent is exported.

The TPP, quoted in dollars, is converted to rupees. To this is added the cost of inland freight, marketing costs and margins charged by the oil companies, the dealer commission and finally the plethora of taxes levied by the Central and State governments.

Now, while India imports more than three-fourth of its crude oil requirement, it is self-sufficient in refining. In fact, with surplus capacity, the country is a net exporter of several petro-products including petrol and diesel. So, using the TPP is not really logical.

This legacy pricing mechanism is meant to protect the margins of the public sector oil refiners — Indian Oil, HPCL and BPCL. It probably made some sense in the earlier days when petrol and diesel pricing were controlled, and the oil refiners suffered huge under-recoveries due to selling below the market price.

But with the prices of these products decontrolled — petrol in 2010 and diesel in October 2014 — and made market-linked, the PSU oil companies suffer no more under-recoveries on this count. On the contrary, these companies have been doing very well financially over the past few years with a sharp increase in profits thanks to the pricing reforms.

So, continuing with the TPP to offer protection to PSU refiners no longer seems justified. There is a need to move to a pricing model that factors costs of refiners plus margins. These refiners will likely have different cost structures, based on their crude oil sourcing, and refining capacities and operational efficiencies. They should be encouraged to price their products independently and transparently based on market principles.

This key change will also help address the problem of near-same pricing by the three PSU oil marketing companies that dominate fuel retailing in the country. For instance, a litre of petrol in Delhi today is being sold at ₹70.53 by Indian Oil, not much different from the ₹70.45 by BPCL and ₹70.49 by HPCL. The uncanny congruity in prices charged by these companies often gives rise to allegations of cartelisation.

Trade Parity Pricing also gives unwarranted benefits to private sector refiners such as Reliance Industries and Essar Oil. These refiners get to sell their petrol and diesel at rates close to that of the PSU refiners in the domestic market. This, despite the superior refineries and crude sourcing abilities of private sector refiners that give them the leeway of pricing petrol and diesel competitively. Increased competition among PSU refiners will also encourage private refiners to price their products more competitively.

Truly ‘dynamic’ fuel pricing not only means more frequent resets, but it should also translate into also true competition among fuel retailers, both public and private, based on cost efficiencies and free market pricing, to give customers more choice. Also, there is an urgent need for an empowered, independent petroleum regulator to enforce price competition in the sector. Only then can the product pricing reforms be said to be complete.

Over the past three years, the international prices of petrol and diesel have fallen while taxes on products have gone up sharply in the country.

So, taxes now routinely equal or exceed the base price of these products. Some cities such as Mumbai and states such as Andhra Pradesh have it worse than others, due to higher incidence of VAT.

The clamour for cutting high excise duties and VAT on petrol and diesel is getting louder. Oil Minister Dharmendra Pradhan, on his part, has made a strong pitch for inclusion of petroleum products under the GST. Currently, crude oil, petrol, diesel, natural gas and aviation turbine fuel (ATF) are not covered under the GST.

On the face of it, bringing petrol and diesel under the GST seems a formidable challenge. The maximum rate (including cess) now under GST is 45 per cent, far lower than the effective rate of 100 per cent or more on petrol and diesel under the current tax regime. Accounting for the benefit of input tax credit, the effective rates under GST will be lower. Will the Finance Ministry and the States acquiesce to such a huge loss in revenue? Petroleum products contribute a chunk of the governments’ tax receipts.

That said, an eventual, even if gradual, shift of these products to the GST regime is imperative to provide meaningful relief to consumers. The resultant lower prices of petrol and diesel can have a multiplier effect on economic growth.

Besides, it can solve problems being faced by oil companies on stranded input tax credit and higher costs arising from these two tax regimes not talking to each other. The Government must explore innovative ways of providing relief to consumers and protecting its pocket at the same time. Can it rise up to the challenge?

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