The enigma of diesel prices

July 12, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Budget considerations make it necessary to raise prices of diesel; political exigencies make that difficult. No wonder Chief Economic Adviser Kaushik Basu was cautious enough to suggest ‘partial decontrol’. But the present is the time to do more than that.

Diesel prices were last increased in June 2011. With the current administered price, marketing companies are forced into under-recoveries which now amount to over 9 rupees per litre. Not all under-recoveries are subsidies. The government funds the major part with oil companies absorbing the balance. Call it whatever but there is an outflow of cash from the government.

The planned under-recoveries keep the price of diesel deliberately low. Diesel is 20 percent cheaper in India than in Pakistan, 27 percent cheaper than in China and 34 percent cheaper than in Brazil. This under-pricing of diesel has resulted in two major undesirable consequences.

First, the under-recoveries which amounted to 812 billion rupees in 2011-12 and may cross 760 billion rupees in the current year in spite of the fall in international prices of crude. The latter would be 41 percent of the budgeted effective revenue deficit had under-recoveries been accounted for, like the subsidies on LPG or kerosene.

Second, petrol and diesel are energy substitutes over a wide range. The deliberate underpricing of diesel has created an unjustified preference for diesel. The calorific content of diesel per litre is 0.93 times that of petrol. As such the price of diesel should have been 63 rupees when petrol is priced at 67.78 rupees. Currently, diesel sells at 41.3 rupees, making it the most economical fuel.

Under the present system of regulation and taxation, petrol is over-priced and diesel very much under-priced. The pricing of petrol has been distorted by differential taxation. In New Delhi, for instance, the VAT is 20 percent on petrol and 12.5 percent on diesel. If petroleum products are taxed like any other products at 12.5 percent, the price of petrol would have been 63.6 rupees per litre. Diesel is underpriced to the extent of under-recoveries without which the price would have been 50.4 rupees per litre. That would substantially reduce the price gap between petrol and diesel and discourage substitution.

More than a third of diesel consumption is by trucks and a sixth by cars. With the huge price difference between diesel and petrol there has been a shift in car production from petrol to diesel. More than 40 percent of the cars currently produced run on diesel. To correct the imbalance, petrol prices should be reduced by knocking down tax and diesel prices increased by eliminating under-recoveries.

In any case, an increase in diesel prices cannot be avoided to salvage the budget and appease international rating agencies. It’s the right time to do it because international crude oil prices are low. But the increase will have to be made in two steps, spread over the year to mitigate the blow to the consumer and soften the inflationary impact.

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