School of Economics | Reforming Fuel Prices
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Reforming Fuel Prices

The sharp increase in petrol and diesel prices has caused furore. Prices of these fuels in India had increased due to a sharp rise in their international prices. 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. And now, despite rise in prices, the Government is holding on to these high taxes instead of cutting them and giving relief to consumers. The consumer price of oil remains the same as it was when the crude price was twice as high.

Fundamental issues:

Pricing mechanism flaw

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.
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.
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.

Way ahead:

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.
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.
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.

High taxes:

The sale price of oil is as high as it was when the crude price was twice as high. During that time, the government used to subsidise consumers; the government, OMCs and upstream public sector oil companies were bearing the losses. The level of under-recoveries (the difference between sales realisation and cost of supply — which is the subsidy to the consumers) over 2002-2003 to 2012-2013 was Rs 25,000 crore for petrol users and Rs 3,38,000 crore for diesel users.
In any case, increase in the cost of diesel or petrol does not increase the revenue of the central government as the excise duty is specific, that is, it remains at the same level in rupee terms. Excise rate on diesel is Rs 17.33 per litre and on petrol it is Rs 21.48 per litre.

Way ahead:

The excise duty rates can be adjusted and be made equal for both diesel and petrol. This can be done in a way that does not change the excise duty revenue of the central government. It will increase the price of diesel by two per cent and reduce the price of petrol by six per cent.
The benefits of doing this will be reduction in distortion, reduced demand for diesel, a fall in demand for diesel-driven vehicles, reduced air pollution, a fall in carcinogenic emissions and a decline in diesel imports.The sale prices of diesel and petrol have increased because of the very high VAT rates imposed by the states. These vary from state to state. Since the VAT rates are in percentage terms, whenever the cost of diesel or petrol increases, revenues of states go up. Thus, the states have a scope to reduce their VAT rates so that sale price of petrol and diesel can be moderated.Ideally, all states should have a uniform GST rate for diesel and petrol. The states insist on keeping diesel and petrol out of GST as they would suffer a huge reduction in their revenues — the tax on diesel and petrol constitutes the bulk of the revenues of many states. A mechanism needs to be developed to get the states to agree on the GST for petroleum products. Then the prices of diesel and petrol will come down dramatically.
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. It needs to rise up to the challenge.

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