Thursday, February 18, 2010

How is the price of petrol and diesel fixed?

How many of us ever analyzed why petrol and diesel vary across all states in India? It is not that it should not vary, but why is the variation caused and what factors play into the price fixation?

India still has Oil prices and the Oil sector under Government monopoly. Unlike several sectors opened for reforms, Oil is still under Govt radar. Just a decade ago, one path breaking reform process was initiated by the then NDA Govt way back in 2001. The process of decentralization of oil prices and allowing international crude prices to play a direct role without Govt's intervention. Govt would intervene only if there is a oil shock or shortage. However, it did not work because there was widespread opposition from all states and some of its own allies, and the implementation was not complete. Now, almost after a decade, UPA Govt is under the same pressure from its own committee head Kirit Parikh who was asked to look into the same. His sharp and urgent recommendation is that Govt should allow market forces and not subsidies and vote bank politics to dominate oil prices.

Even before we understand why this recommended, let us look as to how petrol and diesel prices are fixed and who earns what out of this money.

The picture below explains this very clearly.

Let's take the price of Petrol in Delhi as Rs. 37.97.

Basic Price
Customs Duty
Excise Duty
Sales Tax
Dealer Margin

Note: Basic price includes cost of refining, transport, insurance and marketing margins


It is clear that taxes and duty constitute so much(almost 55% in the case of petrol) that this goes on increasing even if international crude prices go down. This is because Excise Duty which goes to center is its single largest source of income. Sales tax is imposed by the states and that also varies across states and no one is bothered to alter it as is a huge source of income. In states like Karnataka it is just too high. This causes huge disturbance in inflation as well. 

Let's explore some pricing mechanisms used:

Administered Price Mechanism - APM (1970-2001):

In 1970, APM was introduced by which govt would insulate the impact of international crude oil by maintaining an Oil Pool Account (OPA). This Account was filled by people paying excise duty, customs duty and sales tax included in the petrol price. So, using this Oil Pool Account (OPA), the Govt gave money to oil companies to maintain their under-recoveries (because LPG and diesel are sold by Govt at subsidized prices). Till 1990, OPA was positive and Govt was able to maintain balance with domestic prices and oil company costs. In 1991, post liberalization, consumption pattern increased and in late 90's OPA became OPD i.e Oil Pool Deficit running into thousands of crores. This forced Govt to increase petrol and diesel prices and yet running subsidy program for kersoene and LPG. The subsidy program is itself not helping those who have to get it. While kerosene reaches adulterated (done by middlemen) and LPG helps only urban and not rural people, the subsidy runs anywhere between 10,000 - 20,000 crores. The problem with this mechanism is that even if oil prices reduced in the international market, Govt was forced to increase prices just to maintain Oil Pool Account

Import Price Parity (done by NDA Govt in 2001)

In 2001, The NDA Govt led by Vajpayee took a major breakthrough decision of dismantling APM and allowed market prices (international market) to determine domestic prices.  Although this mechanism dismantled Oil Pool Account concept, Govt did not rationalize taxes imposed on states. The result: Increase oil prices again. The Oil Pool Deficit was merged with General Budget and govt began to issue Oil Bonds whenever there was crisis. It is really hilarious that Import Parity Price began to be used when not petro products but only crude oil was imported. The Import parity price (is the price at which the seller exports to another country including cost, insurance and freight expenses) for crude oil is much less than petro products.  So, if Govt was serious it would have reduced this , but it did not do so. And, further, the rule was every 45 days or so, prices will be revised. However, it was a politically sensitive matter to any party to mess with petrol prices as it affects the entire economy.

Trade Parity (2006-till present)

When International prices began to increase, the import parity pricing mechanism never helped us. It just began to increase and increase crossing 120$ a barrel. This had a disastrous effect. So, the Govt led by Manmohan Singh under the recommendation of the economic expert Rangarajan decided to use trade parity mechanism wherein the price will fixed as 80:20 ratio i.e 80% import parity and 20% export parity. The export parity price could be incorporated because Indian began to export certain petro products. So, by shifting to this mechanism, there was a considerable reduction in prices. However, the taxes induced were not changed resulting in the same situation.

Now, future? Deregulation and rationalization of taxes?

This year, the PM Singh got the expert advice of Kirit Parikh who has sharply recommended Govt to dismantle any interference in pricing mechanism and rationalize taxes across the country. Which means prices will be in tune with international prices in a transparent manner and at the same time, Govt will have uniform tax structure across the country. However, it is a very challenging decision which Govt has not yet taken

This decision itself is not going to help unless Govt decides to be flexible in tax imposition. Govt should be ready to have a uniform tax structure and when international prices increase, govt should reduce the tax.

The picture below indicates what happens if we allow our market open to international markets. It can be very deadly. Just see what happens if oil reaches $150 a barrel, petrol will be Rs.76/liter or so.



sunny said...

center should force state govts to have have a uniform tax on the petrol and diesel. form this the smuggling of petrol and diesel across the states will stop and thus the revenue of the states which are hit by these type of smuggling will increase and thus they can decrease the sale tax on the petrol and diesel and give the direct benifit to the common people.

for ex. sales tax on diesel in punjab 8.8% and sales tax on diesel on diesel in rajasthan is 20%. the differe between 1 lts of diesel price is about 3 rupee and thus it promotes smugglers to pruchase the diesel from punjab and sell it in rajasthan.

govt should take necessary action to stop this kind of smuggling

Manwinder Khaira said...

All Across India the rates for petro products should be uniform.!

Manwinder Khaira said...

All petro products should be sold by vehicle Number/ID of purchaser, to check smuggling.!