Diesel price deregulation: Why the NDA government may opt for the second-best solution

Oil and gas stocks have hit the accelerator on the bourses, thanks to the buzz that fuel prices - especially diesel - may be deregulated, and higher gas prices may soon be announced.

However, the celebration may be premature as it is not clear what exactly the Modi government will do on either front: whether it will stick to the UPA recommendation of doubling gas prices to $8.2 per mmBtu or offer another compromise, and whether it will deregulate diesel prices fully, currently limited to 50 paise per month, or offer another fudge where the government retains some degree of pricing control.

My guess is that the government will adopt a compromise between what is economically sensible and what is politically feasible on both gas prices and diesel.

There is, of course, some logic to not letting go of diesel pricing entirely. If prices are fully freed, politically it will remain a hot potato depending which way global prices move. As long as prices are stable, there will be no issue when small adjustments are made frequently. If prices fall, there will be high cheer as diesel prices will be cut. But if prices rise steeply, all hell will be break loose.

Diesel accounts for 44 percent of India’s petro-products consumption and has a weight of 4.67 percent in the wholesale prices index. Thus, high diesel demand has a huge impact on both the external deficit, the fiscal deficit (if subsidies are paid) and inflation.

Full decontrol, even while being the most sensible policy economically-speaking (it is certainly my preferred solution ), is viewed suspiciously by politicians because any sharp increase is politically sensitive. Not surprisingly, a Business Standard report two days ago (5 June) says that the petroleum ministry is unlikely to recommend full price decontrol even after subsidies fall to zero (currently, the diesel subsidy is Rs 2.80 per litre). The cabinet may accept the ministry’s version of partial decontrol where price increases will still need ministry approval.

It’s a bad idea. Giving politicians control over prices will ensure that this discretion will be used whenever the chips are down or before state assembly elections - and many of them are due anytime, starting with Delhi, Haryana, Maharashtra, Jharkhand, etc. It was this political hand on petroleum prices that ruined the fisc - with the UPA giving Rs 8,00,000 crore subsidies on petro-products over its 10-year tenure.

However, it is also not possible to completely rubbish the political concerns. After all, we live in a political economy, and what economists may propose may get you thrown out of political office.

Is there a second-best solution to the problem of diesel pricing - something that is economically sensible and still politically palatable?

I think there is. The real issue is not pricing freedom on the downward side, which all politicians will be happy to offer the oil companies, but freedom on the upside. This means the new policy needs to avoid sharp cuts on the downside, and build a surplus that can be used to smoothen prices if global oil boils over at some point.

Politicians don’t want prices rising too steeply. But this is exactly what could happen if the world economy recovers. Oil prices are currently ruling around $106 a barrel, where the diesel subsidy is Rs 2.80 a litre, but if these move up to $130-150, at the upper end diesel prices would have to be raised to Rs 90 a litre from the current Rs 65. This will be politically damaging for any government.

The best way (or rather the second-best way) forward would thus be to fix a floor on diesel prices after the subsidies are eliminated. If subsidies are zero once pump prices of diesel reach, say, Rs 68 a litre, the government should fix this as a floor, and not allow the oil companies to sell below this level. So, if global crude prices fall, oil companies would make bigger profits, and the surplus could be collected as a windfall gain in an oil price stabilisation account. This money can be used whenever oil prices zoom to temporarily subsidise consumers - thus allowing some protection on the upside.

The advantage of this option is that it gives oil companies pricing freedom on the upside if global prices rise too much. But it also allows them to moderate pump prices as long as there are surpluses in the oil price stabilisation account to subsidise them. And there would be no subsidy burden on the government itself. In the early 2000s, there was similar mechanism and it was called the oil pool account.

Of course, if prices rise well above the point where the oil price stabilisation account’s surpluses become zero, street prices would need to go up. There is no escaping that, and this is where UPA flunked the test. The NDA should learn from it and be prepared. In 2013-14, subsidies totalled nearly Rs 1,40,000 crore on the fuel front.

In a political economy, the second best option may work better than the best. NDA could opt for a floor on diesel prices and build a cushion of surpluses for the future by creating an oil price stabilisation account.

(Disclosure: Reliance Industries, which has an interest in gas prices, has made an open offer for the takeover of Network18, which owns Firstpost and Firstbiz, and several other digital, print and TV channels).