CHAPTER X. attempt has been made to understand the different objectives of oil pricing policy and

Transcription

1 CHAPTER X OBJECTIVES OF OK PRICING POLICY Continuing the study of theoretical concepts, in the present chapter an attempt has been made to understand the different objectives of oil pricing policy and to see whether the current pricing policies meet these objectives adequately. Like in the case of any other commodity of mass consumption distributed through Government channels, the price of oil products should meet the following criteria: a. Economic efficiency; b. Financial viability; c. Social equity. While in a free-market economy, prices of commodities would act as an allocative mechanism by providing appropriate signals to the consumers and producers, in a developing economy, they are also determined by the goals of socio~conomic development and even political expediency. According to Geeta Gauri, the usual objectives of public enterprises' pricing in India are: (a) as far as possible, the prices should cover at least the minimum costs of production and distribution;

2 (c) (d) prices may earn some revenue for the Government; prices are varied in an attempt to maximise consumer satisfaction; prices are used as an anti-poverty measure to rectify malaises arising out of skewed income distribution; and (e) prices are manipulated to provide the structure for economic growth, both at micro and macro level." The first two objectives fulfil the economic efficiency and the financial viability criteria. The third objective can maximize consumer welfare without sacrificing efficiency and viability and is thus Pareto efficient. The last two objectives represent the criterion of social equity. Often there is a trade off between these objectives. For example, in the case of LPG, economic efficiency may demand charging of high rates to small customers while social equity criterion may be achieved by charging subsidized rates. Report of the Talukdar Committee suggested that the basic objective of energy pricing could be to ensure that prices: (i) generate sufficient surpluses to facilitate the financing of investments in the energy sector; (ii) induce economies in the use of energy in all sectors: and (iii) encourage the desired forms of inter-fuel substitution. The report pointed out that the pricing policies in India did not subsewe the first two objectives while the third objective was being met only partially. * Ibid., p.4

3 158 According to the Committee, the first priority must be to raise energy prices so that they at least reflect long term marginal costs and allow for a reasonable return. While for the petroleum industry as a whole, unlike coal and electricity industries, this criterion may be satisfied, there are obvious distortions in the case of individual products. The price paid by the consumer for each product should lie somewhere between the producer's price and the shadow price. Efficiencv Objective Efficiency can have different meanings to different people. The economists view efficiency in terms of allocating scarce resources in such a way that we get maximum output at the least cost. That is, the prices to users should reflect the long-term, marginal social opportunity costs of the resource. At the macro level the pricing should satisfy the conditions for paretian efficiency. From the accountants' point of view, efficiency will be achieved if the pricing ensures a minimum financial rate of retilm to the investor and generates adequate financial ~urplus.'~ Maximization of general welfare is always the prime objective of any public enterprise pricing policy. Welfare can be defined as the excess of social benefit over social costs. It is widely held that welfare maximization occurs when price is set equal to the long run marginal cost (LRMC). There is also the opposite view that

4 159 short-term marginal cost should be preferred. The advocates of the latter view argue that LRMC ignores recurring capital expenditures. The LRMC rule is based on the assumption that once sacrifices necessary to create a durable asset have been made, no further opportunity costs are incurred later on. But this assumption holds good only in a perfectly competitive market economy. In the oil sector, dominated by public enterprises, the economy is far from perfectly competitive. Changes in capital cost due to technology factors can also defeat the application of LRMC pricing principle. In such circumstances, pricing at LRMC could lead to losses. To circumvent some of these problems, public enterprises have relied on average cost pricing (ACP).= The procedure involved in Average Cost Pricing is to work out the accountant's cost for the average firm and to add to this a fair rate of return, commonly referred to as cost-plus or mark-up. Under conditions of constant technology and constant costs with full capacity utilisation, ACP tends to equal LRMC pricing. However, in real world, technology keeps changing over time and there are external economies and diseconomies which affect factor prices. Moreover, ACP does not distinguish between efficient and inefficient firms. LRMC pricing is certainly superior to ACP, but in an economy dominated by public sector, ACP using an adequate margin of profit is easler to calculate and should suffice.

5 According to Gunter Schramm ", the considerations involved in LRMC calculations of energy resources are the following: Marginal costs establish forward looking prices. Such prices reflect the real value of all additional resources that must be utilized in order to make another unit of energy available. These marginal costs include costs of investments that are needed to supply the additional units of energy. If prices are below this level, there will be a net economic loss in the long term because the energy use will be hgher than it would be otherwise and is justified on the basis of real resource costs. The second important principle is that energy prices should reflect the value of the energy resources consumed in their next best alternative use. In the case of easily transportable petroleum products, the next best alternative use isusually given by the export price (f.0.b) or import price (c.i.f)of the product, adjusted for any quantity or quality differential and additional transportation costs. Third, energy prices should reflect all external costs (or benefits, if any). For example, external benefits from use of kerosene or LPG may reduce the overcutting of timber resources for fuel and thereby reduce erosion, recurrent flooding, or reservoir siltation. External costs include pollution costs, costs of vehicular congestion. time lost by passengers and drivers, etc. Fourth, prices of exhaustible, domestic energy resources such as crude oil and natural gas should reflect their foregone current or potential future net value. $7 Gunrer Schramm, "Operationalizing Efficiency (:riteria in Energy Pricing Policy", in Siddayao (Ed.), Op.cir., pp

6 161 Gunter Schramm" describes five types of opportunity costs that determine the economic value of depletable resources. The first consists of the LRMCs of supply; the second represents the foregone future net value of the resource once it is depleted and must be replaced by alternative resources; the third is determined by the net value of the resource in alternative resources (as indicated by its f.0.b. export price, net of production and delivery costs, and depletion allowance); the fourth represents the net value of the resource as a current substitute of other energy resources, net of all differences in delivery and usage costs between alternative fuels; the fifth is determined by the net value of the resource in uses that would not occur if alternative, higher-cost energy or feedstock materials had to be utilized (e.g. fertilizer production or LNG exports whose viability depends on prices below those of alternative fuels. 'The first two of these opportunity costs - the LRM supply and the user costs - are additive and represent the basic economic costs of the resource. If lower prices were to be charged, net losses to the economy would be incurred. The other set of opportunity costs must be higher than the sum of the former in order to produce economic net benefits. They also determine the economic ceiling prices that could or should be charged to users. While in many cases higher prices could be charged if the sale or importation of substitutes at lower prices is prevented, this would be economically be inefficient, even though the users' willingness to pay might be high enough to sustain such price levels. In developing countries like India, where a large segment of society lives below the poverty line, subsidized prices of energy become a socio-political necessity. Sometimes, such subsides also lead to external economies. Thus, cheap kerosene is

7 162 considered effective in reducing excessive fuel wood use and in preventing deforestation and erosion. The example of subsidizing kerosene demonstrates that equity objective is seldom achieved in real life. The actual average price paid by the consumer for kerosene is usually higher than the price fixed by the Government on account of high distribution margins, ignorance of the consumers, mode of purchase and use, and shortages. The consumers are forced to meet at least part of their kerosene demand from the black market because of reduced availability caused by its use in adulteration of diesel and petrol. Table 10.1 and Figure 10.1 show how the consumption of kerosene increased when there was an increase in the price of diesel relative to kerosene, indicating the use of kerosene in adulterating diesel. When in pursuance of the recommendations of the Fuel Policy Committee, 1974, the prices of kerosene and diesel were made almost equal, there was a sudden fall in demand for kerosene. The demand picked up only after 1980 when diesel prices were raised, keeping kerosene prices virtually stagnant.

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9 Table Price Differential of HSD and SK Average Retail Price Consumption Year in Delhi RslLitre in mmt SK HSD Difference of SK - -- Source: Compiled from Indian Petroleum and Natural Gas Statistics, various issues (Latest ).

10 Financial Vibiitv Considerations 165 Prices of petroleum products are fixed in such a way that the producers, refiners and the marketing companies earn a minimum assured margin of profit. The Government's general revenue goals are also to be achieved. Financial viability of the enterprises is important for ensuring their efficient functioning, which in turn will ensure unintempted availability of the products. Non-observance of this criterion will lead to unreliable supplies, as demonstrated by the State Electricity Boards. The financial viability criterion has been met adequately as can be seen if a comparative study of the economics of the public sector enterprises (PSEs) in India is done. While majority of the PSEs have been incurring losses, those in the oil sector have done remarkably well and even generated surpluses. Table 10.2 bears testimony to this. Of the 239 PSEs, only 139 were making profits. All the 14 oil companies were among these 139, accounting for as much as 37.6per cent of the net PSE profits. While the economically efficient prices are fixed taking into account the future costs, satisfaction of financial viability criterion would depend on historical costs as well as future investments. It is usually possible to devise a tariff structure that would satisfy efficiency criterion, with the average tariff meeting the financial requirements.

11 Table 10.2 Sectoral Composition of Net Profits of PSEs Sector Number Percentage of net profits Steel 4 Minerals 9 Coal & Lignite 5 Power 3 Petroleum 14 Chemicals & Pharmaceuticals 10 Services 28 Others 57 Grand Total 130 Note : The remaining 109 PSEs were loss-making. Among them there was no oil company. Source : The Economic Times, 9 February 1997.