Fuelling Inefficiency

The present fuel policy in Nepal is wrong on both efficiency and equity grounds.

Recently, a drama which has been enacted many times in the past few decades repeated itself in Nepal. In the act, the government increases fuel prices, students and political parties’ sister organisations protest, the prime minister meets them and the prices are rolled back. However, by continuing with this tradition, both the government and the protestors have imposed numerous costs on the country, including the continuous drainage of public resources into the bankrupt Nepal Oil Corporation (NOC).The government’s decision to hike prices is yet another testimony to its rent-seeking behaviour that chooses to hit not where the problem is but where the politically weak and vulnerable are. The protestors are also wrong in imposing the status quo, which is extremely detrimental to the economy.

No oil corporation

The NOC is a state-owned enterprise (SOE), an entity created by the government to import fuels on its behalf, and a monopolist — only it can import fuels. The economic rationale for having a trading monopolist would be if, as a single buyer, it were able to negotiate a better price with its seller. But the fuel price is fixed by producer cartels, with little room for buyers. Furthermore, as the NOC has only one potential supplier and refiner — the Indian Oil Corporation — its bargaining power is further weakened.

By harbouring an inept monopolist, the government has imposed huge costs on society. Last year, the NOC suffered a loss of Rs 9.53 billion. This year, it is expected to incur a loss of Rs 21 billion which amounts to about Rs 4,000 per household (there are 5.42 million households in Nepal, according to the 2011 census). The NOC is a chronic loss maker. It has suffered a loss throughout the last decade, barring one year. This is not all. The NOC has a loan worth Rs 41.2 billion, of which Rs 7.1 billion is delinquent. Still the government writes-off its accumulated loss by using tax revenue.

Aggravating the already distorted market, the government raised the prices of items that are not subsidised and kept the price of items that are heavily subsidised untouched. The price of petrol was initially raised by 7.7 percent to Rs 140 per litre, of kerosene and diesel by 8.8 percent to Rs 109 per litre and of aviation fuel (domestic and international) by about 4 percent. The price of the sixth item, liquefied petroleum gas (LPG), remains sacrosanct at Rs 2,334 per cylinder.

Even before the price hike, there was no subsidy for the four products — kerosene, petrol, and both types of aviation fuel. Only diesel and LPG were subsidised. Based on the NOC’s website, on average, the NOC’s selling price for the four unsubsidised items was 9 percent higher than its landed price — Raxual price, plus government tax and the NOC’s cost on administration, transport, insurance, technical loss and dealers’ commission — indicating profit. With increased prices, the selling price will be 17 percent higher than the landed price. For diesel, before its price was subsidised by 9 percent and after the price hike, it will only be subsidised by 4 percent. For LPG, the selling price is lower than its landed price by 37 percent, with no change in the 37 percent subsidy it receives.

Subsidy for the rich

The annual profit was expected to rise after the price hike to Rs 7.6 billion from Rs 4.3 billion from the unsubsidised four items. As for the subsidised diesel and LPG, the annual loss was expected to fall from Rs 25 billion (Rs 16 billion for LPG and Rs 9 billion for diesel) to Rs 20 billion (Rs 16 billion for LPG and Rs 4 billion for diesel).

So a significant portion of the loss is caused by subsidies in two items that contribute more than three-quarters of the NOC’s revenue — diesel (54 percent) and LPG (22 percent) — with a small revenue share from kerosene (1 percent), aviation fuel (6 percent) and petrol (16 percent). The saga of price hike and protests, thus, is about protecting the perks and privileges of those who are benefiting from the use of diesel and LPG, items whose consumption rises with income.

Who are the people benefiting from the Rs 16 billion (more than 62 percent of the NOC’s total) subsidy to LPG? It is mainly higher income urban dwellers, big businesses and international hotels. According to the 2011 population census, only 21 percent of total households reported to using LPG for cooking, others used either wood or cow dung. Thus, the LPG subsidy is confined to only one in five households. And half of the LPG-using households are in the three districts of the Capital, which is also where the political party members and their cadres reside. Compare this with the fact that if kerosene — an item used by poor and people in the remote areas of Nepal — is distributed free of cost, it would cost only Rs 3 billion (less than one-fifths of the LPG subsidy) and far more households would benefit.

At an average annual use of eight cylinders per household at Rs 865, the total subsidy to households alone amounts to Rs 8 billion. The remaining Rs 8 billion subsidy goes to hotels and big businesses. Poor Nepalis, who cannot afford kerosene to light lamps, are subsidising international hotel owners and foreigners. This needs to stop. But the tragedy is that the recent government move only strengthens this perverse policy.

Dismantle NOC

There are several problems with the way the NOC is established, operated and ‘rescued’. Besides burdening the public, it has created distortions in many sectors which demand urgent actions.

First, there is no economic rationale for having an SOE in trading. Nepalis are paying a higher price (let’s not be fooled, subsidy is paid by nobody else but Nepalis) because of the NOC’s inefficiency. The decorated monopolist has done enormous damage. Dismantle it and let the market compete.

Second, fuel subsidies have suppressed incentives for harnessing other energy sources — hydro and solar — in which Nepal could have a competitive edge. Subsidising import of products that can be substituted by potential domestic products is like shooting one’s own foot. The subsidy — which favours importing transport vehicles over producing alternative energy — has distorted investment and must be scrapped.

Third, subsidising diesel on the rationale that it would lower the price of food items by lowering the transport cost — as is heard in the Nepali media — is both illusive and wrong. The subsidy is most likely absorbed by transport cartels. Irrespective, if the objective is to cheapen food, the right policy would be to provide direct subsidies to farmers for food production.

Fourth, even if a subsidy is chosen as a policy goal, it must be income-based not consumption-based. Provide a lump sum subsidy and let the households decide its use. This way, it will not distort the consumption patterns by raising the demand for fuels — causing immense environmental cost — as is the case now.

Fifth, fuel subsidy is like rubbing salt on one’s wounds for Nepal, whose total export value is only 80 percent of fuel imports. Moreover, the increased import of motor vehicles and their parts caused by the suppressed price of diesel has further deteriorated the trade balance. If anything, the optimal policy is fuel import tax, not import subsidy.

To sum up, the present fuel policy is wrong on both efficiency and equity grounds. The time has come to address the root of the problem and dissolve the NOC, which shapes such a policy. Doing so would not only help create an efficient energy market but would also reduce the rents that politicians and their cozy bureaucrats acquire — a necessary condition for Nepal’s economic development.

This article was originally published in The Kathmandu Post on Tuesday, 25 March 2014 and can be accessed at
http://www.ekantipur.com/2014/03/25/opinion/fuelling-inefficiency/387227.html
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