A Mess Called Fertiliser Pricing
Next year, the era of price controls for fertilisers will celebrate its hoary half century. In 1957, when commands and controls began to be imprinted in the DNA of India’s economy and bureaucracy, the Government of India implemented the Fertiliser Control Order to fix the farm-gate price for urea. Realisations were fixed for individual manufacturers based on their costs, and a fertiliser pool was created to subsidise the losses of less efficient manufacturers with extra profits of others. This system operated without any central government subsidy until the early 1970s.
However, matters went for a toss when the oil price shock of 1973 significantly increased the domestic cost of producing urea. Thus, in 1977, a formal cost-plus subsidy regime came into play with the Retention Pricing Scheme (RPS). With the costs of all Indian urea manufacturers being above the desired farm-gate price, the government compensated extra costs to each individual producer. The idea was to provide urea to farmers at affordable rates and also ensure adequate returns to the manufacturers. To be fair to the system, the regime of RPS significantly increased domestic urea producing capacities, and helped grow agriculture to a level where India was no longer dependent on import of food-grains.
Unfortunately, all cost-plus schemes carry a fatal flaw: they create absolutely no incentive to increase efficiency. Recognising this twenty-six years later, the government chose to replace the unit-level RPS with a New Pricing Scheme (NPS) in April 2003. Under the NPS, the domestic urea industry was classified into six groups based on vintage and the feed-stock and, instead of individual retention prices, manufacturers were reimbursed on the basis of group norms. The NPS was to be implemented in three stages: the first from April 1, 2003 to March 31, 2004; the second from April 1, 2004 to March 31, 2006; and the third thereafter.
While the NPS is slightly better than the RPS — being priced according to broad groups and not individual firms introduced a notion of intra-group efficiency — it has been mired in the problems inherent with subsidies. For one, the NPS, like its RPS predecessor, has increasingly created a very messy system of micro-management, where the bureaucracy gets involved in the minutiae of pricing — something that began in the late 1950s and, if anything, has increased over the years. For another, by artificially keeping farm-gate prices low, the system encouraged overuse of urea as well as ground water. Indeed, the systematic leaching of soil in the Punjab, Haryana and western UP has much to do with excessive use of urea. No less significantly, as gas, naphtha and energy prices began to climb, so too did the subsidy bill.
In 2004-05, the revised budget estimate of urea subsidy to domestic manufacturers was Rs.10,143 crore. That translated to almost 22 per cent of the central government’s total subsidy bill, and accounted for over 3 per cent of the centre’s total tax and non-tax kitty. Given the way gas, naphtha and furnace oil prices have been soaring in recent times, and the UPA government’s political inability to raise farm-gate prices of urea, the amount of subsidy is bound to increase in 2006-07.
At the time of introducing the NPS, the government had clearly stated that “there shall neither be any reimbursement of investments made by a unit for improvement in operations, nor any mopping of gains of the units as a result of operational efficiency”. If this were indeed true, it would have been a step in the right direction, for it would have induced the financially stronger units to invest in enhancing productivity. Unfortunately, that is not the case. A fiscally strapped central government wants to do whatever it can to cap, if not reduce, this subsidy. Therefore, a government working group under Y.K. Alagh has submitted a draft report which is music for North Block’s ears. While not compensating producers for productivity raising investments, the group has suggested a new pricing formulae from April 2006 to mop up all interim efficiency gains of manufacturers. How so?
In essence, for the post-March 2006 phase of the NPS, the Alagh working group has suggested updating all cost components to 31 March 2006. In other words, if fertiliser plants within any of the six broad groups improved efficiencies in the interim and, thus, reduced unit manufacturing costs, these benefits will no longer accrue to them. Moreover, several other cost elements are not being taken into account, such as the rise in the cost of bagging, state- and local-level cesses and levies, and the Gas Authority of India’s high transport cost of feedstock. Thus, the government seeks not only to mop up all interim efficiency gains, but also disallow legitimate cost increases.
A little reflection suggests that in an environment of high and rapidly rising naphtha, natural gas and furnace oil prices, it is extremely difficult, if not impossible, to simultaneously cap subsidies and urea prices, and yet give adequate returns to even the more efficient firms in the industry. It is yet another bureaucratic command-and-controls example of trying to achieve multiple objectives with limited instruments.
Few will dispute that a perennially deficit central government needs to control the quantum of fertiliser subsidies. If that’s the objective, then the solution is to cap the total amount of subsidies, and then figure out a simple method of distributing it among the urea plants. Given huge variations in costs between plants using gas, naphtha and mixed feedstock, the per metric ton subsidy in the interim can differ between the three broad groups, with a clear signal that prompts plants to progressively move towards cheaper gas. However, that has to be simultaneously accompanied by price decontrol of urea. In this scheme, therefore, the government caps the total subsidy, but unfreezes urea prices.
The polar opposite is to cap the farm-gate urea prices, but accept the possibility of a rise in the overall subsidy bill.
My own preference is for the former: cap subsidies and free urea prices. There are four reasons why I believe this is better. First, it is a fact that most of the Indian urea industry is globally competitive in terms of conversion costs. In such an environment, mopping up all efficiency gains and disallowing valid costs only to cap subsidies penalises competitiveness and creates a damper on further investments. Second, and this is a corollary to the first, any subsidy-cum-price control regime that fails to give adequate return on capital employed carries the risk of future closure of units and downsizing of industry. Given that imported urea costs around Rs.11,000 per metric ton while the domestic output of gas-based plants cost less than Rs.8,000, it is clearly in nobody’s interest to substitute domestically produced urea by its imported counterpart. Third, I am not at all sure that sensibly capping subsidies while freeing urea prices will automatically lead to a huge rise in farm-gate fertiliser prices. Competitive pressures exerted by the cheaper and more efficient gas-based manufacturers, coupled with their desire to increase market shares, ought to keep a lid on prices. And fourth, this will be a significant move towards not only capping subsidies but also for decontrolling urea prices — a move that will eventually ensure more sensible use of urea according to realistic factor costs.
In first year economics, we were taught a few simple truths: such as, in a supply curve, you could either fix prices or quantities, but not both. For five decades, Indian babu economics has stoutly attempted to do just the opposite: simultaneously fix prices and quantities. Urea pricing is one such example — an attempt to cap subsidies, control prices and still ensure adequate domestic output.
The result has been predictable: incessant bureaucratic tinkering at all levels in an attempt to micro-fix something that is conceptually wrong to begin with. It has given the babus huge powers with a notion that they know economics. In 2006, forty-nine years after fertiliser price controls came into being, shouldn’t we start thinking differently? Or will this continue to be the last holy non-economic cow?
This article is jointly written with Vishal More of CERG Advisory
Published: Business World, January 2006