Pricing Mechanism in India

1. The government policy approach on pricing petroleum products since 1970s has moved between cost-based pricing and import parity pricing (IPP). But, since 2004, the government has been setting consumer prices of petrol, diesel, domestic LPG and PDS kerosene on ad hoc basis so as to ensure petroleum price stability in the country in the face of extreme volatility in international oil markets. Yet, each policy regime gave rise to serious imbalances and change was called for. In order to establish a viable and sustainable price system for the petroleum products, it is important to assess the earlier pricing systems and draw some lessons
3. In the past, the first major policy shift in pricing of petroleum products occurred in 1976, when the Government replaced IPP of the 1960s by cost-plus pricing. This came to be known as Administered Pricing Mechanism (APM), which was applied to the entire oil sector. The objective of the government was to shield the Indian economy from the high and volatile oil prices generated by the first Oil Shock in 1973-74. APM ran its course for three decades and was completely abandoned in April 2002. The major weakness of APM was that it did not induce competition in the marketplace, so it did not fulfill the consumer’s interest for better products and services. Nor did it enable domestic oil companies to generate adequate financial resources for project development and capacity addition in this crucial sector
4. The petroleum pricing reforms analysed above, except APM, did not have any mechanism to manage extreme volatility in oil prices. Even the effectiveness of APM as a self balancing mechanism was based on the premise that any increase in the costs of PSU oil companies on account of crude oil production, import, refining and marketing based on the predetermined formula should be fully reflected in the consumer prices
5. During April 2002 to January 2004 oil companies changed the domestic consumer prices of petrol and diesel and domestic LPG based on market factors. However, kerosene price was not changed. As oil prices started moving upward in 2004, the question of smoothing the volatility in international prices assumed importance
6. The period from 2004 to 2008 witnessed three distinct policy phases to address oil price volatility:

• First, the Government devised a price band mechanism in July 2004. The Government gave limited freedom to oil marketing companies to revise retail prices within a band of +/-10% of the mean of rolling average of last 12 months and last 3 months of international C&F prices. In case of international prices breaching this band, the matter would be taken up with Ministry of Finance for modulation in excise duty rates. The above price band was operated only once effective 1st August 2004 when prices of petrol and diesel were increased by Rs.1.10 per litre and Rs.1.42 per litre, respectively. However, as oil prices rose sharply and there was uncertainty in international oil markets, the price band mechanism was abandoned
• In October 2005, the Government constituted the Rangarajan Committee to examine the pricing and taxation of petroleum products with a view to stabilizing their prices and establishing transparent mechanism for autonomous adjustment of prices by the oil companies. The Committee recommended a formula of trade parity pricing (TPP) for petrol and diesel at refinery level as well as at retail level. The formula was a weighted average of import parity and export parity prices, in which the percentage share of import/export of these products provided the weights. The Committee suggested that these TPP prices should serve as indicative ceilings within which the marketing companies would have flexibility to fix the actual retail prices of petrol and diesel. As regards subsidies, the Committee recommended elimination of subsidy on LPG and its restriction of kerosene subsidy to BPL families. (c) The Government implemented switching over to TPP and rationalised taxes on crude oil, petrol and diesel, but could not implement rationalization of subsidies and other changes recommended by the Committee. Even TPP was confined to the refinery level and the retail prices of petrol, diesel, domestic LPG and PDS Kerosene fixed by the Government remained below their TPP levels.