AN ECONOMIC ANALYSIS OF

DIESEL SUBSIDIES IN INDIA

Submitted To:
Chandrima Sikdar Mam
Submitted By:
Ashwin Kumar-G042
Arpita Mathur-G042
Himank Rathour-G047
Akshaya S-G048
Maulik Shah-G053
Karan Thakker-G061
Manoj Vandrangi-G063

INDEX
1. Introduction
2. Subsidy in the Diesel Industry
3. Share of Government Subsidy in Petroleum Industry
4. Effect of Pricing and Subsidy
5. Changing Trends in Diesel Subsidy in India
6. Demand Along the Years
7. Price Elasticity of Demand of Diesel
8. Factors affecting supply of diesel
9. Supply through the years
10. Price Elasticity of supply of diesel
11. Conclusion
References

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An Economic Analysis of Diesel Subsidies in India

1. Introduction
Fossil Fuel is one of the most consumed sources of energy. However it is one of the depleting
resources and despite of advancements in technology the rate of depletion of the resources is
growing. Diesel, a fossil fuel is consumed for a variety of activities in the country is produced
from crude oil. India heavily relies on import of crude oil for the production of diesel.
Companies that produce diesel fall under two categories:
1. Upstream: They are primarily involved in the exploration and extraction of crude oil
2. Downstream: They are involved in the manufacturing of petroleum products from
crude oil.
The subsidy for diesel is given as under recovery which is calculated as the difference
between cost price and depot price. Currently, the burden of diesel recoveries is shared by the
upstream national oil companies and the Government. However there is no defined system
for the sharing of burden.

2. Subsidy in the Diesel Industry

Need for subsidy
As per a study conducted by Nielsen for the Indian oil ministrys Petroleum and Planning and
Analysis Cell (PPAC), total diesel consumption can be categorized into the following sectors:
Transport (70%), Agriculture (13%) and Others (17%). Thus, the demand for diesel is a
derived demand. The consumer has little or no power to respond to price changes in diesel in
the short run. In this case, the regulator needs to protect the interest of the consumer by not
allowing the price to rise to a level which the regulator feels is too high for the consumer.
When the government (regulator) feels that the equilibrium price (P*) is too high, it sets a
price ceiling (P1) below the price at market equilibrium. Price ceiling is a price control
mechanism which safeguards the interest of the consumers. But in such a case, the supplier
would not be willing to supply the quantity demanded Qd at price P1. This will create an
excess demand for diesel.

In an unregulated environment, the excess demand pressure would lead to an increase in the
price so as to reach the equilibrium price (P*).But in a regulated environment, the
government (regulator) addresses this situation by either increasing the supply or decreasing
the demand. As the demand for diesel cannot be altered much in the short run, the supply
needs to be increased. For the supply to increase up to Q*, the government bears a part of the
cost of production (COP) of diesel supplying companies by providing subsidies to them.

3. Share of Government Subsidy in Petroleum Industry

Continuous increase in Crude Oil prices in the global market has impacted the prices of
Diesel in India. Also various taxes levied on the imports add to the price increment. However,
to protect the interests of Indian consumers, the Government of India has implemented a
certain price ceiling on Diesel prices so as to prevent the prices from exceeding the
acceptable limits. However in such a case there is a high risk of Diesel companies undergoing
under-recovery in terms of revenue which might eventually culminate to losses for the
suppliers. Hence the government provides subsidies to the companies thereby reducing their
cost of production and bearing a part of the under-recovery. An explicit subsidy on Diesel has
not been defined but the prices have been kept in check by properly addressing to the
grievances of the OMCs(Oil Manufacturing Companies).

Petroleum Subsidy in India

110000

40

37.6

100000

35

31.42
96880

90000

28.13

68484

In Rs. Crores

70000

22.13

65000

25

60000
20
50000
38371

40000

10.58

30000
20000

15

in Percentage

30

80000

10
5.65

4.77

14951

3.98
2.2

10000
2683

2724

2820

2852

0
2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14
Period

Multiple factors have contributed directly or indirectly to the increased share of subsidy by
the Indian Government. These may include:

Increase in Crude Oil prices

Increased Import Duty
Downfall of Indian Rupee in Forex market (INR)
Increased demand due to urbanisation and industrialization

As seen in the graph above there has been a continuous increase in the share of fiscal subsidy.
The subsidies can be divided as:
1.
2.
3.
4.

Direct transfer of funds (grants, equity fusions, loan guarantees etc)

Government revenue which is due is not collected (fiscal incentives like tax credits)
Provision of goods and services other than infrastructure
Income or price support

Of these, the government of India issued Oil Bonds till the year 2008-2009 which has a
maturity period of 20 years and interest rates ranging in 6-9%. This was replaced by cash
assistance in the year 2010.
However this fiscal subsidy covers only a part of the difference between cost price and
selling price thereby resulting in under-recoveries. Under-recoveries are difference between
cost price and regulated selling price of OMCs to retailers after accounting for subsidy. The
table below shows the under recovery by the OMCs.

Under-Recoveries by OMCs (in Rs. Crores)

Product
Diesel

2005-06 2006-07 2007-08 2008-09 200910

12,647
18,776
35,166
52,286
9,279

2010-11 2011-12 2012-13

34,706

81,192

92,061

4. Effect of Pricing and Subsidy

Diesel accounts to nearly 44 percent of the basket of petroleum products in our country. Of
that amount 65 percent is used in transportation activities.
Diesel is largely consumed as an intermediate product and thus any price hike in diesel has a
cascading/domino effect on the prices of other products and services. Now to protect the
common-man from the impact of high oil prices in international markets and to buffer the
inflationary trends, the hike in domestic selling prices of diesel has been passed on only
partially to the consumers since 2004. Resulting in subsidy provided to consumers on diesel
to increase from Rs 2,154 crore in 2004-05 to Rs. 92,061 crore in 2012-13, i.e., 57 percent of
the under-recovery for the year.
Oils prices have a direct influence on gasoline and diesel prices. With the increase in the cost
of oil the cost of refining the oil into usable products that can fuel the cars also increases.

Whenever the diesel prices rose in a short period of time people owning diesel engines were
the most affected. These constituted mostly the people in the transportation industry. Smaller
sedan, SUVs and pick-up truck drivers did notice the hike in price but the impact was not that
significant.

Transportation cost directly affects the supply-chain cost associated with any goods. Thus the
commodity even if it is being produced (at price X) at the same original price (which would
be difficult with increase in diesel price), on being transported from the site of production to
the consumer via various channels fuelled by diesel vehicles (Cost Y) leads to an increased
price burden on the consumer (Z+Y, where Z=profit +X).
The above example excludes the increased cost A which arises due to increase in cost of fuel
consumption of the factory (which is fuelled by diesel again). Thus the effective price a
consumer would have to pay would be A+Z+Y instead of Z.
Now with subsidies kicking in the above extra burden of A+Y is minimised to a small extent.
The subsidies provided on diesel act like a buffer and take up most of the impact of A+Y.
Thus the effective price a consumer would have to pay for the above item would come down
to A+Z+Y-B (where B is the aggregate of price decrease caused by diesel subsides)

5. Changing Trends in Diesel Subsidy in India

There has been a continuous increase in the demand of Diesel owing to the difference in its
price with petrol. This has resulted in diesel being used extensively in the transportation
sector. Hence it is necessary to curb the price of diesel to a value which is feasible for
consumers. Diesel prices when curbed through subsidies has a significant impact on the fiscal
deficit of the country as these subsidies have had an increased proportion Year on Year as
seen in the above graph. However this has a flipside; a major portion of the government
income comes from duties and taxes levied on petroleum products. Hence promotion of such
products also supports the government treasury. Prices of diesel are controlled primarily to
keep a check on cascading inflationary impact of high freight charges and transportation costs
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on the prices of essential commodities. There have been talks on the de-regulation of the
prices of diesel but doing this would result in increase in freight charges implemented by the
transport companies. This would further feed into the higher prices of essential commodities
e.g food products.
There has been a visible trend to de-regulate the prices to benefit the larger portion of the
society which depends on the necessary goods whose prices are indirectly impacted by the
diesel prices. With the proposal of implementation of Goods and Services Tax(GST), the
simplification of tax structures can be expected which will eventually lead to a relaxation in
prices of diesel. However given the ever increasing demand for diesel the extent to which this
will impact the prices is still not quantifiable.

6. Demand Along the Years

The following figure shows the diesel consumption over a period of 30 years

Figure shows that consumption gradually rose from 3 million tonnes to 70 million tonnes
between 1970-1 and 2012-13. During that period the share of diesel in total consumption of
petroleum products has varied from a low 27.5% in 1974-5 to a high 43% in 1995-6.
Diesel is mainly used in transport, agriculture, industry and power generation sectors.
Transport Sector
Despite the petrol variants being priced less, the demand for diesel models in most of the
passenger vehicle segments surged due to the widening price gap with petrol and lower price
of diesel. Diesel models have relatively high fuel efficiency; these two factors were the prime
reasons for the increasing consumption of diesel in transport sector.

Non Transport Sector

As Indian farmers learnt that mechanisation is important as it can help them in raising their
farm income by increasing productivity and limiting post harvesting losses, there was a rise
in use of farm tools that run on diesel. With convenient finance options it has become easier
to buy tractors. India is the third largest tractor market in the world.
Power shortage in India is of the order of about 9%, at peak periods it goes up to 18%. This
deficit is being met through power produced by diesel generators. Due to the shortage of
power, number of farmers use diesel powered pumps. Mechanisation and power shortage lead
to the increase in the consumption of diesel in non-transport sector.

7. Price Elasticity of Demand of Diesel

Year

Consumption (in
Million Tonnes)

1990-91
1995-96
2000-01
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
2013-14

21.14
32.26
37.96
41.07
43.62
48.34
52.26
56.78
60.53
64.75
69.57
68.4

Price (in INR)

Delhi)
5.05
9.04
17.06
30.45
30.25
31.76
30.86
38.1
37.75
40.91
48.63
55.48

(For

Price Elasticity

0.665760902
0.199161118
0.104383688
-9.453067933
2.167727909
-2.861655864
0.368660311
-7.189402707
0.832859321
0.394474963
-0.11939264

80
70
60
50
40

Conumption

30
20

Price

10
0

Demand Curve
60

Price

50
40
30
20
10
0
0

10

20

30

40

50

60

70

80

Consumption

As we can see from the graphs above, the demand for diesel does not get affected by its price.
Although there has been a steady increase in the price over the last 14 years, the consumption
of diesel has also increased a great deal. Thus the demand graph is rising upwards instead of
the usual sloping downwards.
There are several other factors affecting the demand of diesel like disposable income, price of
complements, price of supplements and price of substitutes. The income elasticity for diesel
demand is generally low. Supplementary goods for diesel may constitute of specialised
equipment that capture desirable / undesirable by-products from diesel exhaust. The
complementary goods for diesel are motor vehicles, railway engines, motorised vessels, pumpsets, generator-sets etc., i.e., those that use it as for fuel. Substitutes for diesel constitute of other
fuels like kerosene, motor spirit / gasoline / petrol, LPG, natural gas, coal, electricity, etc.

8. Factors affecting supply of diesel

The current state of affairs in the major oil producing countries like Iraq,Arab nations.
The prodution policies set by the OPEC nations has affected the import of crude oil.
This in turn has affected the supply of diesel.
Stocking of the inventories by big countries like the United States.
Severe weather conditions may impediment the import of crude oil which affects the
supply.
The problems that arise at the refineries or inadequate imports lead to irregular supply
of diesel.

9. Supply through the years

The following table shows the available supplies of diesel through the years
2005-06

2006-07

2008-09

2009-10

2010-11

2011-12

2012-13

2013-14

42.29

43.29

44.29

45.29

46.29

47.29

63.95

69.67

Diesel Availability In Original Units (Million tonnes)

10. Price Elasticity of supply of diesel

Year
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13

Prices (in US $/bbl

& LPG US$/MT)
64.7
74.12
91.91
101.75
74.67
95.66
125.38
121.98

Production (in
Million Tonnes)
42.29
43.29
44.29
45.29
46.29
47.29
63.95
69.97

Price Elasticity of
Supply
0.162411094
0.096243604
0.210892914
0.082962807
0.076850471
1.133932635
-3.47140505

11. Conclusion
Diesel is used for various activities that constitute about 40% of the countrys GDP. More
than two-fifth is used in the transportation sector. Therefore any change in the price of diesel
has an immediate impact on macro economy. Diesel subsidies have led to several distortions.
For instance, incentives given for tapping alternative energy resources were used as subsidies.
The pricing policy for petroleum products has led to a huge deficit. Many developed
economies have a special excises like the green tax for petroleum products. There has also
been a constant an effort taken by these countries. The government should prevent the
misallocation of the resources that have a counter-productive effect on the economy.

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References
1. http://www.iisd.org/gsi/sites/default/files/ffs_india_czguide.pdf
2. http://petroleum.nic.in/pngstat.pdf
3. http://www.oxfordenergy.org/wpcms/wp-content/uploads/2013/08/Diesel-PricingReforms-in-India.pdf
4. http://timesofindia.indiatimes.com/business/india-business/Over-13-diesel-consumedby-high-end-cars-SUVs-in-India-study-says/articleshow/29510365.cms
5. http://www.indiainfoline.com/article/news/70-percent-of-diesel-99.6-percent-ofpetrol-consumed-by-transport-sector-5857084233_1.html
6. Fuel prices in India's capital since 1989, Reuters.com
7. Diesel Pricing in India: Entangled in Policy Maze, by Mukesh Anand, National Institute
of Public Finance and Policy 2012
8. Indian Petroleum and Natural Gas Statistics, by Government of India Ministry of
Petroleum and Natural Gas, 2012-13

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