Subsidies have bred inefficiency in the indigenous fertiliser industry over two decades, a trend that is only now being corrected, writes Swati Lodh Kundu.

India's fertiliser subsidy bill has escalated from Rs5 billion in 1980-81 to more than Rs60 billion by the mid-'90s, and further to Rs162.50 billion as per the budget estimate for 2005-06.

The Retention Price Scheme (RPS), the root of this subsidy, has become the backbone of the fertiliser industry. It was introduced in November 1977 by the Marathe Committee in the wake of the increase in crude oil prices in the early '70s, when the prices of both imported fertilisers as well as fertiliser feedstock (naphtha) increased substantially.

This was done to control the fluctuations in fertiliser prices, help build indigenous fertiliser capacity and boost fertiliser consumption. The scheme intended to provide fertilisers at a cheaper rate to the farmers and provide a 'reasonable' return on investment for fertiliser producers, which would boost investment in the industry. The RPS is essentially a cost-plus approach, with some norms for capacity utilisation and conversion coefficients. The RPS guarantees urea producers an assured post-tax return of 12 per cent on net worth.

But while the Marathe committee recommended industry-wide norms, the government adopted a plant-by-plant norm. The plant-specific RPS is revised on a quarterly basis to take care of the price increases in plant inputs. The retail price of fertilisers is fixed and is uniform throughout the country. The difference between the retention price and the price at which the farmers purchase fertilisers is paid back to the manufacturer as subsidy.

As a result, the retention price paid varied between plant to plant depending on the feedstock used (naphtha, fuel oil, gas or coal) and took into account the conversion costs, selling costs, interest on debt, depreciation and capacity utilisation of the plant itself. For instance, the capacity utilisation norm for a gas-based plant has been fixed at 90 per cent. So if a plant were to operate at 110 per cent, the effective post-tax return would work out to 14.67 per cent (12÷90x110).

A higher capital cost implied a higher retention price for a plant, provided the company is able to meet its capacity utilisation norms. As a result, entrepreneurs started to focus on getting their costs approved rather than on reducing costs. This has led to the gold-plating of costs and the understatement of nameplate capacities. The net result of this subsidy scheme was that it failed to give incentives for efficiency. Rather, it helped in building up inefficiency. Setting up of greenfield capacities, for example, became more beneficial than brownfield expansion.

Not surprisingly, therefore, the production cost of urea in India varied between $100 and $300 per tonne, as against an import parity price which was almost half of that. An important reason for the high cost of domestic production is the dominance of naphtha as feedstock, which is more costly than natural gas (LNG). Nevertheless, it can be construed that the urea subsidy, which is primarily meant to improve farmers' ability to afford urea, is actually subsidising to a very large extent, the inefficient cost of production (on account of the high cost of feedstock).

When the RPS was introduced, it was envisaged as a self-sustaining scheme with producers who had RPS below the farmgate price refunding the balance to the Fertiliser Price Fund Account, set up under the FICC (Fertiliser Industry Coordination Committee). Units with a retention price greater than the farmgate price were to receive the difference from the fund.

The expectation was that, initially, there would be a surplus which would be eroded as a larger share of the production came from new and higher-cost plants. However, this surplus got eroded soon both because of the high cost of new plants and the stickiness of selling prices - resulting in budgetary support. This budgetary support became a routine feature.

The table shows that the farmgate price of urea has increased at a very slow rate over the years. Retention prices, on the other hand, have risen very sharply, particularly in the '90s. The trend in the weighted average retention price (WARP) in the '90s is illustrated below:

Source: ICRA

It is natural, therefore, that the subsidy bill move northward.

With the fertiliser subsidy ballooning to over Rs162 billion per annum over the past few years, there has been a debate over the feasibility of continuing with the RPS. The Expenditure Reforms Commission (ERC) recommended 'group retention pricing' (GRP) and gradually phasing out of the RPS, which was implemented with effect from April 2003.

The existing production units were grouped into five categories: pre-1992 gas-based units; naphtha-based units; fuel oil (FO) and low sulphur heavy stock (LSHS)-based units; and mixed feedstock units. The plants were free to source feedstock - either import or purchase indigenous feedstock - from wherever they wanted to. In place of individual RP, a urea concession scheme was introduced in which each group was entitled to a fixed amount of concession. This concession would vary with the rise or fall of the import parity price.

By the year 2006, the number of groups would be reduced from five to two - naphtha / LNG-based units and non-naphtha/LNG-based units. The former would be reimbursed a feedstock differential cost of Rs 1,900 per tonne of urea, while the latter will be viable at a price of about Rs 7,000 per tonne of urea.

The idea was to encourage efficient players while the inefficient players were to be penalised. The impact of the GRP was expected to reward energy efficiency, with a positive effect on the low-cost efficient plants. This was expected to result in the emergence of an energy efficient, internationally competitive industry based on natural gas as feedstock, subsequently reducing the subsidy burden.

The new policy, while acknowledging the high cost of production of urea in the country, penalises the players who are above the average retention prices for the group and does not provide extra profits to any. This reduces the subsidy for the government, without really benefiting any 'seemingly efficient' player (a player whose cost of production is lower than the group average but, otherwise, much higher than the international price). Further, with the current scenario characterised by 100 per cent self-sufficiency, it is likely to lead to the closure of high-cost plants based on costly feedstock.

While the RPS bred inefficiency the GRP is expected to reverse the trend by not only bringing about efficiency, but also reducing subsidies. Only time, though, can tell how effective the new scheme will prove to be.