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The Retention Pricing Scheme: How does it work? - Views on News from Equitymaster
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  • May 12, 2000

    The Retention Pricing Scheme: How does it work?

    The Retention Pricing Scheme (RPS) was introduced in November 1977 in the wake of the increase in crude oil prices in the early seventies when the prices of both imported fertilisers as well as fertiliser feedstock (naphtha) increased substantially. This led to a decline in the consumption of fertilisers and the government, in order to help build indigenous fertiliser capacity and boost fertiliser consumption set up a committee under Mr. Marathe. The outcome of the recommendations of the committee was the RPS.

    The scheme intended to provide fertilisers at a cheaper rate to the farmers and provide a 'reasonable' return on investment for the fertiliser producers, which would boost investment in the industry.

    The scheme works as follows: the selling prices of the fertiliser are fixed by the government and so are the retention prices for the producers. The difference between the higher retention price for the producer and the lower selling prices are paid to the producers by the government. These are based on covering the variable cost and fixed costs and giving a return of 12% on the networth.

    Not all producers are entitled to the same price however. The retention price paid varies between plant to plant and depends on the feedstock used (whether naphtha, fuel oil, gas or coal) and takes 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%. So if a plant were to operate at 110%, the effective post tax return would work out to 14.67% (12/90*110). Thus a higher capital cost implies a higher retention price for a plant provided the company is able to meet its capacity utilisation norms. This is the reason why the newer plants such as Chambal Fertilisers and Tata Chemicals set up in the early nineties get a higher retention price (since they have a higher capital cost which implies higher interest and depreciation) than plants such as Indo Gulf Fertilisers and Zuari Agro. Thus the differences between retention prices (for urea) vary between 3,500/tonne for some plants to as much 8,500/tonne for others.

    However, there is a downside for companies getting a higher retention price. Normally, companies book their sales at retention prices and the difference between the retention prices and the selling prices (Rs 4,000 per tonne for urea) are shown as dues receivables from the government. Therefore the actual cash flows are much less than what appears from examining the profit and loss account. For instance, Tata Chemicals in its annual accounts ended March 1999 had mentioned an outstanding balance of Rs 3,129 m from the government (the net cash before operating activities for the company for the year was Rs 2,734 m).

    Over the past few years with the fertiliser subsidy ballooning to over Rs 132.5 bn (FY99-2000RE) per annum there has been a debate over the feasibility of continuing with the RPS. The arguments against the RPS (based on the Hanumantha Committee recommendations) are that the industry does not face market risks with the return of 12% being assured from day the plant is commissioned. The cost of production for an individual plant does not the matter since the RPS sets the retention price of each plant individually. Further, the industry understates the capacity of the plant, which ensures high capacity utilisation figures. Besides, with the quantitative restrictions having to be compulsorily lifted by April 2001, imports of fertilisers will anyway be an available option. Further, with international prices at $ 150-160 per tonne imports make sense at these prices.

    Particulars Amount
    (Rs m)
    Gross cost push
    Increase in subsidy
    1)  Indigenous feedstock
         and other inputs
    9,505.0 72.2 177.5
    2)  Freight 900.7 6.8 16.8
    3)  Increase in production (464.0) (3.5) (8.7)
    4)  Misc cost increases 3,220.3 24.5 60.1
    5)  Gross cost push (1+2+3+4) 13,162.0 100.0 245.7
    6)  Excess realisation due to
         increase in selling price
    7,805.7 - 145.7
    7)  Increase in subsidy (5-6) 5,356.3 - 100.0

    The industry has been arguing otherwise stating that plants based on naphtha and coal (almost half the industry is based on naphtha and coal) will have to close down and that would amount to a loss of production of more than 50%. Secondly, though international prices are low at the moment, if India were to enter the market, global suppliers would jack up prices, which would nullify the gains from closure of uneconomic capacities. Thirdly, the cost increases for the industry have been far higher than the subsidy that has been given to the industry (see table above). For instance the increase in feedstock and other input costs have outpaced by the increase in subsidy by a large amount. Also it is the local sales taxes (such as say Rs 2,500 per tonne of naphtha) which distort the cost structure of the industry. Besides, the world over governments whether Japan, USA and in the European Union grant much higher subsidies to farmers in order to encourage them to capture market share.

    And so, the debate continues. What both the opponents and the proponents of the RPS however agree on is that the price of urea should be increased gradually by around 10% every year. Economically, it makes sense to abolish the RPS and better ways of subsidy to the farmers could be worked out since a subsidy on fertilisers is not the only way of providing farm subsidy. However, whether the socio-political environment permits this, remains to be seen.



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