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Fertilisers: Options beyond Retention Pricing - Views on News from Equitymaster
 
 
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  • Sep 9, 2000

    Fertilisers: Options beyond Retention Pricing

    The fertiliser industry is a classic case of an industry where, necessary reforms in the policy framework have been avoided in the name of the self–sufficiency. This has led to a situation where the efficient producers (read tax payers) subsidise the inefficient ones, where setting up greenfield capacities is more beneficial than brownfield expansion and the opening up post WTO would now make almost a third of the industry sick!

    The Retention Pricing Scheme (RPS) is the backbone of the fertiliser industry. It 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 lead 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.

    While the Marathe committee recommended industry wide norms, the government adopted a plant by plant norm. This led to entrepreneurs to focus their energies on getting their costs approved rather than focus on cutting costs. This was because the retention price paid varied between plant to plant depending on the feedstock used (whether 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%. 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 led to the goldplating of costs and understatement of nameplate capacities. Consequently, the production cost of urea in India varying anywhere between $100 to $300 per tonne as against an import parity price, which is almost half of that. Over the past few years with the fertiliser subsidy ballooning to over Rs 135 bn per annum there has been a debate over the feasibility of continuing with the RPS. Besides, with the quantitative restrictions having to be compulsorily lifted by April 2001, imports of fertilisers will anyway be an available option.

    Various alternatives have been suggested. One alternative is that the rated capacity of the plants be increased. The average production over the last two year’s could be taken as a benchmark. The government infact has appointed a committee under Mr. Y. K. Alagh and as an interim measure increased the rated capacity of 15 urea units. The second option for the government is to buy fertiliser at retention prices only upto 100 percent or 110 percent of the rated capacity with the rest being bought by the tender systems for which international companies should also be allowed to bid. The third option as has been suggested by the Hanumantha Committee is the scrapping of the RPS. This would have to be accompanied by putting an alternative mechanism based on the long run marginal costs (LRMC). The committee has calculated the LRMC at around Rs 6,050 per tonne and adding the freight and distribution margins the cost would work out to around Rs 6,500 per tonne. Obviously, the naphtha, coal and fuel oil based plants will be in trouble vis-à-vis gas based plants. A one time capital subsidy has been suggested along with the suggested a raising the price of urea by 10–15% every year for the next three years.

    The Gas Advantage
    Variable Cost per tonne of urea (in Rs)
    Year Gas Naphtha Fuel Oil Coal
    FY92 1,797 2,724 2,252 3,461
    FY96 2,242 4,308 3,672 5,421
    FY99 2,806 6,160 5,045 7,904
    Source: FAI, New Delhi

    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. Also it is the local sales taxes and high import duties on feedstocks which distort the cost structure of the industry. Also, the rise in feedstock prices over the year's has far outstripped the subsidy that the government has paid out to the industry.

    Factors affecting fertliser subsidy
    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
    Note: Based on the data of 17 units accounting for about 50%
    of the urea production between 1990-91 to 1996-97
    Source: FAI, New Delhi

    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.

     

     

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