Fuel prices in Sri Lanka : Rationale behind pricing formula | Sunday Observer

Fuel prices in Sri Lanka : Rationale behind pricing formula

The Government ‘was compelled to revise fuel prices in May this year after the Ceylon Petroleum Corporation (CPC) racked up billions in losses. According to news reports accumulated losses at the CPC at the end of 2017 stood at Rs.217bn and it lost a further Rs.18bn to April 2018 before the Government finally got around to revising prices.

The losses are the inevitable consequence of selling products below cost.

The idea behind the formula is that retail prices would move up or down, depending on the price of oil so preventing these losses from accumulating. A formula was promised in May 2018 and apparently in accordance with this, prices were revised on July 5th, only to be reversed within hours by Presidential decree. It was later reimposed a few days later but the confusion did not help business confidence or the reputation of the Government.

Before dealing with the rationale for the formula, it is worth digressing to the principle of collective responsibility. The House of Commons Library, which provides research, analysis and information services for MPs and their staff defines this as:

“Collective responsibility is a fundamental convention of the British constitution, whereby the Government is collectively accountable to Parliament for its actions, decisions and policies. A minister is able to express their views and disagree privately, but once a decision has been made by the Cabinet, it is binding on all members of the Government.”

Although only a convention it has value in that it minimises public confusion and makes for a more predictable business environment, which helps when attracting investment.

The argument for a formula is fairly straightforward: Sri Lanka has no oil so is dependent on imports. Sri Lanka cannot control global oil prices so it cannot realistically hope to control retail prices in the long term. If prices are controlled (in effect subsidised) the cost must eventually be borne by taxpayers.

The problem is that the question of fuel prices is politicised-ministers feel that if prices rise they will be unpopular. This causes losses at the CPC which destabilises the fiscal position, contributes to balance of payments problems and stresses on the banking sector.

The formula will help depoliticise this – if only it were allowed to work. The troubled history of the formula and some of the consequences of controlling prices are worth revisiting.As a result of the balance of payment crisis, Sri Lanka briefly adopted a cost reflective pricing formula in 2002 during which price revisions happened almost every month till September that year. The formula was suspended in 2003, following the outbreak of the Gulf war which threatened to raise oil prices. A new government took office in 2004 and abandoned the price formula the same year under pressure from the JVP which described the price formula as a surrogate ‘plug’ of the IMF.

As the crude oil prices skyrocketed during 2007, pressure on the Ceylon Petroleum Corporation (CPC) to contain fuel prices mounted. Faced with increasing losses, the formula was brought back to life in July 2007 for two months before it was abandoned again, by Cabinet order. As oil prices continued to rise and the losses at CPC mounted, it attempted to manage costs by entering into a hedging arrangement. The hedging contracts were beneficial when international oil prices were increasing, but became costly as international oil prices decreased and the CPC eventually suffered colossal losses, estimated at Rs14bn.

As oil prices rose in the first half of 2008 the Government responded by cutting the VAT on gasoline from 15% to 5% in January 2008. Oil prices crashed in the second half of 2008 but then began to rise for the next two years. A balance of payments crisis in 2009 compelled an increase in VAT on oil to 12%. Oil prices continued to rise so the Government cut taxes again, removing the Social Responsibility Levy and VAT on gasoline imports in 2010. Eventually, the CPC had to be rescued by taxpayers: the Treasury issued Rs. 55 billion worth of treasury bonds in January 2012 to settle debts of the CPC. A sharp revision in fuel prices in February 2012 followed. This sparked a series of strikes by private bus operators and protests that resulted in the death of an individual.

To control the situation the Government decided increase the monthly allowance of kerosene for Samurdhi recipients and provide 50 litres of fuel per day to short-distance buses and 80 litres to long-distance buses at the old diesel price. In addition, the fishing boats were provided with subsidised fuel.

Oil prices began falling after March 2012 but the CPC maintained prices. The benefits of falling oil prices could not be passed to the ordinary citizens due to the need to recover previous losses incurred by the CPC. In the second half of 2014, oil prices fell to the lowest level in 6 years, but local prices remained unchanged.

The present Government elected in 2015, reduced fuel prices as a part of a pledge to reduce the cost of living. Petrol saw the greatest decline in prices. The Government soon ran into balance of payment crisis. Oil prices saw further decline in the following years but already burdened with a mountain of debt, CPC was not in a position to cut back on prices. After 3 years of maintaining the prices, amidst rising losses at the CPC the Government decided to return to the formula in May 2018.

As is evident, the costs of subsidising fuel is eventually borne by the taxpayer but it is not a zero sum game. The benefits of cheap fuel are reaped by richer sections of society who own cars. Sri Lanka’s richest 30% of society consumed 70% of the fuel; meaning that the subsidies paid by taxpayers are consumed by the rich.

This is the rationale to move to a cost reflective formula. Once people get used to regular changes in price, particularly if they are small, frequent changes it no longer becomes a political issue.

There are however legitimate questions that may be raised on the efficiency of the CPC - consumers can expect to pay for higher global prices but not for inefficiency or corruption.

How does the efficiency of the CPC refinery compare with the super refineries of Dubai or Singapore? How well does the CPC do in purchasing oil, are consumers paying for inefficiencies or corruption here? We do not know.

What about quality? Questions surface periodically. In one instance in 2011 low quality fuel caused many vehicles to stall.

The problem is that when prices are set by the Government, even if it is by formula, there is no way to compare. Much of the fuel sold in the country is imported refined, according to the annual report of 2014 (the latest available) the refinery produces only a third of the fuel used in the country. Lanka IOC already distributes fuel, why not increase the competition by allowing other players to enter and freeing the pricing system? It will also provide distributors the incentive to improve quality.

Sources:

[1] Collective responsibility - Commons Library briefing - UK Parliament. 2018. [ONLINE] Available at:https://researchbriefings.parliament.uk/ResearchBriefing/Summary/CBP-7755. [Accessed 12 July 2018]

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