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Uttam Gupta

THE Government is reportedly toying with the idea of `merit'-based pricing for the domestic urea industry. Under the existing dispensation, unit-wise retention prices are fixed to cover the respective reasonable ex-factory cost determined on the basis of prescribed `norms' in capacity utilisation and consumption of raw materials and utilities.

Against this backdrop, what does the concept of merit-based pricing mean and why is the Government so keen on it? How will it implement the system and what will its impact on various stakeholders be? Will it prove a viable alternative to the existing dispensation?

The concept involves boosting supplies from low-cost sources and discouraging production from high-cost units. This will help the Government reduce the overall cost of supplying urea to the farmers. And since the urea selling price is controlled at a low level, this will result in a corresponding reduction in subsidy payments.

To implement the system, the Government will have to identify units in high- and low-cost categories. In the next stage, it will have to decide on the quantum of reduction in production by the former to be replaced by higher output from the latter. It may also consider replacing a portion of the high-cost domestic production by cheaper imports.

The retention prices reveal that the high-cost plants are those largely based on naphtha and fuel oil as feedstock. On the other hand, plants that use gas as the feedstock generally produce urea at low cost. The production cost of these plants also compares favourably with the cost of imported urea.

Put together, all plants based on naphtha and fuel oil account for about 40 per cent of the total urea production capacity of about 20 million tonnes. What then, are the options? Would the Government like to replace the entire 8 million tonnes from these plants by supplies from imports or additional production from domestic gas-based plants? Or, will it go in for substitution on a limited scale, say, by 2-3 million tonnes?

The first option could lead to a disaster. The gas-based plants simply do not have the additional capacity to make up for the loss of 8 million tonnes from plants based on naphtha and fuel oil. A predominant share of this will have to be met from imports. Apart from steep increase in the international price, this will even lead to problems of availability. The horrendous social and economic implications of the plant closure cannot also be wished away.

Under the second option, the Government may distribute the targeted reduction `proportionately' among the high-cost plants. However, while deciding on the quantum, it should ensure that production by any unit does not fall below the normative capacity utilisation of 85 per cent (80 per cent for plants that are more than ten years old). This is necessary to ensure that fixed cost, including capital related charges (CRC), is fully recovered and there is no under-recovery in energy cost.

Considering the above and the restriction on production at 80-85 per cent of capacity, the Government should refrain from raising capacity utilisation by the 5 per cent contemplated under the 7th and 8th pricing package. Likewise, the energy consumption norm will have to be fixed considering the lower production target.

Another option may be to `temporarily' shut down operations by some high-cost units (by arranging plants in the descending order of the retention price and deciding on a cut-off point to fully cover the targeted reduction). However, the Government will have to compensate the affected units for the committed and unavoidable expenses such as wages and salaries, overheads and maintenance expenses.

There are several imponderables in adopting this route. Will payments to a unit not in production be politically acceptable? Will the unit be in a position to resume production after remaining closed for a long period? What happens to the psychology of the workers who will continue to be paid for doing nothing? Will the top professionals continue to stay in such a company? The powers-that-be should seriously consider these questions!

For the purpose of substituting production from high-cost units by increased supplies from alternative sources, the Government should strike a judicious balance between higher production from the domestic low-cost gas-based plants, on the one hand, and imports, on the other. The import option should be exercised only after fully utilising the excess capacity available with the plants based on gas.

While, formulating its stand, the Government should bear in mind that the high production cost of the majority of the plants based on naphtha and fuel oil is primarily due to the high feedstock cost. Thus, as against the gas cost at $1.9-2.5 per million Btu delivered at the factory gate, the corresponding cost of naphtha is $6.5-7.5 per million Btu, and that of fuel oil is about $5-6 per million Btu. The Government has apparently indicated its resolve to bring about a steep increase in the gas price. Gas-based plants may have to pay a high price of about $4.5-5 per million Btu sooner than later. At the same time, after dismantling the administered price regime, the prices of naphtha and fuel oil may decline. Thus, plants based on these feedstocks will be able to overcome their disadvantages.

Hence, the urgent need to avoid any precipitate action that might result in their `permanent' closure.

(The author is Additional Director (Economics), Fertiliser Association of India, New Delhi. The views are personal.)

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