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Strategy
A new approach to some old problems. We see the pragmatic approach of direct
transfer of subsidy recommended by the ‘Task Force on direct transfer of subsidies on
kerosene, LPG and fertilizers’ as having the potential to address the issue of subsidies to
some extent. We compute a potential annual saving of `225 bn for the government
from the implementation of the proposed scheme for LPG and kerosene. However,
there are several challenges that need to be addressed for successful implementation of
the new scheme: (1) Complete rollout of Unique Identification (UID) system in India as
well as (2) full financial inclusion, among others.
Pragmatic approach to handle the menace of subsidies
We see the direct transfer of subsidy as recommended by the ‘Task Force on direct transfer of
subsidies on kerosene, LPG and fertilizers’ as a pragmatic and implementable solution to tackle the
problem of burgeoning subsidies for the government. The task force intends to implement pilot
projects in few locations and submit its final report after incorporating the experience from these
projects. We compute annual savings of `225 bn for the government towards oil subsidies from
the implementation of the proposed scheme.
Government is saddled with subsidies and current subsidy schemes are highly inefficient
Exhibit 1 presents the subsidy on food, oil and fertilizer borne by the government of India during
FY2006-12E. We highlight that the food and fertilizer subsidy is entirely borne by government but
the under-recoveries on oil is also shared by the government-owned downstream and upstream oil
companies. The subsidy burden has increased sharply to `1.6 tn in FY2011 versus `556 bn in
FY2006. The spurt in subsidies reflects (1) sharp rise in consumption of regulated commodities and
(2) spike in commodity prices. In addition, the situation has exacerbated due to the inability of the
current system to limit the subsidy to needful consumers and leakage of subsidized products.
Subsidy on LPG and kerosene will balloon without any preventive measures
We note that the subsidy on LPG and kerosene constitutes a significant chunk of the overall gross
under-recoveries for the oil sector (Exhibit 2). We compute gross under-recoveries on LPG and
kerosene at `575 bn for FY2012E assuming crude oil (Dated Brent) price of US$105/bbl. However,
the gross under-recoveries from cooking fuels balloon to `745 bn at crude oil price of US$120/bbl
assuming (1) no change in retail prices and (2) current subsidy mechanism.
New scheme will likely (1) remove inefficiencies and (2) has potential to improve targeting
The objective of the proposed scheme of direct transfer of subsidies is to (1) remove inefficiencies
in the existing system (dual-market pricing), which will help reduce leakages, and (2) potential to
ensure that the subsidies are utilized only by the targeted vulnerable population, which will help in
reducing overall subsidies. We note that the prevalent scheme provides a blanket subsidy to all
consumers for the subsidized products resulting in (1) errors of inclusion and (2) errors of
exclusions. The current system of subsidies also creates incentives for pilferage and diversion (as is
widely prevalent in the case of kerosene and diesel).
Proposed subsidy framework and solution architecture
“The social programs of India are complex systems with millions of participants that have
evolved over the last few decades. Hundreds of millions of beneficiaries depend upon these
programs for basic sustenance. Such systems cannot be overhauled by legislation alone and
neither is technology a panacea. Eventual success will hinge upon political will, good
governance, incentive-compatible solution design, judicious use of technology, a structured
transition plan, meticulous project management, effective supervision, audit and execution.”
—Interim Report of the Task Force on Direct Transfer of Subsidies
The interim report of the Task Force on Direct Transfer of Subsidies has proposed a general
framework as well as an implementable solution architecture for the direct transfer of
subsidies to beneficiaries, aiming to incorporate the following elements of an effective
subsidy regime: (1) Choice for beneficiaries, (2) one price for all subsidized goods, (3)
transparency in administration, (4) efficiency in production, (5) convenient and effective
grievance redressal, (6) full electronic service delivery, (7) support for all types of direct
subsidy transfer models and (8) effective reporting mechanisms. The framework aims to limit
leakages and minimize inefficiencies prevalent currently. The Core Subsidy Management
System (CSMS) is at the heart of the framework, along with Unique Identification (UID) and
financial inclusion, as described below.
Core Subsidy Management System (CSMS). Exhibit 3 presents the basic architecture of
CSMS, a fully electronic back-office system that automates all business processes related
to direct transfer of subsidies. The CSMS would maintain the subsidy accounts of all the
beneficiaries, and all policies related to subsidy management. It is important to highlight
that the policies and business rules will continue to be framed by the policy makers; the
CSMS will support all forms of direct transfers of subsidies and thus, would be
customizable as per requirements. It would integrate with a number of external systems
including government, partners and service providers for smooth flow of goods and
information and effective monitoring. The concept is similar to Core Banking Solution
(CBS) implemented by all banks today.
Identification module and role of Aadhaar/UID. Robust identification of the
beneficiary is critical in the direct transfer of subsidies and thus, CSMS would be closely
linked to Aadhaar/UIDIA (Unique Identification Authority of India). The Aadhaar/UID
number links to the individual’s basic and demographic and biometric details, confirming
that the person is who she says she is. The CSMS-UIDAI gateway will (1) ensure one
beneficiary has one number across subsidy programs, (2) enable real-time authentication
of identity and (3) enable delivery of welfare benefits and subsidies through direct
transfers into Aadhaar-enabled bank accounts (AEBA).
Direct subsidy transfer module and role of banks/financial inclusion. Access to
electronic payments at the last mile is an integral part of the solution for direct transfer of
subsidies. A number of actions have been initiated by the government of India to facilitate
complete financial inclusion in India using (1) mobile phones, (2) India post and (3) bank
accounts linked to Aadhaar. The latter allows 64 empanelled banks to open accounts for
residents who choose to open one during Aadhaar enrolment without prejudice. Total
financial inclusion is critical for direct transfer of subsidies.
Details of the current and proposed subsidy mechanism for LPG
Current scheme. At present, the government provides a direct subsidy from the budget
at a fixed rate on LPG. In addition, there is under-recovery on LPG given that the domestic
price is lower than the import parity or free-market price. The under-recovery is borne by
upstream companies, downstream companies and the government. The current underrecovery
on LPG is `278/cylinder.
Proposed scheme. The Task Force has adopted a phase-wise implementation of the
proposed scheme which is given below:
Phase I—Capping the consumption of subsidized cylinders for all customers.
The capping of subsidized LPG cylinders for every household has been proposed by
the ministry of oil and natural gas (MoPNG) as an interim measure to reduce the
subsidy burden.
The number of subsidized cylinders allowed for every household and other rules will
be notified by MoPNG before the onset of this phase. However, it must be noted
that the implementation of Phase I is a policy decision of the government and not a
specific recommendation of the task force.
We highlight that the Chatturvedi Committee had made a similar recommendation
in August 2008. The committee has recommended that the entitlement to
subsidized LPG be restricted to six refills in a year and subsequently be phased out
over three years with future entitlements of four, two and zero refills.
We compute an annual saving of `98 bn to the gross under-recoveries if the
entitlement is restricted to six subsidized LPG cylinders per annum (see Exhibit 4). We
note that consumption of LPG in FY2011 was 14.3 mn tons. However, only 9.7 mn
tons of LPG would be required to be sold at subsidized price if the number of
subsidized cylinders are restricted to six per household.
Savings from proposed subsidy mechanism for LPG (Rs bn)
LPG consumption in FY2011 (mn tons) 14
LPG households in FY2011 (# mn) 114
LPG cylinder per household (#) 9
Under-recovery in the present scenario (Rs bn) 3 07
Consumption capped to six cylinders per annum
LPG cylinder per household (#) 6
Subsidized LPG consumption (mn tons) 10
Savings (Rs bn) 9 8
Subsidy to BPL households
BPL households (# mn) 65
Subsidized LPG consumption (mn tons) 8
Savings (Rs bn) 1 32
Notes:
(a) We compute LPG under-recovery assuming crude price of US$105/bbl.
Source: Kotak Institutional Equities estimates
Phase II—Direct transfer of subsidy to customer. Phase II of the project involves
linking of the OMCs database with the Aadhaar-Enabled Bank Account (AEBA). All
LPG cylinders will be sold at market prices and the government would fix the subsidy
per cylinder and the same will be transferred to the targeted customer’s bank
account upon authentication of the delivery of LPG cylinder.
Phase III—Identification and targeting of segmented customers. This phase
would involve identifying the targeted customers who need to be subsidized. Once
the process of identification is completed, the subsidy amount will be transferred for
the targeted customers only.
PDS, kerosene and challenges to the proposed subsidy mechanism
Public Distribution System (PDS). The PDS program implemented in 1951 aims to ensures
the availability of the basic necessities of life (food, fuel) to everyone, especially the belowpoverty-
line (BPL) population, through the network of ~0.5 mn Fair Price Shops (FPS)
operated by the state governments. The latest version of PDS, implemented since 1997, in
the Targeted PDS (TPDS), which is biased towards the ‘really’ poor section like the landless
agricultural laborers, marginal farmers, etc. The distribution to the targeted population is
made through FPS against a valid identity proof, which is the ration card.
Current scheme for kerosene. At present, the government allocates a fixed quantity of
PDS kerosene to the States and Union Territories on a quarterly basis, which is supplied by
the OMCs to the wholesale dealers. The government provides a direct subsidy from the
budget at a fixed rate on PDS kerosene (`0.82/liter). In addition, there is under-recovery
on kerosene given that the domestic price is lower than the import parity or free-market
price. The under-recovery is borne by upstream companies, downstream companies as
well as the government. The current under-recovery on kerosene is `23/liter.
The current subsidy scheme for kerosene suffers from the problems of (1) adulteration of
diesel with kerosene given similar characteristics and (2) diversion to black market given
sharp difference in price of kerosene and alternate fuels. As per NCAER (2005), 39% of
kerosene does not reach the target population; the proportion may have risen over time
given the increased price differential. Thus, the benefits largely elude the targeted
population despite government subsidy, additional support from upstream companies as
well as losses borne by OMCs.
Proposed scheme. Under the proposed scheme, a direct transfer of cash equivalent to
the subsidy as per actual usage of the beneficiaries would be made. The product will be
supplied by the OMCs at non-subsidized rate throughout the value chain. However,
considering the large number of ration cards beneficiaries, an elaborate mechanism is
required for the subsidies to reach the intended beneficiaries, including creation of
Aadhaar-enabled bank accounts (AEBA). Thus, the proposed changes will be done in two
phases detailed below:
Phase I—Direct transfer of subsidy through state governments/ Union
Territory administration. Kerosene will be sold to end-users at market prices in
Phase I. The government will provide for subsidy to the extent of kerosene uplifted
in a State/Union Territory. The state governments will then transfer the subsidy
amount to the customers of kerosene.
Phase II—Subsidy transfer to beneficiaries. This phase envisages transfer of cash
equivalent to the beneficiary. This will be achieved by opening of ‘kerosene’ account
for beneficiaries with Aadhars and transfer of cash subsidy in proportion of the
actual quantity of kerosene lifted by the consumer.
Potential and challenges.
Dependencies on state government/ministries. In Phase-I, the state governments
will be responsible for transferring the subsidy only to those consumers who have
actually lifted the product from the FPS. A failure to evolve an institutional
mechanism for the same may result in public unrest. In general, the task force
provides for implementable solution framework for delivery of direct subsidies to the
intended beneficiary; key decisions on policies and business rules will be prerogative
of the Centre and state governments.
Complete rollout of Aadhaar/UID and financial inclusion. The success of Phase-
II is critically dependent on the complete rollout of Aadhaar (Unique Identification-
UID) as well as financial inclusion program of the government of India (since the cash
transfer will be done to an account linked to Aadhaar identification). We highlight
that Aadhaar/UID as well as financial inclusion goals are yet in their infancy (target to
cover 50% of population by end-CY2014E) and prevalence of Aadhaar-enabled
bank accounts (AEBA) would be a further challenge.
‘Ghost’ ration cards and leakages. The ration card (or Household Consumer Card)
entitles the household to a quota of subsidized basic items (food and kerosene).
There are currently 40-60 mn ‘ghost’ cards in circulation, given issuance of 240 mn
ration cards against a total estimated 180 mn households in India (see Exhibit 6). This
results in potentially significant leakage of subsidy provided by the government. The
leakage can be effectively tackled with UID-based direct transfer.
Errors of inclusion (targeting) and exclusion. However, there is no simple
solution to all the errors of inclusion (targeting) as well as exclusion. In the current
scheme, the state governments are responsible for identifying the beneficiaries; it is
estimated that ~57% of BPL families are covered under PDS. A more robust
mechanism for identification of the vulnerable population needs to be formulated,
beyond the scope of the task force (UID would have limited utility, since it captures
very basic demographic data, at an individual level). We note the failure of past
schemes to implement targeted subsidies (smart card schemes for kerosene) due to
the lack of coordination between various arms of the government and uncooperative
stance of the state governments and local authorities.
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