Pricing consistency

The Government has outlined plans to introduce a transparent fuel pricing formula during the first quarter of 2016, which should be hailed by all as a measure to create transparency and allow price changes to reflect international prices rather than political realities. 

Sri Lanka already has a pricing formula for LPG, which was approved by the Supreme Court. The two major gas companies have to appeal to the Consumer Affairs Authority (CAA) giving their reasons for a proposed hike and can only put it into action if the authority gives its regal nod. While posturing as a transparent pricing formula it nonetheless faced significant impediments to being implemented because of political interference, especially during election time. A fuel pricing formula will hopefully come with a stronger backbone.  

Recent volatility in international fuel prices has highlighted the fiscal risk inherent in the current approach to fuel pricing. Domestic fuel prices are administratively determined and increases in international fuel prices are often not fully passed-through to domestic consumers. This has translated into increased volatility in fuel tax levels and revenues, and substantial fiscal costs over long periods, especially when there is more complete pass-through of international price decreases.

Motivated by a desire to protect fuel tax revenues, some countries have adopted automatic fuel pricing mechanisms. The adoption of such a mechanism is intended to ensure full pass-through of changes, both increases and decreases, in international fuel prices to domestic fuel prices. At the core of the mechanism is an explicit fuel pricing formula, which determines domestic prices as the sum of the import price of fuel products, domestic wholesale and retail distribution margins, and fuel taxes. Domestic fuel prices are then changed at pre-specified regular intervals (e.g. weekly, bi-weekly, or monthly) to fully reflect changes in internationalprices. 

In addition to protecting fuel tax revenues, this approach also protects the margins ofdistributors, thus avoiding the disruption of fuel markets that often results from distributors incurring subsidy arrears due to lack of full pass-through of international fuel price changes. The adoption of an automatic mechanism should also be viewed as the first stage of a transition to a fully liberalised pricing and supply regime, which has typically been a more effective approach to avoiding subsidies and protecting the Budget. 

The adoption of an automatic pricing mechanism with full pass-through of international price changes to domestic prices means that volatility in international prices is directly reflected in domestic fuel price volatility. However, for political and social reasons, governments are often reluctant to pass-through large increases in international price changes instantaneously to domestic consumers. This is often reinforced by a belief that such large price increases may turn out to be transitory. Therefore, some countries have adopted pricing mechanisms that incorporate price smoothing mechanisms that delay the full pass-through of large priceincreases to domestic fuel prices, as well as delaying large price decreases.

Concerns for income distribution mean that taxes on fuels for which the poorest households have a higher share in total consumption should be relatively low. This maximizes the share of the total budget subsidy accruing to these householdsand thus minimizes the fiscal cost of redistribution. 

In the current scenario where fuel prices have remained relatively low, the benefit to consumers would be cheaper fuel. But the Government will have to manage the policy in such a way as to levy tax but not at a prohibitive level. This will be the biggest challenge the new pricing formula will have to tackle.