The gas pricing issue between the government of India and Reliance Industries, brought into the public debate by Arvind Kejriwal, the former chief minister of Delhi, reveals how difficult it is to develop a fair pricing architecture for vital energy resources like gas.
At the heart of the issue is a long-known dilemma for policy makers: whether to link gas prices to an ‘assessed’ price, determined by our government or private Indian participants, or link it to an international market-based price.
India currently uses both methods. The Administered Pricing Mechanism (APM) price set by government for gas and used by the power and fertilizer sectors, is an example of the ‘assessed’ price, while the price that Indian companies pay for imported gas is an example of the market-linked price.
Unfortunately, neither model accurately reflects the physical market – the actual demand and supply – for natural gas in India.
That’s because the ‘assessed’ prices carry distortions within. The ‘assessed’ APM price set by the government is deliberately kept low for the poor who benefit from the subsidized rates. Such assessments have been based on a complex ‘cost-plus’ method that adds the cost of raw material, production, distribution, and marketing. Private companies have also ‘assessed’ prices in the past when bidding for government gas exploration tenders or seeking buyers for the gas produced.  This has ultimately also proved unsustainable.
There are two problems with this method: one, there’s no way of verifying appropriateness or accuracy, because the price-setting processes are opaque. Two, it creates an opportunity for state – or private owner – intervention at every level, as also for corruption, since the assessments are subjective.
The other method is to link India’s natural gas prices to the international market, more specifically to the benchmarks of the U.S., UK, Japan, and those of countries such as Qatar and Australia. The US and UK benchmarks – the Henry Hub and National Balancing Point respectively – are determined by their local gas exchanges, whose prices include not just the cost of raw material, production, distribution and marketing, but also the sophisticated inputs from the financial markets such as volume, speculation, hedging, currency risks, geopolitical developments. The Japan benchmark -Japan Custom Cleared or JCC – is based on international crude prices. Our own gas import contracts such as those with Qatar and Australia are based on JCC.
Although this is a transparent process, the market-linked international price comes with its own limitations for India. Since the gas rates partially depend on crude prices, they become directly affected by the volatility of the global crude oil markets. And if the prices are denominated in dollars, a weakening rupee will cause a loss for the Indian consumer. 
These limitations with the international market-linked prices, coupled with our own inefficient domestic assessments now under scrutiny for corruption, makes price assessment in India sub-optimal at best.
The RIL KG-D6 gas pricing is an interesting case study of how pricing has oscillated between the two models. The price of $2.34/mmbtu proposed by Mukesh Ambani’s Reliance Industries in 2006 to sell gas to brother Anil Ambani’s Reliance Natural Resources Limited (RNRL), was not accepted by the government even though it was the same price that RIL had used to win a bid NTPC had initiated earlier.  The government claimed that the price was not an ‘arms length’ price for RNRL. 
To make it fair, the pricing was then linked to the international price of crude oil. This resulted in the revised price of $4.2 per mbtu for RIL, and was eventually accepted by New Delhi in 2007. 
Since then India has moved to an international market-linked pricing model for gas which is linked to average gas prices in the markets of the U.S., UK etc, for our private and public sector players. This was done based on the recommendations of a 2012 committee headed by C. Rangarajan, the Chairman of the Prime Minister’s Economic Advisory Council. The aim is to incentivise domestic exploration and pricing with even better transparency.  This new pricing is to go into effect for all new contracts, starting April 2014. 
|Phase||Report||Pricing and Profit Sharing Models|
|Pre 1999||Pre-NELP||Assessed Pricing: Administered Price set by government(e.g. PMT gas to Power sector)Market-linked Pricing: Linked to global crude oil prices(e.g. Panna-Mukta Tapti gas to GAIL)Profit Sharing: Royalty + Tax only|
|1999-2012||NELP||Assessed Pricing: Through competitive ‘arms length’ bidding(e.g. RIL gas to NTPC). Also, administered prices continue.Market-linked Pricing: Linked to global crude oil prices(e.g. RIL gas to RNRL or gas imported from Qatar)Profit Sharing: Royalty + Tax + portion of profits (after cost is recovered by producer)|
|Rangarajan Committee||Final Report 2012||Assessed Pricing: <Discontinued> Market-linked Pricing: Linked to international ‘exchange’ traded prices in US, UK, Japan and import prices from Qatar, Nigeria, etc.Profit Sharing: portion of revenues (from the start)|
|Kelkar Committee||Preliminary Report 2013||Assessed Pricing: <Likely to remain discontinued>Market-linked Pricing: Recommendations due for linking to marketProfit Sharing: Royalty + Tax + portion of profits (after cost is recovered by producer)|
*NELP – National Exploration and Licensing Policy
Coincidentally, RIL’s KG-D6 contract is also due for a pre-scheduled revision in the same month – April 2014.  If the norms are used, Reliance too will benefit and sell its gas for about $8.4/mmbtu. 
It is this price increase that the Standing Committee on Finance and the Aam Aadmi Party have opposed. Both are demanding that RIL be persuaded to produce the gas and sell the gas at the pre-revised rate. 
The Rangarajan Committee also recommended that profit-sharing contracts be amended to a revenue-share model at the start of production, to prevent inflation of exploration costs and a loss of subsequent income for the government. By this measure, RIL will get $8 per mmbtu – twice the current rate.
To add to the confusion, a new committee formed in early 2013 under Vijay Kelkar has already dismissed the Rangarajan Committee’s conclusions about profit-sharing and is likely to overturn the recommendations when it submits its final report later in 2014. 
Such is the prevarication and uncertainty of doing business in India. Worse, without incentivising business into domestic gas production, we will continue to be dependent on imports.
It is imperative then, for India to find a solution that reflects our own business and market realities as also the consumer’s purchasing abilities. Now is the right time, with a new government due in Delhi in May, to design and implement a policy architecture that reflects our particular economic make-up.
An optimal answer is to develop our own price assessment architecture, much as the West has. For instance, the U.S. has its own oil and gas production, as also the related structures – the West Texas Instrument benchmark for oil and the Henry Hub for gas – which reflects its own domestic market and exports. This would also mean developing a price assessment process based in rupees which has so far not been comprehensively tested or widely encouraged.
This level of sophistication, however, is difficult for India to achieve on its own because our gas exploration, transportation and the supporting financial markets remain under-developed. Transnational gas pipelines initiatives such as TAPI (Turkmenistan-Afghanistan-Pakistan-India) that could have helped in developing an alternative price signal for India, have only progressed at snail’s pace.
Even the advanced economies of Japan, Korea and China have had difficulty in developing in a gas pricing architecture domestically, relying instead on a simple, market-linked rate pegged to global crude oil prices – as India has also attempted to do. Despite Asia being the fastest-growing natural gas market in the world  more than 80% natural gas traded in Asia is linked to global oil prices.  The region lacks the unity and therefore the heft to negotiate jointly for a competitive rate, thereby paying the higher “Asian Premium”  for its energy.
Some efforts are being made in the region. In 2010, China launched a market for spot trading of LNG for domestic use. The volume and usage has gradually increased, indicating market-rate commitment.  Japan is expected to launch a Futures market for gas in April 2014.
India can take the lead in a regional initiative to develop a pricing architecture with other consuming nations, and thereby leverage our massive annual imports of oil and gas (Asia alone accounts for 70% of the world’s liquefied natural gas market). A small step has been taken. In September 2013, India and Japan – both heavily energy import-dependent – signed an agreement to work towards “rationalizing of LNG prices in Asia Pacific” and “towards the development of a market environment that would enable effective, stable and globally competitive LNG procurement” – a sort of Henry Hub benchmark appropriate for large consuming nations . It will encourage the development of a price assessment process based in rupees – a concept so far not comprehensively tested.
If successful, such an initiative can expand to include the other large importers such as Korea and China which are struggling with the same issues.
Till then though, we will muddle along with sub-optimal solutions.
Akshay Mathur is Head of Research at Gateway House: Indian Council on Global Relations.
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References and endnote:
1. Not all pricing formulas used in these agreements are public but the pricing has to be done at ‘arms length’– that is without collusion or influence
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