City gas distribution: A flawed model
City gas distribution (CGD) networks started in a small way in the northeast region in the 1960s and in Gujarat in the 1980s. GAIL established CGD entities in Mumbai in 1994 and Delhi in 1997. The Petroleum and Natural Gas Regulatory Board (PNGRB) was established in 2007. Thirty-five CGD networks were in place prior to the establishment of the PNGRB and 145 networks have been authorised by the board since then. The 180 authorised CGD networks cover about 45 per cent of the districts (282) and about 50 per cent of the population. The 9th bidding round of 2018 was bigger than all previous rounds put together, offering 86 geographical areas (GA) in 174 districts. The government appears to be in a tearing hurry to auction CGD licenses and the 10th bidding round is on the anvil. Progress on the ground is, however, another matter.
The CGD business model is currently based on the supply of cheap domestic gas (for PNG and CNG, with CNG accounting for the bulk of consumption), which is both inherently flawed and unsustainable. The price of gas produced domestically from nomination fields of ONGC and OIL, and also from earlier exploration and production contracts, is controlled through an administered pricing mechanism (APM) and is about 65-70 per cent lower than the market price, which in India is the price of imported LNG (the current price is about $3.5 per million British thermal units or mmBtu compared to imported LNG price of about $10 per mmBtu). Under the gas allocation policy, city gas enjoys the first priority in the allocation of cheap domestic gas, supply of which is dwindling, while the fertiliser sector enjoys the second priority. This policy has the following perverse consequences:
1. It establishes a huge spread between input prices and output prices, thereby enabling CGD entities to make large profits in a non-transparent manner. There is no mechanism in place to regulate consumer prices for CNG and PNG to match low input prices. While input prices of domestic gas are currently in the range of $3-$4 per mmBtu, output prices, based on the opportunity cost of substitute fuels for CNG like petrol and diesel , are in the range of $30 per mmBtu . This extraordinary spread affords a hefty profit margin for CGD entities. Given the high opportunity cost of substitute fuels like petrol and diesel, there should be no difficulty if the allocation of cheap domestic gas is withdrawn from CGD units and these entities are required to source natural gas at market prices through imported LNG or otherwise. A $15-$20-spread would still be available to CGD units at the current price levels, after taxes (a large spread is generally available regardless of price levels). The implicit CGD subsidy is clearly misdirected towards CGD entities. It is also unnecessary, given the spread available without any subsidy. Even otherwise, with the subsidy on transportation fuels being withdrawn, the hidden subsidy on CNG needs a review. If CNG and PNG consumers have to be subsidised, this should be done in a transparent manner through direct benefit transfer (DBT), as is being done for LPG. There should be no question of subsidising CGD companies.
2. The availability of cheap gas has led to irresponsible bidding, with bidders bidding zero or nominal tariffs in earlier rounds and minimum tariffs in the 9th round to cover network costs and compression charges, with the expectation that all costs will be recovered through the huge spread between input and output prices. Bidders are, therefore, locked-in to inherently unviable tariffs over the contract duration of 25 years. Consequently, as cheap domestic gas sources dry up and/or this gas is withdrawn, bidders will be faced with serious problems of cost recovery, thereby affecting viability and sustainability of the CGD system. This will open up a Pandora’s box of legal disputes, contract re-negotiations, non-performing assets and supply disruptions. The government surely cannot afford such outcomes. These issues can be taken care of if the business model is based on sourcing natural gas at market prices. This will provide a more solid foundation for the expansion of the CGD network in the country.
3. The APM formula for domestic gas imposes a steep penalty on domestic production, mainly by ONGC and OIL. There cannot be a more perverse incentive in a country desperately short of oil and gas. More than $100 billion have been frittered away on oil and gas subsidies over the last decade, therby, dealing a severe blow to exploration & production (E&P) efforts. Withdrawing cheap domestic gas allocation from city gas and selling it at market prices will place desperately needed funds of about ~150-~200 billion annually at the disposal of companies like ONGC and OIL. A sovereign wealth fund could also be created from the sale of this gas at market prices, to be used exclusively for exploration and production, both at home and abroad.
In view of the above, there is a compelling case to review the business model for the rollout of CGD networks in the country and withdraw the allocation of cheap domestic gas for CGD networks. No further bidding round should be held till this matter is decided and all previous winners are put on notice. The transition to market price for gas can be phased over three years to allow CGD entities time to adjust. This will also settle the debate about whether CGD entities are public utilities or not, and could pave the way for a new decentralised regulatory architecture for CGD, something akin to the US, where about 1,200 CGD units are regulated by State Utility Commissions, which cover power, water, cable TV and natural gas. This, however, lies in the future.