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Friday, January 2, 2009

Fuel Surcharge – Government Aided Scam

Circumstances – Massive dip in the oil prices world over.
Good news - A few days back Air India announced a fare cut by 45 to 85 % in various sectors. Others are likely to follow suit.
Bad news – The cut was limited to the basic fare charged and not on the fuel surcharge.

What is happening, one might be tempted to ask. If the fuel prices have gone down, the fuel surcharge should go down, why the basic fare. There is a lot of economics at work here. This is an example of a Government aided scam. Let us try to understand it.

The fuel surcharge here in India was introduced in Nov 2005 for the airlines business, primarily to offset the volatility in the prices of fuel and hence the Aviation Turbine Fuel or the ATF. No, it is not the brain of some over-intelligent Indian economist; it has existed in the west for a lot longer and has pervaded other sectors too, besides the aviation sector as it will, in our country too.

How does the airlines company benefit? On the face of it, it might seem that Rs 500 less in the basic fare or the fuel surcharge is the same thing. It is not. All the concessions, discounts, air mileage redemptions etc are based on the basic fare. When the basic fare is reduced so is the amount of these discounts. Therefore the customer, that is, you and I end up paying more than what we would have if the fuel surcharge was reduced instead. The cost of fuel in an airline operation is just about 30-35% of the total operational costs. Here we have a situation where the basic fare is only about 10-35% of the fuel surcharge. As a result the 82% cut announced by Air India would be equivalent only to about 10-15% of the total fare which by no means is enough, considering that the fuel price has gone down by much more. The Fuel surcharge is split into two rates, one up to 750 kms and the other above 750 kms. So irrespective of whether you are flying 751 kms or 2000kms the fuel surcharge remains the same. Now, the basic fare remaining the same for the two distances can not justified, but fuel surcharge can be, since it is an arbitrary figure decided by the company with no Governmental control over it.

Another profitable instance for the Airlines is the commission they have to pay to the travel agents. This too is based on the basic fare and will result in savings for the Airlines. The same logic also applies to freight. The arbitrary value of the fuel surcharge ensures that every one pays and the overall benefits to the transporter is much more than when he does bulk movement.

How it benefits industry? On the face of it does not, but look carefully it does. Take the example of courier companies. Every time you use the service the company passes on the fuel surcharge to the customer, thereby raising the cost to the customer, accost which in no way is commensurate with the actual costs of operation considering that the freight is always done in bulk. Very soon the fuel surcharges will pilfer into other industries raising the prices of goods. The industry can and will attribute it to the rise in fuel surcharges. Most companies use this tactic to avoid the customer wrath which they would otherwise face if they hiked the cost of the product itself, so they take refuge under the fuel surcharge.

How it benefits the Government? In India the ATF still falls into the category of undeclared goods. Meaning that the governments can charge anything between 4-24% tax on the ATF. If the ATF was brought into the declared goods category there would be a flat tax rate of 4%. If that happens the state governments will stand to loose a huge chunk of it’s tax revenues. They wouldn’t want that, would they. And more the fuel surcharge the more they benefit.

How the citizens lose? The first part I have already discussed. The worthy citizens who are entitled to a discount get lesser of it. The frequent fliers have to fly much more to redeem their miles and they still end up paying the surcharges and taxes. This is just the beginning, when it spreads across the other industries, the people who are not utilizing the transportation services will have to start paying for the goods they buy in the market. The airline operators also indulge in what is called hedging. Hedging is a financial strategy that lets airlines protect themselves against rising prices for Fuel by locking in a price for fuel. In simpler words it is gambling. If the fuel prices fall below the hedged price, the airlines lose money, which forces them to make their future customers pay more for their follies. That could be one reason why the airlines refuse to reduce the fuel surcharge despite the fall in prices of fuel and ATF.

Solution – In India there is no benchmark index on which the fuel surcharge is based. It is arbitrary. Will a benchmark rate help? It is doubtful. The west has tried it and the issue of setting the fuel surcharge rate has only become more confounding and even though there are elaborate formulae defined for the calculations, most people do not understand the rationale. The only way out is to get ATF into declared goods, to reduce the tax burden on the airlines which gets passed on to the customer and directly link the surcharge with the ATF or the fuel price. In this day and age of internet making transactions easier, it shouldn’t be difficult to manage the bookings with a variable surcharge which varies in accordance with the fuel prices. Till such time this happens, the Fuel surcharge will remain a Government aided scam.

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