India: Impact of COVID-19 on adoption of BS-VI norms

India: Impact of COVID-19 on adoption of BS-VI norms

On the 1st of April 2020, India adopted the BS-VI emission norms. This places India in a select group of economies with Euro VI-compliant fuels. However, the move to low sulphur transport fuel is fraught with downside risk given the impact of COVID 19 on the Indian economy. The capital-intensive step by refineries and automobile manufacturers has now moved into a stage where the revival of demand and coordinated price adjustment is essential for cost recovery. 

BS-VI norms

The Bharat Stage VI or BS-VI regulation is an upgrade of the existing emission norms for on-road vehicles in India. BS-VI emission norms have many implications, among the most important is the adoption of a lower permissible level for sulphur content in transport fuel, i.e. 10 ppm or particles per million. The previous standard, BS-IV required 50 ppm of sulphur. The decision was announced in January 2016 by the Indian government, which decided to skip the BS-V stage and leapfrog into BS-VI. At the time, this was seen largely as a reaction to the air pollution crisis in major cities across the country, the starkest example of which was the nation’s capital: New Delhi. When the decision was announced, the government hoped for two trends to play in its favour: (i) the Indian energy industry can ensure supply of the new fuel and (ii) the automotive industry adapts willingly. Indeed, these are the necessary conditions for a smooth and clean transition into BS-VI. 

Supply and the problem of sunk costs

For India’s state-owned oil marketing companies (OMCs), this move was challenging, given that the government was keen on a ‘single-phase’ role out. This meant more capital investments upfront and shortened periods to adequately reform supply lines. In the case of earlier transitions, the implementation was done in phases, Tier-I cities were targeted first followed by the lower tiers. 

Sanjeev Singh, chairman of Indian Oil Corporation, one of India’s largest state-owned refineries commented: “Existing units required a revamp, we had to make modifications and raise capacity”. Bharat Petroleum Corporation Limited, another state-owned OMC reported that it too had invested heavily in upgrading its refineries. The firm reported capital expenditure totalling INR 596 million for the transition. On an industry level, oil marketing companies invested a total of INR 3.5 billion to ensure supply prior to the April 1 deadline.

Since December, the OMCs have been lobbying the government to aid cost recovery through price hikes. While the prices are deregulated, most state-owned OMCs function on moving day average (15 days) as opposed to a cost-plus model. If the hike is agreed to, it could bring upward pressure on the consumer price index which in turn would restrict monetary policy responses for the COVID-19 recovery. Thus, it is unlikely that the government gives in easily. For investors evaluating the financial health of OMCs, the outcome of this negotiation is almost as important as the prospect of quick growth recovery. 

COVID-19 and the destruction of demand

The demand for the new fuel has two key drivers: mobility and the automobile industry sales (future mobility), both severely impacted by COVID-19. India is currently in the midst of a 21-day lockdown ordered by the government to curtail the spread of the virus. This means that all but essential economic activity has been shut down, bringing the mobility of the Indian polity to a halt. As a consequence, fuel consumption is likely to falter, making cost recovery for the fuel supply chains a monumental challenge. 

The automobile industry is also in dire straits. The industry had witnessed structural issues and decreasing sales prior to the outbreak, which exacerbates the industry’s woes. As far as the BS-VI transition was concerned, automobile manufacturers were required to take key decision for product strategy, pricing and inventory management. For instance: Firms had to shorten the inventory cycles of BS-IV compliant vehicles to make way for the new models in addition to considering the increased costs of production for the BS-VI model. There is also the issue of prices. BS-VI compliant models in the two-wheeler segment are 8% – 14% costlier than the average product.

Source: Society of Indian Automobile Manufacturers

Similar to the condition of OMCs, COVID-19 comes as an adverse demand shock for automobile manufacturers. Estimates by brokerage houses state that sales volumes could decline by 40-50% in 2020.  Recently, firms have been forced to rationalise production and even suspend it in some cases given bleak sales forecasts. The Society of Indian Automobile Manufacturers reported that the estimated loss to the industry is INR 230 million per day in lost revenues.

Risk Outlook 

The impact of COVID-19 on the BS-VI transition is likely to be indirect, i.e. it will feed through in the form of financial pressure on OMCs and automobile manufacturers. In both sectors, firms have incurred sunk costs to make way for the adjustment. For the OMCs, the cost recovery is likely to hinge on the outcome of negotiations with the government. Even if the price hike is agreed to, the severe mobility restrictions would place a bearish pressure on fuel demand. COVID-19, in effect magnifies the issue of sunk costs for the industry. It is likely that this will place a short-term pressure on their financial health. Investors have priced this into their valuations with the S&P India BMI Energy Group Index showing a 29% YTD decline.

Source: S&P India BMI Energy Group Index

For automobile manufacturers, COVID-19 and the BS-VI transition have complementary effects: they extend the period of normalisation, most likely now to FY22. With depressed sales volume, high adjustment costs and higher product prices, the valuations of these firms have taken a hit. The S&P India BMI Automobiles Index shows a sharp decline since February 2020. The gloomy outlook for the sector is likely to continue until the spectre of the COVID-19 demand shock fades away. 

Source: S&P India BMI Energy Group Index
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