The Comptroller and Auditor General's (CAG) performance audit of some production sharing contracts instituted as part of the liberalisation of India's oil exploration and production policy may turn out to be the next big scam with more than a whiff of corruption. But, in this season of scams, danger lurks. The danger that much of society can for a considerable period of time miss the wood for the trees. Circumstances strengthen this tendency. In particular the surprising coincidence of a host of revelations of lack of due diligence, bending of the rules, outright manipulation or a combination of all of this that hugely enriches a few individuals and corporations in the private sector and a few functionaries of the state, most often at the expense of the exchequer. Not a day passes without evidence of some new scam.

Whatever may be the cause for this recent increase in scam-related revelations, the surge feeds the notion that corruption has reached unprecedented levels and constitutes the fundamental problem facing India today. The fact that, besides being ethically wrong or morally abhorrent, corruption can influence growth in ways that serve the interests of a few, and can therefore be deeply inequalising cannot be denied. But the reason these developments that are seen as mere instances of corruption have multiplied in number could be systemic and reflect policy shifts that aim to use state resources to inflate private profit. Private enrichment at the expense of the state exchequer may be embedded in the direction that policy in India has taken since the early 1990s. In the process, there may be some in government who use the opportunity to enrich themselves. But to presume that outcomes would have been different had corruption not played a role, may be wrong. Preventing observed outcomes may require more fundamental changes. Ignoring those and focusing on corruption may result in an unconscious alliance between those who want such outcomes and those who are opposed to them.

Consider for example recent allegations of malpractice in India's oil sector. They are based on a leaked draft performance audit report by the CAG of certain blocks of gas and petroleum reserves being exploited under the system of production sharing contracts (PSCs) between the private and the public sectors. Those PSCs, in turn, were designed under the liberalised New Exploration Licensing Policy (NELP) aimed at attracting private capital to do the job that the public sector undertook for long in India. The controversy relates in particular to the D6 Block in the Krishna-Godavari Basin. The right to exploit the block under a PSC was awarded in the first round of bidding (NELP-1) to a joint venture of Reliance Industries Ltd and Niko Resources Ltd (in which the former held an overwhelming majority of shares). The CAG's conclusion is that officials in the Directorate General of Hydrocarbons and the Petroleum Ministry allowed RIL to work the contract in a manner which inflated its profits, while reducing the revenues accruing to the exchequer. In sum, the argument is that RIL was favoured in ways that defrauded the tax payer to increase its profits. Allegations of corruption are only short step away from this conclusion, making it the cause of the transfer from the state to the private sector.

The focus here is on the PSC. Under the liberalisation of rules governing a sector that was earlier reserved solely for the public sector, production-sharing contracts have been designed such that the private contractor, who incurs the capital expenditure and is seen as taking all the risks involved in discovering and supplying gas to the market, has a greater right to the revenue stream that flows from the sale of the gas till capital costs are covered. Even after that, the private contractor has a greater right because it needs to cover operating costs besides getting a share of the profit. It is when the revenues earned rise relative to capital and operating costs that the government's share in production and revenues, which is sheer ''profit'', turns significant. In the case of KG-D6, the contract was structured such that, RIL paid the government 10 per cent of the total revenue computed at a mutually agreed arms length price, until Reliance recovers 1.5 times its investment. The government's take would rise to 16 per cent of that gas value when revenues amount to 1.5 times to two times the RIL's investment, to 28 per cent when revenues amount to two to 2.5 times the investment and 85 per cent thereafter.

Since the government's revenues (embedded in its share of the gas marketed under the production-sharing contracts awarded under various rounds of NELP) are computed in this manner, its interest lies in keeping capital and operating costs needed for any level of production down and in ensuring early realisation of the targeted production levels, so that revenues exceed capital and operating costs by a significant margin. It should be clear from this structure of production sharing contracts that revenues accruing to the private sector are influenced by: (i) the capital and operating costs it is estimated to be incurring; and (ii) to the ''surplus'' revenues it garners depending on the volume of production and the price at which gas is sold, which it shares with the government. If costs are inflated, the profits accruing to the private contractor would be larger than ''legally'' permissible under the contract. And if the costs are inflated and/or the volume of output restricted, the smaller would be the revenues (and profits) accruing to the government. The latter is important because, at any mutually agreed price, if costs can be inflated, it pays the private sector to keep production down, since it would have to hand over a smaller share of revenues to the government, increasing its share in profits substantially. Though the volume of private profit would be lower in any given year because of lower output and revenues, the cumulative profits it earns over time would be much larger.

The CAG's suspicion in its draft performance audit (relating to financial years 2006-07 and 2007-08) seems to be that, in the case of the KG-D6 gas fields, RIL has inflated capital costs substantially. The basis for this suspicion is the fact that the development cost of the block was raised from the original estimate of $2.4 billion when the contract was awarded in 2004 to figures of $8.5 billion in 2006: $5.2 billion for the first phase and $3.3 billion for the second phase. This revision was made through an ''addendum'' to the initial development plan rather than through the preparation of a revised comprehensive development plan. Moreover, the CAG finds that there is a lack of adequate detail with regard to the Phase-II development estimated to cost $3.3 billion. This makes it extremely likely that the private contractor would hike the Phase II development costs through further such ''addendums'' in the future. The net result is a huge loss of revenues to the state, which the CAG leaves unestimated. Presumptions are that, if true, the actual inflation of profits and loss to the exchequer would have been substantial.

There are two ways in which such gain, if any, to Reliance can be interpreted. The first is that it is the lack of due diligence on the part of the government and the officials it nominated to the management committee of the project. Such lack of diligence may, in turn, be attributed to sheer incompetence, lethargy or deliberate omission in return for illegal gratification and this is what, many argue, needs to be investigated. The other is that it may be the result of conscious policy, of which the NELP was a part, to favour private players so as to ''induce them'' to undertake the investments that the government was reluctant to make. That reluctance, it must be noted, cannot in this case be attributed to lack of resources, given the ease with which the initial investment could be recouped.

However, this is not the only way in which Reliance has been favoured. It was also the beneficiary of the pricing policy for petroleum products adopted post reforms, where the belief was that given India's substantial dependence on imported petroleum products, domestic price levels should be calibrated to reflect international prices so as to reduce the subsidy being provided to consumers. In 2004, RIL won a bid to supply 12 mscmd (million standard cubic metres per day) of gas to the National Thermal Power Corporation at a price of $2.34 per mBtmu (million British thermal units). Further, at the time of split between the Ambani brothers leading to an asset sharing agreement, this was the price at which gas was offered to the Anil Ambani-controlled RNRL for use in two power plant projects that it was to set up at Dadri in Uttar Pradesh and Patalganga in Maharashtra.

That was the then prevailing market price. But thereafter the market/international price rose significantly. Taking the cue from there and the principle whereby RIL could set a price for gas in negotiation with the government which earned from it a share in profits, RIL proposed in 2007 a higher price to the government of $4.33 per mBtmu, based on limited bids from a shortlisted set of power and fertilizer companies which would consume the gas. This price was examined by a committee of Secretaries, which recommended lowering it to $4.20 per mBtmu, to take account of the appreciation of the rupee. The pricing formula was subsequently accepted by the government based on the recommendation of an Empowered Group of Ministers (EGoM), which felt that accepting it was important since: ''it would not be in the country's interest to renege on the contractual provisions under the PSCs [production sharing contracts] entered into in good faith under the New Exploration and Licensing Policy."

In sum, the price was not a cost plus price taking account of costs incurred at KG-D6 field, but the rupee equivalent of the prevailing international price. However, once fixed it does not seem likely that the price would be adjusted downwards when international prices decline. Reform first involves large concessions, which once offered cannot be withdrawn since it would ostensibly amount to a breach of faith. If the original price of $2.34 per mBtmu is indicative of where the cost plus price should settle, it could be expected that Reliance would be covering costs in a short period of time and making significant profits, if costs had been inflated as the CAG suspects. The difficulty is that public sector units like the NTPC that are reliant on KG-D6 gas are paying this higher price, reducing their profits and surpluses, which also are state revenues.

But this, possibly, does not complete the story on how RIL is reaping huge gains from KG-D6. The other route is by restricting output, so as to reduce payout to the government as per the production and profit-sharing formula described above. As per the original PSC, the D6 was to produce 40 million mscmd. This was raised to 80 mscmd from a total of 31 wells, which was to be achieved by April 2012. According to the time line in the field development plan, Reliance had committed to putting 22 wells on stream by April 2011, producing 61.88 mscmd of gas. However, as of April there were only 18 wells in production. Moreover, output from these wells has been falling over time. According to reports, Reliance had achieved a production of 53 million cubic metres per day from 16 wells in March last year but since then there has been a drop in production to about 42 mscmd. This has led to a spat between RIL and the government on two counts. To start with, the government has issued an order diverting a larger share of the lower output to core industries such as power and fertiliser. But RIL wants to service non-core sectors including steel, on the ground that diversion to core industries would have financial implications. Essar Steel, which was allocated 3.2 mscmd and is now getting less than one-fifth of that amount, has moved the Delhi High Court, which as of now has upheld the government's position. Secondly, since Reliance has built production facilities to support 80 mscmd of production but production is much less, the DGH wants to protect the government's profit share by reducing the recovery of capital costs to two-thirds of that spent in building those facilities, releasing more surpluses to be shared by the government. These conflicts are yet to be resolved, but the government is clearly not buying the line that reduced production is the result of a drop in reservoir pressure as RIL claims.

Whatever may be the situation, there appears to be more than one way in which Reliance seems to be garnering additional profits at the expense of the exchequer. And not in all cases is that because of explicit collusion with government officials. It really stems from the neoliberal reform that sought to attract private capital into a lucrative and sensitive area like petroleum, believed that it should offer substantial concessions to attract such capital even if at the expense of the exchequer, and opted out of even regulation. It is reform of this kind that is the real problem facing the country. That it provided the ground for increase in corruption should not lead to a diversion of attention from the principal problem at hand. That would amount to gassing the state and shielding the private sector.

Note: This article was originally published in The Frontline, Volume 28 Issue 14: July 02-15, 2011.