Electricity: Overhauling tariff policy for a renewables-driven future

Two questions with surprising answers.

 

First, how much do Indian states subsidise electricity for farmers and households? Second, what is the tax imposed on electricity used by Indian industry? 

On the former, experts point to budgetary subsidy allocations of about ₹2.1 trillion in 2023–24 (see the report to the 16th Finance Commission). But the true “economic” subsidy — measured as the gap between the cost of supply and the price these 

consumers actually pay — is closer to ₹4 trillion (a staggering 1.4 per cent of gross domestic product, or GDP), nearly double the official figure. 

On the latter, policymakers cite electricity duties, which range from zero to 16.5 per cent across states. In reality, the implicit tax on manufacturing through electricity pricing is far higher — often pushing tariffs to nearly 1.5 times the efficient cost for much of the past decade, as Devesh Kapur and one of us document in a recent book, A Sixth of Humanity. 

These discrepancies have implications for policy reforms. But to understand them, we must first understand how electricity tariffs are set in India. The animating principle, indeed the obsession, is equity: Subsidising farmers and households. The challenge then is to pursue this without financially crippling electricity distribution companies (discoms). 

The figure shows the true economic subsidy (the gap between cost and price), and how it has been financed since FY18. It comes from four sources: Explicit budgetary subsidy transfers, higher tariffs on commercial and industrial users (the so-called cross-subsidy), central and state government grants, and discom losses. 

What is commonly reported as the “power subsidy” (₹2.1 trillion) captures only the first of these. The rest are hidden. The term “cross-subsidy” itself is Orwellian. It is, in effect, a punitive tax on economic activity. Because some consumers are charged well below cost, discoms compensate by charging industrial and commercial users well above cost. 

There has been some progress. Discom losses have declined recently. The share of subsidies funded through explicit budgets has increased, and reliance on cross-subsidies has declined. But the remaining tax burden is still large (about 50 per cent above efficient cost), and it continues to undermine the competitiveness of Indian manufacturing. 

Successive reforms have tried to fix this. The Electricity Act of 2003 mandated cost-reflective tariffs and explicit subsidies. 

The proposed Electricity (Amendment) Bill, 2025 pushes in the same direction. Yet, more than two decades later, cross-subsidies persist. 

Why? Because equity is invoked at every stage — by actors who are, functionally, the same entity. State-owned discoms propose tariffs for farmers and households that are already below cost. Regulators — often staffed by former bureaucrats or discom officials — approve them. State governments then announce subsidies relative to this artificially low baseline. 

In a well-designed system, the regulator would determine the true cost of supply, and set tariffs on purely technical grounds. 

Setting tariffs below cost would not be allowed. If governments wish to subsidise certain consumers, they should do so explicitly — by paying the full difference from their budgets. Equity is the government’s prerogative, and its burden, not the regulator’s nor the discoms’. 

The current system creates perverse incentives. By keeping tariffs artificially low, governments can expand subsidies — especially for households — without a commensurate increase in their reported subsidy bill, because the subsidy is calculated against an understated baseline rather than the true cost. This allows states to promise free or cheap power while keeping the official numbers manageable. 

The result is more subsidy than is affordable — and less equity than intended. Nearly 60 per cent of household electricity subsidies accrue to the middle class and the rich (the top 10-20 per cent), not the truly needy. The competitive populism of recent years in electricity pricing is a direct consequence of these distorted incentives. 

But the costs do not disappear. They are shifted to industrial and commercial users who pay through higher tariffs. Future taxpayers pay through eventual bailouts of financially stressed discoms. Note that the central government and state governments, by providing periodic grants, and public sector entities such as the Power Finance Corporation (PFC) and Rural Electrification Corporation (REC), by providing ongoing financing, are all complicit in softening the budget constraint of discoms and allowing the problem to persist.

 

This tariff policy framework once had some logic. When administrative capacity was limited, redistribution had to be done through the price system, differentiating prices by end-user. But that is no longer the case. With direct benefit transfers and better targeting, subsidies can be delivered more efficiently — without distorting prices or taxing industry. 

If governments wish to tax industrial and commercial users, they should do so transparently through electricity duties. Over time, electricity should also be brought under the goods and services tax (GST), allowing firms to claim input tax credits. The current system of cross-subsidisation is a non-transparent substitute. 

Eliminating cross-subsidies, therefore, cannot be done in isolation. It requires a fundamental redesign of tariff policy — clarifying the roles of regulators, governments and discoms. Regulators should focus on technical and consumer protection functions, as the Telecom Regulatory Authority of India does. Governments alone should pursue equity — and bear its full fiscal cost. 

Unless tariff policy is revamped, India’s discoms will be more obstacles than catalysts in the transition to a renewables-driven electrostate. And the war in West Asia is a grim reminder that India’s dependence on imports of fossil fuels is high and has been rising. Resilience will mean reducing that dependence, which, in turn, will require an efficient electricity sector. 

 

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The authors are, respectively, visiting fellow, Madras Institute for Development Studies; principal consultant, Centre for Effective Governance of Indian States; an independent consultant; and senior fellow, Peterson Institute for International Economics