As India's economy accelerates, so does the quest for energy to keep its growth humming. The country's consumption of coal, oil, natural gas, and electricity is projected to rise by nearly 40 percent over the next five years and almost to double by 2020. Already, surging energy demand is outstripping supply (Exhibit 1), raising hard questions about how India will cope in the future. Electricity is such a chronic problem that manufacturers endure an average of 17 major power disruptions every month, according to the World Bank. Despite vast coal reserves, domestic production has lagged behind demand for ten years, and the shortfall is growing. What's more, India imports 70 percent of its petroleum, exposing it to wild swings in world energy prices and pitting it against China and other countries keen to buy hydrocarbon reserves.

India has taken important steps to increase the availability of affordable energy. A reform of the electricity sector, begun in 2001, recapitalized bankrupt state electricity boards and liberalized the generation of power. The country stepped up its efforts to secure oil and natural gas by investing in fields from Russia to Sudan as well as by encouraging private investment in domestic exploration. It is also pursuing agreements with its neighbors to build pipelines that would bring natural gas from Iran, Turkmenistan, and other gas-rich countries in the region.

These measures are bearing fruit. In the five-year period from 2002 to 2007, India will probably add more electricity generation capacity than it did in the previous ten years. Distribution losses from theft and the creaky infrastructure have declined by almost one-third over the past three to five years in a few states, such as Andhra Pradesh and Delhi. India's domestic reserves of oil and gas are growing thanks to recent discoveries, and its national oil companies' portfolio of foreign reserves has increased significantly in recent years.

Yet current efforts won't meet the country's growing appetite for energy. The government estimates, for instance, that coal production will lag behind demand by about 100 million metric tons as of 2012, and India's current electricity-generating shortfall—more than ten gigawatts—is likely to worsen even if all power plants now under active consideration are built. The only choice is to pursue a number of sources of additional fuel, to further liberalize domestic energy markets, and to upgrade the overburdened infrastructure. India must also attract much more private capital, since government spending alone won't be able to finance the more than $225 billion needed for energy projects from now until 2012.

The growing need for energy

India is the world's fifth-largest energy consumer and in the near future will pass Japan to become the fourth largest. Strong economic growth and rising incomes are pushing up demand rapidly. By 2012 India's consumption of energy (excluding biomass) will reach the equivalent of 550 million metric tons of oil annually, up from about 375 million metric tons in 2004. Several parts of India's energy sector may not be able to keep up with that surge.

Supply and pricing challenges

India's greatest energy challenge is meeting the demand for electricity. Given the current pace of economic growth, the country must add about 90 gigawatts of power generation capacity by 2012—nearly doubling today's capacity of 115 to 120 gigawatts. That's the equivalent of duplicating the United Kingdom's entire generating capacity in just seven years. The new power plants, along with transmission lines and distribution equipment, will probably cost about $170 billion. Moreover, the amount of coal and natural gas needed to generate electricity will double: hydroelectric power projects are limited by rough terrain and by the challenge of resettling displaced people, while India's nuclear-power program will take years to benefit from recently renewed technology assistance from the United States. Both coal and gas are abundant in India and nearby countries, but a lack of gas pipelines and other infrastructure could keep electricity in short supply for years.

Take coal. Although India sits atop the world's fourth-largest reserves, domestic production lags behind demand, and imports have grown since 1992. Coal India, the inefficient state-owned monopoly, delivers just 89 percent of its coal commitments to power plants, down from 96 percent two years ago. Unless competition and other major coal sector reforms are introduced, the annual domestic production shortfall is likely to exceed 100 million metric tons by 2012, especially if demand for electricity grows more quickly than anticipated (Exhibit 2). A gap of this magnitude could cut India's growth rate by one percentage point.

Higher coal imports might fill the gap but would raise other difficulties. India's ports and railroads are already overburdened. The average turnaround time for ships in the ports is four days, compared with 12 hours in Hong Kong and Singapore. Substantial investment will be needed before India's ports can handle higher volumes. Also, imported coal will be more expensive, raising electricity generation costs by more than 25 percent and reducing the competitiveness of power-hungry industries such as metals and manufacturing.

Likewise, natural gas will continue to be in short supply. India produced about 26 million tons of oil equivalent (MTOE) of natural gas in 2005. Encouraging its greater use as a clean fuel to generate electricity could push demand as high as 75 MTOE by 2012. Recent domestic discoveries in the Krishna Godavari Basin and liquefied-natural-gas (LNG) terminals that have been completed or are now under construction could supply as much as an extra 25 to 30 MTOE. The difference—20 to 25 MTOE—will have to come from additional imports.

Moving that volume would require pipelines from gas-rich places—Iran, Myanmar, or the countries of Central Asia. But negotiations with those producers are far from complete and might never succeed. Indeed, proposed pipelines from Iran and Turkmenistan would have to cross Pakistan, India's adversary in several wars. Security with Pakistan remains a major concern, despite the recent thaw in relations. LNG arriving by boat will fill the gap in the near term. Petronet LNG (an Indian joint venture) and Royal Dutch/Shell have recently opened two terminals near Mumbai. Further investments in LNG terminals, however, may be limited by concerns that cheaper natural gas from pipelines or inexpensive electricity from new coal-fired generators could eventually undermine demand for LNG.

Reliance on foreign oil

Dependence on imported oil is growing rapidly as more vehicles crowd India's roads, but domestic oil production remains flat. Declining production in older fields has offset recent improvements in the recovery of oil from a few major fields and new discoveries spurred by private investment in exploration. Imports, which met nearly 70 percent of demand and cost India $29 billion in the year ended March 31, will likely rise to meet from 75 to 80 percent of demand in 2020 (Exhibit 3). By then India will have become the world's fifth-largest oil importer, after the United States, China, Japan, and South Korea.

That prospect raises the economy's exposure to oil price gyrations and heightens concerns about supply security. India's state-owned Oil and Natural Gas Corporation (ONGC) recently increased its level of foreign exploration, investing about $3 billion in leases in 12 countries, including Iran, Libya, Russia, and Sudan. But even if all those investments produce oil, they will probably slake only about one-fourth of India's thirst for it in 2020, and the country is likely to face a shortage of refineries to convert oil into gasoline and other useful products. Despite the recent expansion of existing capacity, demand for refined petroleum products is expected to outstrip capacity by 2008-09. To fill the gap, India must invest as much as $10 billion to add 15 million to 30 million metric tons of annual capacity by 2012, excluding the output of export-oriented refineries.

The large investment needed to meet India's growing energy appetite presents a major challenge. The government's ability to spend is crimped by the country's 4.5 percent federal budget deficit and by increased outlays for social programs, such as recently introduced employment guarantees that will cost about $10 billion annually. Foreign investors—from multinational corporations to energy-rich countries keen to gain access to India's fast-growing market—may not fill the gap. Coal mining remains off limits to private companies unless it is tied to a steel mill or a power plant. Moreover, potential investors fear that changes in the political winds could derail infrastructure projects.

Renovating Indian energy

India must rapidly strengthen and reform its energy sector. The task is formidable given the magnitude of the country's energy needs, the breadth of industries involved, the huge investment required, and the political hurdles to overcome. Several areas require urgent attention.

Deregulate and restructure the coal sector

One important step will be deregulating and rejuvenating the coal industry to take full advantage of India's vast reserves. Coal will supply about half of the country's energy for decades, and with the right government measures most of it can continue to come from inexpensive domestic sources.

For starters, India must open coal mining to competition, including private- and public-sector Indian companies as well as multinational corporations. Liberalization will create an open market for domestic coal, spur Coal India to improve its performance, and help attract some of the $10 billion to $15 billion investment required by 2012 to upgrade existing mines and open new ones. The government will have to offer investors access to state-owned mining blocks, while Coal India should be encouraged to develop its unexploited leases in partnership with other mining companies. As the government discovered when it opened domestic oil exploration to private investors, the sooner economically attractive blocks are offered and successes become visible, the faster new production begins. Furthermore, an independent regulator should be installed to allocate government blocks in a transparent and fair way, and the approval process for new mines ought to be streamlined and clear time limits introduced, thereby removing a serious impediment to the rapid increase of capacity.

The government should also begin to deregulate prices—a move that must be implemented gradually and in parallel with increasing competition, since imported coal currently costs about $10 to $12 per million kilocalories of energy, twice as much as domestic coal's price of $4 to $5 per million kilocalories. Critics of deregulation fear that increases will lead to higher electricity prices and windfall profits for mining companies. The government can allay these concerns by phasing in price deregulation over the five to seven years needed for domestic competition to take hold. To ensure that electricity prices don't rise suddenly, it could freeze current prices in supply contracts for existing power plants.

Meanwhile, the government must launch a fundamental makeover of Coal India, whose mining costs are as much as 50 percent higher than those of leading coal-exporting countries such as Australia, Indonesia, and South Africa. To match the productivity of such global rivals, Coal India will have to invest in new technologies and improve its management processes, especially the way it plans investments and executes projects. A first step, providing a catalyst for improvement, would be to allow competition among Coal India's eight mining subsidiaries. Another would be to encourage joint ventures with world leaders in coal mining.

The successful reform of India's oil exploration sector, begun in the late 1990s, shows that a combination of competition, free-market prices, and dynamic company leaders can produce results. Indeed, this recipe raised investment in oil and gas exploration by both domestic and international companies, improved the performance of national oil companies such as ONGC, and spurred the discovery of important new reserves where none were thought to exist.

Orchestrating similar reforms in the coal sector will be more difficult than it was in the oil sector, and policy makers will have to tread carefully. To attract sufficient capital and added technology, they should encourage investment from both local companies and global mining majors. They will also have to issue new regulations supporting a free market, allow the formation of joint ventures or other alliances, and encourage the development of a shared infrastructure, such as dedicated rail lines and power transmission networks. To achieve these goals, the government will have to overcome opposition from strong political and business interests within the sector, which is a traditional source of political influence.

Strengthen the national oil companies

Although India's six national oil companies¹ have made tremendous progress over the past five years, they still have a long way to go to rival industry leaders; ONGC, for example, remains unable to find new domestic reserves as quickly as existing ones are depleted. The Indian upstream companies must improve their exploration technology and know-how as well as increase their use of comparative-management techniques such as the benchmarking of their performance in exploration. The performance of India's refineries also lags behind that of the industry leaders, and a useful first step would be to compare it with globally accepted efficiency benchmarks. India's refineries must reduce their downtime, become better able to match the output of individual products to market demand, and improve the planning and execution of capital projects.

As Indian companies expand internationally to secure oil reserves and increase production, they face greater risks as well as competition from large, established rivals. To succeed, the Indians must build a permanent presence in countries where they want to expand and establish teams of technical and business professionals to bid on overseas opportunities.

The national oil companies could be reformed more quickly if they had fewer ties with the government, which, as the majority owner, still controls decisions such as executive appointments and price setting. Privatization isn't an option at the moment, since it is opposed by parties on the Left, whose political support the current government requires. A compromise would be to create a holding company—run by experienced executives responsible for managing the government's stake in these companies—with less than 50 percent government ownership. That structure would give the boards of the companies greater independence to form alliances, to improve purchasing and price-setting procedures, and to hire talented managers with global experience.

Develop regional energy partnerships

The resource-rich nations of Africa, Asia, and the Middle East are attractive energy partners for India, since they are potential sources of both fuel and investment. These countries, for their part, seek access to large, growing markets like India and need the assurance of long-term demand before they expand oil and gas production. Only recently have the two sides begun to recognize the potential for closer economic cooperation.

Better diplomatic and commercial ties will be needed to make such energy partnerships a reality. India's government should encourage joint ventures and cross-shareholdings between companies in resource-rich nations and India's national oil companies or major energy users. It must also support regional cooperation in areas such as energy security and the creation of Asian markets for oil and gas.²

Strengthen logistics

India's domestic energy supply must be supported by a good distribution infrastructure. But from the seaports that receive shipments of coal and oil to the pipelines, railroads, and electric lines that carry energy across the country, $85 billion to $95 billion in investments will be needed to expand capacity. By far the largest sum—about $40 billion—is needed to strengthen the electricity transmission network, particularly to ensure that power from coal-rich eastern states, where it would make the most economic sense to build new power plants, can reach high-growth markets elsewhere in the country.

The government's plan to invest $2 billion to increase capacity and remove bottlenecks at existing major ports is a far cry from the estimated $30 billion that will actually be needed. The most effective way to improve productivity at important ports would be to privatize them. That process will take time, but in the interim the government can accelerate the turnaround of ships by cutting idle time for machinery, investing in more efficient cargo-handling equipment, and streamlining customs procedures.

The most effective way to improve productivity at India's important ports would be to privatize them, but that will surely take time

In addition, Indian Railways, the state-owned operator, must increase its freight capacity from the coal-producing regions in eastern India and major ports to the demand centers in the northern and central parts of the country. On the Indian rail network, freight trains get a lower priority than passenger trains, a problem that promotes delays and inefficiency. Special freight corridors would raise speeds, cut costs, and increase the system's reliability. The government should establish a work group in the Ministry of Railways, with funding and a mandate to plan and build these special tracks, to raise the $15 billion to $20 billion in capital they require, and to integrate them with existing rail operations. In addition, the railway should lower freight rates for coal and oil, which currently subsidize passenger fares. Improving the utilization of freight cars and passenger coaches would ease this politically sensitive transition by lowering unit costs.

Furthermore, India must spend an estimated $5 billion in the next ten years to expand the country's domestic network of oil and gas pipelines. But transport fees, which are government regulated, are too low for companies to justify fresh investment, and the approval process for pipelines lacks transparency, thereby making investors wary. For oil companies to find new projects attractive, the government must establish clear regulatory procedures and raise fees. Lobbying by companies with competing agendas has delayed a proposed law creating a new regulatory regime. To eliminate this barrier to investment, the government should finalize the bill and parliament should enact it.

Focus technology research

India's numerous technology research institutes are working on energy-related R&D projects, but in a fragmented fashion. The government could get a greater return on its investment by concentrating on a few important types of technology. First on the list, in response to tighter government emission standards, should be the further development of inexpensive clean-coal technologies to generate power. Nuclear power, which will benefit from renewed US technical assistance, should also continue to be a high priority. In petroleum research, the focus should be on areas relevant to India, such as technology to recover oil in deep water, to turn natural gas into liquid fuel, to extract methane from coal deposits, and to extract heavy, illiquid oil. High-voltage transmission and the optimization of distribution networks will be important to provide low-cost, energy-efficient ways of getting electricity from power plants to consumers. Efforts to make plant-based fuels viable for automotive applications are crucial as well.

To help ensure that technology has useful commercial applications, the government should encourage collaboration among private- and public-sector companies and scientific bodies such as the Council for Scientific and Industrial Research and the Atomic Energy Commission. Some of these agencies will likely need additional funding and clear marching orders if they are to be effective partners.

A unified government response

The breadth and urgency of India's energy challenge cry out for a unified response. Yet the government's current administrative structure divides the responsibility for energy-related matters across at least seven primary ministries (Petroleum and Natural Gas, Power, Coal, Non-Conventional Energy Sources, Heavy Industries and Public Enterprises, Commerce and Industry, and the Department of Atomic Energy) and seven related ministries (Railways, Environment and Forests, Water Resources, Finance, External Affairs, Science and Technology, and the Department of Shipping). That division of authority makes coordination difficult and generates piecemeal responses. To sidestep these problems, the government should establish a cabinet committee responsible for coordinating policy on India's resources and for breaking logjams that hinder progress. Then the prime minister and a few powerful cabinet members can focus on the most vital reforms.

India faces major hurdles in providing the energy needed to keep its growth engine running smoothly. Attracting new investment and reforming key industries, including coal, will be essential if the country hopes to avoid crippling shortages and higher, more volatile energy costs.