However, the under-recoveries could decline to Rs 0.8 trillion if diesel prices are increased at Rs 1 per litre every month as being proposed, it said.
"We have increased our estimate of gross under-recoveries on diesel, kerosene and LPG to Rs 1.3 trillion for FY14 versus our previous estimate of Rs 1 trillion, assuming higher crude oil prices, weaker exchange rates and no further increase in retail prices of regulated fuels," senior executive director of the firm Sanjeev Prasad said in a note.
The firm has assumed an increase of USD 5 per barrel to USD 105 and exchange rate at Rs 54 against the US dollar to arrive at the estimated increase in under-recoveries for FY14, it said.
"However, if we were to assume a monthly increase of Re 1 per litre in retail price of diesel for FY14 along with roll-back of cap on LPG cylinders to nine, the under-recoveries will decline meaningfully to Rs 0.8 trillion," he said.
The Petroleum Ministry is considering a gradual increase in diesel prices of less than Re 1 per litre on a monthly basis over the next 15 months in a bid to eventually deregulate retail prices, based on the recommendations of Kelkar committee.
Progressive increase in diesel prices, if implemented, may lead to meaningful savings on fuel subsidies. "We compute annualised savings of Rs 90 billion on diesel subsidies for every Re 1 per litre net increase in diesel price for oil marketing companies," he said.
However, the report said it was doubtful if the government would be able to continue monthly price increases in the second half of the fiscal given that there are many state elections during January-March and the general elections in 2014.
The report further said higher market-linked prices of diesel for the direct bulk consumers will be relatively easier to implement and may reduce the subsidies meaningfully.
"Nearly 18 per cent of diesel is consumed by bulk customers including the Railways, state transport undertakings and private industrial companies, who do not deserve any subsidy, in our view," Prasad said.
The government's plans to increase cap on subsidised LPG cylinders to nine per household per annum from current limit of six can be managed through a price hike.
"We expect the annual savings on LPG subsidies to reduce to nine per cent assuming the proposed cap of nine cylinders per household per annum versus 28 per cent assuming current cap of six," he added.