SPY EYES

India is facing an energy crisis that is slowing economic growth in the world’s largest democracy.

At stake is India’s ability to bring electricity to 400 million rural residents—a third of the population—as well as keep the lights on at corporate office towers and provide enough fuel for 1.5 million new vehicles added to the roads each month.

Shortages of coal, oil and natural gas will require India to import increasing amounts of high-cost fossil fuels, say energy experts, risking inflation and putting the country in stepped-up competition with China, Japan and South Korea. Buying oil from Iran, one of India’s biggest suppliers, is tougher because of U.S. and European sanctions aimed at curbing Tehran’s nuclear ambitions.

With annual demand expected to more than double in the next two decades to the equivalent of six billion barrels of oil, the energy crunch threatens to knock India off its growth path. The national economy has already slowed amid paltry business investment and stalled reforms. It tallied just 5.3% growth in the quarter that ended March 31, the lowest level in almost a decade and well shy of the country’s 9% goal.

Expensive imports have taken a toll on the nation’s finances. Though global crude oil prices have eased in the past few months, India is seeing little benefit because its currency, the rupee, has been dropping against the dollar, the currency used to price oil.

State-run energy companies are racking up billions of dollars in losses by selling auto fuel, cooking gas and electricity at artificially low prices to protect consumers from global cost increases. In May, India’s oil marketers raised gasoline prices 11.5%, the largest increase ever. The move was a sign of new urgency in the government to improve the fiscal health of the oil companies, though prices were cut 3% after a public backlash.

Economists say gasoline prices need to increase more, with the tougher task of deregulating the prices of diesel and cooking gas still ahead.

“The prime minister and a few wise men are beginning to realize that there’s a very bleak outlook in terms of energy security, and that this is going to create the single largest constraint on the economy, one of alarming proportions,” said Gokul Chaudhri, a partner at New Delhi-based consultancy BMR Advisors, whose clients include Indian and foreign energy firms.

Vast tracts of rural India lack electricity. Even in such business hubs as Delhi’s suburb of Gurgaon, companies employ backup generators because of regular outages. Factories are forced to curtail production. And vaccines that require refrigeration go bad because of spotty service.

After top power companies lobbied Prime Minister Manmohan Singh, the government in April issued a presidential directive ordering Coal India Ltd., 533278.BY +0.68% India’s state-run monopoly, to increase production or imports. Officials also cut India’s electricity generation target for the next five years by 25%, reflecting worries the coal shortage will continue.

The government had looked to natural gas. But a production shortfall at the nation’s largest known gas field—operated by Reliance Industries 500325.BY 0.00% —has India racing to increase gas imports.

India now imports three-quarters of its oil, and the price tag has been growing. The import bill was $141 billion in the past fiscal year, a 41% jump over a year earlier. As global oil prices have declined, India’s crude oil import costs have decreased about 15% in dollar terms since January. But the rupee has depreciated 12% over that time, canceling out the gain.

New Delhi is the second-largest importer of Iranian oil behind China, but will increasingly have to look for alternative suppliers in light of U.S. and European sanctions. India has already reduced Iranian oil imports from 16% of total crude purchases in 2008 to about 10%. The government pledged to reduce purchases another 11% in the current fiscal year. Washington last month exempted India along with some other countries from new sanctions.

Domestic oil fields are maturing, production is barely increasing and companies complain regulations are stifling. Cairn India Ltd., 532792.BY +2.16% India’s largest private oil producer, said in March it might scrap a $6 billion spending plan after the government proposed an 80% increase in taxes on its production.

“We are headed 100 miles an hour into a brick wall on energy security unless we do something radically different,” Rahul Dhir, Cairn India’s chief executive, said.

Plans to boost nuclear energy production faltered after the Indian Parliament passed a law that foreign equipment suppliers say would burden them with liability after accidents, rather than plant operators, which is the international standard. Environmental protests after the Fukushima disaster in Japan last year also have delayed the opening of new nuclear plants.

“Are we doing enough to produce our own energy?” Montek Singh Ahluwalia, deputy chairman of the government’s Planning Commission, said. “The short answer is that we need to do more.”

Energy imports will be costly for India’s already shaky public finances, economists say, and the government will have to pass on higher costs to consumers and businesses. That won’t be easy. Residents depend on government subsidies to lower prices for electricity, auto fuels and cooking gas.

Last month, Standard & Poor’s cited India’s yawning 5.8% budget deficit and inability to reform fuel subsidies as reasons it was considering downgrading the country’s debt from investment-grade to junk status. Fitch, another ratings firm, later joined S&P in cutting its outlook on India’s sovereign debt from “stable” to “negative.”

“India has a very distorted system of subsidies,” Jaipal Reddy, minister for petroleum and natural gas, said. “But how, in a vibrant democracy like in India, do you change the system suddenly?”

The country’s energy crunch can be overcome, he said: “We’ll have to pay for more, that’s about all. It does not weaken the long-term growth story.”

Coal shortages are largely a result of Coal India’s inability to produce enough. The state-controlled firm said in April that production in the fiscal year that ended in March was 435.8 million tons—1% more than the previous year but 16% short of the target set by India’s Planning Commission.

At the end of March, 32 power plants had coal stocks described as “critical” by the government—less than seven days worth—and two dozen plants were running at less than 60% capacity.

Coal India needs to accelerate exploration, step up mining operations, improve its rail delivery system and spend some of the $8.8 billion in cash on its books to upgrade equipment, according to a recent draft of a government audit. Coal India didn’t respond to a request for comment.

In Jharli, a village 60 miles west of New Delhi, pharmacist Ram Singh Luhach said he routinely throws away tetanus and rabies vaccines that go bad in a refrigerator that only gets a few hours of electricity a day. Down the road, mustard seed farmer Satveer Singh has a water pump to irrigate his fields. But he only gets about two hours of electricity during the day and five or six at night.

Mr. Singh hooks his water pump up to a tractor that keeps it running for several more hours—with the cost of diesel fuel eating into his $120 monthly income. “If I get more electricity,” he said, “I could double my production.”

A few miles away, a 1,320-megawatt power plant built by Hong Kong-based CLP Holdings Ltd. 0002.HK +1.23% has sprung up, along with housing for 2,500 workers. The first of two 660-megawatt units was ready in January but has been mostly idle for six months because of a lack of coal. CLP said at best it would likely get 60% of what it was originally promised from Coal India and would either have to import coal or run the plant well below capacity.

Rajiv Mishra, CLP’s managing director in India, said in recent months he would start his day by asking how many rail wagons of coal had arrived. The second power-generating unit is ready but the firm won’t start operations without reliable supplies, according to CLP, which has invested $1.3 billion in the plant.

“In India we just don’t solve a problem until it becomes a crisis,” Mr. Mishra said. “We have done what was our responsibility, which is build one of the country’s largest plants on time. But obviously full-scale operation depends on getting sufficient coal supplies.”

At Coal India’s mine 700 miles away in Jharkhand state, 15 men worked in a 400-foot-deep pit on a recent afternoon, digging coal with bulldozers and hauling it across dirt roads in dump trucks. The coal was loaded into rusted train wagons for its three-day journey to the CLP plant.

Workers, who wore scarves against the dusty air, said aging equipment slows their work. They also face security threats from leftist militants who want a share of the mining profits. The militants, part of a broader Maoist movement in India, issued 22 threats last year that forced the Jharkhand mine to shut down—usually for two days at a time, mine officials said.

The coal shortage is hobbling London-listed Vedanta Resources PLC, which is building a 2,400-megawatt power plant in the eastern state of Orissa. Coal India said it could deliver only half the supply promised in 2006, before construction started. “If we’d known this fact,” said Abhijit Pati, the plant’s chief operating officer, “we would never have invested in this.”

After spending $2 billion on the 2,800-acre complex, company officials said they had no choice but to accept a reduced supply. The plant’s three operating units are running at 65% of capacity.

The presidential directive in April requires that Coal India supply at least 80% of what it promised plants or face financial penalties. Coal India’s only choice is to ramp up imports.

To expand production, the Indian government has allotted some coal mines to private firms. But of 194 private mining blocks issued through April of last year, only 28 were running. Many companies blame delays in obtaining environmental permits from the government. The government has said it is the companies that are dragging their feet getting mining operations set up.

Natural gas—which is used in public transportation, cooking fuel and the making of fertilizer—has its own troubles. India was banking on a $5.6 billion project in the Bay of Bengal off India’s east coast. Reliance Industries discovered the gas in late 2002, an apparent energy bonanza.

Output was projected to reach 2.8 billion cubic feet per day in the fiscal year that began April 1. Instead, output is now about 1.05 billion cubic feet per day and could fall to 600 million units in the next two years, the company said.

India’s efforts in April to strike a long-term gas supply deal with Qatar faltered over price, about $20 per million British thermal units, or more than triple the cost of Indian domestic gas.

Exploration for gas and oil discoveries isn’t going well. Since 1998, the government has issued 87 exploration blocks to companies through competitive bidding. Only three blocks have gone into production.

Interest in India is waning among the global oil companies that dominate exploration: Eight of the 37 companies that bid in the last round of auctions were foreign companies, down from 21 in 2008.

Mr. Reddy, the oil and gas minister, said he was considering allowing firms to sell what they produce at higher prices to attract more investment. Companies complain that government price caps are too low.

Policy makers are resigned to costly imports for now. “In all probability the import dependence in primary energy is going to increase,” said Mr. Ahluwalia of the Planning Commission. “The real issue is, ‘Can we pay for that energy?’ ”

—Andrew Browne in Beijing and Arup Chanda in Jharkhand, India, contributed to this article.

The Wall Street Journal