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 India is planning to discourage the diversion of sugar for ethanol production as part of efforts to ensure sufficient supplies of the sweetener in the local market, government and trade sources said on Wednesday.

Lower diversion for ethanol will help the world's second biggest sugar producer in increasing output of the sweetener, which is expected to fall because of below normal rainfall in key growing states.

The government could ask mills not to use sugar cane juice and B-heavy molasses - a byproduct with higher sucrose levels - to produce ethanol, they said.

India's fuel retailers buy ethanol from sugar mills to blend with gasoline and they were paying higher price for ethanol produced from juice and B-heavy molasses.

"After assessing the demand-supply situation, the committee of ministers decided to focus on sugar production this year," said one of the government sources who declined to be named according to official rules.

The government would allow mills to produce ethanol only from C-heavy molasses, a cane by-product that has hardly any sugar content left in it, the second government official said.

The new guidelines for ethanol procurement in the 2023/24 marketing year, which commenced on November 1, will be finalised soon and oil marketing companies are likely to honour contracts already awarded, the first source said.

The government's move is a setback for the industry, which has invested billions of dollars in the last five years to increase ethanol production capacity, said a senior industry official who declined to be named.

"Hopefully, this setback will be short-term, and the government will shift its focus back to ethanol once sugar cane supplies improve," the official said.

Patchy rains in the top sugar cane-growing western state of Maharashtra and southern Karnataka state have raised concerns about this year's sugar output.

The Indian Sugar Mills Association, a producers' body, last month said sugar production is likely to fall 8% to 33.7 million metric tons in the 2023/24 marketing year.

The likely production drop has lifted local sugar prices to their highest levels in nearly 14 years