House of Commons - Agriculture

Select Committee on Agriculture Second Report

II. STATE AND STRUCTURE OF THE DAIRY INDUSTRY

8. In 1998 there were approximately 32,500 milk producers farming in the UK.[14] The industry is predominantly situated on the western side of England but it is of most crucial economic importance in Wales where milk represents 31% of agricultural GDP.[15] In all parts of the UK, however, the number of dairy farmers is in decline. This is part of a long-term trend dating back to at least the Second World War as figure 1 below indicates.

Figure 1: Number of Milk Producers in the UK

Source: UK Dairy Facts & Figures; FUW, Ev. p.23.

*Includes an estimate for Scotland.

This chart also shows a steadying of the rate of decline in 1995-1996 before a further fall in 1998. Over the last two years 8% of UK milk producers, 11% of Welsh, have left the industry,[16] and industry analysts predicted that "the rate of attrition seemed likely to accelerate with the continuing fall in milk prices in 1999".[17]

9. Milk production is regulated by quotas and therefore remains steady at around 14,200 million litres a year, a fall of 13.8% since 1983-84 as a result of cuts in the global EU quota. The high price of extra quota adds to the considerable pressure on dairy farmers to continue to increase efficiency and to expand to take advantage of economies of scale. It is therefore not surprising that the average yield per cow improved by 22% between 1984 and 1998 to reach 5,793 litres.[18] Larger herd sizes can also bring greater efficiency and higher net margins,[19] though gains in economies of scale are mitigated by the costs of buying or leasing additional quota. In England and Wales, the average herd had 75 cows in 1997, and in 1998 nearly 23% of herds consisted of at least a hundred cows.[20] Mr Perkins, Chairman of the RABDF, who farms three dairy herds in Kent with a total of 500 cows, told us that he had reduced his costs of production per litre from 19.5p in 1998 to 18.6p in October 1999, with an estimate of 18p by the end of 1999.[21] This was still on the high side, as Mr Brigstocke of HUKI told us that "the range of the costs of production, both variable costs and fixed costs, will be somewhere between 14p and 22p per litre across the whole spectrum of dairy farms".[22] Similar figures were offered by the FUW.[23] Farmers stressed that while they could try to reduce production costs, "most costs are out of our control".[24] Apart from quota costs, these include wages, veterinary charges, concentrate feed, regulatory compliance and other fixed overheads,[25] in addition to which there are bank charges to cover investment in new buildings or storage tanks.[26]

10. In spite of these investments and improvements, the profitability of dairy farms and thus the income of farmers has suffered a steep decline since the high point of 1996. MAFF forecast that average net margins per cow will have fallen by approximately two-thirds from 1996/97 to 1998/99 in real terms and that income for full time dairy farmers will be 40% lower in 1998/99 than in 1997/98, itself 35% lower than the previous year.[27] Figure 2 below demonstrates the scale and suddenness of the change in dairy farm profitability.

Figure 2: Dairy Farm Profitability
Net Margin (£ per cow)

Source: ONS, MAFF, Milk Marque Estimates; Ev. p.77.

The main cause of this dramatic decline is the price producers receive for their milk. Figure 3 below shows the average price paid to milk producers since January 1995.

Figure 3: Monthly United Kingdom Farmgate Milk Prices,
including bonus payments, pence per litre

*Average prices have been calculated from separate monthly surveys of milk

purchasers conducted in England and Wales by MAFF, in Scotland by SERAD and in

Northern Ireland by DANI. The surveys were introduced following changes to the

milk marketing arrangements in 1994/95. The farm gate price is the average price

received by producers, net of delivery charges. No deduction has been made for

superlevy.

Prices include any retrospective bonuses made by purchasers. Provisional from 1998

onwards.

The current prices are below the cost of production for all but the most efficient farmers, with the result that many of them are questioning how they can stay in business. The FUW believed that "the current situation is not sustainable for even the very best, the very most efficient producers and we have to move from here in order for them to survive, let alone anybody else to survive".[28]

11. One of the key questions we addressed during our inquiry was what determines the price of milk paid to farmers. Potential factors were identified as the impact of currency fluctuations on the intervention price supports for butter and skimmed milk powder under the CAP dairy regime, the procedures for selling milk from the farmers to the dairies and the interplay between different links in the supply chain. Of these, it is accepted that the collapse in the price of milk received by farmers is to a large extent accounted for by the strength of sterling. This has also damaged the competitiveness of other parts of the economy, particularly in internationally traded sectors challenged by cheaper imports and dearer exports. In the case of the dairy industry these pressures are compounded by the intervention price system. As sterling strengthens against the euro, UK sterling-denominated intervention prices for butter and skimmed milk powder fall, pulling down the Intervention Milk Price Equivalent (IMPE), which acts as a marker price in setting milk contract prices. As the pound continues to rise, the sterling value of the IMPE, which is set in euros, falls. At euro1.6 per £1 a 1% decline in the euro against the pound is equivalent to a reduction of 0.625 pence in UK support prices per euro. This differential is now wider because the appreciation of sterling against other European currencies since 1995 has reduced the sterling value of the IMPE and in the absence of green rates (since 1 January 1999) this has had an immediate effect on farmers' incomes. Consequently, in the UK there is downward pressure on the milk price which is not matched by reductions in the prices of most inputs, and UK producers are subjected to a cost-price squeeze which does not affect producers in other member

states. Figure 4 below shows that the UK is now bottom of the European milk price league, the first time in a decade that this has been the case.

Figure 4: European Milk Prices - 1998* (pence per litre)
and percentage change on previous year

*Provisional farmgate milk prices, standardised to 3.7% butterfat.

Source: ZMP; UK Milk Report - 1999/2000, p.15.

12. The UK Milk Report 1999/2000 noted that "while the £ had gone up against the ecu/E by 17.5% in the two years to 1998, the UK milk price fell by 22.5%",[29] thus indicating that factors other than the exchange rate are at play. Milk Marque produced a chart comparing prices expressed as a proportion of the target price in an attempt to remove the currency effect which, Milk Marque claimed, "demonstrates that prices received by UK milk producers have long been amongst the lowest in the EU"[30] (see figure 5 below).

Figure 5: Producer Prices in EU Countries
Percentage Target Price

Source: Milk Marque, Ev. p.76.

This chart and all the other information on milk prices implies that there may be a structural explanation behind the determination of the price paid to the farmer for milk. One clear pattern to emerge from the fluctuation in farmgate prices is a rapid increase in the average price immediately after deregulation and the establishment of Milk Marque as the successor to the statutory Milk Marketing Board for England and Wales, followed by a dramatic fall to the current low levels. From detailed analysis of the sales procedures adopted by Milk Marque at each stage since Vesting Day in 1994, the MMC concluded that the organisation's behaviour had enabled it "to generate unnecessary uncertainty for its customers and so induce them to purchase milk at higher prices than would otherwise have been the case".[31] However, the fall in milk prices after 1996, above that attributable to sterling, implies that the dairy companies quickly learned to work the system to their own advantage. The MMC dismissed allegations of collusion among dairy processors from 1996 onwards but concluded that "Milk Marque's selling system encourages individual processors to bid strategically".[32] We accept that the dairy companies acted commercially in trying to reduce the costs of their raw materials. They were able to cherry-pick the most efficient producers and offer them a better price than Milk Marque which has been in the position of a buyer of last resort for the distant and less efficient producers. Yet while the MMC identified "abuses" of its monopoly position, we are not convinced that Milk Marque's members have benefited significantly from the market power wielded by Milk Marque post-deregulation. The low price farmers obtained for their milk could therefore be linked to some degree to the mechanisms by which it was marketed and the institutionalised division between producers and processors. Moreover, it was these arrangements and their manipulation by both sides which did so much to sour the relationship between Milk Marque and the Dairy Industry Federation with consequences for the whole of the industry.

13. There remains the question of the role of other players in the system, particularly the supermarkets. The Chief Executive of Express Dairies told us categorically that the supermarkets "have no influence over the raw milk price" and that "there is no evidence whatsoever" that changes in supermarket prices have an impact on the price paid to the farmer.[33] We note the concern of farmers that prices paid by consumers have not fallen in line with the collapse of the farmgate price. Given that supermarket pricing is currently under consideration by the Competition Commission, we reserve comment on the relationship between the ex-farm and retail price for milk until we have the benefit of the Commission's analysis. However, we stress that the current desperate situation of many dairy farmers makes it a matter of the utmost importance that the structures for marketing milk now in place enable them to achieve better returns. There are worrying signs that the current pressure on dairy farmers, following the recent price reductions, may cause producer numbers to fall to levels which would undermine the production base, particularly in Wales. We have no wish to see the price paid by the consumer rise but we recognise that the survival of many dairy farmers depends upon an improvement in the returns to producers. Whatever the outcome of the Competition Commission inquiry, we hope that British supermarkets will demonstrate that they recognise the importance of maintaining a large and viable milk production base in the UK.

Milk supply groups and direct supply

14. Since 1 November 1994 milk producers have been able to sell their milk to any purchaser registered with the Intervention Board. There are various means by which they may do so: they may sell through Milk Marque, through other farmer-controlled milk groups or direct to dairy companies. In addition, a small amount of milk is sold direct to consumers from the farm. There have been major changes in the proportion of farmers following each of these routes during the past few years. Milk Marque, the successor to the statutory Milk Marketing Board of England and Wales which controlled the supply of all milk until its abolition in 1994, had 20,300 members in 1995/96, representing a market share of 58% of Great Britain (roughly two-thirds of England and Wales[34]). By 1998/99 membership had fallen to 15,500 with 46% of the British market (or 55% of England and Wales), and by 1 April 1999 it had declined to 13,100, accounting for 39%.[35]

15. Membership of Milk Marque is of course affected by the overall decline in the number of dairy farmers as producers retire or stop milk production. However, many of its members are leaving to join milk groups which either sell direct to dairy companies or act as independent farmers' co-operatives. Excluding Milk Marque, there are now some 40 milk groups ranging in size from 3,500 members supplying 925m litres a year to 10 members supplying 8m litres. Most are contracted to a single dairy group, although the largest tend to have several outlets for their milk.[36] There has been some restructuring of the milk group sector over the last two years as groups have merged and others have moved into processing a proportion of their own milk. Members of milk groups who sell direct to dairy companies can expect to receive a premium of over 1ppl on top of the Milk Marque price.[37] The UK Milk Report 1999/2000 estimated that 45% of all milk in the UK is now sold direct, while 5% is purchased by "farmer-controlled quota-holding milk groups".[38]

16. Finally, many individual farmers sell their milk directly to processors on exclusive contracts, whereby the purchaser registers the farmers' quota with the Intervention Board and in effect holds that quota for the duration of the contracts. One submission from analysts of the dairy industry noted that "the evolution of the market in the last five years has seen the direct buyers contract a higher and higher proportion of their needs, often within a relatively small local area, minimising transport costs and cherry-picking farmers".[39] Among the advantages of these arrangements for the dairy companies are closer co-operation with suppliers to improve quality control, to introduce and guarantee farm assurance schemes, to ensure traceability of milk and to enhance responsiveness to processors' needs, as well as to enable prices to be set commercially and to achieve economies in ex-farm transport costs.[40] Those supermarkets which submitted evidence to us also indicated that they were strongly in favour of dairies working with a number of identified farms for the consumer benefits of safety, traceability, welfare standards, quality assurance and packaging.[41] On the other hand, the DIF identified the advantages for farmers as being consistently higher returns than Milk Marque has achieved.[42] The Federation told us that its members were prepared to pay these premiums in order to develop "a direct farmer base that could then give us a long term arrangement that we could have a proper commercial arrangement with",[43] while Nestlé UK, which originally aimed to obtain 80% of supplies through this route but now used it exclusively, had set up a bonus scheme partly because "it reflects our costs of collection and service" and partly to prevent larger farmers from defecting to other dairy companies.[44] The Chief Executive of Unigate pointed out that such arrangements did not usually cut out Milk Marque completely.[45] Nevertheless, this represents a significant change in the market structures and in the potential for any producer co-operative working within them.

The processing sector

17. According to figures supplied by MAFF, there are approximately 300 milk processors in England and Wales, although the number of enterprises processing milk in the UK is in excess of 1,000 (see table 1 below). The vast majority are small to medium sized businesses, generally cheesemakers or local dairies.[46] At the other end of the scale, seven companies process about two-thirds of milk production in the UK[47] and the largest three together account for nearly 40%.[48]

Table 1: Enterprises by Volume of Milk Processed (1997)

Classes by volume(tonnes/year)	Number of Enterprises	Volume in 1,000 tonnes	Share of Total
5,000 and under	963	292	2%
5,001 to 20,000	37	414	3%
20,001 to 50,000	34	1,112	8%
50,001 to 100,000	9	614	4%
100,001 to 300,000	13	2,021	14%
Over 300,000	9	9,834	69%
Total	1,065	14,287	100%

Source: MAFF, Ev. p.153.

As in the production sector, the last few years have seen significant rationalisation in the dairy processing industry with the closure of a number of plants. According to the NFU, approximately 2.5m litres of capacity has been lost since 1994.[49] The Union identified "one of the main drivers of further rationalisation [as] the changing buying policy of the major multiples with a move away from a multitude of suppliers to at most two or three main suppliers".[50] There was some dispute amongst witnesses as to whether this trend had gone too far so that there was now a lack of capacity in the UK. Certainly, on some recent occasions there has been weak demand for UK milk at the prevailing prices but this cannot in itself be read as reflecting on the physical adequacy of plant to deal with the supply. The DIF also denied charges that UK dairy processing capacity was out of date and inefficient,[51] although we note that the Office of Fair Trading (OFT) accepts that UK dairy processors require 2ppl more to convert raw milk into intervention products than do their competitors in other EU states.[52]

18. Roughly half the milk processed is for consumption as liquid milk. This proportion is in decline as the market for milk continues to shrink, having fallen by 6% since 1990.[53] The widespread change to skimmed and semi-skimmed milk has also had an impact on processing with the creation of large amounts of surplus cream. This, together with other UK manufactured dairy products, is often exported (to the tune of 3 billion litres of milk equivalent in 1996), while the UK imports butter, cheese and other consumer products, equivalent to 4.5 billion litres of milk.[54] The UK has a negative trade balance in dairy products with the rest of the EU, despite being the third largest milk producer,[55] and a positive balance with the world.[56] There is little trade in liquid milk because of its bulk.[57] Trade in other products, and world market prices, has been badly hit by the Asian economic crisis and the collapse of the Russian market, as well as factors unique to the UK such as the price of sterling and consumer resistance as a result of the BSE scare.[58]

Retail sales

19. Despite the decline, the liquid milk market is still worth £3 billion a year[59] with most of these sales now channelled through supermarkets. According to figures from the National Dairy Council, doorstep delivery, the traditional method of selling milk to consumers, accounts for just 35% of the volume sold,[60] around 15% in Scotland.[61] Apart from the 17% used in schools or catering, the rest of the UK's liquid milk - approximately half - is sold in supermarkets or other retail outlets.[62] According to the UK Milk Report 1999/2000, between 1991 and 1997 the average price for a pint of milk in the shops fell by 20% to 24p while that of doorstep milk increased by 17% to nearly 39p, widening the differential from 3.5p to 14.8p.[63] This trend has continued, and milk delivered to the doorstep now commands a premium of 15.7p per pint.[64] In direct contrast to the liquid milk market, UK sales of other dairy products, with the exception of butter, continue to grow.[65] This is true of cheese, where UK cheddar sales alone are worth around £730m a year, but the most dramatic gains have been in yogurt and dairy desserts where annual retail sales are now around £600m and £260m respectively.[66] The market for fromage frais has reached £150m, three times its value of less than a decade ago.[67] We note that many of the products driving the growth in these markets have been developed by overseas dairy companies such as Müller and the Danish-owned MD Foods. We are concerned that innovation has been import-led to such a large extent and, as we argue later, we believe that addressing the causes of this trend and finding means and willpower to reverse it is the key factor which will decide the future of the UK dairy industry.

Marketing of milk elsewhere in Europe

20. The structure of the UK dairy industry is unique in Europe. This is the result of its development from a regulatory process which encouraged the separation of the producing and processing sides of the industry.[68] In other European countries, the two sides were described by Milk Marque as having "coalesced in the form of vertically integrated co-operatives".[69] These agricultural co-operatives give farmers "a commercial involvement in all stages of milk marketing, from production to the processing of milk and dairy products".[70] They also have three crucial differences from milk groups in the UK in that they do not aim to be external suppliers of raw milk, the main role of Milk Marque,[71] they process their own milk chiefly into products rather than fresh liquid milk,[72] and they play a much larger role in their home markets than any UK dairy company does here. The European market is dominated by such companies, with six of the ten biggest milk processors in the EU being producer-owned.[73] As table 2 below indicates, none of the UK dairy companies is large enough to win a place in the top ten.[74]

Table 2: European Milk Processors by Milk Volume
(Million Litres/Year)

Ranking	Organisation	Country	Type	Milk Volume
1	Lactalis	France	Private	6,540
2	Friesland Coberco	Holland	Co-op	5,900
3	Campina Melkunie	Holland	Co-op	4,700
4	MD/Klover	Denmark	Co-op	3,970
5	Bongrain	France	Private	3,700
6	Glanbia	Ireland	Co-op	3,270
7	Nestlé	Switzerland	Private	2,900
8	Sodiaal	France	Co-op	2,650
9	Danone	France	Private	2,150
10	Arla	Sweden	Co-op	2,120

Source: Europe's Dairy Industry 98-99; FUW, Ev. p.27.

The Common Agricultural Policy and the dairy industry

21. The UK dairy industry is of course subject to the CAP dairy regime. Although this inquiry is concerned with the marketing of milk in the UK and therefore with matters within the control of the domestic industry, it would be foolish not to acknowledge the importance of the wider context. As the Minister of Agriculture pointed out, "we can never lose sight of the fact that price supports and quotas and the use of dairy and import quotas are very powerful economic instruments."[75] We have already referred to the influence of the IMPE on setting the price for milk in the UK. There is also an EU target price set annually by the Council of Ministers which determines the overall level of support for milk producers.[76] In addition to these instruments and the quota system for production, the other major components of the dairy regime are export subsidies, import tariffs, intervention buying, aid for private storage, and subsidies to encourage the disposal of milk and milk products on the Community market.[77] MAFF estimated the total cost of the regime at £1.7 billion in 1999, making it the third most expensive support regime in the EU.[78] This estimate makes no allowance for the costs to the industry of buying or leasing quota to increase production and economies of scale. Efforts by the UK Minister and others to reform the dairy regime were largely thwarted during the Agenda 2000 negotiations in March last year but Mr Brown promised us that "I am going to be a strong fighter for further progress in my discussions with other Ministers", attaching "enormous importance ... to the review clause in 2003".[79] We reiterate our support for a rapid end to milk quotas which are a constraint on the development of an efficient, market-focussed industry and we urge the Government to press other EU partners to agree an end to the quota scheme before 2003.