House of Commons - Environment, Food and Rural Affairs

Select Committee on Environment, Food and Rural Affairs Ninth Report

4 The structure of the dairy supply chain: how efficient is the UK dairy industry?

65. So far we have addressed the issue of dairy farmers being unable to identify conclusively what proportion of a retail price increase has been passed back to them along the supply chain. However, there are broader issues about the overall structure and efficiency of the dairy industry which should also be addressed in order to enable dairy farmers to utilise more effectively the share of the retail price that they do currently receive. It is in the interests of all players in the dairy industry to address these broader issues so that, ultimately, the dairy supply chain will be more efficient and farmers will be in a position to command a greater share of the retail price.

66. A key conclusion of the KPMG report was that that the dairy industry, at both processing and milk producing levels, was not as efficient as it could be. The report concluded that, while the liquid milk processing sector was probably operating efficiently, other processing sectors were operating less efficiently than some of the UK's international competitors.[61]

67. Farmers' groups rejected the suggestion that dairy production was inefficient. The RABDF believed that the efficiency of milk production in the UK compared very favourably with leading dairying countries.[62] The FMG argued that the UK was clearly the most efficient dairy producer in Europe:

We have the largest herd size … [which, in England, is the] top side of 70. In Scotland it is over 100. Ireland is 30 … the average cost of production across 400 England and Wales dairy farms [is] about 18 to 18.5 pence per litre. Three years ago … the cost of production was 21 pence. I think there is no denying the fact that UK dairy farmers have been driven down the efficiency route.[63]

68. Although the UK is efficient in comparison with the rest of Europe, it does not appear to be as efficient as some of its international competitors. During his time as President of the NFU, Sir Ben Gill presented the following compilation of international farmgate milk prices:[64]

International farmgate milk prices: € per 100 kg

	Jan 01	July 01	Jan 02	July 02	Jan 03	July 03
Express Dairies (UK dairy)	26.92	31.75	30.86	27.55	27.26	26.16
First Milk (UK co-op)	26.32	32.08	28.04	24.10	25.17	23.90
EU average	31.96	31.87	30.80	29.42	32.20	29.67
USA	26.48	44.92	33.35	23.72	22.86	25.52
New Zealand	11.09	12.37	13.25	9.83	10.38	13.63

69. Obviously, these figures are not wholly comparable because of lower costs in other economies. However, it is certainly true that the New Zealand dairy herds are much larger than those in the UK. The average New Zealand herd has 251 cows and the trend is towards larger herds, with around 26% of herds having 300 or more cows. Herd sizes of fewer than 250 are dwindling.[65]

70. Consequently, we have received evidence that the UK is the most efficient dairy producer in Europe. Yet, despite this, the UK does not appear to be as efficient as some of its international competitors. The structure of the New Zealand dairy industry is inherently more efficient than that of the UK because, as we saw first-hand when we visited New Zealand in 2002, the industry is almost entirely vertically, and thus horizontally, integrated.[66] The New Zealand dairy giant, Fonterra, is owned by the overwhelming majority of New Zealand dairy farmers; it collects all the raw milk sold by its members; processes or manufactures all this raw milk and then markets and sells all the resulting milk and dairy products. By contrast, as we have outlined above, the UK dairy industry is complex and fragmented, and the functions within it are splintered amongst many separate individuals and organisations.

71. Experience to date suggests that the UK dairy sector is yet to exploit fully the benefits that could arise from greater horizontal and vertical integration. Currently, functions in the sector are stratified horizontally—producer, purchaser, processor, retailer—and there are a number of individuals or organisations carrying out each stratum of functions. Within each stratum, there is some limited joining up of functions; greater horizontal integration would involve more merging of these functions, so that there would be fewer players within each stratum. Between the different strata, there is very little joining up of functions; greater vertical integration would involve one or more organisations taking responsibility for carrying out the functions of several—or all—strata.

Greater efficiency through horizontal integration

72. In the dairy industry, the most highly horizontally integrated sector is the retail sector. Supermarkets account for the bulk of retail milk sales.[67] In the past decade, the market share of the major supermarkets has continued to rise. According to the BRC, in 1995, multiple retailers accounted for 45% of retail sales in 1995, rising to 65% by 2002.[68]

73. The processing sector also demonstrates a high degree of horizontal integration; about 90% of the UK's raw milk is processed by the dairy companies, the three or four largest of which dominate the UK liquid milk and cheese market.[69] The issues of the efficiency of smaller processors and whether there remains a serious excess capacity within this sector still need to be addressed.

74. By contrast, very little horizontal integration has taken place amongst producers. There are about 25,000 dairy farmers in the UK at present. Each farmer may dispose of his or her milk in a different way, by selling to a dairy company, either individually or as part of a milk group, or by becoming a member of a farmer-owned co-op and selling through the co-op. The only horizontal integration that has taken place is by way of the co-ops: estimates of the proportion of the UK's raw milk production purchased by the co-ops vary from 40% to 50%. However, the clout wielded by the co-ops is limited, because they process only about 10% of the UK's raw milk (the remainder being sold to the dairy companies).

75. The disparity between the major supermarkets and the primary producers results in an uneven distribution of power along the dairy supply chain, with the balance of power being weighted towards retailers. This uneven distribution of power may account for the dairy market being slow to react to upward pressure on retail prices, as it was in 2003, when prices increased only following direct action by farmers.

76. Farmers' groups told us that the increased market share of the supermarkets has resulted in the balance of power in the dairy supply chain being weighted strongly against producers. In the course of our inquiry, farmers' groups suggested to us that the major supermarkets are using their increased market share to maintain or improve their margins on liquid milk and dairy products, by applying pressure to their suppliers to decrease wholesale prices. The NFU stated that, while supermarket margins have remained relatively stable or increased, farmgate milk prices have declined, and suggested that it is retailers who are to blame for this situation.[70] The FMG believed that UK retailers "currently retain a significant and disproportionate margin on dairy products" and suggested that the retail price rises of July and September 2003, rather than improving the position of farmers, may in fact have served "to pass further control with regards to milk pricing into the hands of retailers".[71]

77. On the other hand, the BRC attributed dairy farmers' financial difficulties to a tendency to over-produce milk, meaning that supply and demand are out of balance.[72] The BRC argued that food retailers have tried to deliver fair returns for farmers via the processors:

but there is a limited amount that we can do. Around 12 billion litres of milk is consumed each year—only a small percentage is purchased via food retailers … other sectors in the chain … include caterers, hospitals and schools and Government institutions.[73]

78. We have been struck by the divergent views within the dairy industry about what factors do, in fact, determine the price of milk. We recommend that the Dairy Supply Chain Forum take the lead in seeking to build a consensus within the industry about the factors that are determinative in this matter.

Can the supermarkets' code of practice redress the uneven distribution of power?

79. When dealing with their suppliers, the major supermarkets are bound by a code of practice, overseen by the Office of Fair Trading (OFT). The code is intended to address certain practices engaged in by the supermarkets that have been found by the Competition Commission to affect adversely some suppliers' competitiveness.[74]

80. The code has been in place since March 2002. Many witnesses felt that, during that time, the code had been ineffective in redressing the effects on suppliers of the large supermarkets' buying power. The farmers' groups we heard from, in particular the NFU and FFA, submitted that the disproportionate power of the major supermarkets was proof that the code was not working properly; the NFU recommended that the code be given 'teeth' by way of legislation.[75] The Minister for Food and Farming agreed that the code had not proven effective. He said that the code "has not actually given any security to the suppliers … including the dairy sector".[76]

81. The OFT's recent review of the code found widespread dissatisfaction among industry suppliers about its operation.[77] Dissatisfaction centred on the fact that it is not possible to complain anonymously under the code and on the use of the concept of "reasonableness" in many of the code's provisions, which suppliers felt created uncertainty. Amongst other findings, the OFT concluded that neither the code nor the general behaviour of the supermarkets could be linked to the changes in the fortunes of UK farmers, especially the amounts they are paid for their produce.[78] However, the OFT also described its findings as being broadly in line with the findings of the Competition Commission's September 2003 report on the various bids for Safeway. The OFT pointed specifically to the Competition Commission's finding that:

… there remained a fundamental imbalance of negotiating strength between supermarkets and most of their suppliers and that the balance of responses to its surveys indicated that suppliers' negotiating strength across all sectors had weakened since the 2000 CC monopoly report. In its surveys of suppliers, 79% to 94% reported that the code had not changed their dealings with the supermarkets and 6% to 15% said matters had worsened.[79]

82. In our recent report on Gangmasters, we referred to the "dominant position of supermarkets in relation to their suppliers" and stated that the evidence we had received during that inquiry suggested that the supermarkets' code of practice had failed to redress the effects of this dominant position. We welcomed the OFT's review of the code and suggested that a more interventionist approach might now need to be considered.[80] In its response to our report, the Government said that it was awaiting the outcome of the OFT's review of the code.[81]

83. We welcome the decisions of the supermarkets to increase the retail prices of liquid milk and cheese last year while specifying that the price increases must be passed along to farmers. However, on the basis of the evidence we have received in this inquiry and the findings of the Office of Fair Trading's review of the code, we agree with the Office of Fair Trading and the Competition Commission that there remains a fundamental imbalance of negotiating strength between supermarkets and most of their suppliers. The code appears to have been ineffective in redressing this imbalance, at least in respect of the dairy supply chain. Supermarkets should carefully examine the way in which they exploit their buying strength and establish whether this is compatible with their oft-stated aim of supporting British agriculture via supply chain partnerships.

84. We are concerned that supermarkets do not necessarily place sufficient weight on assessin the impact of their pricing policies on dairy farmers. We support comments of the MDC that:

… in the normal terms of businesses supermarkets have been doing what businesses do, they have an opportunity to maximise their profitability and they are seeking to do so within the market place. [However,] I totally agree with you that in their terms of social responsibility and their other moral responsibilities then, yes, there are some failings.[82]

85. We urge the supermarkets to place more weight upon their social responsibility to ensure, at the least, a sustainable farmgate price for British dairy farmers. In this regard, we note the BRC's statement that virtually all the major supermarkets' liquid milk requirements are supplied by the major dairies (Dairy Crest, Robert Wiseman's and Arla).[83] If supermarkets are genuinely concerned about the farmgate prices received by all farmers, we suggest that they aim to establish a balanced spread of suppliers by increasing the proportion of products such as liquid milk that they buy from farmer-owned co-ops.

CAP reform

86. Under the reform of the Common Agricultural Policy (CAP), payments no longer depend on production or quota holdings. Dairy premiums have been decoupled and incorporated into the Single Farm Payment (SFP); the first SFP will be made on 1 January 2005. Our recent report, Implementation of CAP Reform in the UK: Part 1, summarises our views on the way in which the Government has chosen to implement the decoupled SFP in England to date, and indicates that this is a subject to which we shall return in due course.[84]

87. The CAP reforms will undoubtedly have implications for the future of the dairy industry, some of which we discussed with witnesses during oral evidence. In the shorter term, the expectation seemed to be that farmgate prices will drop further as a consequence of CAP reforms. The MDC suggested that farmgate prices could potentially fall to around 15 ppl and that such a drop would be likely to impact mostly on raw milk supplied for manufacturing into commodity products, rather than that supplied for processing into liquid milk. The MDC further predicted that a 25% to 30% reduction in milk supply would result in commodities no longer being produced and the lowest value use probably being liquid milk production. Under this scenario, the MDC considered that the UK would import dairy products other than liquid milk from other countries and that processors would need to pay higher prices in order to secure sufficient supplies of raw milk for liquid milk production.[85] DIAL also believed that the CAP reforms would "put producer prices under downward pressure", a conclusion that was supported by all three major dairy companies.[86]

88. We acknowledge the dairy industry's concern about the Government's decision to adopt a 'dynamic hybrid' model, under which the SFP scheme in England will eventually be calculated on an area, rather than a historic, basis. This is likely to prove unfavourable to the industry; payments for a typical dairy farm are likely to be lower than they are now. We anticipate that the decision to adopt this model will exacerbate the effect on the dairy industry of the price falls caused by CAP reforms. There has been particular concern expressed by dairy farmers in the south-west of the country and there are specific worries for the future of tenant farmers on smaller holdings.

89. In the medium term, some commentators have suggested that significant numbers of dairy farmers will choose or will be forced to pull out of the industry. One prediction is that, from a current base of just under 25,000 UK dairy farmers, by 2015 the number of producers will have fallen by around 23% under the "best case scenario" and by 40% in the "worst case scenario".[87] At one extreme, therefore, by 2015 the number of dairy farmers in the UK could have fallen by about 10,000 to 15,000. Such a drop in farmer numbers could cause a shortage of raw milk on the UK market and might create a problem for UK processors, who could find themselves with a surplus of processing capacity, particularly for commodity products such as butter, skimmed milk powder and mild cheddar cheese.[88] That, in turn, could cause farmgate prices to rise, if demand for raw milk increases.

90. However, CAP reforms will accelerate the current trend in the UK towards fewer, larger herds.[89] In order to maintain their profitability, it is probable that those UK dairy farmers who do remain in the industry will have to increase their herd size well above the current average of 75 cows.[90] The prospect of a 40% reduction in numbers of dairy farmers need not mean a corresponding drop in milk production, if those herds that do remain are suitably large.

Continuing milk quotas

91. The Secretary of State for Environment, Food and Rural Affairs has stated that the Government would welcome a phasing out of EU milk quotas.[91] Despite this, following negotiations at the European Council in June 2003, the Council agreed that the current quota arrangements should remain in place until 31 March 2015.[92]

92. There is a strong case in favour of phasing out milk quotas. Professor Colman has concluded that quotas for the dairy sector simply make it more expensive to become and remain a dairy farmer.[93] The KPMG report found that, if support for dairy farmers were to be reduced—as it subsequently has been—then the quota constraints should be liberalised as well in order to minimise the costs for the industry to restructure.[94]

93. We are particularly concerned about the impact on dairy farmers of their financial support being reduced under the CAP reforms while milk quotas remain in place until at least 2015. Necessary restructuring within the industry is likely to be hampered by the inflexibility of quotas. We consider that eliminating milk quotas would be economically worthwhile for the UK and for the EU as a whole and we encourage the Government to continue its pursuit of this policy aim. It is most disappointing that some other EU member states have opposed the initiative to phase out EU milk quotas.

Further horizontal integration in the production sector

94. As we have discussed, the dairy industry is currently characterised by a disparity between the degree of horizontal integration in the retail sector as compared to the production sector. This results in an uneven distribution of power along the dairy supply chain, which operates in favour of the retailers. If dairy farmers were to join together, in order to make the process of raw milk retailing both more unified and more dynamic, it could well go some way towards redressing the uneven distribution of power in the supply chain. We would hope that CAP reforms will spur farmers to greater co-operation and to further development of value-added products.

Greater efficiency through vertical integration

95. A theme that emerged strongly from the evidence before us was the generally perceived need, especially amongst farmers, for greater vertical integration to take place within the dairy sector. The evidence we heard suggested that greater vertical integration, by linking farmers with processing functions, would give farmers a greater ability to participate in price-setting. It would also make the dairy sector more efficient by cutting down on the number of players along the supply chain who need to take a cut of the retail price.

96. There seemed to be general agreement between witnesses that greater vertical integration within the UK dairy sector would offer the best solution to the difficulties currently faced by dairy farmers. For example, the RABDF noted that "considerably more vertical integration has taken place elsewhere than here, resulting in overseas producers being closer to the end market and thus having greater influence on milk price received".[95] The FMG stated that greater vertical integration was a "fundamental objective" of all of the major co-ops in the UK, but that "at this moment in time opportunities … do not grow on trees, they are exceedingly limited".[96]

97. There is a widespread belief amongst farmers that it is pointless to attempt to bring about greater vertical integration in the UK dairy industry because any such attempts are likely to be blocked by UK competition law. The comments of the FMG are representative of farmers' belief that competition law is likely to act as a 'wet blanket' to any attempts to achieve greater vertical integration:

the high cost of pursuing potential vertical integration opportunities is persistently overshadowed with the fear that where opportunity exists to secure and build a more viable future for members/dairy farmers, that the potential opportunity will ultimately be blocked and rejected under current competition rules.[97]

This fear seems to have arisen, at least in part, because of the fate experienced by Milk Marque.

98. Some comments from witnesses have suggested that it is not necessarily the letter of UK competition law that is at issue, so much as the way in which letter of the law is interpreted and applied by the OFT and the Competition Commission. For example, the MDC implied that, by focussing on structure rather than effect, the OFT placed too much emphasis on applying the technical letter of the law, rather than on assessing the practical implications of its decisions.[98] This suggestion was echoed by the NFU:

… frankly, within the British dairy industry, the OFT and the Competition Commission need to look around the rest of the world and see the structures that are developing and need to actually allow structures to develop in the UK that will give us the opportunity to compete with others around the world … all too often they seem to be obsessed with the … relative share of the UK market rather than concerned about how other people, our main competitors around the world, operate.[99]

99. When we put this matter to the Minister for Food and Farming, he told us that he did not believe that UK competition law limits vertical integration in the dairy sector, although:

I think the industry feels that it does … It is not my view that the OFT are unduly negative towards vertical integration, indeed we have a number of recent examples, including now the various acquisitions of Milk Link, the latest one being into Glanbia Food and, of course, The Co-op's joint acquisition of Westbury, which have all been cleared with the OFT which indicates they are not opposed to vertical integration.[100]

The Government stressed to us that the Commission had reached an adverse finding on the 1999 decision of the Monopolies and Mergers Commission about Milk Marque not because of Milk Marque's size but because of its anti-competitive actions.[101]

Does competition law inhibit greater vertical integration?

100. Because of the apparent confusion about how competition law would affect proposals for vertical integration, we decided to take oral evidence from the OFT and Competition Commission about their approach to such matters. The OFT and Competition Commission denied that they were opposed to vertical integration in principle, and said that they were open to approaches from farmers or other groups within the dairy industry.[102]

101. The Government seems to be doing little or nothing to address farmers' perceptions about the application of competition law and the "nervousness" and "reluctance" that the MDC considers this has caused within the industry.[103] Defra states that the OFT is acting to address farmers' concerns by meeting with farming interests to explain how competition machinery relates to their sector, planning to post answers to frequently-asked questions on this subject on the OFT website and reiterating its willingness to provide informal and confidential guidance to parties considering specific mergers or joint ventures so that any potential competition problems can be identified at an early stage.

102. We urge the Government to ensure that greater emphasis is placed on communicating directly to the dairy industry, especially to farmers, information about what forms of vertical integration can be carried out under current competition law. The Government must take steps to foster an environment that is conducive to greater vertical integration. In its capacity as chair of the Dairy Supply Chain Forum, the Government should work towards achieving a balance in the dairy industry so that the interests of UK domestic consumers are not protected to such an extent that UK dairy producers are detrimentally affected.

103. We encourage the Office of Fair Trading and the Competition Commission to take all possible steps to ensure that the dairy sector knows that the competition authorities are not opposed to vertical integration in principle and are open to approaches from within the dairy industry. The Office of Fair Trading and the Competition Commission should be sending clear signals on this point.

104. In the absence of more comprehensive vertical integration in the UK dairy industry, and in the shorter term, farmers will gain more power in their negotiations with retailers only by way of the existing farmer-owned co-ops working towards processing all or most of their members' raw milk. UK co-ops currently own only 2% of processing capacity compared to around 50% in other EU countries, where vertically integrated co-ops are a much stronger presence.[104]

105. In this regard, we were impressed by the example set by the farmer-owned co-op, Milk Link. As can be seen from the following table, it processes a significantly higher proportion of the raw milk it purchases than do other leading co-ops:[105]

Purchasing and processing capacity of farmer-owned co-ops

Co-op	Number of member farms	Litres of milk purchased from producers (% of UK's annual milk production)	Litres of milk processed by co-op (% of milk purchased)
First Milk	4,000	2.5 billion (20%)	400 million (16%)
Dairy Farmers of Britain	3,500	2 billion (15%)	100 million (5%)
Milk Link	2,400	1.4 billion (10%)	700 million (50%)

106. We are concerned that the proportion of farmers who are members of milk groups has declined in recent years. It is clear to us that farmers must take the initiative in bringing about greater vertical integration if they are to strengthen their position within the dairy supply chain. We urge those dairy farmers who are not members of farmer-owned co-operatives to consider carefully their decision to remain outside the co-op framework. Although co-op membership may be a less financially attractive option for farmers in the short term, it is the most effective long-term option available for farmers to gain greater control over when, to whom and at what price they sell their milk. If farmgate prices are to increase, farmers must act to redress the uneven distribution of power currently in the dairy supply chain.

61 Ev 96 [MDC] Back

62 Ev 11 [RABDF] Back

63 Qq 237-238 [FMG] Back

64 "How are we to become dairy farmers?", presentation given by Sir Ben Gill, president of the NFU, to the 13^th Cheshire Farming Conference, 13 November 2003. Back

65 Data from Fonterra New Zealand; available at www.fonterra.co.nz Back

66 Environment, Food and Rural Affairs Committee, Ninth Report of Session 2001-02, The Future of UK Agriculture in a Changing World, HC550-I Back

67 See paragraph 21 above. Back

68 Ev 59 [BRC] Back

69 Ev 86 [DIAL]; Arla, Dairy Crest and Robert Wiseman Dairies dominate the liquid milk market and Glanbia is significant in the cheese market. Back

70 Ev 4 [NFU] Back

71 Ev 73 [FMG] Back

72 Ev 58, 60 [BRC] Back