Select Committee on Environment, Food and Rural Affairs Minutes of Evidence


Memorandum submitted by Arla Foods UK plc (L15)

2.  THE STRUCTURE OF THE UK MARKET

EU support structures within the CAP

  2.1  In the dairy sector support for milk producers is provided by intervention values for butter and skimmed milk powder which since the introduction of the single currency are calculated in euros. These values have not changed since February 1995, although they will be significantly reduced in stages commencing from 1 July 2004 as a result of the agreement reached on the mid term review of CAP Reform last year. The majority of member states therefore have experienced a stable floor price for the base commodity products of butter and skimmed milk powder for many years. In the UK since our withdrawal from the ERM and the decision not to join the euro and the abolition of the Green £ protection, the UK has been faced with daily changes in the intervention values reflecting movements in the value of the £ sterling against the euro.

  2.2  To illustrate this point, since deregulation in November 1994 and the abolition of the Milk Marketing Boards, the daily delivered milk price for intervention products at intervention values derived from the European support prices has ranged from a high of around 24ppl to a low just below 16ppl. Current values over the last few months have been around 19ppl. Given the purpose of intervention was to give European dairy farmers a stable base value and create an effective floor in the market, it can be seen that the UK's decision not to join the single currency has left UK dairy farmers with a volatile, unstable base milk price.

A brief explanation of the how the UK raw milk market has operated in recent years

  2.3  Changes in raw milk prices since deregulation have been driven by four factors; firstly movements in currency as the relative strength of the £ has varied significantly against the ecu and more recently the euro. This has clearly been the single most important factor.

  2.4  Secondly, the commodity markets for butter and skimmed milk powder. At times one or both of these markets has performed well ahead of intervention values for considerable periods. As a consequence this has led to those manufacturing butter and skimmed milk powder to those willing to pay a higher price for milk than the intervention support levels. This has put an upward pressure on raw milk prices generally as those requiring milk for higher value markets and demand markets have needed to pay higher prices for their milk to avoid an increased movement of milk into butter and skimmed milk powder. There have been periods of time since deregulation when strength in either or both of these markets has led to raw milk prices moving significantly ahead of those based purely on intervention values.

  2.5  The third factor has been supply and demand of raw milk. The UK consistently produces around 14 billion litres per year in line with its quota allocation. This factor has only been of minimal importance with one notable exception. In 2001 the major outbreak of foot and mouth disease in Great Britain created an expectation that there would be a significant fall in the amount of milk produced in the UK, which put upward pressure on milk prices. Events showed that milk production was unaffected and the effects and this concern for lack of supply ceased to be reflected in milk prices during the following 12 months.

  2.6  The fourth factor is the impact of the UK supermarkets. They have increasingly become the dominant force in the liquid milk market and the cheese and cream markets. Inevitably as they now take at least 40% of the UK's milk production within the range of dairy products they sell, their buying power does give them a level of influence over the market. In significant sectors of the market such as liquid milk and cheese due to a combination of substantial over capacity with processors and in the case of commodity cheddar cheese and UHT milk the ability for ready import substitution. Although all the UK supermarkets have shown a desire to get closer to dairy farmers, their buyers obviously seek to buy well in what for them has also been a very competitive market place. In more recent times supermarkets have been responsible for generating additional revenue by raising their retail prices which they have specifically requested be passed back to dairy farmers.

  2.7  The attached quote from the Competition Commission report into the Arla Express merger (October 2003) confirms the buying power of UK supermarkets.

  2.8  "Although this also means that the national multiples are increasingly reliant on the major processors for supply, we view the relationship as being asymmetric. As noted above, the national multiples have the ability to switch volumes easily between suppliers, and can also seek to foster alternative sources of supply. In contrast, a processor cannot readily find another avenue to market if it loses sales to a national multiple".

  2.8  The chart below tracks movements since 1994 in intervention prices (converted into pence per litre delivered to dairy) as a result of currency changes between the ecu/euro and the £ sterling. The relative strength and weakness of commodity markets of butter and skimmed milk powder throughout the same period and the milk price paid to producers based on the price paid by Express Dairies to members of the Express Milk Partnership. Note: The EMP price is typically at least 1ppl above the price paid by Milk Marque and its successor co-ops.


Source: Dairy Markets Weekly

  2.9  One point to note is that there is typically a time lag between movements in currency and/or commodity markets and movements in the raw milk price. This arises because for many contracts milk prices are set for 6 or 12 month period. The usual anniversary dates being 1 April, which coincides with the beginning of the European milk year, and 1 October being the mid point in the milk year. It is also true that even commodities such as butter and skimmed milk powder are often sold forward for periods between 3-6 months and will not instantly respond to changes in the currency position.

Historic view regarding the range of milk prices

  2.10  Since deregulation the typical range of farmer milk prices, based on published information, has been between 1.0 to 1.5ppl. The higher prices have consistently been paid by those whose milk predominantly went into the fresh and added value markets such as the fresh liquid sector. The bottom end of the pricing scale has tended to be paid to those producers whose milk predominantly went into the commodity sectors such as butter and skimmed milk powder. The formal end use pricing structure that existed in the days of the Milk Marketing Board ceased at deregulation in 1994. Not surprisingly those processors supplying the liquid market require a fairly level supply for 365 days of the year and pay a premium against milk going into the commodity markets to ensure consistency of supply. Also reflected in the range of milk prices is the difference in costs from one organisation to another. The biggest single item here being collection from farm to dairy. Such costs vary significantly according to whether the milk is going into the dairy direct from the farm or whether it needs to be reloaded and transhipped. Inevitably higher haulage costs do in part tend to lead to a lower producer price. For relatively short periods of time the range of prices has either widened or narrowed, but where it narrows processors in demand markets increase prices to ensure the continuity of the supply that their markets demand, before the gap widens again back to the more traditional levels. Beyond 1.5ppl it would tend to ease downwards as those selling into the bottom end of the market seek to move milk into better markets such as liquid typically tending to pull those prices down until prices fall to within the more typical 1.0 to1.5ppl range.

ARLA FOODS UK PLC'S DIRECT MILK SUPPLIES

  2.11  Prior to the merger both Arla Foods and Express Dairies each bought a substantial amount of milk direct from producers contracted to both companies. In the case of Arla Foods whilst there was broadly one contract some of the producers were in formal groups and others were grouped more informally broadly on a geographical basis. The company met periodically with representatives of the formal groups but on a group by group basis. They discussed issues including milk price, but ultimately milk prices were determined by the company and then notified to producers.

  2.12  In the case of Express prior to deregulation the company with its milk producers formed a separate company currently known as the Express Milk Partnership. All farmers supplying direct to Express had to be a member of the Express Milk Partnership. The Partnership was a limited company, 50% owned by the company and 50% owned by the producer members. There was one contract and one price schedule for all members. The price was negotiated between the company and the producer representatives, as is the structure of the payment system and any other changes to the contractual arrangements that may be felt necessary from time to time. The Chairman of the Partnership is always a producer and there are 10 other producer directors all of whom are elected on a regional basis by the producer members. Express currently has three further directors appointed to the Board of EMP. The Partnership has been in the forefront of developments in farm assurance and farm auditing, and contributes actively to the key issues affecting the industry. For example, it retains regular direct contact with officials at Defra and recently put in a formal submission as part of the consultation process on the mid term review of CAP Reform. The Express Milk Partnership is funded on a 50/50 basis with a small levy to producers on a litreage basis which is matched pound for pound by the company.

  2.13  Following the merger, discussions are at an advanced stage with producers representatives with an objective to bring all the direct supplying producers to Arla Foods UK plc into one group broadly building on the framework of the Express Milk Partnership.


3.  RECENT PRICE MOVEMENTS

Recent retailer impact on producers' milk prices

  3.1  As the £ strengthened against the Euro support prices fell substantially when converted to £ Sterling. By 2001-02 changes in currency alone had led to typical producer prices, excluding seasonality payments, to have dropped to between 16-17ppl, a level that would generally be recognised within the industry as to be below the cost of production for the typical UK dairy farmer. This created great pressure on dairy farmers that led to an increase in the numbers leaving the industry and for the first time in many years militant action by a small but significant number of dairy farmers. This took the form of picketing processors' premises and selected retailers' chilled distribution depots. As a consequence on three occasions over the past two years supermarkets have increased their retail selling prices for liquid milk and then asked their supplying processors to increase their transfer prices to the producer by broadly the equivalent amount and to pass the additional revenue in full back to the producers. The last occasion that this occurred was in July 2003, when the increase was the equivalent of 2ppl on the UK supermarkets' liquid milk sales. This level of increase was in line with what might have been expected to come had normal market fundamentals kicked in but on this occasion that failed to happen. The background is as follows:

  3.2  During the early part of 2003 there was a significant correction with the £ sterling weakening against the Euro which led to the value of milk delivered to dairies going into butter and skimmed milk powder for intervention levels to rise from around 17ppl to 19ppl. Other than forward sales this began to be immediately reflected in the circa 12.5% of national milk supplies going into these two commodity areas. Normally over time such an event would have been expected to put upward pressure on milk prices generally. The next stage in the chain is the cheese market, and on this occasion typically prices for hard pressed cheeses produced in the UK, such as cheddar remained weak, with values in ppl remaining below those achieved for butter and skimmed milk powder. Although Arla Foods are not cheese manufacturers in the UK, we understand the reason for this situation would appear to be that in the previous milk year 2002-03 cheese production in the UK rose substantially to soak up surplus milk and as a consequence the UK started the 2003-04 milk year with unusually high stocks of mild and mature cheddar cheese, and in the case of mild cheddar with significant levels of imported product coming into the country, particularly from Ireland, but also from other states such as South Africa, Australia and New Zealand. The mature cheddar market would also appear to have been in significant over-supply and it has apparently taken the majority of 2003 for the situation on stocks to broadly come back into balance.

  3.3  UK supermarkets have increased retail selling prices for UK produced cheese during the last quarter of 2003 and monies are beginning to flow back to producers from this source as additional revenues are passed on by processors.

  3.4  Processors in the liquid market have also typically increased prices to their middle ground customers during the autumn of 2003. This sector includes small shops, convenience chains, institutions such as hospitals and schools and the now very substantial catering, fast food and restaurant trade. Again some or all of these revenues being passed back to producers in terms of improvements in raw milk prices.

How do monies recovered in the market place get reflected in improvements in raw milk prices to producers?

  3.5  The UK market is not typical of Europe in that approximately 50% of all milk produced finds its way into the liquid market of which well over 90% is sold as fresh pasteurised product, with the major retailers now accounting for something just in excess of 50% of that market. Detailed below is a breakdown of the various sectors of the UK market showing the proportion of milk going to the liquid market, cheese, condensed milk, cream, yoghurt, butter and skimmed milk powder.


Source: CC based on data from MDC Datum/Defra

  3.6  To illustrate the complexity of producer pricing, in the current market climate where price moves as illustrated above have not been caused by market fundamentals but by the pass back of monies recovered from the market place to producers. However welcome the effect this could be seen as a distortion of the market. The following is based on the experience of Express Dairies and Arla Foods plc in July 2003, prior to the pass back of monies recovered from their major retailer customers. This was prior to the merger in October 2003 and after this event there were further recoveries from the middle ground market with additional monies passed back to supplying producers from the newly merged business from November 2003. Both Express Dairies and Arla Foods plc were predominantly players in the liquid milk market. In the case of Express some 50% of their business was in liquid milk to the UK supermarkets. In the case of Arla Foods somewhere between 55-60% of their business was in liquid milk to the UK supermarkets. Therefore in the case of Express 2ppl increase in revenues from their major retail customers was on 50% of their milk purchases enabled them to pay back 1ppl to all of their raw milk suppliers. In the case of Arla Foods on the same basis they were able to pay back 1.15ppl on all of their raw milk suppliers.

  3.7  Both companies had a substantial part of their milk supply from producers with direct supply contracts with the company. Therefore all of those producers received an increase in the case of Express of 1ppl, in the case of Arla 1.15ppl. The majority of both companies' remaining milk suppliers were sourced from two of the three major UK milk co-ops being Milk Link in the Southern part of England and Dairy Farmers of Britain in the Midlands and Northern part of England. The third co-op, First Milk, was only a very small supplier to Arla Foods. Both companies passed back in full either 1ppl in the case of Express or 1.15ppl in the case of Arla to their supplying co-ops, but as was evidenced in the market place this did not result in increases of this magnitude to the co-op members. To illustrate this point the three major co-ops, Milk Link, First Milk and Dairy Farmers of Britain currently produce around 6 billion litres of milk per year. It is estimated that approximately one third of their milk, around 2 billion litres, is sold onto processors for the liquid market. Last July therefore following increases in retail selling prices by the UK supermarkets, it is reasonable to assume that processors typically increased the price they paid to the co-ops for milk for the liquid milk market by around 1ppl. On the basis that a third of their milk goes to the liquid market this move on its own would have generated additional revenues of between 0.3-0.35ppl on average for the co-ops. Further improvements in their prices would then depend on monies recovered from other customers in other sectors of the market and as had already been mentioned it was clear during this period that additional monies from the cheese market for example were not forthcoming.

  3.8  If raw milk prices are to move forward because of additional revenues recovered from the market place rather than driven by market fundamentals, then the raw milk market will not function as one market because different sectors would clearly recover monies at different times with some sectors perhaps recovering no additional revenues at all. The increase therefore that the producer sees will be dependant on the markets that its processor or its co-op sells milk into. UK supermarkets account for just over 50% of sales in the liquid market and the liquid market in total is 49% of total UK milk market. Therefore a much heralded 2ppl on liquid milk sales, being passed back by UK supermarkets, given this is only some 25% of the total raw milk market could lead to increases of 0.5ppl across the total market. However not all processors are in the liquid milk market and those that are have various proportions of their trade with the UK supermarkets. Co-ops likewise have differing amounts of milk sold onto customers in the UK supermarket sector of the liquid milk market. There will inevitably be significant differences in movements in specific raw milk prices. For example on this occasion in July 2003 the highest were 1.15ppl paid by Arla Foods and the 1p paid by Express Dairies. There were cases in July 2003 with some cheesemakers where there were no increases at all because there had been no movement in their market place.

  3.9  During the summer and independently both Express Dairies and Arla Foods UK had decided to move forward their prices in the middle ground market. This process was still ongoing at the point of the merger and therefore subsequent change which took effect from 1 November in raw milk prices was made as one move across the business. In total the middle ground market represents between 15-20% of the new company's business. Recoveries achieved from the market place enabled the merged company, Arla Foods UK plc, to pay an additional 0.35ppl to all milk suppliers from 1 November 2003 and has brought the total increases paid since 1 April to 1.35ppl in the case of suppliers historically to Express Dairies and 1.5ppl to suppliers historically to Arla Foods UK.

  3.10  Shortly prior to the merger both companies increased the price of milk sold by doorstep delivery by 1p per pint. Additional revenues in this sector which is about 15% of the total business has been shared between those providing the service, mainly bottled milk buyers and franchisees and with some money for the first time in three years being retained within the business to defray some of the additional costs that have been taken in the doorstep operation during that period. These cost changes are as a result of the normal increases in costs but also reflect the continued decline of the doorstep business generally. Declines over the last two years in excess of 10% per annum.

4.  THE CURRENT POSITION IN THE RAW MILK MARKET IN THE UK

  4.1  In the second half of 2003 the liquid milk sector and the cheese sold through retailers has seen typically increases in selling prices which have resulted in improvements in producer prices as monies from these increases have been passed to producers. The outcome has been patchy for the reasons illustrated above and as a consequence producers' raw milk prices on the basis of a standard litre of 4.1% fat, 3.25% protein, achieving top band quality premiums and with a producer volume of 1,664 litres per day— ranges from 20.0-20.1 ppl down to as low as 17.5-17.6ppl, a range of 2.5ppl. This is a much wider range than has been typical since de-regulation. The range of 1-1.5ppl has been the norm, as explained above.

  4.2  Historically where the gap widens above this norm it has not proved to be sustainable. The main reason for the gap to close is that sellers achieving the weaker milk prices will attempt to gain a bigger share of those markets achieving better returns. In so doing they will tend to undercut the current prices being paid in the market place and as consequence bring the top end of the market down until the market achieves a better balance. Alternatively if there are pressures in the commodity sector of the market and returns improve raw milk prices at the bottom end of the market rise again closing the gap until it achieves its more normal range.

  4.3 It is worth noting that the co-ops are increasingly investing on behalf of their members in the commodity areas. For example the recent long term leasing by the three co-ops of the Westbury butter/SMP factory and Milk Link's declared interest in Glanbia's British cheese assets.

Prospective Future Changes

  4.4  CAP Reform over the next 3-4 years will substantially reduce support prices for butter and skimmed milk powder. In the case of butter by 25%, in the case of powder by 15% bringing down support prices by the equivalent of around 4.2ppl. Compensatory decoupled payments will be available to dairy farmers but up to a maximum of around 2.5ppl. Therefore if production remains stable and there are no fundamental shifts in milk uses in the UK milk market place, subject to any further realignment of the £ sterling versus the euro, then UK dairy farmers can expect to see a further significant reduction in their incomes. The benefit to them of decoupled payments will be that they may choose to produce less milk or go out of milk production and still be able to claim those payments as long as they retain their land holding. If other producers do not increase their production to fill this gap, then the UK could face a significant problem on the processing side with a surplus of capacity, particularly in commodity products such as butter, skimmed milk powder and mild cheddar cheese leading to a further inevitable shake out on the processing side of the industry. Production is therefore likely to become more responsive to real demand for these products. So whilst raw milk prices to producers are a very important factor in the future of the UK dairy industry, they are not the only critical issue that faces the industry over the next five years as it continues to re-structure to meet the changing market place and to address the significant impact of the mid term review on the Common Agricultural Policy.

January 2004





 
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