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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