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


Memorandum submitted by DIAL (L22)

EXECUTIVE SUMMARY

  1.  DIAL's primary activity is to support the economic sustainability of its members and by implication the sustainability of the entire milk supply chain.

  2.  An essential element of this is that dairy processors and producers are profitable so they can invest in their businesses for the future.

  3.  Dairy farm profitability is a function of the efficiency of milk production and the revenue available from the market place.

  4.  The market for milk and dairy products operates fairly so that dairy farmers fully benefit from any growth in industry revenue.

  5.  There is clear empirical evidence that milk prices over time move in line with market movements. This view is substantiated by independent reports on the operation of the dairy market.

  6.  The rate of price transmission is affected by the complexity of the dairy product supply chain and the multiplicity of factors that affect the determination of raw milk prices.

  7.  In the future enhanced profitability for the dairy sector will stem from:

    (a)  continued investment by dairy processors to improve processing efficiency;

    (b)  focus by processors on value added markets and product innovation;

    (c)  investment by dairy farmers to lower their costs of production particularly through the achievement of scale.

  8.  The role of government should be to assist the industry to implement these strategies which will ensure the economic sustainability of the dairy industry.

DIAL

  9.  This document is the response by the Dairy Industry Association to the inquiry by the Environment, Food and Rural Affairs Committee of the House of Commons into the market price and farm-gate price of milk.

  10.  DIAL is the trade association representing processors and distributors of liquid milk and manufacturers of dairy products in England and Wales. DIAL members account for approximately 90% of the milk processed in England and Wales.

  11.  DIAL's primary activity is to support the economic sustainability of its members and by implication the sustainability of the entire milk supply chain.

TERMS OF REFERENCE

  12.  The terms of reference unfairly prejudice an assessment of whether price transmission is occurring between market prices and farm-gate prices.

  13.  The terms of reference for the inquiry are:

    "The Committee will examine the market price and farm-gate price of milk, and will investigate why recent rises in the former have not led to increases in the latter".

  14.  There is an assumption in the terms of reference that the market is not working fairly. We submit that the competitive forces along the dairy supply chain ensures that the benefits of any market growth are being enjoyed by producers. We believe that the market for raw milk functions fairly and that that neither producers nor processors are in a position to be predominant.

  15.  The perception that market price increases not have been passed back to producers may have been the result of:

    —  Inadequate information on the complexity of dairy markets.

    —  Misconceptions over the way the raw milk market functions.

COMPLEXITY OF DAIRY MARKETS

  16.  Price transmission in the dairy industry is a complex process.

  17.  A common misconception concerning price transmission is that increases in the retail price of liquid milk can be translated into an equivalent increase in the price of all raw milk. For example during the summer of 2003 some organisations have claimed that a 2ppl increase in the retail price of liquid milk sold through multiple retailers should have equated to a 2ppl increase in raw milk prices. This could never have been the case.

  18.  Dairies sell a range of products into a wide variety of markets. Sales of liquid milk in supermarkets only equate to around 25% of all the raw milk produced in the UK. This means that an extra 2ppl on the price of liquid milk in supermarkets only equates to a raw milk price increase of 0.5ppl.

  19.  The remaining 75% of domestic milk production is utilised in the production of a variety of products which are marketed through a number of different marketing channels.

UTILISATION OF MILK

  20.  Raw milk is utilised for a large variety of products beyond just liquid milk.

  21.  By way of indication of the range of products made by the industry, whole milk can be processed and sold as:

    —  liquid milk;

    —  condensed and evaporated milk;

    —  whole milk powder;

    —  cheese, (the by-product of which is whey, which can be processed further into powder and a range of liquid uses); and

    —  separated into skimmed milk and cream, usually with a fat content of 40%.

  22.  Cream can be processed and sold as:

    —  potted cream;

    —  bulk cream for further processing;

    —  butter (the by-product of which is buttermilk); and

    —  butteroil.

  23.  Skimmed milk can be processed and sold as:

    —  skimmed milk powder;

    —  casein; and

    —  blended with whole milk to produce semi skimmed milk.

  24.  The majority of yogurt is made from skimmed milk or skimmed concentrate.

  25.  Skim and cream have different values. Based on the aid provided by the EU for intervention buying of butter and skimmed milk powder, the skim fraction of milk currently has 58% of the value of whole milk and cream the remainder.

MARKETING CHANNELS

  26.  Liquid milk and dairy products are marketed through a variety of channels.

  27.  Any of the variety of dairy products produced by the industry can pass through a number of marketing channels. The industry's primary customers are the major supermarkets.

  28.  However the other marketing channels include:

    —  The doorstep delivery service.

    —  Other multiple retailers.

    —  Other retailers such as corner shops, tobacconists, newsagents etc.

    —  Restaurants and other catering outlets.

    —  Schools, hospitals and other institutional users.

    —  Food processing companies that use dairy products as an ingredient.

    —  Wholesalers and distributors selling dairy products on to retail and catering outlets.

    —  Traders.

    —  Foreign customers, both EU and non-EU.

    —  Common Agricultural Policy support schemes.

  29.  As a result of the complexity of the market for dairy products each market segment will have a different impact on raw milk prices (see table below).




% Of Producer Income Accounted for By:



Liquid

Doorstep 7.3
Top six multiples 22.6
Other multiples 5.5
Independents 2.2
Non-household 7.7
Butter 6.8
Cheese

Retail
Cheddar
Mild2.8
Medium1.1
Mature5.8
Other
Hard 2.3
Blue vein 0.6
Soft and other 1.7
Food services + manufacture 8.4


Full Cream Powder
5.8
Skimmed Milk Powder 5.5
Condensed Milk 3.1
Cream 6.2
Yogurt 2.2
Other Products 2.3


TOTAL
100.0


Source: DIAL estimates.

PASS BACK TO PRODUCERS

  30.  Any price increase in any one market cannot be expected to have a uniform effect on the prices paid to all dairy producers.

  31.  The effect on the price paid to producers of any price change in any product market will be different for individual producers. The benefit to any individual producer will be determined by:

    —  how the producer sells milk in the raw milk market, whether direct to a dairy company or through a producer co-op; and

    —  the proportion of milk individual companies or individual co-ops sell into any particular market.

  32.  By way of example, if prices for liquid milk rise the effect on the payments that can be made by a dairy company to its suppliers will depend on the volume of milk they sell into the liquid market. Many dairy companies do not sell into the liquid market at all.

  33.  The dairy company will then have to decide whether to pass on that increase exclusively to its direct suppliers or to all its suppliers. It may wish to restrict any increase to direct suppliers in order to encourage the supply profile that it requires for the liquid market.

  34.  If the increase is passed on to all suppliers, then the extent to which any individual co-operative member will benefit will depend on the proportion of the co-operative's sales accounted for by that dairy company.

  35.  It will also be affected by the payment policies of the producer co-ops who may wish to retain funds for a variety of reasons including raising capital. Producer co-ops account for over 40% of milk and therefore play a very significant role in affecting price transmission in the industry to producers.

PRICE DETERMINATION AND THE ROLE OF COMMODITY PRODUCTS

  36.  The returns from commodity markets play a key role in determining the long-term trend in raw milk prices and therefore determine the extent to which producer expectations can be fulfilled.

  37.  The fundamental factor affecting the prices that can be paid to producers is that raw milk for any one product market cannot be priced independently of the raw milk used for any other market. The institutional framework provided by the Milk Marketing Board that allowed milk to be priced separately for different products was removed in 1994.

  38.  The price of milk is now determined by the competitive interaction of market forces. Co-ops have the ability to switch milk between dairy companies to achieve the best returns and processors can switch milk between products. Likewise customers can switch supplies between processors. The outcome of this interaction is that prices will be strongly influenced by returns from commodity markets.

    By way of example, if the return from the sale of raw milk for liquid milk was 20ppl and that for commodities 18ppl, then the organisation selling milk for a return of 18ppl would have a strong incentive to offer milk to processors of liquid milk. To achieve a sale, this milk would have to be offered at a competitive price below 20ppl. Individual processors of liquid milk could not ignore this opportunity, otherwise their commercial position could be undermined by their competitors taking it up instead. This process could be accelerated if retailers seek to maximise their competitive position with consumers by being able to offer cheaper milk.

    Similarly the market operates in reverse. If returns to liquid milk are lower than those to the commodity markets, then returns would have to be increased for the liquid market to maintain priority of supply over commodity markets given the need to supply liquid milk on a daily basis.

  39.  This analysis shows that over time all milk prices through competitive forces move in line with movements in commodity markets.

  40.  It is therefore important to understand the nature of the market for these products. Commodity markets are international markets. This means that for these markets the industry is unable to affect the prevailing price and is in the position of being a price taker. This in turn means that the amounts that can be paid to producers for milk supplied for these products have to be adjusted in line with market returns. More than 40% of UK milk is utilised for commodity markets. The UK's exposure to imports means that the UK industry cannot disengage itself from trends in commodity markets. Imports account for over 40% of UK cheese consumption and over 50% of UK butter consumption. A further consequence of this exposure is that prices are heavily influenced by movements in exchange rates.

  41.  Overall, the operation of the raw milk market has two consequences:

    (i)  The mechanics of the market mean that price initiatives in the liquid or cheese markets cannot endure unless they are underpinned by movements in commodity markets.

    (ii)  There will be times when the returns from commodity markets may not cover the production costs of producers. There is no means of ensuring that commodity markets will operate at a level that will ensure that all producers are rendered profitable.

ROLE OF INTERVENTION

  42.  The EU only provides a partial floor to commodity markets by intervention purchasing.

  43.  The European Union acts as buyer of last resort for commodity products through intervention purchasing of skimmed milk powder and butter at fixed prices. This provides a partial floor to the commodity market when prices fall to these levels.

  44.  The raw milk price equivalent from the sale of butter and SMP to intervention is called the Intervention Milk Price Equivalent (IMPE). Intervention prices are set in euros so the value of intervention is directly affected by movements in exchange rates.

  45.  Commodity prices can however fall below the intervention level because the support provided is not comprehensive. Intervention is not available all year round and the Commission also has the option of introducing tendering procedures which reduce intervention prices if the volume offered to intervention during a year exceeds a certain level.

MECHANICS OF PRICE ADJUSTMENTS

  46.  The process by which price adjustments are actually achieved is long and complex and differs depending on the product being sold. Whilst this may result in a lag in price transmission ultimately price changes are communicated through the supply chain.

Market Power and Price Transmission

  47.  The relative market power of the multiple retailers inevitably means that price adjustments are usually quicker downwards than in the opposite direction. The existence of large volumes of milk contracted on a short-term basis by the producer co-ops means that these price adjustments can be communicated relatively quickly.

Milk Production

  48.  Whilst milk production is reasonably predictable overall, marginal changes in peak or trough production levels can have a major impact on capacity utilisation for commodity products. This can have a significant impact on marginal prices.

Currency

  49.  Currency fluctuations directly affect the returns from commodity markets which, because of their tradeability, are extremely sensitive to currency movements. This is demonstrated in the graph below which shows a strong correlation between currency movements and trends in the returns from butter and skimmed milk powder markets.


Stocks

  50.  Stock levels also affect the overall price environment for commodity markets. This is particularly important for the cheese market. During 2003 one of the reasons why the cheese market did not move forward in response to the change in sterling was because of the stock situation in the UK.

Sales from stock

  51.  Dairies buy milk before they know the return from the market. This is particularly true of milk for cheese which, because of long maturation periods, may be sold in a different market environment from the one that determined the price paid for the milk used to make it. Consequently, in subsequent periods the price a dairy can offer producers will be affected by the gains and losses that may have been incurred from the sale of cheese from stock.

Frequency of contract re-negotiation

  52.  Currently, contract re-negotiation between dairies and producers is often focused on the six month periods starting April and October. Whilst some contracts are directly indexed to market returns, many may be fixed for six month intervals. This affects the speed of price transmission.

  53.  Cumulatively, the effect of all these factors is that prices to producers can lag behind movements in the market place both when prices are falling and rising. Consequently producers cannot expect an automatic adjustment in farm-gate prices when there is a change in commodity market price trends. This is one reason why the misperception has grown that recent market price changes have not been fully reflected in producer prices.

  54.  However in the longer run the market does function to transmit price change through the supply chain and to secure appropriate returns to producers. The graph below shows that there is a clear correlation between producer prices and trends in commodity markets.


  55.  This conclusion on price transmission through the supply chain is substantially shared by the report "Prices and Profitability in the British Dairy Chain" which was compiled by KPMG on behalf of the producer funded Milk Development Council. The analysis undertaken on behalf of KPMG by London Economics, found that (page 42 of report):

    —  "in the UK, the retail price and the farm-gate price are more closely connected than in other European countries".

    —  "the level of price transmission on liquid milk in the UK is relatively high in both directions . . ."

Price Environment

  56.   The overall price level paid to producers is also affected by a number of structural factors that are unique to the UK.

Import penetration

  57.  The UK is surrounded by countries that have a structural surplus of milk compared to the domestic consumption of those countries. They are therefore able to trade in our market at marginal cost. The UK's lack of self-sufficiency in milk production means that product has to be imported into the UK market to meet domestic demand. The role of imports is particularly relevant in to the market for cheddar cheese which is subject to significant import penetration, especially from Ireland.

Effect of the Fresh Product Market

  58.  The higher share of UK milk production which is used for fresh liquid milk generates higher service costs. This affects the industry in two ways:

    (a)   Higher transport costs are incurred both for milk collection and chilled distribution. Most European co-ops collect and manufacture on a local basis.

    (b)   The demand profile for liquid milk combined with the seasonality of milk production inevitably results in a low capacity utilisation for butter and milk powder factories. This effect operates both at the annual and weekly level. The priority of supply given to liquid milk along with its flat demand profile results in an exaggerated supply profile to other product sectors.

    In addition the processing of liquid milk fluctuates over the week in response to consumer purchasing patterns. This results in weekly peaks and troughs for plant utilisation for commodity products. Overall the reduced plant utilisation and higher costs affects the returns from commodity markets.

 Role of Producer Co-ops

  59.  The majority of processors are not producer co-ops. Only around 10% of milk is processed by producer co-ops. Consequently the distribution of profits from processing are passed back through dividends to shareholders rather than milk prices as is the case in many other European countries. This distorts price comparisons between the UK and the EU.

  60.  Collectively these differences mean that UK dairy industry is in a unique environment and the problems and challenges that it creates can only be addressed within the actual commercial context of the industry and not through reference to the experience of other EU countries.

PROCESSOR STRATEGIES

  61.  Dairies are pursuing a range of strategies to improve revenue to the industry and   minimise the impact of commodity products on milk pricing.

  62.  Dairies are improving their technical efficiency by investment in new processing facilities and closing old and surplus capacity. This allows them to remove cost from the industry. UK liquid milk processors now operate some of the most modern capacity in the world.

  63.  Dairies are investing heavily in branded value added products. The creation of brands requires significant and sustained investment.

  64.  Dairies are seeking to improve their market position by increasing their scale of operation. This is being achieved by a process of mergers and acquisitions which recently culminated in the merger between Arla and Express.

  65.  These strategies are of immediate commercial benefit to processors. They also benefit producers because:

    —  lower processing costs increases the amount of market revenue that can be passed back to producers;

    —  investment in brands and value added products reduces the impact of commodity markets on raw milk prices as value added products are less exposed to price competition from substitutes. This reduces the impact of downward price adjustments; and

    —  increasing the scale of operation improves the negotiating position of dairies which reduces reduces price volatility. It also provides them with the resources required to invest in new efficient capacity and in the development of branded value added products.

CAP REFORM

  66.  The reform of the CAP will put producer prices under downward pressure.

  67.  The EU commodity market is strongly influenced by the CAP market management tools utilised by the European Commission. Under CAP reform the support provided by the EU for dairy products will fall. The stated objective of these cuts is to bring EU domestic market prices into closer alignment with the world market. In particular the price provided by the EU for intervention product is scheduled to be reduced by 22% over four years. This will reduce the floor price available to the dairy industry. This will have an affect on commodity market prices. Both producers and processors will have to adapt to the lower price environment that will result.

  68.  It is clear that an increase in size is central to producers maintaining their profitability. As part of the work of the CAP Reform Sub-Group of the Lord Whitty Dairy Industry Supply Forum, research was jointly commissioned by DIAL, Defra and the MDC from Professor Colman on the future of UK dairy farming.

  69.  The report states that:

    "The unequivocal conclusion to be drawn is that size is the key to efficiency with herd size increases critical to further costs reductions."

  70.  Defra has a key role in assisting producers to achieve this objective, principally through the decision to be taken on the method to distribute direct payments to dairy producers.

  71.  The report by Professor Colman states that;

    ". . . any attempt to determine the payment on the basis of grassland and standard yields, rather than on the basis of effective quota held, will penalise the most efficient dairy farms and damage the future prospects of the industry."

  72.  The agreement by both DIAL, FMG and the NFU to a joint statement calling for direct payments to be calculated according to quota shows that the view of Professor Colman is shared by the entire industry.

FAIRNESS OF THE RAW MILK MARKET

  73.  The market for raw milk is functioning fairly.

  74.  The OFT has examined the dairy industry on several occasions, ie; Arla/Express merger, various complaints against the marketing practices of processors, the new arrangements for Westbury. It has not acted on these issues so it must be assumed that UK competition authorities are satisfied that markets are functioning fairly.

  75.  UK dairies are not making excess profits at the expense of producers. The KPMG report examined the profitability of UK dairy companies compared to their European counterparts and concluded that:

    "Overall, the net profit margins of UK processors have not increased over the period since 1997 and are in line with the performance of similar organisations in Europe".

January 2004





 
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