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:
— condensed and evaporated milk;
— 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:
— bulk cream for further processing;
— butter (the by-product of which is
buttermilk); and
23. Skimmed milk can be processed and sold
as:
— 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.
— 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
| | |
| | |
Mild | 2.8 |
| | |
Medium | 1.1 |
| | |
Mature | 5.8 |
| | 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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