Memorandum submitted by the Milk Development
Council (L9)
1. EXECUTIVE
SUMMARY
1.1 The market for raw milk is a complex
one due to the number of products produced from it. However, in
general the market does operate in an economically rationale manner
and the majority of prices rises have been passed back to farmers.
The reasonably successful operation of the market does not detract
from the large amount of distress among dairy farmers as market
changes cause substantial restructuring among farmers through
lower farmgate milk prices. The fact that farmer direct action
seems to be needed in order to ensure that prices follow the market
upwards as quickly as they do downwards suggests that the situation
is unsustainable and many believe that farmers need to increase
their representation and power within the supply chain. There
are several ways that Government could assist the restructuring
process that is currently taking place.
2. DAIRY MARKET
OPERATION
2.1 The first issue which needs to be examined
is what has actually happened in the dairy market over the past
year and how much of the changes at retail and wholesale level
have been passed back to dairy farmers. The following tables lay
out the most important changes over the 12 months in a comparison
between October 2002 and October 2003.
£/T or ppl
| October 02 | October 03
| Equivalent Change |
| Multiple Retailer/Middle Ground Milk Price |
46.3 | 48.5 | +2.2
|
| Doorstep Milk Price | 75.1 |
76.8 | +1.7 |
Wholesale Cream
(from Liquid Milk) |
900 | 1030 | +0.6
|
| Mild Cheddar—Wholesale | 1,800
| 2,100 | +3.0 |
Mature cheddar—
Wholesale | 2,100
| 2,100 | 0 |
| Butter/Powder(IMPE) 1 | 17.0
| 19.2 | +2.2PPL |
Weighted Average
Increase2 |
| | +2.3PPL |
| Actual Farmgate Price3 | 18.13
| 19.59 | +1.46PPL |
Due to the nature of this sort of data, these figures are representative but it must be recognised that there is a potential for a small margin of error in the weighted average increase, probably of the order of +/- 0.3ppl.
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1 IMPE = Intervention milk price equivalent— he price
a processor of commodity products for intervention can afford
to pay for milk
2 The weighted average increase is calculated by weighting
the potential increase in the milk price for a particular product
by the national utilisation of milk for the different products
to calculate what the potential overall increase in the milk price
could have been.
3 The actual farmgate milk price is collected by Defra, and
calculated on the basis of returns from all purchasers of milk
each month.
2.2 If we examine the price changes over the past 12
months then we can see that indeed farmgate price rises have risen
in response to retail and wholesale price rises, although probably
not as much as they could have done. It is important to note that
there is likely to be some lag in farmgate prices and indeed we
know that farmgate prices in November increased again, suggesting
that the average increase in the farmgate price will be closer
to 1.7ppl.
2.3 Therefore it appears that the differential between
what in theory could have been returned and what has been returned
is in the order of 0.6ppl. These fractions of a ppl are very important
as they make the difference between a good or bad profit margin
for a company or farm business, but the differentials are not
of the magnitude that some believe they are.
2.4 Not seeing a full pass back of retail price rises
to suppliers does not necessarily indicate that there is any problem
with the market. Many factors determine the retail price, not
just the cost of the raw material. Issues such as competitors
and profit margin expectations also play an important part, as
they would in any market.
2.5 All of the above comments should not detract from
two significant points. Firstly, the price rises that have occurred
have been partly forced through by direct action from farmers—suggesting
that market may not work efficiently. Secondly, the operation
of the market does not detract from the large amount of distress
among dairy farmers as the market forces restructuring on the
dairy farming industry through lower prices. In light of this
it is important to understand the history of the market place
and how prices are set in order to understand the challenges currently
being faced by dairy farmers.
3. MARKET HISTORY
3.1 Over the past ten years there has been a sequence
of events which has led to increasing pressure on dairy farmers.
These are: the abolition of the Milk Marketing Boards, which led
to the end of end use pricing, adverse exchange rate movements
in the late nineties, and CAP reform.
3.2 End use pricing helped to create artificial differentiation
and significant premiums for raw milk for high value uses as compared
to commodity products. The end of the milk marketing boards meant
that raw milk, whatever its use, was the same product and therefore
a commodity.
3.3 Economic theory tells us that the price of any commodity,
with several uses, will always be set by the lowest value use,
unless the use to which the commodity is put is legally constrained
(as with end-use pricing). Of course prices can be higher than
this base, if certain uses require higher service levels incurring
additional costs over servicing the lowest value use (ie precise
supply patterns for liquid milk usage, etc.), and a small premium
(although significantly smaller than under end use pricing) to
ensure that milk is allocated to higher value uses before lower
value uses.
3.4 The removal of end use pricing obviously weakened
the position of UK farmers, and made the price of raw milk dependent
on its lowest value use—commodity products.
3.5 Obviously, the UK and EU market for commodities must
always be looked at in the context of the world market situation,
where commodity dairy products are traded across the world, and
prices set by world supply and demand. There are varying degrees
of protection and support for the dairy sector across the world
leading to influences on world supply and demand, and hence world
prices. In many years, there is a world surplus of milk and dairy
products which can be manufactured in several regions of the world
at low cost, and transported around the world in competition with
locally produced product.
3.6 The price of commodity products is dependent on several
factors including supply and demand for those products. Competitor
costs of production have a significant impact on world dairy commodity
prices, which are significantly lower than the prices for commodities
within the EU. The price for commodity dairy products on the EU
market are protected by the various CAP market support mechanisms
such as intervention buying, Private Storage Aid, export refunds,
import tariffs, and subsidised usage of dairy products. The fixed
intervention price puts a base in the market as, if the price
for commodity products falls to the intervention price level,
then the EU will buy in product in order to stabilise the market
at that price. These mechanisms insulate the EU from the world
market.
3.7 In practice, the market price for commodities within
the EU is usually around the intervention price (although this
may change as a result of CAP reform), and as this is set in Euros,
the sterling/euro exchange rate is very important in setting the
commodity base price in the UK. The strengthening of sterling
during the mid to late nineties has had a significantly adverse
effect on the intervention price in sterling terms and hence the
farmgate price.
3.8 The graph below shows the relationship between supermarket
retail liquid milk prices, farmgate raw milk prices, and IMPE/AMPE
(a theoretical price of what can be paid for milk by processors
of commodity products based on the value of either intervention
product prices (IMPE) or actual product market prices (AMPE)—whichever
is higher).
3.9 The graph indicates that the farmgate price follows
the commodity base price, while the retail price is affected by
several factors other than raw milk costs such as inter multiple
retailer competition which led to liquid milk retail prices falling
whilst raw material costs increased in the early nineties.
3.10 In addition to retail and wholesale price levels,
there are many other factors that play a part in setting milk
prices such as supply and demand for raw milk on both a short
and long term, leading to seasonal fluctuations in prices, as
supply fluctuates on a seasonal basis. Farmer pressure through
direct action has helped to move prices higher, particularly when
the market fundamentals have suggested that there should be a
price rise, but it has not been forthcoming from processors. Whether
this is a sustainable way in which to operate a market is questionable?
4. CAP REFORM
4.1 The recently agreed CAP reform will have a significant
impact on the UK dairy market and will probably make things more
difficult for UK dairy farmers over the next few years.
4.2 CAP reform will reduce the support for the commodity
products through the cutting of intervention prices over the next
four years by around the equivalent of 4ppl in total (assuming
no exchange rate changes). This means that the current lowest
value use for milk will fall by around 4ppl, potentially bringing
all milk prices down by around 4ppl, to around 15ppl.
4.3 This reduction in support will be compensated for
by a decoupled annual payment of around 2.6ppl (gross before deductions
of 10-30%). The fact that the payment is decoupled suggests that
farmers should base milk production decisions on the milk price
alone. However, some commentators expect many farmers to include
the decoupled payment in their decision whether or not to produce
milk, due to a lack of alternatives or lifestyle choices.
4.4 Obviously, with many in the dairy farmer sector suggesting
that current price levels are unsustainable, a further 4ppl drop
(around 21% drop on current milk prices) would make the position
of dairy farmers even more difficult. A critical issue is what
happens to both milk supply in the UK and to EU and world prices
for commodities.
4.5 If the UK milk supply falls due to farmers leaving
the industry by such a degree that commodities are no longer produced
(25-30% reduction in milk supply) then the lowest value use would
probably be liquid milk production, and processors would pay higher
prices in order to secure sufficient supplies to service consumer
needs. Under this scenario, the UK would import dairy commodities
from other countries. At present the smallest 50% of dairy farmers
account for 25% of milk production.
4.6 Work that has been commissioned by Defra, DIAL, MDC,
and NFU from Professor Colman, University of Manchester, suggests
that only under worse case scenarios will UK milk supply fall
significantly below current production levels (which are of course
restricted to a maximum by quotas). This study and other work
carried out by Exeter University suggests that milk prices will
have to fall below 15ppl before milk production will drop below
current production levels. The new intervention prices will see
prices fall to around that level, but of course dairy farmers
will be receiving the decoupled payment on top of the milk price.
4.7 An alternative scenario is that as EU production
falls and the EU exports less dairy products, the EU/world commodity
supply could fall by enough that commodity market prices rise
above the new intervention prices on a consistent and long term
basis. Most evidence and academic reports suggest that although
it is likely that world commodity prices will rise, to around
the new intervention prices levels on average, they are unlikely
to go any higher (apart from on cyclical peaks from time to time).
4.8 All of this suggests that the milk supplied for use
for commodity products will experience the majority of the 4ppl
drop.
5. INDUSTRY CHANGE
5.1 All of these points suggests that a large amount
of restructuring is going to take place both at farm and processor
level over the next few years as these price cuts take effect.
5.2 These price pressures will be a significant problem
and threat to individual dairy farmers, and may lead to continued
militant action. It is likely that the market will eventually
restructure and become sustainable, but there may be a significant
period of difficulty before this point is reached. One of the
MDC's core aims is to enable farmers to cope with the change as
effectively as possible. As part of that process, the issues involved
were analysed in the MDC report "Prices and Profitability
in the British dairy chain" produced by KPMG and published
in March 2003, the conclusion of which was that there were no
excess profits in the dairy chain, although dairy farmers were
not making any profit at all.
6. MOVING THE
INDUSTRY FORWARD
6.1 According to the Prices and Profitability in the
British dairy chain report there are four fundamental problems
with the market:
— Inefficiency in the Processing and Farming Sector
— Restrictions in the regulatory and business environment
Supermarket Power
6.2 According to KPMG, the increasingly large percentage
of dairy products sold through multiple retailers means that the
power of the retailers has increased, leading to a smaller proportion
of the retail price being passed back to dairy farmers. In addition,
the increase in retail power may have the effect of increasing
the speed of farmgate prices following the market down, but slow
the process of farmgate prices following the market up. Nearly
all the Farmers For Action stimulated retail price initiatives
have been retail prices following the commodity market upwards.
However, pressure from FFA has been required to move the price
upwards, suggesting that without this form of direct action, the
market is slower to react to upward pressure than downward pressure
due to the distribution of power along the supply chain.
6.3 The report suggests that there are several ways of
tackling this increase in power. Firstly there must be greater
communication and co-operation throughout the chain, while at
the same time industry restructuring and vertical integration
must take place in order for farmers to play a greater part in
the supply chain. This communication issue is partly being tackled
through the Supply Chain Forum, currently chaired by Lord Whitty
which is providing some useful ways forward for the industry.
6.4 KPMG did look at the benefits of a regulator for
the industry but decided that it would probably not work effectively,
although an improvement in the effectiveness of the OFT Supermarket
Code of Conduct would be beneficial.
Lack of Value
6.5 The second theme that KPMG identified was the lack
of value created by the UK industry. A dependence on commodity
type products, a lack of innovation, and a lack of marketing activity
have all created a market in which the uses to which a litre of
UK milk are put generate a significantly lower return at retail/wholesale
level than a litre of milk in other European countries. This is
particularly apparent if you look at the example of Italy, where
a large proportion of their milk goes into high added value cheeses,
with no commodity production (commodities and some raw milk is
imported). This means that Italian farmers have significantly
better milk prices than in the UK.
6.6 KPMG recommended that much more production innovation
and marketing was needed in the UK to help boost sales volumes
of dairy products. In addition, a low amount of product branding
makes it more difficult for processors to negotiate a greater
percentage of the retail price from retailers. The MDC is currently
working with the rest of the industry to stimulate market development
through a variety of projects, and on behalf of the supply chain
forum has established an industry wide group to tackle the problem.
Inefficiency
6.7 One of the main problems identified by the KPMG report
is that the industry at both processing and milk producing levels
is not as efficient as it could be. KPMG believed that although
the liquid milk sector was probably efficient, other processing
sectors were not as efficient as some of our competitors in the
rest of the EU or world. KPMG believe that these efficiencies
need to be improved in order to provide the maximum possible milk
price to farmers.
6.8 In addition, KPMG believe that there is a significant
problem at farm level, with the gap in production efficiency between
the best and worse dairy farmers being too great. This is borne
out by the latest work conducted by Professor David Colman of
Manchester University commissioned by DEFRA and due to be published
in the New Year. This suggests that part of the problem in the
dairy sector is as much about inefficiencies within the sector
as much as about unsustainable price levels. The MDC is focusing
much of its efforts on assisting dairy farms to improve their
efficiency through a variety of programmes , initiatives and research,
and has established with the Welsh Development Agency and Scottish
Executive a national benchmarking system for dairy farmers.
Business Environment
6.9 The final area that KPMG identified as a problem
was the business and regulatory environment which can be broken
down in to three main areas: CAP and quotas, competition law implementation,
and currency.
6.10 KPMG believe that quotas have restricted and increased
the cost of restructuring of the industry over recent years. KPMG
believes that if support for dairy farmers is reduced (which it
has been since the report was written), then the quota constraints
should be liberalised as well in order to minimise the costs for
the industry to restructure. CAP reform has not significantly
done this, despite the significant reduction in support.
6.11 KPMG fears that although the EU and UK have aligned
competition law, there are some concerns that it is not implemented
in quite the same way. The report suggests that a large amount
of restructuring needs to take place in the dairy industry, and
that although any restructuring will need to be done in consultation
with the competition authorities, it seems important that any
such moves are treated sympathetically and consistently within
an EU context by competition authorities wherever possible.
6.12 In addition, the volatility of the euro/sterling
exchange rate has caused a significant difficulty to dairy farmers
over the past few years, and although the decision will obviously
not be made on the basis of the effect on the dairy sector, entry
into the euro could give a greater deal of security and reduce
the volatility in prices that farmer face.
7. CONCLUSION
7.1 Partly due to direct action from farmers, the dairy
market is largely operating in a manner in which an effective
market would be expected to operate. However, the fact that direct
action is needed tells us that power along the supply chain is
uneven. There are fundamental changes in the EU market support
taking place that are going to lead to large scale restructuring
of the industry and these will create a great deal of difficulties
for dairy farmers over the next few years. There are ways of improving
the position of dairy farmers within the supply chain, which should
lead to the end of a need for direct action, and lead to the market
operating efficiently with dairy farmers gaining back more of
the fractions of a penny that are currently being denied them
by the market. Although these activities such as restructuring
and vertical integration are needed and beneficial to dairy farmers,
they will not reverse the fundamental reduction in market support
that is going to occur. The Government could help to assist the
process of farmers gaining a greater stake in the supply chain
through supporting and facilitating the recommendations that have
been put forward by the "Prices and Profitability in the
British Dairy Chain" report.
January 2004
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