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Tobacco is an addictive product with few substitutes, and the worldwide market is dominated by a small number of large transnational tobacco companies (TTC) which are able to enjoy considerable amounts of market power. As such, the manufacture and sale of tobacco products in almost any market is going to be uncommonly profitable.1 To correct this market failure, we previously outlined the case for imposing price caps on the wholesale prices tobacco manufacturers are able to charge for their products (not on the end price the consumer faces) using the system of RPI-X regulation widely used in the utilities sector.1 Such a scheme would generate numerous public health benefits (box 1) and also allow governments to capture a significant proportion of the excess profits the industry currently enjoys, as tobacco taxes would need to rise to offset any reductions in the price manufacturers are able to charge (box 1)2–4. Given the inherent appeal of the policy suggestion, there is growing interest in its implementation in various markets, including the UK, Ireland and New Zealand.5–7
This paper aims to demonstrate the feasibility of applying such a price-cap scheme to all markets by considering in some detail how it would work in the exemplar market of the UK. To do this, we first determine how much profit the tobacco companies operating in the UK currently make, and then calculate by how much this would be curtailed by price caps, and thus, what additional tax revenue such a scheme could raise. We take into account the costs of running the regulatory agency that would need to be established to run the scheme.
The price cap scheme and the benefits it would bring
The price cap scheme
A RPI-X price capping scheme would set the maximum prices tobacco manufacturers’ could charge based on how prices in the economy have generally changed (the RPI—Retail Price Index—element), an assessment of the genuine costs each firm faces in its production and operations allowing for a reasonable return on the capital employed, and an assumption about the productivity improvements it would be expected to make (the X element). It is important to stress that the price being capped is the wholesale price manufacturers charge to retailers, not the price the consumer pays in the shop. The manufacturers’ profits are thereby reduced while the price the consumer pays would not change (assuming the government simultaneously increases tobacco excise rates to compensate for the wholesale price reductions). In essence, the regulation would seek to mimic some effects of a competitive market where firms face strong pressure to be efficient in their operations, and would generally only make enough profits to just keep them involved in the industry. For this to take place, a regulatory agency, The Office for Smoked Tobacco Regulation (Ofsmoke) let us say, would need to be created so that it could investigate the sector and devise appropriate price caps.
The public health benefits
As we explained in our previous paper, a system of price-cap regulation could bring numerous public health benefits. These occur both because of the reduction in profits and the incentives this engenders, and because a regulatory agency charged with capping tobacco manufacturers’ prices would be required to investigate all aspects of the tobacco industry, thus exposing it to greater scrutiny than ever before. Most obviously, price-cap regulation could prevent the tobacco industry from using price to market its products or undermine the impact of tobacco excise policies,2–4 because maximum prices would now be set by the regulator and reduced industry profits would significantly impair its ability to cut any prices below these. Price differences between brands/products would, therefore, be mainly based on the costs of production rather than attempts to segment the market by price, which should significantly reduce the problem of down-trading to cheaper brands/products. Indeed, the suppression of pricing strategy from the arsenal of the transnational tobacco companies would be a complementary policy to other tobacco control measures, as it would essentially prevent the companies from using price changes as a defence in response to public health measures, such as plain packaging, and might even reduce their future resistance to such measures as their profitability becomes partially insulated from them, as the price caps set would take account of the impact of such measures. Furthermore, price-cap regulation could offer a means of controlling other unwanted industry practices, such as price fixing, cigarette smuggling and marketing to the young, as the regulator would be able to identify such activity and then take it into account when setting the price caps. For example, by forbidding, or tightly restricting the marketing budget if the companies are marketing to children. Companies could be regulated based only on their legal activities (so that they do not benefit from illegal activities, such as smuggling) and potentially even penalised for any undesirable activity in order to provide a strong incentive to act responsibly. There is also significant potential to generate indirect public health benefits through the reduction in the money the industry has available to spend on lobbying or fighting public health measures.
Source: Ref. 1.
Existing regulatory agencies have significant resources, including access to the data necessary to set appropriate price caps for the firms in their industries.8–12 Without such resources and detailed data, our numbers will inevitably be estimates. To that end, we present two scenarios; a conservative scenario (in revenue terms) using relatively unsympathetic assumptions to represent the lower bound of possibilities, and an optimistic scenario using more benevolent assumptions to present more of a best-case scenario. To develop these scenarios, we assume the final price consumers face would not change on the basis that any reductions in manufacturers’ prices would be offset by equal rises in tobacco taxes. Governments might raise taxes beyond this level, but such a decision would fall outside the direct effects of price cap regulation being investigated herein. Therefore, since the final price to the consumer is not being changed, we assume that sales are not affected by the decision to implement price caps.
We utilise profit data for the companies currently selling tobacco in the UK to calculate how much profit would be reduced through the imposition of price caps, and thus, how much additional tax could be raised. Data for 2010 and 2009, the two most recent years available, are used. We assume that all the costs the tobacco firms currently report are legitimate costs as we were unable to obtain data as to where the firms incur their reported costs.
We obtained market share data broken down by product type (cigarettes, hand-rolled and pipe tobacco) for each major company operating in the UK for the 2009 and 2010 calendar years from Euromonitor.13 These were then weighted by product-type share of the total tobacco market to give overall company market share figures. Data on company profits for the closest matching financial years were obtained from the annual reports of the major TTCs operating in the UK, with additional data obtained via Companies House. However, as most TTCs present only regional data on profits, in several instances we had to calculate likely UK performance as outlined below.
Profitability of Imperial Tobacco
Imperial accounted for 44.3% of the UK tobacco market in 2010, and made adjusted operating profits from tobacco in the UK of £614 million from net revenue of £911 million; a margin of more than 67% (£1 equalled approximately US$1.50 as of March 2012). Thus, for every £1 the company receives after paying all tobacco duties, 67p of it is taken as profit. In the 2009 financial year with a market share of 42.9%, the equivalent figures were £601 million profit from revenues of £893 million, also giving a margin of over 67%.14
Profitability of Japan Tobacco International
Japan Tobacco International (JTI) had a market share of 35.2% in 2010 and 35.8% in 2009, but does not provide performance data for the UK market alone, instead including it within the wider Western Europe area. However, JTI is represented in the UK by its Gallaher Limited subsidiary, and accounts for this firm are a matter of public record. UK sales, including duty, were £4344 million in 2010 and £4253 million in 2009, representing 94.8% and 95.1%, respectively, of the company's total revenue in those years, and giving operating profits of £345 million and £312 million, respectively.15 To calculate profit margins, we need to remove duty from the company's revenue. Duty is given only for total sales, so we assigned to the UK market a proportion of total duty paid in line with the UK revenues as a proportion of total company revenues (ie, 94.8% in 2010). This suggests a net revenue of £889.67 million in 2010, generating a profit margin of 38.8% given the £345 million profit. In 2009, net revenue was £854.78 million, implying a profit margin of 36.5%.
Profitability of Philip Morris International and British American Tobacco
Philip Morris International (PMI) accounted for 7.9% of the market in 2010 and 8% in 2009, but does not provide UK-specific data since it reports on an EU basis. For this region, tobacco net revenue was US$8983 million in 2010, generating operating income of US$4502 million, and for 2009, the net revenue was US$9041 million with an operating income of US$4506 million.16 Operating income is a similar accounting measure to the operating profit of the UK-based companies, implying an EU profit margin of 50.11% in 2010 and 49.84% in 2009.
British American Tobacco (BAT) accounted for 7.6% of the market in 2010 and 7.3% in 2009, but again does not provide UK data, reporting instead for Western Europe. In 2010 BAT reported adjusted operating profits for Western Europe of £1054 million on net revenues of £3419 million, a margin of almost 31%. In 2009, the same figures were profits of £994 million on net revenues of £3884 million, a margin of more than 25.5%.17
We note that while both PMI and BAT have subsidiaries operating in the UK, Philip Morris Limited and BAT UK Limited, respectively, the reported figures for these companies are such that they cannot possibly represent their full dealings in the UK given their market share and the finances reported by other TTCs.18 ,19
Given the lack of UK-specific figures for both PMI and BAT, we estimated their UK profitability based on their wider European operations. We know that Imperial accounted for 44.3% of the UK market in 2010, earning revenues of £911 million in the process. This implies that each 1% market share is worth £20.56 million in net revenue. Using 2009 data, the figure is £20.81 million. This suggests that in 2010, PMI made revenues of £162.42 million given a market share of 7.9%, earning profits of £81.39 million given a margin of 50.11%. For BAT, a 7.6% market share implies revenues of £156.26 million, and a profit margin of almost 31% implies profits of £48.2 million. For 2009, we calculate that PMI, earned £166.48 million in revenue, generating profits of £82.97 million, and BAT had revenues of £151.91 million generating profits of £38.74 million.
Profitability of the remainder of the market
The remainder of the UK market, accounting for 5% in 2010 and 6% in 2009, consists of a variety of relatively small companies and own-label products.13 The situation with profitability in this category is unclear, but given the small market share, it will have very little impact on our overall results. We therefore assume that the profitability of this segment is relatively low, and thus, would not be affected by the imposition of price caps under either scenario.
Profits allowed under the price-cap system
Under an RPI-X system, firms are allowed to charge a price high enough to allow them to make sufficient profits to cover all legitimate costs and make a small return. Therefore, we assume that the firms make such a profit by pricing at the maximum levels allowed by their price caps because, as previously suggested,1 a low price strategy would be an unviable response since it would lead to even lower profits. In order to determine an appropriate level for this profitability, we use data on the profitability of large European transnational firms operating in the more competitive non-tobacco consumer staples market segment as a benchmark (see table 1).
A considerable number of comparator consumer staple companies have profitability in the range of 12–20% EBITA (earnings before interest, taxation and amortisation expenses have been deducted, as a proportion of its total revenue) (table 1). EBITA is a similar measure of profit to the adjusted operating profit measure used above. In our conservative scenario we therefore assume that the companies would be allowed to make returns of 20%, while our best-case scenario assumes a 12% return. We assume this rate of return would be allowed on current revenues, as this approach is the nearest we can get to RPI-X regulation with the data available.
The costs of regulation
As with existing UK regulators, the cost of the tobacco regulatory agency—Ofsmoke, let us say—could be covered by the industry itself through fees and levies paid by tobacco companies. These fees are generally set such that the regulator breaks even. As a guide for the cost of Ofsmoke, we consider relevant existing regulators (table 2).
These vary quite considerably, depending upon the nature of the market and the scope of the regulator in question. Given Ofsmoke would only be regulating tobacco products, it would be more akin to the regulators also operating in single markets, such as Ofwat, the Office of Rail Regulation or Postcomm. Therefore, using the budgets for these regulators as a guide, we estimate a budget for Ofsmoke of £15 million in our optimistic scenario, and £45 million in our conservative scenario for both 2009 and 2010.
Since regulation would result in the reduction of the UK operating profits of the tobacco companies, an additional ‘cost’ of regulation is the reduction in corporation tax paid in the UK. In 2009 and 2010, the rate of UK corporation tax was 28%. We therefore assume as a cost a sum equal to 28% of the corporate profits forgone due to regulation. For instance, if regulation resulted in a reduction of profits by £100 million, we assume an associated loss of corporation tax of £28 million as a cost of regulation.
Industry profitability and potential for increased tax revenue
Applying the methodology and data collected as described above, we estimate that both scenarios generate significant reductions in industry profits, and thus, scope for increased taxes (tables 3 and 4). Under our conservative scenario, we estimate a reduction in industry profits of £664.7 million compared with actual performance in 2010, and £617.0 million compared with 2009, while in our best-case scenario these figures increase to £834.2 million and £782.5 million, respectively.
Once the costs of regulation are taken into account, the increase in tobacco tax revenues would be somewhat lower (table 5). Under our optimistic scenario in 2010, we estimate a reduction in corporation tax of £233.6 million (£219.1 million in 2009). With £15 million to pay for the regulator, this leaves a potential increase in tax revenue of £585.7 million (£548.4 million in 2009). Under our conservative case in 2010, we estimate deductions of £45 million for the costs of the regulator, and £186.1 million for corporation tax (£172.8 million in 2009), suggesting a potential increase in revenue of £433.6 million (£399.2 million in 2009).
Given the difficulties in obtaining accurate data, our intention is not to establish a definitive set of figures but simply to demonstrate the broad feasibility of price cap regulation using the UK as an exemplar. The results (table 5) suggest that price caps could give the UK government scope to raise tobacco taxes by approximately £500 million (US$750 million) annually without affecting the price the consumer pays. This represents an increase of around 5% compared with the estimated £10 000 million tobacco tax revenue in 2008/2009, or £10 500 million in 2009/2010.20 This is not a huge proportionate increase, and such sums could, therefore, also be raised by a new profit tax, or by simply raising tobacco taxes without the use of price caps. However, unlike these other schemes, additional tax revenue from price capping comes as part of a suite of public health benefits (box 1), and is also likely to be accepted by voters given that they will face no additional costs personally. Moreover, £500 million still represents significant revenue, being sufficient to pay twice over for UK-wide antismuggling measures (£96.5 million in 2008/2009), smoking cessation services in England (£74 million in 2008/2009), and the associated pharmacotherapies (£56.4 million in 2008/2009).21 Such sums, therefore, represent a significant argument for tobacco price caps to be an exception to the current political trend in many countries for less regulation and smaller government, particularly in the current climate when many governments are running significant budget deficits.
There are several reasons why our figures are likely to underestimate the revenue potential of price capping. First, it is unlikely that all the costs the firms currently face would be accepted as legitimate (eg, money spent on marketing might be deemed inappropriate), and reduced operating costs imply greater scope for tougher price caps. Second, it has been announced that the UK rate of corporation tax is due to fall to 21%, meaning that the associated cost would be lower. Furthermore, because companies are able to claim various deductions from the operating profit used to calculate corporation tax in this paper, the tax actually being paid is likely to be lower than assumed.
Third, the UK tobacco market is widely believed to be one of the most profitable in Europe.22 Therefore, our assumption that PMI and BAT are only as profitable as their European average likely underestimates their actual UK profitability. The same might also be true for JTI, as before it purchased the Gallaher Group, Gallaher reported EBITA margins for the UK of 53.2% in 2004 and 54.1% in 2005.23 These margins are around 15% higher than we assumed, and it is unlikely that margins will have reduced by this much in a market showing increasing profitability. Furthermore, we assumed that the non-TTC share of the UK market was not profitable enough to be affected by price caps when, in reality, some of these firms might be highly profitable.
Fourth, when calculating the profit allowed under price caps, existing firm revenue was used as the basis for the calculations. These revenues include both costs and profits, so using these actually allow the firms a profit margin on both their costs and their existing profits. Therefore, the real profit margins allowed in our estimates are somewhat higher than the 20%/12% figures quoted. This suggests there would be scope for a tougher regulatory regime and even higher tax revenues.
Finally, one might even consider the extreme situation where Ofsmoke takes the tough stance of regulating the entire industry on the basis that it could be run as profitably as Imperial Tobacco, currently the most profitable firm in the UK market. If this were the case, we calculate that under our optimistic scenario, the net gain to government would be more than £800 million per year in both 2010 and 2009.
We can think of only one reason why our figures might overestimate the potential revenue from price capping. Two of the four companies dominating the market are UK-based, and so the government could lose additional tax revenue if lower corporate profits resulted in lower dividend payments to shareholders, and thus, UK taxes paid thereon. However, the standard rate of tax on corporate dividends is 10% in the UK so even if this was the case, it would not fundamentally alter the outline sums identified in this paper. Indeed, even if our models were wrong by 50% (eg, because it also transpires that the financial risk attached to these companies requires a higher level of return than assumed herein), £250 million would still be raised without increasing the price consumers pay. These scenarios seem unlikely, so on balance, our estimates probably significantly underestimate the potential for additional tax revenue associated with price caps.
In conclusion, we have used available profit data for the UK tobacco market to illustrate the potential of applying a price-capping scheme to the prices manufacturers are able to charge. We then used this to outline the potential fiscal benefits to the UK in terms of the extra tobacco taxes that could be generated without affecting the price to end consumer. Although the data available to us are not ideal, in constructing our model we have taken assumptions that are likely to have underplayed the potential of price cap regulation, and as such, we feel confident that our estimates for a net increase in tax revenue of around £500 million per year are reasonable, and if anything, under-represent the true potential. Such a scheme could be applied in any country where tobacco companies enjoy significant market power and are, therefore, able to make excessive profits. Although the sums generated would differ from country to country, it is likely that it would have potential to capture significant sums for governments at a time when most are in need of extra funds. Given the wider health benefits that would also be generated (box 1), and also the political benefits inherent to not changing the price that consumers pay, this policy should be given serious consideration.
What this paper adds
As a result of the market power enjoyed by transnational tobacco companies, the sale of tobacco is unusually profitable. Previous work has established that imposing utility-style price caps on manufacturers’ tobacco prices has theoretical potential to address this market power, curb excess industry profits, and bring numerous potential public health benefits.
This paper demonstrates the feasibility of applying a system of price-cap regulation in the UK tobacco market.
It shows the high profitability of the transnational tobacco companies that dominate the UK market (Imperial Tobacco, for example, has profit margins in the UK of 67%, making it one of the most profitable companies in the country).
Even once the costs of regulation have been taken into account, it is estimated that applying a system of price caps in the UK would raise significant additional revenue, approximately £500 million (range £433.6–£585.7 million) in 2010. This would be approximately enough to fund twice over, UK-wide antitobacco smuggling measures, and smoking cessation services in England, including the associated pharmacotherapies, to help people stop smoking.
Governments wishing to raise revenue and prevent the tobacco industry from undermining tobacco control policies (eg, by offering cut-price cigarettes to undermine the impact of excise and other policies) should give further consideration to a system of price-cap regulation.
The authors would like to thank Deborah Arnott, Rob Smalley, Matt Gooden, David Sweanor and Sanjay Sheth for various bits of assistance in the writing of this paper. However, the responsibility for errors remains entirely our own.
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