Submission on the Future of Tobacco Control from

Adam Spielman

This document is my personal response to the Department of Health invitation for submissions on its consultation paper. I must stress at the start that the views expressed in this document are my own. I am writing in a personal capacity, and not as a representative of Citigroup Investment Research.

My Background Although I am writing in a personal capacity, I believe I am qualified to make this submission because I am the tobacco analyst at Citigroup Investment Research.

What my job entails

I provide independent advice to investors and potential investors to help them decide whether the shares of the main European and US tobacco companies are likely to rise or fall over time, both in absolute terms, and relative to other consumer companies, and relative to the general stock market. I say where I think the shares will go, and why I think they will move in the way I predict, but the more important element of my job is to help institutional investors understand the industry so they can make their own decisions. To succeed in my job I need to know the management of the various tobacco firms and be able to assess as accurately as possible how likely their strategies are to grow profits and hence the share prices. It is just as valuable to an investor to know whether a share is likely to fall, so that they can avoid it, or sell it short, as to know whether it is going to rise. I do not advise the industry, nor am I paid by the tobacco industry, although I can and occasionally do say what actions I think the companies could take to improve their share prices. By and large, I have had positive recommendations on the tobacco shares over the years, and generally this has been correct. Tobacco has been the best performing sector in the FTSE index in the past decade: £100 invested in either BAT or Imperial Tobacco shares in January 1999 would be worth about £550 now; by contrast £100 invested in the FTSE index would be worth only about £124 now1.

1 Dividends re-invested in both cases.

My qualifications

There are two public votes each year in which investors elect who they believe has the best analyst in each sector. I have been elected the No1 tobacco analyst in Europe in each of the surveys in the last two years. I have an MBA from Harvard Business School, and an MA from Cambridge, where I studied philosophy.

Contact details

Adam Spielman adam@spielman.co.uk 020 7986 4211 (day-time) 07968 987 359 (mobile)

Figure 1. Total Shareholder Return – Imperial Tobacco and BAT vs Diageo and FT-SE 100

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Note: Diageo is the world’s No1 spirits company. Source: DataStream

Responses to Questions

Question 1: What smoking prevalence rates for all groups could

we aspire to reach in England?

The evidence in the consultation document supports the view that the Government should focus on reducing smoking among youth and those over 40. The data for adult smokers The table on page 74 of the consultation paper summarises the data from the 2004 update on the Doll et al study. It shows that smokers who quit by about 40 have made little impact on their health. Specifically the table shows: o Smokers who quit before 35 have NOT reduced their life expectancy at all by smoking o Smokers who quit between 35 and 44 have reduced their life expectancy by about 0.75 years2 However, those who quit after 40 see an increasingly sharp worsening of the consequences of smoking. o Smokers who quit between 45-54, 55-64 or after 65, have reduced their life expectancy by about

2.5 years, 3.25 and 4.3 years respectively by smoking. Consequences for public health policy This means that from a public health point of view, by far the greatest gains come from getting the those aged over 35, and especially those aged over 45, to quit. I suspect that this age group is relatively easy to reach as well. Young, non-pregnant adults In fact, the evidence from the consultation paper suggests the Government should be relatively relaxed about smoking by non-pregnant young adults: o As long as individuals quit by around 40, they are doing little long-term harm to their own health o The health effects on other adults around them is significantly less negative than on the smokers

themselves, and this has been further reduced by the smoke-free legislation (both directly due to the reduced smoking in public places, but equally importantly due to the increased culture of smoking outside private dwellings.)

o For a non-smoker who lives in a non-smoking household the negative effects of other people's smoking are minimal (unlike abuse of alcohol and drugs). 1. Smoking does not lead to the unpleasantness (vomit, vocal abuse and noise), unprotected sex,

and fights associated with young people's drunkenness. Nor does it lead to dangerous driving. 2. Smoking does not lead to the crime, social degradation and social exclusion associated with

drugs. 3. Non-smokers no longer have to go into smoky places

o From the Government's / taxpayer's point of view, smoking is extremely profitable: The government's tax take is about £10 billion3 4; the cost to the NHS of smoking related disease is about £1.5 billion.

My conclusion from these facts is that the cost of smoking – both in terms of health and financially – is borne by the smokers themselves, and to a lesser extent by their families. Insofar as smoking is an informed choice, then the government has little reason to interfere. In my view an exception to this is justified in the case of children living with smokers. (An adult who chooses to live with a smoker has made a choice in the matter; a baby born to a smoker has not.)

2 Average for men and women 3 Of this, about £8 billion is from excise tax that would not be replaced if this expenditure were directed to other goods. 4 In addition the government loses about £3 billion due to smuggling.

The data for under-age smoking The latest data on youth smoking in England is intriguing. According to the NHS's 2007 report on under-age smoking5, the prevalence of smoking among 11-15 year-olds suddenly dropped in 2007 after remaining almost constant in the previous two decades. (The number of monthly smokers was 10% in 1986 and had fallen only slightly, to a steady 9% between 2003-06. However, the data showed the largest ever annual drop in 2007, when it fell to 6%.) Given the long-term pattern of only marginal declines, a legitimate first response is to wonder whether the drop in the reported rate for 2007 overstates the true underlying decline. It is interesting to note that there was a similarly unusual drop in the overall smoking rates reported in the 2006 GHS. In its commentary, National Statistics suggest that the under-reporting of prevalence may have increased as the social acceptability of smoking has been reduced6. A reasonable conclusion, in my view, is to assume that under-age smoking did drop in 2007, but probably not to the extent indicated in the NHS survey. Assuming this is right and there has been a drop in under-age smoking in 2007, one may conclude that the smoke-free legislation, implemented in England on 1 July 2007, and the changes in rules on selling tobacco to young people, implemented on 1 October 2007, might have had much more of an impact than previous policies, which have included bans on advertising, promotions and the introduction of hard hitting health warnings. However, I would be wary of coming to a firm conclusion on this, partly because there have not been similar dramatic declines reported in Ireland or Scotland. In addition, I do not know whether the English survey was conducted before or after the changes were implemented. Implications for policy These points imply that the government has a duty to: o ensure those who want to quit can, especially those in their forties and above; o reduce smoking among the under-age (who are deemed to be incapable of making an informed

choice)7; and o effectively inform smokers of the health consequences of smoking. In addition, it appears that a good stage to target smokers would be during pregnancy. I would assume this is a relatively easy-to-reach population because:

o Mothers-to-be naturally are concerned with the health of their children o Most will be turning to the NHS for ante-natal care.

Suggestions for specific targets: Youth: The slow rate of progress until 2006 and the surprising nature of the 2007 data combine to suggest that if the Department wants to set a future target that it can realistically expect to achieve, it should not be too ambitious. Arguably the government could reasonably expect to hit a target of 5% prevalence by 2020. Older smokers: Given the current trends, I would target 15% prevalence (down from 22% in 2006) for 50-59 year-olds by 2020. Pregnant women: There is no data in the consultation document or in the GHS on the current smoking rates for pregnant women, making it hard to suggest meaningful targets.

5 Source: Drug use, smoking and drinking among young people in England in 2007, National Statistics/NHS. 6 "It is likely that the GHS underestimates cigarette consumption and (perhaps to a lesser extent) prevalence . . . Under-reporting of prevalence, however, is most likely to occur among young people. To protect their privacy, particularly when they are being interviewed in their parents’ home, young people aged 16 and 17 complete the smoking and drinking sections of the questionnaire themselves, so that neither the questions nor their responses are heard by anyone else who may be present. This is probably only partially successful in encouraging honest answers. When considering trends in smoking, it is usually assumed that any under-reporting remains constant over time. However, since the prevalence of smoking has fallen, this assumption may not be entirely justified. As smoking has become less acceptable as a social habit, some people may have become less inclined to admit how much they smoke – or, indeed, to admit to smoking at all." General Household Survey, 2006. National Statistics. 7 In addition, the Department of Health reports that the health effects on smoking are worse on those who take up smoking before 18.

Question 3: Do you think the six-strand strategy should continue

to form the basis of the Government’s approach to tobacco control

into the future? Are there other areas that you believe should be

added?

The points raised in answer to Question 1 suggest that the most important strands revolve around helping those who want to quit to do so, and communicating the true dangers of smoking.

Question 5: What more can the Government do to increase

understanding about the wider risks to our communities from

smuggled tobacco products?

For a meaningful debate, there needs to be more accurate estimates of the scale of non-UK-duty-paid volumes, legal as well as illegal. (In this submission I refer to this combined category as “cross border”.) The best available estimates suggest about 25-36% of all cigarettes smoked, both factory-made and those hand-rolled, are cross border. Of the cross-border trade, HMRC estimates about 2/3 is illegal and 1/3 is legal. However, there are reasons to believe the methodology behind these estimates under-estimates the legal cross-border trade. The health consequences are essentially the same whether the cross-border trade is legal or illegal, and therefore I believe the Government needs to measure and consider the impact of legal cross-border trade as well as illegal. Estimating the size of cross-border The table below shows the estimates of cross-border trade, both legal and illegal, provided by HMRC and the Tobacco Manufacturers' Association. Combining cigarette and hand-rolling tobacco8, the two sources suggest that between 25% and 36% of all cigarettes smoked in the UK come from outside. Figure 2. Estimates of Cross-Border Volumes in the UK

Cigarettes HRT CombinedHMRC (2005-06) Absolute Volume Blns of Cigarettes 1,000 Tons Blns of CigarettesTotal Consumption 63-66.5 8.75-10.6 78-84Legal, Duty-Paid 49.5 3 55Illegal Cross-border 5-12 4.35-6.55 12-23Legal Cross-border 5 0.85-1.2 6-7Total Cross-border 10-17 5.5-7.4 19-29% of Consumption Legal, Duty-Paid 74-79% 30-37% 65-71%Illegal Cross-border 8-18% 50-62% 16-27%Legal Cross-border 8% 10-11% 8%Total Cross-border 16-26% 60-73% 25-35%TMA (2007) Absolute Volume Blns of Cigarettes 1,000 Tons Blns of CigarettesTotal Consumption 64.5 11 82.8Legal, Duty-Paid 47 3.55 52.9Total Cross-border 17.5 7.45 29.9% of Consumption Legal, Duty-Paid 73% 32% 64%Total Cross-border 27% 68% 36%

Assumes 0.6g of HRT per hand-made cigarette. Sources: HMRC and TMA

8 Assuming an average of 0.6g of tobacco in each hand-rolled cigarette. (A normal factory-made cigarette has 0.8g of tobacco but in Britain most individuals who roll their own tobacco roll relatively thin cigarettes.)

I believe that the method to make these estimates by the HMRC underestimates the amount of legal cross-border. Legal cross border trade is made up of product that is consumed in the UK that is either (1) bought duty-paid in the EU or (2) bought duty-free by people traveling to the UK: o The estimates for duty-paid sales made in other EU countries are likely to be under-estimated in

my view because HMRC relies on travelers accurately reporting to the International Passenger Survey how much they are bringing in. Many are likely to feel it is safer to under-report.

o The estimates for duty-free sales are likely to be low because HMRC makes the assumption that the average passenger leaving the UK buys as much as the average passenger entering. Again this is likely to be wrong as both duty-paid and duty-free cigarettes are substantially more expensive in the UK and its airports than in almost any other country in the world. This means outbound travellers have relatively little incentive to buy duty-free goods, and inbound travellers have a high incentive.

Question 6: What more do you think the Government could do to:

a. reduce demand for tobacco products among young people?

The evidence from NHS statistics is that restrictions on marketing by tobacco companies has almost no measurable on smoking rates for under-age consumers. In February 2003, all advertising and promotions by tobacco companies stopped in England and Wales. That same year UK health warnings become larger and clearer, with the warnings covering half the back of the pack and almost a third of the front of the pack. Before 2003 UK health warnings were much smaller, often printed in colours that actually reinforced the branding of the individual packs. In addition, misleading terms like "mild" and "lights" were banned in 2003. Sponsorships of sporting events was also phased out from that year. Despite these severe restrictions on marketing, smoking prevalence among 11-15 years was almost unaffected, decreasing from 10% in 1986 to a steady 9% in the period 2003-2006. Unless it is assumed that the 2003 ban on advertising and promotion caused a reduction in youth smoking in 2007 but not before, the only possible conclusion is that the limitations on tobacco marketing imposed in 2003 at most reduced smoking prevalence by 1 percentage point. It is certainly reasonable to question whether further measures on marketing per se would have larger effects.

b. reduce the availability of tobacco products to young people?

The apparent drop in consumption by under-aged smokers in 2007 suggests that there has been an beneficial effect from legislation that clamped down on selling tobacco to young people and the restrictions on smoking in public places. Until 2006 shops were a usual source of supply for 78% of regular smokers aged 11-15, and machines for 17%. Only 22% of this age group were refused on the last occasion they tried to buy at a shop. (And only 13% of male 15-year-olds)9. (Unfortunately there is no comparable data on this since the law has changed.) This shows that until the law changed, shops had not effectively stopped young people from smoking. It would appear that the most effective approach for reducing supply to young people would be to ensure shops obey the law.

Question 7: Do you believe that there should be restrictions on the

advertising and promotion of tobacco accessories, such as

cigarette papers?

There appears to be little logic in banning the advertising of tobacco and not banning the advertising of products that can only be used to smoke, for example, cigarette papers.

9 Table 2.31, Smoking, drinking and drug abuse among young people in England in 2006, National Statistics/NHS.

Question 8: Do you believe that there should be further controls on

the display of tobacco products in retail environments?

As I said in answer to Question 6a, NHS statistics imply that restrictions on marketing had little effect on under-age smoking prevalence in England. As far as I am aware there is no evidence that banning retail displays will be more effective than the collective effects of banning advertising, promotions and sponsorships and introducing large health warnings. Therefore I believe the Government should not expect that controls on retail displays will lead to large drops in youth prevalence, as measured by National Statistics/NHS surveys.

Question 9: Do you believe that there should be further controls on

the sale of tobacco from vending machines to restrict access by

young people? If so, what is your preferred option?

In relation to electronic verification, I believe that in the UK, few if any smokers will go to the effort of acquiring the necessary cards. In the UK, only about 1% of cigarette sales are through vending machines; in Germany and Japan, where electronic verification systems are used, vending machines sell a much, much higher proportion of cigarettes than are sold via machines in the UK. (In Japan I have seen figures ranging from 33% to 50%; in Germany the figure was 23% before electronic age-verification equipment was introduced, but it appears to have fallen to the mid-teens after the introduction of age-verification.) Infra-red may be an impractical solution in England because many vending machines are out of sight of bar staff.

Question 10: Do you believe that plain packaging of tobacco

products has merit as an initiative to reduce smoking uptake by

young people?

The consultation paper puts forward several arguments in favour of plain packaging. However there are some strong arguments against the proposal that need to be considered as well. 1. The evidence in favour of its positive health effects is weak currently; 2. There is evidence from drug abuse that implies the proposal will not reduce youth smoking; 3. Previous restrictions on marketing by tobacco companies have not led to large declines in youth

smoking; 4. There is evidence the desired outcome – reduced youth smoking – could be achieved more

effectively and directly by enforcing restrictions on supply; 5. There are strong arguments that there would be significant side-effects that would have negative

consequences for public health; and 6. There is a material risk that the government could be sued successfully by the industry, and it is

possible the potential damages that would have to be paid to the tobacco companies may run into billions of pounds.

1. Evidence in favour of plain packaging per se is weak

The main argument in favour of plain packaging is that "cigarette packs are essentially mobile advertisements, and that given any sort of cigarette advertising is inappropriate, plain packaging should be introduced." While this sounds reasonable, all the supporting evidence that it would actually have the desired effects comes from studies conducted in the 1990s10, and most were in fact conducted in North America in the early 1990s, when the marketing context was utterly different. Currently there is no data to show the extent to which packaging really attracts young British people to the category. We are now talking about an environment where:

o Nobody born in Britain after about 1996 can remember any tobacco advertising (as it was banned in 2003) (the 1996 cohort is now aged 12; they were 7 in 2003.)

o Point of sales promotional materials are negligible (except for the packs themselves) o It is impossible for companies to use direct mail to market to potential smokers, or to offer

coupons for discounts on certain brands. o There are large, clear health warnings on all cigarette packets that are soon to be reinforced

with harder-hitting images In North America, even now, the context is utterly different.

o Advertising is still possible and direct mailings are still widely used o In the US, shops can have point-of-sale marketing material upto 14 sq. feet in size o Coupons and discounts on individual brands are rampant o The health warnings are almost invisible in comparison with European and Canadian ones

As far as I am aware, and I have looked, there has not been a single study on the impact of tobacco packaging based on data collected in the UK since the advertising ban. It is important to note that in marketing the term "promotion" has two distinct meanings: 1. "Promotion" is usually used to refer to various forms of discounting. For example, a promotion

may occur when a company use some sort of lottery to collect the addresses of potential consumers, and then mail coupons to these consumers that give them a discount on certain brands

2. More infrequently "promotion" means any sort of activity to boost sales. In fact, much of the research into "promotions" which is cited by some public health advocates refers to the first sort, which used to be prevalent in the UK, and remains very common in the US. However, the term "promotion" as it is applied in the context of tobacco packaging in the UK in 2008 is of the second sort, which is utterly different. Clearly the evidence used to support plain packaging needs to be relevant to the current environment in England.

10 See for the example the Consultation Paper footnotes 53 to 56

2. There is evidence that the proposal will not work

Arguably, what data there is suggests that banning brand liveries would have little impact on the target age group. In England, 10% of 11-15-year-olds have taken drugs in the last month11, whereas only 6% of this age group smoked in the last week. 25% of this age group say they have sampled drugs at least once in their lives; only 15% say they have tried smoking. Not only are drugs unbranded, they are illegal even for adults and available only through illicit outlets. This data suggests that banning brand elements on packaging is likely to have little benefit for this age group.

3. Previous efforts to restrict marketing have not worked especially well

As we said in answer to Question 6a, NHS statistics shows previous restrictions on marketing by tobacco companies has had little impact on smoking rates for under-age consumers. In 2003 there was a large reduction in marketing and branding power in the UK o All advertising and promotions by tobacco companies stopped in England and Wales o Sponsorships were phased out o UK health warnings become larger and clearer, and started to cover about 40% of the entire pack o Inappropriate descriptors were banned In 2004, point of sale material12 was limited further. The combined effect of youth smoking was a 1 percentage point cut in incidence, from 10% to 9%. I would argue this is a rather disappointing drop.

4. There are better ways of achieving the same ends

In my view the best and most direct way to reduce underage smoking is by ensuring retailers refuse to serve them. (See question 6b). While the data from drug abuse quoted above suggests that even this is not likely to be entirely effective, it is a direct line of attack on the problem of under-age smoking. In the first year that there was a serious effort to reduce sales by shops to underage smokers, NHS statistics showed the most meaningful drop in under-age smoking ever.

11 Drug use, smoking and drinking among young people in England in 2007, National Statistics/NHS. Tables 2.3 and 3.3 12 Except for the packs themselves

5. There are strong arguments to suppose there would be important

negative consequences

Unfortunately there are likely to be severe side effects from plain packaging: o The only reason for banning brand liveries is because the liveries are assumed to be attractive o To the extent that they really are attractive, however, this will provide an additional reason to

buy cross-border product. It is easy to imagine that with plain packages imposed in the UK, it would be especially cool to be seen with a foreign "real" package.

The Department of Health already recognises the problems associated with illegal cross border trade and is considering how to reduce it13. In my view cross-border is considerably more damaging than the consultation documents suggests, regardless of whether it is legal or illegal. The cross-border trade:

o Means that cigarettes are being consumed here that are not being bought through UK shops. Shop-keepers are potentially the most effective line of defence against under-age smoking;

o Ensures the financial cost of smoking is lower than the Government intends, thereby dulling the Government's most potent weapon in controlling overall consumption and prevalence; and

o Results in losses to the Treasury of £3 billion from smuggled tobacco, and more is lost to legally imported cigarettes.

Furthermore, the legal cross-border trade results in use of tobacco packs whose health warnings are not effective for UK smokers as they are not in English, and most will not have the graphic elements the Government feels are appropriate. Figure 2 shows that at the moment between 25% and 36% of the demand for smoking in the UK is satisfied by cross-border products, legal and illegal, because overseas cigarettes avoid high UK levels of tax. If branded packaging really does make the product more attractive, then one has to expect this proportion will increase, with all the associated negative effects.

6. There is a risk the government could be forced to pay compensation

to tobacco companies

Another reason why the government may want to avoid plain packaging is that there is risk that it may be forced to pay compensation to the tobacco industry, and that this may run into the billions of pounds. While it is impossible to assign a precise probability to the risk that the Government may be forced to pay some compensation, the lawyers I have spoken to are unanimous that it is real. Even if there were only a 5% risk that the Government ends up having to pay multiple billions to the tobacco companies, I believe such a risk would need to be taken into consideration by any government.

13 See paragraphs 2.26, 2.27, 2.28, 2.31 and 2.33 of the consultation document.

Legal action is effectively certain Given the industry went to court to fight some of the previous restrictions on marketing tobacco, it is a safe assumption that it will again. The case would based on the law on property rights spelled out in Article 17 of the EU Charter of Fundamental Rights. This reads: 1. Everyone has the right to own, use, dispose of and bequeath his or her lawfully acquired possessions. No one may be deprived of his or her possessions, except in the public interest and in the cases and under the conditions provided for by law, subject to fair compensation being paid in good time for their loss. The use of property may be regulated by law in so far as is necessary for the general interest. 2. Intellectual property shall be protected. Under the law, there are three broad rulings a court may give: 1. The possible public health benefits are not sufficient to allow the removal of the trade mark rights;

or 2. The public health benefits do allow the Government to deprive the industry of its trade mark

rights, but there must be compensation; or 3. The Government may impose plain packaging, and there is no need for compensation. It is quite possible a court would order compensation I cannot say which of the three outcomes is the most likely, but there is a meaningful chance that the ruling will be No2, given the second sentence of Article 17 says "No one may be deprived of his or her possession, except in the public interest . . . , subject to fair compensation . . ." (The companies will argue that if plain packaging were imposed they would not be able use their tobacco trademarks and designs in any way at all, and thus they would have been "deprived" of their trademarks, as opposed to having them "regulated". The right to a trademark may lapse if it is not used.) Compensation may be large If a court does order compensation, then it could potentially be very large indeed. We outline two valuation approaches that both lead to "fair" values for the brand designs of about £3-5 billion for the UK industry as a whole. 1. Simplified discounted cash flow approach

o The UK industry's operating profit is about £1.2 billion a year. (Imperial Tobacco's UK profit is about £577 million, and it has a 46% share of the market)

o Assuming this figure is constant over time (and in the past it has grown consistently) the present value of this profit is about £17 billion (assuming a 7% discount rate)

o The profitability depends almost entirely on some brands being able to command a premium price (Figures 3 and 4)

o If plain packaging has a public benefit, it is precisely because it will reduce the attractiveness of the brands.

o One might assume that one third of the value of any particular brand is tied to the design (eg a red and white chevron and the distinctive Marlboro type-face), one-third to the name (eg the word “Marlboro”) and one-third to the specific tobacco blend. This would suggest the value of the designs for the tobacco industry in the UK is worth a bit over £5 billion.

2. Precedent transaction approach o In 2007, Japan Tobacco paid £9.5 billion for Gallaher (including net debt). Gallaher's balance

sheet showed £391 million of net tangible assets, implying the value of the intangible assets was about £9.1 billion. Given 46% of Gallaher's profit came from the UK, the value of the UK intangible assets could be estimated at £4.2 billion. As Gallaher had a 38% share of the market, this implies that an open market price for all the intangible assets in the UK cigarette market might be £11 billion. Again on the assumption about a third of that comes from the designs, the fair market value would be a bit under £4 billion.

In conclusion, there is a material risk that a court will allow the Government to impose plain packaging “subject to fair compensation being paid” and that this may run into billions of pounds. This appears to be a considerable risk for the Government to take.

Question 11: Do you believe that increasing the minimum size of

cigarette packs has merit as an initiative to reduce smoking uptake

by young people?

In 2006, most 11-15-year-old smokers tended to buy smaller packs.14

Question 13: What do you believe the Government’s priorities for

research into smoking should be?

I believe more accurate data on the scale of legal and illegal cross-border volumes would be helpful, given cross-border undermines public health priorities, and quite possibly more than a third of cigarettes smoked in the UK are non-duty-paid. In addition, I think the Government should start to consider the dangers of particular ingredients and designs of cigarettes and tobacco products. Do some additives make cigarettes more dangerous? If so which? Is there a meaningful difference in the health consequences of HRT as compared to factory made cigarettes? Can any changes be made to cigarettes to make them less harmful? To what extent is snus really safer than cigarettes?

Question 17: Do you support a harm reduction approach and if so

can you suggest how it should be developed and implemented?

Given how profitable the industry is, I believe the companies would be prepared to spend very significantly on R&D if there was a possibility that they could be allowed to introduce modified risk products. Unfortunately relatively little research is happening currently.

14 Table 2.33 of Smoking, drinking and drug abuse among young people in England in 2006, National Statistics/NHS. Equivalent data is not available for 2007.

Understanding the Tobacco Industry I believe it is important for the Department of Health, and policy makers more generally, to understand how the industry works from an economic perspective, because almost every aspect of the tobacco industry runs in the opposite way to what one may expect. Probably the most surprising (and important) point is that tobacco industry can grow in a market like the UK, even in the face of successful efforts to reduce tobacco use. In fact, in some ways the industry’s objectives are aligned with those of tobacco control. This is because tobacco companies are interested in growing profit; this is quite compatible with simultaneous reductions in consumption and prevalence. As paragraph 2.27 of the consultation document points out, probably the most effective way to reduce consumption is to raise prices; this is also precisely the best way to raise profits.

Pricing

Figure 3 holds the key to understanding the industry and explains how the shares have performed so well despite the declines in volumes. It shows how the retail price of two brands have developed over time, both at the retail level, and for the manufacturer. • Marlboro is now the leading premium brand in the UK: The recommended retail price has grown

to £5.66 for 20 Kingsize now, from £4.82 in late 2004. • Mayfair is a discount brand, and used to be one of the cheapest mainstream brands. Its price has

increased to £4.70 for 20 Kingsize from £3.99 in late 2004. The annual increase in the retail price is shown in percentage terms in the second last line of the table. Essentially prices have increased at 4% a year, which is broadly in line with the increase in average earnings. This means the affordability for most (employed) people has remained approximately constant.

Figure 3. UK Cigarettes – Change in Retail Price and Manufacturers'' Take (£ per Pack of 20)

Premium Cigarettes (Marlboro) Discount Cigarettes (Mayfair) Jul 08 Nov 07 Nov 06 Nov 05 Nov 04 Jul 08 Nov 07 Nov 06 Nov 05 Nov 04Retail Price 5.66 5.44 5.23 5.05 4.82 4.70 4.50 4.32 4.15 3.99Taxes ~ VAT 0.84 0.81 0.78 0.75 0.72 0.70 0.67 0.64 0.62 0.59~ Specific tax 2.23 2.17 2.10 2.05 2.00 2.23 2.17 2.10 2.05 2.00~ Ad valorem tax 1.25 1.20 1.15 1.11 1.06 1.03 0.99 0.95 0.91 0.88Total tax 4.32 4.18 4.03 3.91 3.77 3.96 3.83 3.70 3.58 3.47Trade margin 0.38 0.37 0.36 0.34 0.32 0.25 0.25 0.24 0.23 0.21Manufacturer's Take 0.96 0.89 0.84 0.80 0.73 0.49 0.42 0.39 0.34 0.31Increase ~Retail Price 4% 4% 4% 5% 4% 4% 4% 4% 4% 4%~Manufacturers Take 8% 6% 6% 9% 5% 15% 9% 13% 10% 12%

Note: Specific Tax is levied regardless of retail price; VAT and Ad Valorem tax are proportional to retail price.

Source: Company price lists and Citi Investment Research analysis.

Figure 3 shows the three elements of tax that are levied in the UK. It also shows the retailers’ gross profit. This has grown to 38p for a pack of Marlboro and 25p for a Mayfair. (From a retailer’s perspective, tobacco is very profitable15.) The critical point is what has happened to the manufacturer’s take. This is what is left over when the taxes and retailers’ margin are excluded. For Marlboro this has increased to 96p/pack from 73p in late 2004, and for Mayfair to 49p/pack from 31p in 2004. The last line in the table shows just how fast the prices have risen in percentage terms: between 5% and 13% for any one brand in any one year. (This rise is faster than the increase in the retail price because the specific element of the tax is increasing at approximately 2%.)

15 I have been told that in the US, petrol stations – or gas stations as Americans would say – generally make more profit from selling cigarettes than selling petrol.

From an economic perspective the rapid increase in manufacturers’ prices holds the key to the entire industry: as long as prices rise faster than volumes fall, then net sales will rise. In the UK, the typical decline in duty-paid volumes is about 3-4% a year. If average prices are rising at say 6% a year, and volumes fall at say 4%, then net revenue will increase at 2%. As volumes fall, the total manufacturing costs will decline, as the companies will buy less tobacco and other materials, and run their machines less. (Every so often they will close down a factory to ensure “fixed” costs decline as well.) With rising sales and falling costs, profits will inevitably grow. No wonder the shares have been so strong. It is no coincidence that the increase in prices in the last 12 months has been particularly strong. The industry knew that volumes would decline unusually fast because of the ban on smoking in public places. In anticipation the industry raised prices more than usual in order to protect net revenues and profits. From a tobacco-control perspective this mechanism to grow profits is perfectly acceptable because increasing prices decreases consumption and prevalence.

Downtrading

However Figure 3 above also hints at a major problem the tobacco companies have: namely downtrading16. Figure 3 shows the net revenue for Mayfair is essentially half that for Marlboro. Given the manufacturing costs are almost identical, the difference in profit is vast. Figure 4 below shows the pricing for the main UK cigarette brands for Imperial Tobacco, which is the UK’s market leader. (Marlboro and Embassy are premium brands, and always priced within one or two pence of each other; Lambert and Butler is described as a mid-priced brand. Richmond and Mayfair are also equivalents, and used to be the cheapest commonly available brands on the market. However, a couple of years ago Windsor Blue and Sterling were made available nationally. BAT has introduced Pall Mall to the UK, which is even cheaper, retailing at about £4.15/pack.)

Figure 4. Prices Before and After Tax for Imperial Cigarette Brands (£ per Pack of 20)

Embassy Lambert & Butler Richmond Windsor BlueRecommended retail Price £5.66 £5.10 £4.70 £4.45Taxes (including VAT) (4.32) (4.11) (3.96) (3.87)Retailers' Net Take 0.38 0.29 0.25 0.24Manufacturers' Take 0.96 0.70 0.49 0.34

Source: Company Reports and Citi Investment Research

Again given the fact that the costs are similar to make a pack of Windsor Blue as to make a pack of Embassy, Figure 4 implies that it is worse for Imperial Tobacco if three consumers of Embassy trade down to Windsor Blue than if two consumers of Embassy quit smoking. Partly because cigarette prices are so high in the UK, downtrading is, in fact, occurring rapidly. The chart shows that in 1990 (well before the ban on advertising), premium brands represented almost 70% of the UK cigarette market; now the figure is close to 25%.

16 Switching from expensive brands to cheaper ones.

Figure 5. Premium Cigarettes as a % of Total UK Duty-Paid Market

0

10

20

30

40

50

60

70

80

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

E

Prem

ium

Mar

ket S

hare

(%)

Source: Company Reports and Citi Investment Research

Profits in Practice Imperial Tobacco is the UK market leader, with about a 46% market share. Its audited accounts over time show that UK profits have grown consistently despite the effective tobacco control regime in place in the UK that has led to falls in cigarette and hand-rolling tobacco that are more rapid than in almost any other country, and despite the down-trading.

Figure 6. Imperial Tobacco – UK Duty Paid Volumes, Sales and Profits, 2003-08E (Pounds in Millions)

Year to Sept. £ million 2003 2004 2005 2006 2007 2008EUK cigarette market, bln (duty paid) 54.3 53.2 50.9 49.1 47.9 45.6~Growth -4.0% -2.0% -4.3% -3.5% -2.4% -4.7%Imperial Cigarette Volume (Bln) 25.3 25.2 23.9 23.4 22.9 21.5~Growth 0.3% -0.3% -5.2% -2.1% -2.1% -6.1%UK Sales Including Excise Tax 4,568 4,776 4,710 4,762 4,842 4,701 UK Excise Tax 3,808 3,983 3,910 3,927 3,966 3,839 UK Net Sales 760 793 800 835 876 863UK Operating Profit 406 454 468 506 564 577~Growth 3.9% 11.9% 3.1% 6.1% 11.5% 2.2%

Source: Company Reports and Citi Investment Research

As an analyst, I don’t expect any change in the broad trends. In short, I expect price increases to offset the volume declines and down-trading such that profit continues to rise even in the face of successful tobacco control. From a tobacco company's point of view, measures that reduce consumption – for example the smoke-free legislation – are unwelcome, but they are clearly bearable.

Cross border trade Many people assume that the tobacco companies want to encourage consumers to buy in lower tax countries, because they assume the profits will be lower if the governments take less in the form of tax. In fact the reverse is the truth. Philip Morris would much rather sell a pack of Marlboro in the UK than in Spain, say, because the profits are much higher in Spain, as Figure 9 shows. (However, they would obviously prefer to sell a pack in Spain than none at all.) The maps below show the wide variations in the price of Marlboro around Europe, and also the world. There is no product I am aware of with such huge variations in the price for a single brand. Figure 7. Retail Price of Marlboro in Europe (!/20), 2007

Russia€1.22

Finland€4.30

Austria€4.99

Italy€4.10Spain

€2.95

Iceland€4.85

Sweden€4.93

Norway€8.40

Germany€4. 71

France€5.30

Portugal€3.15

Hungary€2.34

Romania

€1.28

Turkey

Denmark€4.29

Poland€2.09

Ukraine€0.64

U.K.€8.02

Czech€2.99 Slovakia

€2.56

Greece€2.75

Neth. €4.00

Belgium€4.53

Ireland€7.00

Serbia€1.53

Lux.

Switz

€4.18

250 Miles250 Km

Existing EU

Neighbours

€2.46

€4.00

Morocco€2.81

Algeria €2.54

Tunisia €1.72

Bulgaria €2.30

Russia€1.22

Finland€4.30

Austria€4.99

Italy€4.10Spain

€2.95

Iceland€4.85

Sweden€4.93

Norway€8.40

Germany€4. 71

France€5.30

Portugal€3.15

Hungary€2.34

Romania

€1.28

Turkey

Denmark€4.29

Poland€2.09

Ukraine€0.64

U.K.€8.02

Czech€2.99 Slovakia

€2.56

Greece€2.75

Neth. €4.00

Belgium€4.53

Ireland€7.00

Serbia€1.53

Lux.

Switz

€4.18

250 Miles250 Km

250 Miles250 Km

Existing EU

Neighbours

€2.46

€4.00

Morocco€2.81

Algeria €2.54

Tunisia €1.72

Bulgaria €2.30

Source: Company Reports and Citi Investment Research

Figure 8. Retail Price of Marlboro Globally (US$/20),

US (Average) $4.17

Mexico $2.37

US av$4.17

Colombia $1.42

Brazil $1.87

Argentina $1.14

South Africa $2.64

France $8.39

UK $11.18

Spain $4.75

Algeria $3.96

Egypt $1.40

Saudi $1.33

Kuwait $1.76

Italy $6.65

Turkey $3.68

Australia $8.16

Russia $1.49

China $2.29

Kazakhstan $1.29

India $2.00

Philippines $0.70Thailand $1.89

Japan $3.24

South Korea $2.43

Germany $7.46

Poland $3.63Ukraine $0.95

Indonesia $1.15

L.A. $5.36

NY $7.25

Atlanta $3.68

Malaysia $3.01

US (Average) $4.17

Mexico $2.37

US av$4.17

Colombia $1.42

Brazil $1.87

Argentina $1.14

South Africa $2.64

France $8.39

UK $11.18

Spain $4.75

Algeria $3.96

Egypt $1.40

Saudi $1.33

Kuwait $1.76

Italy $6.65

Turkey $3.68

Australia $8.16

Russia $1.49

China $2.29

Kazakhstan $1.29

India $2.00

Philippines $0.70Thailand $1.89

Japan $3.24

South Korea $2.43

Germany $7.46

Poland $3.63Ukraine $0.95

Indonesia $1.15

L.A. $5.36

NY $7.25

Atlanta $3.68

Malaysia $3.01

Source: TMA and Citi Investment Research

What is important to realise is that in general it is precisely those countries with the highest taxes where the profit per pack is highest. This is because the high taxes provide a shield behind which the tobacco companies can raise their own prices. Again, from a tobacco-control perspective, this is a positive outcome. Figure 9. Retail Price of Marlboro by Country ($ per Pack)

$8.71$6.74

$5.36$5.64

$4.95$3.62

$2.06$2.69

$2.87$1.88$1.73

$0.39

$0.47

$0.33$0.34

$2.47$1.65

$2.80$1.82

$1.70$1.13

$2.11$0.98

$0.76$1.36

$0.63$1.10

$1.33$0.68

$0.57$0.62

$0.36

$0.00

$0.57

$10 $8 $6 $4 $2 $0 $2 $4

UK $11.18

France $8.39

Australia $8.16

Germany $7.46

Italy $6.65

Spain $4.75

US $4.17

Turkey $3.68

Poland $3.63

Japan $3.24

Mexico $2.37

Russia $1.49

Saudi $1.33

Indonesia $1.15

Argentina $1.14

Ukraine $0.95

Philippines $0.70

Net PriceTax

Includes federal ($0.39) and av. stateexcise taxes ($1.05), MSA ($0.57) and

buyout ($0.05) payments

Retail Price

Note: Net price includes retailer margin in this chart. Source: Citi Investment Research Calculations based on Citi, and TMA data

It is certain that cross border trade is encouraged by the huge variations in prices between countries: 1. Owing to the requirements of the single market, a smoker can legally take a cheap flight to Spain,

costing perhaps €100 return, and bring back 160 packs of premium cigarettes, saving about €5/pack or a total of €800.

2. A user of HRT could travel to Luxembourg and legally bring back 3kg of HRT, saving about €700 on the UK price.

From an economic perspective it would be wasteful for individual smokers not to do this. 3. If it is possible to make counterfeit cigarettes for say 20p/pack in China, and sell them in London

for £5/pack, then illegal counterfeit and smuggling is an extremely profitable activity. According to estimates by HMRC and the TMA cross-border trade accounts for 16-27% of cigarettes consumed in the UK, and about 60-73% of hand-rolling tobacco. As I have said I believe the HMRC underestimates the amount legal cross-border volumes in the UK. The legal cross-border trade occurs because under the EU Single Market rules, HM Government is obliged to allow consumers to buy goods for their own use in other EU member states. Although these rules are unhelpful from a public health point of view and for the companies, they have to be followed. They provide a useful reminder that tobacco is an industry that needs to be seen in an economic and commercial context as well as in the public health context.

Cross border trade in other countries

Finally I thought it might be helpful to put the UK cross-border problem into perspective: by international standards, the penetration of cross-border factory-made cigarettes into the UK is high, but not exceptionally so, because figures for cross-border trade frequently reach 20-30%. Cross-border is a very significant problem for factory made cigarettes in very many countries around the world, both in Europe and in emerging economies like Brazil17 and Malaysia. In North America the problem revolves around sales of low tax sales from Native American reservations18. According an EU report19, in cross-border trade in 2004 was about 13% of the EU-25 factory-made cigarette market, with 4% to 5% consisting of legal cross border and 8-9% illegal. However, the UK's very high level of cross border for HRT is almost unique, as far as I can tell. The EU report says that there is little cross border trade in HRT (also called fine-cut tobacco) anywhere in the EU, but "[t]he only exception seems to be the United Kingdom owing to the flourishing cross-channel traffic of fine-cut tobacco from the Benelux countries. This cross-channel traffic is fuelled by the low tax rates on fine-cut tobacco applied in the Benelux countries." There is evidence, however, that since this was written, there has been increasing amounts of HRT moving into France, where tax rates are higher. (In 2007, the typical retail price of HRT was €310/kg in the UK, almost four times more expensive than the legal retail price in Luxembourg (€83/kg). The retail price is €130/kg in France but only €99/kg in Belgium) . The UK total tax was 5.6 times as much as Luxembourg's and 4.3 times as much as the Belgian tax. (€168/kg, €30/kg and €39/kg, respectively.)) The report said: "In France and Germany, [factory made cigarette] cross-border shopping soared in 2004 due to the fact these Member States drastically increased their excise duty rates on cigarettes. It follows that cross-border shopping both mitigates and undermines the effects of tax increases. Conversely, cross border shopping is falling in those Member States (Denmark and Finland) whose national excise duty rates have decreased or have been frozen. The fact that cigarettes are highly affordable in certain Member States (Luxembourg, Greece and Spain) triggers cross-border shopping and/or tourist sales. Member States with high taxes on cigarettes (e.g. the United Kingdom) are popular destinations for circumvention due to appealing profit margins." "The upward trend in counterfeit cigarettes mostly coming from overseas territories (China) is a concern for all Member States, as it impacts on tax revenues and undermines health policy."

17 In 2003, an estimated 24% of consumption was from illegal sources. 18 For example in New York state, 30% of sales are from Native American reservations. In some Canadian provinces an even higher proportion of sales comes from First Nations' reservations. 19 Study on the collection and interpretation of data concerning the release for consumption of cigarettes and fine-cut tobacco for the rolling of cigarettes. 27 December 2005.