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First in an occasional series of articles on the key influences on the future of the tobacco market. Following some speculative forecasts on Russian excise tax the issue of cigarette price growth and its potential to influence future demand and smoking habits is examined.
According to the International Tax and Investment Centre (ITIC), current tax plans could cause the price of cigarettes in Russia to be five times higher by 2018 with the average price of a pack of cigarettes up to around RUB145 (US$4.83). This would mean average middle income smokers spending about 12% of their daily disposable income on cigarettes while poorer smokers would be spending as much as 28%, compared to 5% and 7%, respectively, in 2011. Click to tweet! Drawing parallels with the effect of price rises on the markets in Bulgaria, Ireland, Poland and Romania would mean, according to the ITIC, that the proposed tax hikes could cause the Russian market to shrink from today’s 369 billion cigarettes per year to 186 billion in 2018, while at the same time boosting illicit trade from 11% to 35% of the market.
In terms of the tax and price hikes and consequent volume fall, and Russia being a strong smoking culture these tax changes may not come to pass. However the interesting element of the forecast is the predicted effect of price on demand. Price has become so important in the tobacco market that the pricing power of the companies is seen as the primary indicator of corporate health such that the major companies quote the financial effects of price rises and product mix improvements on their sales and profits as if price has become a new product sector.
The WHO has called price the primary instrument of tobacco control. Analysis of the connection between cigarette price rises and demand has led to the generally accepted hypothesis that a 10% rise in cigarette price means a 4% fall in cigarette demand or in other words a price elasticity of demand (ED) factor of 0.4. In fact when this rule of thumb is applied to individual cases Euromonitor International analysis shows that the ED factor varies considerably from country to country. This is because other factors may either mitigate or exacerbate the effect on demand of price. Such factors – positive and negative in terms of effect on demand – will include public smoking bans, impact of recession on consumer spending power, rise in illicit trade and, at the other extreme, rising smoking population and downtrading.
In the table below, all the markets apart from Turkey may be described as developed as opposed to developing. The average ED factor of 0.4 is meant to apply to developed countries. However, analysing growth in prices paid set against cigarettes volume falls, where these have occurred, in Western Europe, shows variation between 0.7 in Spain and 0.1 in Italy demonstrating the influence on volumes of factors other than cigarette prices. In Spain the ED factor of 0.7 was due to a combination of price rise, economic downturn and a public smoking ban – a triple whammy. Where the countries are developing and consumer spending power is weaker, price rises may have a larger impact so that the ED factor is higher.
Source: Euromonitor International
Note:* ED = elasticity of demand. A rise in price of 10% is estimated to produce a fall in volume of 4%, ie an ED factor of 0.4. Variations demonstrate that price is not the only factor causing volumes to fall.
Another key aspect of price is that it is the only tobacco control measure which, from a government point of view, is tax generative – the others all cost money to impose and maintain. In 2011 the Russian Finance Ministry said it was considering hiking tax rates to RUB3,000 (US$100) per 1,000 cigarettes by the year 2015 as part of plans that would seek to add RUB1.9 trillion (US$66.9 billion) to the federal budget over three years. Such a tax hike would represent a ten-fold increase over the 2011 rates but would only bring Russia up to the average level of cigarette tax in European countries, which is EUR64 (US$90) per 1,000 cigarettes. According to reports, The Health and Social Development Ministry is considering other bills aimed at cutting smoking, including banning smoking on all public transport by 2014 and in cafes, bars and restaurants by 2015.
The operating environment in Russia, one of the world’s best and most profitable markets for tobacco companies because of its size, high prevalence and smoking culture, is becoming more challenging: requirements to print health warnings on cigarette packs reportedly cost the industry US$28 million while new regulations requiring warning images on packs by 2014 are projected to cost a similar sum. These costs however are insignificant when set against the potential losses generated by the halving of Russian cigarette volumes by 2018 speculatively postulated by the International Tax and Investment Centre as the consequence of the quintupling of cigarette prices (see first paragraph).
Euromonitor International’s latest findings suggest that although in most markets and virtually all developed markets price growth, together with other factors, will cause volumes to fall, on a global basis and largely due to smoking population growth in China, the global cigarette market will actually grow in volume 2011-16. However the key point is that average prices paid will also rise – due to tax hikes and company imposed prices rises, and a continuing trend towards premiumisation where product mix will contain a higher proportion of premium cigarettes and more consumers will uptrade than downtrade. This rise in average prices will enable the value of the global market to increase by some 28% 2011-16 thus ensuring tobacco industry profits to continue to rise, albeit with an increasing proportion coming from today’s developing countries as prevalence in developed countries continues to fall.