Europe has shied away from regulating electronic cigarettes (‘e cigarettes’) as medical devices.

Tobacco control researchers have been furiously debating the safety and desirability of these products, which have surged in popularity over the past year (see ‘Regulation stacks up for e cigarettes’).

The European Commission had proposed to regulate e cigarettes as medical devices, as part of a major revision of tobacco control in the European Union (EU). But after negotiations this week, it seems that the nicotine inhaling devices will instead fall under the same rules as other tobacco products.

Some scientists believe that e cigarettes are less harmful than conventional cigarettes, and thus can help reduce the burden of disease from tobacco smoking. But others counter that with few controls on advertising and sales, the devices will make smoking socially acceptable again and that they can provide a gateway to conventional cigarettes for young people.

Politicians in the European Parliament have been pushing to have e cigarettes regulated as medical devices and therefore subject to tougher controls only when their marketing makes health claims (see ‘Europe on collision course over e cigarette legislation’). And they seem to have won over the other arms of the EU the Council of Ministers and the Commission although formal sign off on the deal is still required before it comes into force in 2014.

Tonio Borg, the EU health commissioner, said today that the agreement reached yesterday will put in place clear safety and quality standards for this growing sector of the market .

The deal will also mean all cigarette and tobacco products will have to have health warnings covering 65% of their packaging. Flavoured tobacco including menthol cigarettes will be banned.

Impact of illicit cigarettes on philip morris' european business — trefis

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The European Union (EU) contributes around 35% of Philip Morris International s (NYSE PM) revenues (net of excise) and is the most profitable division for the company, with adjusted EBIDTA margins of over 50%. The division contributes over 25% to the company s total value, by our estimates. However, as we have written earlier, the changing patterns of illegal trade in tobacco pose a threat to Philip Morris in Europe (See Philip Morris Potential Downside From The EU’s Illegal Cigarette Trade). In this article we revisit the issue of illicit tobacco in Europe in the light of new research. 1

See Our Complete Analysis For Philip Morris International

Changes In Pattern Of Illegal Trade Of Cigarettes

A major source of illegal cigarettes in Europe in the last decade was smuggled cigarettes made by large companies such as Philip Morris. These cigarettes were transported by smugglers to their target markets, circumventing the excise tax checks. This created a black market for such goods and enabled their sale at significantly lower prices than their tax paid equivalents sold for. Tobacco companies such as Philip Morris did not lose out in the process, since they did not benefit from the taxes. In fact, they were accused by European authorities in a lawsuit of scheming to smuggle cigarettes and obstruct government oversight of the tobacco industry. 1 The cigarette companies subsequently made a deal with the authorities, agreeing to pay fines called supplemental payments if large quantities of a company’s non tax paid products were caught. 2

Other forms of illicit tobacco have since become dominant. A form of contraband called cheap whites have emerged as an important threat. These are cigarettes that are legally manufactured by small firms in countries with lax tobacco product regulations. However, they are marketed outside the tax paid channels to foreign countries with high excise tax levels on cigarettes. They often resemble the authentic brands of large companies in appearance. Consumers without high levels of brand awareness but high price sensitivity may down trade to these as they are cheaper. This becomes possible since consumers are charged neither the brand premium nor the excise taxes. 1

Another form of illicit cigarettes is counterfeits. These are lookalikes of major brands that are made by counterfeiters and sold as originals. Since their sales are not reported to the government or the companies, the counterfeiters stand to gain the brand premium in addition to their own price mark ups on the products. In the United Kingdom, 46% of all large cigarette seizures in 2007 08 related to counterfeits. The majority of such counterfeits are produced in China and shipped directly to Europe or through Southeast Asian countries. 1

Estimates Of Illegal Cigarette Sales In Europe

Philip Morris contracted KPMG to conduct a study on their behalf to estimate the size of the illicit cigarette market in Europe. This endeavor, called Project Star, found that 10% of the cigarettes consumed in the European Union in 2013 were illicit, 33% of which were cheap whites, whose consumption increased 15% year on year to reach 19.6 billion cigarettes. Contraband sales were estimated at 35.6 billion cigarettes, or 60% of all illicit cigarettes consumed in the EU. The remaining 7% were most likely counterfeits. 3

Industry independent research has suggested that the above estimates may be biased towards the higher side. This is because the tobacco industry has a vested interest in overstating the illicit tobacco problem.
One reason is the need to leverage the dependency of illicit cigarettes on high excise taxes as an argument against high excise taxes on cigarettes. Secondly, the existence of counterfeits are blamed on plain packaging laws, and cited as a reason for repealing them. Thirdly, since regulators do not hold Philip Morris responsible for cheap whites and counterfeits as opposed to contrabands, there exists motive for these to be over stated. 2

Impact On Philip Morris

Assuming the results of Project Star for 2013 are correct, cigarette companies have about 40% of their sales usurped by cheap whites and counterfeits. We are assuming the contrabands were purchased legally before being smuggled. With 10% of the cigarettes consumed estimated to be illegal, 40% of these amount to 4% of all cigarettes consumed being counterfeits or cheap whites. If we assume that all companies suffer equally from this loss of sales, Philip Morris loses 4% of its Europe revenues to illegal cigarettes. With revenues from Europe for Philip Morris coming in at $28.3 billion in 2013, illicit cigarettes reduced the company’s top line in Europe by $1.13 billion.

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Notes

1. Combating The Illicit Trade In Tobacco Products From A European Perspective &#8617 &#8617 &#8617 &#8617
2. Towards A Greater Understanding Of The Illicit Tobacco Trade In Europe &#8617 &#8617
3. KPMG Study On The Illicit Cigarette Market In The European Union &#8617