Table 2 Proﬁtability (measured using the EBITA margin (%)) for Europe’s two major tobacco companies and comparator European consumer staple companies Company 2004 2005 2006 2007 2008* 2009* 2010* 2011* Tobacco companies British American Tobacco 24.0 28.1 28.7 30.0 30.7 Imperial Tobacco Group 40.2 41.5 42.9 45.0 28.2 Food companies Cadbury 15.6 15.9 14.4 13.5 12.0 Danone 12.7 13.1 13.3 12.1 14.4 Nestle 12.7 12.9 13.5 14.0 14.3 Premier Foods 12.9 13.7 13.8 12.5 11.9 Consumer products companies Unilever NV 15.5 14.8 14.3 14.5 14.6 Henkel 9.4 9.7 10.2 10.5 10.3 L’Oreal 15.3 15.6 16.4 16.6 15.5 Reckitt Benckiser 19.3 20.1 21.5 22.6 23.4 Beverage companies Heineken NV 13.6 13.1 13.0 14.8 13.2 SABMiller 18.1 20.2 16.9 16.8 16.6 Carlsberg 8.8 8.7 9.6 11.5 13.2 Diageo 28.7 29.0 28.2 28.3 28.5 31.1 37.7 13.0 16.9 14.4 12.0 14.7 9.0 14.3 23.9 13.5 16.8 16.0 28.9 32.1 39.4 13.8 15.7 13.0 11.9 14.9 10.6 14.9 23.2 14.0 17.3 16.3 31.5 33.7 39.5 14.9 15.9 13.2 11.7 15.1 11.6 15.5 23.6 14.4 18.5 17.1 31.8 Various Citigroup ‘Consumer Central’ business analyst investment reports. *Estimated values markets, particularly high tax markets where speciﬁc taxes predominate, cigarette companies are using tax rises to disguise price increases. This raises an issue, as reported in recent years by city analysts, that small, gradual tax increases, even at high rates of tax, may beneﬁt the industry (in contrast to large intermit- tent tax increases) while having relatively little impact on consumption.7 10 11 Some even suggest that the major trans- nationals now support higher speciﬁc taxes, albeit implemented gradually.12 As a result, high tax countries such as the UK, for example, are now often the industry’s most proﬁtable.11 It also partly explains why industry proﬁts are increasing in most western markets despite declining cigarette sales.13 Second, this emphasis on speciﬁc taxes has further reduced competition in the market. Speciﬁc taxes tend to reduce price differentials while ad valorem taxes widen them making it harder for cheap brands to remain competitive (box 1). Speciﬁc taxes therefore tend to favour the major tobacco companies (which sell predominantly expensive cigarette brands or have a wide brand folio covering all price segments) over smaller companies mainly selling cheaper brands, and have probably contributed to the former ’s growing predominance. This situation beneﬁts the tobacco industry while disadvan- taging the consumer, and reducing potential beneﬁts to popu- lation health and the public purse. The extreme proﬁtability of cigarettes gives tobacco companies both the incentive and the resources to ﬁght public health measures designed to reduce tobacco consumption, and an enormous interest in opposing anything that could disrupt the current cigarette-dominated nicotine market. The pricing power of these companies also creates signiﬁcant economic rents for the tobacco companies which ought to be captured by the state and used for wider social beneﬁts. CHANGE IS NEEDED: WHAT ARE THE OPTIONS? There are three main approaches through which this particular market failure and related problems can be addressed, and any organisation charged with preventing market abuses would wish to consider each. First, creating more competition in the market; second, nationalising tobacco companies; and, third, regulating Tobacco Control 2010;19:423e430. doi:10.1136/tc.2009.034470 Special communication to overcome the negative consequences of market failure. The ﬁrst would be both undesirable (as increased competition in the cigarette market would have negative public health conse- quences) and largely impossible given the existing barriers to market entry, which, as outlined above, will increase as tobacco control measures progress. Thus attempts to dismantle domi- nant cigarette companies or encourage new entrants to the cigarette market would almost certainly fail. The only way in which competition could potentially be increased is if a broader market in nicotine products could be created wherein smokeless tobacco and other nicotine products could compete with cigarettes. This too might raise public health concerns and, even if it were achievable, competition would be severely limited because the major cigarette manufacturers have now acquired virtually all the large independent smokeless tobacco manufac- turers,15 and at least some, recognising cigarettes as their most proﬁtable product, lack incentive to promote smokeless tobacco to compete with cigarettes while having every incentive to promote dual use in a way that maintains the cigarette market. Nationalisation of transnational companies would capture the excess rent accruing to the industry for governments, but would be impractical, given the large revenues governments would need to buy out the companies, the difﬁculty of engendering public support and, in the case of transnational corporations, the complex legal challenges. Closely related proposals to remove the proﬁt incentive from tobacco manufacturing by buying out the tobacco companies and transferring the assets to a not-for- proﬁt organisation with a public health mandate would face similar problems. Regulation to overcome the problems of market failure, therefore, seems a more attractive and practical proposal, and we propose below a system of price cap regulation. However, we ﬁrst note that implementation of sufﬁcient tobacco control regulations, with plain packaging being a key example,16 17 might also limit proﬁtability. The impact of such policies on proﬁts would, however, be far less certain than price cap regu- lation, particularly given the industry’s well-documented history of circumventing previous advertising restrictions,18e20 and less immediate. Nor would other regulations raise money for the treasury. The key issue, however, is that one would not preclude the other: price cap regulation would make it easier to implement other tobacco control policies such as plain pack- aging because arguments about their negative impact on industry revenue would no longer apply and if such policies did adequately address the excess returns, then price regulation could stop. A PROPOSAL FOR CHANGE: PRICE CAP REGULATION We propose that the problems outlined above can be most easily addressed by the application of a system of price cap regulation, such as RPI-X,21 22 to tobacco products wherein the cap is applied to the manufacturers’ pre-tax price but not the retail price. The rationale would be threefold. First, to help address the market failure described above and control the excessive margins enjoyed by the industry (without having to weaken essential tobacco control policies). Second, to increase government revenue by restricting the price the industry can charge, thus enabling governments to increase taxes and transferring rent from the tobacco industry to the government. Third, to bring public health beneﬁts though a number of means outlined further in the next section. To our knowledge only one previous (unsuccessful) proposal has been made to regulate manufacturers’ prices, in British Columbia, Canada, in 1998.23 Rules on minimum retail prices 425