Tesco is in dairy farmers' good books after dropping the price it pays for milk by just 1ppl. But what are the wider implications, asks Michael Barker

Tesco's bi-annual milk price announcement is awaited with nervousness, and understandably so. The supermarket is responsible for a third of all retail milk sales in the country, and pricing decisions made in Cheshunt are closely scrutinised by the industry.

Many feared the retailer would follow the lead of processors and farmer co-ops including Arla, Robert Wiseman and Dairy Farmers of Britain, which in January dropped their prices paid to farmers by at least 2ppl, citing reduced production costs. But this week it surprised many by dropping the price it pays its direct milk suppliers by not much more than 1ppl to 27.43ppl.

Coming in the wake of news that UK milk production has fallen to a 35-year low and with more farmers expected to quit the industry, its decision has been met with general relief across the industry.

The view that Tesco acknowledges the importance of its role in boosting - or undermining - UK farmer confidence is substantiated by the retailer itself.

"The new price is designed to ensure dairy farmers can continue to run sustainable businesses against a backdrop of continuing volatility in UK, European and global markets for farmgate milk," says a Tesco spokeswoman, adding that the new price is "well above the current market value of farmgate milk" and "reflects our continued commitment to the long-term sustainability of the farmer members of the Tesco Sustainable Dairy Group".

In a retail environment in which price negotiations are usually ultra-sensitive and closely guarded, Tesco's approach in publicly revealing the price it pays suppliers is unorthodox but understandable given the precedents its decisions set.

Gaining plaudits

Of course, Tesco's move isn't motivated purely by altruism. It is eager to move away from the milk industry spotlight, especially in the wake of the OFT price-fixing allegations, which it continues to fight.

"Tesco doesn't want to be seen to be leading the market because it's a lot of extra pressure," says one source. "This week's price change puts other retailers under pressure not to push prices down. It sets a tone for the market."

The Tesco price announcement is of huge significance to the industry, agrees NFU Dairy Board chairman Gwyn Jones, although it shouldn't be. "It's critical in the sense that the industry is rather pathetic and watches Tesco," he says. "This 'follow the leader' mentality has got to stop."

Other retailers, of course, point out they make their own pricing decisions, in many cases based on a fixed premium above the processor price. Tesco on the other hand employs consultants Promar International to calculate a price that measures cost changes on dairy farms and produces an analysis of current market conditions.

The additional detail, plus the fact Tesco is Tesco, means it is invariably the Promar price that attracts the most attention.

Fortunately, says DairyCo head of market intelligence Huw Thomas, it has generated a new price that is still far above the EU's Intervention Milk Price Equivalent - the base rate the EU says should be paid - of 19.9ppl. "Tesco's model is the kind we need if farmers are going to reinvest," adds Thomas.

Jones echoes this, adding that Tesco dairy category manager Alain Guilpain had stuck to the supermarket's promise of giving farmers a fair deal. "I was confident Tesco would not break its word," he says.

While Tesco's decision looks to be good news for farmers and dairy producers, its consequences for consumers are less clear.

Analysts disagree on the extent to which farmer price and shelf price are related, but evidence from The Grocer 33 price survey shows Tesco's milk announcements tend to be followed by a change in shelf price. Last April's 0.5ppl increase, for example, was followed in May by an increase in the cost of four pints in the supermarkets from £1.34 to £1.44, while October's 0.75ppl rise was accompanied by a further shelf increase to £1.53, its current price.

Shelf price

Tesco says it is unable to comment on the likely impact on the shelf price because of the ongoing OFT investigation. But it doesn't seem out of the question to expect a drop to follow.

Whatever happens to the price, however, Tesco will continue to court criticism from the dairy industry for its branded promotions.

Milk became a battleground in the price war between Tesco and Asda in March.

Two litres of Wiseman's branded discount line Fresh n Lo was sold on promotion at 85p instead of the usual £1.06 as Tesco went head to head with Asda's Arla-supplied milk.

Both supermarkets came under fire from the NFU for the promotion, which the union claimed undermined attempts to secure stable pricing at a time of dwindling milk supplies.

Robert Wiseman has doubled the volume of Fresh n Lo it sells to Tesco since the brand was rolled out nationally last year, from

40 million litres a year at launch to 80 million now, giving the milk just under a 10% share of the retailer's liquid milk sales.

But Wiseman's share of Tesco's own-label milk supply fell last month when the supermarket, in a "strategic rebalancing" that surprised many, switched 40 million litres of own-label milk to Arla. The move, which did not affect Wiseman's branded milk, reduced its share of Tesco's overall milk sales from 60% to 55%.

Some claim Tesco is upping the volume of Fresh n Lo it sells to give it more short-term shelf price flexibility. Having more branded milk allows it to circumvent its pricing strategy and run promotions if it can increase sales of Fresh n Lo, claims one supermarket supplier source. "That means it is not beholden to the margins on standard milk," he says.

Promotional strategy

Another dairy industry source, however, insists the supermarket has offered guarantees that - whatever promotional strategy it adopts - the price it pays will never fall below the cost of production.

"Tesco was seen for years as a symbol of everything wrong with the relationship between farmers and supermarkets. It is trying to step away from that," he says.

Tesco's latest price announcement may signal its stance is softening, but the same cannot be said about its arrangements with cheese suppliers. While retailer margins on milk have barely changed over the past year, cheese margins are growing, according to a DairyCo report this week.

Tesco has come in for criticism recently for its sourcing of Irish cheese, which is perceived as cheaper than UK equivalents. Problems are now arising with own-label Cheddar, with producers arguing they are not being supported by supermarkets.

Critics even claim such tactics are undermining the work done to premiumise British cheese if they drive down overall category value.

"The flipside of Tesco's work on milk is that it doesn't look after its cheese farmers well. I struggle to reconcile this," says Jones.

Tesco may be winning the PR battle on milk, but it hasn't won the war just yet.