Russia’s invasion of Ukraine has wreaked havoc on the regional tobacco market.
By Vladislav Vorotnikov
Russia’s invasion of Ukraine has wreaked havoc on the tobacco industry in the post-Soviet area, prompting the world’s largest cigarette companies to shut down Ukrainian factories and curtail investments and marketing activity in Russia. The current crisis is also likely to provoke a dramatic rise in the illegal segment of the tobacco market in this part of the world.
Since the beginning of the conflict, BAT, Japan Tobacco International and Philip Morris International faced mounting public pressure to sever their ties with Russia.
On March 23, Ukrainian Finance Minister Serhiy Marchenko appealed to Western tobacco companies to stop doing business in Russia. Marchenko wrote in a statement posted on his Facebook page that all cigarette manufacturers had pledged to suspend new investments, while BAT considered transferring business to a third party. However, he added, those steps were clearly not enough.
“My conviction is that there can be no compromises and smoothing alternatives,” Marchenko wrote.
Since Feb. 24, more than 1,000 multinational businesses have said they’re curtailing, suspending or severing ties to Russia compared to only the few hundred that abandoned South Africa over Apartheid, research conducted by the Yale School of Management showed. The Russian government responded to the mass exodus of Western brands by threatening foreign firms leaving the country with forced nationalization of their production assets.
On May 16, Russia went through with its threats and nationalized a major factory that belonged to French car maker Renault, sending a clear signal to all Western companies that curtailing operations in the current conditions would come at a heavy cost since it would mean losing their production capacities.
The Russian authorities are keen to avoid a shortage of cigarettes on the domestic market as it would spark social unrest, something the country had already seen during the final days of the Soviet Union.
“In 1990, a shortage of cigarettes led to massive strikes and even to plant and factory shutdowns,” said Ekaterina Pozdeeva, an analyst of the Moscow-based think tank Finam. “In Moscow, more than 100 cases of riots over tobacco were registered. The workers demanded at least two packs per hand. The USSR was forced to buy $300 million worth of cigarettes from the USA.”
On the other hand, over the past 25 years, Western tobacco companies invested roughly $5 billion in the Russian tobacco industry, Pozdeeva said. Losing this money would be quite painful, so most companies opted for transferring their businesses to local market players.
For instance, BAT has transferred business management to its Russian distributor and partner, SNS Group, which plans to maintain the same level of production and supplies. Philip Morris International also said it considered options for restructuring and transferring assets but has not yet made any concrete decisions.
Imperial Brands said in a statement on April 21 that it had transferred its business in Russia, including its Volgograd factory, to local investors and would write off €225 million ($294 million) of its tobacco assets in the country. Japan Tobacco International also suggested that it would change the Russian owner of its local business.
With annual sales ranging between 200 million and 230 million cigarettes, Russia is among the world’s largest tobacco markets. In 2020, the value of the Russian cigarette market was estimated at RUR1.4 trillion ($23 billion), bringing RUR600 billion of taxes to the federal budget, the Russian federal statistical service Rosstat estimated.
Biting Sanctions
The Russian cigarette industry, however, is likely to feel the sting of sanctions as all tobacco and almost all raw materials are imported to the country, according to Maxim Korolev, head of the Russian Tobacco informational agency, adding that it is not clear whether import replacement in this field is even possible.
“On the one hand, paper-based aluminium foil supplied by a Russian company, after several years of quality improvement, has become widely used by many Russian tobacco factories,” Korolev said. “On the other, the domestically produced polypropylene film has not reached the required quality level in terms of some key parameters, and none of the tobacco companies uses it.
“Factories also use domestic corrugated cardboard for master cases, but we do not make coated cardboard for the cigarette packs,” he said, adding that fast import replacement is not anticipated in this field.
On top of that, Russia experiences problems with leaf tobacco imports. Over the past few months, Russian businesses complained about a lack of tobacco for homemade cigarettes.
Igor Moiseev, chairman of the Pogar Cigarette and Cigar Factory, commented that the supply disruptions are primarily attributed to logistics issues. Moiseev said that before the Russia-Ukraine crisis, Germany, Denmark and the Netherlands were the main suppliers of tobacco for homemade products, and most tobacco was delivered by road through Belarus.
“Today, even with an advance payment, no one can guarantee that the cargo will be delivered [from Europe to Russia],” Moiseev said. “Difficulties in making wire transfers also affect import. And the majority of suppliers operating in this segment of the tobacco market are small[-sized] and medium-sized companies with limited resources.”
Korolev said that Imperial Tobacco was forced to stop the operation of its factory in Russia due to a lack of tobacco, estimating that other market players may have stocks of tobacco large enough to maintain operation for up to six months. On the other hand, Korolev added, most tobacco for cigarette production is imported into Russia from South American and African countries that have not publicly supported Western sanctions against the country, so there are good chances that the supply disruptions could eventually be sorted out.
Oleg Barvin, a spokesperson for BAT, confirmed to the Russian newspaper Kommersant that all market participants experienced logistics problems with delivering tobacco and other raw materials for cigarette production to Russia. Barvin added that despite these challenges, the company ensured uninterrupted production and distribution of products.
On the other hand, the sanctions are not expected to impact the Russian e-cigarette market. As explained by Kirill Plokhikh, director of the business faculty at Synergy University, Russia imports most e-cigarettes from China. Plokhikh added that some share of nicotine-containing liquids for vapes was supplied to Russia from Western countries, but in this segment, too, buyers could swiftly shift to Chinese suppliers.
Tobacco Industry Bounces Back in Ukraine
The Russian invasion forced all Ukrainian cigarette makers to pull the plug on operations, but several have already relaunched production, with some even eyeing restoring production performance to the pre-war level.
Galina Vorobieva, director of Imperial Tobacco Production Ukraine, said that despite fears voiced by Western officials since October 2021 about the upcoming Russian invasion, nobody in Ukraine took it seriously.
“Although we assumed such a course of events, we did not believe until the very end that it [the Russian invasion] could happen,” said Vorobieva. “We had a plan on how to act in the event of a real threat to the enterprise and personnel. And it is very good that we had it. In the early morning [of Feb. 24], we turned off the equipment, asked people to hop on buses and took them home.”
Imperial Tobacco considered moving its Ukrainian factory to Western parts of Ukraine even though it would take at least six months to relocate equipment.
“When we realized that the situation had become more or less controllable, we decided to resume production. It was not an easy decision because we understand that there are still risks,” Vorobieva said, estimating that the factory was out of service for 46 days.
With much of Ukraine’s tobacco production offline, demand is met primarily by imports from the European Union, according to the Ukrainian tobacco association Ukrtabak.
Illegal Market Flourishes
The current crisis promises to dramatically boost the size of the illegal cigarette market in the region. A quarter of Russians have already switched to illegal cigarettes, a survey conducted by the analytical agency Ipsos in April showed. In early April, nearly 25 percent of respondents admitted buying illegal tobacco products, 8 percent more than in mid-March.
Not only consumers and retailers suffer from illegal products. From 2016 to mid-2021, the federal budget “lost” almost RUR300 billion in tax revenues due to illegal tobacco products, the Russian Accounts Chamber calculated.
The Moscow-based think tank Kantar TNS Russia estimated that the share of the illegal sector grew tenfold, from 1.1 percent to 10.7 percent, recently. In 2021, the share of illegal tobacco products on the market reached at least 11.5 percent, according to a study by the government’s National Scientific Competence Center.
The main supplier of illegal tobacco products to Russia is Belarus. Before the adoption of the first Russian anti-tobacco law, Belarus produced 15 billion cigarettes a year with a population of 10 million. Today, the population remains about the same, but cigarette production has grown to 35 billion sticks.