• April 17, 2024

A New Reality

 A New Reality
Photo: Delovoy Petersburg

Two years into the Ukrainian conflict, tobacco businesses still scramble to adapt.

Contributed

Since Russian forces crossed the Ukrainian border on Feb. 24, 2022, tobacco business on both sides of the conflict has been a roller-coaster ride. As the second anniversary approaches, tobacco companies have yet to fully adapt to the new reality.

In 2022, sweeping Western sanctions triggered massive disruptions in the supply of raw materials for tobacco factories in Russia and Belarus. The logistics havoc that followed the first EU sanctions packages took a heavy toll on production costs. Besides, the restrictions directly prohibited the delivery of some raw materials to the country.

Nearly two years since, this issue is yet to be fully solved, according to Sergey Glushkov, head of the communications department at Japan Tobacco International Russia.

“Two years ago, 100 percent tobacco and more than 90 percent of nontobacco materials were produced abroad. However, after necessary raw materials were included in the list of dual-use products and were placed under the U.S., EU and Japanese sanctions, tobacco companies operating in Russia started diligently looking for suppliers in China, India and other markets,” Glushkov said on the company’s social media networks in Russia.

In addition, to mitigate risks, the company puts a lot of effort into import replacement. JTI Russia has localized foil, plastic film, cardboard packaging, most paints and some raw materials. As a result, the share of localized raw materials has nearly tripled compared to pre-sanction times, though it is still falling miles short of the desired level.

Raw material supply is still a pressing issue, which is far from being sorted out, Glushkov admitted.

There are many reasons why sanctions keep executives of the Russian tobacco factories awake at night. As Western technologies are no longer available on the Russian market, modernization issues also come to the fore.

Some necessary equipment and production lines are nearly impossible to get, Glushkov stated, adding that this situation might push factories to somehow rejiggle operations. He didn’t elaborate, only admitting that this would incur costs.

Numerous reports indicated that Russian businesses find creative and effective ways of circumventing Western sanctions, sourcing necessary raw materials in third countries like Turkiye, China, Kazakhstan and Georgia.

However, as Western countries double down on their efforts to close the existing loopholes allowing Russian firms to bypass the restrictions, this work is growing trickier by the day. U.S. President Joe Biden signed an executive order in December announcing secondary sanctions on foreign banks suspected of supporting Russia’s campaign in Ukraine.

This move has seemingly hit the target, as banks in Turkiye, one of the largest hubs for re-exporting Western goods to Russia, have started closing Russian corporate accounts following threats of secondary sanctions from the United States, the local press reported, citing market players.

There are problems in China as well. A major Chinese bank for Russian importers, Chouzhou Commercial Bank, ceased operations with Russian and Belarusian companies. Occasional reports indicate difficulties Russian business has in other jurisdictions.

In Ukraine, plans are drafted to move cigarette factories to safer territories (Photo: Fifth Channel)

Seeking a Safe Harbor

On May 28, a kamikaze drone hit Imperial Tobacco Group’s factory near Kyiv, Ukraine. Although the destructions reportedly were insignificant, this event once again reminded foreign investors operating in the country that in the context of constant shelling, no place can be considered entirely safe.

Imperial Tobacco Group resumed operation soon after the Russian troops fell back from Kyiv. Galina Vorobieva, director of Imperial Tobacco Production Ukraine, claimed that the company faced a hard choice whether to resume operation, as safety risks were undeniable.

Plans were drafted to move the production to a Western region, which is considered safer, but the wheels are yet to be set in motion.

Philip Morris International, in turn, has recently confirmed plans to build a new cigarette factory near Lviv, not far from the Polish border, to manufacture around 7 billion cigarettes per year.

Maxim Barabash, director of Philip Morris Ukraine, explained that the company is primarily driven by safety concerns, as the factory in Kharkiv in the eastern part of Ukraine sits too close to the battlefields.

The Ukrainian authorities estimated that every third building in Kharkiv had been damaged by shelling. For this reason, putting the local factory into operation never seemed like a feasible option.

“We understand that in the medium term, it will be challenging for us to put the Kharkiv factory back into full operation. And we need local production as soon as possible to meet the demand on the Ukrainian market,” Barabash told local press.

In the good old days, the Kharkiv factory manufactured 20 billion cigarettes per year, of which nearly half was exported. It is hard to imagine this now, but a share even landed on the Russian market.

The Lviv factory will manufacture less because export is not in the cards. Besides, the demand on the domestic market has plummeted by roughly a third as millions of Ukrainians fled from the country seeking shelter in the neighboring countries.

The fate of the Kharkiv factory remains vague. According to Barabash, Philip Morris is not contemplating shutting it down completely, but the company also won’t need two production assets.

Almost all smaller tobacco factories continue operation in the country despite multiple challenges, spanning from worsening labor shortage to waning demand and flourishing illegal trade. A recent report by the Kyiv School of Economy indicated that the share of the shadow segment of the cigarette market in Ukraine spiked to a record-breaking 20 percent.

Illicit cigarettes remain a problem in both Russia and Ukraine. (Photo: Russian government)

Looming Nationalization

Since early 2022, all leading Western firms have been pressured to sever their ties with the Russian and Belarussian markets. Not all tobacco firms, however, were quick to do so.

In August 2023, Ukraine’s National Agency on Corruption Prevention even added Philip Morris International and Japan Tobacco International to the list of “international war sponsors” for not pulling a plug on Russian operations. The Ukrainian government agency claimed that both companies generated solid revenue in Russia and kept paying taxes to the Russian budget.

Imperial Brands was the first of the global tobacco firms to leave Russia in April 2022, followed by BAT in September 2023.

JTI Russia decided to continue its business in the country to not deprive customers of the products they are accustomed to, Glushkov unveiled. Despite that, JTI will not introduce a new generation of tobacco-heating devices to the Russian market. JTI also complies with all regulatory rules when working on the Russian market, Glushkov emphasized.

In March 2022, JTI announced that it suspended new investments and marketing activities in Russia. In April 2022, the company claimed it mulled various options for developing its business in Russia, including transferring it to new management.

Negotiations on the sale of PMI’s Russian business have reached a dead end, Jacek Olczak, CEO of PMI, told the Financial Times in February 2023. He explained that PMI’s position was that it would rather keep its business in Russia than sell it on unfavorable terms, at an unfair price to shareholders.

However, the reality is that Western firms running business in Russia no longer have an option to sell it, at least under reasonable terms. Since the middle of 2022, the Russian authorities have been consistently tightening screws for the foreign companies seeking an exit from the market.

In October 2023, the Russian government stipulated that to sell Russian assets, investors from the countries deemed as unfriendly will need to make a voluntary contribution to the Russian budget comprising at least 15 percent of the cost of the deal. During the previous year, this contribution was limited to 10 percent.

Besides, the Russian government commission on foreign assets requires Western firms to offer a nearly 50 percent discount on their assets for the deal to get a green light from the Russian regulator.

However, even fulfilling these terms doesn’t guarantee a success. In July 2023, Russian President Vladimir Putin signed an order to nationalize the Russian operations of Danone and Carlsberg—both companies were working on selling their Russian assets.

The move, among other things, has largely discouraged other foreign firms from executing their exit plans. The threat of forced nationalization has been looming over assets of foreign firms during the past two years.

The Russian tobacco industry must be nationalized, claimed Biysultan Khamzaev, a member of the State Duma Committee on Security and Anti-Corruption, in an interview with state press on Jan. 19, 2024.

“I would nationalize [assets of] all tobacco corporations in Russia. I would do it following the example of China. They established the China National Tobacco Corp. The system should be in the hands of the state, not private corporations. But it turns out that they earn money while the burden on the state, healthcare and social services rise,” Khamzaev said.

Although the public attention to hostilities in Ukraine has tangibly diminished, the challenges they brought to the tobacco business are still as real as ever. As the war grinds into the third year, the future of the tobacco factories in all countries involved remains highly uncertain.