DUE TO DIRTY POLITICS AND WRONG DEMOCRACY SYSTEM WE ARE FACING DIFFERENT CHALLENGES AGAIN AND AGAIN -SUGAR CRISES IN 2017-18 WAS REPLICA OF 2007-2008

COMPETITION ASSESSMENT STUDY ON THE SUGAR SECTOR IN PAKISTAN

COMPETITION COMMISSION OF PAKISTAN ISLAMABAD 2 Disclaimer The Competition Assessment Study on the Sugar Sector in Pakistan has been prepared under the supervision of the Research Department of the Competition Commission of Pakistan. The views expressed in the report do not necessarily reflect the Commission?s views or position arising out of, or impacting upon, any enquiry, investigation or other proceedings carried out by the Commission. Neither the Commission, nor its Members, employees and any of its Consultants, assume any legal liability or responsibility for the accuracy, completeness or any third part use, or, the result of such use of any information contained in this report. Publication of this report is designed to assist public understanding of competition issues. 

Preamble Sugar is an essential commodity in the consumption basket of all segments of society. Its production and distribution constitutes one of the major sectors of Pakistan?s economy with significant backward and forward linkages. It is therefore desirable to assess competition issues in the sector with reference to its structural features, i.e. a chronic lack of efficiency in the sugar mills, a variety of impediments to technological upgrading and a lack of competitiveness when compared to sugar sectors in other developing countries. There is, too, on the face of it, evidence of a history of collective decision-making by the mill-owners through PSMA (Pakistan Sugar Mills Association). The development of the sugar sector of Pakistan reveals many twists and turns from the very beginning in 1948 to its present position in 2010. The current problems are the outcome of a combination of economic and political factors and a policy of interventions that have been primarily driven by short term ad hoc considerations. The impact of these factors has reinforced each other over the years and effectively removed any impetus for competitive innovation and selfsustained growth in the sector. The owners of mills have never seriously addressed the inefficiency that exists in the sector when measured against regional and international benchmarks. One hypothesis for the existing state of affairs is that the sugar industry has not felt impelled to establish a dynamic, competitive structure conducive to improving productive and commercial efficiency (via the production and sale of by-products together with refined sugar) and has hence failed to respond to the challenges/opportunities emanating for Pakistan in the regional and international markets. Despite being the fourth or fifth largest country in terms of the area devoted to sugarcane cultivation, favourable agro-climatic conditions and a supportive irrigation system, Pakistan, far from being a regular exporter, has actually had to import sugar from time to time. In the process, significant economic injuries have been inflicted on both sugarcane growers and endconsumers. This report is an attempt to understand the nature of the problems facing the sugar industry from a competition perspective, the role of official policy interventions and to offer solutions in that regard. The long term objective is to have a viable sugar industry in the country capable of looking after itself. 4 Table of Contents Chapter 1: Historical Background 1.1 Trends in Cane Cultivation 1.2 Growth of Sugar Industry 1.3 International Comparative Picture 1.4 Relative Performance of Sugar Mills 1.5 Sugar Trade Balance Chapter 2: Current State of Sugar Sector of Pakistan 2.1 Political Economy of the Sector 2.2 Current Levels of Production 2.3 Causes of Recent Sugar Crises i) Government Failure ii) Role of Sugar Mills and Traders iii) Wholesalers and Retailers Views Chapter 3: Organization of Production and Trade in the Sugar Industry and its Effects on Competition 3.1 Organization of Production and Trade 3.2 Marketing System i) Barriers to Entry ii) Fixation of Sugarcane Prices iii) Inter-relationship among Key Variations Impacting on Sugar Production iv) Excessive Cultivation of Sugarcane v) Current Cost Structure of Sugar Production vi) Mill-Farmer Interaction 3.3 Taxation Policies for Sugar Industry i) Sugarcane Cess Fund ii) Sales Tax and Excise Duty Chapter 4: Diversification through Vertical Integration 4.1 Impact of Distorted Policies 4.2 Path Towards Optimal Resource Use through Competition 4.3 Hidden Potential of Pakistan?s Sugar Industry 4.4 Value Chain Originating from Sugar Industry 4.5 Impact of Diversification on Cost of Sugar Production Chapter 5: Conclusions and Recommendations 5.1 Conclusions 5.2 Recommendations References

CHAPTER I Historical Background Sugar, an essential consumption item, is a major carbohydrate derived mainly from sugarcane and to a smaller extent from sugar beet. There are three main sugars: sucrose, fructose and glucose. Sucrose is in fact a combination of fructose and glucose and the body quickly breaks it down into these separate substances. Sugar is separated from cane and beet for commercial use through a process called ?refining?. The sugar manufacturing process consists of technically simple steps of extracting and boiling the juice till it crystallizes as raw sugar after removing the liquid from the syrup. Raw sugar is washed and filtered to remove non-sugar ingredients and colour. This sugar is crystallized, dried and packaged as refined sugar. For beet sugar, the sugar beet is washed, sliced and soaked in hot water to separate juice from the beet fibre. The sugar-laden juice is then purified, filtered, concentrated and dried in a series of steps similar to cane sugar processing. Pakistan?s sugar industry has so far achieved limited success in creating a competitive environment whereby it can aim at achieving higher levels of technical and price efficiencies through by-product development and economies of scale. With low levels of land productivity of sugarcane and sucrose contents and outdated technology, its financial viability rests almost entirely on ensuring low prices of cane supplies but these, too, are not determined on a competitive basis. Currently, the cost of sugarcane in the total cost of sugar production accounts for over 80 percent1 , which demonstrates an excessively high share of sugarcane - often with low sucrose content – in the final price of sugar. It is noteworthy, too, that the sugar mills comprising the industry (over 80 in number) show considerable variation in terms of obtaining cane yield levels and value addition. This indicates the latent potential of the industry as well perhaps its excessive expansion over the years that has manifested itself in camouflaging high levels of inefficiency in the sector as a whole. The relatively long value chain – from the purchase of sugarcane from the growers to the sale of refined sugar to retail consumers – should create opportunities for the forces of competition to operate at different points. Whether these opportunities are exploited in the spirit of competition or subsumed within a schema of collective decision-making and thus make itself open to the disadvantages of anti-competitive practices are choices that PSMA appears to have made in favour of the latter outcome (see Box in Chapter 5). The result is that the members of PSMA are hardly free agents operating in the industry on the basis of contestability. PSMA has instead sought to create an industry structure in which all participants can thrive regardless of their levels of efficiency. In this context, this study aims at identifying the causes that have hampered the sugar industry to move towards a more competitive structure and environment in which individual players are incentivised to innovate and produce the many by-products that sugar refiners do across the world. By competitive is meant a structure that all or most sugar producers in the country operate at a level of efficiency that matches the best. Such an environment is essential for the achievement and continuation of comparative advantage in the industry in the long term, both domestically and internationally. The aim is to have a commercially viable sugar sector capable of standing on its own feet and meeting the challenges of domestic and international competition. 1 Based on PSMA Annual Report, 2008. See Table 2(pp. 17) 2 The first chapter of this report highlights the historical background. The second chapter presents the current state of the sector. The third chapter discusses the prevalent production and trade practices in the sector and the resulting competition issues. Chapter four discusses the prospects of diversification in the industry and chapter five provides a set of conclusions and recommendations in a small to medium-term development framework in order to improve competition in this important industry. 1.1 Trends in Cane Cultivation The history of cane cultivation in Pakistan reveals a tradition of an open pan industry which was common in Punjab and Khyber Pakhtunkhwa (old NWFP). The first centrifugal sugar mill was established at Rahwali, Punjab in 1936. At the time of independence in 1947, Pakistan (then West Pakistan) had two sugar mills which produced 9,510 tons of sugar in 1948. The number of sugar mills steadily increased over time. By 2007/08, a total of 79 sugar mills constituted the sugar industry of Pakistan. The cultivation of cane took place on 1.24 million hectares (constituting 5.3 percent of the total cropped area) and produced 63.89 million tons of sugarcane implying an average yield of 51.5 tons per hectare (Table 1). Table 1 Sugar Industry Data (Units as specified) Province # Mills Cane Production (Million Tons) Cane Crushed (Million Tons) Sugar Production (Million Tons) Recovery Rate % Punjab 42 40.31 33.06 2.95 8.92 Sindh 29 18.79 16.73 1.56 9.32 KP (NWFP) 8 04.79 2.98 0.23 7.62 Total 79 63.89 52.77 4.74 8.98 Source: Government of Pakistan, MINFAL, Agricultural Statistics (2007/08). 3 Chart 1 0 5 10 15 20 25 30 35 40 45 Production Levels (in Million Tons) Recovery Rate (Percentage) # Mills Cane Prod. Cane Crushed Sugar Prod. Recovery Rate Punjab Sindh NWFP Of the total cane produced, 52.77 million tons were crushed by the sugar mills to produce 4.74 million tons of refined sugar. However, the proportion of total cane crushed by mills varied across the provinces based on the level of demand as well as the relative prices of refined sugar to the products of the traditional open pan industry (namely gur and khandsari). The sucrose content (reflecting the quality of cane produced, process of transportation to mills, technology employed in producing sugar and the length of the crushing season) was on average 8.98 percent, with significant variations across provinces (Table 1). In 2008/09, a total of 82 mills were nominally in existence with six mills out of production. Whereas the acreage under cane and the number of sugar mills increased substantially in the country as compared to the base period of 1948, the levels of cane yield per unit of land and the recovery rates have shown no ostensible improvement over time. Table 2 Sugarcane Yield Levels across Provinces (2002-08) (Tons per hectare) Province 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 Punjab 48.7 52.7 46.3 51.3 48.0 45.1 Sindh 60.9 58.4 61.4 43.5 56.2 53.4 KP (NWFP) 45.7 45.6 45.0 45.3 45.3 48.1 Total 51.5 53.2 49.2 48.9 49.7 47.3 Source: Government of Pakistan, MINFAL, Agricultural Statistics (2007/08). 4 Chart 2 0 10 20 30 40 50 60 70 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 Punjab Sindh NWFP Table 2 shows yield levels of cane across provinces since 2002/03. It reflects a declining trend in yields across provinces over time. However, Sindh seems to have a significant lead over other provinces (with the exception of 2004/05). A basic reason for Sindh?s higher yield level is the fact that a large proportion of mills in Sindh are located in the southern part of the province which has higher humidity levels due to the region?s proximity to the sea – the single largest factor attributable to higher yield levels. Another important aspect relates to increase in cane cultivation and establishment of new mills in the country, thereby extending it to areas which may not be suited for cane cultivation – a persistent practice causing excessive cultivation of cane. It implies that climatic factors have been largely ignored as a result of which the industry?s expansion has continued in areas which were not the most efficient for cane cultivation. Increase in acreage of cane cultivation and expansion of the sugar industry without giving due consideration to low yield levels and sucrose content was carried out to improve profitability of cane relative to other competing crops. The control over cane prices by the government and politicization of the sugar mills licensing process with a simultaneous neglect of financial and regulatory controls aggravated an already adverse situation. This tendency accentuated over time and caused serious levels of economic injury to the industry. It denied efficiency gains to the industry which could have been realized in the presence of healthy domestic and international competition. 1.2 Growth of Sugar Industry The number of sugar mills in the country increased from only two in 1948 to six by 1960. This reflected passive growth and was confined to Punjab and KP (NWFP) only. During the period 1961-1970 the number increased rapidly to 20 mills. This was a period when cane cultivation was incentivized in Sindh through establishment of sugar mills. The size of the industry further increased to 34 by 1980. During the 5 1980s it added 26 new units increasing the total to 60 mills. Since the 1990s, however, the process of expansion has slowed down and the industry had added 19 new units by 2007/08. The expansion of the sugar industry over this period is not only characterized by an increase in the number of sugar mills but also by substantial enhancement in the per mill crushing capacity, i.e. from 2,000 TCD (tons crushed per day) to over 4,000 and 6,000 TCD. Keeping in view both these factors, the average production of refined sugar per mills increased from 4.75 tons in 1947/48 to 60.00 tons in 2007/08 (Table 2A). Table 2A Relationship between Numbers of Sugar Mills & Sugar Production (in ‘000’ tons) Year # Sugar Mills Sugar Production Sugar Production / Mills 1947/1948 02 9.5 4.75 1959/1960 06 82.8 13.80 1969/1970 20 599.9 30.00 1979/1980 34 586.0 17.23 1989/1990 60 1,857.0 30.95 1999/2000 67 3,542.0 52.86 2007/2008 79 4,740.0 60.00 2008/2009 82 3,189.0 38.89 Sources: 1. Economic Survey of Pakistan, Government of Pakistan. 2. 25 Years of Pakistan in Statistics, Government of Pakistan. 3. PSMA, Mill-Wise Final Statement for 2008/09. However, the above picture does not fully explain the efficiency of the sugar mills. The recent average capacity utilization rates of the industry range from 60 to 70 percent. These low utilization rates reflect insufficient supply of cane and/or excessive crushing capacity that the industry has created over time. 1.3 International Comparative Picture Table 3 shows a comparative picture of average yield levels of sugarcane across major cane producing countries. It reveals that Pakistan?s average yield level was 49.2 and 53.2 tons per hectare during 2006 and 2007 respectively. These yield levels were substantially lower in relation to comparator countries, except Cuba. This, in part, reflects significant levels of inefficiency in the production of cane in Pakistan. The increased cost of sugarcane production was counterbalanced by excessively high prices of cane fixed by the government annually. As a result, the cost of sugar production increased substantially over time. Currently, sugarcane accounts for over 80 percent of the total cost of sugar production.2 2 PSMA Annual Report 2008, op. cit. 6 Table 3 International Yield Levels of Sugarcane (Tons per Hectare) Year World Brazil China Egypt Cuba India Thailand Pakistan 2007 70.8 76.6 86.1 119.6 27.7 72.6 63.7 53.2 2006 69.7 74.4 82.6 118.6 27.8 66.9 49.4 49.2 Source: Government of Pakistan, MINFAL, Agricultural Statistics (2007/08). Chart 3 0 20 40 60 80 100 120 World Brazil China Egypt Cuba India Thailand Pakistan 2007 2006 Table 4 provides information on the top five countries in the world during the period (2005-2007) in terms of average cane acreage, total production and yield levels. Only in the case of acreage, Pakistan ranked fifth in the world during 2005 and 2006 and fourth in 2007. Table 4 Top Five Countries in Terms of Area, Production & Yield of Sugarcane Rank Area Production Yield 2005 2006 2007 2005 2006 2007 2005 2006 2007 1 Brazil Brazil Brazil Brazil Brazil Brazil Egypt Egypt Egypt 2 India India India India India India Columbia Columbia Columbia 3 China China China China China China Australia Australia China 4 Thailand Thailand Pakistan Mexico Mexico Thailand Guatemala Guatemala Australia 5 Pakistan Pakistan Thailand Thailand Thailand Pakistan Argentina Mexico Guatemala Source: Derived from Government of Pakistan, MINFAL, Agricultural Statistics (2007/08). 7 This rather impressive position was lost in the rankings made in the context of total production where Pakistan could only maintain fifth position in 2007. However, it could not enter the top five ranking countries in terms of average yield levels. Table 5 displays a ranking of seven major Asian countries in sugarcane yield levels during the period 2005-07. This ranking is in the context of 17 major sugar producing countries which account for over 85 percent of world sugar production. With the exception of China, the rest of the South and South-East Asian countries rank quite low in terms of sugarcane productivity. It is evident that Pakistan ranks lower even in the regional context. Table 5 Ranking of South Asian / South-East Asian Countries in Terms of Sugarcane Yield Levels across 17 Major Sugar Producers in the World Country 2005 2006 2007 1. China 12th 4 th 3 rd 2. India 11th 11th 10th 3. Indonesia 7 th 8 th 10th 4. Pakistan 16th 16th 15th 5. Thailand 15th 15th 14th 6. Vietnam 14th 14th 15th Source: Derived from Government of Pakistan, MINFAL, Agricultural Statistics (2007/08). 1.4 Relative Performance of the Sugar Mills Sugar mills in Pakistan vary significantly from each other across different performance indicators including the following: i) Crushing Capacity The capacity indicator of crushing cane i.e. TCD (tons per day) varies significantly ranging from a low of 1500 to over 8,000. ii) Plant Technology Internationally, the technology in producing sugar from cane has developed considerably over time. The newly established mills use the latest technologies and some old ones have also acquired new technologies (though on a limited scale). iii) Diversification Of the total 80-plus sugar mills currently operating in the country, only a few have opted for diversification in the range of products and that, too, on a limited scale. A full scale diversification in the product mix of sugar mills in Pakistan could create the basis for producing a large number of products in the 8 downstream industries. The process has yet to start.3 Only a handful of mills (4 or 5) have established distilleries to create value addition from molasses. iv) Sucrose Content The annual statements prepared by the Pakistan Sugar Mills Association (PSMA) show significant variations in the overall recovery rates achieved by mills annually. For example, during the year 2008/09, the variation in the recovery rates across provinces were as follows: Punjab Province: 7.5 to 11.25 percent Sindh Province: 7.9 to 11.30 percent KP (NWFP): 7.9 to 9.71 percent Whereas these variations are attributable to the quality of cane, timings of harvest and shipment to mills and the technology used for conversion into sugar, they also indicate the degree to which mills and farmers interact with each other. A major inefficiency in cane pricing policy is the exclusive use of weight for price determination. Although a key determinant in the cost and efficiency structure of a sugar mill, sucrose content is not incorporated into the pricing of sugar cane. On occasion, the sugar mills in Sindh have paid premium payments based on sucrose contents (over and above the cane price) to all growers. This represents a classic case of an adverse selection problem, where each supplier is provided additional benefits on the basis of the overall recovery rate achieved by all the mills in a given season. Such a practice sets perverse incentives for growers to plant better quality sugar cane which produces higher sucrose content. On the contrary, growers of inferior quality sugar cane can free ride on their more efficient counterparts. In the long run, this causes a gradual decline in the overall recovery rates achieved by mills. v) Sugarcane Yield Levels Although, the old system of allocating each mill a zone from where sugarcane was supplied has been discontinued and mills compete with each other in procuring cane, it remains an undeniable fact that certain geographical locations in Pakistan are less suited to sugarcane cultivation than others. By ignoring this fact and permitting new mills to be established in relatively unsuitable areas/regions, excessive and inefficient cane cultivation has been promoted in the country. In addition, within the more suited areas/regions there are significant variations in the yield levels of sugarcane. These differences are attributable to low investment capacity of farmers (particularly small farmers) as well as lack of dissemination of technical knowledge to farmers by the mills and research institutions to improve cane yield levels. In certain suitable regions, the variability in yield levels across farms ranges from 20 tons per hectare to as high as 150 tons per hectare. 3 Details on such achievable potential have been provided in the subsequent sections of this Report. 9 Since the average yield level in Pakistan is less than 70 percent of that achieved by major sugar producers in the world (reference Table 3), it is apparent that sugar production in Pakistan is costlier than other competitors. Currently, as mentioned earlier, sugarcane cost alone accounts for over 80 percent of total cost of sugar production (inclusive of taxes) in Pakistan. In light of the above, a lot needs to be done in improving productivity of sugarcane and sugar production in Pakistan. It also reveals that the future expansion of the industry needs to be based on a rationalized pricing mechanism. Since the land allocation to sugarcane accords Pakistan a status of fourth or fifth largest country in the world, the same needs to be maintained in the total production of cane. This will help in minimising Pakistan?s sugar import bill in the years ahead taking ?good? and ?bad? years together. Further efficiency improvements at the sugar mills can create a potential for exports, especially through greater diversification of the sector?s products. 1.5 Sugar Trade Balance The world sugar trade scenario indicates 11 countries as net exporters of sugar during the next 10 years and 18 major net importers. 4 A growth of over 38 percent in the world sugar trade is forecast by the year 2018/19. Whereas this expected growth forecasts may provide opportunities for some countries to reap benefits through trade, some may keep increasing their sugar imports on account of economic inefficiency. According to the forecast, Pakistan would not only remain a net importing country during the next decade but its import requirements may increase to 1.48 million tons. These estimates have been prepared under the following assumptions: 1. Sugarcane acreage will increase from 1.077 million hectares in 2009/10 to 1.147 million hectares in 2018/19. 2. Sugarcane yield level will increase from 53 to 56 tons per hectare 3. Recovery rate from sugarcane will remain unchanged at around 8.5 percent. 4. On the domestic consumption side, the estimates show a growth of 26.6 percent during the period 2009/10 and 2018/19. Despite the possibility of upward or downward estimation bias in these estimates, it is apparent that by maintaining the status quo of the sugar industry, the country will have to import a significantly higher volume of sugar in the next 10 years in order to meet demand. The resulting impact on employment and foreign exchange resources would be significant unless drastic and unconventional measures are taken to reverse the situation. Therefore, in order to effectively manage production and consumption levels, the country will have to spend over $ 1.0 billion on sugar imports by 2018/19 (based on the current world price of refined sugar). 4 FAO Outlook on World Sugar Prices, Production and Consumption (2007). 10 Other estimates5 , though somewhat different, portray a bleak scenario for Pakistan?s sugar sector. All point in the same direction i.e., due to internal inefficiencies in the production of cane and sugar, and rapidly increasing sugar consumption at home, Pakistan will have to rely increasingly on imported sugar to meet its requirements. The implications of such imports on an already deteriorating trade deficit and local unemployment could strain an ailing economy. ________________________ 5 USDA, Foreign Agricultural Service, “Sugar: World Production Supply and Distribution” May 2009; and USDA, Foreign Agricultural Service, GAIN Report (No.PK-9005), “Pakistan Sugar