Analyst, Governance and Sustainable Investment
- New alternatives to cigarettes, which cause less harm to users, are changing the tobacco industry
- This rapidly growing product area is positioned to play a key role in improving the ESG profile of tobacco companies
- We engaged major tobacco companies to develop expertise, implement robust oversight and adopt leading marketing practices to ensure they can successfully manage the opportunities and risks in these products
The tobacco industry is undergoing a period of profound transition. Tobacco companies, which in recent years have seen sales of cigarettes stagnate in the developed markets, face a new playing field, emerged with the rise of alternative nicotine products. These are typically called electronic cigarettes (e-cigarettes) and are handheld electronic devices, which vaporize a fluid containing nicotine, as opposed to traditional combustion-based products. Noncombustible products promise a significant reduction in harm compared to cigarettes although the full extent of health benefits and risks are still uncertain.
For investors, the emergence of e-cigarettes presents an interesting medium-term growth opportunity, which could improve profitability and reduce regulatory pressures on the industry. Companies that are repositioning their product portfolio in favor of developing leading e-cigarette products stand to be big winners from this potentially disruptive transition. JPMorgan estimates that 60% of smokers in the developed world could have switched to e-cigarettes by 2030.1
In the United Kingdom, the number of e-cigarette users quadrupled over the past four years, reaching 2.8 million users in 2016. Global sales figures, shown in the following chart,2 reveal a similar picture and project continuing rapid growth of the segment in the coming years.
On the downside, the new technology represents certain risks to investors. These include contradictory and incomplete claims made by companies and academic researchers on the potential for e-cigarettes to reduce adverse health impacts. There are also concerns, which focus on the practices of tobacco companies such as marketing, product quality and safety management as well as board oversight. At this early stage of development in the product category, it is crucial for the board and senior management to actively monitor market movements and evolving customer preferences such as device functionality, flexibility to select e-liquids and the overall vaping experience. Especially the latter, according to major tobacco companies, has been a major hurdle for the success of alternative nicotine products to be perceived as a satisfactory substitute for traditional cigarettes.
Recent studies investigating the use of e-cigarettes reveal that the product is almost exclusively used by people who are or have been consuming traditional cigarettes. Action on Smoking and Health (ASH) estimates that 98% of e-cigarette users in the UK are either current or former smokers.3 This aligns with the idea that e-cigarettes are an effective a tool used 1) to quit smoking or 2) to switch to a less harmful alternative. Researchers found that people who intended to quit smoking were about 60% more likely to succeed if they used e-cigarettes compared to quitters who tried alternative nicotine substitutes such as nicotine patches or gums.4 To date however, scientific evidence is not conclusive, and the suitability of e-cigarettes as a tool for long-term smoking cessation remains to be seen.
A similar dispute can be observed with regard to the harm reduction potential of e-cigarettes. While academic studies that compare e-cigarettes and other noncombustible nicotine products with their traditional peers largely find that these products cause less harm to the users, when assessed on an absolute basis, the evidence is less conclusive. The lack of understanding about the potential long-term impacts of inhaling vaporized products where the chemical additives have not been explicitly safety tested remains alarming. This is a risk that requires more attention before a conclusion about the health impact of e-cigarettes can be better drawn.
Alongside risks and opportunities specific to the health impacts of e-cigarettes, the success of the product category will depend on the extent to which companies establish robust product stewardship practices around marketing and product safety management. E-cigarettes have already attracted negative public attention stemming from smaller niche players infiltrating the market with substandard quality products and selling liquids flavored like children’s sweets.5
We expect well-established big tobacco companies to implement leading product quality and safety management practices. We see this as a critical way to build customer trust and differentiate from the smaller players in the market.
We have engaged several global tobacco companies to express our expectations in sufficiently managing the risks and opportunities in this emerging product space. In Q2 2016, we wrote to the chairmen of six big tobacco companies: Philip Morris International, British American Tobacco, Altria Group, Japan Tobacco, Reynolds American and Imperial Brands.
We asked for assessments of the companies’ performances against a set of good practice industry standards we have identified, including:
- Clear expertise and robust oversight of these new products.
- Research and development to assess health impacts of tobacco products.
- Dedicated investments and capital expenditure directed to the development of products with reduced health impacts.
- Adopting transparent marketing and distribution standards and monitoring systems for e-cigarettes, also referred to as Responsible Marketing.
- Implementing a transparent and robust framework for public policy engagement, including full disclosure of positions on key themes, topics and bills (e.g., advertising, branding, health warning and smoking restrictions), membership in trade associations and expenses on the company website.
- Establishing robust internal control and audit mechanisms globally to help ensure compliance with the above mentioned standards and to facilitate the identification of potential breaches as well as reactive measures.
We have received responses from all six companies, including acknowledgment of our points and recommendations. All six major companies are either directly or indirectly (through subsidiaries) involved in the distribution and marketing of noncombustible nicotine products, albeit with different levels of participation and regional penetration. Accordingly, responses confirmed that non-combustible nicotine products represent a growing business opportunity, which the boards are carefully monitoring and the companies are increasing related research and development budgets, alongside considering the acquisition of other companies.
Most companies we engaged with, also conduct in-house research to evaluate and enhance the quality and safety of their products. As a result, tobacco companies have largely welcomed recent regulatory updates, such as extending regulatory oversight of the EU Tobacco Products Directive in Europe as well as Food and Drug Administration in the United States to include noncombustible nicotine products under their control.
Conclusion and next steps
Our engagement has provided an initial insight into the approach major tobacco companies are taking with regard to alternative tobacco products. All companies we engaged with perceive this rapidly growing area as a business opportunity and have developed and launched such products, either internally or through acquisition.
However, the level of involvement, measured in terms of depth and breadth of market penetration, varies significantly between companies and across regions. The leader in terms of practice and vision we have identified include Philip Morris International, which declared its intention to switch all current adult smokers, who intend to continue smoking, from cigarettes to non-combustible products.
Also in terms of product stewardship, including such areas as product quality and safety as well as responsible marketing, we noticed significant discrepancies in the scope and quality of company measures. There was general acknowledgement about the importance of such standards for successfully exploiting the commercial opportunities in e-cigarettes.
The next step on our agenda is to use the gathered insights to further engage with lagging companies especially in trying to close the gap around product stewardship quality and implementation. We will also closely monitor the performance of leading companies in meeting their commitments in driving the segment of alternative tobacco products. We believe that with strong management by leading companies in the risks highlighted, e-cigarettes could trigger a paradigm shift within an industry that has strained under the storm of negative public perception for a very long time.
1 JPMorgan research “Global Tobacco – the disruptive potential of NNPs – Next Gen Tobacco” July 2016
2 Daily Telegraph “Vaping Takes off as e-cigarette sales breakthrough $6bn” 23 June 2015
3 Action on Smoking and health “Use of electronic cigarettes among adults in Great Britain”
4 University College London survey of smokers in England, published in Addiction, May 2014
5 Daily Mirror “Children ‘addicted to sweet tasting e-cigarettes’” 19 June 2014