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01 December 2011

Last week's editorial titled "RJC's Diamond Chain of Custody: Destroying rather than Adding Value" triggered a vast amount of reactions as well as some welcome news. In a telephone conversation over the weekend, Responsible Jewellery Council (RJC) Vice-Chairman John Hall informed us that the launch of the organization's Chain of Custody (CoC) framework will be delayed until appropriate input can be considered from a dialogue with members of the trade and industry in Israel, India and elsewhere. Thus, for the time being, CoC is nearly off the table.

As noted last week, CoC would require a segregation of diamonds between those from a "good" (CoC-compliant) source and those from a "lesser" (non-CoC-compliant) source. The non-CoC-compliant sources would include smuggled goods, diamonds from areas where human rights violations are taking place, diamonds suspected of being used in money laundering, and, of course, diamonds from the 50 percent of world producers that are not participating in the CoC scheme. For instance, diamonds from Russia would not be viewed as being CoC-compliant. In order for a parcel of diamonds to maintain its CoC-compliant status, no non-CoC-compliant goods may be mixed into the assortment.

Seeing the Light

Responding to our previous editorial, which critically commented on the disruptions the CoC would cause and expressed doubts regarding the ability to implement it, a sales director of one of the major rough suppliers wrote in an e-mail: "Chaim,  I have had so many customers saying the same thing. Thanks for bringing this up. I hope you can have the RJC see the light. Good luck."

The RJC directors must have seen "some" light, because the CoC has now been moved to the side, though it isn't completely off the table just yet. As we were not yet sure whether the RJC fully realizes the extent of the value destruction inherent in its proposals, industry economist Pranay Narvekar and this author presented a background paper to the organization showing that the CoC will impose an additional cost of US$1.25-US$1.7 billion on the diamond and jewelry industry. In other words, the diamond manufacturers and traders would be confronted with some 17-25 percent additional costs - without having any real chance to pass on these costs to the retailer or consumer.

The document was prepared to assist the RJC's decision-making process. It was pointed out that these additional costs would need to be borne by either retailers who demand CoC-compliant diamonds, or by producers who require their customers to be CoC-compliant.  The exact sharing of the burden will be determined by market forces of demand and supply and will depend on whether the consumer will be willing to pay the additional 8-10 percent price increase.

Generic versus Brand

There is considerable evidence that if a consumer is offered two identical diamonds - a branded and a generic stone - she will go for the branded item if it's offered at the very same price. If the branded price is higher, she will buy the generic diamond. As the very premise of RJC's CoC-compliance system is based on CoC diamonds being more desirable and thus more expensive, the retailer will not be able to sell these goods. No testing has yet been done offering consumers a CoC and a non-CoC diamond at different price levels; maybe one can save the money as the outcome is clear.

The Purpose of the Impact Analysis

Our financial impact document provided to the Board and Standards Committee of RJC did not draw conclusions but solely provided economic facts.  It was argued that the CoC initiative for the diamond industry will bring about many changes in the way the industry works at a micro level.  The purpose of the impact analysis is to estimate the direct financial costs that the industry will have to bear. It was based on the premises that the CoC initiative will essentially require diamond companies to segregate their inventories into two separate parcels: one where all documentation exists to ensure the CoC and another parcel where it does not.


Estimating the Impact

To understand the total scope of this exercise, it is critical to realize that the CoC will mainly affect the goods that are not individually tracked.  For large stones that are polished individually, it will be easier to compile the necessary paperwork. However, for the stones that are polished in parcels, the CoC will mean a huge overhead.  Assuming that typically this would be the case for a majority of stones that are below 0.5 ct in polished, the impact of this exercise will be the most on the following categories:

  • About 50 percent of value of the polished (expected to be about US$24 billion in 2012)
  • About 87.5 percent of carats (typically the stones below 0.5 carat)
  • About 99.5 percent of stones (all stones except large stones that are polished individually)
  • About 2- 3 million parcels in stock globally (not counting the 3-4 million single stone parcels)

Impact on Diamond Companies

The impact of CoC on the manufacturing-factory front will be minimal as manufacturing will typically be on a parcel-to-parcel basis.  There will be a cost involved in the added documentation.  The main effects will be felt on the assortment, sales and transaction cost areas.

In a typical diamond company, the efforts involved in assortment, stock management and sales are proportional to both the carats and the parcels involved.  If there are two parcels, the efforts in stock management and sales are doubled for the same turnovers, while in assortment, the efforts are nearly 1.5 to 1.7 times higher, as it is much more difficult to assort smaller parcels, along with the time required to account for and match the parcels.  The administration costs will actually be higher on all goods, i.e. including certified stones, as companies need to keep a record of the CoC status of those stones as well.

It is estimated that the industry carries about at least 2-3 million parcels, apart from stones that are certified (and that could add another 3-4 million parcels as each stone is a single parcel).  The volume of these parcels will in effect go up by about 50-60 percent (3-4.8 million parcels) as companies are forced to keep separate CoC-compliant (CoC) and non-CoC-compliant (NCoC) stock.  The global average parcel size will come down from about 4.1-6.2 carats to 2.6-4.1 carats.

The picture is quite different when it comes to actual transactions.  Typical polished diamonds change ownership at an average of 3-4 times before they reach their end use in jewelry.  Also, polished stock turns are about 2.5-3 for the industry.  The number of transaction in the industry will go up from the current 20-30 million per year to about 30-48 million per year for the affected parcels.

In the downstream areas, the direct overhead costs are expected to be about US$1.25 billion per year.  These include assortment personnel, administration and finance, compliance and the required offices and infrastructure for the same.  These costs could be expected to go up by about 50-60 percent as a result of the CoC (including documentation at factories).  It, however, also recognizes the fact that some of the smaller companies and individuals will decide to opt out and decide against keeping CoC stock.  For many of the small single-person outfits, this would be a serious impact on their bottom line and their ability to survive.  The impact of this on pipeline costs will be about US$625-US$750 million per year.


Holding Costs of Inventory

The other affected area will be inventory holding.  It is a well-known principle that inventory in a supply chain increases with the number of stocking points.  The inventory affected will primarily be the smaller stones, and the increase will be fuelled by the need to maintain minimum stocking for the prospective buyers.  This increase is expected to be about 30-40 percent of the affected inventory.  These goods account for a greater share of the pipeline inventory, as they typically move more slowly than the certified and larger stones and would account for about US$6 billion.  The cost impact of this @ 10% weighted average cost of capital would be about US$180-US$240 million per year.  It would also mean a one-time capital requirement of US$1.8-US$2.4 billion as this inventory is built up.

There is one other area that would be felt more sharply by the smaller traders dealing in small parcels and who are the life-blood of the industry.  They play the critical role of consolidating similar diamonds by purchasing these from smaller polishers.  They will also face a large drop in available quantities due to the presence of CoC and NCoC diamonds.  The lack of these volumes from the smaller players will lead to a value loss of about 1-2 percent as they will not be able to buy efficiently and will affect about US$5 billion of goods.  The impact of this would be about US$50-US$100 million per year.

Rough trading will also not be spared from this impact.  The inability of manufacturers to mix goods will mean that they will tend to under-assort the rough parcels in order to make minimum quantities necessary to manufacture.  This will result in yield losses, which will translate into a value loss.  This loss is expected to be about 1-2 percent of the resultant polished and will be about US$120-US$240 million per year.

The total cost on diamond companies is expected to be US$975-US$1,330 million per year, and a one-time capital requirement of US$1,800-US$2,400 million.


Impact on Jewelry Companies (Diamond-Related Only)

For jewelry manufacturing companies, the main challenge will be the procurement and raw material inventory management area, including the assortment and bagging of the goods.  It will become hugely more expensive for companies to source diamonds as quantities available would be much smaller.   Lesser availability typically results in lower quality of the product, however this impact has not been factored in.  Procurement costs are about 0.5 percent of the procurement cost for jewelry manufacturing companies and the major effort is spent on the smaller diamonds, not the certified ones, which are based on the certificates.  This cost will increase by about 40-50 percent as availability becomes difficult.  This impact on jewelry companies will be about US$48-US$60 million per year.

The inventory holding in jewelry companies will also be affected, as it will become more difficult to source the diamonds, given the smaller size of the parcels.  This will force companies to increase delivery times and also keep more average stock to ensure that orders are fulfilled.  Jewelry companies carry about US$2 billion of polished inventory of the relevant stocks and they could be expected to increase this by up to 50-60 percent.  The cost impact of this @ 10 percent weighted average cost of capital would be about US$100-US$120 billion per year.  It would also mean a one-time capital requirement of US$1.0-US$1.2 billion as this inventory is built up.

The total cost on jewelry companies is expected to be US$148-US$180 million per year, and a one-time capital requirement of US$100-US$120 million.


Impact on Retail Companies

Retail companies, especially companies that source their finished jewelry, will see lesser impact on their costs.  The main impact would be on the paperwork and documentation required by them and their suppliers.  Retailers who source loose diamonds would face the same problems as that of jewelry manufacturers.

Diamonds are not homogeneous products, unlike say gold or silver.  There are multiple parameters, and each parcel has a specific characteristic.  The critical issue for larger retailers would be the availability of diamonds either for themselves or for their jewelry vendors. This is true especially for large roll-outs and programs, which are across their entire network.  This requires sourcing of specific sizes of diamonds in specific color, clarity, make and price bands.  With the CoC and NCoC diamonds being available, this would make the task doubly difficult.  The large chains with typically 500-plus outlets will be the most affected and it could skew their cost and structures, making some of them unviable due to the diseconomies of scale.


Cost of Audits

The CoC audit conducted by the RJC will also be something that has not been conducted on any other industry.  The necessary documentation trail and paperwork will be quite onerous and will require detailed scrutiny.  It will affect all companies including diamond companies, jewelry companies and retail companies that agree to be part of the CoC.

The responsibility for this exercise will fall on the auditors, many of whom might not be geared up for this.  Much of this checking will be based on the documents provided by the companies and might not be verifiable or checked by the auditors.  The RJC might be placing an unbearable burden on auditors and they may take a reputational risk by agreeing to an audit.  In the RJC's eyes, a qualified audit report would defeat the very purpose of it.

As these audits are new and conditions onerous, audit companies would be expected to put in a fair amount of effort in verifying the facts, with the cost of such audits reaching between US$20-US$100,000 per entity, depending on the size of the entity.  To establish the CoC, one needs to remember that the CoC-compliant goods need to pass through the hands of companies, all of which are compliant, which would mean that a fair number of companies would end up going for the certification.

Even considering an average cost of US$25,000 per entity and about 5,000-8,000 entities undergoing the audit, covering diamond and jewelry companies only, it would mean a cost of about US$125-US$200 million per year.  Retail company costs have been excluded. The total audit cost on diamond and jewelry companies is expected to be US$125-US$200 million per year.

Overall Impact on CoC-Diamond Costs

The overall impact, including audit costs, on diamond and jewelry companies is expected to be about US$1,248 - US$1,710 million per year.  For implementing the CoC, an additional one-time capital requirement will be about US$2,800-US$3,600 million.  This would be required to finance inventories, which banks in Antwerp and Israel do not do.  So for the industry it might just become unaffordable as new capital will be required.

The industry is actually a mid-supply chain industry that displays the characteristics of a perfectly competitive industry.  This shows up in their margins, which are typically slim, except in cases where there is a major price fluctuation.  Hence all costs would be expected to be passed on to the relevant consumer or the producer, i.e., either the retailers who require the CoC diamonds or by the producers who insist that their customers are CoC-compliant.

Developed countries, including the US, Europe, Japan and Australia, account for about 55 percent of global diamond consumption.  The quality of diamonds in jewelry is typically lower, as developing countries like China and India are bigger consumers of the larger, better quality diamonds.  The other 45 percent of consumption is in developing countries, which are also the major growth drivers for diamonds.  Consumers and hence retailers in these countries are less likely to see CoC as a critical issue.  Retailers in these countries are fighting to grow their market shares and would possibly look for the cheapest diamonds, not necessarily CoC-compliant diamonds.

Overall, the diamonds that would need to absorb the costs would be about 60 percent of the total consumption in these markets.  The total relevant diamonds procured in these countries would be about US$7,920 million per year.

The cost impact on these diamonds would be about a 16-22 percent increase in procurement price. Given the mark-up and costs at a retail level (total jewelry sale of about US$35 billion plus retailer costs), it will translate into at least an 8-10 percent increase for the consumer. This level of difference in prices might even prompt consumers from developed countries to buy jewelry online from e-retailers located in countries that do not enforce the CoC.


Conclusions and the Way Forward

The conclusions presented by Pranay Narvekar and this writer to the RJC first claim, as already mentioned, that imposing the CoC will impose an additional cost of US$1.25-US$1.7 billion on the diamond and jewelry industry.

This is bound to lead to a contraction not only of the number of players in the industry (many small firms will close doors) not only in the cutting centers but also in the jewelry retail sector, especially in the United States. In typical jewelry stores, loose diamonds and diamond jewelry account for 40-45 percent of total sales, and gross margins tend to be high. But the bottom line of jewelers provides mostly for a one-digit profit figure - and their vulnerability to price shocks is considerable. The RJC's proposed CoC system will increase prices - and put the suppliers of non-CoC-compliant goods in a competitive advantage.

The bankruptcies, the closings and the staff redundancy will - at the end of the day - be among the CoC-compliant RJC members. Ironically, the non-CoC-compliant non-RJC member retailers will do better - and may even flourish.

But a reduction of demand will also impact rough producers. Assuming producers must absorb some of the CoC costs, if rough prices fall, the impact of this will be felt more by the alluvial producers, especially the small miners who have limited capability to manage the necessary paperwork and could see their margins shrink to the point of being unviable.

As one bourse president asked rhetorically: who asked the RJC for such Chain of Custody system? Where is the consumer asking for it? What tangible benefits will anyone get? Why cause tremendous industry dislocation, redundancies, confusion and harm to employment of the very marginalized groups we all want to help?

The industry dialogue that will take place during most of 2012 will provide the RJC and all stakeholders with the answers. We'll keep you posted.