REFORM OF THE ISRAELI DAIRY SECTOR: THE EXPERIENCE OF QUOTA REMOVAL AND PRICE VOLATILITY IN THE EU
ENPARD-IAMM Seminar Exploring potentially useful lessons from the EU experiences Tel Aviv, 18-19 May 2016
Trevor Donnellan Principal Researcher Teagasc (The Agriculture and Food Development Authority) Ireland [email protected]
Overview
• Brief summary of EU dairy sector
• Evolution of Dairy policy in the EU
• Motivation for milk quota removal
• Critical factors influencing outcome of milk quota
removal
• Experience of milk quota removal to date
• Volatility in Dairy Price and Dairy farm incomes
• Mechanisms to deal with Price and Income volatility
2
Global perspective on Dairy over the next decade
• Strong consumption growth trends
– population
– incomes
– increasing meat and dairy consumption (outside EU)
– limited range of consumption substitutes for dairy
• Consumption of dairy growing globally
– regions globally where production is not traditional
• Continuing export opportunities for regions with
surplus milk production
– EU, US, Oceania
3
Complexity of EU dairy sector
• EU dairy sector quite diverse across the Member States
– in terms of both farm sector & processing sector
• Member State milk prices span a wide range
– 25 to 40 cent/kg in 2014
• Member State production costs differ
– And of course costs differ within member states also
• Strong variations in Member State average farm size
– between 3 and 141 dairy cows
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Share of EU27 Milk Production 2013
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DE FR UK NE PL IT ES IE DK BE AT SE CZ FI PT HU LT RO SK LV ES EE SI BU LU CY MT
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75% of EU milk production in just 6 countries FR, DE, UK, IT, ES & PL
Contrast in scale and intensity of dairy farms across the EU
• EU-15 average
– 54 dairy cows milk yield of 7,337 kg/cow
– 385,000 litres milk/year
• EU-10 average
– 19 dairy cows milk yield of 5,695 kg/cow
– 105,000 litres milk/year
• EU-2 (BU & RO) average
– 5 dairy cows milk yield of 3,445 kg/cow
– 15,500 litres milk/year
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EU dairy processing sector
• 91 % of milk production is delivered for processing
– But share is much lower in parts of Eastern Europe
• Specialised dairy products vs generic commodities
– High value added and lower value added dairy products
– eg. specialist cheeses vs commodity butter
• EU15 modern, larger, more efficient milk processing facilities
that rest of EU28
• All of these factors suggest that quota elimination would not
have a uniform impact across the EU
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The EU Dairy Market: A few important things to remember
• Mainly dependent on concentrate feed, with
cows housed for much/all of the year
• Except where grass is main portion of the diet
– Such regions typically have lower production costs
– Since grass is a cheaper feed than concentrates
• Production to expand where costs are lower
– i.e. regions that favour grass production
– But the milk price farmers receive is also a critical
consideration
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EU Policy (1968-2003) Price Stability in Dairying
• Stated objective of Treaty of Rome 1957 – “to stabilize markets”
• Stable price policies established in 1960s – dairy, beef, grain, etc
• EU prices substantially above world market price
• Target Price for Milk
• Intervention stocks and Private Storage Aid
• Export Refunds
• Import Tariffs
• Subsidised Consumption
• Milk Production Quotas (introduced in 1984)
EU Policy (reform of 2003) Enter Price Volatility
• End of explicit EU price stability policy
– global market volatility permeates EU market
• Much lower “safety net” intervention prices
– reduced from 2004 to 2006
– unchanged since 2007
• Change of emphasis in EU Agricultural Budget
– introduction of direct payments for dairy farmers
– much less emphasis on price stability
Changing times for EU Dairy Sector
• Removal of EU Milk Quota System in 2015
• Created mixed sentiment across the EU
– growth opportunity in some Member States (MS)
– a threat for dairy sector in some MS
• Concern for international market volatility
– Volatile milk prices and volatile farm production costs
– Some concern that quota elimination could exacerbate
volatility
• Voluntary production restraint 2016?
– Currently a hot topic in Brussels
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EU Milk Price trends 2001-2016 Source: European Milk Market Observatory
Causes of Dairy Price Volatility
• Characteristics of the demand for food – inelastic demand
• Combined with unanticipated variation in supply – due to weather, disease, etc.,
• Small changes in supply can cause large changes in price
• Policy change in EU – Low dairy inventory levels in recent years
• Biology of dairy – Production responses small in short run (yield adjustment)
– Greater in long run (herd size adjustment)
Consequences of Price Volatility
• Low prices cause financial problems – e.g. low margins, cashflow management and debt servicing
• High prices lead to substitution away from dairy – difficult or impossible to reverse (want stable ingredient prices)
– Buyers favour fixed price contracts or lower levels of price variability found in price of other food ingredients
• Extreme volatility leads to procrastination – slows investment, innovation and R&D decisions
– wait and see mentality takes root
– culture of (empty pipe) minimal stockholding, which itself contributes to volatility
Forward Contracts
• Agreement to purchase/sell specific quantity at a specific price at a certain point
• Counterparty risk is an issues – farmer defaults on delivery (due to production problem) or – buyer defaults on payment
• Risk to farmer of default can be reduced – only lock in a share of production in the contract
• Conflict of counterparty interests – sellers want to lock in high prices /buyers want to lock in low prices
• Education required – necessary to underpin adoption of tools – for both processors and farmers
• Now available for milk production in Ireland – Glanbia and 5 other milk processors
Futures Market
• A future is a forward contract that is traded on an exchange – Quality, quantity, time and location
• A solution more suited to processors than individual farmers
• The contract’s delivery price changes as the real commodity market price changes
• Buyers and sellers must have a margin account – Positive or negative payments to/from the account
• Market can include participants from outside sector – Speculators – Widens pool of market participants
Dairy Futures Markets in the EU
• Growing demand for futures based risk management solutions in dairying
• In Europe primarily driven by demand from the dairy buyer or customer side – Already used for their non-dairy ingredient purchases
• Reluctance on dairy seller side – Could rely on EU policy to stabilise market in the past
– Unfamiliar with futures markets trading as a result (need to hire expertise from other sectors)
– no milk contracts listed on the EU exchanges
Production risk and insurance
• Weather, disease, flooding, fire, accident require insurance
• But insurance is not mandatory (and this pushes up prices) – leads to adverse selection problem
– those insured are a higher risk group than whole population
– higher insurance premiums result
• Moral Hazard – Where insurance affects the behaviour of the insured
– Leads to the requirement for an insurance excess
• Government (taxpayer) – provider of “free” insurance? – Crowding out of private insurance
• Subsidised insurance premiums – Can make insurance look more attractive
Dairy Insurance in the US
• US has moved from product price support to income support and latterly insurance tools
• Livestock Gross Margin for Dairy (LGM-Dairy) insurance program – launched in 2008 – protects against loss of gross margin (market value of milk - feed costs) – pay out is insured gross margin minus actual gross margin
• Margin Protection Program for Dairy (MPP-Dairy) – launched in 2014 – offers protection when margin falls below a certain dollar amount – producer can pick the margin dollar amount – cover a specific percent of historic production (up to 90%) – premium depends on level of cover chosen
Other tools to address Income Volatility (1)
• Tax Income Smoothing – Tax system is used to make after tax income less
volatile than pre-tax income
– Tax liability is calculated over several years rather than over an annual basis
– Good years compensate for bad years
• Now available to farmers in Ireland – Farm profits in years 1, 2 and 3 can be added together
for tax assessment purposes
– Recently changes now allow averaging over 5 years
Other tools to address Income Volatility (2)
• Voluntary Supply Constraint
• Collective action to limit production – where producer organisations (POs) and interbranch
organisations (IBOs) agree to limit production
• Allowed by EU legislation under limited circumstances – voluntary & temporary (Art. 222 of CMO Regulation)
– limited in order to prevent anti-competitive behaviour
• Issue of how to regulate such agreements – potential free rider problem
– those that do not limit their production stand to derive greater benefit
EU Post Quota: Likely Outcomes (1)
• Volatility is likely to continue
– milk prices, production costs and farm margins
• Quota elimination to have relatively minor
implications at EU28 level
– EU milk production will grow slowly beyond 2015
• At MS & regional level within MS impacts could be
more appreciable
– Milk production will reorientate towards regions to better
reflect comparative advantage
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EU Post Quota : Likely Outcomes (2)
• Expansion in milk production needs management/oversight
– the milk quota will be replaced by other limiting factors
– issues at the farm level and beyond the farm
• Difficulties with access to land, labour, water and capital
– will impede expansion for some producers
• Processing, storage, distribution, marketing
– Needs forward planning
– e.g. 3 year time horizon required to commission, design and build new
processing plant
– Need to secure new markets for additional product
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Conclusions (1)
• EU dairy sector is quite diverse
• Quota removal means that other constraints limit production
• Quota elimination will lead to differing outcomes across the EU member states
– More efficient dairy producers to benefit
– in regions where alternative farm enterprises are not particularly profitable
• Volatility is not going away
• Price based income volatility is one of a number of risks farmers face
Conclusions (2)
• Tools exist to limit the adverse impact of price volatility – available for processors and dairy farmers
• Education is required to understand how these tools work
• Diversity of EU dairy sector at farm level – makes the design of effective incomes support
instruments more difficult
• Market solutions more advanced in US than EU – for price and income volatility mgt.
Thank you!
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Gradual Price Convergence and Greater Volatility
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Agenda for change in EU Dairy Policy
• EU dairy consumption is flat
– contrasts with the growing demand globally
• EU wanted a share of global dairy growth
• MS milk quotas were increased in run up to 2015
– Series of 5 annual 1% quota increases in 2009-2013
• But production static or declining in some MS for several years
– BU, HR, EL, HU, PT, RO, SK, SI, SE
• Failure to fill quota due to:
– dairy farmer exits,
– lack of new entrants to dairy farming,
– limited production growth from the remaining dairy producers
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Cap Reform 2013 – to present
• End of the EU milk quota
• But other policy levers were retained
– public intervention
– support for private storage costs for butter
– export refunds can be used in cases of market imbalances
– specific ad-hoc measures in case of emergency/ significant market disturbances
Post Quota Milk Production Levels: What factors are important?
• Farm milk price in the Member State
– and the range of milk prices within the Member State
• Costs of production at farm level: influenced by
– the production system in the MS (concentrates vs grass)
– rate of tech adoption by farmers
• Farm size (in terms of milk volume)
– Small farms will remain under pressure
• Milk processing industry
– modern plants can process milk at lower costs
– can farmers benefit from these efficiencies ?
– higher farm milk prices vs additional processor profits ?
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Post Quota Milk Production Levels: What factors are important?
• Economic performance of dairy sector vs agricultural sectors and
vs wider economy
– In some regions of EU dairy faces competition
– competition for land/water from other agricultural sectors
– competition for labour from other sectors of the wider economy
• Dairy will persist in some higher cost regions
– Where no other agricultural or non agricultural opportunities exist
• Environmental constraints
– Intensification limited by GHGs/nitrates policy
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European Dairy Sector in “Crisis”
Causes of Price Volatility over last decade
• 2007/8 Peak: Strong demand due to growing world economy, combined with modest scarcity due to drought in Oceania and low to zero stocks
• 2008/09 Low: Weak demand due to global recession, combined with a modest surplus due to increased output in Oceania, US and growing stocks
• 2013/14 Peak: Strong demand, China, other Asia, etc., milk output static NZ
• 2015/16 Low: Weak demand from China, Russian embargo, removal of EU quotas, Oceania/USA increased output
Price Volatility is a reality
• Price variation desirable and inevitable in all free markets – Flags up supply and demand imbalance – Highlights competitive position – Leads to resource reallocation
• Significant increase in price volatility EU dairy sector – expected to persist (may even increase) – EU dairy policy continues to become more market focused
• Exceptional price volatility brings numerous challenges – increased risk for all participants in the dairy supply chain – creates many problems for processors, farmers and other
supply chain participants
Price Volatility Defined
• Not easily defined
– common to think of volatility as increased risk
– but risk is subjective
• “Price volatility is a directionless measure of the extent of the variability of a price” Gilbert and Morgan (2010)
• Volatility is about highs as well as lows
– Speed and degree of change in prices constitute volatility
• Price volatility is one of a number of risks
– Others include financial risk, asset risk, policy risk, legal risk and currency risk
Low level of trade contributes to volatility of world prices
• Only 8% of world milk production is traded – Milk is mostly consumed in country of origin
• Structure of world dairy trade differs from grain market – more grain traded internationally
• Small changes in world milk production or world consumption can have a large impact – Can lead to large changes in volume available for world
dairy trade
• Makes international dairy prices prone to volatility
Challenges associated with dairy and risk management tools
• Mix of traditional and new (higher value added) products
• Processor price differentials may result – Different levels of farm milk price due to differing product mix
• Possible to Increase production through yields in short term
• Herd increase allows further increase over medium term – Today’s decision can have impact on supply well into the future
• Cutting production (culling) is a last resort – Farm operates below capacity, loss of progress in herd genetics
• Long supply chains represent an information problem – Delayed transmission along the chain
– Changing market sentiment can take a long time to reach the farmer
– Falling prices and rising production can be observed at same time
Market based solutions
• Farmers are price takers – so can’t control prices or price risk
• But risk can be transferred to 3rd party
• Broad range of instruments to manage price/income volatility – Market instrument – derivatives
– Hedges a farmer’s prices risk
• Derivative value increases as price falls
• Forward contracts, Futures Market
Volatility in input costs
EU Post Quota : Likely Outcomes (3)
• Processors moving up value chain
• Reflect fact that EU dairy market is mature
– Growth cheese, fresh products and specialist dairy products
(e.g. infant formula, athlete performance drinks)
• Sector needs export opportunities outside the EU
• Commodities a bargain basement business?
– Possibly not, strong demand in developing countries
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% Change in EU Milk Production 2015 vs 2014
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German Milk Production to 2020
• Largest milk producer in EU – 30 million tonnes, over 4 million dairy cows.
– Production concentrated in North West & Bavaria
– Mix of bulk commodity & specialised local products
– Growing trend towards housing cows in some regions
• Cows number rising in last couple of years
• Positive outlook
• Expectations of 1 per cent increase p.a. – Strongest growth rate in coastal regions and in the lower
Rhine and in mountain areas
French Milk Production to 2020 • 2nd largest milk producer in EU
– 24 million tonnes milk, 4 million dairy cows
– Strong tradition of mixed farms
• Average dairy herd size is slightly smaller than Ireland – Drive to increase farm size, particularly herds > 100 cows
• Profitability suggest expansion in some regions – but competition from the crop sector for land
• Parts of processing sector uninterested in processing additional volumes of local milk – Multinational food businesses content to grow internationally
• Jury out on whether French production will expand – but some experts reckon that expansion of 2% p.a. is possible
UK Milk Production to 2020 • 3rd largest milk producer in EU
– 13.5 million tonnes (10 percent below quota)
– Driven by rapidly contracting producer numbers
• Feed use increasing due to land constraint
• Evolving two tier milk price system – those with contract to supply supermarkets directly
– and those without
• Two tiers of milk price and profitability – Margin over cost vs market determined price
• Stable to slightly contracting production outlook
Dutch Milk Production to 2020 • 4th largest milk producer in EU
– 12 million tonnes milk production, 1.5 million dairy cows
– densely populated & intensively farmed
• High productivity and low feed prices – but very high land prices – shift towards housing
• Strong export orientation (~ 70% exported) – efficient highly concentrated processing sector
• High profitability suggest expansion possible – but environmental factors are an area for concern
– need to process animal manure
• Netherland to expand by about 1.5 percent p.a. – with environmental constraints hindering faster growth rate
Polish Milk Production to 2020
• 5th largest milk producer in EU – 10 million tonnes, 2.5 million dairy cows
– low yields and small farms
– but developing rapidly
– deliveries increasing as a share of production
• Consolidation improving the competitiveness of processing sector
• Farmer and industry sentiment is quite positive – Like Ireland well over quota in 2014/15
• Production to expand 2 to 4 % p.a.
Ireland
• 7th largest milk producer in EU – Production of 5.5 million
– Low yields
– Low costs
• Grassland based – But only 20-25% of grassland is currently dairy
• Very ambitious expansion plans – Production likely to increase by >10% in 2015
• Strong growth to continue over next decade
• Long term aim to become NZ of northern hemisphere
Other EU MS
• Represent ~ 25% of current production
– MS where national quota no longer filled
• Some increase in MS with small quota share
• Elsewhere future production static/declining
– Removal of quota will have no direct impact
• But these MS could face greater competition
– from MS which are expanding their production and their
export capacity
50 Source: Reuters
51 Source: Reuters
52 Source: Reuters
Other Measures to deal with price/income volatility
• Off farm income
• Farm diversification
• On farm technology choices
Role of Government in Risk Management
• Government risk-related policies can impact on farmers’ risk management strategies
– Crowding out of on farm and private market solutions (OECD 2009, Tangermann 2011)
• Important to evaluate
– effectiveness of policy in achieving its aim
– effect of policy on other risk management measures
Types of Risk
• Market/Price
• Production
• Financial
• Institutional/Legal
• Can be categorised as Micro, Meso and Macro Risk
Price Volatility Concerns
• Population and income growth • Use of crops for Biofuel • Oil Prices • Low Stock levels • Climate change? • Production growth in more marginal regions • Short term Gov Policy (limiting trade) • Long term Gov Policy reforms (trade liberalisation) • Currency movements
Different Risk require different solutions
• Many of the measures available are not new – But are not generally in use in EU
• Risk reduction, risk mitigation and risk coping
• Farm, Market and Government level
• Systematic risk can be dealt with at a higher level – Mutual funds/insurance (production risk)
– Market instruments (price risk)
• If the systematic risk is very high then the risk may need to be dealt with by government – Drought, disease, sustained low prices (residual risk)