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United Kingdom - Risk management in agriculture: a discussion document

 

Risk management in agriculture: a discussion documentExecutive summary (DEFRA – UK)

1. All types of economic activity involve risk. These risks may take many forms. They may include risks relating to physical production, input and output prices, currency movements, institutional change, legal liability and personal circumstances. Agriculture is generally regarded as one of the more risky activities because of the price inelastic nature of demand and short run supply and its exposure to natural shocks. In this report we focus upon the risks for agricultural producers relating directly to prices and revenues. A parallel assessment is underway relating to the commercial risks associated with animal disease controls.

Reasons to manage risk

2. Interest in strategies and tools for managing market risk has increased in recent years. Two developments in particular have prompted additional attention to the subject.

a) the Agenda 2000 reform of the CAP secured reductions in production-related support for some of the main CAP commodities. Further progress in this direction can be expected in the medium term. Movements towards lower levels of CAP support prices and a more liberal global agricultural trading system may involve greater price volatility in the future for EU and UK producers.

b) UK agricultural producers are subject to some specific risks, most importantly a major currency risk, since CAP support prices and payments are denominated in Euros. Exchange rate fluctuation has become an important determinant of the volatility of UK farm incomes during the last decade. The potential for such impacts is likely to be reinforced when the present residual EU agrimonetary arrangements expire in 2002.

Strategies for managing risk

3. Risk management involves choosing among alternatives that have uncertain outcomes and varying levels of expected returns. Various strategies and tools exist to assist producers to manage market risk. These all share the characteristic that they involve a reduction in average income or revenue over time in order to ‘purchase’ a lower probability of an extremely low income or revenue in exceptional years.

4. Strategies for managing risk might be considered to fall into two categories. One set of strategies, which we might term “business diversification” has long been employed by UK producers. This includes among others, the use of mixed enterprise farming to reduce the risks associated with production of a single commodity. In this case, foregoing economies of scale associated with specialisation is the price paid for a more certain income stream. Although the CAP is often considered to have encouraged a greater degree of commodity specialisation, nevertheless UK farmers still diversify enterprise output to a significant extent. Diversification into non-agricultural on-farm activities such as tourism, or off-farm income sources such as paid employment, is also popular. It is estimated that more than one quarter of English farms have some form of non-agricultural income (excluding income from investment, pensions and social payments), although there are variations by region, farm type and size.

5. However, there is a further category of risk management instruments which is the principal focus of this report: these are measures which involve sharing risks with others. These tools are provided mainly through private financial markets. They include forward contracts, futures and options contracts, crop insurance and revenue and income stabilisation schemes.

Employment of financial risk management instruments

6. In some parts of the world, particularly the USA and Canada, the use of private financial markets for managing market risk is already significantly developed.

·                     production contracts

7. Production contracts are made between producers and economic agents downstream in the supply chain. The contracts usually specify in detail the inputs to be supplied by the contractor, the quality and quantity of the commodity to be delivered, and the sum to be paid to the grower. In the US, in 1998, 14 percent of the total value of production was produced under production contracts. These contracts are mostly used for livestock: poultry and poultry products accounted for over 50 percent of the total value of commodities under production contracts, and cattle and pigs for another 41 percent.

·                     marketing contracts

8. Marketing contracts are agreements between a buyer and a producer that set a price and/or outlet for a commodity before harvest or before the commodity is ready to be marketed. The producer usually remains fully responsible for the management decisions during the production process. In the US, marketing contracts are more widely used than production contracts: in 1998, 21 percent of the total value of US production was sold under marketing contracts. Topping the list of crops under marketing contracts were fruits and vegetables (with US $10 billion, or, 45 percent of total production, sold under a marketing contract), followed by cotton, corn, soybeans and sugar. For cattle, just under 10 percent of the value of production was sold under marketing contracts. For dairy products this was more than 60 percent. In order to stimulate the use of futures and options markets for livestock products, the US has started pilot programs for dairy, cattle and pig farmers, involving training in the use of these tools and in some cases subsidisation of premia payments.

·                     crop and revenue insurance

9. In the US a wide range of crop and revenue insurance schemes exist. Schemes are subsidised by the Government, in the form of public contributions towards premiums and administrative costs and through the provision of reinsurance (in total more than 50 percent of the insurance costs are subsidised). Participation is generally high in the states in which insurance schemes are available. Most schemes relate to arable crops, which are technically more amenable to insurance solutions. It is often claimed that many of these schemes face several (interrelated) problems: governmental subsidies are considered to be provided in a complex way and it is argued that schemes are not well designed with respect to two common market failures in insurance markets – “adverse selection” (a situation in which only high risk cases seek insurance) and “moral hazard” (a situation in which the insured individual takes unreasonable risks once a policy has been taken out). Furthermore, transaction costs can be high (including monitoring costs and administrative costs), schemes cover uninsurable risks, and governments continue providing ad hoc disaster relief (thereby severely undermining the system). Resulting problems can be summarized as ‘incentive problems’: farmers do not get the right incentives for responsible self-risk management, and, because of the moral hazard and rent seeking opportunities for insurers, the same applies for insurance companies.

10. In Canada, a revenue insurance program existed from 1991 till 1996. The program was abandoned because of several difficulties, from which the use of a 15-year-moving average to establish guarantee prices was the major one. As an alternative, Canada introduced the net income stabilisation account (see below).

·                     safety net programs

11. The Canadian net income stabilisation account (NISA) works on a whole-farm basis. Farmers put money into a bank account, governments match the farmer’s deposits (‘a dollar for a dollar’), and each farmer can withdraw from the account in adverse times. So far the participation rate of farmers in NISA is high, but the extent to which farmers withdraw money from the accounts is disappointing. Anecdotal evidence suggests that farmers have come to regard the NISA as a pension fund and still look to Government to provide ad hoc relief from short-term income difficulties. The Canadian Government has recently introduced the Agricultural Income Disaster Assistance program (AIDA). AIDA is designed to target assistance to Canadian farmers who experience a sudden and severe drop in their farm income for reasons beyond their control. The program is funded 60% by the federal government and 40% by the provincial governments. Farmers are paid an indemnity by the government if their margin falls below a certain level.

12. In the UK (as in the rest of Europe), the use of many of these tools is less well developed.

·                     production contracts

13. Production contracts are used principally for pigs, peas, beans, and poultry. The majority of UK pig and poultry production is produced under some type of production or marketing contract, often with a third party owning the animal. In the horticulture sector it appears that around one third to one half of national output is covered by contracts (either production or marketing) with multiple retailers. These types of contracts are likely to become more important with increasing attention to food safety and animal welfare issues. There appears to be some interest among multiple retailers in widening the commodity coverage of production contract arrangements.

·                     marketing contracts

14. Marketing contracts are (among others) used for milk, pigs, sugar beet, cereals and potatoes. For cereals, contracts take the form of forward fixed price contracts, regional pools, minimum price contracts, and guaranteed base price contracts. Forward sales to merchants may account for around one third of UK grain production. So-called cost-plus contracts exist or have existed for field scale vegetables, pork and flowers. Between 40 and 50 percent of potato production is estimated to take place under a production or marketing contract, either with a processor or multiple retailer.

15. Futures and options contracts can be considered as a specific form of marketing contract. Such contracts are only available in the UK for a small number of commodities and those that are available are not yet widely traded (although markets are growing). Contracts exist for wheat, barley and potatoes on the London Exchange. Contracts are mainly used by traders, co-operatives and food groups, rather than individual producers. Previous attempts to operate contracts on LIFFE for pigs, beef and sheep failed due to thin markets.

16. Tools such as foreign currency hedges (through the commercial banking sector) are also used mainly by food industry companies rather than farmers.

·                     crop insurance

17. Insurance against certain specific natural events (such as hail damage) is widely available throughout Europe. More extended packages are provided in France (agricultural calamity fund), Spain (multiple peril crop insurance schemes comparable to US) and Italy (pilot programs for frost insurance). In the Netherlands there has been some discussions between Government and interested organisations whether public-private partnerships would enable the development of a crop insurance scheme that covers all kinds of extreme weather events (for which currently ad hoc disaster relief is provided). In the United Kingdom, commercial cover is available (for example through NFU Mutual) against certain natural disasters, including hail. In addition, one private UK company has recently introduced the first commercial revenue insurance scheme for cereals. This operates on the basis of the London LIFFE futures price and historic regional yield. Take up is thought to be limited so far.

·                     safety net programs

18. Several schemes exist in European countries that allow farmers to smooth incomes over a longer time period, or to transfer money into an account in a high-income year while withdrawing it in a low-income year. In the UK, sole traders such as farmers can set trading losses forward against future profits of the same trade, against other income of the same or previous year or against capital gains of the same or previous year under the Corporation Taxes Act. Companies, including farmers can set trading losses forward indefinitely against future profits of the same trade or against other profits of the same or previous year.

19. Overall, the extent of employment of financial risk management instruments by UK producers appears to vary by type of instrument. Production contracts and some types of marketing contracts, particularly contracts with downstream participants in the supply chain, appear to be fairly common instruments adopted by some types of producers in respect of some commodities. It would seem likely that larger and possibly more specialised producers are in the best position to adopt this form of risk management. The use by UK producers of other instruments such as insurance, futures, options and particularly currency hedging seems to be very limited.

Why do UK farmers not make greater use of some types of financial risk management instruments?

20. There appears to have been little academic research undertaken into the reasons for the perceived low use of many of these tools by UK farmers. One contributing factor will certainly be the extent of employment of traditional business diversification strategies outlined in paragraph 6. However, consultations with stakeholders have suggested a number of possible additional explanations:

·                     the existence of CAP and other subsidies

21. The CAP results in substantial transfers to farmers from consumers in the form of inflated agricultural commodity prices. In addition, the UK Exchequer paid over £2.6 billion to UK farmers in direct subsidy in 1999. These sums are large in relation to the aggregate income of the industry, which equalled £2.3 billion in the same year. CAP and other subsidies raise the average level of agricultural income (although in a highly inefficient way). They are also likely to lower the probability of extremely low incomes resulting from negative events and thus reduce the demand for risk management tools. A study undertaken for the European Commission (DG Financial Affairs) pointed out that “the availability of other forms of subsidy that give farmers higher and more stable incomes, such as price support schemes, reduce the chances that farmers will want to buy commercial income insurance”. The degree of production-related support provided by the CAP varies considerably between commodities.

·                     the strength of the industry’s balance sheet

22. The value of the agriculture industry’s assets consistently exceeds its liabilities by a large margin. As a result, farmers as a whole are in a relatively good position to raise money from private capital markets when the need arises (although clearly this is not the case for some individual farmers). It may be that some farmers regard commercial loans as a more efficient strategy for dealing with exceptional instances of low income than the use of other risk management tools. Part of the reason for the strength of the industry’s balance sheet is the existence of CAP support, which tends to become capitalised in asset values.

·                     cultural factors relating to the provision of public support

23. It has been suggested that the history of sustained public financial support for the agriculture industry has generated an environment in which producers have come to expect that Government will provide compensation for events resulting in substantial negative consequences for incomes, including adverse currency movements. As a result, incentives to ensure private provision of risk management tools have been weakened. The study carried out for DG Financial Affairs points to the tendency for ad hoc disaster relief by governments to undermine private risk management products.

·                     inadequate information and training

24. There is a strong consensus that only a minority of UK farmers possess the knowledge and training which is necessary to understand and deploy risk management tools. This factor appears to be a particular obstacle to the greater use of currency hedging, futures markets and private insurance. Some of these tools are likely to be used to a greater extent by UK firms downstream of agriculture (commodity traders, food manufacturers), although in some other European countries co-operatives within the agriculture sector also appear to make use of some of these tools. The limited history of co-operative organisation within UK agriculture would appear to place UK producers at some disadvantage in this respect. However, several industry bodies are currently involved in the provision to their members of information and training in the use of risk management tools. These bodies include the NFU, HGCA, NPA and MLC.

·                     the costs of using risk management tools

25. A number of organisations consulted claimed that private risk management tools are frequently “too expensive”, or do not meet farmers’ needs. There may be a number of reasons why private instruments might be perceived as expensive or otherwise inadequate. One possible explanation is that demand for risk management tools may be relatively low given the present institutional environment in which farmers operate (see the points above relating to the distorting effect of agricultural support). Another possible explanation is that farmers may misperceive risk. (It was claimed to us that at the peak of incomes during the mid 1990s, few farmers worried about the prospect of a collapse of incomes, whereas in present circumstances farmers may be unwilling to lock into what they consider to be unsustainably low prices). If misperception of risk is a reality, it is likely to have its root, once again, in inadequate information and training. These are explanations which relate to the demand for risk products.

26. It is possible also, that there might be explanations relating to the supply of these instruments, especially with respect to insurance schemes. Asymmetric information (where the insured knows more about the potential risks to his business than the insurance company) is one issue. Another is systemic risk: that is, a situation in which a downside risk impacts on most of the industry in the same way. These problems make the provision of insurance coverage for a number of agricultural risks difficult and expensive. Asymmetric information involves problems of “adverse selection” and “moral hazard”. Both problems lead to high monitoring and administrative costs for insurance companies. With systemic risks, multiple insureds can suffer losses at the same time. Insurance companies have problems pooling such risks themselves and adequate reinsurance capacity is not usually available when the scale of the systemic risk is large.

Future of financial risk management tools

27. As the process of CAP reform and trade liberalisation continues over the coming years, a number of the factors currently inhibiting the use of private risk management tools are likely to decline in importance, suggesting that both the demand for and supply of these instruments may increase in the medium term.

28. Moreover, there are a number of developments in private markets which seem likely to improve the efficiency of market risk management tools in the years ahead. Opportunities for dealing with moral hazard and adverse selection affecting insurance markets appear to be increasing. Insurers may link their underwriting practices to objective criteria established for other risk management tools. Potential exists for monitoring farmers’ behaviour using global positioning systems and integrated remote sensing. In addition, research is increasing in the field of “objective transparent indices”, which would overcome the problem of monitoring individual behaviour. There are opportunities to develop capital markets through the use of derivative products to overcome problems associated with systemic risks.

29. In respect of currency fluctuation, products exist to enable exporters to cover their risk. Furthermore there is now recognition of the specific needs of small business with limited exposure to such risk. Banks are now offering to ‘batch’ smaller risks together to make larger more viable contracts. The financial services industry is also beginning to recognise that the farming industry has specific needs and that the current range of risk management products will need to be tailored to fit their particular circumstances.

Role for Government

30. Whether there is a role for Government in assisting the industry to make greater use of tools to manage market risk is a question considered in the report. In seeking to answer this question the report tries to identify whether there is prima facie evidence of market failure giving rise to less than optimal employment of risk management tools. It is considered that the deficiencies identified in paragraph 26 relating to information and training are examples of possible market failure. There may also be a degree of market failure associated with the supply side arguments in paragraph 28, although developments in private markets may mitigate these problems in time.

31. Unfortunately, there is little hard evidence concerning the relative importance of the various factors in UK farmers’ decision-making process and in the supply decisions of the risk management industry summarised at paragraphs 22-28. As a result, the degree of market failure and the appropriate type and extent of Government action is difficult to identify with any degree of confidence. In these circumstances, it is necessary to consider the risk that Government intervention might be inefficient.

32. In addition, there are certain criteria which it seems appropriate to apply to determine the nature of any Government involvement in this area, in order to limit the risk of policy failure. Any action should

·                     be consistent with the Government’s wider policy towards agriculture and the future of the CAP;

·                     be WTO compatible;

·                     involve minimum interference with the functioning of the market;

·                     avoid compensation for long-term sectoral decline.

33. In principle, some types of intervention, for example action aimed at facilitating market creation or improving the operation of private markets, could be feasibly undertaken at the national level. Some other types of intervention, if considered appropriate, might need to be undertaken at EU level, taking account also of the future of other types of EU policy intervention in agriculture, particularly under the CAP.

Consultation / next steps

34. The Ministry welcomes comments on the analysis contained in this paper. We would also like to invite views on strategies aimed at facilitating the greater use of risk management tools, while minimising the risks of distortion associated with public intervention. This is likely to require

                                            i.                        identification of those factors for which the strongest case can be made that a significant market imperfection exists which discourages the optimal use of risk management tools, and

                                          ii.                        suggestions for ways of improving the ability to accurately measure the extent of and reasons for any remaining problems related to private provision

35. In particular, there are a number of specific questions arising from the analysis on which views would be welcome:

(i) measures to improve the functioning of private markets for risk management products.

on the demand side

·                     is there a need for greater provision of information and training for farmers in the identification of risk and the use of financial risk management tools? Useful initiatives have already been taken in this area by several industry bodies, which are the appropriate organisations to carry this work forwards. Is there a need for further action and how might such a programme best be organised?

on the supply side

·                     is there a need to stimulate the private provision of financial risk management tools? There may be a need, for example, for the development of techniques to deal with asymmetric information, risk management contracts that are more tailored to the need of farmers (e.g. smaller currency hedging contracts, new futures contracts), and capital market innovations. If so, how might these developments be facilitated?

(ii) systematic research into UK farmers’ perceptions of risk and their reasons for preferring some types of risk management strategies and tools.

36. The present study has revealed an absence of research evidence concerning UK farmers’ attitudes to risk and risk management. As a result, the present report is largely based on qualitative information and the views of industry stakeholders. Is more robust quantitative evidence needed of UK farmers perceptions of risk and risk management? If so, how should this information be collected?

(iii) measures to improve risk spreading across the supply chain

37. Is there a need for more information and understanding of the role of production and marketing contracts in pooling risks and improving the efficiency of supply? If so, how should this information be provided?

Author: Department for Environment, Food and Rural Affairs