The support and subsidies provided to European farmers through the Common Agricultural Policy (CAP) has been the main reason for the limited participation of producers in risk management activities and, in particular, the use of derivative markets as a means for controlling price or yield risk. Over recent years, however, agricultural price support in the EU has been reduced and further reforms are ongoing; this is in part, a result of the necessity to change the policies of the internal market due to: the increasing cost to the taxpayers and consumers in supporting the agricultural sector, the cost of supporting the accession of the ten new member states, as well as pressures from WTO to liberalise and open the agricultural markets, particularly following the August 2004 WTO Agreement. Although the level of market price support is still very considerable, there has been a shift in support to the agricultural sector from trade distorting measures to decoupled direct payment to farmers and payments connected to rural development strategies. This implies that, where intervention prices previously offered a security net at a relatively high level below which prices would not fall, farmers’ revenue is now becoming more volatile and linked to the world prices. Preliminary investigation and statistical analysis of wheat prices suggests that, overall, the volatility of farm gate prices in EU member states has increased significantly, as a result of cuts in intervention prices and a reduction of other price support measures, following both the 1992 MacSharry and the AGENDA 2000 reforms. The ongoing reforms will result in further cuts in market price support measures which, combined with the commitment under WTO to improve market access, should increase the volatility of agricultural prices even further. Given this, the best way forward for farmers to cope with high price volatility and market uncertainty is to use market based instruments (derivatives and insurance products) in order to reduce income variability associated with price risk, provided that such instruments can be readily accessed and are economically affordable and properly understood. This report considers and outlines the opportunities and challenges related to the effective use of market based risk management products, particularly derivatives, in the European agricultural sector. Currently, the extent of use of the risk management instruments by European producers appears to vary across the EU member states and also by the type of instrument. Production and marketing contracts, particularly those with downstream participants in the supply chain, appear to be fairly common instruments adopted in a number of markets by some producers. Diversification of production and income from non-farming activities, such as rental businesses and off-farm work, are other popular risk management strategies. Insurance policies are also particularly popular in member states where insurance premia are subsidized by the government. Consistent with the trend in European agricultural policy towards reduced market intervention, in recent years, several commodity exchanges have launched new contracts on agricultural products such as milling wheat, corn, live hogs and rapeseed. As is shown in the report, derivative contracts offered by European Exchanges provide a fairly effective method for agricultural price risk management, and European producers can get the same level of risk protection as can the US farmers, using the “more established” US derivatives markets. Despite this, however, the uptake of derivative contracts by EU producers is rather limited. For instance, in the UK, it is estimated that only 11% of producers actively use derivatives for the purposes of risk management, and the level of futures trading activity is no more than equal to the level of physical production; whereas in the US, not only a higher proportion of farmers actively use derivatives, but also the volume of futures trading is, on average, 10 times higher than the level of the physical market. The main reasons for the low uptake of market-based risk management tools in the EU, identified in the report, include: Availability of Price Support through CAP Perhaps the most important reason for the limited use of market based risk management products for agricultural price risk management by farmers and producers is the security that has been provided by CAP and the inbred expectation that the consequences of price volatility will be borne by the taxpayers. In ensuring stable farm prices, the CAP has meant that producers have had little or no incentives to resort to market-based price risk management instruments. However, the ongoing reforms in CAP will result in greater variability in production prices and, hence, will make farmers more aware of the need to use risk management tools. Training and Market Information The second most important cause of the low participation in derivatives markets is lack of familiarity or understanding of risk management products due to inadequate information and training. Only a small number of European farmers and farming consultants have the knowledge, training and resources, to participate in agricultural derivatives markets and to use them for price risk management purposes. Structure of Existing Derivative Instruments The affordability of derivative instruments can sometimes be a dissuasive factor in the uptake of these products by farmers. Examples of this include the cost of buying option contracts, and the access to funds required to cover initial margins (in the case of futures contracts) and variation margins (in the case of futures and options contracts). Issues such as: quality and location mismatches between the physical production and the futures contracts; liquidity risk, due to the low trading volume in these markets; and the mixed perception of derivatives, are also reasons for the low uptake of derivatives by European producers. Regulatory Restrictions Financial regulators such as the Financial Services Authority (FSA) in the UK and the Autorité des Marchés Financiers (AMF) in France, classify private farms (i.e. nonlimited companies) as retail investors rather than professional hedgers. This means that non-limited company farms, despite seeking to use financial instruments for hedging purposes, have to be recognised by both Futures Exchanges and their member companies in the same way as would an individual speculator. Due to regulatory requirements, the treatment of this category of financial instrument user is more complex, time consuming, and costly, and hence less attractive to all parties involved. Availability of Alternative Risk Management Tools Finally, the availability of alternative risk management methods such as, land and product diversification, crop insurance and production contracts, is another contributing factor to the low uptake of market-based price risk management instruments. Although farmers may perceive these methods to be more readily understandable and simpler to use, they may not be as efficient as other risk management techniques - such as derivative instruments and insurance policies. One of the major challenges to providers of risk management products is the diversity of the European agricultural sector due to differences in agricultural products, production levels and the structure of farm sectors across the member states. Taking these parameters into consideration, along with the reasons for the low uptake of derivatives by producers, as well as experiences from other less “protected” agricultural markets (most notably South Africa and Australia), this report proposes a number of measures to encourage and enable farmers/producers to use more efficient and effective market risk management tools to control their price, yield and income risk, i.e. Establishing an Educational and Training Programme for Agricultural Risk Management It is essential for producers to better understand the benefits of using market instruments (particularly derivatives and insurance) to manage their risk, and to be able to use such instruments confidently and effectively. The challenge is to motivate all producers to learn and eventually use these instruments in order to help them to focus on their core business activities. Training should not only be targeted at producers but also at those consultants, banks, trading houses and other organisations, to whom farmers turn for assistance in managing their risk. For instance, in the UK, Farmcare has been sponsored by the Department for Environment, Food and Rural Affairs (DEFRA) to undertake a major risk management training and registration programme for all farming consultants (“The Risk Management Network”). It would also be beneficial to align such initiatives with the activities of other organisations actively involved in the promotion of derivative instruments in the agricultural sector, such as the Agricultural Working Group of the Futures and Options Association. Similar educational programmes have also been established by the Home-Grown Cereals Association (HGCA) in the UK, as well as in other member states, such as France and Greece. The objective of these educational programmes is to improve growers’ understanding of the basic mechanics of the grain market and the need to adopt a more strategic approach to grain marketing. These developments have been very well received by market participants and have also influenced their attitudes and perceptions towards the use of risk management tools. Delegate responses have shown that attending workshops has greatly improved their understanding and willingness to use risk management techniques including options and forward selling, based on the futures markets. This further illustrates how effective and properly implemented training schemes can affect farmer’s goals and attitudes towards risk management. Therefore, more comprehensive training programmes, co-ordinated by the appropriate authorities at European level, would greatly increase the awareness of risk in agricultural business and enhance the uptake of risk management instruments and techniques across the industry. Channelling Market Based Risk Management Products through Farmer focused Organisations Any new scheme for the education and promotion of market mechanisms for agricultural risk management should invest and build relationships with farmer-focused organisations such as Co-operatives, Farmer Controlled Businesses and Merchants. These organisations are ideal vehicles for training farmers, advising on and taking collective action in risk management activities on behalf of their members; and training schemes should enhance their ability to efficiently distribute information to the critical mass. They can also play an important role in creating economies of scale for farmers, by reducing the cost of using market risk management instruments. For instance, the World Bank Project on Commodity Risk Management presents an interesting case of how agricultural risk management projects can be tailored to meet the needs of small-scale producers. A similar approach could also be applied to promote and implement risk management projects for farmers in the EU. Development and Marketing of Flexible Derivative Instruments The diversity of the agriculture industry and business in the EU in terms of, number of products, quality differentials, regional disparities, and production cycles, indicates that more flexible risk management instruments are needed. Therefore, the success of new market-based risk management schemes and products greatly depends on their flexibility in terms of fulfilling the needs of users, simplicity in terms of trading and regulation, liquidity, efficiency and cost effectiveness. The use of flexible and tailor made Over-The-Counter products, which can be used along with exchange traded products seem to be the best way to address the need for product diversity in the agricultural sector. Such instruments can be designed to manage not only price risk but also crop yield risk, as well as weather risk, across a wide range of applications in the agricultural sector. Proactive Involvement of Exchanges, Banks and Financial Institutions The role of exchanges, banks and financial institutions working with the agricultural sector is of utmost importance because they finance farming and agricultural ventures. Experience from other agricultural economies (South Africa, Australia and the US) indicates that such institutions can have a vital role in providing appropriate infrastructure, training, and instruments, for market-based risk trading. Agricultural Policy Management The Commission and Member States need to be sensitive to the impact that the CAP, and in particular, market management activities under the CAP have on the liquidity of existing derivative markets and the development of new ones. The experience in South Africa was that during the transitional period where the Maize Board and the nascent SAFEX Agricultural Markets Division coexisted, the development of SAFEX AMD and its liquidity were threatened by the ongoing attempts by the Maize Board to continue managing the market, and in particular maize exports Overall it seems that there are opportunities for farmers and producers in different member states to make wider and more effective use of derivatives, and other risk management instruments, to stabilise their income, and that these instruments are capable of providing a viable and effective form of income protection for agricultural farmers – as they do in other sectors of the economy. It is also interesting to note that the concept of risk management is not new to the European Agricultural sector given that, prior to the post-war government policy of subsidising agricultural production, producers traditionally relied on forward dealings as a means of managing price risk, often in the form of rudimentary “to arrive” contracts. There are however, a number of issues that need to be investigated further, prior to the development of an effective action plan for making the use of market-based risk management instruments more attractive to EU producers, particularly:

1. a detailed review and assessment of the different risks which EU farmers face and of the extent to which farmers, in different regions and engaged in farming different crops, etc. are likely to use risk management products. This is an important step as very little is known about the individual goals and attitudes of farmers towards risk in different regions and member states. Understanding the producers’ needs across the different member states can also assist in appropriately channelling risk management products to the end users more efficiently;

2. the cost and effectiveness of alternative risk management tools in reducing risks associated with farming activities needs to be assessed and measured against the cost and effectiveness of the use of central subsidy under the CAP, in order to identify the economic impact of transition;

3. the need for financial service suppliers, i.e. exchanges, banks and brokers to engage more closely with the farming community. Understanding producers’ needs across the different member states will help to ensure the development of appropriate derivative and insurance products;

4. further investigation on the issue of how CAP reforms are going to affect all EU farmers and producers and, most importantly, how risk management tools can alleviate the problem of higher volatility of prices in different sectors, and across agricultural products, since this study is necessarily concentrated only on arable crops, most notably wheat, as it is the single most important agricultural produce of the EU and receives the largest share of subsidies under CAP.

Amir Alizadeh PhD and Nikos Nomikos PhD, Centre for Shipping, Trade & Finance, Cass Business School