Who Really Benefits from Single Payment Scheme (SPS) Under

Who Really Benefits from Single Payment Scheme (SPS) under Convergence of Payments? Micro evidence from Northern Ireland Kehinde Oluseyi Olagunju*, Simone Angioloni and Ziping Wu Agri-food and Biosciences Institute, Belfast, UK

Contributed Paper prepared for presentation at the 93rd Annual Conference of the Agricultural Economics Society, University of Warwick, England

15 - 17 April 2019

Copyright 2019 by Kehinde Oluseyi Olagunju, Simone Angioloni and Ziping Wu. All rights reserved. Readers may make verbatim copies of this document for non-commercial purposes by any means, provided that this copyright notice appears on all such copies. The research paper was undertaken as part of the Northern Ireland Department of Agriculture, Environment and Rural Affairs Evidence and Innovation Programme (Project E&I 180201). *Corresponding author: Agricultural and Food Economics Branch, Agri-Food and Biosciences Institute (AFBI), 18a Newforge Lane, Belfast BT9 5PX, UK. Email: [email protected] Abstract The degree of capitalization of subsidies into land rents has been mainly determined by different payments implementation systems and land markets. The 2013 EU Common Agricultural Policy (CAP) reform introduces changes in the implementation of decoupled payments towards convergence of payments and associated payment conditions. Using a two- step dynamic system Generalized Methods of Moment (GMM) estimation technique, this paper investigates the effect of these changes on farmland rental rates in Northern Ireland(NI) where a short term conacre land rental system is dominant. The model is able to control for expectation error and unobserved heterogeneity, and endogenous covariates all at once. Our estimates suggest that the capitalization of decoupled payments into land rental prices increases as the payment subsidies converges towards flat rate. Specifically, on average, the marginal effect on rental rates of an additional pound of the SPS is 9 pence (21 pence), increasing to 18 pence (42 pence) following the 2015 reform in the short term (long term). Given that about one third of land are rented in NI, the increase of land capitalisation rate is of particular relevance in designing more efficient future subsidy policy.

Keywords: Land market, CAP reform, Land rents, Dynamic System Generalized Methods of Moment (GMM). JEL Code: C13, Q11, Q12, Q15, Q18 1. Introduction Agricultural support remains one of the most important main ways of agricultural intervention in the world. In 2017, about USD 315 billion were paid by governments in 35 OECD countries to support agriculture. Seventy two percent of the support (estimated to be USD 228 billion) were used as production support that are transferred to producers which is equivalent to 18% of gross farm receipts in these countries (OECD 2018). In the EU, the direct support accounted for 30% of total farm net value added in 2015 (FADN 2018). Since 2005, EU has introduced the Single Payment Scheme (SPS) aimed to move away its payment from production-oriented policy to a so-called decoupled payment system, and shifted the focus of the payment from agricultural production towards on environmental protection and stewardship. Consequently, the payment has been decoupled from key production inputs such as crop areas, animal numbers etc. but it is linked to historic entitlements and / or land areas. Farmers are obliged to maintaining their land in good agricultural and environmental conditions and respect environmental, food safety, phytosanitary and animal welfare standards. In 2013, the EU Commission and European Parliament have jointly agreed a ‘New CAP’ for the period 2014-2020 in which the joint provision of public and private goods has been placed as the core of the agricultural support policy and all member states are asked to move towards a uniform payment per hectare at national or regional level by the start of 2019 and more flexibility has been left for member states to implement the policy so as to make EU agriculture more competitive and sustainable (EC–European Commission 2013). Under the 2005 SPS, three models presented to EU member states for implementation namely the historical model, regional model and the hybrid model. Within the framework of the historical model, payment entitlements are based on the support that the farm received in the reference period in the coupled subsides which makes it varies widely among farms while under regional (flat rate) model, the entitlements within a given region have an equal per hectare values, therefore, all farms within the same region receive same value of entitlements per hectare. The hybrid model which is a blend of historical and regional models, exists in two forms namely; the static and the dynamic forms. Unlike the latter that transits to becoming a flat rate model step-wisely, payments entitlements in the former are calculated using a part- historic/part-flat rate payments with no further transition towards a regional model. The 2013 CAP reform has further targeted to reduce the heterogeneity of payments per hectare in region or member state which mainly concern member states that implemented the historical and static hybrid model under the 2005 payments scheme through a Basic Payment Schemes (BPS) and to add greening measures to enforce its links with environmental sustainability. In order to achieve the objective of 2013 SPS, member states are expected to attain a flat rate model by 2019 (EU 2013). This is known as “convergence of payments” which exists in two forms namely the full convergence and the partial convergence1.

1 Under the full convergence, an equal per hectare payment is granted to all farms in a given region. This is similar to the regional SPS model. Under the partial convergence, the payment heterogeneity across farms is reduced but is not completely eliminated. The mechanism of partial harmonization consists of reducing payment rate to farms with higher value payments and increasing payment rate to farms with low value payments. Farmers receiving less than the national average receive more and vice versa. In both cases, Member States could choose either to

Although decoupled, the direct payment is still regarded to have partially capitalised into land rental price and affected farm production. Both theoretical and empirical studies have been conducted extensively on the impact of decoupled payments on land prices and rents, albeit with different conclusions. The extent to which this occurs – capitalization of decoupled payments on farmland rental prices – is of agricultural policy concern in two major aspects. First, as a proportion of payments are capitalised into land price / rent that increases the use of marginal land and affects crop production, the payments may distort the relative prices between land, labour and capital in farm production and product market, then reduce the production efficiency. Second, as the SPS is still a key instrument for income support to farmers, it provides information about how payments get leaked from the targeted main beneficiary, farmers, to the landowners. In the case landowners are not farmers and the capitalization rate is high, a large share of the payments gets leaked out of farming sector resulting to transfer inefficiency of the payments (Roberts et al. 2003). For instance, in the US about 60% of the agricultural land is owned by non-farming households, likewise in the European Union, according to Ciaian et al. (2014), majority of land that is rented out is owned by non-farming operators, signalling misallocation in case of high capitalisation of payments on land rents. Dynamically, the market may, as argued by Roberts et al. (2003), also alter both income distributional and production effects of the payments. The production effect of land rental capitalisation , however, may be insignificant , because a small share of the payments is dissipated via lower output prices (due to greater quantities supplied) and higher prices for input factors besides land (due to greater quantities demanded), thus benefits to commodity consumers and suppliers of other factor inputs. Haven’t affirmed above that SPS is decoupled from production decisions, but not decoupled from land, economic reasoning and theoretical model suggest that SPS may increase rents on agricultural lands to which payments are attached (Roberts et al. 2003; Ciaian & Swinnen 2006; Kilian et al. 2012). This theoretical assertion has also been examined empirically by Allen Klaiber et al. (2017) for Bavaria; O'Neill and Hanrahan (2016) for Ireland; Guastella et al. (2018) for Italy; Michalek and Ciaian (2014) for all EU-15 Member States; Ciaian and Kancs (2012) and Van Herck et al. (2013) for EU new member states. While Allen Klaiber et al. (2017), Ciaian and Kancs (2012), Van Herck et al. (2013) and O'Neill and Hanrahan (2016) reported evidence that SPS is significantly capitalized into rent, Michalek and Ciaian (2014) find much lower level of capitalization. Guastella et al. (2018) showed SPS did not significantly capitalized into rents. Hence, there is no unanimity on the magnitude of the actual capitalization effects of direct payment, as it depends on a number of other factors such as type of support, institutional arrangement, imperfections in factor markets, the structure of competition in the food supply chain and transaction costs (Alston & James 2002; Ciaian & Swinnen 2006; Kilian et al. 2012; Feichtinger & Salhofer 2016).

introduce flat-rate payment in the first year of the reform implementation (i.e. in 2015) or to introduce gradual harmonization of payments where the full convergence would be reached at least by 2019 or 2020 (European Commission 2015).

To date relatively little is known about the incidence of the 2015 CAP Pillar I payment reform on land rents. Two possible reasons for this are the lack of data and perhaps researchers still feel that it may be too early to examine this issue. One study that recently investigated this is Allen Klaiber et al. (2017) in Bavaria, Germany where long-term rental contract is predominant. However, as established by Gocht et al. (2013) capitalization rate of payments differs with land rental contract system. The overarching aim of this study is to examine the capitalization rate of SPS following the 2015 reform under a peculiar short-rental system in Northern Ireland (NI). Unlike the multiple year land market system, rents are adjusted on yearly basis and reflects the current farm business income (including gross revenue and subsidies). In the case of multiple year land rent contract, rents are not adjusted on yearly basis and may not reflect current agricultural returns therefore under the rental system examining capitalization of SPS may produce bias estimates (Patton et al. 2008), thereby making the Northern Irish context ideal to study the effect of subsidies on the land capitalization rates. From policy perspective, this study will provide new insights into the incidence of the SPS payment reform on land rents and the impetus for redesigning payment scheme in the EU. Indeed, this study is timely in view of the recent consultation by the EU regarding the future of the CAP in the European Commission - DG AGRGI policy document titled “the reform of the cap towards 2020”. Likewise in the UK, the findings from the study is equally coming so aptly in view of the consultation on the new structure of direct payments when the UK finally leaves the EU as contained in the briefing paper of the UK House of Common on “Brexit: Future UK agriculture policy” (https://www.parliament.uk/documents/commons-library/Brexit-UK-agriculture- policy-CBP-8218.pdf ) and the report of the session 2017 -19 on “Brexit and Agriculture in NI” by the Northern Ireland Affairs Committee. The presentation of the remaining sections of the paper are as follows. The second section details the agricultural subsidies and land rental market in NI. The third section provides theoretical background for the study. The fourth and the fifth section discuss the empirical model and data used to analyse the objective of the study respectively. The sixth section presents the empirical findings from the analysis. The last section concludes the paper. 2. Agricultural Subsidies and Land rent in Northern Ireland

Land is a fundamental input in agricultural production and, in particular, the developments in Northern Irish agricultural land markets and institutions have long been of interest (Young 1977). Approximately 75 per cent of the total NI land area of 1.36 million hectares is used for agriculture, including common rough grazing (DAERA 2017). Similar to the United States and other European Union (EU) member states, a large share of land transactions in NI takes place through rental market. In 2017, 28% of land areas were rented while the remaining 72% were self-owned in NI (DAERA 2017). In contrast to the rest of the UK, agricultural land is under short-term rental contracts, known as conacre rental system, whereby land is leased on a seasonal basis (normally for 11 months or for a shorter period) without entering into a long- term commitment. The prevalence of this peculiar rental system was a product of the Irish Lands Act introduced between 1870 and 1925 which sought to dissolve the rigid relationship between landlord and tenant, and discouraged long-term leasing. In the land rental market, the bargaining process between the landowner and the rentee occurs in different ways in any time of the year but concentrated in the winter and spring seasons.

Some landowners may decide to set up a bid for the land which will be conducted by an auctioneer, while others may prefer an informal arrangement in which the rents are established orally which can never occur in a long-term rental system. There is no legal binding that the contract between the rentee and the landowner will be extended and or renewed for the next agricultural production season which may affect the magnitude of investments that rentee may want to put in the land. Also, as a result of the flexibility under this rental system as against what is obtainable under the long-term rental system, it enables farmers to adjust their farm size and perhaps farm structure from time to time, without any economic and financial burden to purchasing additional land, to any changes in economic situations (Alexander 1963; Young 1977). In NI, a static hybrid model of the SPS (commonly referred to as Single Farm Payment – SFP) was introduced in January 2005 which was based on an historical and a flat rate component, with no further transition towards a flat area payment model unlike the dynamic hybrid model adopted in England, Germany and Finland where there is continuous transition towards a flat- rate payment. The motivation for adopting the static hybrid model is to enhance a smooth transition by making sure that farmers who benefit from the production-based payment scheme should benefit, in equal portion, from the SPS scheme in the future. The historical component, which forms about 80% of the payment scheme, was based on payments claim pattern during the 2000-2002 reference period for farm enterprises under the arable, beef and sheep scheme, but for dairy farmers the dairy premium was included based on milk quota held in 2005.This was calculated by taking the average number of eligible hectares/animal declared in 2000, 2001, 2002 multiplied by a set percentage of subsides received in 2002. The area component of the SPS payments was obtained by multiplying the number of entitlements by fixed area rate. In 2013, SPS further underwent reform giving birth to the Basic Payment Scheme (BPS).

In January 2015, NI introduced stepwise harmonization of entitlements towards a regional average or a flat rate in accordance with the 2015 CAP reforms of the SPS. Under the new scheme, payments have been divided into BPS and some additional payments, including green direct payments and payments for young farmers. Receiving BPS payments follows the same rules as SPS payments before the 2015 reform. Farmers were allocated entitlements and need the same number of eligible hectares to active payments each year. Green payments account for 30 percent of all direct payments and are paid on the condition that farmers undertake practices that are beneficial to the climate and to the environment. For all these payments, receiving BPS payments is a precondition. To receive payment a farm business must hold entitlements which they then can activate against an equivalent hectare of land in order to claim payment under the BPS. Entitlements with value below the regional average will increase by 71.4% of the difference between their initial unit value in 2015 and the regional average by 2019 in equal annual steps. Payment entitlement with a value above the regional average will be subjected to a linear decrease to the difference between the initial 2015 unit value and the regional average in order to generate the required funds for the increase in entitlements which are below the regional average (DARD 2015). The rate of transition is consistent with achieving a flat rate for entitlements by 2021. For example, if the initial entitlement values declared is less than the regional average, then it will be step-wisely increased over the years

4 to approach the regional average and vice versa. Changes in payment conditions before and after 2015 are reported in Table 1.

Table 1. Changes in Payment Conditions and Way of Payment in Two Systems SFP* BSP* Payment eligibility Farmers are entitled to the Area-based scheme based on conditions payment if : new entitlements which is (1) An active farmer; eligible: (2) Hold payment entitlements (1) 2013 payment >€100 or and have eligible agricultural alternatives; land, and (2) An active farmer, and (3) ≥ 0.1ha of eligible land @ (3) >3 ha of eligible land @ May 15 in the year of claim. May 15, 2015 Way of payments (1) Single Farm Payment (1) Basic Payment Scheme Scheme (SPS); (including Greening (2) Less Favoured Area Payment and Young Compensatory Allowances Farmers’ Payment); (LFACA) Scheme; (2) Areas of Natural (3) Northern Ireland Constraint Scheme; Countryside Management (3) Northern Ireland Scheme (NICMS); Countryside Management (4) Organic Farming Scheme Scheme (NICMS); (OFS; (4) Organic Farming Scheme (5) Farm Woodland Premium (OFS; Scheme; (5) Farm Woodland Premium (6) Farm Woodland Scheme Scheme; (6) Farm Woodland Scheme Harmonisation Payments are not harmonised To achieve a regional flat rate under this scheme. of payment in 2021, a linear yearly adjustment will be used for those entitlements paid above or below the regional average. *In terms of nomenlcature, both can be referred to as SPS. The average farmland rental shares for the last 15 years in NI, defined as the rented agricultural area in total farmed area, ranges between 28% and 34% (Figure 1). During the production- based payments scheme, a marginal increase from 31% to 34% was observed in the rental share between 2002 and 2003, and this was maintained until the replacement of the scheme in 2005. A relatively stable share of rented area, slightly above 30%, was observed throughout the Single Farm payment scheme, 2005-2012 however, there has been a decline since the 2012 when the SPS reform was implemented in NI. Between 2012 and 2017, the share of rented areas in total farmed areas decreased steadily from 32% to 28% (DAERA 2017) . While the rental share in NI is smaller compared to England and Wales with rental share of about 43%,

5 it is larger relative to rental share of about 19% in Republic of Ireland (Ciaian & Espinosa 2016). In real terms, the average conacre rental per hectare of agricultural land in NI was declining in the years preceding the shift to decoupled payments in 2005 while between the beginning of the single farm payment scheme and the basic payment scheme, the average conacre rent has increased by 42% in the period between 2005 and 2015. This increase becomes more obvious if we examine average rental rates by land use in the last ten years. The overall real “average” rental values for all use are close to rents paid for grassland which is rented for about £240 per hectare with potatoes rent about 2.7 times that value at £649 per hectare, suggesting that different production and land quality may have contributed to the rental difference. The trend of the overall average values of real rent has been fairly stable over the past 10 years although grassland rents fell by about 17.6 % between 2003 and 2006, while cereal rent was about £ 271 per hectare fell by about 27% in 2005. Rental values of conacre for potatoes increased by about 43 % between 2004 and 2008, perhaps as a result of allowing SPS entitlements to be enabled on such crops for the first time (i.e. because of the area payment of the hybrid system). Given the fairly increase in the overall averages, the net land rental expenses becomes sizable constituting about 3% of the total expenses of NI agriculture, marginally above the overall UK, where net rent constitute 2% of the total expenses (DAERA 2017).

40.0 229.9 240.0 221.8 216.4 35.0 212.1 220.0 208.0 202.7 199.0 198.4 194.5 30.0 191.1 190.9 191.2 191.8 200.0 186.5 185.3 25.0 180.0

20.0 160.0

15.0 140.0 Conacre rental prices £/ha prices rental Conacre

10.0 120.0 Reented area total % of in farmed Reented area 5.0 100.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Years

Conacre rental price Rented area in % of total utilized agricultural area

Figure 1. Percentage of rental area and average conacre rental prices in NI, 2002-2016 Source: Authors’ own calculation based on DAERA Statistical Review of NI Agriculture (various editions). *Conacre rental prices are real 2015 prices.

360 900

310 800 700 260 600 210 500 160

400 all uses all uses 110 300

60 200

10 100 Rent per hectare (£/ha) for potatoes Rent per hectare (£/ha) for grass,cereals hectare per Rent for (£/ha) grass,cereals and Year

Grass Use Cereals All Uses Potatoes

Figure 2. Average conacre rental prices by type of use, 2000 – 2016 Source: Authors’ own calculation based on DAERA Statistical Review of NI Agriculture (various editions). *Conacre rental prices are real 2015 prices.

3. Theoretical Considerations Land capitalisation of agricultural support has been a heavily debated topic in last two decades. Discussions are mainly focused on three main issues: (1) why does land capitalisation occur? (2) Will there still be land capitalisation after payments are decoupled from production? Lastly, what are the other factors that affect the land capitalisation in the case of decoupling?

Capitalisation refers to value redistribution among production inputs in the market, resulting from market and policies changes. In the case of agricultural support, capitalization into different input prices depends largely on the conditions attached to receiving the support. For example, McErlean et al. (2003) show that cattle payments in Ireland before 2005 has partially capitalised into the prices of different animal groups as the payments were paid specifically to limited number of animals in two trenches in cattle farms under the CAP in the period after MacSharry reform. By affecting the production process, including demand for different inputs, the support is redistributed to different production inputs. The extent at which payments is considered in production decision is, however, conditioned on whether the payments are directly coupled or decoupled and if any other conditions are attached to the payment. In a directly coupled system such as deficiency payment system, payments are usually regarded as an additional price premium to the product. In this case, increase in the payment will move production curve downwards to increase production, and subsequently increases demand for agricultural inputs and their prices. As a result, payment becomes capitalised into the scarce resources, for example land as an input in production process. The level of land rent is however determined by the difference between the productive capacity of the land and the margin of production, which is associated with exclusive land ownership. With

7 the deficiency payment, more marginal land is likely to be utilized and both the margin of production and land rent increase. In other cases, for example, if the payment is given to a certain group of labour, the wage rate for the group will increase. When the payment is strictly decoupled without any additional conditions, production inducing impact of the payments is regarded to only relate to its wealth and insurance effects of the payments under uncertainty (Hennessy 1998; Antón 2001; Esposti 2016). As most of farmers are risk averse, the payment affects farm decision via insurance effect to lower the production risk and wealth effect to make farmer less risk averse. Dynamically, it affects farm consumption and investment then to affect long term output. Each of these individual impacts are believed to be insignificant but the overall impact is not clear (Rude 2008). If its production effects are negligible, the rent effects or so called capitalisation of payments on land rent may also be insignificant.

The SPS scheme in the EU is more complicated than the strictly decoupled case. In practice, to receive SPS, farmers need to have its historic entitlement, and are also required to meet certain eligibility conditions for subsidies (e.g. cross-compliance condition and greening measures). Payments under the SPS are no longer coupled with production, but since at least certain amount of eligible land is required to activate entitlements, then they cannot be said to be decoupled from entitlement / land. If the support is only attached to entitlement and the entitlement is tradable, then entitlement price would be part or full value of the support. When the payments are attached to other conditions such as land and other compulsory compliance and good farming conditions, the capitalisation situation will be more complicated. Different pathways to the incidence of agricultural subsidies on rental prices have been extensively studied in theoretical literature (Courleux et al. 2008; Kilian et al. 2012; Ciaian & Espinosa 2016; Raihan et al. 2017). Theoretical propositions from these studies demonstrated that the extent of capitalization of SPS is contingent on the ratio of the amount of entitlements to the eligible land area that is available to activate them. There will be no effect of capitalisation of SPS when the eligible land area exceeds the entitlements number in a region because there will zero incentive to pay for additional rent for additional land. In this situation, the entitlement of the SPS will be allocated to other conditions /constraints for receiving SPS. In contrast, if the number of entitlements is greater than the available land area, the support will be capitalised into land rent and a shift from historical model to flat rate model will lead to increase in the incidence of SPS on land rent values (Michalek & Ciaian 2014). The main reason for this is that land rents prices (and the capitalization of the SPS) are determined at the margin and the demand for land will increase at the margin as harmonization of SPS takes hold. However, under entitlement surplus and the regional model, full capitalization occurs only with a perfectly inelastic land supply and zero elasticity of substitution between other input factors and land and/or a perfectly elastic supply of other inputs (Kilian et al. 2012). In all other cases, SPS payments will either shift land demand upward by less than the payments associated with land (due to input factor substitutions) or increase the price by less than the demand shift (due to increased land supply). Therefore, under the SPS, land capitalisation is not only determined by the payment but also the nature of agricultural input markets.

Ciaian et al. (2014) argue that apart from budgetary change, the implementation details of the 2013 CAP reform such as the reference period for entitlement allocation, regionalization and payment differentiation will be the main determinants on land capitalisation. Therefore, the effects will be vary across farms, regions and member states and if the stock of entitlement maintains after the reform, the land value is likely to be lower driven by the SPS budget cut. The CAP “greening” and CAP payment differentials but if the payment is based on land use after the reform as triggered by active farmer condition, then land capitalisation will be increased.

A shift from historical and or static hybrid model to flat rate payments could cause a rise in the extent of SPS capitalization this is because they tend to reduce asymmetric information on land prices while adding transparency to land market (Ciaian et al. 2014). The unit value of entitlements within a region tend to become homogenous, which could be observed by all market actors including the landowners at zero cost. In contrast with what is obtaining in historical/static hybrid model, the values of entitlements differ among farmers therefore the exact value may be unknown to land proprietors, which may weaken their bargaining situation. In sum, the capitalization rate may be smaller under static hybrid model as a result of asymmetric information relative to the flat rare model. The rise of capitalisation in the case may also related to the way the support was paid. In the case that payment was associated with land quality such as that in England before 2015. The convergence of payment is likely to increase the margin for low quality land, therefore to increase rent for low quality land and push up the capitalisation of payment on land rental price.

Other significant factors that may affect the exact capitalization rate of SPS on rental prices include land market flexibilities and credit market imperfections (Ciaian et al. 2010; Michalek & Ciaian 2014; Ciaian & Espinosa 2016). How these factors mediate in the relationship between rental prices and SPS depends on the particularities of these factors and on how they interact with SPS. For instance, it is expected that farmers that are credit constrained may not have the wherewithal for productivity gains, however SPS may be used to replace the missing finance, resulting in higher input use, higher productivity and hence, provide incentives to rent additional land (Ciaian et al. 2010; Michalek & Ciaian 2014). Another important determinant of SPS capitalization according to Ciaian et al. (2010) and Michalek and Ciaian (2014) is the “good agricultural and environmental” conditions tied to SPS payment. Farm eligibility is contingent on the farmers satisfying the cross-compliance requirements. Given that the cross- compliance obligations come with extra cost to land use, it results in reduced marginal returns from land thereby reducing the willingness to pay for extra land rental price and subsequently the capitalization rate of SPS. With respect to land market flexibilities, Ciaian et al. (2014) argue that change in the incidence of SPS on rental price is gradual with a long-term contract while rental prices adjust faster to market and policy changes under short term land contract, as in NI and the Republic of Ireland. This is because rental prices do not change until expiration of contract under the long-term contract, resulting in slower adjustment of rental rates. Therefore, we would expect that capitalisation ratio in the short term contract such as conacre to be relatively higher than long term contract.

Literature suggests that the capitalisation of payments on land rent are very much conditional. Gocht et al. (2013) note disparities between theoretical hypothesis and results from empirical analysis of capitalization of SPS. They argue that incidence of capitalization varies with the different implementation models, structure of land markets and transaction costs. For example, O'Neill and Hanrahan (2016) have explored the incidence rate of 2003 CAP Pillar I payments on rents in Ireland. They found the policy measure significantly capitalized into rents under a short-term rental system. In contrast, Guastella et al. (2018) addressed similar objective but under long term land contract system in Italy. They show that the 2003 CAP Pillar I payments do not significantly capitalized into rents.

4. Empirical approach The primary goal of this study is to estimate the relationship between the Single Payment Scheme (SPS) and the per hectare conacre rent and therefore we follow previous studies in this field that modelled the demand for land as the summation of several factors (Patton et al. 2008; O'Neill & Hanrahan 2016):

퐶푅푖푡 = 휌 ∙ 퐶푅푖푡−1 + 훽0 + 훽1 ∙ 퐸(푅퐸푇푖푡) + 훽2 ∙ 푆푃푆푖푡 + 휷3 ∙ 푿푖푡 + 휇푖 + 휀푖푡, (1) where 퐶푖푡 is the per hectare conacre rent, 퐸(푅퐸푇푖푡) is the expected market return, 푿푖푡 denotes a series of farm specific variables including time shifters, 휇푖 is a fixed term to capture the unobserved heterogeneity at the farm level while 휀푖푡 is the idiosyncratic error term of the farm

푖 in year 푡. 훽1and 훽2 only capture the short-run effect of SPS and market returns. The long-term effect of these main variables of interest are estimated dividing the respective coefficients by (1 - 휌) (Hendricks et al. 2012). The presence of the lagged dependent variable on the right- hand side of equation (1) can be explained considering two aspects. First, although the system of agricultural land rental in NI is predominantly on annual basis, evidence suggests that there is substantial slowness or inertia to change the rent conditions from one year to another one with farmers that rent the same plot of land at the same conditions over time (O'Neill & Hanrahan 2016). Second, if we assume that the conacre rent is the result of the effect of the independent variables such as previous subsidies, previous market returns, previous production chocies, etc. over a sufficiently long time horizon, then these can be factored out as a lagged dependent variable (Hamilton 1994).

Estimation of equation (1) is realized throught two expedients. First, it is first differenciated to remove the fixed term 휇푖. This techique is preferred because it does not produce biased estimates as alternative approaches such as the within transformation (O'Neill & Hanrahan

2016). Second, expectactions are not observed and the variable 퐸(푅퐸푇푖푡) is replaced with its realized value. This introduces an additional source of disturbance in the error term 휀푖푡 that will be thus correlated with 푅퐸푇푖푡. This problem could be handled by instrumenting 푅퐸푇푖푡 with variables not correlated to 휀푖푡. However, since first differentiating of the equation (1) generates correlation between ∆퐶푅푖푡−1 and ∆휀푖푡, a two-step System-GMM estimator is usually preferred. For dynamic panel data models like this, the two-step System-GMM estimator has the great advantage as it controls for lagged depenent variable, unobserved heterogeneity, and endogenous covariariates all at once. In litreature, these models are called Arellano-Bond

10 estimator (Greene 2012), see Roodman (2009) for details. The standard errors of this estimator is downwardly biased, however, to reduce this bias the Windmeijer (2005) finite-sample correction for standard errors is incorporated.

The secondary goal of this study is to analyse whether the reform of SPS in NI starting from 2015 generated a different impact on the land rents. To do so, we compared the estimates of the previous model over the entire 2010-2016 time period, called Pooled Model, to those from a model that employs a slope-shifter for the years post reform, called Extended Model:

∆퐶푅푖푡 = 휌 ∙ ∆퐶푅푖푡−1 + 훽1 ∙ ∆푅퐸푇푖푡 + 훽2 ∙ ∆푆푃푆푖푡 + 휷3 ∙ ∆푿푖푡 + 퐷푡 ∙ 훽4 ∙ ∆푆푃푆푖푡 + ∆휀푖푡, (2) where 퐷푡 = 1 for periods 2015 and 2016 and ,0, if otherwise. The coefficient 훽4 captures the individual effect of SPS on the conacre rent pre and post 2015 reform. A statistically insignificant coefficient indicates that there is no differene pre and post reform. Conversely, a positive and statistically significant coefficient indicates that the reform of SPS increases the land capitalization. See Allen Klaiber et al. (2017) for a similar approach on this field. 5. Data The data employed in this study are sourced from the Northern Ireland Farm Business Survey (FBS). Each year, the Department of Agriculture, Environment and Rural Affairs (DEARA) conducts a nationally representative survey of Northern Irish farm businesses, as part of the European Union Farm Accountancy Data Network (FADN). The FBS cuts across all farm types and details a wide range of structural and financial data, such as farm structure, input cost, output, taxes, subsidies and other economic and financial indicators. For the purpose of this study, we focus on the years from 2009 to 2016 in order to capture the pre and post 2015 reforms of the SPS. Besides, we focus on farms with an amount of utilized agricultural land larger than one hectare. This was made to avoid cases of small farmers that rent small plot of land from relatives at a very low price and, at the same time, to avoid cases of poultry and pigs farmers where the usage of land is not a primary factor of production. Overall, the dataset contains 2,360 observations and 76% of the farms were reselected in the survey every year. The variable of main interest of this study, the per hectare conacre rental rate, is defined as the ratio between the total amount total conacre rent paid and the area taken in conacre. The SPS payment is defined as the ratio between the total SPS payment received by a farmer divided by the net area, where the net area is given by the summation of the owned land plus the taken land and minus the land rented out. Similarly, the market returns variable is defined as the ratio of the gross margin, subsidies excluded, and the net area (Ciaian & Kancs 2012). In addition to SPS payments per hectare, farmers also receive other forms of payments such as the agri- environmental payments, disadvantaged area payments and general subsidies which are included in the model. Due to the excess number of zeroes, these amounts were aggregated in the variable called Other Subsidies defined on per hectare basis (Ciaian & Kancs 2012). We also include a series of farm level variables potentially connected to the conacre rent. Given that land rents may increase with the share of family labour due to productivity differences between family and hired labour, we include the share of family labour with respect to the total

11 labour where labour costs were considered to calculate the shares (Allen Klaiber et al. 2017; Guastella et al. 2018). To account for farm access to credit, we also include the assets-to- liability ratio defined as total asset value dived by the summation of the total asset and liability value (Ciaian & Espinosa 2016). We include the share of livestock in the total output, to account for specific production choices. This variable was defined by dividing the value livestock output by value of total farm output (Patton et al. 2008; Ciaian & Kancs 2012). The variables measured in monetary units were corrected for inflation using the appropriate annual price indices published by the UK Office for National Statistics (ONS). Besides, farmers who are engaged in off-farm employment may have less time and resources to commit to agriculture and so may rent less land, ceteris paribus (Holden & Ghebru 2005). For this reason, we include a binary indicator to detect farms with off-farm activity. Finally, to account for farm-owned factor inputs, we include rental ratio constructed by dividing the area rented by the total area farmed. The summary statistics of the data used in the model are presented in Table 2. For the pre-reform period, 2009-2014, the average conacre rental price paid is 185.57£/ha while the SPS payments is 248.79£/ha, however, after the reform, 2015- 2016, the average rental price paid and the SPS payments received are 234.46£/ha and 208.29£/ha respectively.

Table 2. Summary Statistics for dependent and independent variables Variable Pre-2015 reform (2009 -2014) Post-2015 reform (2015 -2016)

Mean Minimum Maximum Mean Minimum Maximum (Std dev.) (Std dev.) Dependent variable Conacre rent 185.57 17.36 565.90 208.29 15.91 613.10 (£/ha) (75.713) (81.048) Explanatory variables SPS payments 248.79 0.00 943.27 234.46 46.93 512.94 (£/ha) (115.014) (77.121)

Other 38.26 0.00 345.00 32.56 0.00 159.30 subsidies (35.661) (29.324) (£/ha)

Net market 270.94 -782.38 2945.21 130.03 -817.70 1796.83 income (£/ha) (424.806) (318.500)

Asset 0.67 0.11 1.00 0.62 0.08 0.93 liabilities ratio (0.149) (0.144)

Share of 0.92 0.00 1.00 0.90 0.00 1.00 family labour (0.145) (0.158) in total labour

Off-farm 0.32 0.00 1.00 0.32 0.00 1.00 dummy (0.467) (0.469)

Share of 0.69 0.00 1.02 0.70 0.00 0.97 livestock (0.221) (0.209) output in total output

Rental ratio 0.35 0.01 0.98 0.34 0.01 0.98 (0.222) (0.218)

6. Results and discussion The results of the two-step System GMM estimator incorporating the Windmeijer finite-sample correction for standard errors are presented in Table 3. The set of instruments included in the differenced equation of the model are the second lags of conacre rents, market returns, SPS payments and Other government payments while the lagged changed in these variables are included in the level equations as instruments.

We report two sets of models as described in the methodology section: model (1) captures the overall capitalization rate of SPS into rental prices, and the second model estimates the capitalization rate following the 2015 reform of the SPS. The model specification is supported by the diagnostics statistical tests as reported in the lower part of Table 3. First is the Arellano- Bond statistics tests for the autocorrelation of the residuals. The test suggests the rejection of the null hypothesis of no first-order residual serial correlation, AR(1), but not the hypothesis of no second-order serial correlation, AR(2), which must be the case for the GMM estimator to be consistent. Second, the Hansen test statistics of over-identifying restriction is statistically insignificant, suggesting that the set of instruments employed fulfil the exogeneity condition (validity of instruments) required to obtain consistent estimates. The lagged conacre rents are highly significant suggesting that current rental prices depend on past land rental rates. Notably, the coefficient of lagged conacre rents reduced slightly in model (2) when the 2015 SPS reform was specifically accounted for. This rationalises the dynamic model specification employed in this study. Considering the estimates of model (1) in Table 3 for all farm types, the results reveal that additional pence given to farmer as SPS payments increases farm land rents by about 10 pence in the short term and 24 pence in long term. This estimate does not differentiate between 2005 and the 2015 SPS payment reform. In order to incorporate the 2015 SPS payment reform, we report model (2) which is based on interaction term between SPS per hectare and reform years, 2015 and 2016 as “SPS × reform”. The estimation results show that, on average, the capitalisation effect of SPS payments grows significantly from 9 pence (21 pence) to approximately 18 pence (42 pence) of each pound of the payments in the short run (long run) following the implementation of 2013 CAP reform in 2015. The capitalization effect of the SPS payments convergence in NI can be explained by the following possible reasons. First, during the pre-2015 SPS payments scheme about 80 percent of the payment that farmers receive are based on historic production pattern between the periods 2000-2002 suggesting that farmers that are mainly located in LFAs may have received lower subsides per hectare during the pre-2015 payments scheme possibly due to low production recorded during the reference period. However, with the implementation of the 2015 SPS payment scheme which allows farmers receiving lower subsides per hectare to get more payments and vice versa. This therefore indicates that farms located in LFAs constituting the larger percentage of farms in NI may probably receive more in the post 2015 suggesting incentives to rent additional land. Second, every farmer in NI will all move towards a flat-rate entitlement value per hectare by 2021. The unit value of entitlements tends to become homogenous and well known by land owners, thereby boosting their bargaining position relative to the farmers. This exposition is in line with theoretical predictions by (Ciaian & Espinosa 2016). Furthermore, from our estimates in Table 3, differing incidence of direct payment across different types of farms were observed. For dairy farms, cattle and sheep farms, and mixed farms, the results revealed that the extent to which payments are capitalized into rents increased significantly to 27 pence (25 pence), 20 (57 pence), and 25 pence (130 pence) in the short term (long term) respectively after the convergence of payment takes hold in NI. These results provide evidence that land owners capture policy benefits because rental prices are inflated by the subsidies.

Quite surprisingly, the empirical findings show that market income does not significantly capitalized into land rents. O'Neill and Hanrahan (2016) and Guastella et al. (2018) reported similar findings in Ireland and Italy respectively. One may expect farmers’ production decisions to be more market oriented after agricultural support has been decoupled from current production, but this seems not to be the case. This may be attributed to two main reasons: first, subsidies form a major portion of the cash income of N. Irish farmers, about 71%, which makes farmers economically inviable without receipts of subsidies. According to Howley et al. (2012), many farmers now rely solely on subsidies rather than market income to take production decisions including the demand for inputs. Another possible explanation for insignificance of market income as a determinant of conacre rental prices is that many N.Irish farmers take farming as habits and are not guided by market principles. In addition, some farmers also engage in off-farm activities, and they commit large portion of their income to non-farm activities that do not directly require land.

The coefficient of the variable representing other government subsidies payments (including mainly agri-environment and Less Favoured Areas payments) is not significantly capitalized into rents. This may probably be because they form insignificant proportion of farm business income. In addition, Less Favoured Areas payments (LFA) in NI, for example, are designed for farmers cultivating marginal lands with low productivity level thereby providing less incentive to rent additional land, and consequently attracts lower rents. The estimates of all the covariates are also reported in Table 3. Although not all of the covariates are significant, but they all have expected signs. The livestock output ratio variable is positive and significant, suggesting that farms with higher livestock share may require large expanse of land that is of good quality for animal grazing thereby providing motivation to rent additional land. The share of rented land in the total land area cultivated is negative and significant. This rather expected, because farms with higher share of rented farmed land area incur higher rental cost due of rental payments to landowners. Higher rental cost serves as disincentive to farmers to rent additional land. The asset-to-liabilities ratio, which shows farmer’s credit worthiness, is found to be negative across all the farm types. This suggests that farms with smaller asset- liabilities ratio tend to have more credit implying higher rents. The coefficient of family labour ratio variable is found to decrease rental prices, but statistically insignificant. Though not statistically significant, off-farm employment dummy variable is negative, suggesting that participation in off-farm activities may reduce farms sole dependency on land and associated costs.

Table 3. Estimation Results of Two- Step dynamic “robust” system GMM , 2009-2016

Dairy farm type Cattle and sheep farm type Mixed farming type 2Pooled data (All farm types) (1) (2) (1) (2) (1) (2) (1) (2) Lagged conacre rent(£/ha) 0.378*** 0.357*** 0.652*** 0.652*** 0.805 0.803*** 0.587*** 0.573*** (0.090) (0.089) (0.112) (0.108) (0.080) (0 .078) (0.069) (0.070) SPS Payments (£/ha) 0.149** 0.119* 0.098** 0.093** 0.149 0.112 0.100**** 0.088*** (0.072) (0.068) (0.047) (0.044) (0.059) (0.068) (0 .025) (0.025) Other subsidies(£/ha) 0.007 0.014 0.162 0.217 0.143 0.109 -0.014 -0.022 (0.111) (0.111) (0.283) (0.292) (0.280) (0.254) (0.143) (0.143) Market income(£/ha) -0.004 -0.003 -0.038 -0.047 -0.022 -0.019 0.001 0.001 (0.008) (0.008) (0.052) (0.048) (0.016) (0.016) (0.016) (0.016) Share of livestock output 125.037*** 130.976*** 62.232** 65.139** 48.064** 46.994** 61.136*** 62.503*** in total output (42.895) (41.326) (30.857) (30.743) (18.672) (20.078) (19.372) (19.543) Rental ratio -2.085 -5.647 -31.071** -30.444** 0.965 0.213 -22.120** -22.977** (19.861) (19.344) (15.302) (14.920) (19.613) (20.595) (10.920) (11.037) Asset –liabilities ratio -54.515* -56.758* -7.261 -12.692 22.67 25.04 -7.643 -6.293 (29.913) (31.600) (17.711) (18.489) (31.61) (30.733) (13.455) (13.435) Share of family labour in -41.639* -44.434** 6.074 5.136 21.41 20.52 -13.049 -14.221 total labour (21.097) (21.162) (16.939) (16.071) (15.768) (18.220) (12.432) (12.336) Off farm dummy -11.240 -9.991 2.867 4.343 7.343 7.197 -2.042 -2.108 (7.216) (7.038) (7.715) (7.531) (11.176) (10.942) (3.640) ( 3.630) SPS payments × reform - 0.146* - 0.105** - 0.142* - 0.093*** (£/ha) (0.088) (0.047) (0.075) (0.040) Statistical tests AR (1) p-value 0.000*** 0.000*** 0.000*** 0.000*** 0.003*** 0.002*** 0.000*** 0.000*** AR (2) p-value 0.184 0.218 0.235 0.203 0.525 0.420 0.369 0.338 Hansen p-value 0.339 0.283 0.610 0.653 0.267 0.394 0.288 0.321 Note: *** P < 0.001, ** P <0.01, * P<0.1; We validate that there is mis-specification problem by consucting OLS and Fixed effect model. The estimate of lagged conacre rent between the range of estimates generated from the OLS and Fixed effect model. Results are available on request

2 In the model for the pooled data containing all the farm types, we include sector specific dummies to account for sector differences which may influence rental prices. 16

7. Conclusion The capitalization effects of agricultural supports into land rental prices has received considerable attention in academic literature, and among agricultural policy analysts. In NI the implementation of the 2013 CAP reform in January 2015 led to the shift from static historical payments scheme, a system based partly on historical production pattern and area farmed, to a payment system that transitions towards a flat rate. According to theoretical literature, the capitalization rate of subsidies on rents depends largely on the subsidy type, conditions for receiving entitlements, land market flexibilities etc. In this paper, we examine the degree to which SPS payments have been capitalized into farmland rental prices after the implementation of the 2013 CAP reform of SPS under a peculiar short-term rental system in NI. To achieve the objective of the study, we used the two-step dynamic GMM estimator and employed the NI Farm Business Survey panel data covering period 2009–2016. Specifically, the data covered six years (2009 – 2014) of the 2003 SPS payments scheme and the first two years (2015 – 2016) of the 2015 SPS payment system. The results of our analyses show the capitalisation effect of SPS payments grows significantly from 9 pence (21 pence) to approximately 18 pence (42 pence) of each pound of the payments in the short run (long run) following the implementation of 2013 CAP reform in 2015. Although the estimates are low, compared with those reported by Michalek and Ciaian (2014) for other EU countries, SPS significantly influenced land rents in NI. Based on these estimates and the 2017 Statistical Review of Northern Ireland Agriculture data on land renting (28% land area rented), the aggregate leakage of the decoupled payments after the 2013 CAP reform to the non-farming land owners was estimated to be approximately 12 percent. Moreover, if we consider the 12 percent as the leakage rate to unintended beneficiaries, only about £34.6 million from £288.2 disbursed as SPS payment in 2017 is leaked out from the farming sector. The results provide an evidence that the 2015 CAP reform, even if decoupled from production, may leak out of farming sector, defeating the income support purpose of payments. These findings have strong policy implication for redesigning future payment scheme. References Alexander, D.J., 1963. A Note on the Conacre System in Noethern Ireland. Journal of Agricultural Economics 15, 471-475 Allen Klaiber, H., Salhofer, K., Thompson, S.R., 2017. Capitalisation of the SPS into Agricultural Land Rental Prices under Harmonisation of Payments. Journal of Agricultural Economics 68, 710-726 Alston, J.M., James, J.S., 2002. The incidence of agricultural policy. Handbook of Agricultural Economics 2, 1689-1749 Antón, J., 2001. Decoupling: a conceptual overview. In: OECD Papers Organization for Economic Cooperation and Development, , Paris Ciaian, P., Espinosa, M., 2016. The Impact of the 2013 CAP Reform on the Decoupled Payments' Capitalization into Land Values. Directorate Growth & Innovation and JRC- Seville, Joint Research Centre

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