In Pursuit of the Sustainable Supply Chain: How Coffee Is Doing It by Alden Dowds

In Pursuit of the Sustainable Supply Chain: How Coffee Is Doing It By Alden Dowds

In an age of increasing interconnectedness, technology and mature capital markets, outcomes naturally trend toward maximum efficiency. But the expediency of pursuing the most efficient outcome in a given scenario means we may fail to adequately consider the temporal necessity of planning for future generations. This might prove inequitable and ultimately unsustainable over the long term. Put simply, does our current system reward short-term solutions at a longer-term, harder-to-quantify cost?

4 Brown Brothers Harriman | COMMODITY MARKETS UPDATE In line with this mode of thought, a necessary guiding • Economic Sustainability: Relative to the rest of the sup- hand – the sustainability initiative – has recently garnered ply chain, farmers may lack the bargaining power to ensure increased interest across a range of industries. Central to a living wage as well as the technical skills necessary to this initiative is the development of a market-based system deploy the risk management strategies necessary to pro- of certifications and verifications (together “voluntary sus- tect that wage. Without knowledge of and/or access to tainability standards” or “VSS”) to reward producers for bank credit and hedging derivatives, these individuals are adhering to a code of sustainable practices. But is a laissez- often exposed to falling commodity prices and rising input faire system adequate, or is a top-down approach necessary prices, either of which could negatively impact an undiver- to overcome the hurdles to a sustainable supply chain? sified income base. Falling income may prompt substitution to more profitable crops or inhibit planting altogether. The For green coffee, widely considered a pioneer in the pursuit prosperity of the farmer who produces the good is the key of sustainability, answering this question is a race against to ensuring the sustainability of the good. the clock. With new consumer demand expected to create a deficit equivalent to Brazil’s annual production, and pal- • Social Sustainability: Provisions for basic human needs – ates and preferences pivoting toward specialty varietals, the food, water, shelter, education and healthcare – comprise the coffee supply-demand balance looks increasingly fragile on social pillar of sustainability. If unmet, producing nations will likely a global scale. In order to meet the quantity and quality of see a generational flight of human capital to cities or occupations coffees demanded by future generations, we must identify that offer a higher living standard and the potential for a more and ultimately overcome the challenges to realizing a fully consistent wage. Social aims also encompass gender equality, sustainable supply chain. child labor and other working conditions. If these basic human needs are not met, the supply chain may not be sustainable. Defining Sustainability Despite the increased level of scrutiny within the narrative, a pre- • Environmental Sustainability: In order to protect the eco- cise definition for sustainability, somewhat paradoxically, continues system and ensure the long-term viability of land used for to elude the public. In a broad sense, sustainability is about ensur- intensive farming purposes, it is critical to provide proper ing that a given product will be available at or beyond the amount training and education to farmers regarding deforestation, soil demanded in perpetuity. As applied to agro-industries and com- degradation and water pollution related to pesticide and fertil- modities in particular, sustainability aims to alleviate a triumvirate of izer runoff. Though applicable to farmers, environmental best social, environmental and economic concerns, any of which could practices are increasingly aimed at a wider audience in order drive an imbalance between the demand for a given product – both to reduce the potential impact of climate change on produc- quantity and quality – and its readily available supply. tion. Volatile temperatures and rainfall directly inhibit growth and also increase the propensity for disease and pests. Though the sustainability initiative affects every step of the supply chain, energies tend to be focused at initial production – par- The Three Pillars of Sustainable Agriculture ticularly in the tropical commodity sector – where fragmented smallholders face imperfect information and technical training, reduced access to capital and market transparency, and limited Soial bargaining power. By implementing sustainable practices and promoting investment at the farm level – the foundation of the Bearale Euitale supply chain – it follows that traders, processors, consumers and other downstream players will be better positioned to support the Sustainale Enironmental Eonomi sustainability initiative. While the three pillars of agro-related sus- Viale tainable development are broadly defined and often overlap one another, they incorporate the following concerns.

Issue 2 2016 5 Continuity in a Cup Economic progress in developing countries, including traditional Following the 1989 collapse of the international quota system exporting countries, has enhanced consumer purchasing power and move to a free market, the coffee industry experienced and increased coffee popularity among cultures previously domi- multiple price declines – most notably in 1992 and 2001 – that nated by tea consumption. As a result, demand for coffee, which drove sales prices well below the associated production cost averaged 100 cups per every person in the world in 2015,2 is and nearly dismantled the supply chain altogether. As a result expected to increase an additional 25% over the next five years, of these calamitous events and the heightened attention that according to the International Coffee Organization. All else being followed, coffee has attained a central role within the broader equal, the coffee supply chain currently faces a deficit approximate sustainability discussion and is widely regarded as a model for to annual production in Brazil, the world’s largest coffee producer. the necessity (and success) of a dedicated initiative. Further complicating this deficit, consumers – particularly those New York Coffee Futures Prices in the U.S. – are demanding a finer cup, increasing the uptake (Arabica, Daily Front Month Close) of so-called specialty coffees. According to the National Coffee 350 Association, the percentage of U.S. adults drinking specialty cof- Quota System Free Market 300 fee on a daily basis nearly quadrupled to 34% between 2000 3

250 and 2015. Specialty coffees inherently require more intensive l

r e 200 husbandry and capital commitments from farmers as well as s t n

e topographical characteristics – including shade, moisture and

150

. S . elevation – unique to few producing areas. U 100

50 In order to meet the growing consumer demand for coffee across 0 the globe and the shifting preferences in the developed world, it 1980 1985 1990 1995 2000 2005 2010 2015

Source: Bloomberg. is critical to not only onboard additional acreage but to also provide producers with the proper training, technology and incentives At the crop level in coffee, there are several agronomic and market to enhance productivity and meet the rigorous set of hurdles structure idiosyncrasies that run counter to long-term sustainabil- required to cultivate gourmet flavor profiles. Given the coffee ity: a three- or four-year crop cycle from planting to harvest wherein sector’s capacity to create economic value from crop – it com- supply cannot respond to price movements in the near term; sus- prises more than 20% of export income in Guatemala, Honduras ceptibility to adverse disease, pests and weather conditions; a and Nicaragua and over 50% in Burundi, Rwanda and Ethiopia4 – concentration of supply in emerging markets where political and to cup – 1.6% of U.S. GDP in 20155 – the sustainability initiative economic instability may be higher; a fragmented supplier base has drawn the focus of members at all levels of the supply chain. wherein more than 70% of supply originates from small-scale farmers with no more than a few acres1; and index-linked price formation The Landscape of Sustainable Coffee Initiatives disposed to volatility, speculative short-selling and potential distor- Unfortunately, diagnosing the challenges to sustainable produc- tions between fundamentals and prices. tion is far simpler than prescribing a working solution. At present, a handful of not-for-profit organizations offer eponymous cer- More recently, however, the question of sustainability has grown tification programs – Fairtrade Certified, Organic, Rainforest beyond the crop to encompass a variety of additional concerns related Alliance, UTZ Certified and Smithsonian Bird Friendly – to to consumption patterns that are emerging at the macro level and reward producers for implementing a given set of sustainability adding additional stress to an already fragile supply-demand balance. 2 Conversion rate of 1 pound of coffee to 36 cups; excludes shrinkage during roasting. 3 For more information on U.S. premium coffee consumption, see the December 2015 Commodity Markets Update article, “The Continued Rise of Premium Coffee in the U.S.: Will It De-Commoditize Coffee?” 4 Source: Hivos, IUCN NL, Oxfam Novib, Solidaridad and WWF, “Coffee Barometer 2014.” 1 Source: Hivos, IUCN NL, Oxfam Novib, Solidaridad and WWF, “Coffee Barometer 2014.” 5 Source: National Coffee Association.

6 Brown Brothers Harriman | COMMODITY MARKETS UPDATE standards across the aforementioned economic, social and environmental pillars. Certification is [T]he concept of sustainability is dynamic, voluntary and, upon successful audit by accred- ited third parties, commonly rewarded with and VSS, rather than adopting a one-size-fits- premium pricing. These programs not only play all approach, must be flexible with respect a critical role in transmitting value to customers, but also provide auxiliary services to producers to local context and involve concomitant in the way of farmer training, market access and broader supply chain transparency. investments of time and money in order to achieve a lasting impact.” Though all certifications aim to ensure the longev- ity of the coffee supply chain (as well as that of other agricultural commodities), each emphasizes a unique path in achieving that unified goal. Far from exhaustive in name or description, the following standards bodies In addition to a broad set of environmental protocols, this cer- are the most recognized among those with on-product labeling. tification focuses on labor conditions, including age and wage requirements, access to health and educational services, occu- Fairtrade International (FLO and FLO-CERT; Fairtrade) has pational safety programs and nondiscriminatory labor and hiring traditionally focused on alleviating poverty at the cooperative policies. Though not guaranteed, these coffees often earn a 5% level by pairing smallholders with pre-crop financing and directly to 10% premium beyond uncertified equivalents.7 influencing the sales process. Fairtrade certification mandates $1.05 and $1.40 per pound price floors for washed Robusta and UTZ Certified also takes a more holistic approach to sustain- Arabica coffees, respectively (additional 30-cent premium for ability, mandating a scaling system of environmental standards, organic varietals), and includes an additional 20-cent fixed social farm professionalization and worker health and safety. Though premium to be used for reinvestment in local communities. not guaranteed, these coffees often earn a 2.5% to 5% premium beyond uncertified equivalents.8 International Federation of Organic Agriculture Movements (IFOAM; Organic) certifies that a given product has been As an alternative to the aforementioned on-product certifica- produced in an ecologically sound manner, as the “health of indi- tions, the 4C Association offers a verification-based program viduals and communities cannot be separated from the health of that establishes a baseline of sustainable practices from which ecosystems – healthy soils produce healthy crops that foster the producers can pivot to compliance with more rigorous standards. health of animals and people.” Organic husbandry prohibits pes- Verification, though encompassing similar processes to certifica- ticides and synthetic fertilizers, mandates actionable plans for the tion, is noncompetitive, does not carry a consumer-facing label, prevention of soil erosion and incorporates a number of other pro- is not meant to serve as a reference for external stakeholders cesses to conserve biodiversity. Though not guaranteed unless and solely acts to enhance the supply and uptake of all verified double-certified with Fairtrade, organic coffees often earn a 10% and certified coffees. A handful of for-profit institutions have also to 15% premium relative to nonorganic equivalents.6 developed their own sustainability and quality improvement programs (for example, Starbucks’ C.A.F.E. Practices program and Rainforest Alliance builds on IFOAM, taking a more holistic Nespresso’s AAA Sustainable Quality guidelines), for which pur- approach to sustainable development at the community level. chases under other certifications often comply.

6 Source: ENTWINED, Finance Alliance for Sustainable Trade, IDH, International Institute for 7 Ibid. Environment and Development and International Institute for Sustainable Development, “The State of 8 Ibid. Sustainability Initiatives Review 2014.”

Issue 2 2016 7 An Imperfect Approach Though multi-certified coffees may distort the figure, it is esti- The aforementioned programs, in addition to direct partner- mated that just 25% of VSS-compliant coffee produced in 2012 ships between certifiers and major roasters, have been critical was actually sold as such.10 Broadly speaking, the supply-demand in expanding the footprint of the sustainability initiative within mismatch stems from a lack of uniformity across coffee quality the coffee industry. As testament to this finding, the production and flavor profiles, which, due to the inherent role of preference at of certified and verified coffees increased from 15% to 40% of the consumer level, implies that a given bean cannot fulfill all sales global production between 2008 and 2012, making coffee the single most saturated agricultural commodity in terms of stan- Colombia Producer Economics, Arabica dard-compliant production.9 Despite the broad reach of VSS, 300

250 l

however, producers – especially those from the poorest brack- r e 200

s ets – often fail to realize the intended benefits of implementing t 150 n e

sustainable farming practices, which could ultimately inhibit prog- . 100 S . ress toward a fully sustainable supply chain. U 50 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Standard-Compliant Coffee Production Costs Prices Paid to Growers Source: nternational Coffee rganiation. Produced and Sold in 2013 2,500 Certified Coffees Verified Coffees Costa Rica Producer Economics, Arabica

2,000 200 s

1,500 l s

r 150 n e o T

1,000 s t i 100 r n t e e

500 . M

S 50 . U 0 Fairtrade Organic Rainforest UTZ Certified 4C Association Starbucks Nespresso AAA 0 Alliance C.A.F.E. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Production Costs Prices Paid to Growers Source: nternational Coffee rganiation. Produced Sold Source: Hivos, UC , fam ovib, Solidaridad and F, Coffee arometer 201.

A major barrier to entry originates from the tradeoff that Ecuador Producer Economics, Arabica producers face when seeking verification or certification: 250 increased capital commitments at the outset for economic l

200 r e gain over the long term. Compliance with VSS magnifies pro- 150 s t n duction costs due to enhanced labor practices, environmental e 100

. S husbandry and regular audit and evaluation fees. In theory, . 50 U certification signals a higher quality and standard of care to 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 consumers, rewarding producers with premium pricing, that, Production Costs Prices Paid to Growers Source: nternational Coffee rganiation. when combined with higher yields and more efficient farm management, should more than offset these costs. In practice, Guatemala Producer Economics, Arabica however, standard-compliant coffee production outpaces asso- 250 l ciated demand, and a material portion is not sold as certified 200 r e 150

or verified, which reduces the supposed benefits of premium s t n

e 100 pricing and market access for sustainable producers and poten-

. S . 50 tially creates an additional obstacle – beyond access to initial U 0 capital – for producers not yet adhering to VSS. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Production Costs Prices Paid to Growers Source: nternational Coffee rganiation.

9 Ibid. 10 Ibid.

8 Brown Brothers Harriman | COMMODITY MARKETS UPDATE contracts and that sustainably produced coffees may fail to achieve A common problem with VSS and other attempts at solving the strong cupping scores. In order to overcome this natural bottleneck sustainability question in the coffee sector is the tendency for mar- and capture excess supply, major roasters must continue to inte- ket forces to allocate the greatest benefit to those producers that grate sustainable initiatives within their sourcing practices, and the can provide standard-compliant coffees at the lowest cost, which, sector as a whole must further educate and involve retail custom- more often than not, coincides with the subset of producers who ers – the ultimate determinants of coffee consumption. have access to the most resources and stand to benefit the least from VSS on a relative basis.11 This paradox raises the question of By the same token, many of the existing verifications and certifi- whether certifications – whose uptake is dictated by downstream cations do not guarantee a minimum sales price, leaving farmers consumers (“the market”) – are the right approach to developing a exposed to commodity price movements. Of important note are sustainable supply chain that ultimately starts at the farmer level. the 2002/2003 and 2012/2013 harvests, where the combination of price volatility and steady or rising input costs drove sales prices This is not to say that VSS are ineffective. In fact, quite the opposite is well below the associated production cost, affecting producer live- true. Following a wide-ranging study conducted from 2009 to 2013, lihood – and subsequently coffee quantity and quality – across a the Committee on Sustainability Assessment (COSA) reported that, handful of countries. Unfortunately, price floors are imperfect tools among a sample of 18,000 farms across 12 countries, certified coffee for protecting smallholder income: When prices fall below a floor, farms, on average, experienced enhanced economic and environmen- it is ultimately the consumer’s decision to bear a higher cost of tal performance. However, the concept of sustainability is dynamic, purchase or substitute toward a cheaper, uncertified alternative. and VSS, rather than adopting a one-size-fits-all approach, must be flexible with respect to local context and involve concomitant invest- Looking at sustainability intensity, or the degree to which a coun- ments of time and money in order to achieve a lasting impact. The try’s aggregate production comprises standard-compliant coffees, challenge for certifiers and others involved in the coffee sector is to VSS adoption is particularly concentrated among the largest cof- expand upon and improve the existing blueprint in order to capture pro- fee producers – Brazil, Vietnam and Colombia – and countries in ducers that either did not benefit from implementing VSS, or, in some Latin America. In contrast, mid-tier producers across Southeast cases, were unable to enter the market altogether. Asia and Africa, with the exception of Kenya and Tanzania, tend to be underrepresented. It follows that successful VSS imple- Next Steps mentation favors first-mover countries and those with capacity Regardless of whether verifications and certifications are the perfect for commercialization, and that marginalized producers in periph- solution, or even the “right” solution, it is clear that VSS have made a eral countries may need additional support to overcome barriers meaningful contribution to ensuring a sustainable coffee supply chain. to entry when pursuing sustainable farming practices. Beyond their positive impact at the farmer level, VSS, through roaster partnerships and on-product labeling, have helped to raise consumer Sustainability Intensity by awareness of sustainably produced coffees. Improving the mechan- Producing Country in 2012 ics and implementation of VSS are critical to ensuring the program’s % of total production that is standard-compliant Brazil 41% success; however, consumers, by way of purchasing patterns, will ulti- Tanzania 60% Vietnam 40% 30% Thailand 50% Colombia 0% 60% mately decide the fate of the sustainability initiative, notwithstanding 40% Kenya Indonesia its ultimate form. With sweeping change to palates and preferences in 23% 11% 30% mature coffee markets and entirely new loci of consumption coming Ecuador 20% Peru 1% 30% 10% online over the next few years, this phenomenon will ring truer than

El Salvador 0% Honduras 22% 24% ever. In order to overcome the economic, social and environmental challenges that threaten producers’ ability to meet the quantity and Papua New Guinea Ethiopia 8% 10% quality of coffees that the world demands, every step of the value

Cote d'Ivoire India 0% 15% chain, from crop to cup, must act cohesively.

Costa Rica Mexico Source: D, Finance lliance for 32% 21% Sustainable rade, DH, nternational nstitute for nvironment and Nicaragua Guatemala 33% 13% Development and nternational nstitute Uganda for Sustainable Development, he State 11 11% of Sustainability nitiatives Revie 201. Ibid.

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