Tools and polices for agricultural risk management Ben Breen1, Thia Hennessy1, Trevor Donnellan1, Kevin Hanrahan1 1. Rural Economy and Development Programme, Teagasc Copyright 2013 by [author(s)]. 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. Abstract Volatility in international agricultural commodity prices has been higher since 2000 than in the previous two decades (FAO, 2011). This fact and a movement away from excessive government intervention into agricultural markets have increased focus on the need for private risk management markets and strategies. WTO green box rules and a newly emerging holistic approach to agricultural risk management undermine the use of historically popular stabilisation tools such as price support mechanisms, border protection and public intervention. This paper reviews the market tools and government policies that currently exist for managing agricultural risk. A multi-criteria analysis is adopted to critique the various risk management tools available. Tools are assessed according to criteria such as costs (by whom they are incurred), benefits (to whom they accrue), political and budgetary acceptability, feasibility, functionality and effectiveness in controlling risk. This allows for all tools reviewed to be ranked according to the various criteria. It is argued that governments should support the development of private solutions to agricultural risk and that government risk- related policies should focus on “residual risk”. Keywords: Agricultural commodity price volatility, Holistic approach to agricultural risk management, Multi-criteria analysis JEL code: Q18, D81 *Corresponding author: [email protected] 1. Introduction By their nature, agricultural markets are predisposed to high levels of output uncertainty and price volatility due to certain characteristics which they possess. Two in particular set the stage. Firstly, the level of agricultural output a producer can generate is highly dependent on unpredictable factors like weather patterns and animal or crop disease outbreaks over which farmers have little to no control and cannot predict. These unpredictable factors alone constitute a substantial set of risks that farmers must deal with. Secondly however, because agricultural commodities tend to have low elasticities of supply and demand, prices must adjust significantly to with changes in production or consumption in order for the market to reach equilibrium. This makes agricultural commodity prices highly volatile over time, which can make revenues generated from agricultural production highly variable from year to year. To deal with the various risks that they face, farmers have developed a diverse set of risk management strategies at the farm-level and involving third party (market) participation. These strategies can range from actions as simple as securing an off-farm income and or on farm product diversification, to more complex solutions such as technology choices on-farm, portfolio optimisation and the use of financial derivative products to hedge output and input price risk. In addition to on-farm and market-level solutions to risk, governments also design policies to shield their agricultural sectors from various price and production shocks. In recent years however, the idea of a holistic approach to agricultural risk management has highlighted the fact that government risk-related policies can impact greatly on farmers’ risk management strategies, and should therefore be implemented coherently, so as not to supersede existing on-farm strategies or “crowd out” private market solutions (OECD, 2009a; Tangermann, 2011). This is critical because it suggests that when evaluating the performance of any risk-related government policy, one must take into account, not only the effectiveness of the policy in achieving its aim, but also its impact on existent or potential on-farm and market level solutions to risk. In this paper, we review the agricultural risk management policy literature to identify, (1.) the nature of the risks which EU agricultural producers face, (2.) the emerging policy concepts directed towards agricultural risk management within the EU and (3.) the risk management strategies, tools and policies which will best equip EU producers and policy makers to manage agricultural risks. We then assess the performance of the various risk-related tools and policies across multiple criteria to determine their potential and applicability to current risk management initiatives within the EU. In section 2, we outline the various types of risk that agricultural producers face and the diverse management strategies that exist to deal with them. We pay particular attention to agricultural commodity price volatility, given that is has become controversial in the aftermath of the food crisis of 2007/2008. We also review the agricultural risk and policy literature to determine recent trends in ideas about how agricultural risk should be handled at the farm, market and state level. In section 3, we look specifically at market risk management tools in action and evaluate their usage and effectiveness in different countries at various points in time. In section 4, we turn the focus to government risk-related policies and observe the performance of various initiatives historically and in different countries. In section 5, we use a multi-criteria analysis approach to determine which tools and policies under review have the greatest potential to satisfactorily fulfil the needs of producers, consumers and governments in dealing with agricultural risk effectively. The relevant criteria are determined by reference to the relevant literature and policy documentation and findings from the observation of risk management strategies in action. The concluding section offers a discussion of the results of the MCA and the literature review. 2. Agricultural risk, farmer’s management strategies and government risk-related policy 2.1. Agricultural risk and uncertainty An important distinction that exists in the agricultural risk literature is that between risk and uncertainty. Harwood et al. (1999) describe risk as “uncertainty that matters” and involves possible events that may effect a person’s welfare. This is important, because it means that while there must be uncertainty for risk to arise, uncertainty does not become a risk per se until it has the potential to impact upon an individual’s welfare. It is along these lines that Newbery and Stiglitz (1981) argue that producers are not truly concerned with uncertainty relating to agricultural output and prices, but rather to variability of their incomes, in other words, uncertainty is not a problem for individuals until it has an impact on welfare. For some, agricultural risk can fall into either of two categories; business or financial (Huirne et al., 2000; Hardaker et al. 2004). Business risk includes production, market, institutional and personal risks, while financial risk arises from financing methods, such as debt. Other studies have classified risks into more diverse categories (Musser and Patrick, 2001; Baquet et al., 1997); production, marketing, financial, legal/environmental and human resource risk. To these, Moschini and Henessy (2001) add technological uncertainty. Holzmann and Jorgensen (2001) include more general types of risk, particularly to reflect the risks faced by producers in developing nations, such as natural, health, social, economic, political and environmental risk. They also refer to the systemic and non-systemic nature of risk; micro level risk is idiosyncratic and affects only an individual producer, meso risks are those that impact the community and macro/systemic risks can affect an entire region. OECD (2009a) combines the systemic and non-systemic classification of Holzmann and Jorgensen (2001) with the four sources of risk identified by Harwood et al. (as shown in Table 1.). Table 1: Types of risk and idiosyncratic/systemic distinction Type of risk Micro (Idiosyncratic) risk Meso (Covariant) risk Macro (Systemic) risks affecting an individual or affecting groups of affecting regions or nations household households or communities Market/prices Changes in price of land, Changes in input/output new requirements from food prices due to shocks, trade industry policy, new markets, endogenous variability … Production Hail, frost, non-contagious Rainfall, landslides, Floods, droughts, pests, diseases, personal hazards pollution, contagious diseases, (illness, death) assets risks technology Financial Changes in income from Changes in interest other sources (non-farm) rates/value of financial assets/access to credit Institutional/legal Liability risk Changes in local policy or Changes in regional or regulations national policy and regulations, environmental law, agricultural payments Source: OECD Secretariat, adapted from Harwood et al. (1999) and Holzmann and Jorgersen, 2001 2.2. Agricultural commodity price volatility Agricultural commodity price volatility has increased since 2000 in comparison with the preceding twenty years. As a source of uncertainty that can have a major impact on a farmer’s income and welfare, it constitutes a significant source of agricultural risk. As earlier stated, agricultural commodity price volatility arises primarily out of the dependency of output on unpredictable factors like weather and disease and inelasticity in the supply of, and demand for, agricultural