Market-based price risk management An exploration of commodity income stabilization options for coffee farmers Lamon Rutten Frida Youssef July 2007 © 2007 International Institute for Sustainable Development (IISD) Published by the International Institute for Sustainable Development The International Institute for Sustainable Development contributes to sustainable development by advancing policy recommendations on international trade and investment, economic policy, climate change, measurement and assessment, and natural resources management. Through the Internet, we report on international negotiations and share knowledge gained through collaborative projects with global partners, resulting in more rigorous research, capacity building in developing countries and better dialogue between North and South. IISD’s vision is better living for all—sustainably; its mission is to champion innovation, enabling societies to live sustainably. IISD is registered as a charitable organization in Canada and has 501(c)(3) status in the United States. IISD receives core operating support from the Government of Canada, provided through the Canadian International Development Agency (CIDA), the International Development Research Centre (IDRC) and Environment Canada; and from the Province of Manitoba. The institute receives project funding from numerous governments inside and outside Canada, United Nations agencies, foundations and the private sector. International Institute for Sustainable Development 161 Portage Avenue East, 6th Floor Winnipeg, Manitoba Canada R3B 0Y4 Tel: +1 (204) 958–7700 Fax: +1 (204) 958–7710 E-mail: [email protected] Web site: http://www.iisd.org/ Lamon Rutten is Joint Managing Director, Multi Commodity Exchange of India Frida Youssef is Coordinator, Commodity risk management and Finance, United Nations Conference on Trade and Development (UNCTAD) This report has been written in a personal capacity. The views and opinions expressed herein do not necessarily reflect the positions of the authors’ organizations. Tackling Commodity Price Volatility This paper is published as part of a larger project, sponsored by the Norwegian Government, on policy options to tackle the problem of commodity price volatility. More research and papers can be found at http://www.iisd.org/trade/commodities/price.asp Contents Acronyms ............................................................................................................................ii Summary .............................................................................................................................1 Introduction........................................................................................................................4 1. Coffee farmers’ price risk exposure: An examination..............................................7 1.1 The volatility of coffee prices.............................................................................8 1.2 Farmers’ exposure to coffee price risks ..........................................................13 2. Price Risk Management in Practice........................................................................19 2.1 Price risk management markets and instruments .........................................19 2.2 Experiences with price risk management for coffee farmers........................22 2.2.1 Brazil ............................................................................................................24 2.2.2 Colombia......................................................................................................24 2.2.3 Costa Rica ....................................................................................................24 2.2.4 Guatemala ....................................................................................................25 2.2.5 India .............................................................................................................25 2.2.6 Mexico..........................................................................................................26 2.2.7 Nicaragua.....................................................................................................26 2.2.8 Tanzania.......................................................................................................26 2.3 Lessons..............................................................................................................27 3. Moving Forward: Enhancing access to coffee price risk management markets 28 4. Recommendations....................................................................................................33 Annex: An overview of market-based commodity price risk management instruments and their uses...............................................................................................36 Literature...........................................................................................................................42 Figures, Charts, Tables and Boxes Figure 1: Coffee price changes….…………………………………………………………........ 7 Chart 1: Nominal prices for mild Arabica and Robusta coffee, 1985 2006…………...…............. 9 Chart 2: Coffee prices, 2004–2007, as compared to World Bank forecasts…………….............. 11 Table 1: Frequency of month-to-month price changes for mild Arabica and Robusta…….......... 9 Table 2: World Bank forecasts of Arabica and Robusta prices, 2004–2015………………. ....... 10 Table 3: Risks faced by coffee-producing households in the Dominican Republic……….. ....... 14 Box 1: Special marketing arrangements and their impacts on farmers’ risk exposure…….......... 12 Box 2: Cooperatives’ price risk exposure............................................................................. ................. 17 Box 3: India’s e-choupals: How technology can help cross the “last mile”..……………… ....... 30 Acronyms ANACAFE National Coffee Growers Federation BBC British Broadcasting Corporation BM&F Bolsa de Mercadorias & Futuros COFEI Coffee Futures Exchange of India CPR Cédula de Produto Rural CRDB Cooperative Rural Development Bank FAO Food and Agriculture Organization FEDERACAFE National Coffee Growers Federation of Colombia IBRD International Bank for Reconstruction and Development ICE Intercontinental Exchange ICO International Coffee Organization IDA International Development Association IMF International Monetary Fund ITF International Task Force on Commodity Risk Management in Developing Countries KNCU Kilimanjaro Native Cooperative Union KYC Know Your Customer LIFFE London International Financial Futures Exchange (now called Euronext.liffe) MCX Multi Commodity Exchange of India NCDEX National Commodity & Derivatives Exchange NGO Non-governmental Organization NMCE National Multi-Commodity Exchange of India NYBOT New York Board of Trade OTC over-the-counter PTBF price-to-be-fixed UNCTAD United Nations Conference on Trade and Development U.S. United States ii Summary Coffee prices are highly volatile and unpredictable. As the minimum prices offered by fair trade buyers only apply to a small percentage of world coffee trade,1 most growers are faced with considerable price uncertainty. This poses severe problems for them. Most of the 20–25 million households engaged in the coffee sector are smallholders, without the financial wherewithal to withstand serious financial shocks. Naturally, they try to mitigate their risk exposure through such practices as diversification and reduced use of inputs. Traditional risk management measures are costly. They lead to a considerable reduction of farmers’ incomes, particularly poorer farmers. In the past, governments have tried to provide safety nets through such mechanisms as marketing boards, which buy at guaranteed prices, or price stabilization funds—but these also have proved to be very costly for farmers. Market-based risk management instruments can provide a more effective alternative, allowing farmers to optimize their risk/reward equation at a lower cost. While overall, use of these market-based instruments does not reduce the volatility of coffee earnings, it makes them more predictable, at least over a 6–12 month time horizon. This, in turn, makes it possible for farmers to better plan their activities, and improves their ability to raise bank finance. The four major categories of risk to which farmers are exposed are: price, weather, pest and health. Market-based instruments are readily available for price risk, and are starting to emerge for weather risk. Organized exchanges offering the most basic of these instruments, futures and options, have operated for a long time, providing transparency to the market, and low-cost risk transfer tools for those able to access them. While use of price risk management instruments is an incomplete solution, it has sufficient merits on its own and will make the overall burden of risk more bearable. There is a wide range of market-based price risk management instruments available: traded on organized futures and options exchanges or the over-the-counter market; incorporated into the pricing formulas of physical trade transactions; or encapsulated in financing deals. None of these instruments fundamentally alters the risky character of the marketplace, but they empower those active in the market to manoeuvre a way through these risks, considerably improving the certainty of receiving or paying certain prices six months, one year or even three years in the future (for soft commodity markets such as coffee, risk management markets rarely offer instruments beyond this time horizon). Futures