CAP reform uncertainty and the market for entitlements

One little-emphasised feature of the current negotiations on CAP reform is that the rules for eligibility for payments under the new basic payment scheme (and thus also the other proposed layers of Pillar 1 direct payments such as the green payment, young farmer’s payment, area of natural constraints payment and redistributive payment where these are adopted) are in a state of flux. New amendments and modifications continue to be introduced at successive stages of the negotiation process. This uncertainty is reflected in the market for Single Farm Payment (SFP) entitlements and the prices farmers are willing to pay for entitlements where they become available.

The Commission’s original proposal was that farmers would receive entitlements based on the number of eligible hectares declared in 2014 (Article 21 of the direct payment regulation). I have previously discussed how the requirement for an eligible farmer to have received a payment (and thus have activated at least one entitlement) in 2011 was introduced into the Commission’s October 2011 proposals at the last minute.

This was in response to Irish concerns that defining eligibility for the new basic payment scheme solely on the basis of land farmed at a date in the future (2014 in the Commission’s proposal) would lead to drastic disruption of the land rental market (characterised in Ireland by annual leases). Farmers would have a huge incentive to stop leasing out land in order to obtain a valuable entitlement in 2014, causing enormous problems for those farmers relying on the leased land.

Possessing at least one entitlement in 2011 can be seen as a ‘gatekeeper’ condition which must be fulfilled before taking into account the other criteria for eligibility for payments in 2014. The intention was to dampen speculation in the land market in the run-up to the entry into force of the new regulation.

Parliament and Council amendments

The European Parliament mandate would give some greater flexibility to member states in their choice of the ‘gatekeeper’ year. Farmers who in any one of the three years 2009, 2010 or 2011 had activated at least one payment entitlement, who received an entitlement from the national reserve in 2012, who received a coupled payment or who could show that they were actively farming in 2011 would be prima facie eligible to receive entitlements based on their eligible area in 2014 provided they meet the other eligibility conditions.

The Council’s general approach proposes to amend the Commission’s proposal more radically. The number of payment entitlements allocated to a farmer can continue to be equal to the number of eligible hectares declared in 2014. However, as an alternative, the number of payment entitlements granted may be equal to the number of eligible hectares activated in 2012, 2013 or 2014 under the current SFP scheme.

Furthermore, the Council proposes that member states that operate the SFP on a regional or regional hybrid basis can decide to continue with the existing allocation of payment entitlements (that is, the 2013 or 2014 basis depending on when the new system kicks in). But as this option is already included in the alternative in the previous paragraph, it is not clear what additional value it has.

As regards the gatekeeper condition, Member States would now have an option to decide that payment entitlements will only be allocated to farmers who, in 2010 or 2011 received a direct payment, or were allocated payment entitlements through the national reserve in 2012 or 2013 (other provisions cover some special cases).

Thus, under the Council’s proposal, a farmer’s entitlement could be based on her 2012 claim, her 2013 claim, or her 2014 claim under the current SFP scheme (given that the new scheme will not now come into effect until 1 January 2015) or her 2014 eligible hectares actually farmed. They may also implement a gatekeeper condition that a farmer must have activated at least one entitlement in either 2010 or 2011 to be eligible to receive the new entitlements. Member states have to communicate their decision to the Commission by 1 August 2013 (note this optimistic assumption that the legislation will be approved before this date). So until then, at least, farmers cannot know the basis for their entitlements for 2015 and beyond.

In addition, two other possible amendments will also have a bearing on the number of entitlements allocated to farmers when the new scheme enters into force.

The Parliament proposed an amendment that, where the number of hectares declared in 2014 exceeds the number of hectares declared in 2009 by more than 45%, then the total number of 2014 hectares could be capped at 145% of the 2009 total. The Council proposes to lower the threshold to more than 35% of the 2009 declared area, and to give member states the option to cap at either 135% or 145% of the 2009 area. This restriction would only affect farmers who applied for more entitlements in 2014 than they had in 2011.

A second amendment proposed by the Council would allow member states to apply a reduction coefficient if the eligible hectares declared by a farmer consist of permanent grassland located in areas with difficult climate conditions, especially due to the altitude and other natural constraints like poor soil quality, steepness and water supply. Where used by a member state, this option could potentially exert an important influence on the value of entitlements in that member state.

As an aside, this ‘base updating’ is not currently in breach of WTO Agreement on Agriculture rules for decoupled support. However, the revised draft modalities for the Doha Round Agreement circulated by the Chair in December 2008 would require payments eligible for the green box to be based on a fixed unchanging base period save in exceptional circumstances.

The market for entitlements

There are two stylised facts about entitlement trading. The first is that the value of entitlements appears in most EU countries to be much less than their net present value. The second is that higher-priced entitlements appear to sell at a higher multiple of their value than lower-priced entitlements (an exception to this generalisation may be Germany and England which opted for the dynamic hybrid model implying a flattening of the payments over time, see here for English evidence that the higher the value of the entitlement the lower the multiple of the face value paid due to the regional hybrid system).

Buying an entitlement to a stream of future payments is an investment decision. How much the entitlement is worth depends most immediately on the duration of the stream of payments, the value of those payments, any risk associated with the payments, and the interest rate. But other factors play a role.

Many member states have placed restrictions on the transfer of entitlements. For example, a member state may decide that entitlements may only be transferred or used within a specific region. Member states may also require that a proportion of the entitlements are siphoned off for the national reserve when a transfer is made. Such restrictions lower the price of entitlements.

Other factors influencing their value are that entitlements are associated with cross-compliance costs and the fact that the direct payment income is taxable while the purchase of the entitlement is not tax-deductible. There may also be transactions costs in bringing buyers and sellers together (although the number of websites by agricultural valuers offering to help buy and sell entitlements suggests that this is not a major issue). But even when these caveats are taken into account the price of entitlements has been below their estimated net present value.

One answer to this puzzle given by Kilian and Salhofer (2007) is that the market for entitlements is not an independent market because, to be valuable, entitlements must be activated. That is, a farmer must show that he has a hectare of eligible land for each entitlement he possesses. Thus, there is only a demand for entitlements from farmers who have naked land, that is, land without existing entitlements. The price of entitlements will be determined by whether there are surplus entitlements relative to eligible land, or vice versa.

If there are more entitlements than eligible land, then the price of entitlements will be driven down towards zero. At first sight, this may seem strange. If the entitlement provides a stream of direct payment income, surely it must be valuable.

But if a farmer needs to acquire a naked hectare in order to activate the entitlement, and if naked hectares are scarce, then the higher rent paid to acquire that naked hectare is going to eat into and offset the expected direct payment income. In the limit, this could drive the price of entitlements down to zero.

Thus, their explanation for the relatively low price of entitlements is that eligible land is scarce relative to the number of entitlements. But this cannot be the whole story because the discounting of the price of entitlements also occurs in countries (such as Ireland) where there is a considerable amount of naked land available.

The other stylised fact is that higher-valued entitlements sell at a higher multiple than lower-valued entitlements. By definition, this means that there is a (relatively) greater supply of low-value entitlements and/or a (relatively) greater demand for high value entitlements. In particular, it appears that very few high-value entitlements come on the market. One might speculate on the reasons for this differential behaviour (one possible reason is that, if there are fixed cross-compliance costs, the net stream of income from a higher-valued entitlement is relatively greater than from a low-valued entitlement).

Consequences of reform proposals for market for entitlements

Changes in the rules for establishing entitlements under the new CAP have the potential to influence the current market for entitlements (for example, if a member state decided to base future entitlements on the entitlements declared in 2013 or 2014 under the current SFP scheme there would be an incentive for farmers to acquire more entitlements).

The current market for entitlements is also affected in those member states that use the historic SFP model by the proposals for future internal convergence. In member states using the historic model, the current value of entitlements will be reflected in the value of entitlements in the period 2015-2020 although to a declining extent as internal convergence takes place.

Under the Commission’s proposal, all payments in a region must have a uniform unit value by 2019 with a first step of 40%. Under the Council amendment, the first step shall be no less than 10%. Making use of this flexibility alone would give current payments greater influence on payments in the coming period.

The influence of historic payments will be even more important in member states that opt for the new approximation model for internal convergence proposed by the Council. Under this model, the historic variability in the value of entitlements will still be very evident by the end of the period.

The approximation model is that member states may decide that payment entitlements whose unit value in 2014 is lower than 90% of the national or regional unit value in 2019 shall have, for claim year 2019 at the latest, their unit value increased at least by one third of the difference between their unit value in 2014 and 90% of the national or regional unit value in 2019.

Additionally, member states may provide that no payment entitlement shall have a unit value higher and/or lower than fixed percentages of the national or regional unit value, for claim year 2019 at the latest. In other words, member states can opt for a maximum and minimum payment per hectare although no percentages are specified. Finally, the Council amendments introduce the possibility of a redistributive payment on the first hectares, which would redistribute payments from larger to smaller farms, but not necessarily from farms with high-value entitlements to farms with low-value entitlements

What is important is that the unit value of entitlements in 2014 will be determined by the value of entitlements which the farmer holds in 2013.

Thus, in contrast to the Commission’s proposal that all entitlements within a member state should have a uniform value by 2019, the new amendments mean that the value of entitlements held in 2013 will have a much stronger influence on the value of future entitlements. This is even more the case if the Council amendment that the 30% greening payment can be based on the value of a farmer’s entitlements rather than a uniform payment per hectare were chosen by a member state.

If farmers in 2011 or 2012, anticipating that the Commission’s proposal would come into force, strongly discounted the significance of the value of entitlements in the current period for their value in the next period, that would have dampened their enthusiasm to purchase particularly high-value entitlements. Under the Commission’s flattening proposal, the carryover effect of high-value entitlements would rapidly diminish (as this press report in early March before the Agricultural Council meeting confirms)

Under the proposed amendments from the Council and Parliament, however, the carry-over effect of high-value entitlements held in 2013 is greatly enhanced, while there is now an extra penalty imposed on those with low-value entitlements in 2013. This is both because of the slower rate of internal convergence proposed under the amendments, as well as the option to use the approximation model.

It is not yet clear that farmers understand these signals, at least in Ireland where the Minister has committed to using the approximation option if it is eventually approved in the final legislation.

Recent press reports (see here and here) suggest that, while interest in acquiring entitlements has increased in Ireland, there is as yet no clear trend favouring higher-valued entitlements over lower-valued ones. This is despite the fact that, assuming the Council’s amendments are accepted, there are now much stronger reasons for buying high-valued entitlements than there were before.

However, nothing has been agreed until now. The Agricultural Commissioner continues to insist that there should be a minimum convergence threshold by 2020, so the final outcome remains uncertain. So any farmers thinking of buying entitlements for 2013 before the window closes in a month’s time will still be taking a gamble.

Photo credit: Merrionstreet.ie under CC licence

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