What might be the production, consumption and trade effects of the Commission’s proposals to redistribute direct payments by moving to a flat(ter) structure of direct payments across the Member States, and to redistribute payments within Member States by moving from the historic basis of farm payments (in the majority of Member States which operate this system) to a regional flat rate system?

A silly question, some might respond, for are not the EU’s direct payments decoupled (leaving aside the continued existence of a share of coupled payments) and thus not meant to have an effect on farm production? If a direct payment is truly decoupled, then moving payments from one farm to another, or from one country to another, will affect relative incomes but not output.

But there is widespread agreement that even decoupled direct payments do have an effect on production, even if there is less agreement on how strong this effect is in practice. There are now a number of studies which attempt to quantify these effects.

These include the yet-to-be-released Commission draft impact assessment of changes to the direct payments regime, as well as studies using the CAPRI and AGMEMOD models. The general message from these studies is that the production (and thus trade) effects are likely to be small, but that the distributional effects across and within countries could be significant.

Commission AIDS7K model

One approach is illustrated by the Commission’s farm income impact modelling using its AIDS7K model based on FADN data. Because this is a static model with no behavioural structure, it cannot directly calculate possible changes in the structure of production.

However, the Commission reports possible income changes by farm type. If the assumption is made that higher incomes on some farm types will be associated with increased production, and vice versa, then some inferences can be made on the likely direction of production changes.

As a general rule, a uniform flat rate would reduce support in more productive regions and sectors in favour of more marginal regions. In any move towards a flat-rate payment either between or within Member States, grazing livestock (beef and sheep) farms are the main beneficiaries (along with wine and horticultural farms). According to the Commission, moving to a uniform flat rate per hectare of potentially eligible area (PEA) across the EU as a whole (note that in the scenario it models farmers in several Member States continue to receive a limited amount of coupled direct payments (suckler cows, sheep and goat, cotton, Article 68, Posei)) would see farm net value added per Agricultural Work Unit increase by 10% on beef and sheep farms. Farm net value added would fall marginally on milk and arable farms.

(If account were taken of the greening component in Pillar 1, which means farmers must incur additional costs to become eligible for the payment, then the income gain to grazing livestock is reduced and the income losses on milk and arable farms but also pig and poultry farms are exacerbated).

AGMEMOD study

These production effects are more formally modelled in two well-known sector models AGMEMOD and CAPRI. In each case the results are, in part, determined by the modellers’ assumptions about how direct payments impact on production as well as by the policy scenarios that they assume.

The AGMEMOD 2020 combined model is an econometric, dynamic and partial equilibrium model representing each of the 27 Member States. Direct payments are incorporated as add-ons to the relevant producer price to form a reaction price (livestock, livestock products) or expected gross returns (crops).

Coefficients are applied to these add-ons to determine their production effect. For example, a coefficient of 1 would imply that farmers perceive direct payments as equivalent to a similar price increase, while a coefficient of 0 would imply that they treat them as totally decoupled.

The coefficients used in AGMEMOD vary across countries and commodities, for example, to reflect differences between the historic and regional SPS systems. For historical payments the coefficients vary between 0.3 and 0.6 and for regional payments between 0.1 and 0.5. The coefficients for coupled payments lie between 0.5 and 1.0.

Results of moving to a uniform flat-rate payment across the EU as a whole are reported in a recently-published AGMEMOD simulation [access to ScienceDirect required] for wheat, barley, maize, beef, pork and milk. Unfortunately, the consequences of moving to a uniform EU flat-rate payment are conflated with an overall reduction in the CAP budget for direct payments (by around 54% in the final year of implementation). Another important difference with the Commission analysis is that coupled payments are assumed to be decoupled in this analysis, which has particular consequences for the beef results. Despite these more severe assumptions, the production effects are estimated to be very marginal (ranging from 0% to -0.8% of commodity production in 2020) apart from beef where production is estimated to fall by -3.3%.

The AGMEMOD study does not report the expected commodity market price changes although these are presumably correspondingly small. AGMEMOD assumes exogenous world prices which are not affected by the EU net trade balance. To the extent that world prices respond to a reduction in EU production, then the AGMEMOD results, small as they are, also represent upper-bound estimates.

CAPRI study

A second study published by the EU’s Joint Research Centre uses the partial equilibrium CAPRI model together with a specially tailored farm group component called CAPRI farm type (CAPRI FT) to analyse the impact of a flat rate for direct payments at NUTS 1, MS and EU levels (with the level of redistribution and potential impacts increasing in moving to an EU flat rate). The farm models are behavioural programming models in which production and land use (but not farm structure) change in response to changes in relative profitability of different enterprises.

In the CAPRI model direct payments have an impact on production through their partial capitalisation in the returns to land. As direct payments change, so does the cost of land. Thus a reduction in direct payments will favour land-intensive production and vice versa. Land has an elastic supply curve in the model and, at the margin, is in competition with non-agricultural uses such as forest, recreation or nature reserve. So if direct payments fall sufficiently, land moves out of agricultural production and overall production will fall.

The study assumes that if land moves out of production the equivalent direct payment is lost and so overall expenditure on direct payments falls slightly in the scenarios modelled. The scenarios also assume that payments which are coupled in the baseline are decoupled in the scenarios, which will particularly affect beef and sheep as noted earlier.

This study also shows relatively small production and price impacts. In the EU flat rate scenario, which represents the most radical redistribution of direct payments, production generally falls (by -1.3% and -1.9% for cereals, by -1.7% and -0.8% for oilseeds, and by -0.6% and -0.2% for meat in the EU-15 and EU-10 respectively). The maximum price increase was for cereals of 1.5% for the EU-15 and 2.9% for the EU-10, while for meats prices are projected to increase by 1.1% in the EU-15 and 1.2% in the EU-10. The small magnitude of the impacts is due in part to the role of entitlements in limiting land use expansion while allowing for some substitution between grassland and arable land.

Given the small price and production changes, income effects are mainly driven by the redistribution of decoupled payments and to a lesser extent by land use changes. As regards farm types, large and medium size farms and dairies, mixed crops and livestock, general field and mixed cropping, olives, cereals and oilseeds and permanent crops are particularly negatively affected. Small farms tend to be less affected. On the other hand, the most extensive production systems, such as sheep, goats and grazing, the residual farm category and mixed livestock farms, realized higher premiums and incomes. These income changes correspond closely to those projected in the Commission’s AIDS47 model. They are aggregate changes, and there can also be redistribution within farm type groups with some farms gaining income and others losing. These distributional effects are analysed in detail in the study.

Conclusion

The Commission’s 2013 legislative proposals to be released next month will contain a number of measures likely to affect the level of EU domestic production and thus the impact of EU agricultural policy on third countries. The most significant will be the market measures confirming the elimination of milk and sugar quotas. But changes in the design of direct payments, including the overall budget for these payments, redistribution across farmers and member states, the introduction of the greening component, and the extent to which payments can be coupled or not, can also potentially have market effects.

Redistribution of direct payments (moving from the historic payment for entitlement payments to a regional flat-rate system in the EU-15 Member States plus Malta and Slovenia, and moving to greater convergence in the value of payment entitlements across Member States) will tend to shift payments from more productive to less productive Member States, and from more intensive to less intensive farms within Member States.

Redistribution of payments on its own would thus be expected to have a negative effect on EU production. Recent studies support this intuition but suggest that the effects will be very marginal, in most cases less than 1-2%. The effects are somewhat larger for cereals than for livestock but still rather small. Overall, therefore, the studies support the view that the EU’s direct payments are rather decoupled in practice.

The Commission’s proposals for the design of direct payments after 2013 include a greening component which, according to the draft legislative proposal (yet to be released on 12 October next and thus subject to change) will be mandatory for farmers in receipt of the basic income payment – thus becoming what I called in an earlier post a form of super-cross-conditionality.

In the impact assessment to be released with the legislative proposal the Commission has made some estimates of the cost of implementing these green measures. In this post, I examine these costs using information in the draft version of the impact assessment (Annex 12 Impact of Scenarios on the Distribution of Direct Payments and Farm Income).

This version was completed before June 2011 and the favoured proposal in the draft regulation now differs somewhat from the version examined in June. In particular, the obligation to maintain a green cover during winter has been dropped, but on the other hand the area to be setaside under the ecological focus requirement has been increased from 5% to 7% (see this post for a summary of the draft direct payments regulation).

The effect on farm income in 2020 of greening direct payments is determined by two factors. First, the implementation of the green measures increases the costs of farming either directly or in the form of loss in income. Second, various of the green measures (the requirement to maintain the 2014 level of permanent pasture, the requirement for crop diversification and, particularly, the ecological set-aside) will have an impact on supply and thus market prices. Thus, the greening leads to an increase of agricultural prices which tends to counterbalance the impact of the measures on cost.

The study concludes that the cost of greening will amount to €33/ha of potentially eligible area (PEA) in 2020. Just half of this figure is the cost of maintaining permanent grassland (€17/ha PEA). I have not been able to find any IACS figures on the size of the EU eligible area (if anyone knows where these can be found, please let me know). But the Commission estimates that the average direct payment will be €267 per ha PEA and, assuming a budget for direct payments of around €40 billion, this works out at a PEA of 151 million ha in 2020 (this compares to a utilised agricultural area of 178 million ha in EU-27 today). Using this figure, the cost of greening would amount to approximately €5 billion. This compares to the value of the green payment (30% of €40 bn) of around €12 billion.

Costs for the maintenance of permanent grassland and the ecological set-aside are in general the highest. For instance, among regions, the cost of maintaining permanent grassland in areas where an alternative use of land exists varies between €5 and €620/ha, with an EU average of €216/ha of grassland. With 5% of set-aside, the average cost per ha of land to be set-aside is €260/ha, but in some regions the costs per ha are more than €1,000. When the cost of greening is brought back to the total PEA, the amounts are lower. It is estimated that 29% of farms would have a cost between €15 and €30/ha of PEA, 4% would have a cost higher than € 200/ha of PEA, and about 21% of farms would not experience any cost.

In general, the costs are estimated to be highest in the Member States where maintaining large areas of permanent grassland is economically challenging due to pressure to substitute grassland by fodder crops (the Netherlands, Slovenia and Belgium).

It is interesting to speculate what is the value of the environmental benefit to be gained from incurring this cost? The Commission study cannot answer this question because of a lack of data on the environmental impact of the green measures. Instead, it quotes some figures on the land area likely to be affected by these measures.

Overall, for the EU-27, it estimates that 25% of the PEA will be affected. The risk of ploughing permanent grassland is reduced on about 13 million ha. On about 1.7 million ha of land, farmers receive incentives to cultivate alternative crops, mitigating the negative effects of monoculture, while about 3.6 million ha of arable land are set aside for ecological purposes. [It also estimated that an additional 20 million ha of arable land green cover is applied during winter time but, as noted above, this measure seems to have been dropped from the draft regulation].

But, in themselves, these figures do not give any insight into the size of the environmental benefits to be gained on these areas. Given this, it will be hard to answer the question posed at the beginning of this post whether incurring a €5 billion cost in this way is the most effective way of increasing the production of environmental public goods by farming.

Commission methodology

At a technical level, the credibility of the Commission estimates can be assessed by examining the methodology used. The Commission methodology is sophisticated and appears well suited to the task. My main criticism would be with the estimate of the cost of maintaining permanent pasture, which seems to me to be over-estimated. This is because the Commission methodology seems to assume that all permanent pasture that could be converted into arable cropland would be by 2020 in the status quo scenario. Its model does not have the capacity to estimate the proportion of permanent grassland that would actually be under threat in 2020, given the configuration of relative profitability (gross margins) between grazing livestock and other enterprises at that time.

The Commission’s analysis is carried out with FADN data at farm level using the AIDS7K model which covers 81,000 farms in 27 Member States. Expected prices and yield estimates in the scenario year 2020 are based on results taken from the Commission’s AGLINK-COSIMO model. Additionally, the labour input has been adjusted according to observed trends. The following steps are involved.

Crop diversification: This measure requires farms to cultivate at least 3 different crops, with no crop allowed to cover more than a 70% of the total arable land. It is assumed that the profitability of the additional crops corresponds to the average regional gross margin of field crop farms with diversified arable crops. Therefore, the costs are assumed to be equal to the difference between the farm’s individual gross margin of arable land and this average regional gross margin. In the cases where the farm individual gross margin is lower than this regional average it is assumed that there are no additional costs.

Ecological set aside: 5% of arable land has to be taken out of production. Costs for the implementation of the measure arise if the amount of fallow land on the farm is lower than the area to be set-aside. For each hectare to be additionally set aside it is assumed that the costs equal 2/3 of the farm individual gross margin of arable land. The idea is that farmers will set aside the less productive areas first (with the assumption that their gross margin is 2/3 of the farm average).

Preservation of grassland: Farmers have to maintain their permanent grassland. The cost of the implementation of this measure would be an opportunity cost. To estimate this cost, it was necessary to assess on each farm whether there is an opportunity to convert grassland to arable land or not and to quantify the magnitude of the opportunity cost.

There will be little or no opportunity to convert grassland in farms with poor soil quality. For the simulation it is assumed that this is the case on farms with a low share of arable land (less than 5%) and on farms where sheep and goats represent more than 70% of grazing livestock units. Furthermore, it is assumed that rough grazing and 10% of the remaining permanent pastures cannot be converted.

For the remaining permanent pasture it is assumed that the opportunity costs are 2/3 of the difference in gross margins between permanent grassland based dairy and beef production systems and alternative systems at regional level. Only a fraction of the difference is kept in order to take into account that the newly converted grassland would probably not have the same level of productivity as land already in fodder crops (the most productive areas have been converted into arable crops before).

For the calculation of the difference in gross margins at regional level, it is considered that there are no opportunity costs in regions where permanent grassland is not relevant or where there is no alternative identified (no cattle production). Otherwise, in regions where grass-based and forage crops based feeding systems co-exist in specialised farms, it is assumed that the first alternative to cattle production based on grass is to intensify production adapting the feeding system by ploughing the grassland to produce forage crops. Finally, in the remaining regions, where cattle production takes place in mixed cropping-livestock farms, the farm gross margins per hectare of utilised agricultural area in mixed and specialised cropping farms are used.

Green cover: I include this because it is included in the draft Commission study even if it appears to have been dropped from the draft legislative proposal. During winter, farms have to apply green cover on 70% of their arable land and the area covered by permanent crops, excluding the area of ecological set-aside The costs of the implementation of green cover are estimated based on assumptions on the affected area and the costs per ha. As there is no information on green cover available at farm level several assumptions had to be made: first, it was assumed that a large part of the area covered by cereals is covered during the winter, as in most cases a large share of the cereals are winter crops. As in the FADN it is not differentiated between winter and summer crops it was assumed that on each farm the share is equal to the national shares of winter and summer varieties published by EUROSTAT. Furthermore, it was assumed that 30% of the area of permanent crops is already covered. The costs per ha of land to be additionally covered in order to meet the requirement are assumed to be equal to 50€.

Market effects: These gross costs of implementing the green measures are the appropriate measure to compare with the value of the environmental benefits to be achieved. However, in terms of the impact on farm income, these gross costs will be offset by a transfer from consumers through higher commodity prices. These are reported in the Commission study by farm type rather than by commodity. The income effect over all farms is reported to be an increase of +0.6%, with more positive effects on crop farms (2.6%) and grazing drystock farms (+1.2%), while enterprises using grain as a feed are worse off (income on milk farms would fall -0.2% and on pig/poultry farms by -8.4%).

Overall, farm income falls by -2.8% on average in the Integration scenario (which includes the greening option, but also includes the effect of capping, where the money saved by capping and diverted to rural development is assumed lost to farmers). It seems that the positive impact of the market effects from reduced supply do not compensate farmers for the increased cost of implementing green measures in Pillar 1.

Overall, these results are probably quite a good guide to the likely outcomes of the proposals in the draft legislative proposal because, although the green cover requirement is removed (thus reducing costs), the ecological focus area requirement is increased from 5% to 7% (thus raising costs).

Photo downloaded from http://www.flickr.com/photos/13847552@N03/3906560447/ under Creative Commons licence

Three of my Irish colleagues at the Teagasc Rural Economy Research Centre have conducted an interesting simulation to estimate the extent to which farmers treat the Single Farm Payment (SFP) as coupled or decoupled. Using the EU-wide partial equilibrium simulation model AGMEMOD, Peter Howley, Kevin Hanrahan and Trevor Donnellan project Irish production in the cattle and cereals sectors (these were the sectors with the most important payments in the pre-SFP era before 2005) under two assumptions: first, that farmers treat the SFP as fully coupled, and second, that they treat the payment as fully decoupled.

They then compare the levels of production that are projected under the alternative assumptions of full and zero coupling with actual observed output values in Ireland over the period 2005-08. Based on this experiment, they conclude that farm operators to a large extent treat these payments as fully coupled, but that the supply-inducing effect is smaller than for the previously coupled payments. [...]

It’s no wonder that the Commission suppressed the Court of Auditors report on cross compliance for as long as it could – the report is damning and undermines the Commission’s case for the legitimacy of EU farm subsidies.

Speaking in 2005, Agriculture Commissioner Mariann Fischer Boel explained how she sees cross compliance in relation nearly 40 billion euros of public expenditure on payments to farmers:

“I would emphasise that decoupled payments are not “money for nothing”. To get the cheque in the post, a farmer has to respect a demanding range of standards related to the environment and animal welfare. We call this system “cross-compliance”.”

Today’s report by the Court shows that such a view is at best wishful thinking and at worst deliberately deceitful. Cross compliance does not represent a ‘demanding range of standards’ at all.

It should be stressed that this study is the biggest and most comprehensive to date. The Court says that it “carried out an audit in 2008 of the cross-compliance policy at the Commission and in seven Member States representing the diversity of agriculture across Europe”.

The top line conclusion pulls no punches:

“the objectives of this policy have not been defined in a specific, measurable, relevant, and realistic way, and that at farm level many obligations are still only for form’s sake and therefore have little chance of leading to the expected changes, whether reducing the size of payments or modifying farming practices.”

Senior officials at the Court are reported to be fuming at the suppression of the report until after the CAP health check was concluded. They should rest assured that their work has not been in vain: this report will play a big part in the discussions of the future of the CAP as part of the EU budget review.

Read the press release and the full report (60+ pages).

Czech agriculture minister Petr Gandalovic made an curious statement at the informal Agriculture Council meeting held earlier this week in the French Alps. Mr Gandalovic, who will assume the chairmanship of the Council under the Czech EU Presidency in the first half of 2009, told his colleagues:

“The more specific you make the policy, the more room you give to bureaucrats who make the decisions. Non-targeted payments give more power to farmers.”

In case it’s not clear, Mr Gandalovic was making the case against targeted payments. In doing so, perhaps inadvertently, he touched on a question that goes to the very heart of the debate about the future of the CAP: the extent to which the CAP’s 54 billion euros of annual public expenditure should be targeted on clearly defined objectives and measurable outcomes. It is a debate raging right now within DG Agriculture, a power struggle that is pitting CAP ‘modernisers’ who seek a greater role for the current rural development pillar against CAP ‘consolidators’ who defend the “Fischler settlement” and the current Commission Health Check agenda. What it boils down to is a debate over the fundamental role of public policy in agriculture. [...]

Roger Waite, editor of Agra Facts, talks about how the Commission’s health check proposals have gone down in recent meetings of the Agriculture Council. Debate has been focused on the extent to which EU farm subsidies will be further decoupled from production levels. We look ahead to the French presidency which begins tomorrow and discuss the role of NGOs in the debate over the future of the CAP in both health check and EU budget review.

Economists have long been interested in the costs associated with policies transferring income support to farmers. These costs include not only the resource costs associated with distorting production and consumption choices away from the market optimum (assuming that market prices fully reflect the social value placed on resources and outputs), but also the transactions costs of administering and monitoring the policy, indirect costs associated with distortions in other markets (for example, if tax revenue has to be raised to pay for direct payments or export subsidies), as well as rent-seeking costs. [...]

Given that milk quota has been actively traded in the UK, producing so-called ’sofa milkers’, it should come as no surprise that Single Farm Payments are now being bought and sold. Agricultural brokers WebbPaton did fifteen deals in one day recently. The market has been described as ‘ferocious’ with rights to subsidies ‘flying off the shelf’. There’s an element of risk, but an investor could receive one-third of the original investment back each year. [...]

The past week has seen a series of revelations in the media about the way that decoupled farm subsidies are operating in Scotland. It has become evident that farm subsidy entitlements are being sold by farmers and that investors – who may never have set foot on a farm – are buying up entitlements to claim the new Single Farm Payment, which accounts for the bulk of the European Union’s €48.5 billion Common Agricultural Policy. [...]

A report commissioned by the Indian Department of Commerce and carried out by UNCTAD’s Indian team challenges the EU’s argument that decoupled aid payments have only a minimal trade distorting effect. According to the researchers’ model, EU farm exports would fall by a massive 45 per cent if Green Box subsidies were removed and production would fall by close to 6 per cent. [...]