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.

Farm interests routinely threaten that any reduction in support will provoke a slump in production, endangering EU food security, and threatening massive land abandonment to the detriment of rural life and biodiversity. The findings of the Scenar 2020-II – Update of scenario study on agriculture and the rural world, commissioned by DG Agri, strongly contradict such panicmongering about the looming end of EU agriculture.

The study looks at three scenarios. The reference case assumes a 20% (nominal) CAP budget reduction, reduced intervention stocks, full decoupling, a 30% direct payment reduction, a 105% increase for the second pillar, and a moderate Doha agreement (based on the Falconer paper, including the elimination of export subsidies). The conservative scenario presumes that the Health Check results are largely maintained, direct payments reduced by only 15% and second pillar payments raised by 45%. The liberal scenario is very liberal indeed, with a 55% CAP budget reduction, no intervention stocks, no direct payments, a 100% increase for the second pillar and no tariffs.

Among the most interesting results is that the volume of crop production will grow slowly in all scenarios (around 0.25% per year). Even the vulnerable livestock sector loses only 4% in the liberal scenario over the entire 2007-2020 period. Agricultural land use remains roughly unchanged in the reference and conservative scenarios, and declines by a mere 6% in the liberal scenario (due to the decline in the EU-15, driven mostly by the abolition of the Single Farm Payment).

More significant differences arise when it comes to land prices. These remain largely unchanged in the reference and conservative cases, but decrease by 30% in the liberal scenario. This is nothing the public need worry about – but it explains the heavy lobbying of landowners for the preservation of a ‘strong’ CAP.

The study also analyzes the situation of rural regions. It concludes that strong rurality is not synonymous with negative economic or demographic trends. 422 regions have a negative and 435 regions a positive demographic trend (with negative developments in the eastern Member States and at the southern and northern borders of the EU). The study also finds that ‘There is no evidence that the EU-27 regions with an above average agricultural employment are generally showing negative reactions. Hence, it shall be emphasised that rurality and agricultural vocation are not a sign of weak development perspectives.’ This further undermines the rural development approach of the CAP that spreads money to all rural regions, often in positive correlation with their agricultural production.

A last point to consider: surveys of life satisfaction and happiness give very similar results for urban and rural areas. Since ‘happiness’ is in vogue (and heads of states from Bhutan to France argue for happiness accounting to complement GDP figures), why worry if rural regions have a lower GDP per capita, so long as people there are equally satisfied?

The EU dairy market is now recovering from the severe drop in milk prices in 2009. Perhaps the clearest sign of this recovery is the setting of export refunds on dairy products to zero since mid-November, as world market prices for dairy products have strengthened in recent months.

It is thus an opportune time to evaluate the EU’s response to the crisis, and to see what lessons might be drawn for how the Union can address similar problems in other farm sectors in the future. My view is that there is a lot to be learned from the dairy crisis, and that the outgoing Commissioner deserves credit for the way she handled it.

EU milk prices improving

Let us first review the evidence that the milk market is improving. The trends in the EU market prices (proxied by the German price and represented by the blue line) and the EU intervention price (the red line) for butter and skim milk powder (SMP) have been graphed by CLAL.it and are reproduced below.

The German butter price is now back to the level of 2002 before the cuts in intervention prices. The recovery in SMP prices has not been as strong, but even so these are now comfortably above intervention levels. EU dairy farmers also benefit from an additional €5 billion per year in the form of direct payments (3.5c/kg milk) to compensate for the reductions in intervention prices.

Farm prices are responding to the better prices for dairy products, although with some lag. The average EU price for standardised 4.2% fat milk, according to the LTO, has risen to €27.06/100kg in October 2009 from its lowest point of €23.74/100kg in April. It is now back at the levels of Spring 2007, before the big run-up in prices in 2008.

The recent USDA market outlook for dairy products in 2010 foresees continued strong prices into 2010 as economic growth recovers particularly in developing countries. While the large stocks of SMP in particular overhanging the market are seen as a negative factor, it observes that in the US most of these stocks are committed for domestic food programmes and that the EU is unlikely to release its stocks on to the market soon for fear of the political fallout from producers.

The Commission’s response to the dairy crisis

Assuming that prices continue to strengthen throughout 2010, it is useful to review what lessons were learned for crisis management when faced with a substantial fall in the price of a farm commodity. The Union’s responses to the collapse in domestic milk prices in 2009 can be divided into market management measures and income support measures.

Among the market management measures were

In total, the Commission expects to spend up to €600 million on market measures this year.

Among the income support measures were:

Reflections on the Union’s response to the dairy crisis

A first observation to make is that, while the Commission did resort to market management measures such as intervention and export subsidies, much more emphasis on this occasion was put on income support measures.

It was noticeable that the Commissioner firmly set her face against any increase, even temporarily, in intervention prices and against a reduction in quotas, arguing that both would be against the spirit of the Health Check intended to move the CAP in a more market-oriented direction.

Although the future of export refunds after 2013 is uncertain (the EU has committed to their elimination but only in the context of a successful outcome of the Doha Round in which similar disciplines applied to other forms of export support), it is likely that the greater emphasis on direct income support measures in response to crisis is here to stay. While the loud voices calling for stronger support measures as part of a food security policy for Europe would doubtless like to see stronger market management measures, these are effectively beggar-my-neighbour responses unless undertaken as part of a global framework (e.g. a global stocks policy).

A second observation is that the income support measures included both a relaxation of state aid restrictions (allowing Member States to fund payments to producers) and a Community scheme. While the national state aids were permitted only in the context of a measure taken as part of a wider response to the economic crisis, they do flag a possible direction for future responses to agricultural market crises. When the figures come in, it will be interesting to assess how much use the individual Member States make of this opportunity.

A third observation is that the payments will be made to producers only with a lag (the exception is the speeding up of the disbursement of the standard Single Farm Payment). This means that payments will reach farmers after the crisis has passed and when incomes are already recovering. Clearly, payments should reach farmers at the time when they are most needed, and hopefully the decision to allow the Commission to respond to future dairy market crises on its own initiative may facilitate this in future.

A fourth observation is that there is now little headroom in the EU budget up to 2013 to fund unexpected crisis management measures. The outgoing Commissioner has made clear that funding the €300m emergency aid from the 2010 budget has utilised any remaining headroom and, apart from the use of the safety margin, any further call on the agricultural budget would trigger the financial discipline mechanism requiring a cut in direct payments.

Price volatility on agricultural markets is expected to increase in future (though whether this is a reasonable presumption to make deserves further analysis, and the outcome depends on the interaction between production shocks and their distribution where climate change is expected to increase volatility, trade policies and their implications for price transmission from world to national markets, and government behaviour particularly with reference to stocks).

Presumably these lessons will be analysed by the High Level Experts’ Group on Milk which is looking into the medium and long-term future of the dairy sector and which will deliver its final report by the end of June 2010. A very useful input is the report on price volatility in the dairy sector commissioned by the European Dairy Association and written by my Irish colleagues Michael Keane and Declan O’Connor.

The 2009 EU dairy market crisis was handled well by the outgoing Commissioner. There was no back-tracking in the direction of CAP reform, and a number of innovative new instruments to address income volatility in a particular sector are being tested. The lessons learned from this experience will be an important input into the discussions on the shape of the CAP post-2013.

Update 5 January 2010: When writing this post, I had not seen that the French have made use of the national state aid provision to provide up to €700 million to farmers affected by the crisis. Aid under this new scheme can be granted until 31 December 2010 and will take the form of direct grants, interest rate subsidies, subsidised loans as well as aid towards the payment of social security contributions. See http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/1866&format=HTML&aged=0&language=EN&guiLanguage=en,

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[...]

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