Temporary supply management for milk offers no solution

The agenda for Ministers meeting at the Agriculture Council meeting tomorrow Monday 14th March includes a discussion of the difficult market situation facing a number of agricultural sectors, including dairy, pigmeat and fruits and vegetables. Ministers will assess the adequacy and effectiveness of the market support measures currently in place, and whether additional measures could be envisaged.

At last month’s February Council, member states were invited to submit concrete proposals on possible additional measures, on top of the €500 million aid package adopted by the Council last September (extraordinarily, only 10 out of 28 member states have so far introduced schemes to spend this money). More than 100 initiatives and measures were submitted, which have been summarised by the Dutch Presidency under five headings:

• Extension or reactivation of existing measures, like storage
• Flexibility in implementing the current regulatory framework, for instance as regards the recovery of penalties
• Accelerating already launched initiatives, like addressing unfair trade practices in the food supply chain
• Preparatory and supporting actions like studies or setting up monitoring bodies
• New measures, such as support to producers who voluntarily reduce their milk production.

In this post, I want to focus on the last of these proposals, for a temporary scheme of supply management for milk. I first look at the political momentum that has built up behind this proposal, despite the lack of a single published study to investigate whether it would have any impact or not. I then summarise some of the reasons why, in my view, seeking to regulate the EU milk market by managing supply would undermine rather than support the future of dairy farming in the EU.

Political momentum behind regulating milk supplies

Temporary supply management has been championed by the dairy producer organisation the European Milk Board for many years. Its most recent proposal for a Market Responsibility Programme calls, during a period of market crisis, for both a scheme of voluntary suspension of milk supplies for which farmers would be compensated, as well as a punitive ‘market responsibility levy’ on producers who continue to expand production. Ultimately, its proposal calls for a scheme of obligatory cutbacks by all producers if the earlier measures are not sufficient to restore milk prices to a level which provide an adequate margin to milk producers.

However, not all of the EMB member organisations appear to have signed up to this element of compulsion. John Comer, President of the Irish Creamery Milk Suppliers’ Organisation which is the Irish member of the EMB, made clear in an interview this week that any system of milk supply control must be a voluntary scheme. “No Irish farmer can be disadvantaged by any measure that is taken. Irish dairy farmers responded to a national plan to expand dairy production and processing, made commitments and investment, and should not now be penalised,” he said. However, this is not what the EMB proposal actually says.

A voluntary reduction scheme was also suggested by the French government in the ‘French memorandum’ circulated to the Agricultural Council prior to its February meeting. This was listed as a structural measure, implying that it was not seen as something that could be introduced in the short-term to address the current crisis. This French position has been supported by the new agricultural think tank Farm Europe. It has proposed a (further) €500 million scheme to compensate producers who would voluntarily withdraw between 2 and 2.5 million tonnes of milk. This would amount to between 1.4 and 1.8% of total EU milk production. Regrettably, it has provided no figures or analysis to show what impact this might have on the milk price and milk margin received by dairy farmers.

In the submissions made by member states prior to the Agriculture Council meeting tomorrow, there was a difference between those member states supporting voluntary measures only and those prepared also to consider mandatory production reductions.

Among those member states supporting a voluntary measure (paying dairy farmers to reduce production) were the following:

• Belgium proposed that producers’ organisations could be encouraged to work on temporary, voluntary and financially supported reductions of the European supply.
• Luxembourg was also open to considering voluntary steps to decrease production by producers while stressing its opposition to any return to mandatory production controls in the form of quotas.
• The Czech Republic suggested the introduction of support for producers’ organizations in the dairy (and pigmeat) sector on the basis of the fruit and vegetables sector rules (including voluntary regulation of the supply).
• Portugal also supported mechanisms to reduce deliveries in the milk sector in the short-term, and proposed creating a model to support temporary reductions of production based on inter-branch agreements or contract management in the medium-term.
• Slovenia also came out in favour of establishing an alternative system for production limitation in the medium-term (subventions for reducing milk deliveries or decreasing the milk herds.

Among those member states explicitly calling, in addition, for mandatory controls on production were:
• France made by far the most elaborate proposal, including options for a compulsory reduction in supplies as well as voluntary schemes. The French proposals are outlined in more detail below.
• Bulgaria called for a mandatory reduction in milk deliveries by member states with the size of the reduction determined by the increase in milk production in each member state in 2015 compared to 2014. It proposed a compensation of EUR 0.30/kg, which is the average EU buying-in price per kg milk in 2015. If the crisis conditions have not been mitigated after a 12 month period then the restriction of production and super levy payment by the producers would be continued for another 12 months.
• Finland also expressed its willingness to examine measures to limit production in crisis situations, under the prerequisite that they are applied throughout the Union.

Member states expressing support for the idea of supply management without, however, being very specific about how this might be achieved included:
• Greece called for a study of the proposals from producer organisations in the dairy sector for a centralised supervision system and a mechanism to balance dairy production across the EU as a whole and ensure prices for producers which are above costs.
• The Slovak Republic called for the (re)introduction of partial dairy market regulation without, however, specifying the form that that should take.
Member states explicitly opposing any attempt to regulate supply, either on a voluntary or compulsory basis, included:
• Ireland specifically argued that regulating supply in times of price downturns is not an appropriate response. It held that measures taken only within the EU will disadvantage EU farmers and co-ops, will undermine efficient production and will adversely affect the ability of farmers to benefit when the market turns in their favour.
• The UK also cautioned against measures seeking to restrict the production of milk (or pork) during periods of low prices, pointing out that it would damage the long-run competitiveness of the industry by penalising the most entrepreneurial and efficient farmers.
• Sweden also indirectly warned against market-distorting measures without mentioned temporary supply management by name.
• Germany also appeared to come out against temporary supply management, arguing that “As a return to cumbersome and inflexible state quantity control in the EU would not be workable or even cost-effective under the conditions of globalised markets and international interdependence, market-compliant, responsible action by all economic operators is the preferred option.”

Subsequently, however, French and German agricultural ministers addressed a common letter to Commissioner Hogan in which they called for voluntary measures directed at farmers and processors to reduce production, compensated by funds from the EU budget.

The French options for milk supply management

France further elaborated on its proposal in its Memorandum for a temporary supply management scheme for milk by putting forward three options.
The first option would be based on regulation and would not require a contribution from the EU budget. It proposed that the Commission should first announce (using its powers under Article 221 of the CMO Regulation), that it would adopt a measure designed to limit milk production volumes in the member states, if there were no voluntary reduction in production within a specific time-frame (for instance, within two months). If this announcement were not sufficient to bring about a significant decrease in production (a figure of the order of -3% is mentioned), then the Commission would require all processors to reduce their milk collection by this amount and would apply a super levy to those processors which increased their collection of raw milk from producers.

A second option would be to restrict production on a voluntary basis, in which case compensation would be required financed from the CAP budget. Specifically, the second option is a scheme to reduce peak production in the months May through September 2016 by 3% compared to 2015, by paying a financial incentive of 10c/litre. Limits would be applied on the amounts of milk removed (a minimum of 5,000 litres per farm and a maximum reduction of 20% per farm) to limit the administrative costs of paying for very small amounts of milk removed, while also limiting deadweight effects through the cessation of activity. If funding from the EU budget were insufficient, then additional funding could come from Member State budgets or even, it is suggested, from processors on a voluntary basis.

The third option would be to encourage a voluntary reduction in supply through the activities of producer organisations, making use of Article 222 in the CMO Regulation which allows the Commission to give producer organisations, associations of producer organisations and recognised interbranch organisations a derogation from EU competition rules during periods of severe imbalance in markets, through the implementation of certain measures and in particular ‘temporary planning of production taking into account the specific nature of the production cycle’. To ensure a broad uptake, the French submission suggests broadening the concept of producer organisation temporarily to allow, for example, processors to plan production temporarily, and by giving producer organisations a financial incentive to take up this measure via supplemental financial support or by restricting access to other market support measures only to processors which participated in a supply reduction measure.

French Agriculture Minister Stéphane Le Foll has claimed the support of 15 to 20 countries for the third option.

Commissioner Hogan, in responding to questions from members of the European Parliament’s Agriculture Committee (COMAGRI) last Monday (7 March 2016), indicated his willingness to look at the feasibility of allowing producer groups to regulate supply under Article 222 of the CMO Regulation, although he warned that DG Competition might have a different view on this. He also noted that only 10-15% of the EU milk supply would at best be covered by such actions.

Presumably, we will hear more tomorrow at the Council meeting about the Commission’s views on this topic.

A voluntary scheme to reduce milk production

Would a voluntary scheme under which EU dairy farmers were compensated for reducing production be successful in raising EU milk prices and dairy farmer margins? To answer this question (and, I repeat again, no country or organisation making this proposal has put forward any analysis on this subject), requires looking at three crucial variables: the rate of slippage, the overall price elasticity of demand for milk, and the supply response of EU producers to higher prices.

The importance of the slippage rate can be easily explained. Suppose an EU agency offers 20c/litre to EU farmers who are willing to reduce their milk deliveries below some reference quantities (which could be deliveries for the same months in the previous year, or deliveries over the previous 12- month period). This may attract some dairy farmers who had not previously thought of reducing their milk deliveries. But it would most certainly also attract those dairy farmers who were anyway planning on reducing their milk deliveries.

While paying the former group of dairy farmers to reduce their milk supply would, indeed, contribute to restoring a better balance between supply and demand on the EU milk market, paying the latter group would not. Money paid to dairy farmers who were planning to reduce production in any case is just waste, what economists call ‘deadweight loss’ and what I am here calling ‘slippage’.

Because of the significant ongoing structural change in the dairy sector across Europe, the slippage rate is likely to be high. To put a figure on it, I would suggest a figure of 50%. Farm Europe, in estimating that it would cost €500 million to compensate the withdrawal of 2 – 2.5 million tonnes of milk seems to base this estimate on a compensation payment of 20-25c/kg milk. But with a slippage rate of 50%, between 1-1.25 million tonnes of this milk would have disappeared as these producers anyway planned to reduce production. Thus, to attract sufficient farmers to have a net removal of 2-2.5 million tonnes, the cost of the scheme will be at least €1 billion.

(It is possible that Farm Europe based its estimate on the French government’s proposal to pay compensation of 10c/litre and have built in a slippage rate of 50% into its estimate, but its proposal is silent on these important technical details. It is left to readers to decide what volume of milk might actually be offered for withdrawal if the compensation were as low as 10c/litre ).

What would be the impact on the EU milk price?

Let us suppose that the administration is in place to manage a system of voluntary supply reductions (this supposes that the responsible Milk Agency has information on the deliveries profile of those applying, can quickly identify the cheapest bids (if an auction system is used), can monitor their compliance with their contracts to reduce production, and has the means to fine those who do not comply). What would be the impact on the EU milk price of withdrawing between 1.4 – 1.8% of the EU milk supply, as proposed by Farm Europe?

This depends on a single parameter, the price elasticity of demand for raw milk (or, rather, its inverse). We can agree that, in the short run, the price elasticity of demand is likely to be rather inelastic. For the sake of argument let us assume a figure of -0.5, which gives us an inverse elasticity of -2. This tells us that, for every 1 percentage reduction in supply, the price will go up by 2 percentage points.

Thus, the consequence of spending €1 billion would be, at best, to raise the EU milk price by between 3-4%. Now this is not insignificant, but it is hardly likely to persuade dairy farmers that the crisis is over.

But the story does not end here. While some dairy farmers might be persuaded to accept compensation of 20-25c/kg to reduce their milk deliveries, other dairy farmers will want to continue to expand production. Current low milk prices might currently limit their enthusiasm, but now assume that the Commission introduces a voluntary suspension scheme which, lo and behold, has improved their prospects. With the higher milk price after the introduction of this scheme, they will be incentivised to increase their production even more, thus offsetting a good deal of the milk withdrawn by the farmers enrolled in the voluntary suspension scheme.

This is precisely the mechanism to which Commissioner Hogan referred in his remarks to the COMAGRI meeting last week when he resolutely refused to consider increasing the intervention prices for dairy products. In his view, by providing an additional market for milk, this would merely encourage farmers to increase production, when the restoration of balance on the milk market requires a reduction in supply. It is hard to put a figure on this, but we can be sure that the actual increase in the EU milk price following a voluntary incentive scheme is likely to be a good bit smaller than the 3-4% increase that the architects of the scheme had hoped for.

Only a mandatory scheme would work…. but at what cost?

One can, of course, criticise the precise figures I have chosen to use in this example. What is striking is that none of the advocates of voluntary supply controls have told us what their figures are, nor what the basis is for their advocacy of what could be an enormously expensive scheme with little benefit to milk producers.

It is clear that, if supply management is to work, then it would have to be mandatory, at least by controlling the supply of expanding producers. This is precisely the proposal of the European Milk Board, which would place a levy equal to 110-120% of the milk price on all producers delivering more milk than in their reference period alongside its proposal for a voluntary suspension scheme.

Such a scheme would potentially have a much greater impact on the milk price, but only because it would remove a much greater proportion of milk from the market. Under some scenarios, I estimate that it could involve up to 10% of the EU milk production being withdrawn from the market. Undoubtedly, this would have an impact on the EU milk price, but the long-term consequences for the industry would seem to be the equivalent of shooting itself in the foot.

All seem to be agreed that milk price volatility is here to stay, and will be a feature of dairy farmers’ planning in the future. The EMB proposal for temporary supply management thus envisages regular interventions in the market every few years. Think about the consequences for the competitiveness of the dairy sector of a situation in which between 6-10% of EU milk supplies would be regularly withdrawn every 3 years or so.

During each withdrawal period, the EU’s competitors on world markets would be rubbing their hands with glee. They would benefit from the higher world market prices due to the EU’s supply control, without being obliged to restrict their own production. EU dairy processors would gradually lose market shares on key markets, as they would be unable to guarantee regular deliveries. Those expanding dairy farmers in the EU, likely to be among the younger and more innovative farmers, would be less likely to undertake investments given the additional policy risk that they might be forbidden from delivering the additional milk if dairy markets turned down. Banks would be much less willing to lend to dairy farmers knowing that farmer borrowers could arbitrarily be told to restrict their milk deliveries without warning. Processors and retailers would be much less willing to pay premium prices for milk if they could not rely on stable supplies. Over the whole milk cycle, it seems likely that the average price paid for milk would be significantly lower with a scheme of temporary supply management in place than it would otherwise be.

Conclusions

Milk price volatility is indeed a real concern. It is one that dairy farmers and processors must meet together. Forward pricing contracts with processors are essential, but require active futures markets to allow processors to hedge their risks. Variable rate loans, where repayments are geared to economic conditions on the milk market, would also provide additional flexibility to dairy farmers to cope with downturns (a good example is the MilkFlex loan introduced by Glanbia last week in Ireland – see also here). National tax arrangements which would allow farmers to build up tax-free surpluses during good years which could be drawn down in poor years would also be of benefit. Insurance-type schemes which would allow farmers to protect a given margin in return for an annual premium should also be explored.

Farmers need to learn how to cope with volatility. A return to regulated markets provides no solutions.

This post was written by Alan Matthews

Photo credit: Dairy farmers protest in Helinski via Twitter