coffee market

Oxfam: International Commodity Research – Coffee Confidential: Not for distribution or publication

The Coffee Market – a Background Study


Acknowledgements This background study was written by Oliver Brown, Celine Charveriat and Dominic Eagleton. The authors want to thank the following persons for their useful comments: Mehmet Arda, Maria Jose Barney, Bart Ensing, Penny Fowler, Brian Lewin, Lamon Rutten, Denis Seudieu, Robert Simmons, Marcelle Strazer, Kevin Watkins, Michael Wheeler and Pete Williams.

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EXECUTIVE SUMMARY '[When prices are low], we sacrifice a lot in the way of clothing, tools and food. We can’t afford meat, we had to buy other parts of the animal which were inferior. We can’t eat eggs, or drink milk...When the children get ill we don’t have the money to take them to the doctor… One always lives with uncertainty, always in debt; it's always borrow here, borrow there; we live dependent on credit... Of course, there is no peace living with such uncertainty. You don't know whether to take out a loan or not because you could lose the money you've invested.’ Vitelio Menza, small coffee producer in Colombia1 Providing livelihoods to farmers in developing countries is a crucial challenge for reducing world poverty. When fairly priced, export crops, such as coffee or cocoa, can help millions of farmers and their families to lift themselves out of poverty. In the case of coffee, 70% of the world’s supply is provided by smallholders cultivating less than 10 hectares in 80 countries in Africa, Asia and Latin America. However, the extreme volatility and long-term decline in coffee prices on international markets endangers the livelihoods of the 10 million small coffee farmers dependent on coffee for their primary source of income. In December 2000, international coffee prices hit a 30-year low, with further falls expected. On December 21, the average international price for Arabica was 63.7 US cents/lb, while Robusta stood at a mere 32.6 cents/lb. 2 These prices barely cover production costs in many countries, let alone afford a decent living to farmers. To give a concrete example, a typical small coffee farmer in the Kilimanjaro region of Tanzania made around $60 from his production of coffee this year (or only 16 US cents a day), not enough to cover essential family expenditures such as primary school fees and medicines. The livelihoods of millions of rural workers involved in coffee picking on big plantations and coffee processing factories also directly depend on coffee. When prices decline, rural workers involved in coffee harvesting and processing find themselves unemployed or see their wages decline as farmers attempt to reduce production costs. At a country level, the economic growth of many of the Least Developed Countries is closely linked with coffee production, as well as other primary commodities. Many producer countries depend on coffee exports for a large part of their foreign exchange earnings (for instance 67% in the case of Ethiopia) and their government revenue. When international coffee prices are low, governments have difficulties meeting debt service obligations and are unable to make much-needed investments in basic health, education and infrastructure. The adverse market conditions faced by small producers are the result of chronic world oversupply of coffee and high volatility of international coffee prices. They also derive from a buyer-driven coffee supply chain and poorly designed market liberalisation reforms in producer countries. Current coffee oversupply is massive. Certified stocks of green coffee reach 200,000 tonnes in the United States alone, which represents more than 20% of its annual domestic consumption. There are several factors behind this imbalance between supply and demand. On the supply side, production has increased at a faster rate than demand due to new technologies, such as higher yielding trees. Moreover, many developing countries are introducing coffee (such as Viet Nam) or expanding production (such as Brazil).

1 Testimony published in ‘Spilling the Beans’, Fair Trade Foundation, UK (www.fairtrade.org.uk). 2 ICO Statistics.

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Oversupply is also fuelled by the lack of viable alternatives for small coffee producers. Diversification out of coffee, advocated by Northern governments, is rarely profitable nor feasible given current market conditions. First, most cash crops (such as cocoa for instance) have seen a drastic decline in prices. Moreover, food crops are not much more profitable than coffee, which would not justify the significant costs involved in switching production, in the absence of access to credit or technical support. This low profitability of food crops results from dysfunctional local markets as well as lack of market access in OECD countries. Therefore, as long as coffee harvesting costs are covered (harvesting is usually done by the family), farmers keep on producing, even with rapidly falling prices. To make things worse, coffee prices are very volatile in the short-run: for example, international coffee prices tripled in the first six months of 1997 before losing half their value in the next six months. Between January and December 2000, prices declined by a staggering 40%. Price volatility makes the life of coffee farmers difficult since they never know in advance what the international price will be when the harvest comes, and so cannot plan their production accordingly. At the macro level, volatility has adverse effects on the ability of governments to calculate revenues and social spending, as well as their capacity to service debt. The ways the coffee supply chain operates means that small farmers usually capture less than 10% of the retail price of coffee. Small farmers, often cash strapped and isolated, are easy prey for local traders, exporters and subsidiaries of multinational companies, which can offer them low prices in exchange for their crop. The fact that processing is controlled by powerful multinationals, and that retail outlets are concentrated in the hands of supermarket chains, means that buyers can set the rules of the game, especially in the context of current oversupply of green coffee. Big buyers can pick and choose, playing one producer country against the other. They can also increase their profit margins and set retail coffee prices much higher than they should be, which reduces demand for coffee and therefore international prices. The difficult conditions faced by producers are not only the result of international markets however. A better local market environment can make a sizeable difference in terms of improving farmers’ income. Good access to technical assistance, inputs, credit, transportation, and marketing information are critical for ensuring that small farmers get the best possible price for their products. They are also necessary conditions for improving yields, quality of production and processing capacities at the farm level. Taxation at the local and national level can also place a heavy burden on small farmers, as can regulations that prevent competition between intermediaries along the supply chain (such as trade or export licenses for instance) or discourage the creation of strong small producers’ associations. Despite the obvious importance of local conditions on market outcomes, few producer countries have policies in place that provide small farmers with a level playing field. Poorly designed coffee market liberalisation reforms in producer countries have left many small producers without any access to credit, inputs or markets, and clearly unable to compete with bigger plantations. Yields and quality of crop have decreased in some producing countries following these reforms—for instance in Tanzania – reducing even further the meagre income of small producers. As outlined in this paper, major policy changes are urgently needed to provide relief to small producers and allow them to earn a decent income from their activities. The current initiative of the World Bank’s International Task Force on Commodities, designed to help small producers insure their production against price risk, provides the beginnings of an answer, but is far from sufficient to resolve the acute problems faced by small coffee producers. This initiative would shelter small farmers from extreme price volatility, but doesn’t address the problems caused by oversupply, local market conditions or growing domination of the supply chain by powerful multinationals. Moreover, the initiative is unlikely provide the smallest and poorest

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producers with effective protection against price volatility due to a lack of appropriate financial intermediaries in many producing areas. To have a real positive impact on farmers’ welfare, policy changes need to lead to higher as well as more stable incomes for small farmers. But this goal cannot be achieved if the acute problem of oversupply is not adequately addressed, as continuing oversupply is the main factor behind the current decrease in international coffee prices. Oversupply is clearly incompatible with the objective of raising small farmers’ income. In fact, any measure contributing to the increase of farmers’ income is bound to worsen the already acute problem of oversupply, if it is not accompanied by a strategy bringing about a healthier balance between world demand and supply. In the short term, it is crucial to provide some much-needed relief to small producers. This entails supporting and extending the current supply management scheme put forward by the Association of Coffee Producing Countries to stop the dramatic slide in prices. Producer countries have not only to reduce exports, but also limit production capacity in the medium term to avoid the further building of stocks which feeds into price decline. Over the long run, the balance between demand and supply needs to be re-established through diversification out of the coffee sector and the adoption of more sustainable methods of production. However, development assistance for diversification projects must be seriously revamped. In the past, assistance has been limited and poorly co-ordinated, which means that small farmers were often encouraged to diversify in other cash crops with similar oversupply problems such as cocoa. As a means to improve the balance of power along the supply chain, fair trade initiatives try to level the playing field for small farmers. But they cover only 1% of the world coffee market. Major processing companies and supermarket chains, which often buy directly at the farm gate through subsidiaries, should follow the example set by fair trade and provide a stable and decent price to coffee farmers – not just a few cents above market prices. When buying bulk coffee from intermediaries – the majority of their purchases – multinationals should require from their suppliers decent producer prices, the use of environmentally sound production practices and good working conditions for farm workers on plantations. Similarly, supermarket chains should demand that products on their shelves meet these basic requirements. To ensure that farmers get the best deal possible, representative and accountable small producers’ associations have to be developed in all producing countries, for instance through capacity building projects financed by donors. Finally, producer countries need to design policies geared at making local markets work for small producers. This involves creating strong, accountable and transparent regulatory bodies in the coffee sector to provide marketing information and monitor competition along the supply chain. Moreover, technical assistance, better access to credit and inputs, as well as investments in infrastructure and storage facilities are paramount to allow farmers to make a decent living and compete with bigger producers.

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CONTENTS

Acknowledgements_________________________________________________________ i

EXECUTIVE SUMMARY___________________________________________________ii

CONTENTS ______________________________________________________________ v

SECTION 1: INTERNATIONAL MARKETS ___________________________________1 1.1. The downward spiral in coffee prices and its causes _____________________________ 1

1.1.1. Chronic oversupply: the principal root of price decline _________________________________ 1 1.1.2. Factors driving oversupply _______________________________________________________ 2 1.1.3. Other explanations to price decline: the role of the international market structure _____________ 5

1.2. The problem of price volatility: coffee highs, coffee lows _________________________ 6 1.2.1. Traditional factors contributing to volatility __________________________________________ 6 1.2.2. Reasons for the recent increase in volatility __________________________________________ 7

1.3. The impact of coffee price volatility and decline on small producers and governments 9 1.3.1. Small producers________________________________________________________________ 9 1.3.2. Governments _________________________________________________________________ 12

1.4. Policy Responses _________________________________________________________ 14 1.4.1. Producer price stabilisation and insurance schemes ___________________________________ 14 1.4.2. Regulatory changes to limit speculation on commodity exchanges________________________ 16 1.4.3. Supply management schemes ____________________________________________________ 16 1.4.4. Diversification________________________________________________________________ 18 1.4.5. Product differentiation _________________________________________________________ 19 1.4.6. Sustainable Production _________________________________________________________ 19

SECTION 2: PRODUCTION, PROCESSING AND MARKETING ARRANGEMENTS21 2.1. Capturing value along the supply chain ______________________________________ 21

2.1.1. A brief overview______________________________________________________________ 21 2.1.3. From the export point to the supermarket shelf: the international coffee supply chain _________ 25

2.2. Policy Responses _________________________________________________________ 31 2.2.1. Fair trade ____________________________________________________________________ 31 2.2.2. Developing in-country processing: opportunities and challenges _________________________ 35 2.2.3 Strengthening producers’ associations ______________________________________________ 36 2.2.4 Towards appropriate market regulation _____________________________________________ 37 2.2.5 Contract farming ______________________________________________________________ 38

ANNEX: THE ETHICAL TRADE INITIATIVE __________________________________ 40

SELECTED REFERENCES ___________________________________________________ 42

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SECTION 1: INTERNATIONAL MARKETS

This section highlights the different problems faced by small producers (i.e. low and highly unstable prices) as a result of the way international markets currently function. After exploring the various causes of the decline in international prices and of their high volatility, this section shows what impact low and unstable prices have on small farmers’ welfare, as well as macroeconomic performance in countries dependent on coffee export earnings. 1.1. The downward spiral in coffee prices and its causes The past 50 years have seen a consistent and drastic decline in the international price of commodities. Throughout the 1980s, commodity prices fell by an average of 5% a year. By 1990 they were 45% below their 1980 level, or 10% lower in real terms than in the midst of the Great Depression in 1932.3 In the case of nominal coffee prices, there has been a decline of almost 70% over the last two decades, representing a total loss of US$88 billion in export revenues, or $4.5 billion annually. In real terms, the loss reaches almost $160 billion dollars or around $8 billion a year. 4 Chart 1: Long-term Trend in International Coffee Prices

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1.1.1. Chronic oversupply: the principal root of price decline The coffee market is currently in a situation of oversupply, as shown by the high level of stocks compared with world coffee consumption. Currently certified green coffee stocks in The United States reach more than 20% of the country’s annual consumption.5 According to the Economist

3 The South Centre, International commodity Problems and Policies: the key issues for developing countries, 1996. 4 ICO statistics, 1980 to 2000. The export loss is estimated by 1) calculating the export revenues over 20 years under the assumption that the 1980 price ($1.5/lb remained constant, and 2) substracting actual export revenues. We assume that coffee export demand is perfectly inelastic to price change. 5 Reuters and Bridge News Newswires, December 2000.

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Intelligence Unit, stocks of green coffee are expected to rise to 74% of world consumption by 20026. This clearly shows that supply is by far superior to demand. Even if production was sharply reduced, it might take several years to absorb these large stocks.7 While world demand has risen slowly, world production of coffee has increased fivefold since 1950.8 Between 1980 and 1999, production increased by an estimated 18% (see chart below).

Chart 2: World Coffee Production 1980-99

World Coffee Production (by season, 1980-99, million bags)

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1.1.2. Factors driving oversupply Higher yields, lower costs and new plantings This increase in production is mainly due to technical innovations, which have given the farmer higher yielding and more pest resistant coffee trees. In the case of Colombia, the introduction of the Caturra plant at the end of the 1970s together with increased plantings, saw production rise by 50%. Today, many plantations use cutting-edge technology to increase yields and reduce production costs (see Box 1). Moreover, wages of plantation workers are very low in most producing countries due to the high incidence of poverty and unemployment in rural areas. In Tanzania for instance, they currently average around $1 a day.9 This reduces production costs and enables plantations to keep producing even when international coffee prices are low. Finally, plantation area of coffee seems to be increasing worldwide. In the case of Brazil, production, which already accounts for about 30% of world production, is forecasted to expand further in the next two to three years due to new plantings. Moreover, new producing countries have entered the market. For instance, Viet Nam increased its production almost by 400% over the last 10 years and now produces 7% of the world’s coffee. 6 EIU World Commodity Forecasts, July 2000. 7 Ibid. 8 ‘Spilling the Beans’, Fairtrade Foundation (www.fairtrade.org.uk). 9 For 300Tsh per coffee tin and average production of three tins a day. Based on household interviews conducted by Maarifa/OXFAM GB in the Kilimanjaro region in December 2000.

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Box 1: High-Tech Coffee Plantations In Brazil’s north eastern state of Bahia, agro-businesses have converted a barren plateau into the world’s most productive coffee growing region. A favourable climate and large-scale mechanisation has led to big yields averaging 4200 kg/ha, with some farmers reporting an enormous 6600kg/ha (compared with 300kg/ha for small producers). Pruning and harvesting is mechanised, dramatically reducing labour costs. Tree density is substantially higher than elsewhere, boosting yields and optimising water and fertiliser costs. Costs are further reduced by economies of scale, with an average plantation size of around 1,000 hectares. The region has some 10,000 hectares of plantations, an area expected to double in size in the near future. Colombian coffee growers are monitoring progress in the region as they are deeply concerned that competition from Bahia could wipe out traditional growing regions. Observers expect coffee production to migrate from the south of Brazil to Bahia, where the market is much more competitive. Luiz Sibin, a coffee plantation owner from Sao Paulo, has sold three plantations and will plant 550 hectares in western Bahia with the revenue: ‘It’s a large investment and current prices aren’t encouraging, but the return is much better here… I look forward to this world coffee crisis because we’ll see who is competitive and who isn’t.’ Luiz Sibin’s comments suggest his company has little concern for the effects its operations could have on increasing oversupply, nor do does it seem concerned with engaging in the cooperation required between producers to regulate production. The concern is also that these powerful actors exert a strong influence over decision-makers, and that as a result, government policies are favouring industrial production over smallholder production. Source: Financial Times; November 15 2000 Sluggish demand The problem is that demand has not increased as quickly as supply. World coffee consumption has been increasing over the last two decades, but only very slowly at around 1% per annum. In OECD countries (which consume 70% of the world’s coffee), demand is now more or less stagnant. Even if the price of coffee substantially declines, demand will only marginally increase since coffee has a relatively low price elasticity.10 That is to say consumers do not drink a lot more coffee when its price declines. This feature is exacerbated as savings in price are rarely transmitted to the consumer in the form of a cheaper cup of coffee – the increase in profit is absorbed by the intermediaries rather than passed onto the consumer.

The less mature markets of Asia, Eastern Europe, South America and North Africa provide better prospects for growth in coffee consumption over the long term, as do the internal markets of the producer countries themselves. Expansion of consumption in these new markets primarily depends on these countries’ macroeconomic performance and rise in individual income, as coffee is either non-traditional drink or still a luxury good.11

10 The FAO estimates that the price elasticity is around –0.2 among industrial countries. But price elasticity is also non-linear. Therefore, a sharp increase in international coffee price does reduce demand for coffee more than a sharp decrease would increase demand. 11 Coffee demand has a high income elasticity. As income rises, demand for coffee rises.

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Slow response of supply to price decline The problem of oversupply is also due to a slow response of supply to price decline. In theory, declining prices should lead to decline in supply and a subsequent increase in prices. However, this has not really been the case in coffee markets where exports continued to increase while prices declined throughout most of the 1990s. There are several reasons for the failure of the supply to adjust to declining price. Chart 3: The Supply Response to Long-term Price Decline (1980-99)

What makes a producer continue producing coffee, even when international prices keep falling, are the relative prices of other cash and food crops. Even when prices decline, coffee production might still be more profitable than cocoa, cotton or maize because producer prices for these commodities might be lower or production costs higher. Relative profitability statistics from Tanzania show that, while profitability of growing coffee declined between 1995-1998, coffee is still more profitable than other crops, in terms of man-day output and relative input to output prices.12 The problem of coffee oversupply is therefore intimately linked with the long-term decline of prices in most export crops produced in developing countries. An aggravating factor is the continuing agricultural protectionism of the United States and European Union, which prohibits profitable diversification in other major food crops and distorts relative prices. Second, even when it becomes more profitable to grow other products, farmers might remain in the coffee sector because it is expensive to switch to another crop.

Comparing International Coffee Prices and World Coffee Exports

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Price volatility also contributes to slowing the supply response to long-term price decline. Because of past price fluctuations, farmers always hope that the prices will increase again. When price on international markets hikes, farmers rush to plant more trees to take advantage of the higher prices. Once the trees are producing, the variable costs of harvesting and processing are relatively low so that it makes sense to keep continuing producing even with lower prices, as long as variable costs are covered. In addition, the land is often unsuitable for other crops. As a result, many farmers will avoid tearing up their long-lived trees (average life span 25 years) in the hope of a future upturn in price. In fact, coffee trees become fixed assets. Third, the response of supply to price decrease is hampered by competitive devaluations: when a country devalues its currency against the dollar (all coffee transactions are made in dollars), the price that producers receive in local currency increases. Competitive devaluations can then guarantee or even increase the domestic price to producers, even when dollar prices on international markets decline. Since producers receive more money, they expand production, which can further depress 12 Agriculture in Tanzania since 1986: follower or leader of growth? IFPRI, November 1999.

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world prices as world supply fails to decrease in response to a declining price. This effect is magnified when a major producer country with a high production capacity undergoes a devaluation of its currency, such as Brazil in 1994. As a result of the financial crisis in Asia, Asian countries have become much more competitive relative to Africa and Latin America because of massive currency devaluation (by as much as 70% for the rupiah/dollar exchange rate). As a result, coffee production costs are now between 50 and 60% lower than those of Africa and Latin America. Their variable costs are also much lower than their competitors, which means that they could survive even lower international prices.

1.1.3. Other explanations to price decline: the role of the international market structure The high level concentration along the coffee supply chain is clearly not to the advantage of producers, who are price takers. Multinationals involved in the coffee sector control an ever-increasing percentage of processing, marketing and retailing. Because they are facing a multitude of small producers in 80 poor countries, multinationals can set the rules of the game. This buyer-driven supply chain means that multinationals capture most of the value-added linked with the production of coffee. Multinationals can put a downward pressure on producer prices by playing one producer against the other or by encouraging new countries or regions to start producing coffee via foreign direct investment. Such an explanation would also help explaining why the gap between producer and retail prices has been increasing over the last two decades. There is empirical evidence that concentration along the supply chain and product differentiation allows manufacturers to be extremely slow and less than generous in passing on international coffee producer price decreases to the consumers.13 As a result of this market structure which produces high coffee consumer prices, world demand for coffee is less than it would be under perfect competition. Given that demand for coffee is fairly inelastic to price changes, a perfectly competitive market would not be sufficient to solve the oversupply problem. Nevertheless, the cost to producer countries of lack of competition along the supply chain is far from negligible. A World Bank study estimates that the cost to developing countries amounts to US$20 billion a year in additional export revenues from coffee (see section 2 for further discussion).14 Under the same assumption, total coffee export revenues would have increased by 50% for El Salvador, 28% for Kenya, 27% for Madagascar and 25% for Colombia.

The reason why retail prices are not closely linked with producer prices is that the high level of concentration in the industry is detrimental to competition in the coffee retail market. The entrance of new firms on the market, necessary to ensure competition (i.e. lower retail prices) is made difficult by the enormous size of the major coffee manufacturers, who enjoy economies of scale. To secure their market share, roasters have also made huge investments in branding and advertising, which shelters them from price competition. In addition, the vast majority of coffee is sold in supermarkets, which makes it easy for supermarket chains not to pass producer price decreases on to consumer prices and increase profit margins (see Section 2 for a more detailed discussion about the major players in the supply chain).

13 Morisset, J. Unfair Trade? Empirical Evidence in World Commodity Markets over the past 25 years, World Bank (1997). 14 Under the assumption that the spread between producer and consumer prices had remained at minimal level registered over the last two decades. See Morisset, J. Unfair Trade? Empirical Evidence in World Commodity Markets over the past 25 years, World Bank (1997).

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1.2. The problem of price volatility: coffee highs, coffee lows The volatility of price on coffee markets is very acute both from year to year (see chart 1) and also on an intra-year basis. For instance, the price tripled in the first six months of 1997 before losing half its value in the next six months. While volatility is partly due to structural factors linked with the production of the coffee crop itself, the recent increase in volatility can only be explained by factors largely unrelated to market fundamentals, such as destabilising speculation on commodity exchanges.

1.2.1. Traditional factors contributing to volatility Coffee price volatility is not a recent phenomenon. Because coffee yields are vulnerable to temperature or precipitation changes as well as disease, the volume of production can vary widely from one year to the other, which causes prices to spike. The vulnerability is enhanced by the relatively high degree of dependence the world coffee supply has on Brazil, which accounts for 20% of all exports. For example, prices reached a record level in 1977 due to inclement weather in Brazil in 1975 and 1976 (see chart 1).

Volatility is also the result of the ‘natural coffee cycle.’ When prices increase, farmers are encouraged to use more inputs and expand planting to take advantage of higher prices. This additional production contributes to depressed prices as supply expands. When prices decline, farmers stop using inputs to reduce production costs, which reduces yields and contributes to price increases. This is exacerbated by the lag between plantation and harvest, which varies between 18 and 24 months. The yield of the coffee tree peaks after 5 to 7 years. While the investment response to price change is very quick, the output response to investment is slow. As a result, the extra supply might arrive on the market when prices are on the decline, magnifying the downturn in the coffee cycle.

Chart 4: Coffee price volatility in 1997

Coffee price volatility in 1997

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1.2.2. Reasons for the recent increase in volatility

It is difficult to pinpoint the exact cause of the short-term volatility of coffee prices, but it seems to have increased over the last two decades as a result of:

1. The development of commodity exchange markets. 2. The failure of international cooperation to stabilise prices. 3. Market deregulation.

Because of the steep increase in commodity trading volumes, ‘the tail now wags the dog’, with paper deals (i.e. futures deals) making up around 80% of the coffee trade, with only 20% based on sales of real coffee. Volatility of price encourages futures trading, which in turn magnifies volatility.

The futures markets help traders to minimise their exposure to the risks of price fluctuations by ‘hedging’: balancing a future purchase or sale in the exchange against an equal and opposite commitment in real coffee. Any changes in price will therefore cancel each other out, and the trader is protected. Exporters also use the commodity exchange system to reduce their exposure to price fluctuation.

A significant portion of paper trade is the result of pure speculation from large commodity funds and individual speculators (see Box 2). Increased communication, computer based trading and rapid information sharing have also contributed to the rise of speculation. A recent initiative is to develop trading over the Internet, which might fuel speculation further and exacerbate volatility.

Box 2: The role of large commodity funds in coffee price volatility There is evidence that increased speculative activity from large commodity funds (major banks, hedge funds, pension funds) increased the level of volatility on coffee markets between 1993-1996. Their investments were not motivated by market fundamentals but by the perceived need to diversify their portfolios outside of traditional financial instruments. Due to their enormous size ($7 trillion dollars for pension funds), their increased participation (up to 25% of total open interest) contributed to an artificial hike in the coffee market, and their departure, a corresponding slide. If speculators are active on both sides of the market (e.g. when the number of speculators buying contracts is roughly equal to those selling), prices will remain relatively stable. However, speculators’ impact on price fluctuation is sometimes magnified by ‘herd’ behaviour. Investment decisions are based on fluctuations in other financial markets and are often automatically executed by computer programmes, which risks herd behaviour and further price volatility. Sources: Christopher Gilbert and Celso Brunetti, Speculations, Hedging and Volatility in the Coffee Market, 1993-1996, Queen Mary and Westfield College, University of London; UNCTAD, New Types of Non-Trade Related Participation in Commodity Futures Markets, 1996. Nevertheless, commodity exchanges do have their advantages, in that they allow market to ‘discover’ an international price reflecting world demand and supply. Because of their size, they are very liquid, which means there are always players ready to buy or sell. This helps exporters and international traders to insure themselves against price fluctuation risks related with changes in world production. Some observers argue that speculator-induced volatility is an occasional occurrence, and not a systemic problem that prevails most of the time. This is because 40 to 70% of transactions are closed on the same day they are initiated, which has no impact on day-to-day prices. But the increased volatility has hurt small producers most, since they do not have access to hedging markets. Volatility leads them to make ill-informed investment decisions based on price movements that are largely unrelated to supply and demand. What is needed is regulatory reforms that find an

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acceptable trade-off between protecting small producers against wild price fluctuations, and at the same time do not choke the market. The failure of international cooperation to stabilise prices has meant failure to curb volatility. The value of coffee plummeted in 1989 when the pricing mechanism of the International Coffee Agreement (ICA) fell apart after disagreements on quotas between producer countries, who flooded the market with coffee by exceeding their quotas and releasing stocks originally held to sustain prices. No new international agreement was subsequently negotiated despite rapidly declining prices. Current producer countries’ efforts to stabilise prices through a decrease of their exports are often counteracted by the non-compliance of other producer countries and massive private stock releases in Northern countries. A new retention scheme was recently approved by the Association of Coffee Producing Countries (ACPC), though it has not succeeded in lifting prices so far (see next section for further details). Market deregulation (see Box 3) has fundamentally changed the market environment as private traders, exporters and multinationals are playing an increasing role in the production, marketing and trade of coffee in producing countries. It is very likely that these changes could further contribute to greater volatility in world prices as the number of market players, often poorly-informed, increases. Box 3: Impact of trade liberalisation and market deregulation Until the 1990s, most producing countries heavily regulated their coffee sectors. The sector was dominated by state-sponsored marketing boards, which were solely in charge of purchasing coffee from producer cooperatives and selling it for export or domestic consumption. Marketing boards also offered a price stabilisation scheme to their producers by fixing the internal price for coffee on a monthly or yearly basis. In years of low prices, many countries, such as Tanzania, sheltered producers by fixing a much higher internal price. While these schemes protected producers from volatility, they also reduced their share of the export price, as national marketing boards were particularly inefficient and export taxes were high. During the 1980s, Ugandan coffee farmers received only 30% of the export price. In addition, the coffee sector was heavily taxed. These taxes were meant to provide additional government revenue, finance the marketing boards and encourage production of food rather than cash crops. In Ethiopia, the formal and informal tax burden was estimated at 40% of the coffee export price, which greatly reduced the share of the price given to the producers. However, marketing boards provided subsidies or credits for the purchase of inputs as well as technical assistance to improve yields. Under pressure from the World Bank and the IMF, most producing countries underwent comprehensive market deregulation. It is worthwhile mentioning that some countries have not completely liberalised their marketing systems such as Tanzania, Kenya and Ethiopia, who have kept a public auction system. Others such as Colombia have not deregulated the market at all. In the countries which underwent deregulation, private traders were allowed on the market, price stabilisation was abandoned and export taxes substantially lowered. This resulted in a significant increase in the average producer prices, as they received a greater share of the export price. In Tanzania, the share of the export price given to producers rose to 70% after liberalisation. On the downside, producers are now extremely vulnerable to price volatility on markets. Many of them have also lost access to inputs as subsidised credit has disappeared and private banks consider lending to small producers too risky. As a result, yields have declined in most African countries, undermining the initial benefits of liberalisation for farmers’ income. Another problem is that quality of production has decreased because of the dismantling of quality monitoring systems previously managed by marketing boards.

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Lower quality has discounted the international price of coffee exports of many countries (Haiti for example), thereby reducing producer prices further. Source: FAO Agricultural Services Bulletin 135, 2000, ‘Export crop liberalisation in Africa’. 1.3. The impact of coffee price volatility and decline on small producers and governments Low and unstable coffee prices result in serious financial hardship for farmers and their families, as well as plantation workers. They also contribute to worsening the macroeconomic performance of countries dependent on coffee for foreign exchange earnings and government revenue.

1.3.1. Small producers There are 10 million small coffee producers around the world, who produce roughly 70% of world coffee production, on farms smaller than 25 acres (see table 1 for details). The vast majority of these smallholders grow coffee on farms between 1 to 5 hectares. Many of these farmers intercrop coffee trees with cash crops such as bananas, and food crops for subsistence (such as maize). Table 1: Production structure of coffee

Production Structure of Coffee (estimate) Smallholders (less than 10 ha) 70% Medium size (10-50 ha) 15% Plantations (>50 ha) 15%

Source: SOMO/Food World R&C, Controlling the Supply Chain, 2000.

As shown in box 1, small farmers are now exposed to price risks that were previously absorbed by the government. In periods of low prices, such as 2000, international prices can fall below production costs. The current prices for Robusta and Arabica are 33 US cents and 64 cents per pound respectively, and farmers are getting only 50 to 70% of these international prices because of marketing costs.15 These prices are close to or below production costs in many countries (see Table 2). As a result of low prices, small producers cannot earn a decent living. The impoverishment of small coffee farmers and their families (about 25 million in total) worsens the already high incidence of poverty in rural areas. Under current prices and market conditions, a small Arabica farmer from the Dominican Republic with a two hectare farm (5 acres) would make only US$130 a year (36 cents a day) after his costs have been met.16 A higher price, on the contrary, could help these families to stay out of poverty and provide employment opportunities for farm workers as well. If the same small producer in the Dominican Republic was paid a ‘fair trade’ price for his crop (currently $1.26/lb), he would receive instead $950 dollars annually, or $2.60 a day.

15 ICO statistics, international prices for December 21st. Discount or premiums are not included, which understates price for high-quality coffee and overstates it for poor quality. 16 Based upon a production of 1320 lb of coffee (5 bags/ha), producer prices of 64 cents /lb (i.e. 100% of Other Mild Arabica New York price) and production costs of 54 cents/lb.

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Table 2: Comparison of Coffee Production Costs (1987/89, US cents per lb)17

Countries Arabica

Robusta

Brazil 0.55 n/a Cameroon 0.67 0.88 Colombia 0.73 n/a Costa Rica 0.64 n/a Dominican Rep. 0.54 n/a Ecuador 0.66 n/a El Salvador 0.58 n/a Ethiopia 0.44 n/a Guatemala 0.73 n/a Honduras 0.67 n/a India 0.64 0.79 Indonesia 0.47 0.69 Ivory Coast n/a 1.12 Kenya 0.96 n/a Mexico 0.76 n/a New Guinea 0.68 n/a Nicaragua 0.65 n/a Philippines n/a 0.84 Tanzania 0.68 0.89 Uganda 0.49 0.61 Zaire 0.8 0.84 Source: Landel Mills Commodities Survey, A World Survey of Coffee Bean Production Costs, 1990.

To cope with low or negative revenues from coffee, farmers sell cattle or food crops (originally meant for the family’s own consumption), work on plantations as casual labourers or gather firewood to produce charcoal for instance. But despite these additional efforts, they usually fall further into debt, fail to pay school fees for their children or even have to cut food consumption. ‘My son Isaiah (aged nine) will have to stay at home because I could not get enough for the coffee. Just to keep the other two in school I will have to sell my pig.’ Tatu Museyni, a 37-year old widow living with six children on a coffee farm in the Kilimanjaro region.18 Some farmers abandon coffee production and turn to food crops, which provide a lower but more stable income. Some produce illegal crops, such as cocaine, or engage in coffee smuggling to evade taxes on coffee. Unable to pay debt payments, others even lose their farm and have to migrate to cities in hope for a better life. Falling coffee prices also have adverse consequences on the livelihood of rural workers, who work as coffee pickers in plantations or in processing factories.

17 Unfortunately, there is no more recent data that is on coffee production costs that is publicly available. 18 Based on household interviews conducted by Maarifa/OXFAM GB in the Kilimanjaro region (Moshi-rural and Hai districts) at the beginning of December 2000.

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‘There won’t be much work this year because of a bad harvest and low coffee prices. This is very bad for me because I have no other way to make money.’ Eulogi Njau, a small farmer in the Kilimanjaro region, who works as a casual laborer on coffee plantations to complement his declining income from coffee production.19 Faced with declining prices, producers want to reduce labour costs, which amount to 70% of total production costs as coffee production is labour intensive. As they do so, rural unemployment rises, wages decline and working conditions worsen (see Box 4).

Box 4: Working conditions on plantations 30% of the world’s coffee comes from medium size farms (10-50 ha) and big plantations (larger than 50 ha). The plight of the many labourers working on these plantations is often forgotten. Countries with major plantations are Brazil, Guatemala, India, Kenya and Viet Nam. Other countries with large farms are El Salvador, Zimbabwe, Tanzania, Indonesia and Papua New Guinea. Although some producer countries maintain decent labour standards in the coffee sector, this is not always the case. Working conditions on plantations can be very poor and the use of child labour common. In the case of Kenya, 30% of the coffee pickers are below 15 years of age. Guatemala is a case in point. 3,000 plantations account for roughly 80% of the country’s production with the remaining 15% coming from 30,000 small producers (with farms of less than 2 ha). The workers on the plantation often live and work in extremely poor conditions. This is not for want of regulation: Guatemala has a comprehensive codigo de trabajo – the problem is that it is not implemented. The Fair Trade Organisatie recently carried out a study of working conditions on these plantations and came up with some disturbing results. They studied 33 plantations and found none paid the minimum wage, the majority did not even pay half the minimum wage and some paid a little as 13% of the wage. According to the Central Guatemalan Statistical Office the minimum wage is seen as covering only 40% of basic needs.20 Working days of 10-12 hours are the rule, not the exception and discrimination against women was widespread – in some plantations they are paid half as much as the men. Child labour from as young as aged 6 is prevalent and housing and sanitation arrangements are very basic. The situation is worst for seasonal workers who are unable to bargain collectively for their rights as their job security is already extremely fragile. The report sees four main reasons causing this problem; a low level of unionisation, a feudal mentality, corruption (in the lack of implementation of the labour laws) and high unemployment. An interesting point is that the wages and treatment of coffee pickers in Chiapas, Mexico is much better, showing that plantations in Guatemala could raise their labour standards without losing their competitiveness. NGOs21 are currently developing proposals for codes of conduct in the coffee sector (For a more detailed discussion of ethical trade, which seeks to improve working conditions on plantations, please refer to annex). The code of conduct would also apply to traders, exporters and roasters, who, due to vertical integration, are moving closer to the origins and control a higher percentage of the supply chain. As a result, they could easily track where the coffee comes from and how it has been produced. Source: Bart Ensing, ‘The viability of a code of conduct in the coffee sector in Guatemala’, Fair Trade Organizatie July 2000.

19 Ibid. 20 Central Guatemalan Statistical Office. 21 Such as the Working Group on a Code of Conduct in the Coffee Sector, which includes major Dutch NGOs.

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In addition to the long-term decline in prices, farmers face a high risk of price fluctuations between the beginning of the coffee season and harvest time. Price uncertainty has major consequences for individual farmers’ welfare. Because particularly poor farmers are usually averse to taking risks (due to their lack of assets and savings), they tend to avoid making investment decisions that could turn out to be loss-making in the event of a price fall. This results in lower-than-optimal investments and sets in place the cycle of poverty. A further problem is that because farmers don’t know if their crops will be profitable, they often grow food crops for their own consumption as a guarantee against price volatility. But inter-cropping limits their capacity to specialise and profit from economies of scale derived from larger production of coffee to increase their income. Because of risk, farmers are also unable to invest in processing or storage, which reduces their production as well as their capacity to generate higher profits. Finally, price volatility reduces their capacity to use crop as collateral to get access to credit.

1.3.2. Governments Long-term commodity price decline and volatility affects governments by undermining their capacity to undertake vital public investments on social and economic infrastructure, efforts at domestic policy reform, debt restructuring and external resource mobilisation. Of the eleven countries in this study, two rely on coffee for more than 50% of their export revenue (Ethiopia and Uganda) and three depend on coffee for more than 20% of their revenue (El Salvador, Guatemala and Honduras).22 (See chart 5). While the general level of export tariffs has fallen, many countries such as Ethiopia and Honduras still rely on coffee export taxes for a significant proportion of government revenue. In other countries, such as Tanzania, taxes on coffee have been shifted closer to the farm gate rather than disappeared. Local taxes on coffee, which represent around 20% of the local auction price, provide a substantial part of local tax revenues. Other governments are affected more indirectly when lower prices depress economic activity and subsequent government revenue.

Price declines have caused a huge loss of income for producer countries. Despite the fact that the volume of exports has increased by over 30%, the 50 or so developing countries which export green coffee receive fewer export revenues today than they did in 1980 (in nominal terms and even more so in real terms). 23 If international prices had remained stable at their 1980 level, producer countries would have received almost $4.5 billion annually in additional export revenues between 1980 and 2000, or $67 billion in total (a figure which represents more than 20% of total development assistance).24 For the last three year alone, since 1997, the price slump has cost developing countries that export coffee around $10bn. These extra funds could have enabled producer countries to avoid further rural poverty, indebtedness as well as dependence on aid and debt relief.

To pick a particular country, Uganda would have received an additional $260 million in export revenues every year between 1980 and 2000 (which represents around 60% of annual total exports and development assistance). The cumulative loss suffered by Uganda since the mid-1990s is equivalent to half of the debt relief that the country will receive under the Heavily Indebted Poor Countries Initiative.25 22 ICO Statistics (www.ico.org/markinf.htms). 23 FAO Statistical Database (www.apps.fao.org). 24 See footnote 4 for references. 25 Calculations based on the difference between export revenues had the 1997 price remained constant and actual export revenues.

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Higher coffee prices could have contributed to lift thousands of families out of poverty. A typical small Robusta farmer in Uganda would have received 70% on average for his coffee. This would have made a huge difference for the 500,000 small farmers producing coffee in a country where 50% of the rural population is poor. Chart 5: Developing countries’ dependency on coffee

0

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Dependency on primary commodities and coffee

Primary commodities

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1.4. Policy Responses In this section, we discuss policy changes needed to shelter producers from high price volatility and halt the decline in international coffee prices. In the case of volatility, this section analyses the usefulness of price insurance schemes and proposes to complement this approach with more drastic measures, such as regulations designed to limit speculation on commodity exchanges. In terms of the long price decline, the benefits of stronger supply and production management to halt the decline of prices in the short-to-medium term are explored. Diversification and sustainable production methods are also discussed as longer-term solutions to the imbalance between world supply and demand.

1.4.1. Producer price stabilisation and insurance schemes

These schemes attempt to shelter producers from international price volatility instead of trying to reduce international price volatility directly.

Except in Colombia, where the National Coffee Fund still limits producer price volatility by fixing the internal price for coffee, national price stabilisation programmes have been abandoned in almost all producing countries. When crop liberalisation programmes were put in place by governments pressured by the World Bank and the IMF, no other mechanism was created to protect farmers though it was clear that these reforms would leave them without any protection in countries. Counting on private players to offer price insurance was unrealistic as financial and insurance markets are clearly underdeveloped in most producing countries. It is worthwhile mentioning that both the United States and the European Union do not leave it to the market to provide farmers with protection against price volatility. European Union governments stabilise producer prices through the Common Agricultural Policy. The United States provides subsidies for crop revenue insurance, which covers them against price decline and crop loss due to bad weather. No one is arguing in favour of replicating these costly schemes in producer countries. But the central role of government in agricultural production and marketing suggests that it is not realistic to expect poor farmers from the developing world to deal with price volatility while farmers in OECD countries with much higher incomes, access to credit and markets, cannot do it without public intervention.

Widening small farmer access to price insurance: the World Bank initiative

To fill in this vacuum created by ill-planned liberalisation reforms, an International Taskforce on Commodity Risk Management led by the World Bank (ITF) has just launched an initiative focused on widening the access of small farmers to price insurance products available on financial markets to protect them from price volatility. Greater access to financial market risk management schemes would enable farmers to shelter themselves from price volatility at a lower cost and more efficiently than with traditional risk coping methods (such as inter-cropping or informal credit). But they are many obstacles to extending access to small producers: - Cost: Small farmers might not be able or willing to pay for the premium (i.e. crop insurance or option). The World Bank initiative only allows the farmer to secure a price for the future that is based on market price levels prevailing at the time the insurance is purchased. So a grower wishing to secure the market price for coffee in, say, February 2000, to sell in September 2000, would have to pay an insurance premium equivalent to more than 10% of his total proceeds from coffee. This

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represents a significant proportion of the grower’s final income for insuring prices over 8 months only.26 - Volumes involved: To limit transaction costs, insurance and financial market instruments always involve large volumes of commodity, which is much higher than the production volume of small producers. For instance, small producers in Guatemala produce less than 3,000 lbs, while the lot size of contract futures in New York is 37,500lbs. - Risk: providers of risk management instruments (local traders, exporters, and international commodity exchanges) are vulnerable to several types of risk.27 Therefore, providers are unlikely to sell instruments to small producers or to producers in the poorest countries or at a very high price. - Political obstacles: farmers might not have information about these instruments and might not be willing to use them. In Africa, cooperatives, which would be natural intermediaries for linking the farmers to financial markets, often impose further taxes on farmers and therefore have a bad reputation. To ensure wider access to small producers, the World Bank proposes to create an international organization to help mediate the gap between providers of risk management instruments and interested entities in developing countries (such as large farmers and producer cooperatives, commodity traders and processors, local rural banks and public bodies). The intermediation agency would provide partial guarantees (notably against sovereign risk) to encourage market offer of price insurance to small farmers, provide price insurance directly (in the absence of market supply) and provide core services and technical assistance. While generally working on a commercial basis, the agency would have a separate budget (fueled by aid resources) to help the poorest producers pay for the premium of price insurance. But this approach has serious limitations. None of these measures would protect farmers against long-term price risk as they have a maturity of between 1 to 12 months and, in exceptional cases, up to 24 months. In addition, in periods of very low prices, these instruments might provide a price floor that is still below production costs. While such schemes would help stabilise the level of farmers’ income, the level at which it would be stabilised would be still insufficient to prevent further indebtedness and impoverishment. Unless they are complemented by production risk instruments, these instrument do not provide income protection, since the farmer is still vulnerable to a catastrophic decline in production volume. Finally, there is a possibility, albeit limited, that these instruments could worsen chronic oversupply. This is because farmers would have a secure floor price and wider access to credit, and might be tempted to invest to increase yields or plantation area to take advantage of potentially higher prices at harvest time. Finally, the implementation of the World Bank proposal requires significant capacity building in producing countries to make sure that small farmers gain access to price insurance. Too often, these instruments never reach the intended targets. At an international level, it is crucial to choose a proper institutional home for the proposed organisation that guarantees efficiency, solvency and sense of ‘ownership’ by developing countries. At national level, efficient, transparent and accountable financial intermediaries have to be found, which might prove difficult especially in the poorest producer countries. For instance, one of the pre-identified candidates by the World Bank in Tanzania, Kilimanjaro Native Cooperative Union, appears to be widely discredited among small farmers for lack of transparency in the management of its funds.

26 A new approach to Commodity Price Risk Management? Wheeler, 2000. 27 Such as commercial risk (default of counterparty due to insolvency), basis risk (change in the relationship between local and international price due to location, quality, storage, transportation and processing costs), Country risk (country-specific risk such as government policy change—e.g. export bans or weak legal infrastructure to resolve contract disputes) and events risk (default due to natural or man-made disaster).

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Though welcome after years of inaction in the international community, the commodity risk management initiative launched by the World Bank in 1999 is not likely to make much difference to the livelihoods of small producers unless a solution is found to the problem of oversupply. Enabling farmers to secure a floor price via insurance will only lock them into poverty if international coffee prices remain at current levels.

1.4.2. Regulatory changes to limit speculation on commodity exchanges Since there is a clear link between the activities of commodity exchanges and increase in price volatility, limitations on speculative transactions could be explored as a complementary approach to the ITF proposal. Funds for subsidising price insurance premiums could be raised by a fee on transactions in the commodity exchanges. A transaction fee (similar to those already in place to finance the management of LIFFE, the London commodity exchange) would make it less profitable to enter the market for purely speculative reasons. But such a fee needs to be carefully designed to avoid reducing liquidity on the coffee markets, as there is still a need in these markets for price discovery and for hedging against volatility caused by weather and crop disease. Too high taxation might also stimulate the development of off-shore centres refusing to abide by these rules, and replacing London and New York as commodity exchanges. Less distorting measures could be introduced such as limitations on speculative positions and an increase in marginal requirements (which would limit destabilising speculation from large commodity funds and individual speculators).

1.4.3. Supply management schemes

Supply management schemes differ from the instruments described above because they attempt to reduce the world supply of coffee by reducing exports and retaining production in stocks. Their usual objective is to reduce volatility by smoothing the flow of exports through building and release of stocks. But they can also have more ambitious long-term objectives, such as permanently reducing world supply to raise prices on international markets.

The most ambitious programme in this area has been the International Coffee Agreement (ICA), negotiated in 1962 under the auspices of the UN to secure cooperation between producing and consuming countries, balance supply and demand, maintain fair prices and encourage coffee consumption.28 Between 1963 and 1989, 24 import and 44 export countries cooperated through the ICO to stabilise the price through export quotas and buffer stocks. However, the economic clause of the agreement, which gave rise to the export quotas, was suspended in 1989 after disagreements between member countries over quota levels. The subsequent release of withheld stocks flooded the market and largely undermined the price of coffee (as can be seen in chart 1).

A violent drop in prices and a general lack of confidence followed the suspension of the International Coffee Agreement in 1989. The Association of Coffee Producing Countries (ACPC) was formed in this vacuum in September 1993. The 29 member countries29 immediately agreed to implement a coffee retention plan to try and halt the precipitous decline in prices.

28 ICO website: www.ico.org/index.htm 29 ACPC member countries: Angola, Bolivia, Brazil, Burundi, Cameroon, Central African Republic, Colombia, Congo, Costa Rica, Cote d’Ivoire, Democratic Republic of Congo, Ecuador, El Salvador, Ethiopia, Gabon, Ghana, Guatemala, Honduras, India, Indonesia, Kenya, Madagascar, Nicaragua, Nigeria, Rwanda, Tanzania, Togo, Uganda, Viet Nam.

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The ACPC’s aim is to try to balance world supply and demand to stabilise coffee prices at a level that is fair to producers, yet consistent with increasing consumption. At the beginning of October 2000, as prices reached new lows, the ACPC members started to implement a new coffee retention plan. Signatories agreed to retain 20% of their stock when the price was below 95 cents/lb, to not add to stocks between a price of 95 to 105 cents and to release stocks thereafter. Countries producing less than ½ million bags annually are exempt from this scheme but are asked to inform the ACPC of the volume of their exports each month. For the first time, India, Indonesia and Viet Nam agreed to participate, which significantly increases chances of success.

A limitation of this agreement is that it is difficult to ensure compliance if consumer countries do not participate in the schemes by requiring certificates of origin for all coffee imports entering their markets. To resolve this issue, the ACPC has hired an international consulting firm, which will monitor practices in all participating countries. Despite this safeguard, the high cost of the scheme makes it unlikely that all countries will fully implement the scheme. A major international trader, Louis Dreyfus, has offered financing to countries such as Guatemala and Viet Nam to help pay for the stocks required by the scheme. As of December 2000, the ACPC agreement has failed to raise prices due to a combination of high stocks in consumer countries and unsatisfactory implementation by producer countries. Difficulties caused various rumours of an upcoming collapse, with the potential withdrawal of Brazil and Colombia. Nevertheless, the government of Viet Nam confirmed its plan to stop signing export contracts of coffee until further notice, in an effort to stop the Robusta price decline on world markets.30 The other major difficulty lies in the fact that the current retention scheme can only marginally increase the international price, thereby limiting benefits to the smallest producers. Any attempt to sharply increase international prices would lead to massive accumulation of stocks as individual farmers would increase production capacity to take advantage of higher prices. In addition, the accumulation of stocks is costly and cannot be unlimited in time, unless some of the stocks are physically destroyed. Sharp price increase would also contribute to decrease demand, especially in new markets.

Finally, the size of speculation on international markets places additional hurdles. Speculators accumulate stocks in low price periods to sell them as soon as the price increases enough. For example, US speculators released massive stocks of coffee in 1994-95, causing a collapse of the international price, countering supply control efforts from the ACPC. One way to resolve these issues is the adoption of production management strategies among producer countries. Production has to decline in the medium-term for a retention plan to be effective and sustainable. In the interim, it might be necessary to destroy coffee stocks so that they cannot put a downward pressure on prices. But such a plan requires close cooperation and trust among producer countries. As importantly, it demands strong monitoring regulatory bodies in producer countries to discourage new plantation, encourage higher quality crop, diversification and more sustainable methods of production. However, such schemes are politically sensitive in many countries – especially Brazil, where massive destruction of stocks following the world economic crisis of 1929 failed to prop up prices. Nevertheless, in November 2000, coffee officials from Mexico and five Central American countries have discussed the option of removing one million bags from the world market, possibly through means of destruction.

Another prerequisite for real success of supply and production management is the participation of consumer countries and major private players in these schemes. International institutions such as the

30 Bridge News Daily World Coffee Update, December 2000.

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IMF and World Bank could also provide much needed financial support, through sector loans as well as debt relief.

1.4.4. Diversification

Diversification out of the coffee sector is an essential component to a long-term solution to oversupply. By reducing production, diversification out of coffee production would ensure higher producer prices and allow farmers to earn a decent income. Some countries have successfully developed other activities such as non-agricultural commodities or light infrastructure. For instance, Colombia’s dependence on coffee exports has significantly decreased over the past decade due to the development of the oil industry. But many producing countries do not have non-agricultural commodities to diversify into or have only limited industrialisation prospects, at least in the short-run due to a lack of human capital and access to technology. Therefore, diversification within the agricultural sector itself needs to be achieved, especially in the Least Developed Countries. Sustainable sources of employment have to be found in this sector to reduce the higher incidence of poverty in rural areas and prevent further urbanisation. An example of this comes from Kenya during the early 1990s, where a diversification programme to increase production of fruit, vegetables and flowers met with considerable success. But successful agricultural diversification out of the coffee sector faces various hurdles. First of all, it is not always possible to grow these other crops in place of coffee because of weather, soil and altitude factors. But more importantly, diversification must be profitable to the farmer, which means that the profitability of switching coffee production to another crop must be higher than the profitability of coffee. The problem is that most cash crops face a long-term decline in prices similar to coffee. In addition, diversification has high transition costs as producers have to tear down coffee trees, plant other crops and learn production techniques.31

A diversification fund, financed by compulsory contributions from producing countries, was established in 1968 under the auspices of the ICO. Before the fund’s liquidation in 1973, US$ 72 million were committed to about 30 projects. Another US$ 30 million were made available to the ICO for diversification projects via the Common Fund for Commodities, established under the auspices of UNCTAD. However, none of these initiatives are big enough to make a difference in coffee production patterns.

Diversification of agricultural production has continued in various countries in an uncoordinated fashion. For instance, coca producers are encouraged by the European Union and the United States to grow coffee via subsidies and tariff exemptions, which is clearly ineffective in the long run as coffee production is not as profitable as coca. Moreover, it feeds into world coffee oversupply, hurting all producers in the process. In other cases, diversification out of coffee transfers surplus situations in other commodity markets, such as cocoa or spices. In the process, other small producers are hurt. These experiences clearly establish the need for a common diversification strategy and the coordinated financing of projects between producing countries and donors, as well as better information and economic analysis of the different sectors. Agricultural research also needs to advance to widen the range of crops that can be grown on tropical soils, as well as alternative uses for coffee and other export crops. One of the most important hurdles to successful diversification is the trade and non-trade barriers remaining on major food crops produced in the United States and the European Union. As a result, developing countries can only grow crops that cannot be produced in Northern countries and are

31 Wyeth, J. (1989) Diversification: eight lessons from Honduran experience in the coffee sector; IDS Discussion Paper.

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effectively shut out of the production of maize, wheat and rice and other essential food crops. Even worse, food crop producers often face stiff competition on their domestic markets because of cheap food imports from OECD countries. This continued protectionism contributes to impoverishment of small producers, stalled economic development in developing countries and dependence on aid.

1.4.5. Product differentiation As Brazil and Viet Nam move towards marketing lower grade Robustas as a bulk commodity, it makes sense that other countries should concentrate on marketing higher quality varieties to differentiate their products and reduce direct competition with the coffee giants. Moreover, the ‘specialty’ coffee market is in full expansion, as showed by the rise of Starbucks and Costa coffee bar chains, providing market demand for high-quality and differentiated gourmet coffees. Colombia’s Federacion Nacional de Cafeteros (FNC), a non-profit organisation owned and controlled by Colombia’s 500,000 coffee farmers, has developed a programme to maintain minimum standards for Colombian coffee exports in order to promote a quality that is distinct from other origins. In addition, global advertising campaigns (‘Juan Valdez’ and ‘100% Colombian coffee’ campaigns) were launched to create consumer recognition and demand for coffee of Colombian origin. As a result, Colombian coffee sells at a significant price premium on the international market, which, according to FNC literature, provides a higher standard of living for small producers. Colombia was the first to promote an origin as opposed to a brand, and its marketing strategies have led to opportunities outside traditional commercial segments, including speciality coffee, freeze-dried and liquid extract products. Another success story is that of the Blue Mountain Coffee of Jamaica, one of the most expensive coffees in the world due to effective marketing strategies and tight quality controls. Unfortunately, very few producing countries have followed such strategies. Instead of seeing coffee as a strategic sector for raising incomes in rural areas, many countries have rushed into developing massive production capacities of low quality coffee in the hope of increasing their export revenues. But most countries have shot themselves in the foot as total export revenues from developing countries have shrunk over the last two decades rather than increased. Similarly, few countries have developed effective sector-wide strategies to maintain high quality exports, most of the policies focusing on raising government revenues by taxing coffee production as well as other cash crops. Providing a recent example of these misguided policies, the New President of Ivory Coast has just announced his plan to finance universal heath insurance through taxation of cocoa, coffee and other agricultural commodities, at a time of historically low international prices—both in the cocoa and coffee sectors.

1.4.6. Sustainable Production The increase in the volume of world coffee production and the use of more intensive methods can have adverse consequences on the environment (see box 5 below). It can also lead to oversupply and the disappearance of smallholders, who find it hard to compete with plantations which have higher yields, younger trees, and better access to credit, inputs and more efficient production technologies. Box 5: Coffee and the environment The massive increase in world production registered since the 1950s has adversely affected the environment in many producing countries through soil degradation, water contamination and deforestation, as producers abandoned traditional methods and turned to input intensive techniques. For instance, wet processing, which increases the quality of coffee, can be environmentally damaging

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through the use of large quantities of water to ferment and wash the cherries, which is then released into the natural environment. Given the low prices and their volatility, very few producers can afford investing in cleaner methods to produce coffee (which costs at least US$1,000). Traditionally, farmers have used non-coffee tree species for shade under which to grow coffee. This means that coffee has been a factor in limiting deforestation (such as Haiti and Mexico) and erosion on steep slopes (in the Kilimanjaro region for instance). Shaded coffee also helps maintain biodiversity by protecting migratory birds and other species. This being said, almost all varieties of coffee can be grown without shade, provided a strict management and fertiliser regime is followed. But these techniques have negative effects for the environment, as the run off from increased use of fertilisers, insecticides and herbicides pollutes water sources, causing greater damage than ‘traditional’ practices. Organizations such as Conservation International are trying to encourage and support the continuation of shade grown coffee in Mexico where a nearly all coffee is shade grown – for the time being. However, when coffee prices are as low as they are now, producers start tearing down trees, to replace them with food crops, for instance, thereby worsening the already acute problem of forest disappearance. Ironically, sluggish coffee prices and high production costs among smallholders have contributed to protecting the environment. Many farmers stop using fertilisers and fungicides when prices are low, which reduces environmental problems and also ensures organic or semi-organic production. But farmers rarely see direct benefits from producing organic coffee, since the cost of obtaining an organic coffee production label is prohibitive for most small farmers’ associations. To ensure a long-term balance between supply and demand and protect the environment, methods of production that foster environmental conservation and higher bean quality must be encouraged. This is especially true in countries where higher and more intensive coffee production leads to environmental degradation because of deforestation and water pollution. Sustainable production is also desirable because it is best done at a smaller farm scale (rather than plantations). Finally it responds to greater demand for organic and higher quality coffee. Sustainable production requires incentives towards environmentally sound techniques as well as a higher premium for quality products on local and world markets.

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SECTION 2: PRODUCTION, PROCESSING AND MARKETING ARRANGEMENTS This section analyses how the coffee supply chain is buyer-driven, not producer driven. This means that retailers and roasters set the rules of the game, not small coffee farmers, who receive only a very small share of retail prices. This section also explores the different policy responses that would change the balance of power between producers and intermediaries and help farmers capture a higher share of the retail price for coffee. Policy responses identified in this section include mainstreaming fair trade practices, developing in-country processing and strengthening of producers’ associations. 2.1. Capturing value along the supply chain After presenting a brief overview of the supply chain, this section attempts to study in more detail the different stages and players along the supply chain, starting from farmers and finishing with retailers.

2.1.1. A brief overview Because of the way the international coffee supply chain works, the link between producers and consumers is lost. Coffee is traded down a complex line of intermediaries, ranging from local traders, exporters, international traders, roasters and retailers, who each capture a percentage of the retail value of coffee (See Chart 6). Most of the retail value of coffee is captured during the second stage of processing, which occurs outside of the producing countries. In fact, less than 30% of the $43 billion generated by world coffee sales remains in coffee producing countries.32 The remaining 70% is shared among multinational companies who control most of the international coffee supply chain. Analysing why these intermediaries capture the lion’s share of profits is critical to understand what can be done to help farmers capture a higher share of retail prices. While it changes hands, coffee undergoes a complex transformation, which can be summarised as follows: First stage: processing from the farm to the point of export: - Arabica beans are normally processed using the wet method, where, after removing the outer

flesh, cherries are left to ferment on the farm and the bean is sun dried to lower its moisture content. The farmer then sells the bean encased in a light skin or parchment (hence parchment coffee) to a private trader. The local trader transports coffee to a curing factory, where the parchment is removed and the beans are sorted. Afterwards exporters take care of grading, packaging and transporting up to the port where coffee is exported.

- Robusta beans, on the other hand, are generally processed by a more straightforward method. The picked cherries are sun dried for several days before being sold to a processing plant which removes the casing with a mechanical mill before sorting, grading and packaging the beans for export.

32 Calculation based upon total value of coffee exports from developing countries and compared with total value of world coffee sales (MTI/ICO.1998. International Coffee File).

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Second stage: processing from the import point up to the supermarket shelf: - Roast and Ground Coffee: Coffee beans are roasted, and mixed with other varieties and country

origins to produce a blend that fits consumer preferences. Afterwards, roasted beans are ground, packaged and transported up to the retailing point (usually supermarket shelves or coffee bars).

- Soluble Coffee: Roast and ground coffee is further processed to produce soluble coffee through a elaborate process of extraction, drying, agglomeration and aromatisation. Afterwards soluble coffee is packaged and transported up to the retailing point.

Source: Adapted from the Economist Intelligence Unit, Coffee to 2000.

Indicative Value Chain from Farm Gate to Supermarket Shelf

(% value captured)**

20%

11%

6%2%8%

2%

30%

15%

7%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%VAT

retailer (excl.VAT)

roaster

import duty

internationaltrader

export tax

exporter

local trader

farmer

Export point

Import point

Farm gate

Supermarket Shelf

** The percentages along the supply chain are derived from the indicative data gathered by EIU and seem to roughly represent what happens in reality, keeping in mind that percentages, at least up to the export point, might vary significantly from country to country, depending on taxation, regulations and market conditions.

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2.1.2. From the coffee farm to the export point Farmers According to EIU estimates (see chart 6), small farmers receive in average around 20% of the retail price of coffee. But in fact, specific examples seem to indicate that many small farmers receive a much lower share of the retail price. In Tanzania, small farmers from the Kilimanjaro region interviewed in December 2000 reported that the farm-gate price for parchment coffee was around 28 US cents per pound. This represents only around 9% of the average retail price of roast and ground coffee in the US and around 4% of the retail price of gourmet ‘Kilimanjaro’ coffee. 33 To provide another example, Arabica producers in Rwanda got only 9% of the retail price of German Roast Ground Coffee in 1999.34 Even worse, Robusta producers of the Central African Republic received only 6% of the retail price of soluble coffee sold in the US.35 One reason why farmers get such a small percentage of the retail price is due to the fact that they receive a low share of the export price of green coffee beans. This price, which is set on commodity exchanges is shared among farmers, local traders, exporters and governments (via taxation). In general, small farmers are likely to get a rough deal because they have little power over private intermediaries, cooperatives and governments, especially in a context of world-wide coffee oversupply. Small farmers rarely have a choice regarding the timing of his sales or the identity of the buyer. As a result, it is estimated that farmers only receive between 50 and 70% of the export price of coffee. But this does not mean that all small farmers get a similar deal, depending on their country of origin. For instance, while farmers might 35% of the export price in Kenya, they can get up to 85% of the export price in Uganda. How much farmers receive for their coffee mainly depends on the role of local traders and exporters, marketing costs and processing capacities at farm level. Local Traders and exporters Following liberalisation of the coffee sector in most producing countries, most of the green coffee is bought from farmers by private traders and exporters, the remaining part being bought by cooperatives. These intermediaries provide an important service to coffee markets, by buying from different farmers and remote regions, as well as processing and transporting coffee in quantities big enough to be exported and bought by international traders. Where private markets are functioning relatively well (such as in Uganda), marketing costs and margins kept by local traders and exporters are limited. But unfortunately, this is not always the case because of the financial vulnerability of poor farmers and a lack of competition among intermediaries.

33 Figures calculated under the assumption that 1.25 kg green beans yield 1kg of ground coffee, and that the retail price excludes VAT. 34 Figures derived from ICO, Coffee Statistics, December 1999 and LMC, Coffee Newsletter, July 2000, under same assumptions as 34. 35 Figures derived from ICO, Coffee Statistics, December 1999 and LMC, Coffee Newsletter, July 2000, under the assumption that 2.3 kg green beans yield 1 kg of soluble coffee, and that the retail price excludes VAT.

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For instance, in remote areas, local traders often are the only market players and can exploit their oligopsony.36 One anecdote tells of an Indonesian farmer who tried to take his coffee to the local town to sell at a higher price, thereby bypassing the local trader in his village. However, the traders were communicating by mobile phone and all offered the original price. As retaliation, they refused to purchase coffee from this farmer altogether. 37 Small farmers, contrary to plantations, are rarely able to by-pass these intermediaries as they do not have basic processing or transportation facilities. In addition, small producers do not have good access to international price information in many countries, which enables local traders to take a bigger margin by offering them a very low price. Finally, farmers cannot chose the timing of their sale as they lack access to credit or warehousing facilities, and often have to sell their harvest in advance to cover immediate expenses. To give a concrete example, producer prices in Cameroon for the 1999 campaign varied by 30% depending on the region and fluctuated by 36% over a four-month period.38 But small farmers cannot afford to store or transport their coffee to another place, which drastically limits their ability to take advantage of market opportunities. The lack of competition at the intermediary level is often caused by inadequate market regulations (such as trading licenses, which limit entry of new players). Another cause is the growing vertical integration of the coffee supply chain, which limits the number of global market players. In many places, local traders and exporters are subsidiaries of the international traders who have extended their operations (and profit margins) outside their traditional boundaries. Independent exporters find it difficult to compete with multinationals because they do not have access to cheap financing, contrary to international players. Ultimately, this threatens competition at country level, if the exporting sector is dominated by only one or two multinationals. Marketing costs High marketing costs (in-country transportation, processing and taxation) reduces the share captured by farmers. Farmers living in coffee producing regions far away from any export point, for instance in big and landlocked countries, are bound to receive a lower price than farmers close to a sea port. Processing costs mainly depend on the number of processing factories (pulperies and curing factories), whether they are private or public and competitive with each other. Processing costs are usually fairly limited since parchment coffee is produced by farmers themselves (see next paragraph). Taxation can represent a significant part of marketing costs. While most countries have abandoned export taxes, a multitude of other taxes, often at local level, place a heavy burden on farmers by reducing the farm-gate price offered by private traders. In Tanzania for instance, it is estimated that 20% of the field buying cost is due to local taxation, whose revenues rarely seem to benefit the coffee-growing communities themselves. Processing capacities at farm level The price captured by the farmer also depends on how much processing is done at a local level. Most farmers produce parchment coffee because it yields a price five times as high as fresh coffee berries. This requires them to wash, pulp and dry coffee on their farms, work usually performed by women and children. But very few small farmers have the required skills and equipment to process quality parchment coffee, which reduces the price they can get from private traders and can also hurt the overall quality of a country’s production (see section below on country differentials for further details).

36 Oligopsony refers to a limited group of buyers who can exercise power over suppliers. 37 FairTrade Foundation, ‘Spilling the Beans’. 38 CICC Info, Le Magazine des Planteurs du Cacao et Café du Cameroon, June 1999.

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To produce higher quality parchment coffee, some producers regrouped in associations or cooperatives and acquired processing facilities to produce coffee parchment. But lack of access, know-how and buyers for the final products can make it difficult for farmers to take over the processing of cherries without external or public support.39 In other countries, private companies provide the processing services to farmers for a fee, which avoids the problems faced by farmers who wish to purchase pulperies. Some farmers’ groups go one step further in processing coffee by taking parchment coffee to curing companies and selling coffee ready for export. In Tanzania, farmers’ groups helped by the US NGO Technoserve, managed to sell high-quality cured coffee directly at the auction is Moshi, which enabled them to receive 40% more in 1999 than farmers selling parchment coffee to private traders.

2.1.3. From the export point to the supermarket shelf: the international coffee supply chain The international coffee supply chain is composed of importers, roasters and retailers as well as speculators on the commodity exchanges. While these market players have little to do with the actual production of coffee, their buying power has an enormous impact on international coffee prices as well as buying practices, both of which determine most coffee farmers’ livelihoods. A buyer-driven supply chain Most of the wealth generated by world coffee sales (around 70%) is captured by intermediaries outside of the producing countries. The share taken by international intermediaries is increasing as shown by the growing gap between consumer and producer prices over the last two decades. For instance between 1975 and 1993 the international price of coffee declined by 18% on world markets, but that paid by the consumer in the US increased by 240%.40 Coffee manufacturers attribute the growing gap to increasing costs. But increasing costs seem to justify only part of this gap. As coffee blends require coffee from various countries, transportation costs are substantial, especially since many coffee producing areas are far away from international ports. However, the diminishing share of producer prices in final retail value cannot be attributed to increasing transportation costs. On the contrary, transportation costs have decreased over the last two decades because of the development of bulk transportation. Nor can the increasing gap between producer and consumer prices be attributed to increasing trade barriers. Both the European Union and the US have low tariffs on coffee. The US has zero tariffs on green and unprocessed coffee. Under the Uruguay Round agreement, the EU’s tariff on unroasted green coffee is to be reduced over the next five years from 4% to zero, that on roasted coffee from 13.8 to 7.5%, and that on roasted decaffeinated coffee from 16.5 to 9%. Within the framework of the Lomé Convention, coffee from ACP countries is exempt from import duties for unprocessed and processed coffee, as well as from the Least Developed Countries. The same goes for four South American countries (Bolivia, Colombia, Ecuador and Peru) and a number of Central American countries (Panama, Costa Rica, Honduras, Nicaragua, El Salvador and Guatemala). They are temporarily exempt from import duties to prevent coffee producers from succumbing to the temptation to switch to the production of cocaine and encourage coca producers to switch to coffee.41 Instead, one of the main reasons of this growing gap between producer and consumer prices seems to be the result of current market structures, dominated by a handful of multinationals, who often

39 See ‘Experience of Mexican Farmers from Xalapa-Coatepec’, Plantations, Recherche et Dévelopement, September-October 1994. 40 Morisset, J. Unfair Trade? Empirical Evidence in World Commodity Markets over the past 25 years, World Bank (1997). 41 EFTA Fair Trade Yearbook 1997.

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control the production of coffee from the farm-gate to the supermarket shelf. The fact that there is chronic oversupply of coffee on world markets and lack of coordination among producing countries reinforces the power of buyers in the supply chain because they can pick and choose between suppliers as well as change ingredients of their blends. Moreover, the behaviour of consumers in OECD countries enables big multinational roasting companies to take the lion’s share of coffee profits. In fact, most customers are willing to pay higher prices for coffee in exchange for the ‘image’ sold together with the physical product by major coffee brands through massive investments in branding and advertising. As a result of these developments, the spread between consumer and producer prices has been rapidly growing over the last two decades. The Role of Commodity Exchanges Commodity exchanges, as seen in part 1, enable markets to discover an international price that reflects world demand and supply. They also ensure transparency on world markets by providing a single, publicly available price for Arabica and Robusta (contrary to other agricultural commodity markets such as tea where there are no international commodity exchanges). But markets also determine country ‘differentials,’ which has an important impact on export prices, and therefore farmers’ income. Sometimes these differentials can have a crippling effect on a country’s production, such as in the case of Haiti, which has seen a sharp decline in its export price due to a change in the differential set on commodity exchanges. Notwithstanding local market conditions, two farmers getting the same percentage of the export price might still have a very different level of income, given that export prices differ from one country to another. The first obvious difference is between the two main types of coffee, as Robusta is roughly twice as cheap as Arabica. But they are more subtle differences as well. Even if there is a ‘basis’ international price for Robusta and Arabica set on international commodity exchanges, export prices do vary quite widely depending on crop quality, reputation of the exporting country as a producer, and demand for particular varieties. Price differentials, as they are called, vary from year to year, depending on changes in demand and availability of a particular variety of coffee or its close substitutes. For instance, when there is a bad harvest in Kenya, coffee from the Kilimanjaro region in Tanzania will fetch a higher premium on the world markets. As a result of these price ‘differentials’, a Robusta producer in Burundi gets on average 2.5 times the amount received by a Robusta producer in the Central African Republic. In the Arabica sector, a producer from Rwanda gets half as much per pound than a Mexican producer, and five times less than Jamaican farmers, whose produce is in short supply and in demand.42 While a farmer from Kenya receives only 35% of the export price of coffee and a Tanzanian around 50%, as a result of these differentials the Kenyan farmer is much better off as coffee from Kenya receives a higher premium on world markets. This is why coffee is smuggled from Tanzania to be sold in Kenya at a higher price for the producer. This example highlights the trade-offs involved in liberalisation. While farmers get a higher percentage of the export price in liberalised markets, marketing boards in non-liberalised markets ensure a higher quality of crop at country level and therefore guarantee a quality premium on world markets for all the country’s coffee exports. Country-wide differentials can be unfair to high-quality producers living in countries where the coffee export sector is poorly run. In fact, it shows that there is a market failure to reward producers for high-quality coffee. Nevertheless, more research needs to be done on how to reform commodity exchanges in order to provide a fairer picture of the different qualities of coffee offered on the world

42 ICO Coffee Statistics No. 17.

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markets. The dismantling of commodity exchanges might not necessarily be in favour of farmers, as the example of world tea markets shows. International Traders

According to EIU estimates, international traders only receive less than 10% of the retail price. With technological and infrastructure development, transportation costs have decreased rather than increased over the last 30 years. On the downside, periods of low prices make it more difficult for traders to make profits. Moreover, roasters have successfully shifted price risks to exporters and international traders thanks to their just-in-time buying strategy, which means that coffee can remain in warehousing for up to two years, which exposes intermediaries to high price risk. As a result of the reduced profitability of trading, the level of concentration in the industry has increased. The six largest traders account for 50% of the world’s coffee. The two largest of these, the Neumann Group and Voll Café, are well ahead of the rest of the field, handling in the region of 27-29 million bags each year. The Neumann group also invests in processing activities in producing countries such as in Uganda, reinforcing the trend toward vertical integration. According to industry experts, trading firms are competitive with each other, making profit by trading high volumes but retaining very low margins. Roasters Roasters capture a very large share of the final market value of coffee (around 30% according to EIU estimates). This is due in part to the reduction of their production costs, as well as a reduction in warehousing costs through just-in-time purchasing strategies. The high degree of concentration in the sector also produces large economies of scale, which should under perfect competition reduce processing costs. But this is also the result of massive investments in brand recognition and advertising, which allows roasters to set high retailing prices, which have little to do with the level of international coffee prices. The roasting market is divided between the roast and ground market (which accounts for 80% of all coffee) and the soluble market (20% of the market share). Each market has widely different characteristics. Table 5: Major roasters’ market position

US EU Market Position

Roast and Ground

Soluble Roast and Ground

Soluble

1 Kraft/ Philip Morris

Nestlé Kraft/ Philip Morris

Nestlé

2 Proctor and Gamble

Kraft/ Philip Morris

Sara Lee/ Douwe Egberts

Kraft/ Philip Morris

3 Nestlé Proctor and Gamble

Nestlé Others

Source: ICO Coffee International File (1998-2002). While the market for roast and ground coffee is fairly diversified in Europe, it is more concentrated in the US where General Foods/Kraft Foods (owned by Philip Morris) is by far the biggest producer. In the EU market, which represents around 50% of roast and ground coffee sales in both value and

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volume, Philip Morris is the leading company in the roast and ground sector in terms of world sales, with Sara Lee/Douwe Egberts and Nestle following in second and third position respectively. Each company handles a dozen or more different brands. The soluble market (20% of total market) is much more concentrated, with Nestlé as the number one player. Its global market share is thought to be around 55%, far ahead of Philip Morris, with a share of 22%.43 As one of the very few truly global brands Nestlé has a huge competitive advantage over any rivals, and a position that allows the company to maintain undisputed leadership of the growing market for instant coffee. Roasters are protected from competition by their sheer size, which enables them to discourage new entrants from the market. There are also major technical obstacles to roasting in producing countries. Phytosanitary barriers, patents on processing technology, or in the case of the EU, an escalating tariff against Brazil’s soluble coffee (the largest producer of processed coffee among developing countries)44 might also provide them with additional protection. As a result, Nestlé (see box 6) and other multinationals such as Philip Morris-Kraft Foods are big enough to provide price leadership in the market and will usually increase their margins rather than pass on international coffee price reductions to consumers. As shown in table 5 (see below), only a small percentage of the decline in international coffee prices is passed on to consumers in the form of lower retail prices. When consumer prices decline, they go down much less than international prices, indicating that intermediaries increase their margins. In 1989, when the world price fell by 50%, farmers suffered an immediate fall in their incomes – yet there was no noticeable reduction in the retail price for coffee. But when market prices went up in 1994, so did the cost for consumers. This is symptomatic of commodity market prices in general. Prices can go up very quickly, but tend to stick when the market comes down. Some soluble coffee retail prices have even increased at the same time as international prices have fallen. Soluble processing margins ranged between $3 to $8 a pound in 1999 (to be compared to producer prices as low as 12 cents per pound).45 Manufacturers and market analysts cite the cost of packaging, transport and staff as the main components of product price. But market analysts point out that ‘brand-building’ is also responsible for the big price increases. This is where price hikes are simply a way of making a product look more desirable compared to a ‘cheaper’ rival. Analysts also lay part of the blame for high, sticking prices with consumers. They argue that the manufacturers have no reason to put the price down as there is no consumer resistance to it. 46

43 ICO Coffee International File 2000. 44 Inter Press Service, ‘Brazil claims EU imposes unfair coffee tariffs’ 10/08/99. 45 Figures calculated by using data from LMC Coffee Newsletter, July 2000. 46 The Guardian, December 14th, 2000.

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Table 5: Retail price compared to international price fluctuations

Retail and International Price Fluctuations (1997-1999)

Ground Coffee Soluble Coffee International price International price Other mild indicator (-) 45.2%

Robusta Indicator (-) 4.6%

Retail price Retail price German Roast (-) 6.9%

US Soluble (+) 0.6%

US Roast (-) 16.7%

UK Soluble (-) 3.9%

French Roast (-) 8.9%

Japan Soluble (+) 13.7%

Source: LMC Coffee Newsletter, July 2000. Such pricing behaviour shows that major actors (such as roasters and retailers) have market power and that markets are not fully competitive. The current trend towards oversupply and lower international prices is clearly in their advantage. This being said, roasters specialised in high quality products are concerned about low prices. Higher prices are regarded as necessary to ensure continuing quality (for instance for the best washed Arabica coffees to be produced). So there appears to be a trade off between larger margins in the short-term and higher product quality in the long-term. Box 6: Nestlé Coffee is Nestlé’s most important product, accounting for between 10 and 15% of total group sales, though this predominance has declined since 1980 when half of Nestlé’s profits were generated by coffee. Nestle makes around 33p of profit on every pound of the 720,000 tons of coffee its buys every year.47 As one of the world’s largest buyers of coffee, Nestlé has a great deal of experience (and leverage) in capturing the very lowest prices possible. The company is able to lead retail prices which has the effect of providing a ‘price umbrella’ for the entire industry. As the year 2000 drew to a close, and Robusta prices were trading at a 30-year low, Nestlé – the market dominators in the UK – upped the price of a 100g jar on the British supermarket shelf by 10 pence. Nestlé has carried out some vertical integration and has factories in a number of producing countries (Brazil, Mexico, Colombia, India, the Philippines, Thailand, the Ivory Coast and Indonesia). Through its presence in producing countries, Nestle claims that it is buying nine times more coffee directly from growers than fair trade organisations. Nestle also reports that it pays prices similar to those paid by fair trade organisations: ‘we usually pay a premium over the market price, and the price we pay is protected.’ However, Nestle refused to disclose to the authors how much they pay over the market price or what their floor price is, and as such, it is difficult to quantify their claim. If they do pay a premium, it appears to be very low: Producers in Cote d’Ivoire (where Nestle buys around 10% of total production) reported that in September 1999, Nestle’s prices were only slightly above the average producer price of 25 cents/lb.48 Sources: Nestle. 1998. Nestle and Coffee. A Partnership for Fair Trade. Nestle UK Ltd; Nestle. 2000. Consolidated Accounts of the Nestle Group; The Guardian December 14th, 2000; Afrique Agriculture. 1999. No. 273 (September).

47 Fairtrade Foundation, ‘Spilling the Beans’.

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Retailers Retailers, the gate keeper’s to consumers, obtain a relatively high share of the consumer price, while they don’t incur major costs or risk. The vast majority of coffee is bought in supermarkets, which gives them significant market power over the supply chain. Supermarket chains often join forces to purchase primary commodities, which usually plays to the disadvantage of suppliers. In addition, the fastest growing segment of the roasting market are the retailers’ own label brands. Added together, the retailer and roaster share of the consumer price make own label coffee brands highly profitable. Overall, the own-label brand share of the market in Europe is thought to be around 15%.49 Another category of coffee retailing, currently in full expansion, is performed by international chains of coffee bars, such as Starbucks, Costa or Tchibo. Their impact on coffee markets and small farmers is yet to be seen. Appealing to the younger generation, they could reenergize demand for coffee in OECD countries as well as export consumption habits in less mature markets (such as China for instance). Because their business depends on younger generations, they are also vulnerable to accusations of poor buying practices that work at small farmers’ disadvantage and could potentially become a positive force in the coffee industry, if NGOs and consumer pressure convinces them that it is profitable to do so. For instance, Starbucks and Costa have recently made available fair trade coffee in their stores.

49 ICO Coffee International File, 2000.

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2.2. Policy Responses Strategies to help farmers capture a higher share of the retail price involve changing the balance of power between farmers and other players along the supply chain. Effective empowerment policies identified here include mainstreaming fair trade practices, developing in-country processing and strengthening producer associations.

2.2.1. Fair trade Fair trade (FT) has been defined as ‘trade which promotes sustainable development by improving market access for disadvantaged producers, and by campaigning. It seeks to overcome poverty through a partnership between all those involved in the trading process: producers/workers, traders and consumers.’50 The goals of fair trade include: - Improving the livelihoods and well being of small producers by improving market access,

strengthening producer organisations, paying a better price and providing continuity in the trading relationship.

- Raising awareness among consumers about the negative effects on producers of international trade so that they exercise their purchasing power positively.

- Setting an example of partnership in trade through dialogue, transparency and respect. - Campaigning for changes in the rules and practice of conventional international trade. Coffee is the most important FT commodity, accounting for 1.7% of the European coffee market51. Coffee began being sold in the UK by FT organisations in the 1970s, when it was marketed and sold through Oxfam shops and mail order channels. By the 1990s, efforts to increase awareness saw clearly branded FT coffee products being sold through mainstream as well as alternative outlets. By far the most significant UK brand is Cafedirect, and has developed a small but solid niche in both the instant and roast and ground market. In 1999 its roast and ground coffee captured a 4% share of the UK market. Cafedirect’s has seen big increases in its turnover, averaging around 70% per year. Its turnover for the year ended March 1999 was £7.2 million, up from £0.5 million in 1994/95.52 A guaranteed minimum price of US$1.26/lb for FT coffee was agreed between producers and the Fair Trade Labelling Organisation (FLO) in June 1995, and is reviewed on a regular basis (see table 6 below). The floor price has frequently brought considerable relief to small producers involved in FT schemes. Between 1989 and 1994, in 1996 and since May 1998 (apart from two months during that year), the world market price has been well below that minimum price. The FT price is often accompanied by a 5 to 10% ‘price premium’ paid over and above the FT price, with the funds earmarked for community projects such as schools and sanitation works. The floor price guarantees an income that provides adequate livelihoods and capacity building for farmer organisations, and can make FT an effective means of promoting sustainable rural livelihoods and poverty reduction. FT channels are seen as giving small coffee producers a better deal by cutting out local market intermediaries and improving access to the market. The lack of a need to earn a return on capital employed or pay dividends to shareholders also enhances the capacity of FT to provide a redistributive transfer from rich consumers to poor producers.

50 Oxfam Corporate Strategy Paper ‘A Fair Trade Strategy for Oxfam, 1998. 51 Oxford Policy Management, Fair Trade Study, 2000. 52 Cafedirect Annual Report 1999/2000

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Table 6: Guaranteed minimum prices for Fair Trade coffee as specified by FLO-International (US cents per lb F.O.B. – Feb 2000) Type of coffee Regular Certified Organic

Central America, Mexico, Africa

South America, Caribbean

Central America, Mexico, Africa

South America, Caribbean

Washed Arabica 126 124 141 139 Unwashed Arabica

120 120 135 135

Washed Robusta 110 110 125 125 Unwashed Robusta

106 106 121 121

Studies have shown there have been real livelihood gains for small scale coffee farmers under FT agreements. It was found that through their participation in the Cerro Azul cooperative in Costa Rica, farmers during the years from 1989-95 enjoyed coffee incomes that were on average 39% higher than farmers in the area who were not involved in fair trade.53 Similarly, a study from Haiti found an increase in farmers’ income as well as greater general access to food and increased gender equity within coffee cooperatives.54 According to a recent report, the most significant impact of FT initiatives relate to the cooperative capacity building activities, and to improving market transparency and information.55 Fair trade can also have a positive effect as it forces mainstream market operators facing competition from FT brands to adapt their own practices. In some cases, competitors have had to match fair trade prices to ensure adequate supplies of good quality coffee. It is reported that in northern Haiti, intermediaries were unable to purchase enough coffee on the local market due the success of a FT initiative there (see box 7). This prompted local intermediaries to buy a container of coffee at $1.24/lb – 60% more than they had previously paid. Box 7: Oxfam and Fair Trade Coffee in Haiti Over the last five years Oxfam has been involved with ‘Support to the Coffee Ecosystem’, a programme aimed at developing the capacity of a network of coffee cooperatives in the north and north-east of Haiti, in cooperation with the Haitian NGO SEFADES. A joint study conducted in 1993 by Oxfam and SEFADES found that coffee is an integral part of the overall ecosystem. By stabilising the price for producers, they would be less inclined to cut down coffee trees in favour of charcoal-making, thus halting further destruction of Haiti’s already decimated forest cover. The study revealed that farmers in the area suffered many problems – low production, lack of technical support, poor quality, lack of credit and low prices on the international market. It was as a result of these findings that Oxfam and SEFADES joined forces to support farmers in overcoming these difficulties. Oxfam works at the programme level with SEFADES, which provides technical support, training and management to a network of seven farmer cooperatives – five in the north and two in the north-east region. The objective is to have a financially autonomous, self-managing farmers’ organisation, with Oxfam eventually withdrawing from the programme. There are five main elements to the SEFADES programme: 1. Production 53 Fair Trade in Costa Rica: An impact report, Lorraine Ronchi, University of Sussex (MA Thesis). 54 Analysis and conclusions of the participatory impact assessment process of APECA-Haiti, Oxfam paper, unpublished. 55 Oxford Policy Management, Fair Trade Study 2000.

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2. Quality control and marketing 3. Support and credit 4. Communication 5. Institutional strengthening As well as receiving training, the cooperatives came together to agree on organisational statutes and seek legal status for their organisations. FEDECARES, an NGO from the Dominican Republic, along with coffee cooperatives from Nicaragua and El Salvador, came in to offer their support on these issues so the Haitian farmers could learn from their experiences and not repeat the same mistakes. The programme has met with considerable success in helping the cooperatives attain the capacity to produce export quality ‘washed’ (processed) coffee, most notably with the gourmet Haitian Blue variety, which is being exported directly to the US at $2/lb. Oxfam’s programme has clearly had a positive impact in terms of increased access for small producers’ to local financial services, and increased capacities in the administration of financial resources as well as in management. The coffee crops provide early season loans to the producers, which are then repaid with their coffee harvest. By securing this form of credit, the producers are not as likely to resort to the local loan sharks (who charge rates of up to 200%), or to sell their coffee to the speculators at sub-optimal prices due to their immediate financing needs. The loans from the Coffee Project also permit the producers to harvest their coffee only when it is ready and not according to when the local speculator wants to purchase it, thus improving the decision-making responsibility of the producer and allowing him/her to harvest higher quality coffee. The project has also had positive impacts in terms of increased incomes, greater access to food, and more children attending and remaining in school. To Luckson Bastien, an accountant and technical consultant with the Sainte Helene Cooperative in Carice, the FT coffee programme means; ‘… another step forward for us. We want to be able to produce ready-made ground coffee in future. We’re also looking at better prices on the local market in order to improve life for people in the community.’ Other positive developments include a stronger emphasis by multinationals on making their own trading practices more transparent or even adopting fair trade practices. A recent development has been the addition of FT lines by the coffee retailers Starbucks and Costa. This is the first time the fair trade movement has made serious inroads into the mass consumer market, where, according to fair trade groups, there is a ‘groundswell’ of consumer interest in fair trade products. Taylor’s, a small UK based packer, has launched a coffee brand based on fair trade practices. The project is unique in that Taylor’s donates 50% of the profits made from the brand to farmers’ cooperatives and community projects, as well paying the minimum FT price of $1.26 (see box 8). But there are downsides and limitations. Mainstream competitors to FT brands have increasingly been contesting the claims made by the FT movement. They argue: �� against the idea of unproductive ‘middlemen’, stating that intermediaries provide a range of

services such as marketing, information and bulking. �� that labelling coffee as fairly traded or ethical implies that other trading relationships are

exploitative, and that the activities of many mainstream companies already pay a fair price (Nestle, for instance, makes such a claim).

Experience from the cocoa sector has shown that middlemen can play an extremely positive role. In Indonesia for example, liberalisation has led to high numbers of middlemen entering the cocoa

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market. This has given producers greater access to markets and created more transparency, as greater competition has forced middlemen to give producers a high share of the f.o.b. price in order to stay competitive.56 Another criticism is that fair trade may encourage inaction in the wider policy environment, as it provides the opportunity to ease one’s conscience simply by buying a jar of fairly traded coffee. European politicians point to the fact that they drink a brand of fair trade coffee in the European Parliament as evidence that they are doing something about low prices. It is argued that by providing an ‘excuse avenue’, FT removes decision-makers’ urgency to act on raising prices for all growers. Fair trade prices are only available to a very limited number of producers, and there are criticisms that FT initiatives exclude the poorest groups through restrictive membership criteria, and that they rarely extend to those most geographically marginalised. However, it should be noted that new producer groups are restricted access because the FT market is expanding too slowly to absorb all of the potential supply. There is also criticism that because the premium is usually pooled, benefits will sometimes accrue to cooperatives rather than the individual producers.57

Despite its small market share, fair trade is very important because it raises consumer awareness about the welfare of small farmers. As shown by several examples, it can also spark positive changes in the behaviour of other market players at local or international level. But these changes are still marginal. If fair trade is to have a wider impact, it has to be brought out of the ‘niche’ market. Mainstream companies have to be pressured by consumers and NGOs to give similar prices to small producers. Because they have big economies of scale and large profits, most multinationals would still be fully profitable if they gave higher prices to producers. In addition, closer relationships between farmers and multinationals would foster higher quality production, which is to their advantage. Finally, fair trade has shown that consumers are ready to pay a little bit more for coffee produced on a fair trade basis. This means that a leading brand adopting these practices would incur fewer costs and could actually profit from fair trade practices by capturing a higher share of world markets. NGOs involved in fair and ethical trade could play an essential role in monitoring the claims of mainstream brands and certifying that products are bought at a fair trade price. Box 8: Feel Good coffee Feel Good coffee is a project set up by Taylor’s, a small, family owned coffee and tea manufacturer based in the UK. In August 2000, Taylor’s launched its Feel Good brand, which buys coffee directly from farmers’ cooperatives in the southern Mexican state of Oaxaca, and from the Matagalpa region of Nicaragua. Farmers are guaranteed a minimum price for coffee, which is equivalent to the price paid by fair trade organisations ($1.26/lb). Feel Good coffee pays the full market rate when prices are high, ensuring coffee farmers get a good return from their crop. Strong emphasis is placed on building long-term, close relationships with the producers. As well purchasing coffee at a premium price, 50% of the profits from Feel Good coffee are donated to the farmers’ cooperatives. The funds are earmarked to be spent on community projects in areas where the coffee is purchased, thereby ensuring the wider community also benefits from the project. Although Taylor’s is a small company, they own other established brands and have the economies of scale to make the Feel Good scheme commercially viable. The fact that they are an independent, family-owned company with no shareholders to consider is also an enabling factor. Nevertheless,

56 The cocoa marketing sector in Sulawesi, Plantations, Recherche, Developpment, May – June 1998. 57 Development in Practice 10 No. 2 Partnerships in fair trade: reflections from a case study by CafeDirect.

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even for mainstream companies who are responsible to shareholders, investors do not necessarily represent an obstacle, as shown by the recent success of ‘ethical investment’ initiatives by several pensions funds in the US and the UK. Another reason that mainstream coffee manufacturers are not attracted to launching brands with fair trade values is because this implies their other products to be somehow ‘unfair’. Yet Taylor’s have shown that having a fairly traded product does not necessarily mean commercial suicide. It has also been demonstrated that not only is it viable for a commercial firm to pay a fair price to producers, it is also possible to channel half of the profits made from the coffee back into local communities. Source: www.feelgoodcoffee.co.uk

2.2.2. Developing in-country processing: opportunities and challenges As seen in the section above, more processing at the farm or cooperative level increases profits for the farmer. But experience shows that cooperatives needs to have both adequate financial and technical support to develop the skills needed in high quality processing.58 Given the high profitability of further stages in processing (roasting and packaging), developing these activities in producing countries would also create most value added in country (creating new economic activity, raising export and government tax revenues). It would also improve the bargaining power of producers in front of consumer countries. But there are significant technical obstacles to such a change: 1/. Blending: Often up to 20 different country origins are needed to produce coffee blends that fit consumer preferences in industrial countries, although single country origin coffee is growing in terms of market share. Given the deficit of South to South infrastructure, blending in developing countries seems expensive. Import restrictions between producer countries make blending in developing countries even more difficult. For instance in September 2000, the Brazilian government suspended its imports of coffee from Viet Nam due to risks of disease. 2/. Shelf-Life: Contrary to unprocessed coffee, roast andground coffee doesn’t survive transportation well and can be damaged by increased moisture during the sea voyage. 3/. Transportation: It is more expensive and bulky to freight coffee as a processed product (increased weight, risk of breakage). In the case of soluble coffee, coffee would have to be reagglomerated in the consumer country as the European tastes are averse to spray dried (powdered) coffee (agglomerated coffee tends to break down in transit). 4/. Packaging: getting packaging material suitable to Northern consumer preferences is also difficult. 5/ High premium to label promotion (advertising and branding costs). 6/ Intellectual property rights Given that processing has been developed by Northern manufacturers, they own patents on processing technology, which prevents companies in developing countries to have access to cutting edge technology.

58 Sallee, Goud. 1994. Mexico: Coffee producers running their own factories. Plantations, recherche et developpement (September-October).

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7/ Import tariffs in developed countries Processed coffee production in developed countries was long protected by tariffs, but most of them are currently being dismantled (See Section 2 for details). Nevertheless, stringent phytosanitary standards make it difficult for smaller companies in developing countries to export to OECD countries directly. 8/ Market concentration Market concentration among the big roasters makes it difficult for new entrants to develop processed products for OECD countries. In-country processing would have to be done by the multinationals that already control a share of the market. It would seem that the scope for in-country processing is limited in the face of these obstacles. Nevertheless, few of them would be insurmountable with the appropriate policies in place. Even if transportation costs were to increase, processing costs would decrease as wages in developing countries are much lower than developed countries. But it would require major investments in producing countries (in processing and transportation facilities), technological innovation and, even more importantly, access to developed countries’ markets (especially access to major supermarkets). Recently, several international traders and roasters have invested in producing countries to develop processing facilities, such as Neumann who invested US$ 3.5 million in Uganda. These moves indicate that there might be a change towards more processing in producing countries.

2.2.3 Strengthening producers’ associations In many countries, marketing boards and local offices of government agriculture services provided price stabilisation as well as inputs to small farmers – albeit inefficiently and at a high price. Their breakdown as part of liberalisation programmes has left a vacuum that needs to be filled. For instance, several case studies show that post-liberalisation yields have decreased because of lack of access to inputs as few traders offer inputs on credit.59 One of the biggest obstacles to farmers making a better living is the small volume and sometimes poor quality of their production, which cannot be sold as such to international buyers or even at a very low price. Pooling production in a farmers’ group up to a critical mass is necessary to market products directly to the auction or even export level. Farmers’ groups are also more likely to obtain loans necessary to purchase equipment and tools for higher quality processing. In many countries, local producer associations could also help smaller farmers take advantage of the programmes and technical assistance from national producers’ associations (such as ANACAFE in Guatemala), government assistance programmes (such as ASERCA in Mexico) and NGOs (such as Technoserve). Finally, through stronger producers’ associations, small farmers could have a voice in policy-making decisions at local and national level regarding reforms to regulations and taxation in the coffee sector. But existing farmers’ cooperatives, for instance in Africa, are often weak, debt-ridden or discredited. They lack financial transparency and are rarely held accountable by their members who largely distrust them. Therefore, awareness raising campaigns as well as support to capacity building are urgently needed, starting from the grassroots level to ensure more representative producers’ associations.

59 FAO 2000, Export crop liberalisation in Africa. Agricultural Services Bulletin 135.

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2.2.4 Towards appropriate market regulation Following the liberalisation of the coffee sector in many countries, small producers are faced with the challenges as well as the opportunities provided by free markets. Small farmers’ income depends on the balance of power along the supply chain as well as the presence (or lack thereof) of the tools they need –such as credit, insurance, technology – to thrive in a free market environment. In the absence of these elements, a free market environment might prove disadvantageous to small farmers. Following market liberalisation, many small farmers face a difficult situation. Their yields have decreased in most countries because farmers cannot afford the price of insecticides and fungicides necessary to protect trees against diseases. This is due to the end of subsidies on inputs increasing their prices as well as the loss of farmers’ access to credit, which was previously provided by marketing boards. Moreover, their access to information and technical assistance has worsened because of the decline of funds directed towards agricultural extension services. At the same time, farmers are faced with the risk of price volatility without any access to price insurance. As the problem of oversupply worsens, the smallest producers face the risk of being driven out of the market by competition from big plantations, which do not face the same dilemmas. This could potentially result in the impoverishment of millions of small farming families, as well as having negative effects for the environment. In addition to providing rural employment, small farms have much more sustainable methods of production, which, for instance, prevent deforestation because of tree shading and intercropping. These issues need to be taken into account with appropriate policies in favour of smallholder farming. To avoid such a negative outcome, a better balance has to be found between heavy-handed public intervention in coffee production and marketing and no regulation at all. The absence of any public intervention leaves smallholders without any technical or financial support while they face intense competition from plantations and also downward price pressure from intermediaries. Keeping a strong regulatory body that ensures quality control at the border enables countries to keep a high price premium for their exports on international markets. This regulatory body should also monitor markets to ensure that there is a high enough level of private competition in the marketing chain and prevent domination of the domestic market by a single multinational company. When dwindling, competition should be encouraged by decreases in barriers to entry of new competitors (reduction of taxes and licensing fees for example). This regulatory body could be responsible for monitoring working conditions on plantations. In terms of production management, state intervention (via regulation and targeted subsidies) can have an important role by encouraging the rejuvenation of the tree stock held by smallholders, while strictly limiting new plantations and other practices adverse to production control and environmental protection. State intervention is also warranted to encourage low-productivity producers, when appropriate, to diversify into other crops, an essential component of production management in the long-term. State intervention can also be used to provide producers with information on world demand trends, so that they can plan production according to the market fundamentals. Finally, governments should consider turning public estates into nucleus estates rather than leasing them out to big multinationals. The state can also play a key role in leveling the playing field for small producers. Efficient extension services, which provide smallholders with access to technical assistance, are essential to maintain yields and encourage higher quality production. Rural infrastructure development (ensuring all weather access roads for instance) is also crucial to help small producers located in remote areas gain access to markets. When private markets fail, the state has to act as a facilitator to develop access to

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rural finance and insurance for smallholders. In addition to financial regulatory reforms, public intervention can provide guarantees to the banking sector, or build storage facilities to help farmers use their crop as collateral. The state should also encourage the formation of producers’ associations and cooperatives that represent small producers, and provide quality and timely information on international prices to help cooperatives negotiate with intermediaries.

2.2.5 Contract farming One of the farmers’ main complaints about liberalised markets is that private traders have no long-term relationship with farmers but just buy coffee to whoever passes through their local agents. This limited relationship between intermediaries and farmers is not only detrimental to producers, it can also be costly for buyers, as they have no way to improve quality and reliability of production in the countries they operate in. Moreover, given the current trend toward vertical integration of coffee manufacturers to control production from the coffee farm to retail outlets, changes in the relationship between farmers and intermediaries along the supply chain might be on the horizon. To control the supply chain entirely, some multinational companies have acquired plantations and start producing coffee themselves. Though attractive, direct production also has its risk and costs. As the experience of ‘nucleus’ estates in Asia shows, leasing individual plots to farmers, while keeping a common marketing policy can be more profitable than hiring coffee pickers and processors to work on a big plantation. Such a system falls under the larger category of contract farming. Contract farming refers to a system where farmers grow crops for a central processing or export unit, with the terms of the purchase agreed in advance through contracts. Contract farming has been expanding across much of rural Africa, Asia and Latin America in recent years. It is particularly well adapted to perennial tree crops such as coffee for which economies of scale are associated with processing, coordination and long-term, high-quality maintenance is needed. Contract farming is a way of allocating risk between producer and contractor; the former takes the risk of production, and the latter the risk of marketing. Typically, the grower provides land, labour and tools, but is supplied by the contractor with credit inputs and technical advice. The terms and conditions of contracts vary considerably. At one extreme, the company pays the market price on delivery and has little control over production. At the other extreme, prices are fixed and the contractor exercises rigorous control over all aspects of production. In general, contracts usually specify how much produce the contractor will buy, and what price they will pay for it. Contract farming is considered by many Western donors as an appropriate tool for achieving economic growth through free markets and the private sector. It is seen as a way of incorporating low-income growers into the modern agro-industrial sector. Contracts give smallholders the benefits of modern technologies, information, credit inputs, access to new markets and other services needed to cultivate lucrative non-traditional crops. There is evidence that in many cases, contract farming has raised the incomes of smallholders, created employment opportunities and developed local.60 While benefits for certain growers have been realised, recent studies have shown that the poorest members of rural populations are often excluded from contract farming and have been directly or indirectly harmed by these schemes. Many agro-processors prefer to contract with larger scale growers as it minimises the transaction costs of working with large numbers of smallholders. However, contract farming that excludes smallholders can lead to concentration of land ownership and displacement of the rural poor.61 There are also concerns over food security, as contracts often enforce monocropping, either specifying the amount of food crops to be planted, or banning their 60 Key, N. and Runsten, D. (1999) ‘Contract farming, smallholders, and rural development in Latin America’, World Development 27 No. 2. 61 Ibid.

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cultivation altogether. In many areas this regulation has led to spiralling food prices, though others argue that nutrition is more likely to be improved by contract farming through raised incomes.62 Contract farming has also been criticised for excluding women, especially where the scheme involves land redistribution. A further criticism is that contracts are usually weighed in favour of the companies, who draft the documents themselves. In the initial phases of the contract, farmers will be attracted by price, credit and technical incentives offered by the company. But once they are satisfied growers will not desert the programme, companies may lock farmers into production and debt by exploiting gaps in the contract.63 Nevertheless, it is possible that coffee and cocoa growers are in a relatively good bargaining position vis-à-vis contracting companies. As coffee and cocoa are easier to process and market independently than other smallholder crops, it is easier for farmers to break the contract and sell their goods to the highest bidder. As a result, companies often depend on the state to ensure they receive a market monopsony. Given these risks, it is necessary to ensure that contracts between intermediaries and growers are fair and equitable and indeed produce a ‘win-win’ situation. Closer monitoring of contract-farming practices by local and national governments is urgently needed to limit risk of exploitation. Finally, more research needs to be done to discover whether contract farming really results in higher and more stable income for small coffee farmers and if so, under which conditions.

62 ODI Working Paper 139, ‘Equity and efficiency in contract farming schemes’, October 2000. 63 Ibid.

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ANNEX: THE ETHICAL TRADE INITIATIVE The Ethical Trading Initiative (ETI) is a UK based partnership of NGOs (including Oxfam, the Fairtrade Foundation and Save the Children), trade unions and high street companies.1 The ETI’s aim is to ensure that internationally recognised labour standards are observed at all stages in the production of high street goods sold in the UK. The ETI seeks to achieve this by promoting the implementation of codes of conduct that embody such standards, which are backed by monitoring and independent verification. Corporate members of the ETI must provide an annual progress report which provides an overview of their supply chain monitoring. The reports must include details of management responsibility for ethical trade, areas of compliance and non-compliance with the codes, and corrective action taken. The ETI Code contains provisions including the following: No forced labour Freedom of association Safe and hygienic working conditions Living wages to be paid No excessive working hours In the case of agricultural commodities (such as coffee and cocoa), ethical trade is aimed at ensuring workers on plantations enjoy these rights. Ethical trade is distinct from fair trade in that it targets workers employed in plantations, exporting businesses and processing plants. By contrast, fair trade targets small farmers, and supports them to become involved in international trade by guaranteeing a minimum price to producers. Codes of conduct need to be monitored effectively to ensure proper implementation. ETI figures show that of the 14 UK corporations that have ETI membership, eleven were able to provide a progress report in the form requested. They revealed that 1,183 suppliers were evaluated for ethical performance during 1999. Of these, more than 65% were found to be in significant breach of the ETI Code, a figure that illustrates the scale of the challenge.2 A recent report suggests that the growth of direct relations between commodity producers and commodity buyers (because of vertical integration) can potentially contribute to the improvement of working conditions on plantations.3 If direct relations exist, cocoa buyers and processors can be held accountable for labour conditions on plantations that they use as suppliers. Another way in which ethical trading can benefit plantation workers is to emphasise code provisions that ensure freedom of association. This would strengthen worker organisations at the local and national level. These issues point to an overlap between ethical and fair trade, which, although distinct, can complement one another. An example from the coffee sector in Mexico reveals that many small farmers work on large plantations part-time to supplement their income. However, after forming an association that sells to the fair trade market, its members have ceased working on plantations as they have increased productivity and incomes as a result of entering the fair trade market.4

1 These include Anchor Seafood Ltd, ASDA Stores Ltd, CWS Retail, Levi Strauss & Co (Europe, Middle East and Africa), Littlewoods plc, Marks & Spencer plc, Premier Brands UK Ltd, Safeway Stores plc, J Sainsbury plc, Tea Sourcing Partnership, Tesco Stores Ltd, The Body Shop plc. 2 Ethical Trading Initiative, Annual Report 1999/2000 (www.eti.org.uk). 3 Fair Trade Organisatie, The viability of a code of conduct in the coffee sector in Guatemala, July 2000 4 Ibid.

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Plantation owners have responded by arguing that it is unfair that buyers request improved labour conditions without contributing to the cost. But many plantations do have relatively good living and working conditions on their plantations, and a good relationship with their workers, which proves that it is possible to do so without going bankrupt. Good working conditions and salary also attract better skilled workers and increase labour productivity. Ethical trade’s advantage over fair trade lies in the fact that it is more widely applicable. Presently, the fair trade market is too small for transnational corporations to source all their primary commodities from. However, buying from sources that adhere to ETI codes of conduct would be more viable for TNCs. A downside is that plantations will often simply sign codes of conduct to create the impression they have an acceptable policy, yet do nothing to implement the code in practice, a situation that points to the importance of effective monitoring.

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SELECTED REFERENCES Bart Ensing. 2000. The viability of a code of conduct in the coffee sector in Guatemala. Fair Trade Organisatie. Economist Intelligence Unit. 2000. World Commodity Forecasts: Food, Foodstuffs and Beverages. July. Ethical Trading Initiative. 2000. Annual Report 1999/2000, www.eti.org.uk Food and Agriculture Organisation (FAO). Statistical Database. www.aps.fao.org FAO. 2000. Export crop liberalisation in Africa. Agricultural Services Bulletin 135. Fair Trade Foundation. 1999. Spilling the Beans. www.fairtrade.org.uk. Food World R&C/SOMO. 2000. Controlling the Coffee Supply Chain. International Coffee Organization (ICO).1999. Coffee Statistics No. 17. December. ICO. Daily and Monthly Price Statistics. www.ico.org. Key, N. and Runsten, D.1999. Contract farming, smallholders, and rural development in Latin America. World Development. Vol. 27 No. 2. Landel Mills Commodities survey (LMC). 1990. A world survey of coffee bean production costs. LMC. July 2000. Coffee Newsletter. Morisset, J. 1997. Unfair trade? Empirical Evidence in World Commodity Markets over the past 25 years. Working Paper. World Bank. Market Tracking International Limited/ICO.1998. Coffee International File (1998-2002). DMG Business Limited. Nestle.1998. Nestle and Coffee. A Partnership for Fair Trade. Nestle UK Ltd. Nestle. 1999. The Coffee Cycle. Nestle UK Ltd. Oxford Policy Management. 2000. Fair Trade Study. The South Centre. 1996. International Commodity Problems and Policies: the Key Issues for Developing Countries. Wheeler, Michael. 2000. A new Approach to Commodity Price Risk Management?. Unpublished Paper. World Bank/IFPRI. 2000. Agriculture in Tanzania since 1986: Follower or Leader of Growth? Wyeth, J. 1989. Diversification: Eight lessons from Honduran experience in the coffee sector. IDS Discussion Paper.

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