Peter Book, Head of Agriculture, Asia Pacific
Social: Managing the supply side.
A challenge in many regions is the transport from the farm of the right food to the consumer without physical loss or spoilage. Putting transit losses aside, there is a question of getting the “correct” food and influencing the supply chain.
Farmers tend to grow/raise what they know and are often reluctant to pursue risky strategies. Risk transfer can be used to influence their decisions in two obvious ways:
• No recourse funding: Food manufacturers (or governments) can provide direct or in kind (seed, chemicals, fertilizer) credit when the farmer forward contracts the sale of the crop to the manufacturer. The credit is offered on a no recourse basis if the enterprise fails due to any or a range of pre-agreed causes, with the manufacturers availing themselves of either an indemnity or index-based risk transfer product. The risk of individual or widespread enterprise failure is transferred. The credit greatly reduces the risk of ruin to the farmer and provides the manufacturer with a means to influence the type and quantity of produce grown close to end markets or manufacturing facilities.
• Targeted subsidization: Where an agricultural insurance scheme already exists the farmer’s production decisions can be influenced by altering the level of subsidization or the tax treatment of insurance on a per enterprise basis. By reducing the cost of insurance the relative cost to establish the targeted enterprise is reduced and its overall level of production should increase. This practice has been utilized in European countries to stabilize food production and can be effective in addressing the economic imbalance between cash crops and food crops.
Economic: Supply shocks and post-loss financing.
Having looked at optimizing individual production and how to influence what is produced and where, the next question revolves around what happens when a large loss occurs. The two following examples have similar triggers but the application of the risk transfer products is different:
• Supply shocks: Widespread losses have dire consequences for farmers and the population dealing with resulting food shortages and high prices. It has been suggested that one of the contributing factors to the tensions that led to the Arab Spring were price increases on basic foodstuffs triggered by drought in Russia.¹
While price hedges may alleviate stress in some situations, a more immediate and localized solution is often required. Weather, production or event-based “CAT”-style indices can be used to trigger instruments that pay a pre-agreed amount. These instruments offer a speedy mechanism for providing funds to a central body to allow for the purchase of replacement food stocks or the subsidization of food costs until prices return to equilibrium.
An effective determination of the amount of funds may involve a pre-agreed quantity of a food staple (such as rice) multiplied by an index price (based on markets for replacement food stocks) in the 7 - 14 day period after an event (such as a cyclone), adjusted for a pre-agreed delivery cost.
• Post-loss financing: After dealing with food costs there is still a need to address the loss to farmers and hasten their return to full production to mitigate an ongoing supply shock. In many developing markets farmers have limited access to finance and rely on retained earnings (or retained surplus stocks) from prior years to establish the following year’s enterprise. When a loss occurs farmers may be unable to immediately return to the same level of production as they build up replacement seed or stock.
A risk transfer instrument could be structured to compensate based on the area affected multiplied by the prevailing cost to re-establish crops. The funds could be used to provide cash grants to affected farmers allowing them to commence farming again at full production levels.
Drawing such funds from consolidated revenue would require their diversion from other uses and borrowing them is likely to occur when the cost of funds is at its highest. A further advantage of this approach is that the amount required is determined in the relative calm of a pre-loss situation and not in the midst of a crisis.
¹ World Economic Forum, Global Risks 2014 Ninth Edition