Policy Risk: Implications for Dairy Farm Management
Department of Rural Economy, University of Alberta, Edmonton, Alberta T6G 2H1, Canada
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Take Home Messages# Introduction
Dairy producers in Canada have enjoyed a reasonable amount of protection for their industry. This protection has come in the form of the supply management system that has evolved over the years (3). A combination of production controls, restrictions on importation of dairy products, control or restriction of interprovincial movement for milk, dairy products and quota, and cost of production pricing for milk at the farm level provide producers with a relatively stable environment in which to operate their businesses. This stability, in turn, results in a greater degree of
Acertainty@ for producers when making dairy management decisions.In recent years, however, the situation has changed, with more changes yet to come. There have been challenges (as of yet unsuccessful), through NAFTA, GATT, WTO, etc. to the current supply management system. As a result of international trade negotiations, import quotas for dairy products have been converted to tariffs, which are scheduled to be reduced gradually over time. As well, within Canada, regional pooling arrangements have resulted in a weakening of the interprovincial barriers to trade in milk, dairy products and quota.
The net result of these (and future) changes may be a greater degree of
Auncertainty@ for producers. This uncertainty or risk may manifest itself in several ways. However, it is important for dairy producers to recognize what these risks are, what their magnitude is, and the implications for farm management decision making. The changes in sources and levels of risk may impact on decisions as to the size of the dairy operation, adoption of new or improved technology, risk management strategies, etc. These changes also provide the context and the focus for this paper.The objectives of this paper are to a) outline the source(s) of policy risk or uncertainty that face dairy producers in western Canada; b) discuss how these risks are manifested in terms of an individual producer
=s operation; c) discuss how these risks may affect farm management decision making by dairy producers; and d) identify some alternative Astrategies@ that may considered by dairy producers in order to Amanage@ these risks.# Risk - Background
In any discussion of risk, it is necessary to begin with a working definition for the term. Risk is a term that has different meanings for different individuals. For some, it may be characterized as the probability of a loss. For others, risk is the degree of variability associated with a particular factor. For the purposes of this paper, risk is defined as the chance of a gain or loss, resulting from an uncertain situation (i.e., a situation where the outcome is not predetermined), that affects the well-being of the decision maker (2).
In order to assess and manage risk, a decision maker or analyst must be able to measure the amount of risk that is present. Depending on the nature of the risk and the decision maker
=s situation, there are different means of quantifying the level of risk. These include the probability of a negative outcome (e.g., losing money or going bankrupt), some measure of dispersion (e.g., variance) or the value of the worst-case scenario. Any or all of these may be appropriate in specific circumstances. For example, a producer who is burdened with a significant debt load may be less concerned with variability in prices than he/she is about the chances of being forced out of business.Within agricultural production, there are many sources of uncertainty and risk. These include uncertain crop yields, product prices or interest rates, uncertainty with respect to market availability for products, uncertainty with respect to possible changes in regulations governing production practices, etc. These various sources may be categorized into two types of risk; business risk and financial risk. Business risk is the risk resulting from production and marketing activities for the decision maker. Sources of business risk include uncertain yields, prices, etc. Financial risk is the additional risk that arises from the use of debt financing. Financial risk incorporates uncertainty in interest rates and asset values. The presence of financial risk (i.e., debt financing) amplifies the effects of business risk.
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Policy Risk and Dairy ProductionPolicy risk arises from uncertainty relating to the policy making process. Producers make decisions based on current policies and their expectations regarding future changes in policy. However, policy sometimes changes unexpectedly, or expected changes do not occur. These possibilities result in policy risk.
Within dairy farming,
Apolicy@ is very important. The supply management system governs much of the decision making by dairy producers in Canada. The impacts of any changes to this system would be significant. The process of changing policy is relatively slow, compared with the speed at which some other factors change, such as commodity prices. However, dairy producers are also not able to respond to these changes immediately. Milking technology, herd size and capacity, production practices, etc. cannot be changed instantaneously. As a result, policy risk is an important potential source of risk for dairy producers.In considering policy risk as it applies to dairy production in Canada, there are several aspects of policy that, if adjusted, could change the level of risk faced by producers. These include changes to the current pricing system (i.e., cost-of-production based), the introduction of regional pooling agreements, reductions in the amount of protection provided from international competitors, and changes to the production quota system. Changes in these factors, all of which are beyond the control of individual producers, could have impacts on the decision making process; that is, they could affect the way in which producers make decisions, and the
Abest@ management practices for dairy producers. This is dealt with in the following section.# Policy Risk and Farm Management
Manifestation of Policy Risk
While there are multiple sources of policy risk for dairy producers, the effects at the farm level can be largely characterized in terms of two parameters; milk price and quota values. In both cases, policy risk may affect the level and the variability for these factors.
With respect to milk price, this may be affected by a number of factors. The recent move to regional pooling of milk revenues between provinces means that prices received by producers in a particular province depend not only on environmental factors in that province, but on conditions in other provinces as well. This will have effects on price levels and the variability over time.
Another factor that may affect farm-level milk prices in the future is the international trade situation. Currently, Canadian producers enjoy a significant amount of protection from international competition. Changes in this situation may lead to adjustments in policies related to milk pricing; that is, moving away from formula pricing based on costs of production to more
Amarket-based@ pricing. This may lead to increased variability in prices as well. Table 1 provides an indication of the relative variability of returns for dairy production in relationship to other enterprises. While the level of relative variability (i.e., the coefficient of variation) may not increase to levels approaching some other agricultural enterprises, it is likely that relaxation of interprovincial and international restrictions in the sector will result in greater variability in returns over time.Table 1. Mean and Standard Deviation of Real Return on Assets for Selected Agricultural Enterprises (1980-95) and Financial Markets (5).
|
Enterprise |
Mean (%) |
Standard Deviation (%) |
Coefficient of Variation |
|
Dairy |
12.5 |
5 |
0.40 |
|
Hogs |
33 |
54 |
1.64 |
|
Cattle Finishing |
16.6 |
29.5 |
1.78 |
|
TSE300 |
9 |
19 |
2.11 |
Quota values may be affected by changes in the level and variability of milk prices. The value of quota is tied to the profitability of milk production in the province. If milk prices decrease or become more variable, or are expected to do so, it is likely that quota values will decrease.
A more extreme possibility is that the production quota system will change or be eliminated. Depending on the way in which this is done, and the nature (or lack thereof) of compensation for producers holding milk quota, this will have a significant effect on the asset base (i.e., balance sheet) for Canadian producers. The impact on asset values becomes particularly important in cases where there are significant levels of debt. This provides a link between policy risk and financial risk, in that the effect of changes in quota values is
Aamplified@ by the presence of a sizable debt load.Implications of Policy Risk for Farm Management
Farm management encompasses much of the management decision making by agricultural producers. This includes short-term and long-term decision making with respect to production, marketing, financing, capital investments, etc. In some cases, the decisions involve significant investments over several years. For dairy producers,
Afarm management@ includes decisions relating to a multitude of questions, including:In making these types of decisions, the primary farm management
Atool@ is budgeting, both long-term or short-term. The budgets include benefits and costs associated with the alternative(s) under consideration. The option providing the greatest net benefits is the one that is chosen, assuming an objective of generating maximum or at least satisfactory net returns.With all of these decisions, there is a certain amount of uncertainty, leading to risk. Risk is not always explicitly incorporated into budgeting, but is typically considered at least subjectively by the decision maker. Within the context of benefits and costs, risk represents an extra
Acost@ to the decision maker. This cost occurs because a) the presence of uncertainty means that there is a possibility of a negative outcome, resulting in fewer benefits to the decision maker; b) in response to uncertainty, decision makers often choose Aless risky@ options, resulting in less efficient use of resources that would be the case without risk; and/or c) decision makers also sometimes engage in risk management strategies (e.g., purchase insurance) which have explicit costs associated with them.For dairy producers, then, policy risk involves an additional cost of doing business. For example, any uncertainty surrounding future quota values may deter a producer from purchasing quota (or as much quota) in order to support a herd expansion strategy. In not expanding or expanding to a lesser degree, the producer may not be able to exploit size economies in dairy production and become more cost efficient.
# Risk Management Strategies
In response to increased risk, agricultural producers or managers have several options. They may simply ignore the risk and accept the consequences. Alternatively, producers may incorporate the
Acosts@ of risk in making farm management decisions (i.e., within the budgeting process). Finally, managers may decide to try and adjust the amount of risk that they must incorporate into their decision making process. All of these are legitimate, and in some cases optimal, responses depending on the nature of the risk and the decision maker=s attitudes towards risk.From a dairy producer
=s perspective, there are several strategies that may be considered in response to the presence of policy risk. These include reducing risk in other areas (e.g., use of risk-reducing inputs), holding reserves, diversification, participation in public risk management programs and enterprise expansion. These are discussed briefly below.Risk Reducing Inputs
The use of risk-reducing inputs is an attempt to offset risk from one source by attempting to reduce the amount of risk from another source. Historically, dairy producers have been protected from most price risk through formula pricing and the production quota system. In particular, changes (i.e., variability) in input prices have been incorporated into the pricing formula for milk. Changes in this pricing system may result in greater exposure to input price risk for dairy producers.
Changes in these factors may lead producers to consider managing the risks associated with inputs into milk production (e.g., feed, genetics). For example, milk production per cow is at least partially determined by nutrition. Providing rations that include feeds of lesser nutrient variability may result in less uncertainty in terms of the resulting production levels, thereby reducing production risk. Other examples of risk-reducing inputs may include increased use of proven sires, alternative feeding systems, etc.
Holding Reserves
Holding reserves is a risk management strategy that involves maintaining sufficient financial reserves so that the manager is able to accept and cope with the consequences of any uncertainty. One means of implementing this strategy is to simply hold cash reserves in order to deal with any negative outcomes.
Insurance is another example of holding reserves. In return for paying an insurance premium, the decision maker is able to draw on a pool of funds (i.e., make an insurance claim) in the event of a negative outcome. From a dairy producer
=s perspective, an example of this type of strategy might be the use (or increased use) of crop insurance to protect against yield risk in crop production. In the event of a crop failure, the producer is able to receive an insurance payout in order to offset the increased costs of purchasing the necessary feed.Diversification
Diversification is a time honoured strategy for risk management. The principle behind diversification is to
Anot have all of your eggs in one basket@, or to use a dairy equivalent, to Anot put all of your milk into one pail@. Diversification involves incorporating more than one investment or enterprise into the overall portfolio for the manager. If returns from one enterprise are lower, hopefully returns from one of the other enterprises will be higher, thus offsetting the effects of the negative outcome. The effectiveness of diversification depends on the degree of correlation in returns between alternative enterprises, the number of enterprises included, and the average level of returns (and variability of returns) associated with each alternative.With respect to dairy production, some dairy producers operate
Amixed farms@. These operations generate income from not only dairy production, but also beef/hog/crop production. This is a form of diversification. Dairy producers who allocate at least part of their time and energy to off-farm employment are also practising a form of diversification. However, most dairy operations are relatively specialized, with the manager focussing time and effort on the dairy enterprise alone. Any crop enterprises are maintained for the purpose of supplying inputs into the dairy enterprise.One problem with considering diversification as a risk management strategy for these specialized operations is that in order to diversify one of two things must occur. Additional resources may need to be found to invest in alternative enterprises. This may require debt financing, thus adding to the financial risk and perhaps defeating the purpose of diversification. Alternatively, resources must be diverted from the dairy enterprise in order to support the alternative enterprise. This would likely have the effect of reducing the efficiency associated with the dairy enterprise, again rendering the overall risk management strategy less effective.
Having stated that, however, there are diversification options that may be considered by dairy producers. These may include
Aadding value@ to by-products of the milk production process. Two of these by-products are beef calves and manure. For example, depending on physical, financial and human resources, it may be possible for dairy producers to consider keeping bull calves and raising them as feeders, thus diversifying into beef production.Public Risk Management Programs
Besides internal risk management strategies, there are public risk management programs that are designed to aid agricultural producers in managing the risks associated with production and marketing activities. These include the Net Income Stabilization Account (NISA) program and, in Alberta, the Farm Income Disaster Program (FIDP). These programs tend to involve a combination of subsidization and stabilization over time in order to improve farm performance and reduce risk (e.g., 4).
While these types of programs have always been present, in one form or another, the importance or relevance for dairy producers may increase as other sources of protection (e.g., cost-of-production pricing) begin to weaken. However, reliance on public programs is effective only as long as such programs continue to exist. Just as changes in dairy policy may cause producers to look for alternative risk management strategies, changes in government attitudes towards safety net programs may have the same effect.
Dairy Expansion
Dairy expansion may not seem like a viable and appropriate response to increased risk. Expansion requires additional (maybe significant) resources, perhaps resulting in increased debt load and leverage which in turn leads to increased financial risk (i.e., further exposure to risk). However, given the evidence of size economies in dairy production (e.g., 1, 6, 7), dairy expansion can result in increased cost efficiency for producers (i.e., reduced average costs of production). This improvement in terms of costs may make it possible for producers to better cope with reduced levels and increased variability in milk prices. However, before undertaking such a strategy, producers would have to carefully weigh the costs and benefits associated with expansion (e.g., if it requires significant quota purchases, what are the implications if the quota system changes).
# Concluding Comments
It should be noted that there is no discussion in this paper as to the
Abest@ response to policy risk in dairy farming. The reason for this is that the optimal strategy will depend on individual circumstances. For example, whether or not adjusting input use is the best response to increased risk depends on the results of a detailed budgeting process. It will also depend on the subjective attitudes towards risk held by the individual producer.Instead, this paper has focussed on the process involved in assessing policy risk and its effects. This has included discussion of the sources of policy risk for dairy producers, how policy risk enters into the decision making process for dairy farm management decisions, and some general strategies that may be considered by dairy producers in response to increased levels of policy risk in the future.
In the current policy environment, Canadian dairy producers are relatively sheltered from many sources of risk. This situation may change in the future, however, and it is important for the future viability of the dairy sector in western Canada that producers recognize this and take appropriate actions in terms of farm management decisions, particularly from a long-term perspective.
# References