The Future Of European Dairy Policy

This report examines the EU dairy sector and international market developments. Particular attention is paid to the decline in intervention prices as applied in recent years and the possible impact of the abolition of the milk quota system. It also analyses the potential impact of a new WTO agreement and stricter environmental legislation.

calendar icon 26 July 2010
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Trends in dairy farm structure, milk prices and dairy farm income

Although the (binding) milk quotas effectively fix milk production at farm level this has not precluded structural adjustment. This is particularly true for member states where quotas were freely tradable, but also when there were significant restrictions on quota trade, structural change did not come to a standstill.

The net result of structural change is a decline in the total number of dairy farms in all member states considered, significant increases in dairy farm scale (herd size), and a declining share of small farms in total milk production.

The farm gate milk prices measured in nominal terms declined slightly in the period 2001-2006 and showed strong fluctuations thereafter.

Income per (family) working unit in dairy has increased over the period 2000-2007, with the main explanatory factor being farm scale increase. As such structural adjustment within the dairy sector is an important factor to cope with the negative impact declining prices may have on farm income.

The critical milk price (the milk price a farmer needs to cover all his costs - including depreciation - and to secure continuity of farming) in 2006-2007 for the observed member states was on average €0.34/ kg of milk. The critical milk price not only significantly varies over member states, but even more so over farms within member states.

For the period 2002-2007 the average critical milk price in the Netherlands was about €0.32/ kg of milk; 29 per cent of the farms had a lower critical milk price and 36 per cent had a higher one. About 10 per cent of the Dutch dairy farms had a critical milk price of €0.22 /kg of milk.

The larger the scale of a dairy farm the lower is its critical milk price, as larger farms tend to have lower costs of production as well as a lower 'cost of living' per unit of milk produced.

Recent market developments

Regarding recent market developments the following conclusions can be drawn.

The dairy market has been subject to several shocks, which were partly related to phenomena associated with the dairy sector itself (impact of weather circumstances), partly with agriculture as a whole (the impact of changing feed prices), and partly with the macro economy (worldwide economic recession).

Dairy markets are in general characterised by inelastic demand and supply. This implies that small changes in demand and supply (shocks) can cause large changes in price.

Recent developments as such underscore that the dairy sector is increasingly intergrated with the rest of the global economy, in particular with energy markets and currency markets (exchange rate impacts).

Until recently the EU dairy sector has been effectively protected from price volatility by its dairy policy, which not only supported prices but also stabilised them.

Due to the lowered intervention prices, the current policy functions more as a safety net provision against very low prices.

Price volatility in the EU will increase. Extreme price volatility only occasionally occurs. Stabilisation of prices and avoiding extreme downside as well as upside price swings generates several benefits to stakeholders in the sector by reducing uncertainty, avoiding substitution of dairy products for other products etc.

Possible price developments in the years to come

Both modelling studies and projections carried out in the research project that over time prices will increase due a demand increase.

Under normal circumstances the EU milk price is projected to be above intervention price equivalent milk price, which has been substantially lowered.

According to the projections used in this study EU exports of cheese, butter and whole milk powder seem to be very difficult without export subsidies, which consequently will occur against lower prices.

Reduction of import tariffs as part of a WTO agreement affects most EU cheese markets. However, diversity of cheese varieties is great which implies many different prices on segmented markets.

Recent outlooks on dairy markets indicate favourable market developments leading to significant higher international prices. At such (higher) prices import competition will be much less and export opportunities will increase for all EU dairy products.

As becomes clear when comparing the most recent outlook projections, uncertainty on projections is great, reflecting uncertainty with respect to global macro-economic developments. As such the results from our analysis should be interpreted with caution.

Policy scenarios and model simulations for the Dutch dairy farms sector

From the previous analysis the following conclusions can be drawn.

The model simulations confirm the negative impact on the profitability per kilogram of milk associated with the recent reforms of the EU's dairy policy will be compensated for by the continuing structural change (increase in farm scale lowers costs of production per unit of milk).

The simulations with DRAM show that in case of an extra increase in milk quota in the period before 2015, gross margins will be affected in a limited way. For small and extensive farms the gross margin per farm declines with €2,000, while for large intensive farms it increases by about €5,000.

After quota will be abolished in 2015, it is expected that milk production will further expand in the Netherlands by about 11 per cent. Thereby it is taken into account that a new WTO agreement may lead to an eight per cent further milk price decline.

A considered more strict environmental legislation might curb this expansion effect, but only slightly.

Transitional policies: ways to quota abolition

In this section several policy instruments are reviewed. First the classical policy instruments are considered and their potential contribution to contribute to a soft landing is assessed.

Second, both public and private measures are reviewed with respect to their potential contribution to addressing the negative impacts of price volatility.

With the 2003 Fishler reform intervention prices for dairy products were substantially lowered, but due to favourable market circumstances this initially did not lead to a strong actual price decline. When market circumstances worsened (2008-2009) the milk price significantly declined to the low intervention price level. As a response the EU Commission offered to option for compensatory direct payment.

Since the EU's milk production did not actually increase, not direct relationship is observed between the increases in the milk quota during the period 2006-2009 and the decline in the milk price.

Increasing the degree of tradability of quota both within and over member states would favour the structural adjustments in the dairy sector, which in the end will unavoidably take place after full implementation of the dairy policy reform. This in particular holds for farmers and/or countries which currently face binding quota constraints. Increased tradability of quota would help the dairy farm sector to prepare for quota abolition and further milk price decline.

The dairy policy reform, including an increasing withdrawal of the public sector requires new public - private arrangements and a redefinition of each others roles and responsibilities.

For example, strong public policy interference might hamper the development of private instruments. In contrast, having a public supported independent market information system might contribute to the advancement and well-functioning of private instruments. The big challenge is how to find an adequate balance. Given its mandate (which includes a responsibility for some degree of price stabilisation), there remains a role for the EU Commission to arrange or contribute to a safety net, in particular to cope with extreme downside prices and/ or income risks.

The changing policy environment is most likely to induce new developments to cope with price volatility. As regards the public policies, currently the intervention policy provides protection against extremely low price swings. In addition, the single farm payment contributes to the stabilisation of dairy farmers income.

Several options available to the private sector to cope with price volatility were touched upon in this study. However, it is still not clear to what extent they will be a substitute for previous public measures.

For example, a futures market can contribute to manage price risk but currently does not exist in the EU, and may not arrive without public and private efforts. In the US, where there is a dairy futures market and there are futures markets for other agricultural commodities, it is known that only a limited number of farmers participate.

An adequate assessment of the impact and potential contribution of public and private measures, and the interaction of private and public measures was beyond the scope of this short study.

July 2010
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