CAP Reform – the Luxembourg Agreement 2003 and Decoupling Lecture 9. Economics of Food Markets Alan Matthews

Lecture outline To describe the component elements of the Mid Term Review (MTR) Agreement in 2003 and how it has been implemented To review studies on the impact of the MTR both in the EU and Ireland To provide an economic analysis of decoupling of direct payments

The MTR Agreement June 2003 Agreement –Intervention price cuts (rice, dairy) –Decoupling –Cross-compliance –Modulation –Financial discipline Mediterranean package April 2004 Sugar November 2005

Intervention price cuts - dairy Dairy quotas will be maintained until the 2014/15 season. Asymmetric price reductions for butter and SMP. The intervention price for butter will be reduced by 25% between 2004 and 2007 (10% more than agreed in Agenda 2000), for SMP, prices will be cut by 15%. Compensation payments are provided to milk producers as part of the Single Farm Payment from 2007, but Member States may introduce it from 2005.

Decoupling: rationale for Commission proposals Simplification of payment arrangements Encourages greater market orientation Will reduce pressure on environment Will improve efficiency of income transfer to farmers Will make it easier to extend CAP to accession countries Will make it easier to defend payments in the WTO

Decoupling – the options Full or partial decoupling –Various shares of payments can remain commodity- specific (coupled) – next slide Time of implementation –Between 2005 and 2007 Choice of payment schemes

Partial payment options

Calculation of entitlements Historic payment scheme SFP aid per hectare = (Sum of farmer’s individual aid / average of farmer’s eligible hectares ) * payment rate for 2002 Deductions made for national reserve Regional Aid – flat rate SFP aid per hectare = (Average Sum of aid in region / Average eligible hectares in region ) * payment rate

Payment options in the UK Northern Ireland – static vertical hybrid –Consists of a flat rate, area based payment topped up on historic basis for individual farmers Scotland – historic entitlements –Top slice the payment using the National Envelope mechanism to provide specific support to beef Wales –Adopted the historic model England – dynamic hybrid –Moving to a flat rate system from historic entitlements over a transition period to Two regions defined with different flat rate entitlements

The Single Farm Payment in Ireland Financial ceiling applicable to each Member State – Ireland €1,322m (including dairy premium) Where sum of entitlements exceed ceiling linear % reduction applies 3% reduction for modulation, increasing to 5% - €5,000 threshold (85% of modulated funds remain in Ireland for Rural Development) Up to 3% reduction for National Reserve Entitlements can be leased with land, and sold with or without land Stacking of entitlements allowed in some circumstances

Decoupling: the effects Output effects –By how much will output fall –What will be the knock-on effects on agro-industry and agri- services Environmental benefits arise through more extensive production… … but danger of land abandonment in marginal farming areas Long term sustainability

Cross compliance - requirements Farmers receiving direct payments -SPS- must respect cross compliance –Statutory Management Requirements (Annex III) –Good Agricultural and Environmental Condition (Annex IV) Farmers - as all citizens - expected to respect legislation without support. So payments cannot be justified on multifunctionality grounds that society is paying farmers for unpriced services valued by society The monitoring of standards: Introduction of farm audits –Mandatory for producers receiving more than €5,000 in direct payments –Financial aid for audits to be available

Statutory Management Requirements (SMRs) From 19 Community legislative acts 5 directives on environment –Wild Birds, Groundwater,Sewage Sludge, Nitrates and Habitats 4 Directives/Regulations on the identification and registration of animals 7 Directives on public, animal and plant health 3 Directives on animal welfare Directives apply as implemented by MS

Modulation : budget rebalancing Key problem is how to increase the funding of the second pillar within the constraint of a fixed overall agricultural budget Modulation already introduced as a voluntary option in Agenda 2000 Commission’s original 20% modulation proposal opposed: –Leads to redistribution within farming –Leads to redistribution between member states –Countries find it difficult to find the counterpart funds –Second pillar schemes have high transactions costs –Agricultural Ministers not necessarily keen on second pillar spending –Problems in finding sufficient worthwhile rural development projects

Modulation decision Distribution of funds raised through modulation –One percentage point will remain in the Member States where the money is raised –Remaining amount will be allocated among Member States according to: criteria of agricultural area agricultural employment GDP per capita in purchasing power –Every Member State will receive at least 80% of its modulation funds in return Budget year to 2013 Farms with up to € direct payments a year 0% Above € %4%5%

Financial discipline Direct support will be adjusted from 2007 when forecasts indicate that CAP Pillar 1 expenditure comes to within €300 million of the ceiling set out in the Financial Perspectives Expectation that this will be needed to cover costs of Bulgarian/Romanian accession (7%) plus possible costs of any further CAP reform

Impacts of decoupling Many studies –Teagasc FAPRI-Ireland –OECD –Commission Impact studies –FAPRI-US –Dixon/Matthews (forthcoming) We look at some results from the Dixon/Matthews study

Change in volume of output as result of MTR Source: Dixon and Matthews, forthcoming

Farm Incomes SHORT RUNLONG RUN Cause Primary factor price indexOutput(c)GVAF Primary factor price indexOutput(g)GVAF (a)(b)=(a)+(b)(d)(e)(f)=(e)+(f)(h) Dairy Market Reform Decoupling Rest of EU Total

Change in agricultural greenhouse gas emissions (CO2 equivalent)

Growth in importance of direct payments in the CAP Introduced in MacSharry reform, strengthened under Agenda 2000

Source: US FAS Gain Report No CAP Reform 2003

Decoupled payments – conceptual overview OECD dimensions (OECD, 2001) –Theoretical dimension – how do agricultural policies, including direct payments, potentially affect production and trade –Empirical dimension – what do we know about the actual production and trade impacts of different types of agricultural policies, including decoupled payments –Regulatory dimension - ‘best practice’ in the design of the most decoupled policies or policy practices, not least to be WTO compatible.

Decoupling - definitions Full decoupling –policy is fully decoupled if it does not influence production decisions of farmers and if it permits free determination of market prices –Importantly, both the shape and the position of the supply and demand curves should not be changed Effective full decoupling –Where policy results in a level of production and trade equal to that which would have occurred if the policy were not in place –Example would be a coupled payment combined with a quantitative restriction equal to the old production level

Example of how the definitions differ Although new policy (represented by S’) yields the same level of output initially, adjustment to a demand shock leads to a different output level than before

The degree of decoupling Comparing the degree of decoupling requires a reference, usually taken as the output effect of market price support From producer perspective, defined as 1 minus the ratio of the production effect of the policy package over the production effect of the equivalent (in PSE terms) price increase

Can decoupled payments affect production? Source: Baldwin June 2003 CAP Reform

Decoupled payments in an uncertain world Where farmers are risk averse –Wealth effects: Change in farmer’s total wealth can affect his attitude to risk –Insurance effects: If policy reduces the total risk faced by the farmer (e.g. price stabilisation scheme) it will have positive effect on output

Decoupling in a dynamic world Where there are capital market imperfections, any kind of income support – even decoupled – will be partially reinvested in agriculture Where there are expectations of a future policy change and farmer can hope to influence this (e.g. change in base acreage for a payments scheme) decoupled scheme can affect production.

Source: OECD 2005 Decoupling – Policy Implications