Dairy contracts in European countries: research

Executive Summary

• This report presents the results of analysis on compulsory contracts or mandatory written contracts (MWCs) applied within the dairy sector of European countries, looking into their impact and how they currently operate. This evidence will allow stakehodlers to come to an informed view as to their likely suitability and application in Scotland.
• The purpose of this study is threefold:

a. to provide an overview of the current dairy landscape in Scotland. This part of the work comprises a quantitative overview of the Scottish dairy sector structure based on available data and;

b. to provide an overview of how these contracts are structured and operate in selected representative countries in Europe. As part of this work, case studies for six countries were constructed for: France, Hungary, Italy, Poland, Romania and Spain;

c. to compare the Scottish sector with that of countries where MWCs are in operation; to examine and assess how MWCs could be applied in Scotland and likely impact of doing so and recommend to both industry and the Scottish Government steps to maintain the industry's long-term future.

Overview of the current dairy landscape in Scotland

Structure of the industry in Scotland

• Scotland produces about 1.5 million litres of milk (around 9% of the UK milk production) and about 43% is in the hands of cooperatives. The evolution of the Scottish and the Rest of UK production is similar.
• The top 5 processors account for around 94% of the all milk collection – with the top 2 accounting for around 56%. Farmers’ production depends strongly on them due to the exclusivity of milk delivery.
• Almost 80% of the milk collected in Scotland is used for drinking milk and cheese (most of which is Cheddar). Both markets are very competitive at the retail level, which is the main market destination.
• Milk production is seasonal, increasing in spring and decreasing in autumn. Information by processor shows that not all of them see the seasonal variation in milk collection (e.g., maybe due to contracted milk explains a lower proportion of the processors’ need and the remaining is completed with milk purchase on the spot market).
• Prices paid to farmers for different milk uses (except between 2015-16) have a very close evolution. This is due to the fact that milk does not have differentiate utilisation. The reflection of this is that milk is considered commodity and its price follow the international price of traded commodities such as SMP or cheese.
• Milk uses by processor are in very competitive categories: drinking milk and cheese. The retail market is highly competitive, with private labels being an important category in both product category. Processors supply retailers with branded and private label product because the need to produce at full capacity to reduce their cost per unit of output.

Dairy contracts in Scotland

• Contracts are usually open ended (“evergreen”) with processors generally committing to purchase all the milk produced on a farm (i.e. exclusivity) during the period of the contract.
• Notice periods for pricing agreements are generally long, from a minimum of three months to up to 12 months required from the farmer to the processor, with sometimes longer notice periods required from the processor to the farmer.
• Farmers’ participation on the negotiation of contracts depends on the type of organisation i.e., whether it is a co-operative, a private company negotiating with a producer organisation, formal representative framework set up for the purpose or through dialogue at ad-hoc meetings. Similarly happens with the resolution of conflicts.
• Base prices in contracts are depend on commodity markets’ prices (e.g., skimmed milk powder, cheese, butter).
• Prices paid to farmers tend to consider the following elements: valuation of the milk by constituent content (e.g., butterfat, protein), quality requirements, pricing adjustments for milk quality, volume collection, transport, farm management practices.
• Because of the competitive environment faced by processors, price clauses in contracts between processors and suppliers have historically been built around flexibility, i.e., the use of what is termed ‘purchaser discretion’, which means that a processor (milk purchaser) has the right to vary the price paid to farmers as and when they see fit.

Comparison of dairy sector features in the studied countries

• The following table compares the features of the dairy sector in each one of the analysed countries.

Comparison of dairy sector features in the studied countries

Notes: 1/ Percentage of milk collection in the most recent year with information (i.e., 2016 or 2017).

Introduction of mandatory contracts and farm price volatility

• The impact of the implementation of MWCs (under the EU agricultural Common Market Organisation (CMO) regulation) on raw milk price volatility was investigated in twelve member states using time series models.
• Results showed evidence that in France, Hungary, and Slovakia milk price volatility decreased after the implementation of MWCs.
• However, in the rest of analysed countries were varied, with raw milk prices’ variance either found to be constant (Bulgaria, Cyprus, Italy, Poland, Portugal, and Romania) or to vary in a non-significant manner over the period studied (Lithuania, Slovenia and Spain).
• The above results can be due to a variety of causes such as that written contracts were commonly used before the 2012 Milk Package or the fact that CMO regulation included not only prescriptions about the introduction of MWCs but also other recommendations (e.g., implementation of dairy farmers’ PO and IBOs).

Comparison of Scotland and countries where MWCs have been applied

• The aim of the CMO rules was to improve stability in the EU dairy sector by promoting better contractual relationships and addressing the imbalance of bargaining power between farmers and first purchasers.
• Whilst there are points in common in the dairy sector of each country, such as retailers are the stakeholders with most significant negotiation power; there are substantial differences amongst all of them, which makes analysing and comparing them methodologically challenging. This also speaks positively about the adaptability of the CMO rules behind MWCs to the different business environments.
• None of the studied cases pointed out that MWCs brought problems for their dairy sectors and in at least one case (i.e., France) processors were grateful that the exclusivity clause was eliminated as part of the introduction of MWCs.
• Establishing MWCs may bring an initial cost for the industry to adapt their current contracts and practices but it may increase the transparency and certainty for dairy farmers.
• However, there are important factors to consider regarding the implementation of MWCs:
  • It is important to consider their structure together (e.g., volumes, pricing and contract length) instead of analysing each clause independently and keeping the other aspects unmodified.
  • Under the current market structure, characterised by highly vulnerable processors due to their products’ portfolio and changes in their costs of production, it is not feasible to introduce pricing mechanisms and minimum contract duration without taking into consideration delivery volumes.
  • An example of the above could be the case of a contract between a processor and farmers, where the conditions are a contract length of year (i.e., the conditions of the contract cannot change during that period), the price paid to farmers depends on the international price of skimmed milk powder (SMP) through a formula, and the farmers deliver all the milk they produce to the processor (i.e., under exclusivity). If the price of SMP increases dramatically, it will encourage farmers to produce more and the processor will face a substantial increase on the total costs of milk and will need to dispose the excess of milk without necessarily having a market for it.
  • There are at least two ways to reduce the processor’s vulnerability in the above example: one way would be to consider a contract where the exclusivity clause is eliminated and replaced by an agreed in advance schedule of milk delivery (i.e., agreed volumes). The second way, would be to maintain the exclusivity clause but replace the price formula by a type “A&B” pricing, where the processor would pay price A for an agreed volume of milk and much lower price for any milk delivered in excess of the agreed volume. The low price should discourage farmers to produce in excess.
  • The elimination of the exclusivity clause worries some processors that it will create them problems to ensure a reliable supply of milk. The observed abroad experiences indicate that processors operate without any problem by asking farmers to state in the contract their expected quarterly or monthly milk supply for the contract period (e.g., a year), also including clauses that allow for deviations from those values and penalties in case of very significant deviations.
  • Note that the effectiveness of the A&B pricing depends on the reaction of the supply to the set prices. If the B price is set too high, low cost producers may still over deliver.
  • The introduction of POs can be a good way not only to improve the bargaining power of farmers but also to organise milk supply for processors.

Recommendations for the Industry

• The motivation of this study was the results of the consultation on the formal extension of the GCA’s remit to cover primary producers (February 2018), which announced to introduce legislation governing contracts between producers and purchasers (i.e., MWCs) to provide extra transparency and certainty for dairy farmers by setting out minimum terms within a contract.
• In general, the study does not find reasons why the MWCs cannot be applied to the Scottish dairy market. However, the specific conditions need to be negotiated between the parties:
  • To avoid excessive exposure of processors to risk and therefore damages to the dairy supply chain, it is important that volume delivered clauses should be considered together with pricing and minimum contract time duration.
  • Thus, one option would be to eliminate the exclusivity clauses and replace them by agreed volume to be delivered.
  • Given the seasonality of the production annual contracts are probably the most suitable duration of the contracts (evergreen contracts can be negotiated by the parties).
  • Farmers commit on contracts a schedule of quarterly or monthly volumes, with deviations negotiated.
  • Another option would be to consider a pricing mechanism of the “A&B” type, while maintaining the exclusivity clause.
  • Written offers in advance (i.e., a formal offer is sent to the producer say two months in advance of the contract termination date) can be useful to avoid difficulties to producers trying to terminate their contracts within a reasonable period (e.g., if significant changes to prices or the terms of contracts are proposed.)
  • The pricing scheme chosen (i.e., fixed, formula or a combination of both) is also subject to negotiation and might depend on the duration of the contracts. The industry can benefit of encouraging POs. For farmers, they can provide bargaining or at least greater help with understanding the details behind the contracts. For processors they can provide an organised way to collect milk reducing transaction costs.
  • In addition, establishing an IBO, bringing together all the stakeholders, would be useful for the industry as it will allow them to discuss supply chain issues. It could be a way to develop collaboration on the dairy supply chain.

Recommendations for the Scottish Government

• Encourage the formation of POs led by negotiators with skills and experience and are able to gain the trust of farmers. A strategy for this needs to be established with probably the Government supporting financially the starting of the POs, although they should be supported by the farmers.
• Encourage the industry to create an IBO, with the participation of all the stakeholders i.e., farmers, processors and retailers, to discuss dairy supply chain issues and move towards a collaborative approach.