Dairy contracts in European countries: research

1. Introduction

1.1 In order to understand the current policy environment surrounding the discussion on mandatory written contracts (MWCs) one should go back to the proposal introduced by the European Commission (EC) in 2010 in preparation for the elimination of milk quotas in March 2015.

1.2 Uncertainty over the impacts of the abolition of milk quotas in 2015 coupled with a period of intense price volatility in 2007–09 led the European Commission to establish the High-Level Experts’ Group (HLG) on Milk in October 2009 (HC-EFRA, 2011). Based on the HLG reports in June 2010 and December 2010, the European Commission released its proposal on ‘Contractual relations in the milk and milk products sector’ (i.e., the ‘Milk Package’) (European Commission, 2010), where it stated that the problems of the dairy sector were:

• Inadequate price transmission along the chain, in particular as regards prices received by farmers.
• The value-added in the chain had become increasingly concentrated in the downstream sectors, notably with dairies.
• The volume of milk to be delivered during the season was not always well planned and there was a potential lack of adaptation of supply to demand as farmers were obliged to deliver all their milk to their buyers.
• There was a lack of widespread use of formal, written contracts containing basic elements and made in advance of delivery (e.g., lack of clear pricing, where in some cases, those buying milk were able to change the price at short notice, or even retrospectively without the option of a farmer stopping to supply milk to that buyer).

1.3 The Milk Package proposal put forward the following four recommendations (with the new rules applying only until 30 June 2020):

1. Member States could opt to make it compulsory for dairy producers and processors to provide farmers with written contracts specifying a price or price formula, the delivery volume, the duration of the contract and the timing of collections.

2. Dairy producer organisations (POs) would be allowed to be established so they could jointly negotiate contract terms, including price, as long as they do not exceed 3.5% of EU production or 33% of national production by volume.

3. Interbranch organisations (IBO) could be set up across the supply chain to improve transparency and promote best practices, without distorting competition.

4. An explicit legal basis for Member States to allow for the collection of information from processors on raw milk deliveries on a monthly basis.

1.3 The House of Commons - Environment, Food and Rural Affairs Committee (HC-EFRA) (2011) discussed the EU proposal and highlighted that the forthcoming abolition of quotas, coupled with growing global demand for dairy products, was creating a window of opportunity for UK dairying; moreover, UK milk production was increasing for the first time in nearly ten years. However, despite the surge in global food prices, milk prices remained below the average cost of production, threatening the ability of some dairy farmers to continue producing and indicating serious issues of price transmission.

1.4 HC-EFRA recommended written contracts should specify either the raw milk price or the principles underpinning price, the volume and timing of deliveries, and the duration of the contract. They concluded that it would be essential for the new form of contract to be made compulsory, otherwise there would be no improvement in the system. In addition, they agreed with the principle of increasing farmers’ negotiating power through enabling producer organisations to jointly set prices with processors, although they recommended that national competition authorities should be required to approve the formation of producer organisations that cover over 20% of national milk production to avoid distortions of competition.

1.5 The Committee also insisted that Defra should take more proactive steps to increase investment in processing and reduce farmers’ production costs, including supporting innovative research and development. As large-scale dairy holdings were a significant future development for the industry, and could raise issues beyond the responsibility of planning authorities, Defra must establish its position on large-scale dairying.

1.6 Low milk prices in 2012 created financial difficulties for UK dairy farmers, particularly in the summer of 2012, when processors announced a series of milk price reductions to be implemented at short notice. Although some of these price cuts were subsequently withdrawn, ministers from the UK administrations worked with industry representatives to help secure an industry-led solution, which resulted in September 2012 in the signing of a voluntary code of practice for contractual relationships between dairy processors and producers inspired by the measures of the Milk-Package (Dairy UK et al., 2012). As of March 2013, it was estimated that 85 per cent of British milk was bound by the principles of the voluntary code. A report published in March 2013 by the House of Commons – Welsh Affair Committee (HC-WAC) (2013) concluded that:

• The new voluntary code of practice was an important step forward to redress the balance in the contractual relationship between dairy producer and purchaser. All dairy processors who have not yet signed the voluntary code should do so.
• The code must be given time to work. The UK Government should set out precisely when and how it intends to measure the success or failure of the voluntary code.
• Should the voluntary code fail in its objectives, the UK Government must legislate for a statutory code of contracts in the dairy industry.

1.7 A 2014 review of the Voluntary Code of Practice (‘Code’, hereafter) chaired by Alex Fergusson, MSP, identified a high degree of commitment to the continuation of the Code. It stated that where it had been used most effectively it had benefitted both the producer and processor; however, more needed to be done to get the wider industry to appreciate all of the potential benefits. The review put forward seven recommendations:

1. The current notice of termination should remain unchanged.

2. The Code should clarify that a 30 day notification of a price change is only required in the case of a price decrease.

3. A good practice clause should be written into the Code to ensure that the producer is fully aware of the details of any new contract they are considering.

4. The wording in the Code, regarding early termination/payment of liquidated damages, should be changed.

5. Contracts should allow a producer to supply other purchasers where they wish to expand their production and the purchaser does not want to purchase the additional milk under the contractual terms and conditions, or where there is a ceiling on total volume of milk to be delivered within a 12-month period.

6. There should be wider adoption of the Code, with the possibility of expanding it to include retailers, whilst maintaining the voluntary nature of the code.

7. The Code should include a requirement for DairyUK, NFU and NFUS to meet at least every 6 months to review progress and engage in an on-going dialogue on any code-related issues.

1.8 In March 2015, dairy quotas were eliminated and milk prices were left to be determined by the market. The period after the elimination of the quota was characterised by a decreasing trend in the average price of milk (as observed in all EU milk prices across the EU). However, when disaggregated by milk contract prices, the results showed significant heterogeneity (with some prices rising in the period), reaching a gap between the highest and the lowest price of up to 18 pence per litre in August 2015, when the average price was 23.3 pence per litre (Costa-Font and Revoredo-Giha, 2018). This situation raised concerns about whether the average milk price for the UK calculated by Defra was a good indicator of the general trend of overall milk prices (AHDB, 2015).

1.9 In 2016, a formal call for evidence was launched by the UK Government to explore the case for extending the remit of the Groceries Code Adjudicator (GCA) beyond enforcing the Groceries Supply Code of Practice, and, for example, to cover relationships between farmers and processors. The consultation revealed a number of specific concerns for the dairy sector (which were already pointed out in the introduction of the Milk Package) such as:

• problems with the balance of bargaining power in the groceries supply chain;
• examples of unfair or unclear contract terms;
• difficulties caused by late payments;
• and a lack of trust and transparency that discouraged good relationships across the supply chain.

1.10 It is important to note that most large retailers highlighted problems with extending the GCA’s remit and argued against any further intervention, warning that this could dilute its effectiveness by adding further responsibilities. There were also concerns about funding and doubts of how any extended role for the GCA could be delivered in practice (Farm Business, 2018; ABC, 2018).

1.11 In February 2018, the UK Government announced that a formal extension of the GCA’s remit to cover primary producers would not be appropriate, and instead, it would identify certain actions to address the main concerns. One of the announced actions was to introduce legislation governing contracts between producers and purchasers under Article 148 of the EU Commission (note that under the voluntary code, contracts are not subject to governance). The objective of legislating dairy contracts was to provide extra transparency and certainty for dairy farmers by setting out minimum terms within a contract.  These would include, at a minimum:

• the price payable for the delivery of milk – expressed either as a static price or a formula;
• the volume of raw milk to be delivered and the timing of deliveries;
• the duration of the contract;
• details of payment periods and procedures;
• arrangements for collecting or delivering raw milk; and,
• rules that apply in the event of force majeure

1.12 Industry commentators believe that introducing mandatory written contracts (MWC) could help to reinforce the responsibility of operators in the dairy chain (farmers and milk buyers) and increase their awareness of using market signals to improve price transmission and to adapt supply to demand because MWCs aim to: i) ensure the presence of a contract and ii) specify a range of criteria that must be included.

1.13 Note that currently, the European Commission gives Member States discretion as regards whether they should apply MWCs between dairy producers and processors for the delivery of raw milk.  The EC (2014) provided an update of the Milk Package implementation indicating that 12 countries had adopted MWCs with different characteristics.  The latest information (as of 2016) indicated that Slovenia and Poland had introduced them since January and October 2015, respectively. In addition, there were some modifications of the positions taken as regards the mandatory contracts. Thus, Cyprus, which had introduced compulsory contracts in June 2013, modified its position by making them compulsory only for recognised producer organisation (PO) and associations of producers’ organisations (APO) and for a minimum duration of one year; since April 2015 contracts in Latvia were no longer made compulsory; and the minimum duration of the contracts in Italy was extended to one year. These changes brought the number of countries applying MWCs to 13.

1.14 In the aforementioned context, the aim of this research project is to provide an analysis of the MWCs in European countries as there is currently limited evidence on the impact of these in the countries in which they currently operate. This evidence will allow Scottish Ministers to come to an informed view as to their likely suitability and application in Scotland. Specifically, the purpose of this study is threefold:

1. To provide an overview of how MWCs 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.

2. 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 (e.g., Economic Report on the Scottish Agriculture, Milk Utilisation Survey and Kantar Worldpanel, AHDB dairy prices) and it also covers factors that affect farm gate prices, e.g., how farmers, processors and retailers work together to establish contracts considering the structure of these contracts, their duration.

3. 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.

1.15 The structure of the report is as follows: it starts with an overview of the current dairy landscape in Scotland including contracting practices. It is followed by a review of the evidence on dairy contracts in European countries based on six case studies. The next section discusses the similarities of the Scottish sector with that of countries where MWCs are in operation in order to analyse how these could be applied in Scotland and their potential impact. Finally, the report provides recommendations to both industry and the Scottish Government steps to maintain the industry’s long-term future.