Dairy contracts in European countries: research

5. Discussion

Important points

• 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 the fact in all the countries retailers are the stakeholders with significant negotiation power; there are substantial differences between all of them. This speaks 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. In at least one case (i.e., France) processors were grateful that the exclusivity clause had been eliminated.
• 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.
• It is important to consider the structure of the MWCs together (e.g., volumes, pricing and contract length) instead of analysing each clause and keeping the other aspects unmodified.
• Under the current market structure characterised by processors that are highly vulnerable (due to their products portfolio) and changes in their costs of production, it is not feasible to introduce pricing mechanisms to the contracts and minimum duration without removing the current exclusivity clause from the contracts.
• The elimination of the exclusivity clause worries some processors that it will create them problems to ensure a reliable supply of milk. The observed experiences indicate that processor 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.
• The introduction of POs can be good way not only to improve the bargaining power of farmers but also to organise the milk supply for processors.

5.1 This discussion covers two topics: (1) a comparison between the Scottish dairy sector with those of countries where MWCs are in operation and (2) an examination and assessment of how MWCs could be applied in Scotland and their likely impact.

5.1 Scottish dairy sector and countries that implemented MWCs

5.2 Table 6 provides a comparison of the structure of the dairy sector in Scotland with those of countries that have implemented MWCs. The purpose of the Table is not to present an exhaustive description of each country’s sector but to highlight major charateristics.

5.3 Whilst there are points in common in the dairy sector of each country such as the fact in all the countries retailers are the stakeholders with substantive negotiation power; there are substantial differences between all of them. This speaks about the flexibility of the CMO rules behind MWCs to adapt to the different business environments.

5.4 Whilst France and Italy and to a less extent Hungary, are characterised by strong processing sectors with branded products that highlight the quality of the product, in Scotland the quality of the products is taken as given (as a standard) and not a source of differentiation (therefore, they do not command a premium). The effect of this is that processors have less negotiation capacity with retailers.

5.5 The above effect is reinforced by the fact that processors sell private label products to retailers. This allows processors to reduce their average costs by expanding their production, which reduces their average overheads/fixed costs (i.e., as mentioned in DairyUK contribution “[p]rocessors require a continuous flow of product, to maximise utilisation of processing plant”). However, although one should expect that retailers take the lion’s share of the increasing in profits brought by the expansion on the production (and therefore, low marketing margins by processors), there is no information about the negotiations between retailers and processors.

5.6 In categories such as drinking milk and cheese (particularly Cheddar), processors operate in an environment of intense competitive pressure and uncertainty over market returns (DairyUK), which can be exemplified by the importance of private labels on the drinking milk and Cheddar categories. Figures 16 and 17 presents the evolution of the provate label shares on both categories from 2006 to 2017 in Scotland by major retailer.

5.7 As shown in both Figures 16 and 17, the presence of private labels is significant, particularly on drinking milk. Their presence increases the competition within the category and retailers negotiation power.

Table 6: Comparison of dairy sector features in the studied countries

	Scotland	France	Hungary	Italy	Poland	Romania	Spain
Cooperatives collection (%)1/	UK (26) Sco (43)	54	40	68	74	3	36
Farming and processor	Little product differentiation. Contracts are evergreen, exclusive and price can change under ‘purchaser discretion’. Price based on commodities price.	Several PO sell to a processor. 5 year contracts and follow the CMO rules with variety of price arrangements. Farmers’ union are politically strong.	POs negotiate on behalf of farmers. 6 months contracts. Follow CMO rules. Similar contracts operated before 2012.	Imports of milk to drinking milk and other products. Important proportion of domestic milk is to PDO cheeses. POs pool the milk and manage the logistics. Contracts are 1 year and follow CMO rules.	Law does not set a minimum length contract and the conditions are left to negotiation (although they comply with the CMO rules). Processing cooperatives are important and private processors are multinationals	Large milk informal market. Introduction of contracts aimed to formalise the sector. Producers are very small (about 3 cows).	Minimum length is a year. All sales of milk must be covered by a contract. The price can be either fixed, variable or a mixture Contracts offered from the largest processors are dominated by fixed price (around 70%).
Processor and retailer	Lengths of contracts differ by product and retailer. Very competitive enviroment. Processors supply private labels and branded products.	Branded are very important (75% of the market). Negotiation of branded and private labels. Processors also produce private labels where the have very low margins, Retailers negotiate jointly against processors.	Strong retailers, mostly multinationals importing dairy products. Reputation of brands help on negotiations and provide some stability. Well diversified processors.	Retailers have negotiation power but brands are important (represent quality to consumers)	Big retailers are multinationals and have negotiation power over processors.	Retailers are multinationals and have negotiation power.	Retailer have negotiation power.
Organisations	Only 1 producer coop (MSA)	70 POs and IBO (currently only processors and producers, farmers’ union but not POs)	POs and IBO (includes producers, processors and retailers).	48 POs and no IBO.	No POs or IBO. However, have an institution that checks that contracts are complete according to the CMO.	Created POs were transformed into cooperatives. No IBO	8 POs (cow’s milk) and IBO (producers and processors). IBO keep record all the contracts and produce indicators for the sector.

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

5.8 It is important to note that the described situation may explain low marketing margins^[6] but not necessarily farmgate price volatility, except in the case when processors are in need to exercise their ‘purchaser discretion’ on prices paid due, for instance, to a sudden change in their relationship with retailers.^[7]

Figure 16: Scotland - Private label share on total sales of drinking milk

Source: Own elaboration based on Kantar Worldpanel data.

Figure 17: Scotland - Private label share on total sales of Cheddar cheese

Source: Own elaboration based on Kantar Worldpanel data.

5.9 It has long been accepted that the main source of farmgate price volatility is their condition as commodity (i.e., the same milk can be used for different purposes and it is paid according to the wholesale commodity prices e.g., skimmed milk powder, butter or mild cheddar) (Milk Development Council, 2006; DairyUK contribution). This implies that farmgate prices are exposed to the vagaries of both international markets and domestic supluses or deficits of milk.

5.10 In the above context, low marketing margins together with fluctuating farmgate milk prices and the exclusivity clause, where the processor has to purchase all the milk that is offered by farmers, imply high business risks for both producers and processors. Based on the above description of the Scottish sector the next step is to analyse how MWCs can be applied to Scotland and their effects on the sector.

5.2 How MWCs can be applied in Scotland and their likely impact

5.11 As mentioned farmers and processors operating in Scotland already market of milk through contracts. Therefore, this section will concentrate on those elements in the CMO that are not found in the Scottish contracts (i.e., as describe in the DairyUK contribution) and based on the lessons gathered in the six studied European cases.

5.12 It is important to note from the start that the aim of the CMO 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. This was also stated in the ‘Groceries Code Adjudicator Review: Part 2’ according to which, “[t]he Government plans to introduce compulsory written contracts in the dairy sector in 2018. This has a potentially valuable role to play in providing extra transparency and certainty for dairy farmers […]. Formal consultation will be undertaken on the necessary secondary legislation. Our aim is to launch the public consultation by March 2018” (HM Government, 2018).

1. Compulsory formal written contracts

5.13 One of the main concerns raised in the GCA consultation (HM Government, 2018) was a significant pattern of unfair or unclear terms and conditions in contracts between producers and the processors, slaughterhouses, or manufacturers that they supply. These concerns were particularly prominent in the dairy sector.

5.14 Establishing a mandatory contract content as in the CMO should bring an initial cost for the industry to adapt their current contracts and practices (an evaluation of the cost can be found in Defra, 2013) but it may increase the transparency and certainty for dairy farmers.

5.15 Some countries (e.g., Spain) yearly publish a contract model (without mandatory application) that may be used by the industry as a blueprint contract. This allows farmers’ organisations to provide general advice to milk producers, usually the part less informed in the contractual negotiation, as to contract interpretation.

5.16 In addition, the contract may contain mediation clauses that are similar across cases.

2. The written offer: ‘evergreen’ contracts

5.17 The GCA consultation also raised the difficulties that producers face in trying to terminate their contracts within a reasonable period if significant changes to prices or the terms of contracts are proposed. These can have major commercial implications for a small producer (HM Government, 2018).

5.18 In fact, it is common practice within the UK dairy sector the use of rolling or ‘evergreen’ contracts. These contracts renew automatically after each period under the same contract conditions. This, in addition to the use of long notice periods to terminate the contract may perpetuate a non-negotiated contractual relationship.

5.19 Some countries have tried to improve this situation by imposing milk buyers the obligation to make a mandatory written offer in advance. This formal offer is sent to the producer two months in advance of the contract termination date comprising the conditions of the contract for the following period.

3. Price determination, its changes and exclusivity clauses

5.20 A number of respondents to the GCA consultation highlighted the challenge posed by variations to specifications or contract terms, especially if imposed at short notice (HM Government, 2018).

5.21 As explained in the DairyUK contribution, processors are exposed to commercial pressures (e.g., low margins at the retail market, variable farmgate prices and quantity variability as result of production seasonality combined with the exclusivity clauses), therefore, pricing clauses in contracts between dairy processors and their supplying farmers have historically been built around flexibility reflected on the purchaser discretion to vary the farm gate price as and when they see fit.

5.22 Processors have argued that purchaser discretion is a natural consequence in order to balance the commercial risk that they are assuming by taking all the milk that their suppliers produce as a result of supply exclusivity clauses.^[8] This circumstance connects price negotiation with the issue of milk volume management.

5.23 Most of the existing applications of MWCs on the European dairy markets follow the CMO regulation recommending that the price should be freely negotiated and agreed by the parts and included in the contract, either in a fixed or variable form for the duration of the contract. Clearly under the current conditions (i.e., processors buying all the milk produced by their farmers) this pricing system, would mean exposing them to a significant business risk.

5.24 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.

5.25 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.

5.26 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.

5.27 Eliminating exclusivity clauses would liberate processors from the burden of seasonal surplus of milk eliminating significantly the quantity risk. However, at the same time it would require setting volumes on the contracts leaving the responsibility for managing the marketing of any potential production surplus on the producers (or their organisations). This is the case in all the studied countries.

5.28 Another potential advantage of eliminating exclusivity on contracts is the possibility of farmers to decide what to do with the milk surplus once they have honoured their contracts. Farmers may decide to sell it to the processor if both parties agree, sell it to a different processor or decide to process it themselves.

5.29 A concern expressed regarding the elimination of exclusivity is that it may affect the stable supply of milk to processors. In all the studied countries, quantities supplied and variations are established into the contracts without bringing any problem. For instance, in France, cooperatives accept all the milk from their associated farmers whilst private processors set quantities as part of their contracts, having the possibility to buy additional quantities from their farmers at their discression. A problem that might occur is the potential existence of moral hazard issues in which a farmer reports not being able to honour its contract with a processor and instead market the milk to another one due to a better price. This could be avoided by reporting all the sales of milk a competent authority, for instance, to an IBO. This could also be avoided by the presence of PO organising the supply of milk.

5.30 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.

5.31 As regards the pricing of milk, one of the aspects of concern is the lack of indicators that are suitable to establish formulas or set fix prices. However, current practices use price indicators available in the market (e.g., wholesale prices) moderated with other factors such as the companies’ economic results as well as quality and seasonal factors. As mentioned, the CMO proposal is very flexible as it allows the Member States to introduce the specific legislation and companies to adapt their pricing to their specific situation and products. The diversity of business environments where the CMO has been applied and how it has been adapted by the Member States reflects its flexibility.

5.32 It is important at this point to ask the question whether this pricing would imply higher or less volatile prices to farmers. Under the CMO rules prices are negotiated between processors and farmers and most probably the price formulas will be based on the same commodity prices that currently determine the prices of milk in Scotland.  Therefore, one should not expect higher prices or less volatile prices due to the introduction of MWCs. However, what MWCs would avoid is the the sudden changes in conditions coming, say, from changes originated from processors’ customers (e.g., retailers). The discussion points out that there is not a lack of market price indicators to base the price formulas and a much more important point of discussion as regards the introduction of MWCs is the elimination of purchasers’ discretion right to change prices when they see fit.

4. Producers’ organisations and interbranch organisations

5.33 As noted by HM Government (2018) compared with other, more powerful players in the groceries supply chain, primary producers are much smaller and disaggregated. The lack of bargaining power of many farmers and growers was an important theme raised by those responding to the Call for Evidence (i.e., GCA consultation).

5.34 Producers’ organisations have been useful devices in some of the European countries under study to solve both issues: strengthening producers bargaining position in the negotiation of contracts and milk volume management. POs depend on farmers’ initiative and cannot be imposed, say by the Governments. However, the Government can initially foster them as they need to led by a professional team that need to gain the trust of farmers. As in the studied countries POs need to be funded by farmers.

5.35 It is clear that although international conditions matter for the industry; as explained before, the particular structure of the dairy supply chain is also important. Interbranch organisations are structures that are useful for stakeholders (where all the parties are represented) to discuss issues concerning the supply chain.