Agriculture and Rural Development Discussion Paper 3 The World Bank Coffee Markets New Paradigms in Global Supply and Demand Bryan Lewin Daniele Giovannucci Agrigulture & Rural Development Department Panayotis Varangis World Bank 1818 H Street, N.W. Washington, D.C. 20433 http://www.worldbank.org/rural Agriculture and Rural Development Discussion Paper 3 The World Bank Coffee Markets New Paradigms in Global Supply and Demand Bryan Lewin Daniele Giovannucci Panos Varangis First printing or Web posting: March 2004 ©The International Bank for Reconstruction and Development Agriculture and Rural Development Department 1818 H Street, N.W. Washington, DC 20433 Agriculture and Rural Development Discussion Papers is an informal series produced by the Agriculture and Rural Development Department of the World Bank. These papers raise concepts and issues for discussion in the broader development community and describe ongoing research and/or implementation experiences from the Bank. The findings, interpretations, and conclusions are the authors' and should not be attributed to the World Bank, its management, its Board of Executive Directors, or the countries they represent. Some of the numbers quoted are estimates or approximations and may be revised at a later stage. About the authors Bryan Lewin was previously the Economist of the Association of Coffee Producing Countries and now works in the Agriculture and Rural Development department of the World Bank on commodities and risk management. Daniele Giovannucci is a former corporate executive and market strategies expert. He advises international agencies and governments and is a senior consultant for The World Bank Group. Panos Varangis is a Lead Economist in the Agricultural and Rural Development department of the World Bank, dealing with issues related to commodities and commodity risk management. Cover graphic Alex Baluyut, 2002. A farmer tending to coffee cherries. Country unknown. Contents Acknowledgements ..................................................................................................................... vii Acronyms and Abbreviations ..................................................................................................... ix Executive Summary..................................................................................................................... xi 1. Introduction................................................................................................................................1 Historical Background .................................................................................................................................. 2 Paradigm Shifts in Supply and Demand ....................................................................................................... 6 Paradigm Shifts--Some Broader Trends.................................................................................................... 13 Looking Forward: The Current and Forthcoming Crop Years ................................................................... 14 2. Prices.........................................................................................................................................19 Introduction................................................................................................................................................. 19 Prices and Farmers Problems of Information Access ................................................................................. 20 Price Volatility............................................................................................................................................ 20 Approaches to Managing Risk.................................................................................................................... 23 Retail Prices, Concentration, and Shifts in the International Marketing Chain.......................................... 33 3. Demand: Volumes and Trends ...............................................................................................38 Overall Demand Picture.............................................................................................................................. 38 The Change in Consumer Drinking Habits................................................................................................. 39 Volume Trends............................................................................................................................................ 41 Regional Consumption Patterns.................................................................................................................. 49 Consumption in Coffee-Producing Countries............................................................................................. 59 Soluble Trends ............................................................................................................................................ 62 4. Supply: Volumes and Trends..................................................................................................63 Colombian Milds ........................................................................................................................................ 65 Other Milds (washed arabicas) ................................................................................................................... 68 Natural Arabicas (Unwashed)..................................................................................................................... 74 Robustas...................................................................................................................................................... 83 Exports From Producing Countries............................................................................................................. 91 5. Outside The Commodity Box: The Differentiated Markets................................................94 Commodities Systems and Other Options: Differentiation or Diversification ........................................... 94 Definition of Differentiated Coffees........................................................................................................... 99 iii iv The Nature of Differentiated Markets....................................................................................................... 105 Sustainability............................................................................................................................................. 107 Certification .............................................................................................................................................. 108 Market Awareness .................................................................................................................................... 111 Availability ............................................................................................................................................... 112 Price Premiums......................................................................................................................................... 113 Critical Competitive Factors..................................................................................................................... 114 Source Countries....................................................................................................................................... 115 6. Differentiated Markets: Size and Outlook ..........................................................................116 Appellation Coffees .................................................................................................................................. 117 Specialty and Gourmet.............................................................................................................................. 117 Sustainable Coffee Overview.................................................................................................................... 118 Organic...................................................................................................................................................... 121 Fair Trade.................................................................................................................................................. 123 Eco-Friendly or Shade .............................................................................................................................. 125 Sustainable Coffees: Helping Producers to Capture Diverse Forms of Value.......................................... 125 Appendix Quick Reference on Coffee Production..................................................................128 7. References...............................................................................................................................129 List of Tables Table 1 Global production, 1997 to 2004 ..................................................................................................... 6 Table 2 World Bank Forecasts of Arabica and Robusta Prices, 2004-2015............................................... 15 Table 3 India: producer risk perceptions by farm size (acres).................................................................... 29 Table 4 Nicaragua: producer risk perceptions by farm size........................................................................ 29 Table 5 Risks faced by coffee producing households in India (number and percent of people reporting risk as very important) ....................................................................................................................................... 30 Table 6 Risks faced by coffee producing households in the Dominican Republic (percent reporting risk as very important)............................................................................................................................................ 30 Table 7 Per capita consumption of coffee in selected importing countries (kilograms)............................. 43 Table 8 Shares of offtake by importing region ........................................................................................... 44 Table 9 Market share of producing origins in Western European imports................................................. 52 Table 10 Consumption breakdown in Germany, 1999-2001 (metric tons)................................................. 53 Table 11 Scandinavia: imports from origin and market share .................................................................... 55 Table 12 Poland, Hungary, Czech Republic, and Slovakia: imports from origin by share ........................ 57 Table 13 Imports into South Korea from producing countries: quantities and market share ..................... 59 Table 14 Receiving station returns in El Salvador for crop years 1997-2003 ............................................ 70 Table 15 Illustrative basic production costs of a farm yielding two tons/hectare....................................... 90 v Table 16 Illustrative production costs for a 10 hectare farm, Lam Dong Province .................................... 91 Table 17 Coffee year exports, 1994-2003................................................................................................... 91 Table 18 Soluble exports by origin............................................................................................................. 94 Table 19 FLO international conditions for sustainable coffees (U.S. cents per pound) ........................... 102 Table 20 Comparison of conventional and differentiated markets ........................................................... 106 Table 21 Volume and share of sustainable coffees in key European markets, 2001 ................................ 120 Table 22 Organic coffee sales in select European countries..................................................................... 122 Table 23 Fair trade coffee in select European countries........................................................................... 123 Table A1 Fifty-five coffee-producing countries by principal type and region ......................................... 128 Table A2 Share of export value of commodities represented by coffee................................................... 129 List of Figures Figure 1 Arabica and robusta prices, 1970-2002 .......................................................................................... 1 Figure 2 Balance of Supply and Demand in Coffee years 1992/93-2003-2004, including forecast............. 2 Figure 3 Global Production Trends by Region............................................................................................. 3 Figure 4 Global production: total production and production excluding Brazil, Colombia, and Vietnam... 5 Figure 5 Global usage by type 2002-2003 compared with 2001-2002 (July/June) ...................................... 9 Figure 6 Usage of coffee by U.S. industry by type, 1996 and 1999 ........................................................... 10 Figure 7 Usage of coffee by German industry by type, 2001 and 2002 ..................................................... 10 Figure 8 Arabica and robusta futures prices in U.S. cents per pound......................................................... 16 Figure 9 Possible path of developments in producer and consumer stock levels ....................................... 17 Figure 10 Availability and prices................................................................................................................ 18 Figure 11 Monthly volatility of arabica and robusta prices ........................................................................ 21 Figure 12 Arabica futures prices and the level of speculative involvement ............................................... 23 Figure 13 Nicaragua: aggregate percent of producers willingness to pay for risk management ................ 31 Figure 14 India: willingness to pay five percent of strike for price protection........................................... 32 Figure 15 Relative coffee values: CIF prices as a percent of retail price.................................................... 36 Figure 16 Indexed ICO prices and retail prices .......................................................................................... 37 Figure 17 Disappearance of coffee in importing countries in rolling 12 month totals ............................... 42 Figure 18 Share of types in global blends................................................................................................... 47 Figure 19 United States: usage of Brazilian coffee and price relative index.............................................. 47 Figure 20 U.S. consumption and retail prices............................................................................................. 50 Figure 21 Northern country consumption and usage of natural arabicas.................................................... 51 Figure 22 Germany: per capita consumption and retail prices (nominal)................................................... 53 Figure 23 Germany: market share of mild arabicas, and the division between primary and secondary milds55 Figure 24 Brazil: consumption by type....................................................................................................... 61 Figure 25 Production has risen as prices have fallen.................................................................................. 64 vi Figure 26 Arabica production changes vs. ranked production costs since 1994/95 ................................... 64 Figure 27 Arabica production changes and ranked cost of production....................................................... 65 Figure 28 Colombia: rolling 12 month production January 1956-October 2003........................................ 67 Figure 29 Mexico and Central American coffee production (60 kilogram bags) ....................................... 70 Figure 30 India: planted area ...................................................................................................................... 72 Figure 31 Brazil: tree stock and planted area estimates.............................................................................. 75 Figure 32 Brazilian production, 1882-2003................................................................................................ 76 Figure 33 Brazil--arabica coffee prices, September 1996 to October 2003 .............................................. 78 Figure 34 Brazil: tree stocks and densities, 1960-2003 .............................................................................. 79 Figure 35 Brazil: yields by state ................................................................................................................. 80 Figure 36 Green and soluble exports from Brazil: 12 month totals to December 2003.............................. 82 Figure 37 Vietnam: changes in planted area, area age, and coffee production........................................... 88 Figure 38 Derived data on yield of trees more than five years old and previous-season robusta prices .... 89 Figure 39 Exports from producing countries and export revenues............................................................. 92 Figure 40 Exports to all destinations, total volume and by type................................................................. 92 Figure 41 Robusta exports: market share by region, 1989-2002 ................................................................ 93 Figure 42 One hundred years of commodity prices (Real price of a mixed basket excluding petroleum). 96 Figure 43 Key factors for the expansion of sustainable coffees ............................................................... 115 List of Boxes Box 1 Coffee Producers in India................................................................................................................... 2 Box 2 Brazil's advantage.............................................................................................................................. 4 Box 3 The impacts of paradigm shifts on producers................................................................................... 11 Box 4 Colombia's National Federation of Coffee Growers (FNC) ............................................................ 68 Box 5 Selecting appropriate standards: some sample questions............................................................... 104 Box 6 Some useful shorthand definitions ................................................................................................. 105 Acknowledgements The authors would like to acknowledge contributions and assistance with data and field work from the International Coffee Organization, United States Department of Agriculture, and coffee trade companies, including Louis Dreyfus Corporation, Neumann Kaffee Gruppe, Noble Resources and Volcafe, Starbucks, CECAFÉ (Brazil), National Federation of Coffee Growers (Colombia), and VICOFA (Vietnam). Peer reviewers were Lynn Brown, Derek Byerlee and Martin Raine. Useful advice and comments on drafts came from Pauline Tiffen (World Bank CRMG), Pablo Dubois (ICO), Neil Rosser (NKG Statistical Unit), Hank Dunlop (Ecom Trading) Reto Ghilardi (Volcafe), Mark Lobering (Proctor and Gamble), Jens Nielsen (Noble Resources), Diego Pizano (Federacion Nacional de Cafeteleros) Ana Vorhinger (Armajaro Trading), Claude Barfield (American Enterprise Institute), Chris Wille (Rainforest Alliance), Liam Brody (Oxfam), Mary Williams (Starbucks Coffee) The authors would like to thank Adolfo Brizzi (SASRD), Martin Raine (LCSES), Mark Cackler (LCSER), Mathew McMahon (LCSER), Jock Anderson (ARD) and John Nash (RDVCG), whose support and encouragement made this study possible. Weights and Measures 1 hectare (ha) = 10,000 m2 = 2.47 acres 1 quintal (qq) = 100 pounds = 46 kilogram 1 metric ton = 2,205 pounds 1 bag of coffee = 60 kilogram = 132.3 pounds 1 metric ton = 16.67 bags Million = 1,000,000 Prices In October 2001, the International Coffee Organization introduced a new calculation method for the Composite Indicator. In order to keep long-term price series consistent, this report has maintained the previous calculation method. Coffee and Crop Years In this paper, references are made to production and demand quantities, and supply/demand balances using both crop years and Coffee Years. Each crop year covers an overlapping 18-month period, starting in April of one year with the Indonesian and Brazilian robusta crops, and finishing in September of the following year with the end of the crops in Central America, Colombia and Vietnam. The Coffee Year is recognized as being the International Coffee Organization's accounting period of October to September. Where the coffee is harvested across this period, as in the United Republic of Tanzania, for example, the crop year is split according to the proportion harvested. In some cases, an entire crop gets moved back one year from its crop year. An example of this effect can be seen in Brazil, where the 2002-2003 Brazil Crop Year production is recorded in the 2001-2002 Coffee Year as it is assumed to have been harvested by the end of September. This paper represents the views only of the authors and not the positions of the World Bank Group, its members, or its Board of Directors. vii Acronyms and Abbreviations ACPC Association of Coffee Producing Countries ABIC Associacao Brasilera da Industria de Café AEKI Indonesian Coffee Exporters Association AFD Agence Française de Développement ANACAFE Asociacion Nacional del Cafe (Guatemala) CECAFÉ Conselho dos Exportadores de Café Verde do Brasil CFC Common Fund for Commodities CFF Compensatory Financing Facility CIMS El Centro de Inteligencia sobre Mercados Sostenibles CONAB Companhia Nacional de Abastecimento (Brazil) CRMG Commodity Risk Management Group (World Bank) DKV Deutsche Kaffee Verband ECA European Coffee Association ECLAC Economic Commission for Latin America and the Caribbean EMBRAPA Empresa Brasilera de Pesquisa Agropecuária EUREP European Retailers Produce Working Group EUREP-GAP European Retailers Produce Working Group-Good Agricultural Practice FAO Food and Agriculture Organization of the United Nations FEBEC Federation of Brazilian Coffee Exporters FLOI Fair-trade Labeling Organization International FNC Federación Nacional de Cafeteras de Colombia G&S Grades and Standards GAP Good Agricultural Practice standards GATT General Agreements on Tariffs and Trade GIO Geographic Indications of Origin GIS Geographic Information Systems GMO Genetically Modified Organism GTZ Deutsche Gesellschaft für Technische Zusammenarbeit HACCP Hazards Analysis at Critical Control Points IBC Instituto Brasileño do Café ICA International Coffee Agreement ICAFE Instituto Costarricense del Café ICO International Coffee Organization ICP International Coffee Partners IFOAM International Federation of Organic Agriculture Movements IHCAFE Instituto Hondureño del Café IISD International Institute for Sustainable Development IMF International Monetary Fund ix x IPM integrated pest management ISEAL International Social and Environmental Accreditation and Labeling Alliance ISO International Standards Organization LIFFE London International Financial Futures and Options Exchange MARD Ministry of Agriculture and Rural Development MRL Maximum Residue Levels NCA National Coffee Association (U.S.) NGO Nongovernmental organization NPK nitrogen, phosphate, potassium (variable proportions) NFCG National Federation of Coffee Growers NYBOT New York Board of Trade OAMCAF African and Malagasy Organization of the Coffee OCS Office Coffee Service OTA Organic Trade Association SAI Sustainable Agriculture Initiative SASA Social Accountability Sustainable Agriculture SCAA Specialty Coffee Association of America SMBC Smithsonian Migratory Bird Center SMEs Small and Medium Enterprises SOE State Owned Enterprises SPS/TBT Sanitary and Phytosanitary/Technical Barriers to Trade UCDA Uganda Coffee Development Authority UNCTAD United Nations Conference on Trade and Development USAID United States Agency for International Development USDA United States Department of Agriculture VICOFA Vietnam Coffee and Cocoa Association WTO World Trade Organization Executive Summary About 20-25 million families--mostly smallholder farmers--in more than 50 developing nations produce and sell coffee. A number of them are facing considerable difficulties because of the dramatic decline in the price of coffee to 100-year lows in real terms. Since 1970, prices have averaged a 3 percent per year price decline for arabica coffees and a 5 percent decline for robusta. Nicaragua provides a stark example of the impact: Between 1998 and 2001 poverty rates increased by more than 2 percent among those farmers who remained in the coffee sector. In contrast, poverty rates among rural households as a whole fell by more than 6 percent. A similar picture emerges for primary school enrollment rates--falling by 5 percent for households that stayed in the coffee sector and increasing by 10 percent among all rural households. In several coffee-producing countries, coffee accounts for at least 20 percent of the total export earnings. By some estimates, approximately 100 million people are directly affected economically by the coffee trade. It goes without saying that with a crop of such significance for some countries, the destabilizing effect of the price crisis sparks concern precipitating bank failures, public protests, and dramatic falls in export revenues. The consequences of the crisis in each country and region have been different according to the industry structure of the country concerned. In Central America, for example, a region with relatively larger farms (compared to Africa) using higher amounts of additional nonfamily labor, there has been high labor displacement, as well as both a worsening of poverty levels among smallholder farmers and default problems in the banking sector. In regions such as Africa, the social costs, particularly for smallholder farmers, are also acute, and difficulties are aggravated at the national level due to balance of payments problems and lost revenues, jeopardizing broader government antipoverty measures. Historically, coffee price volatility has been a fact of life because of weather shocks (mainly in Brazil) and is not the sole source of the crisis. In recent years, significant structural changes in the coffee markets mean new and emerging paradigms are likely to dictate coffee's future, which will have permanent effects on the livelihoods of the millions who depend on it. One area of structural change is in the nature of supply, particularly increases in both the quantity and quality of Brazilian and Vietnamese coffees. Along with Colombia, these three countries now account for about 61 percent of total production and, in 2002, 55 percent of global exports, each one having strengthened its domination of a different market segment. Increased access to financial and futures markets particularly in countries, such as Brazil, have enabled some producers to better manage risk. This will have an impact on supply, making it easier to smooth shipments across wide cyclical production swings that occur particularly in Brazil. The market oversupply was not entirely unexpected, but the depth of its impact has been a shock to most participants and observers. A combination of policy and market failures left producers without access to realistic information about developments elsewhere, while policy signals isolated them from the consequences of expanding production; however, even with good information it is unlikely that many coffee producers would have had the capacity for a suitable response due to their limited resources, as well as lack of viable income alternatives in many poor rural areas. Roasters have responded to the shift in supply by adapting their technology to increase their use of lower-cost natural arabicas and robustas. They also introduced greater flexibility in their blends to respond to lower- priced availability, though there is recent anecdotal evidence that this tactic may have sometimes resulted in a negative consumer response as coffee quality declined. The increasing concentration of roasters has enabled xi xii them to work with lower inventories by pushing increased just-in-time logistical demands down to their suppliers. Such demands have favored the largest trading companies and led to considerable concentration in this part of the supply chain, as well. A consequence of the decline in coffee prices has been a decline in the share of the final retail price that is received by producing countries. This decline has been caused by two factors. First, the coffee roasting and retail industries have made profits by developing new products and by taking advantage of various value- adding activities, such as marketing, branding, differentiation, and flavoring. As an example, the recent expansion of demand for soluble coffee, which is among the most profitable parts of the business, has enabled the industry to capture increased value from less expensive raw materials, such as robusta coffees. Second, the noncoffee components included in the retail price of coffee, such as wages, packaging, and marketing, have grown and now represent a much more significant share of the total retail price than the actual coffee itself. Interestingly, a number of countries that import coffee earn billions of dollars annually in taxes from it. In some of these countries, these taxes alone are approximately equivalent to the coffee revenue earned by the producing countries. Volatility in the producers' share of the retail value will still be more influenced by changes in the price level of green coffee than by changes in any other cost component because the value-adding costs are independent of the price of green coffee. Green coffee prices are the single most volatile expense incurred in putting roasted coffee on the market shelf and, consequentl,y one of the major determinants of changes in the producing countries' share of the retail value. Producers' ability to capture fair value from their output will require that producer organizations and producer countries act to improve their capabilities and their bargaining position with a clear understanding of these two factors--and of the structural changes and the market failures mentioned above. Many countries perceive the commodity trading system to be increasingly onerous and partly responsible for the loss of share of market value. The dominant trade paradigm for the coffee industry is of pricing set according to the New York or London exchanges. However, a growing group of producers and coffee firms are pursuing strategies that are independent of commodity pricing and the exchanges. Many of these alternatives include some differentiation of the coffee, usually by either quality or cultivation processes. A number of companies in the industry, including some that are household names, are adopting standards or developing purchasing criteria that transparently link their buying to positive socioeconomic and environmental effects in developing countries. Such emerging trade paradigms may offer producers alternative ways to capture the long-term value of sustainability by linking superior prices to demonstrable advancements in both the quality of the coffee and to more sustainable cultivation and trade practices. These new trade strategies are also consistent with a complex demand picture. There are structural changes in demand both at the consumer level and at the industry level. These changes include stagnant overall growth in the traditional major importing countries, increased demand for soluble coffee, increased demand for differentiated and higher-value products, new technology allowing greater fungibility in coffee supplies, and geographic-generational shifts in the popularity of different types of coffee products. At the same time, in many markets there is increasing preference for espresso-style coffees that do not depend as much on the flavor profiles of high-quality washed arabica coffees. These shifts, and the strong competitive response of the largest producers, particularly Brazil, are reducing the demand for certain types and origins of coffee, leaving the worst-affected countries with large social and economic costs. Global coffee consumption has shown noticeable regional differences. Consumption has been mixed in producing countries but is typically low, and Brazil, now the world's second-largest consumer, still sets the benchmark for increasing domestic consumption. Its concerted approach to improving labeling, consumer xiii perception, and quality while using effective market segmentation provides lessons that are relevant for other countries wanting to expand consumption. Emerging markets in Asia, Eastern Europe, and the former Soviet Union, which are not traditional coffee consumers, are posting rapid growth in consumption. This is primarily for inexpensive, soluble coffees, though tastes are evolving toward improved quality and novel characteristics, such as premixed cappuccino. Soluble is an important key to developing these traditionally tea-drinking markets because most consumers are unfamiliar with coffee-brewing methods and paraphernalia and less able to afford these. North America and Japan are growing slowly. Northern European consumption, particularly in Germany is stagnant, but in southern Europe, there are some increases. It seems that in this region the differentiated product market is growing the fastest. The differentiated product market requires that producers distinguish their products by distinct origin, defined processes, or exceptional characteristics, such as superior taste or few defects. These can be traded through more lucrative channels than the typical industrial grades that flow in the undifferentiated commodity channels and include: Geographic Indications of Origin (appellations) Gourmet and specialty Organic Fair trade Eco-friendly or shade grown Other certified coffees While these differentiated segments can provide some producers with competitive advantages and added value, they are not necessarily easy to access and are still relatively small. Nevertheless, they are important because of their growth rates and their potential to provide better social, economic, or environmental benefits for farmers. Though much of the coffee industry feels that premiums paid to growers for differentiated coffees are reasonable, it may be prudent to de-emphasize price premiums as a reason for entering these markets because it is quite plausible, at least in some cases, that these premiums will diminish. These markets should not however be discounted because they can often have a considerable impact on the income of farmers. Besides premiums, there are several other convincing arguments for fostering the differentiated segments, particularly those certified as organic, fair trade, or eco-friendly because of their positive externalities in the field such as: Increased use of rural labor and organizational development Crop diversification and reduced input costs minimize financial risk Better natural resource management and biodiversity conservation Reduced risk due to improved drought and erosion resistance Crop resilience to adverse weather Fewer health risks due to potential mishandling of agrochemicals Currently, the differentiated markets import roughly 6-8 million bags of green coffee which represents about 9-12 percent of the total to the developed markets in North America, Western Europe, and Japan, as well as a somewhat larger percentage of profits. Some of the extra value of these coffees is created and captured in xiv consuming countries, but to the extent that some of this higher value is kept by producers for their differentiation, these markets are breaking the pattern of a declining producer share of revenue. Because many producers are showing strong interest in these coffees, a word of caution is warranted. As more of these coffees come onto the market, the ensuing saturation could significantly diminish their prices. These markets are still small and even modest changes in supply and demand can impact prices. Most of the major coffee companies are instituting increased requirements for sustainable growing practices that will require further adoption and certification of these practices. Several very large buyers that are now testing the market with these products claim that there is a limited supply if they should decide to make a stronger commitment. As markets for differentiated coffees grow, there is an increasing need for consumers to understand the sometimes complex verification or certification processes that apply to the standards-oriented coffees, such as organic, fair trade, eco-friendly, Utz Kapeh, and those using Geographic Indicators of Origin (GIO). The legitimacy of third-party certification is a vital market mechanism that can prevent indiscriminate use of these terms. The alternative may be a loss of consumer confidence that would cost the entire industry by damaging one of its few fast-growing segments. Perhaps more importantly, failure to improve clarity of these standards and to support third-party verification could also damage one of the few niches in which small coffee producers have a chance to be competitive in a lucrative global trade. This is particularly important as various organizations, including corporations, are developing their own independent sustainability principles and standards. Differentiated coffees, particularly those espousing social and environmental benefits, can provide a unique and positive image for a beverage whose appeal has become stale in many of the more mature markets. Differentiated coffees are not a panacea, and industry surveys indicate that two other factors are equally or, perhaps, more important to be competitive in today's coffee markets: quality and consistency. The high value placed on consistency underscores the industry's preference for steady and predictable quality given the costs and risks of sourcing from new suppliers. This critical competitive factor has several implications, particularly for smaller suppliers, regarding the need to improve basic business practices, as well as agronomic practices in their cooperatives and organizations. Differentiation, while increasingly popular, is only a partial answer in the near term; other answers are needed for the majority of coffee producers. One often proposed is the diversification of some farmers away from a strong dependence on coffee. Though this can be conceptually sensible for some geographic areas, there are very few alternatives that either come close to coffee's valuable characteristics, such as its marketability and long shelf life, especially for remote rural areas, or which present realistic alternatives for the terrains in which coffee is currently grown. Trade protectionism in industrial country markets particularly continued high levels of subsidy in industrial countries for their own farmers, pose additional obstacles to diversification into other activities or into higher value or processed products and thereby leave producers with limited access to these markets. Given the long-term historic cycles, it is highly likely that supply will eventually align more closely with market demand for a period and that prices will recover somewhat. While conditions for producers will certainly improve as that happens, it will not signal an end to their problems because the economic causes of these cycles suggest that they are likely to continue to repeat themselves regardless of the actual levels at which supply and demand would actually converge. Price recovery then, given the inherently cyclical nature of current coffee markets, is likely to be only temporary, while other issues of social, environmental, and economic sustainability will remain. Structural changes in the ability to manage and finance supplies and the reduction of the historically high weather-related risk also lowers the likely frequency with which prices might return to the previously reached highs. xv The structural changes in the global coffee industry over the past few years will have a powerful influence on the nature of these markets. This influence could be as important as the cyclical, often weather-related, shifts in supply and demand that have considerably influenced the coffee market in the past. Understanding these changes is important; otherwise in today's free markets there is little hope of relieving the considerable damage caused by market failures, such as imbalances in the trading chain and the persistent failure of private markets (coffee, credit, and risk). In order to thrive in this new business environment, coffee producers must understand the characteristics and the nature of these structural changes. Their governments must be more agile in creating favorable business environments to allow them to successfully adapt to the new demands of the marketplace and to help them potentially shape it. In the current situation of liberalized markets and decreasing state support for agriculture it will be increasingly incumbent upon producer and trade organizations to provide necessary services. Fostering the necessary research, extension, risk management, diversification, and marketing will all require dedicated long-term programs to strengthen and train such organizations. As agriculture increasingly takes on industrial characteristics, these organizations will also need to establish closer relationships and direct linkages with buyers and roasters to adequately respond to market demand and form integrated value chains that help to assure the sustainability of each member. More broadly, governments need to focus on rural development that will increase competitiveness and reduce dependency on a few primary commodities by broadening the range of products produced by the agriculture sector, improving production and marketing systems, and supporting the creating of nonfarm activities. This will enable countries and sectors to more easily adjust to the kind of price swings and structural changes in world markets experienced by the coffee industry. 1. Introduction More than 50 nations, almost all in the developing world, produce and export coffee. A number of them are facing considerable difficulties because of the dramatic decline in the price of coffee which has fallen to its lowest levels in 30 years, and to 100 year lows if adjusted for inflation, as a result of worldwide oversupply (see figure 1). Some of these countries are dependent on coffee exports for a significant portion of their international trade and export income as indicated in the preliminary tables. The destabilizing effect of the price crisis has sparked concern in some of these countries that have experienced bank failures, public protests, and dramatic falls in export revenues. Figure 1 Arabica and robusta prices, 1970-2002 450 400 deflated) 350 300 (MUV 250 lb Arabica prices 200 per 150 100 cents 50 Robusta prices US 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Source: ICO, customized subset of data sent to author, taken from ICO database; World Bank Global Economic Prospects, 2004 Between 17 and 20 million families are directly involved in coffee production. Evidence of considerable human hardships in many producing regions confirms coffee's importance as a primary--and sometimes only--source of cash income for many farmers (IDB, USAID, World Bank 2002; Oxfam 2002). Most of the world's coffee is produced by smallholders utilizing just a few hectares of land. In the past year, many reports have confirmed the heavy toll on farmers that have had to sell below cost or even give up their coffee farms because current prices do not even cover the most basic costs of harvesting and transport to market, and estimate economic losses for small coffee farmers at US$4.5 billion per year. The losses can be measured in even more profound ways. In many rural areas, the annual coffee income means the ability to pay for children's schooling, purchase basic necessities such as clothing and medicines, and settle debts (see boxes 1 and 2). 1 2 Coffee Markets Box 1 Coffee Producers in India "Reduced to penury by low prices for more than 2 seasons, coffee growers of the southern Indian state of Karnataka have started taking their own lives. The burden of debt and heavy losses, in spite of recent marginal price improvements, have led at least half-a-dozen planters to commit suicide." Source: Financial Times, August 15, 2002 Historical Background Looking at its long-term context, the cause of the price decline is clear--a trend moving from the production deficits of the early 1990s to the more recent surpluses, the largest of which was in the 2002- 2003 crop year, shown as the 2001-2002 Coffee Year (see figure 2). These surpluses of coffee that led to the current crisis were not entirely unexpected: The coffee trade had been expecting a Brazilian crop well in excess of 40 million bags for several years, and mostly bad weather prevented its earlier occurrence. Other countries have also expanded production due to periods of profitable prices in the 1990s. Coffee production is no longer managed by producing country boards or by international agreements so that, although liberalization certainly increased producers exposure to market price volatility, it helped to raise the farmers' share of these higher market prices in many cases, thus adding to the incentive to expand. Figure 2 Balance of Supply and Demand in Coffee years 1992/93-2003-2004, including forecast 15,000 160 BALANCE Composite Price sgab 10,000 140 5,000 120 amrg kilo 0 100 60fo -5,000 80 '000's-10,000 60 -15,000 40 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 Source: Author calculations based on an October-September accounting period However, these supply changes have not been global. As depicted in figure 1.3 of supply from each of the three main producing regions since 1960, African production has never passed its peak in 1972, while Asia and Latin America have both increased. New Paradigms in Global Supply and Demand 3 Figure 3 Global Production Trends by Region 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1 3 1 3 5 3 5 7 7 9 1 1960/196 1962/196964/1965 1968/1969 1972/197974/197976/1977 1980/1981 1984/198986/198988/1989 1992/1993 1996/199998/199000/200002/2003 1 1966/1967 1970/197 1 1 1978/1979 1982/198 1 1 1990/1991 1994/1995 1 2 2 Africa Latin America Asia Source: USDA Foreign Agricultural Service, "Production, Supply and Distribution" database The historical context of the current situation is a repeated cycle (see figure 1). A substantial increase in prices caused by frost or drought in Brazil, followed by new cyclic price lows 5-7 years later, accounted for by the gestation period for new plantings to bear fruit. This has been caused by increased production following each price spike and by improvements in agricultural efficiency as prices fell, which have had some impacts on the next cycle through both improved efficiency and in bringing in new entrants (see figure 1.4). In effect, the history of coffee prices can be regarded as a series of shocks that sometimes introduced a new paradigm shift. The current shifts are among the most substantial ever experienced. The origin of this cyclic behavior lies in a combination of the low, short-run inelasticity of both demand and supply, combined with the fact that coffee production has a tendency for production shocks. Moderate price increases do not have much impact on consumption levels, so that when production falls below demand, consumption must be met from stocks. In a period of a large production falls, relative to the volume of available stocks, the probability of an elimination of these stocks increases, thus raising the value of the stocks to those that need them.1 The price rises that follow induce an increase in production 1This issue is discussed in more depth in section two. 4 Coffee Markets that lowers prices again, but because of the low elasticity of demand, expanded supply drives prices down below short-run marginal costs and eventually lowers supply below demand, which, in tern, raises prices and the value of stocks. Unfortunately, market signals, such as the price falls, do not appear to help producers much once they have planted new coffee. Coffee is a tree crop that takes several years to enter viable production and, as a result, may already be in the ground (a considerable investment) by the time market signals reach the producer. The brunt of the ensuing boom and bust cycles are borne mostly by farmers who typically have the highest relative investment and the highest level of risk in the trade chain. Other mechanisms, such as market information, are costly, opaque, and riddled with conflicting signals, while membership of cartel- like organizations can send false signals to producers that their governments have the means to bail them out of the consequences of ill-advised planting and investment decisions. Increasing consumption is a strategy supported by both producers and the rest of the coffee industry; however, efforts to increase consumption are unlikely to completely resolve the structural issues that plague coffee producers. Only the imbalance between supply and demand and the elasticities of each (not their actual levels) give rise to the cyclic problem. The most evident implication is that the current behavior of the market can be repeated even at higher levels of demand. Any increase in world prices above long-run equilibrium marginal production costs resulting from demand increases may prompt an increase in production from those with production costs below that equilibrium level. A long-term goal of raising equilibrium prices might, therefore, depend on raising demand beyond the ability of the current low-cost group of producers to supply it. This seems to be highly unlikely in the near-term, and the cyclic increase in production that would follow an increase in consumption would lower prices back to long-run marginal costs. In 1993, prior to the two 1994 frosts in Brazil and the following drought, world exportable production was estimated by the USDA to be about 75 million bags giving rise to an overall deficit. The loss of about 13 million bags of Brazilian production in 1994 pushed prices to a very high level in anticipation of a large deficit in the 1995-1996 season. Not all countries were immediately able to benefit--in particular, those countries in which grower debts and poor production capacity was a result of falling prices (which began in 1989 and lasted until coffee prices reached their (then) record lows in 1992). Box 2 Brazil's advantage "To give you an idea of the difference, in some areas of Guatemala, it could take over 1,000 people working one day each to fill a container of 275 bags, each weighing 69 kilogram. In the Brazilian cerrado, you need five people and a mechanical harvester for two to three days to fill a container. One drives, and the others pick. How can Central American families compete against that?" Source: Patrick Installe, quoted in "Mugged, Poverty in your coffee cup," Oxfam 2002 New Paradigms in Global Supply and Demand 5 Figure 4 Global production: total production and production excluding Brazil, Colombia, and Vietnam 120000 110000 100000 World Production sgab 90000 60kgfo 80000 '000's 70000 World Production excluding Brazil, Colombia, and Vietnam 60000 50000 40000 1970/71 1971/72 1972/73 1973/74 1974/75 1975/76 1976/77 1977/78 1978/79 1979/80 1980/81 1981/82 1982/83 1983/84 1984/85 1985/86 1986/87 1987/88 1988/89 1989/90 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 Source: USDA Foreign Agricultural Service, "Production, Supply and Distribution" database Things changed quickly in the second half of the 1990s. Brazilian replanting quickly expanded the productive capacity to include low frost-risk areas without the prior Instituto Brasileño do Café (IBC) credit restrictions that placed constraints on tree density and agronomic techniques. At the same time, the development of mechanized irrigation and harvesting assisted in cutting production costs (see box 2). Currency depreciation helped to protect Brazilian growers from reduced world dollar prices, even if this advantage has been reduced more recently by the recovery in the value of the Brazilian Real. Considerable investments in production of both new entrants into coffee growing as well as in other traditional producing countries has contributed to the current coffee surplus. The quality of coffees from some of these new entrants is improving, thereby increasing the threat they represent to the traditional suppliers of better-grade coffees. In particular, Brazil's combination of overall quality improvement, the development of both pulped naturals and of full washing capabilities are allowing roasters to use these coffees in place of a range of the lower-grade Central American coffees. Improvements in quality from Vietnam as evidenced by grading results from the futures markets and elsewhere allow roasters to use more of these coffees also. Some of those countries unable to expand production after 1994 due to high producer debts were more able to do so after the 1997 price spike, and new price lows in the market have followed 5 years later as the surpluses come to market. The consequence is that when current consumer stock levels were added to supply, total availability was higher as the market hit its low point than at any previous time, including the period immediately following the end of the ICO agreements (see figure 9). 6 Coffee Markets In January 1997, when consumer stocks reached their post1989 low of about 7.9 million bags, about 2.25 million bags were robusta. By the time the stock growth had peaked in August 2001 at 21 million bags, robusta stocks had grown by 6 million bags, but arabica stocks were up by more than 8 million bags, and the biggest gain was in stocks of washed arabicas. Given the big increases in overall demand in emerging markets for robusta coffee and the greater usage of Brazilian coffee, these relative stock changes call into question the claims that the drive to the 2001 lows in the market was solely a consequence of the oversupply of these particular coffees--even if in the 2002-2003 crop year, it was clear that there was an excess of natural arabicas. Given the global expansion of productive capacity described above, coffee production in the 2002-2003 crop season was the largest in history. The recent December 2003 estimates by the USDA are listed in table 1. For 2002-2003 the estimate of total production of 124.15 million bags are approximately in line with current estimates by the world's largest coffee traders, The reductions for 2003-2004 are almost entirely accounted for by decreases in both arabica and robusta production in Brazil. Table 1 Global production, 1997 to 2004 1997/1998 1998/1999 1999/2000 2000/2001 2001/2002 2002/2003 2003/2004 Colombian Milds 13,498 12,509 11,821 12,026 13,229 13,179 13,352 Other Milds 27,965 27,380 31,698 28,480 26,123 25,585 26,318 Naturals 23,436 35,024 30,178 30,717 28,540 43,667 26,217 Robusta 32,753 33,506 39,706 45,638 42,834 41,720 39,345 Total 97,652 108,419 113,403 116,861 110,726 124,151 105,232 Colombian Milds 14% 12% 10% 10% 12% 11% 13% Other Milds 29% 25% 28% 24% 24% 21% 25% Naturals 24% 32% 27% 26% 26% 35% 25% Robusta 34% 31% 35% 39% 39% 34% 37% Total 100% 100% 100% 100% 100% 100% 100% Source: USDA Foreign Agricultural Service, "Production, Supply and Distribution" database, December 2003 (crop years) Paradigm Shifts in Supply and Demand Apart from oversupply, there are two types of paradigm shifts underlying the current situation: 1. A structural change in the nature of supply, particularly increases in both the quantity and quality of Brazil and Vietnamese coffees. 2. Structural changes in demand, comprising increasing demand for high-end, differentiated products, new technology allowing greater flexibility in blending, and geographic-generational shifts in the appeal of different types of coffee products. There are dramatic changes in the nature of this new supply. Of particular note is that global supply has become more concentrated. During the previous period of low prices in 1992, USDA data shows Colombia, Brazil, and Vietnam produced 44 percent of world production. In 2002-2003, 60 percent of world supply came from these three producers, and this figure is likely to increase unless production in other countries significantly reverses its decline. For some roasters, these three suppliers can provide almost everything they need, leaving them to buy only small amounts of coffee from other countries. New Paradigms in Global Supply and Demand 7 A particular point to note from figure 4 is that total production from the remaining producing countries has been falling now for 4 years, though the recent increase in prices may have halted the decline in some countries. Comparison with the situation in Brazil is particularly marked, as some estimates suggest that the 2-year average production cycle could stabilize in coming years in excess of 40 million bags--or about 10 million bags higher--than in the late 1990s. After accounting for Brazil's market share, and given projected near-term demand growth, this would leave demand for approximately 72 million bags needed from the rest of the world--just over current production levels. In other words, if Brazilian production is able to stabilize at current levels there is little room in the near term for production recovery by other origins. Additionally, stocks are available to make up any near-term supply shortfall. An additional impact of the increasing dominance of the largest three producers is the consequence for some countries of the resurgence of Colombian production. In the past 3 years, production has recovered by 2 million bags from the recent low of 9.7 million, which is the production equivalent of a medium- sized Central American country. Colombian coffee now sometimes trades at a discount to some of the higher-quality Central American coffees. As a result, these countries are now feeling the combined pressure of being squeezed on the prices for their lower-quality output by Brazil and on their higher- quality production by Colombia. Many smaller countries that are negatively affected by the actions of the largest producers have an economic exposure to coffee that is substantially higher than that of the largest producers. These larger producers have available a wider range of policy choices whose associated costs might have much less economic impact than they would do if made elsewhere. This imbalance in the consequences of decision making in individual countries raise further considerable difficulties in dealing with the coffee crisis on a global scale. Paradigm shifts in consumer markets and roaster behavior have occurred in importing countries, and these changes have consequently affected producing countries. Demand recovered from the small drop seen as a result of the price increase in 1994-1995 and as a result of economic liberalization and growth in the developing economies, such as in Eastern Europe and parts of Asia and Latin-America (notably Brazil), world demand has reached about 113-114 million 60 kilogram bags. Initial estimates for 2002 suggest that demand in consuming countries grew by about 1.5 percent, down from 1.9 percent growth in the previous year; however, within this data, a number of features have emerged: 1. Demand in the major importing countries is growing only slowly. 2. New markets are emerging and growing fast, driven by the availability of cheap coffees in soluble form. 3. New channels for higher quality and differentiated markets are emerging rapidly in many countries. 4. Roasters have learned to increase their use of natural and robusta coffees by processes, such as steaming to remove the harshness of taste. 5. Roasters have learned to work with lower working stocks, but this has increased the logistical demands made on suppliers which favor the largest trading companies. This has led to concentration of the supply chain in the hands of fewer major traders. 6. Roasters have become more flexible and willing to make short term switches between coffee types in order to take advantage of lower prices. 8 Coffee Markets 7. The concentration of roasters, particularly in a period of oversupply, demonstrates the fact that consumer coffee markets are "far from a model of textbook economic efficiency" with rapidly clearing markets and without high-cost barriers to entry (Lindsey 2003). Instead, price responses can be slow and lag well behind perceived changes in events. For instance, reported retail price falls hardly reflect the changes in green coffee prices in the world markets even though, as a report commissioned by the Dutch government states, "At the supply chain down to the countries of origin, there is no evidence of cartel behavior of the roasting industry (RIAS 2002)". There is also a more complex picture emerging below the surface in which there is a very real increase in demand for high-end quality products and an increase in products reflecting changing lifestyles, such as specialty solubles, instant cappuccinos, etc., that are appealing to younger drinkers. At the low end, solubles are growing fast, fueled by demand in the emerging and the tea-drinking markets. In the middle are the undifferentiated commercial coffees which has had stagnant and, in some cases, eroding growth. Regional differences are very evident in coffee consumption: Northern European consumption, particularly in Germany is stagnant, but in southern Europe, there are some increases. Eastern Europe is showing notable gains, and consumption is up in much of the region. The increase in consumption there and in parts of Asia recovering from economic problems is being driven by the high availability of cheap robustas allowing the roasters to offer a product at affordable prices. In Brazil's domestic market, the roasters have taken the opposite approach by concentrating on labeling and improving quality, which has enabled Brazil to become the world's second-largest consumer. Such a strategy may be relevant for other producing countries that want to expand domestic consumption. At the current time, the majority of the world's producer will still sell their coffee to the large roasters that dominate the market volumes. The available evidence from previous large Brazilian crops is that many roasters will aim to maximize their use of Brazilian arabicas as far possible. The initial indications from disappearance data is that in the July and June period of 2002-2003, which makes up the major period of the export of the large Brazil crop, the substantial increase in natural arabica usage was offset by reduction in the usage of both washed arabicas and robusta. Figure 1.5 compares global offtake by type in the July/June 2001-2002 and July/June 2002-2003 periods. It is clear that Colombian Mild usage fell only slightly in the period, and that robusta and other mild usage was affected more substantially. Proportionally, the largest fall was seen in the Other Milds category. New Paradigms in Global Supply and Demand 9 Figure 5 Global usage by type 2002-2003 compared with 2001-2002 (July/June) 0.4 0.35 0.3 2002/03 0.25 2001/02 0.2 0.15 0.1 0.05 0 Colombian Milds Other Milds Natural Arabicas Robusta Source: Authors' calculations based on all export and stock data referenced in paper In some countries, very high robusta usage appears compatible with levels of natural Arabica usage only if there is a high availability of Colombian Milds and/or SHB/SHG coffees for the balance of the blend. As figure 5 illustrates, natural arabicas took market share from both washed arabicas and from robustas, but not from the Colombian Milds group. Some of this affect is particularly noticeable in certain countries. Figure 6 depicts the way the United States industry has adapted its usage of different coffees according to availability. The additional natural arabicas have replaced mostly the secondary milds and a very small amount of robustas and, at the same time, there was some increase in the usage of the better-quality washed arabicas. In 2002, it became clear that in some cases roasters were willing to push usage of natural arabicas to very high levels without this type of compensatory change. Figure 7 depicts how both Colombian Mild and better-quality washed arabica lost market share to Natural arabicas, while the robusta share in particular remained unchanged. 10 Coffee Markets Figure 6 Usage of coffee by U.S. industry by type, 1996 and 1999 COLOMBIAN MILDS 0.35 0.3 Low Natural Arabica Usage:1996 High Natural Arabica Usage: 2002 0.25 0.2 0.15 ROBUSTAS 0.1 Primary Milds 0.05 0 NATURALS Secondary Milds Source: Data derived from U.S. import data and trade data on stock changes by type Figure 7 Usage of coffee by German industry by type, 2001 and 2002 COLOMBIAN MILDS 0.35 0.3 0.25 2001 0.2 2002 0.15 0.1 0.05 ROBUSTAS 0 OTHER MILDS NATURAL ARABICAS Source: CECAFÉ, customized subset of data sent to author, taken from CECAFÉ database; F.O. Licht, compilation of various published datasets; ICO, customized subset of data sent to author, taken from ICO database There are a number of potential consequences to this. Suppliers have to adapt to these new market conditions, and recommendations for this are outlined in the recent studies undertaken by the World Bank New Paradigms in Global Supply and Demand 11 and others. They make it clear that not all producers can stay in the market, and market conditions are already inducing some producers to withdraw.2 In particular, high Brazilian usage will lead to continuing falls in the usage of low-grade, washed arabicas. This could lead to prices for these coffees falling to the same levels as natural arabicas, making it uneconomic to grow these coffees in competition with the lower production costs. Producers at this level will continue to exit the market (see table 15). Conceptually, the overall market can be perceived as a quality pyramid with inexpensive soluble coffee at the bottom, standard commercial blends in the middle, and progressing toward high-end and differentiated coffee at the top. While the top and bottom are growing at a healthy pace, the middle section, representing most of the space of the pyramid, has been stagnant. This middle section represents the great majority of the total volume, and its stagnation presents a challenge to sustainable growth for the many producers of average quality producers who supply it. This is particularly true for those that are neither able to significantly lower their costs nor improve their quality or otherwise differentiate themselves. A number of such producers, particularly those in the arabica milds category, are already feeling enormous pressure in the fight for a relatively static market share. Box 3 The impacts of paradigm shifts on producers The consequential impact of the new paradigms as illustrated by both the production changes described above and the usage patterns illustrated in figures 1.5 through 1.7 discussed are wide-ranging. In an oversupplied market, in particular, the decisions made by buyers are the critical determinants of what happens to sellers. These paradigm shifts have substantially reduced the demand for certain types and origins of coffee, leaving their producers with fewer opportunities to sell their coffee. In the worst-affected countries, the resulting adjustments have large social and economic costs: Inadequate support for the coffee sector that does not improve quality or speed diversification has aggravated unemployment and increased the potential for social unrest in rural areas. The most significant social problems are located in areas with both relatively high labor costs and large farms that are heavily dependant on seasonal labor--particularly in Central America. Places in which farmers have stopped employing this labor, the social consequences have been severe, and there have been knock-on effects in the rest of the rural economy and in the banking sector, with several large banks across the region ceasing to exist. The problems are not restricted to this region, and countries such as Vietnam have also experienced problems. The data in the table to the right shows how dependant Country Rural Labor Employed in the Central American rural areas are on employment Coffee (Percent) from coffee. In the past two crop years, seasonal Costa Rica 28 employment is reported to have dropped by 20 percent El Salvador 17 and permanent employment by 50 percent. Guatemala 31 Additionally, the coffee crisis has occurred at the same Honduras 26 time that drought hit food crop production. The overall Nicaragua 42 consequence has been increased malnutrition and food Total Central America 28 insecurity in these regions. It has led to people leaving the rural areas and moving either to the cities, or cross- Source: ECLAC 2002 border: Some of the deaths reported in the deserts of Texas were of coffee farmers from southern Mexico seeking alternative employment north of the border. 2 2IDB, USAID, World Bank. 2002. Managing the Competitive Transition of the Coffee Sector in Central America. Available at www.iadb.org/regions/re2/coffeeworkshop/ as well as World Bank sectoral studies on Mexico, Central America, and Colombia. 12 Coffee Markets Box 3 The impacts of paradigm shifts on producers Nicaragua: Changes in Poverty Rate, 1998 - 2001 There have been several studies undertaken of the impact on poverty in the producing areas of Central 5.00% America. Most show that, while many workers were 2.40% able to find alternative employment, there was real Non Coffee Exited Coffee Entered Coffee 0.00% hardship for small coffee producers. A recent World Coffee Bank publication documented the impact of the coffee -1.80% crisis in Nicaragua. Poverty rates increased by more -5.00% than 2 percent between 1998 and 2001 for those farmers who stayed in the coffee sector, but fell 6 percent for all rural households overall. The net -10.00% primary school enrolment rate for those same households fell by more than 5 percent while that for all -15.00% rural households increased by more than 10 percent.3 -15.60% According to recent studies in Colombia's coffee -17.90% regions, even the most successful zones have suffered -20.00% clear and measurable setbacks in key social indicators. Smaller farmers have been hit the hardest by the need to reduce meals and food consumption. As a result of the crisis, many farmers, particularly smaller ones, reduced the attendance or the number of children enrolled in school, although access to safety net programs in some countries was conditional on maintaining school attendance. The very real and dramatic social impacts of the current coffee crisis have been documented by a number of researchers and are the subject of an in-depth study soon to be published by the World Bank (Oxfam 2002; World Bank 2002a;etc). Accordingly, this report will focus primarily on other topics while recognizing and acknowledging the primary importance of these social consequences. Source: Oxfam 2002; World Bank 2002a; ECLAC 2002 For a small number of producers, the fact that some consumers are focusing more on the quality of what they are drinking is signaling that a focus on quality rather than quantity will be rewarded. The more agile producers have already begun to adapt their production, as differentiated coffees, such as those bearing a particular appellation or are organic, are becoming more evident. In many countries, a growing acknowledgement of the environmental and social problems of coffee producers has led to the development of markets for coffee that is third-party certified to be sustainable. This shift is being fueled by a growing number of coffee companies that are pioneering efforts that encourage the coffee industry to move toward more environmentally friendly practices and more equitable economic relations and social benefits for producers. These companies' new sourcing principles are increasing demand for organic, eco- friendly, and fair trade coffees that are collectively termed "sustainable coffees." In recent years, the markets for differentiated coffees have shown strong growth and higher than average prices. These coffees include: gourmet and specialty, Geographic Indications of Origin (appellations), organic, fair trade, and eco-friendly or shade grown. Producers are finding that their previously fringe niches are quickly moving toward mainstream credibility and earning substantial revenues along the way. In order to get beyond the highly competitive and volatile commodity-based trade, many producing countries are looking toward differentiated and value-based products. Developing a competitive position based on such processes that are more difficult to duplicate presents a potentially more viable long-term 3Some of the contents of this box, including the graph, were based on "Volatility Risk and Innovation: Social Protection in Latin America and the Caribbean," Fall 2003 issue. New Paradigms in Global Supply and Demand 13 strategy. Differentiation can present a feasible competitive platform, especially for countries lacking the necessary factors to be competitive as bulk raw material producers. Such process-oriented strategies lend themselves well to many of the poorer producing countries and present a rare opportunity for rural smallholders to participate in global markets while also safeguarding their natural resources. Differentiating a product or service or adding value in the country of origin involves an understanding and management of a set of more complex issues, including current market trends, appropriate (though not necessarily state-of-the-art) technology, multiple distribution channels, and the sometimes complex logistical, financial, and risk management requirements of supply chains. Integrating smallholders and the poorest farmers requires that more attention be paid to strengthening organizational and managerial capacities of institutions such as trade associations and cooperatives The differentiated coffees, particularly sustainable coffees, can have other advantages for farmers and rural communities that are completely distinct from their marketability. Their development often provides benefits and positive externalities for which functioning markets, which would allow them to capture additional financial value, do not currently exist. This has been demonstrated in more than one project (Pagiola and Ruthenberg 2002; Giovannucci and others 2000a). For example they can offer: Improved natural resource management and biodiversity conservation On-farm diversification Community or organizational development Increased rural self-sufficiency Reduced farmer and family health risks from misuse of agrochemicals As is explored in later sections, the markets for differentiated coffees are quite limited and although they are growing quickly, this is from a very small base. Available estimates put them at 9 percent to 12 percent of total green coffee imports (roughly 6-8 million bags) to the developed markets in North America, Western Europe, and Japan. Paradigm Shifts--Some Broader Trends The focus of this report is the paradigm shifts that have occurred that affect the coffee industry at many levels. These include considerable consolidation of the industry, combined with policy signals that may not be in the best long-term interests of farmers, particularly the smaller ones. Market failures, especially in the realm of information, access, and supporting institutions are also hampering producers' ability to adapt to changing conditions. Although we have not tried to calculate empirical effects, there is now a large body of academic work and considerable anecdotal evidence suggesting that inefficiencies in the coffee market have contributed significantly to the deepening of the current market crisis. At the macro level, a distinct paradigm shift coalesced in the 1990s to impact trends at the consumer, business, and governmental or regulatory levels. This is affecting not just the coffee trade but food and agriculture in general (Giovannucci and others 2000b). The increasing globalization of food trade and the accompanying concentration or consolidation of firms in the industry have an increasing influence on both the supply and demand sides of the coffee trade. In particular, we can identify developments in three environments of note: · A new policy-regulatory environment: A combination of multilateral and regional trade agreements, use of subsidies, and governmental requirements, such as the Japanese Agricultural 14 Coffee Markets Standard, the United States bioterrorism law, EU standards for contaminants, minimum residue levels, and ochrytoxins are making entry into fast-globalizing markets, more demanding than ever for products across the agricultural spectrum. · A new business environment driven by increasing firm consolidation and concern about consumer interests and increased liability, requires "due diligence" and competitive standards, such as those for sustainability that are increasingly being applied to coffee. Supply chain concentration also demands ever-increasing levels of standards and performance measured by global rather than local performance standards. Major buyers, whether traders, roasters, supermarkets, or coffee chains, are increasingly creating their own standards that can be imposed on the agrifood chains in developing countries. · There is a new consumer environment that features increased food safety concerns, a focus on health and diet, and increasingly globalized consumer tastes. In more developed markets, experts predict that social and environmental concerns, especially ethical ones will continue to emerge as not only competitive differentiators but as basic rules of the game and prerequisites for participation. These new environments will fuel elevated concerns for quality, food safety, and sustainability particularly, but not exclusively, in the more mature markets. Though coffee is typically considered safe, it will probably not be exempt from this overall trend.4 This implies a fundamental shift in the role of standards from merely reducing transaction costs to serving as strategic tools for differentiation, quality and safety assurance, market penetration, and product niche definition (Giovannucci and Reardon 2000). Several of the so-called sustainable coffees, such as organics, intrinsically incorporate improved standards and traceability in their certification and also appear to meet consumers demand for specialized and safe products. As a result, they could be considered as a potentially useful part of a producing country's strategy. Looking Forward: The Current and Forthcoming Crop Years Table 1 of global production as estimated by the USDA illustrates that expected production changes in most areas are expected to be very small, with the exception of Brazil. Despite the fall in futures prices that occurred last year, the strengthening of differentials during that period for many grades of washed arabicas meant that many better-quality washed Arabica producers sold for prices at least as good as the previous year. Conversely, a lack of demand for low-grown coffees in particular in the face of higher Brazilian Arabica availability is leading to production from these areas dropping markedly. Authors estimates of production in the coming year, compiled from public and private sector sources give rise to similar estimates of those of the USDA, except in Vietnam, where private sector estimates have risen sharply now that the new harvest is well under way. This document assumes that production in the 2002-2003 crop year was 123.2 million bags and will be approximately 106 million bags in 2003-2004. Even with this lower current production level, many analysts predict that further coffee price recovery is likely to be slow, at least for the near term. Such a situation threatens the sustainability of coffee production, and, consequently, production will drop below demand for the first time in 5 years in the 2003-2004 season. The December 2003 USDA production 4Remote possibility of Ochratoxin A or Acrylamide contamination are the main notable exceptions, and these are relatively rare. New Paradigms in Global Supply and Demand 15 estimate of 105.232 million bags suggests a deficit close to 9-10 million bags. Table 2 details World Bank forecasts of prices to 2015. While this deficit will decrease the existing Table 2 World Bank Forecasts of Arabica and stock overhang, the continuing rate of usage of Robusta Prices, 2004-2015 stocks will be a key determinant of prices, which are heavily influenced by both the Year Arabica Robusta quantity and ownership of the stocks--a build- 2004 68.00 38.00 up of stocks in consumer hands generally being 2005 72.00 40.00 regarded as more negative for prices than 2006 74.43 41.40 stocks held in producing countries.5 A notable 2007 76.94 42.85 aspect of the 2002-2003 exports was the large 2008 79.54 44.34 quantity of stocks exported--Central America, 2009 82.22 45.89 Ethiopia and Vietnam, in particular, all had 2010 85.00 47.50 considerable quantities of old crop coffee. This 2011 86.91 49.21 does now suggest that--with the exception of 2012 88.87 50.98 Brazil, some coffee left in Vietnam and a small 2013 90.87 52.83 quantity of stocks in Colombia--2003-2004 2014 92.91 54.73 coffee exports will not exceed exportable 2015 95.00 56.70 production. Source: World Bank 2004 Consequently, it is the high level of consumer stocks that will remain the principal limiter on the potential for price increases (see figures 1.8 and 1.9). Additionally, the possible deficit figure is very close to the estimated stock build of arabicas in Brazil over the course of 2002-2003, giving roasters plenty of choice of stock sources to use. This also implies that, depending on Brazilian shipment patterns, consumer stock levels may not change very much. Much of the worst in the decline in production in the Latin-American washed arabica production has already occurred, but losses will continue in the low-grown areas where producers cannot compete with Brazil in price and quality, which itself will continue to improve. Brazilian production is approximately 33 million bags, down from 51 million bags in 2002-2003, according to the USDA. Although this is at the lower end of recent trade estimates, some of the high-yield areas had very high sensitivity to input usage, raising the financial risks faced by those producers earlier in the growing season more than those that were able to use fewer inputs and waited until later to spend; however, the widespread use of irrigation in the robusta areas will protect robusta output levels. With the 2003-2004 and the scale of the 2002-2003 better confirmed by shipment levels, market attention is focused on the prospects for 2004-2005. This is expected to be an "on-season," though a combination of reduced planted area, some weather problems, and the fact that trees can take time to return to yields seen in 2002-2003 has led to estimates for that season that are much lower than 2002-2003. The main published figures so far are from the Brazilian government of 35.79 million bags--an on-year production level last seen in 1998-1999, and for which the USDA estimated there were 3.3 billion producing trees 5Location is used here as a proxy for ownership, as the critical determinant is whether or not they are hedged. More recently, the tendency of producer stocks to be more concentrated in the hands of the three largest producers, more transparent, and to be hedged has lowered the need for a distinction. Some models now treat them alike and look at availability in total, although the comparative efficacy of this remains to be tested. 16 Coffee Markets compared to about 5 billion today. A Brazilian research group, Safras y Mercado, puts production at 41.2 million bags, which would be closer in line with the yields seen in 1998-1999. Figure 8 Arabica and robusta futures prices in U.S. cents per pound 135 115 95 ArabicaFuturesPrices 75 Robusta FuturesPrices 55 35 15 Source: New York Board of Trade, data accessed from Web site (www.nybot.com); London International Financial Futures and Options Exchange (LIFFE), data provided to author Higher prices at London International Financial Futures and Options Exchange (LIFFE) early in 2003 resulted in greater incentives to robusta producers, though limited affects from the El Niño (which mostly affects Africa and parts of Asia) may have contributed to an overall reduction in robusta output. New Paradigms in Global Supply and Demand 17 Figure 9 Possible path of developments in producer and consumer stock levels 80000 Derived producer stocks, actual consumer stocks Projected stocks 70000 Total stocks 60000 bags 50000 kilogram 40000 Producer stocks (derived data) 60 of 30000 Consumer stocks 000s'20000 10000 0 1996q4 1997q2 1997q4 1998q2 1998q4 1999q2 1999q4 2000q2 2000q4 2001q2 2001q4 2002q2 2002q4 2003q2 2003q4 2004.q2 2004.q4 2005.q2 Source: Authors' calculations from published and unpublished data provided to author from private traders; USDA Foreign Agricultural Service, "Production, Supply and Distribution" database; ICO, customized subset of data sent to author The levels and variations in stocks in the hands of producers and consumers could consequently develop with stocks only dropping below their current levels at the end of 2003 (see figure 10) and the largest variation remaining the stocks in the hands of Brazilian producers. A primary driver of uncertainty in the coffee market is the prospects for Brazilian production, and that countries' vulnerability to weather shocks. The level of vulnerability to drought in the coffee growing regions is discussed further in the Brazil section of this document, and there are some demonstrations from the impact of previous droughts on production levels in both Brazil and elsewhere from past data worth considering here. Looking first at a major Brazilian drought affected crop, production in the 1986-1987 crop was about 14 million bags, down from 33 million bags the year before--a crop size that had only previously been exceeded in 1965 by the rebound from the drought-affected 1964 crop. Consequently, the very low crop of 1985 was an off-year that had followed a very large crop and into a time of severe stress. 18 Coffee Markets Figure 10 Availability and prices 200000 140 bags 195000 130 190000 120 Availability 185000 110 kilogram 60 180000 100 of 175000 90 170000 80 000's in 165000 70 Composite price 160000 60 155000 50 Availability150000 40 1997q3 1998q1 1998q3 1999q1 1999q3 2000q1 2000q3 2001q1 2001q3 2002q1 2002q3 2003q1 2003q3 2004.q1 2004.q3 Note: Availability is defined as total stocks + 12 months forward production. Source: Authors' calculations from published and unpublished data provided to author from private traders; USDA Foreign Agricultural Service, "Production, Supply and Distribution" database; ICO, customized subset of data sent to author, taken from ICO database Actual losses in 1986 are difficult to measure. In January 1986, the USDA Tropical Products report described Brazilian production potential as being between 27 and 33 million bags, with the range dependant on the on-off cycle, but the picture is obscured by the fact that IBC data showed the productive capacity of Brazil growing faster than the USDA's data predicted. Due to the huge crop in the previous year, the likely potential for 1986 was probably no more than 22-23 million bags. This would put the total loss between 33 and 50 percent.6 The consequence of the 1999 drought was to eliminate much of the potential production increase. (Figure 35 in the next section suggests that overall yields everywhere except the smaller states of Espirito Santo (increase) and Parana (big decrease) were otherwise little changed through this period. The impact of a drought on the following year's production can be enormous. Increases in productivity that are typical after droughts could, for example, occur in some areas in 2004-2005, depending on prices, though the very reduced drought and the late return of rains will make this only a minor affect. Other countries also experience this effect: It was particularly noticeable after the last major El Niño. Low rainfall in some robusta countries during El Niño was followed by spectacular production in the following year. In particular, Cote d'Ivoire production doubled, and evidence from Vietnam suggests that the recovery phase from the El Niño drought led to a big increase in production (see figure 38). 6Association of Coffee Producing Countries, Market Report, November 1999. New Paradigms in Global Supply and Demand 19 If production outside the big three producers does continue to decline, then, by 2004-2005, the share of these three countries should easily exceed 60 percent of total production, with Brazil exporting substantially more than Colombia, Vietnam, and Indonesia combined. With trend demand growth leading to a figure close to 88 million bags, a situation potentially arises where the market is oversupplied in 2004-2005 but is dependant on a natural arabica usage figure well in excess of 30 percent in order to balance supply and demand by each individual type. If the global coffee industry cannot take natural arabica usage to this level, then sharp falls in the global stock levels of washed arabica and robustas could occur, while Brazil is left with a stockpile of natural arabicas. This would lead to sharp swings in prices; for both futures prices and for individual country differentials (see figure 8). 2. Prices Introduction Figure 1 graphically illustrates the current problem in the coffee markets--prices only just recovering from 100 year lows when adjusted for inflation. Over the period shown since 1970, prices have averaged a 3 percent per year price decline for arabica coffees and a 5 percent decline for robusta. In the sections on historical background (see section one) and supply (see section four), we characterize the price decline as a series of cycles of about 7 years duration within the falling trend, which itself has been driven by a combination of increasing productivity; rising production as new lower-cost producers enter the market; rising producer share of export prices; and a sequence of renewed planting and renovations that follows price spikes that occur occasionally, usually following a frost or drought in Brazil. The short-run inelasticity of supply and demand drives prices higher following a production shock, but the long-run response to these higher prices is to raise production by bringing in new entrants and encourage rehabilitation of farms. This, then, drives prices down until they are below long-run marginal production costs. The combination of short periods of high and volatile prices and long periods of low prices and low volatility is common to many other crops, not just coffee, and its causes have been extensively analyzed (Deaton and Laroque1992). In these types of scenario, the value of stocks become key. Unlike the case of money, for example, it is not possible to "borrow" from production that has not been already produced, and, as a result, the available stocks become the limit of additional supply when production drops suddenly. In some types of consumer markets, lost sales cannot later be recovered: for example, in food and beverage markets, what has not been consumed today will not be compensated by double consumption tomorrow. This is very different from some manufactured products, such as automobiles or motorcycles, in which a consumer may be prepared to go without an item for a certain period while they waits for his exact choice to become available. The stock-out cost for a product, such as coffee, is proportionally much higher than for a product that a consumer will definitely buy but will delay their purchase until the product becomes available, and the value of stocks rises through an increase in market prices. Once excess supply is in the system and prices have fallen, these stocks act as a restraint on price increases coming from short-run supply fluctuations because traders will hold stocks for both speculative reasons, expecting to sell them for a profit at a later date if prices rise, and for precautionary reasons, expecting to meet sales obligations to roasters during shorter periods of coffee unavailability. 20 Coffee Markets Prices and Farmers Problems of Information Access Quality Incentives and Price Signaling Coffee is typically sold as a commodity and, though it is graded and classified, this is done in bulk lots that usually mix together the production of many individual growers. This process does not distinguish or reward those with superior or differentiated characteristics and sometimes does not penalize lower quality producers. When a wide range of grades is produced by farmers and mixed at collecting stations, it becomes possible for processors with better grading equipment to unsort the mix according to more exacting requirements. When the structure of differentials allows it, they sell the individual components at a higher total value than the mix, thus capturing quality rewards but also reducing the incentives for growers to maintain or improve quality. This higher value would have otherwise accrued to the growers if the ability to maintain differentiation and capture its value existed. But without such incentives, growers eventually learn that the only requirement is to simply meet the minimum standards and, therefore, incentives for differentiation is lost. Coffee quality improvement efforts or projects must start with a clear understanding of farmer incentives and how to structure the supply chains to deliver these benefits to the individual farmers. Information Distribution and Price Discovery Because of the economic importance of coffee, considerable asymmetries in the distribution of market information exists; however, this is not just the problem in coffee but also in several other commodities. Some of the best information is closely held by large traders, while publicly available data may at times be inconsistent: for example, the significant data discrepancies over Brazilian production levels between the Foreign Agricultural Service of the USDA and the Brazilian government. Data and information flows have also suffered as a result of low prices, with the statistical bodies of producer countries unable to maintain accurate information collection and dissemination in the face of funding shortfalls. The increased availability of primary research tools such as weather satellite data on the internet at very low cost has somewhat lessened the information asymmetry problem, and, particularly in the case of coffee supply and demand data, the ICO retains a large amount of accessible data on their Web site, though this sometimes lacks the benefit of effective access in rural areas and the limited use of, or comparison with, alternative data sources. Advantages still accrue to those best able to access, interpret, and utilize different sources effectively. Price Volatility Despite the rather general use of this term, it is useful to break down this concept into the two different but often interchanged meanings: the inability to predict prices before an event and the retrospective measurement of their level of variation. Many factors, such as the levels of stocks, sudden changes in the supply/demand balance, and inadequate information all contribute to changes in the level of price volatility. Variation in prices is in itself not necessarily harmful if the parameters of this variation are known in advance and can be factored into decision making, but this is often not the case with commodity prices: The variability of prices around an apparent long-term trend is usually far in excess of the size of New Paradigms in Global Supply and Demand 21 the trend itself .7 This creates policy problems for governments when trying to decide how to respond to a situation because it may only be clear in hindsight whether a price move was variation around the trend or a genuine shock. Volatility levels have also changed over time (see figure 11) . Work done by the Federación Nacional de Cafételeras de Colombia (FNC), for example, suggests that volatility of coffee prices was higher outside the periods of the international stabilization agreements, though, at times, the agreements were suspended when shocks caused prices to be very high and volatile. Research by Gilbert (1989) and others suggest that overall commodity price volatility has increased with the breakdown of the Bretton Woods currency agreements and that the consequence of higher volatility in meeting dollar-denominated debt has had an impact on commodity earnings. Figure 11 Monthly volatility of arabica and robusta prices 30 25 20 15 10 5 0 60 65 70 75 80 85 90 95 00 A ra b ic a P ric e V o la tility R o b u s ta P ric e V o la tility Source: ICO, customized subset of data sent to author, taken from ICO database The unpredictability of prices makes it more difficult for farmers to plan. Because tree crops such as coffee requires farmers to take a long-term view, this unpredictability limits farmers' access to credit for improved production and may lead them to adopt low-yield, low-cost production techniques that limit their ability to improve their living standards. As Deaton (1992) notes, "It is a good deal easier to forecast prices once the future is safely past." It has been suggested that unpredictability has a direct impact on marketing margins--that as prices become more volatile, those parts of the marketing chain with direct exposure to prices will attempt to 7Some studies have claimed that there is no long-term downtrend in commodity prices, only a series of negative breaks or "shocks" in otherwise trendless data; however, the consensus appears to be that there is a weak long-term trend but that the ability to discern it is dependant on the time periods chosen and commodities included in any index. See Sarris 2003 for a full discussion of the literature. 22 Coffee Markets raise their margins to compensate.8 When this happens at the expense of farmers, it represents a direct revenue transfer to the traders. Uncertainty also limits coffee producers' ability to respond to market signals, particularly when the actual level of prices is obscured by short-term volatility and when weakening of coffee institutions leads to a lessening of the quantity and quality of available information. This lack of information and understanding contributes to the problems of inadequate policy responses to both positive and negative shocks that have occurred in producing countries. It may also have helped lead to the large swings in supply and demand that, as described in section one, resulted from large price changes. A survey (discussed in more detail below) of coffee farmers in India undertaken by the Commodity Risk Management Group of the World Bank confirms some other studies indicating that farmers are willing to accept lower incomes in return for reduced volatility. At the micro level, if barriers to access to futures and options markets can be diminished, this would allow producers to more efficiently self-adjust their exposure to risk. The consequences of volatility and unpredictability at the micro level remain an area of active research--with some studies suggesting that diversification at the national level has reduced many countries vulnerability to shocks in any one specific commodity, with some exceptions, notably parts of Africa (Gilbert et al 2003). Recent work by Cashin and others has focused on the structural behavior of commodity prices, including the trends and volatility issues that have been discussed. A basic conclusion has been that commodity price shocks in a number of commodities--including coffee--are so long-lasting that they make stabilization schemes of the types described in the previous section unviable. Instead, international cooperation should focus on managing the consequences of volatility through the use of some compensatory financing systems during periods of price shocks (the idea behind the creation of the EU's former STABEX facility, or the IMF's Compensatory Financing Facility (CFF), and not in attempting to manage the volatility itself through interventions in the markets. Speculative Activity and Volatility Prices have been increasingly affected by relatively new factors, such as the actions of fund managers and financial speculators. Futures prices reflect not just current physical market prices but also the expectations of future events that can have a major impact on prices. The Commitment of Traders Report allows an analysis of the behavior of large speculators and traders, and speculative activity is an important part of the market (see figure 12). It is not clear that speculative activity has necessarily led to an increase in market volatility. Studies of futures markets for commodities, such as cocoa and petroleum, concluded that investment funds can actually increase liquidity and speed the reversion to "fair value" (Gilbert 1994; Weiner 2002). There have been some arguments that speculator activity is responsible for reinforcing trends once they start. There is some weak but not very conclusive evidence that those speculators without access to good information will simply follow what they see other funds doing: herding. This information is available from the Commitment of Traders Reports, but the study of the petroleum markets suggests that this type of activity only occurs among the smallest speculators. The impression given by the chart above that the large speculators are driving the coffee price is not supported to any extent by actual data analysis. 8This area is currently the subject of research by members of the International Task Force on Commodity Risk. New Paradigms in Global Supply and Demand 23 Approaches to Managing Risk Approaches to managing risk can be subdivided into two often distinct realms: those pursued by the public sector and those pursued by the private sector. Governments have historically taken positions to help their coffee farmers, recognizing that export revenues from the sale of coffee have made vital contributions to many of their farmers and economies. These interventions have been at two levels-- international cooperation through agreements, including those that set up the economic clauses of the International Coffee Agreement (ICA) and the Association of Coffee Producing countries (ACPC), as well as at the domestic level through policies, such as the destruction of coffee or the use of internal price stabilization funds and other forms of price support schemes. However, many such interventions have a poor track record. Figure 12 Arabica futures prices and the level of speculative involvement 20000 140 130 15000 120 C F 10000 S C U 110 E T U F R 5000 100 U E T S U 0 90 R P E O S S I 80 -5000 P T R I I O 70 C N -10000 E 60 S -15000 50 -20000 40 October-98 October-99 October-00 October-01 October-02 October-03 NET LARGE SPECULATOR POSITION CSCE FUTURES PRICES Source: Commodity Futures Trading Commission, data accessed from Web site (www.cftc.gov); New York Board of Trade, data accessed from Web site (www.nybot.com) Despite this poor record, continued government support for commodity producers, including coffee farmers, has ranged from debt restructuring or forgiveness to direct and indirect subsidies, though this support, in many cases, has mostly helped larger farmers whose indebtedness threatened the banking systems. While this may have sometimes been necessary to avert deepening crises, farmers have subsequently expressed expectations for further government intervention, including hope for international assistance, such as a return to the economic clauses of the International Coffee Agreement (IDB, USAID, World Bank 2002). Government support may be useful in reducing the impact of strong commodity shocks on the more vulnerable segments of their population but should be cautiously undertaken because it also sends a false signal that the government is capable of bailing out growers from the consequences of unrestrained production increases. Furthermore, government bailouts contribute to the creation (or 24 Coffee Markets continuation) of a culture of nonrepayment of loans by producers, further discouraging private banks from lending to the agricultural sector. In the long run, government support can be potentially more damaging, not to mention more costly, if it encourages the sector's inappropriate exposure to risk. International Policy Partly as a consequence of the Great Depression, the price of coffee collapsed from 22.5 cents per pound to 8 cents per pound in 1931. One of the earliest attempts at international cooperation among coffee producers was a plan to destroy excess production--primarily by Brazil--in the period between 1930 and 1937. Brazil held 26 million bags of coffee in stocks, against worldwide consumption, which, at the time, was estimated at 25 million bags. In the first year, Brazil destroyed slightly more than 7 million bags, and, in 1937, the country destroyed 17.2 million bags at a time when consumption was 26.4 million bags. Brazil soon lost market share as other countries failed to honor the 1936 Bogotá agreement on price differentials, and, at the 1937 Havana conference, Brazil made it clear that it would not act as the world's warehouse and price supporter. When the Pan-American Coffee Bureau failed to deliver a solution to the developing impasse, higher exports resumed and prices soon dropped to 6.5 cents per pound. Lack of transparency and inadequate mechanisms for accountability weakened these agreements. Free-rider problems were very evident: For example, African production expanded dramatically in this period. There have been many attempts since then to regulate the coffee market through cooperation at an international level, and their history is well-covered in numerous books and papers such as Gilbert (1994). The economic clauses of the International Coffee Agreement (ICA) was the main instrument of international efforts to keep coffee prices stable and at some predetermined levels. This was done through controlling coffee exports at an individual country level via export quotas. Surpluses above the quotas were held as stocks in producing countries or sold to nonmember quota importing countries mainly in Eastern Europe and Asia. The primary distinguishing factor of the economic clauses of the ICA was that, unlike the Bogotá agreement, and ACPC, they were a joint participation by both producers and consumers in market intervention. While the economic clauses of the ICA were successful for awhile in keeping international prices within their pre-agreed band, except when frost or drought in Brazil pushed prices higher, nevertheless, problems developed that later led to the collapse of the program. In the international markets, coffees were being diverted to importing countries that were not members of the ICO, so that governments in importing member countries perceived that their consumers were being disadvantaged relative to consumers in nonmember countries. Some producers shipped in excess of their quota but disguised this in several ways, including rebagging the coffee offshore. The coffee industry claimed that the quota allocation among countries did not make available the coffees they needed--a problem that was not considered to have been solved by the introduction of selectivity. Consequently, in 1989, a number of countries withdrew from the program and it collapsed. Various attempts were made over the next 4 years to revive it but without success. Work done by the World Bank at the time supported the idea that quotas had succeeded in stabilizing prices (Akiyama and Varangis 1990). This was not always to the producers' advantage. For example, when Brazilian production fell in 1985 the price increase that followed was less than it would have been had there been no quotas in the previous year because of the high levels of stocks that had been acquired. It is not clear that all the benefits accrued from the stabilizing effect were evenly distributed. In particular, Akiyama and Varangis (1990) indicate that most of the benefits accrued to the larger producers with New Paradigms in Global Supply and Demand 25 higher quota shares often at the expense of smaller but dynamic/low-cost producers or producers whose coffee quality had increasing demand. These producers were constrained under the ICA quota system. At the domestic level, state-managed governing bodies, such as the coffee boards, were often inefficient, and, under the ICO programs, their management of the export quotas gave them opportunities for rent seeking (Bohman and Jarvis 1999). When this rent seeking was combined with the inefficiencies, the marketing boards induced in their markets, it served to divert a significant share of the export value of these crops away from the producer toward either governments, the marketing boards themselves, or the export sector. even if they managed to smooth market signals and responses which most likely contributed to lower domestic volatility (Giovannucci, et al. 2002a). It was not surprising that, in many cases, the end of the ICO quota schemes led to both a dismantling of the coffee boards and a rise in the producers share of the export price. The formation of the ACPC that followed the collapse of the economic clauses of the ICA in 1989 represented a return to a policy of unilateral cooperation between producing countries. The ACPC focused on the need to target a reduction in the levels of consumer stocks using the arguments developed in the opening of this section. Although the ACPC was credited with helping to raise prices initially, events, such as the 1994 frosts and drought in Brazil, became more significant price influencers. Free- rider problems and export quota distribution problems that had become common in the period of economic clauses of the ICA were experienced here, as well. A significant impediment to the implementation of the ACPC agreements was the very liberalization and dismantling of the marketing boards that had followed the end of the ICA economic clauses--effectively the control mechanisms for export flows had been lost. In addition, access to risk management tools among those actually responsible for implementing the retention plans--usually the export sector--meant that this coffee was hedged in the futures and options markets and the price response to the coffee's existence transferred into the markets regardless of whether the coffee was actually shipped. Some studies of market management schemes, such as those surviving for diamonds and oil, have concluded that the single most important factor for the success of these programs is a hegemonic producer willing to sacrifice its own immediate "good" for the longer-term benefit of all producers (Spar 1994). In the long-run, it is not clear that even this will hold. In the case of oil, the price has been so far above production costs for many Gulf states that it has helped influence the opening up of Central Asian sources. Even so, in neither coffee nor cocoa does the natural hegemonic producer indicate any interest (in the case of coffee) or capability (in the case of cocoa) in performing this role, even if it were able to commit the necessary resources. A more recent class of international policy initiatives is based on the concept of raising overall quality standards by introducing minimum quality standards into the market as represented by both the ICO's coffee quality-improvement program referred to as ICO Resolution No. 407 and by minimum import standards as in the proposed U.S. Coffee Purity Act. There has been support at the level of international organizations, and ICO Resolution No. 407 fits with Article XI of the General Agreement on Tariffs and Trade (GATT) which does specifically allow for such measures. The ICO resolution requires exporting member countries of the ICO to not export coffee that has more than a certain number of defects9. 9These defect classifications include: · An excess of 86 defects per 300 gram sample for arabica coffee (New York green coffee classification/Brazilian method or equivalent). 26 Coffee Markets The resolution also encourages efforts from both producing and consuming countries to eliminate substandard coffees from their domestic markets. Such standards are also expected to reduce the possibility of dangerous mold contamination. Some exceptions on moisture-content are allowed for a few specialties, such as Indian Monsooned coffees that traditionally have higher moisture content. Resolution No. 407 has been met with two opposing points of view: Proponents of quality standards policies argue that eliminating the supply of the lower-grade coffees would ensure that consumers are drinking "pure" coffee rather than triage and defects that are alleged to be included in many commercial blends; raise the average quality of retail products and, consequently, stimulate demand; and reduce the total availability of green coffee, slightly increasing prices. Opponents argue that regulation is not needed to do what markets will do naturally since roasters have access to large quantities of high-quality, tenderable-grade, and exchange-certified stocks and make the conscious decision that their consumers are satisfied with the inclusion of lower-quality stocks to keep prices low; are readily able to remove defects from their raw materials if they wish; and that such regulation could hurt the poorest producers who are least able to upgrade their standards. Some producing countries have voiced support for the standards, and countries ranging from Vietnam to the Central African Republic have already introduced public resolutions designed to foster trade in higher standards. Unless governments and trade associations take a strong stand, the decisions are likely to remain in the hands of coffee buyers and traders because, though the resolution is binding on ICO producer members, there is no enforcement system. Domestic Policies Governments have used different ways of managing coffee prices internally. Countries, such as Colombia and Papua New Guinea, have favored the use of stabilization programs. A second group of countries have focused on ways to smooth prices internally without going against the trend--for example, India used a pooling program that spread the revenues more evenly across producers, and Costa Rican coffee law requires that the prices farmers receive are a function of the average price over the season and not just at the time of sale. A recent variation of these domestic solutions is the put options plan for coffee producers in Brazil. Stabilization funds have gradually been phased out in most countries, though in the light of the coffee crisis, a number of countries have sought financial support from the multilateral organizations to re- introduce them. The Papua New Guinea stabilization fund has been extensively analyzed by Kannapiran (1999) and others, and the findings clearly illustrate some of the general problems of stabilization funds. In Papua New Guinea, the main method of distributing stabilization fund payments was through the coffee processors, who were responsible for passing on the stabilization payments and then reclaiming the money from the fund. Changes in the available funds were never announced in advance in order to prevent hoarding.10 A number of studies have questioned the efficiency of this system and, while most · An excess of 150 defects per 300 gram for robusta coffee (Vietnam, Indonesia, or equivalent). · A moisture content below 8 percent or in excess of 12.5 percent when measured using the ISO 6673 method for both arabica and robusta coffees. 10Colombia's fund also had this problem: When the internal price was linked to a moving average of the futures price, farmers would wait through some of the averaging period in order to speculate on the likely change in the internal price at the end of the averaging period. New Paradigms in Global Supply and Demand 27 studies did see that the stabilization fund payouts were fully reflected in what farmers received, some of the evidence for this is contradictory (Simmons and Yarbro 1993). Also contradictory is evidence on the success of these schemes in the short run. For example, some evidence from the Papua New Guinea cocoa and copra price stabilization funds suggested that these funds had been successful in stabilizing prices but not at stabilizing incomes, which are a function of both prices and quantity variation. This dual price and quantity variability may also account for why there may have been little macroeconomic benefit to stabilization (Kannapiran 1999). Stabilization funds suffer from a number of structural weaknesses. As discussed above, the tendency of commodity prices to have short spikes and long troughs means that stabilization funds have a tendency to run out of money before a recovery can occur. In the case of Papua New Guinea, this led to the fund having to borrow from the government--loans that later had to be forgiven. There is also an assumption that the stabilization fund managers can better invest the levies received during periods of high prices than can individuals, and producer support for stabilization funds may, therefore, be indicative of a problem of lack of access to financial services. Much of the work done in Papua New Guinea and elsewhere on commodity stabilization funds has made the general conclusion that these funds may be an entirely inappropriate instrument through which to achieve producer income stabilization. If governments wish to stabilize rural incomes, they would be more likely to succeed by addressing that issue directly. Another contribution to the demise of stabilization funds was the expectation that the efficient market signals of a liberalized economy would replace the need for most public sector management of the markets. As World Bank reports have highlighted in some countries, such as India, demand came from growers themselves for an end to centralized control of marketing resulting in clear improvements to producer prices (Akiyama et al 2001). The dismantling of some of the African parastatal organizations resulted in farmers recapturing large increases in their share of the export price from the marketing boards (Bohman, Jarvis and Barichello 1996). Nonetheless, in Costa Rica, the averaging system still functions, though larger farmers are asking for participation to be made discretionary. The put options scheme in Brazil is a new variation on the idea of a buffer stock. In this arrangement, farmers purchase the right to sell their coffee at the strike price of the option to the government, which would add the coffee to its existing stockholding. There was good demand for these products initially when local prices were close to the strike price, but, in the first round of product sales, the combination of rising futures prices and a weakening Brazilian Real substantively increased local prices, and demand for the options fell so low that, in the last auctions of the first round, none were sold at all. The options program was considered to have had the effect of allowing farmers to hold back coffee from immediate sale, thus being partially responsible for the internal price increase that occurred after its introduction (see figure 33). Not all domestic policy reforms were beneficial to everyone. In some cases, the end of a uniform- managed internal price meant that producers in more remote areas saw their prices fall disproportionately as competition focused on more accessible production. In Mexico, for example, Bohman and others demonstrate that the tax and regulatory regime under quotas benefited smallest farmers and exporters at the expense of larger farmers, while, in Kenya, planting restrictions to keep supply in line with quotas mostly benefited larger farmers. Other accounts of the issues arising from liberalization reforms can be found in a variety of sources, including a study sponsored by the ICO and the World Bank (CFC 2000). 28 Coffee Markets Since the collapse of the ICA agreement, several countries particularly in Central and South America have used emergency funds in the form of governments issuing coffee bonds to provide financial support to their coffee producers. The repayment of the funds is contingent on higher prices in later years. For example, Costa Rica and El Salvador have used emergency funds in the past to support the income of producers when prices declined. The funds were repaid because of the recovery of coffee prices during from 1994 to 1997. Without this temporary price recovery, the repayment would have been questionable. To respond to the coffee crisis after 1999, both Costa Rica and El Salvador--and now Honduras--are again using emergency funds, the repayment of which will rely on the recovery of world coffee prices. If recovery is slow and prices remain at relatively low levels, it will hamper the ability of farmers to repay. In addition, Costa Rica, El Salvador, Guatemala, and Nicaragua are using programs to restructure the debt of coffee farmers. These programs mainly benefit the medium and larger farmers who receive formal credit. At the same time, some of these countries are starting to embark on longer-term projects to diversify, renovate their coffee plantations, and improve the marketing and quality of their exportable coffees. The main focus of domestic policy response so far still remains the short-term solution: keeping producers in coffee production by providing support to prices and solving their debt problems. In addition, most small producers and laborers have not benefited directly form programs aimed at helping the coffee sector. Responses to low coffee prices do not include necessary measures to address the longer- term problems of structural imbalances and the need for horizontal and vertical diversification for some of the producers. Though the short-term costs and benefits of government policies bailing out coffee farmers are certainly debatable, small farmers do not always receive accurate and timely signals and may not be in a position to respond appropriately, regardless of the signals. At the producer level, decisions that result from delayed or inaccurate policy and market signals have left producers at a significant disadvantage. Even so, the most successful coffee-producing nations have benefited from a measure of continuity and order through strong sectoral institutions that have adapted to their new roles and have helped growers understand and respond to market signals; however, only few such institutions exist. Types of Risks at the Micro/Household Level Surveys of farmers undertaken by the World Bank's Commodity Risk Management Group, as well as various rural vulnerability assessments, indicate that price, weather, and health risks are the most important risks that rural households face.11 A recent survey of coffee farmers in India showed that producers regard weather and prices as their main concerns, regardless of their size as producers (see table 3). Risks are ranked, with five as the most important and one as the least important. It is noticeable that the relative rankings of risks change only for the lower ranks. In particular, concerns about health risks decline with farm size, but concern about the consequences of government policy increases with farm size. An earlier survey conducted in Nicaragua produced similar results (see table 4). In Nicaragua, the most important risk was ranked three and the least important risk was ranked as one. 11Reports by the CRMG containing the surveys can be found at www.itf-commrisk.org. Surveys of note can be found in the reports on Dominican Republic and Nicaragua. New Paradigms in Global Supply and Demand 29 Table 3 India: producer risk perceptions by farm size (acres) All Farms 0-10 10 - 25 25-50 50-100 100-200 200-400 > 400 Rainfall/weather 4.68 4.77 4.68 4.63 4.61 4.45 4.91 4.60 Fall in rice 4.33 4.17 4.42 4.32 4.59 4.39 4.04 4.20 Unstable prices 4.16 4.10 4.22 4.17 4.22 4.12 3.68 4.30 Crop pest/disease 3.56 3.59 3.44 3.61 3.62 3.67 3.45 3.90 Changes in 3.1 2.96 3.11 3.13 3.08 3.13 3.41 4.00 government policy Withdrawal of 2.85 2.82 2.95 2.88 2.80 2.81 2.40 2.40 credit Fall in other crop 2.75 2.71 2.76 2.78 2.91 2.63 2.50 3.00 income Illness 2.1 2.18 2.18 2.11 2.05 1.78 1.95 1.40 Loss of off-farm 1.57 1.57 1.55 1.51 1.63 1.58 1.68 1.70 income Source: World Bank and Coffee Board of India 2003 Table 4 Nicaragua: producer risk perceptions by farm size Type of Risk All Farms 0-4.99 5-9.9 10-19.99 20-49.9 >50 Weather Risk 2.19 2.21 2.15 2.07 2.23 2.25 Fall in International Prices 3 2.98 3 3 3 3 Drop in Yields from other crops 2.51 2.55 2.6 2.52 2.54 2.35 Loss of Employment 1.63 2.15 1.54 1.46 1.44 1.54 Bad Health 2.9 2.97 2.93 2.93 2.9 2.81 Lack of Access to Credit 2.85 2.74 2.85 2.94 2.86 2.87 Source: World Bank 2002a When Indian coffee farmers were asked which was the single most important risk, as opposed to a ranking question detailed in table 3, they ranked these slightly differently overall, with a fall in prices as the issue of most concern, as shown in table 5. This result reflects the finding of other CRMG surveys, although this particular survey separated out attitudes towards price instability from attitudes toward unexpected price falls. India coffee farmers otherwise appear to have considered price volatility much less important than an unexpected fall in price. A similar situation can be seen from the data derived from the survey undertaken in the Dominican Republic (see table 6). Farmers can manage risks, including price risks, in a number of ways, including: 1. On-farm diversification to include other products or differentiating their product with, for example, specialty or certified products. 2. Off-farm diversification to nonfarm enterprise or offering rural labor. 30 Coffee Markets 3. Developing long-term contracts with buyers. 4. Formal risk management mechanisms, such as options or futures markets. 5. Reducing exposure by limiting costly external inputs (organic or avoiding credit). 6. Financed inventories to extend the sales periods and allow greater flexibility. Sometimes risks are traded off. For Table 5 Risks faced by coffee producing households in India example, irrigation and higher input usage (number and percent of people reporting risk as very can lower yield volatility but may leave the important) producer more exposed to price risk due to the higher costs. Other techniques such as For whom is the most important risk? long-term contracts may simply be closed Type of Risk Number Percent to smaller farmers because, in the absence Rainfall/weather 183 36.7 of information about producer and their Fall in price 194 39 credit track record, the buyers may be Unstable prices 88 17.7 Crop pest/disease 6 1.2 unable to distinguish between those Changes in government 13 producers who will honor forward sales in policy 2.6 the event of a price rise and those who will Withdrawal of credit 8 1.6 default. Working credit bureaus can help Fall in other crop 1 income 0.2 reduce these risks but are difficult to apply Illness 5 1 in the informal credit environment of many Loss of off-farm income 0 0 rural areas. There are very few cases of clear public policy or regulatory support of Source: World Bank and Coffee Board of India 2003 such private bureaus; however, many of Table 6 Risks faced by coffee producing households in the these techniques, whether formal or Dominican Republic (percent reporting risk as very informal, may be inadequate or fail important) altogether when prices are in long-term decline or stay below the cost of Less than 5 5-10 6 Years Production Bags 12,000 350,000 10,000 300,000 250,000 8,000 200,000 6,000 150,000 4,000 100,000 2,000 50,000 0 0 85/86 86/87 87/88 88/89 89/90 90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 Source: VICOFA, data provided to author; USDA Foreign Agricultural Service "Production Supply and Distribution" database The falls in prices to record lows have resulted in an end to new plantings. According to the VICOFA data, 2- to 3-year-old trees account for about 27 percent of all productive capacity. Government policy to reduce planted area is being implemented to a very modest degree, and uprooted trees are noticeable through parts of the producing areas. In some cases, trees were stumped as far back as possible and are likely to re-enter production again within a few years. It is likely that the tree removal has been concentrated in the areas of lowest marginal profitability. Financial institutions are not lending for new coffee development unless farmers are switching to arabica under plans approved by local government (People's Committees). These committees also have some influence over the choice of replacement crops for which farmers can borrow for startup costs; however, many farmers are already in debt to their banks and find that this limits their ability to borrow for crop substitution. Yields Most sources quote an average yield of two tons per hectare. Yields of this level are very high compared to most other producers. Even the current record robusta crop in Brazil is based on an expected yield in some areas of as much as 1.8 tons per hectare. These are levels not seen there previously, for example. Yield data indicate that they are very sensitive to input changes. Output has a direct correlation with input levels--specifically, 1 ton of NPK produces 1 ton of coffee, which rises to 2.5 tons of coffee and 3.5 ton New Paradigms in Global Supply and Demand 89 of coffee with 1.5 or 2.5 tons of NPK, respectively. Productivity at this level is going to depend heavily on the ability to maintain both irrigation and input usage. Colombian research offers an example of the magnitude of the drop in productivity when fertilizers are withdrawn as they experienced a 30 percent decline in the two years following the ending of fertilizer subsidies. During the course of a 2002 field visit, it was clear from the state of the trees at the end of the drought period that the final production data for 2002-2003 will have been determined by both the extent to which the farmers were be able to pay for irrigation and local microclimatic conditions. With the return to higher prices in late-2002, intensive irrigation was visible almost everywhere, and the main concern of farmers seems to be the increase in fertilizer and irrigation costs due to the increased cost of petroleum. Figure 38 shows an illustrative (given the data limitation) indication of how yields on mature trees behave relative to the likely money that a farmer has available from one season to pay for inputs in the next, given the generally low level of access to credit. The substantial limitations of the data make an exact elasticity calculation impossible, although the indicative number is in line with the very high dependence on fertilizer and irrigation and suggests that a period of low prices in which inputs are withdrawn could lead to the types of productivity drops currently being discussed as having occurred for the recent crops. Figure 38 also indicates the possible impact of El Niño on productivity. Figure 38 Derived data on yield of trees more than five years old and previous-season robusta prices 2.4 16000000 2.2 14000000 Price (-1) 2.0 12000000 1.8 10000000 1.6 8000000 1.4 6000000 1.2 Yield 1.0 4000000 0.8 2000000 90 91 92 93 94 95 96 97 98 99 00 01 02 Source: ICO, customized subset of data sent to author, taken from ICO database; author's calculations based on published and unpublished data provided by private traders; Data presented at the U.S. National Coffee Association Annual Conference, March 2002 Production Costs Claims of production costs vary widely, with estimates as high as US$600 per ton for private farms to US$1,000 per ton for the state farms when all the social costs, such as the provision of schools and local infrastructure are included. As there has been little financing available to much of the private sector for establishment costs, and land has mostly been appropriated, many farmers have relatively few startup or 90 Coffee Markets fixed costs. Discussions with lenders in the coffee regions suggest that they see default problems arising when prices drop below US$450 per ton. State Farms Separate production costs for state farms are difficult to impute because, in some farms, the contract with the farmer involves a fixed volume exchange between inputs from the farm and salary payments on one hand, and the delivery of coffee at the other. The figure quoted above of up to US$1,000 by the state- owned enterprises (SOEs) is attributed to the high social costs incurred by state farms, but anecdotal evidence suggests that no new social benefit activities are being planned that would give rise to such costs and suggest that efforts were being made to transfer any residual liabilities to the government. Small Farms See table 15 for an illustration of the breakdown of production costs. For the level of inputs quoted, the farmer is expected to get two tons per hectare, which would cost US$257 per ton. Table 15 Illustrative basic production costs of a farm yielding two tons/hectare Quantity Price (dong) Value (dong) Labor 210 days 15,000 3,150,000 Fertilizer 1.5 tons 2,500,000 3,750,000 Chemical 4 apps 50,000 200,000 Irrigation 3 apps 250,000 750,000 Total Cost /Ha 7,850,000 or US$523 Total Cost/ton 3,925,000 or US$262 Source: Authors' calculations based on data from small farms visited, May 2002 This approach does not address the fact that, in the absence of alternative employment, farmers will need enough money from their farms to cover both living and production costs. Assuming farmers are willing to tolerate a reduction to just basic living costs, then production costs become input costs and living costs combined. In the example presented in table 15, this would take production costs up to about US$340 per ton. However, this is not likely to be a sustainable arrangement, but it would allow farmers a short timeframe to see if prices rose again. Valuing the labor closer to the higher market rates of 20,000 VND per day raises the production costs to US$340 per ton. Large Farms Discussions with larger farmers needing specialist labor for certain tasks showed that they faced labor costs well in excess of that assumed for a small farm using family labor (see figure 28). New Paradigms in Global Supply and Demand 91 Table 16 shows author calculations made for a 10 hectare farm visited in Lam Dong province. Some Table 16 Illustrative production costs for a 10 of this data is out of line with the costs quoted hectare farm, Lam Dong Province elsewhere. In particular, the yield of two tons per Quantity Price (dong) Value (dong) hectare, and 3 kilogram of fertilizer per tree is out Labor 270 days 23,000 6,210,000 of line with other estimates. This farmer claimed Fertilizer 3 tons 2,500,000 7,500,000 his own production cost estimate was nearer to Chemical 4 apps 50,000 200,000 US$600 per ton. Irrigation 3 apps 250,000 750,000 Total cost/ha 14,660,000 Exports From Producing Countries Production Cost (dong) Cost (US$) Exports from producing countries have fluctuated 2 tons/ha 7,330,000 481 with production and, to a limited extent, attempts to manage stock flows. The two largest falls in Sources: Authors' calculations based on conversations with local farmers and traders, May 2002 exports reflect, first, the drought in Brazil of 1976; the frost and drought of 1994 came at the end of a period of falling production following the collapse of the ICO agreement and the subsequent price fall in 1989. Table 17 and figure 39 illustrate the problem from the producer perspective: Exports in 2002 were approximately 89.7 million bags before accounting for producer re-imports--down from the highest ever in 2001. But export revenues (at US$5.25billion) fell to their lowest levels since 1978. Table 17 Coffee year exports, 1994-2003 Type of coffeee 94/95 95/96 96/97 97/98 98/99 99/00 00/01 00/02 02/03 Colombian milds 11,139 13,448 13,082 12,169 11,851 10,794 11,360 11,821 11,885 Other milds 19,120 24,447 23,316 22,461 23,491 26,745 23,373 20,863 20,771 American 15,435 19,857 18,878 18,139 19,034 21,799 18,805 16,470 16,429 Asian 2,020 3,096 2,864 2,937 3,147 3,543 3,262 3,218 2,890 African 1,664 1,495 1,575 1,385 1,309 1,403 1,306 1,175 1,452 Natural arabica 14,625 12,109 18,091 16,578 21,282 18,304 20,797 23,133 24,590 Robustas 21,448 26,053 28,492 28,164 28,087 33,613 35,494 32,860 31,837 American 4,646 3,832 3,219 3,011 4,248 2,969 3,010 5,585 5,775 Asian 8,922 12,544 14,007 15,049 14,608 19,875 23,759 20,140 19,244 African 7,879 9,677 11,265 10,104 9,231 10,770 8,725 7,134 6,818 Total 66,332 76,057 82,981 79,371 84,711 89,456 91,025 88,677 89,083 Colombian milds 16.8% 17.7% 15.8% 15.3% 14.0% 12.1% 12.5% 13.3% 13.3% Other milds 28.8% 32.1% 28.1% 28.3% 27.7% 29.9% 25.7% 23.5% 23.3% Natural arabica 22.0% 15.9% 21.8% 20.9% 25.1% 20.5% 22.8% 26.1% 27.6% Robustas 32.3% 34.3% 34.3% 35.5% 33.2% 37.6% 39.0% 37.1% 35.7% Total 100% 100% 100% 100% 100% 100% 1.00 100% 100% Source: F.O. Licht, compilation of various published datasets; ICO, customized subset of data sent to author, taken from ICO database; CECAFÉ, customized subset of data sent to author, taken from CECAFÉ database; authors' calculations based on published and unpublished data provided by private traders 92 Coffee Markets Figure 39 Exports from producing countries and export revenues 16,000,000 95,000 90,000 14,000,000 Export Revenues 85,000 s 12,000,000 80,000 00' Bags 75,000 kg US$'0" 10,000,000 60 of 70,000 's nuese 8,000,000 65,000 000' Rev s:t 6,000,000 60,000 Exports Expor 55,000 4,000,000 50,000 2,000,000 45,000 6 8 4 6 8 0 2 4 0 2 1994 199 199 6 8 196 196 1970 1972 197 197 197 198 198 198 1986 1988 199 199 2000 Source: USDA, Foreign Agricultural Service "Production, Supply and Distribution" database; F.O. Licht, compilation of various published datasets; ICO, customized subset of data sent to author, taken from ICO database However, within this, the export data shows a number of major trends that reflect the changes in production described above. The most significant is the change in share of Brazil in 2002. Provisional export data for the year suggests exports were unchanged in 2001, but Brazilian exports rose almost 4.6 million bags--and from 25.5 percent of global gross exports to 30.4 percent (see figure 40) Figure 40 Exports to all destinations, total volume and by type 45% 95,000 COLOMBIAN MILDS OTHER MILDS 40% NATURAL ARABICA 90,000 ROBUSTAS TOTAL 35% TYPE 85,000 BY 30% S 80,000 EXPORTS 25% EXPORT OF 75,000 20% SHARE 70,000 15% 10% 65,000 89/90 90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 Coffee Year New Paradigms in Global Supply and Demand 93 Source: ICO, customized subset of data sent to author, taken from ICO database; authors' calculations based on published and unpublished data provided from private traders; CECAFÉ, customized subset of data sent to author, taken from CECAFÉ database In the case of robusta exports, figure 41 shows that the proportion of exports in world supply represented by Asian producing countries has grown dramatically. Although the actual volume of South American robusta production is growing again, the fact that Brazil's internal usage of robustas has also grown has meant that until 2000 their market share of exports was falling. However, with the big increases in production in Brazil, this has reversed and can be expected to continue. It is also clear that regardless of who takes larger share between Brazil and Asia, it is the African robusta producers who are gradually losing their markets. Figure 41 Robusta exports: market share by region, 1989-2002 0.7 0.6 Asia 0.5 0.4 Africa 0.3 Latin America 0.2 0.1 0 1989 1990 1991 1992 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source: F.O. Licht, compilation of various published datasets; ICO, customized subset of data sent to author, taken from ICO database Almost all global coffee exports are of green coffee: ICO data shows that in the period 1996-2001, 94.5 percent of all coffee was exported as green coffee. Opportunities for value-added products outside of the soluble industry have been limited. In the same period, soluble exports accounted for 5.4 percent of volume (see table 18). The United States and Japan continue to protect their markets for processed coffee products while the EU has, in most cases, opened up to competition from producing countries. In some cases, outright tariffs have been reduced, but nontariff trade barriers, such as internal taxes, still exist. These substantially restrict the potential for value-added exports from producer countries. Despite such difficulties, four of the developing countries, Madagascar, Ethiopia, Uganda and the United Republic of Tanzania, have been able to export some processed coffee products averaging US$3.4 million per year 94 Coffee Markets from 1995-1999. Most of this is to neighboring countries since they lack access to the higher paying developed markets. Table 18 Soluble exports by origin (000 bags green bags equivalent.) Country 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Brazil 2,697 2,708 2,558 2,569 2,374 1,678 1,962 2,066 2,494 2,562 Colombia 487 524 486 585 627 645 527 599 598 609 Other Latin America 556 621 751 571 582 658 576 694 875 736 Asia 400 459 569 606 913 983 966 1,060 1,183 1,223 Africa 348 282 225 307 394 410 460 409 404 468 Total 4,488 4,594 4,589 4,637 4,889 4,374 4,492 4,828 5,554 5,599 Source: ICO, customized subset of data sent to author, taken from ICO database; F.O. Licht, compilation of various published datasets The ability of producing countries to capture the value added by roasting and grinding has been limited by a number of factors that include the fact that most coffees are sold as blends and are, therefore, roasted together, as well as shelf-life limitations of finished product. However, especially estate and single origin coffees, are starting to roast at origin, and some more innovative projects are aimed at giving producers a share in the benefits derived from processing and marketing--a recent example is the new soluble plant in Bulgaria that is partly owned by Vinacafe and which purchases Vietnamese robustas from state owned farms. 5. Outside The Commodity Box: The Differentiated Markets Much of the focus of the previous sections of this paper has been on coffee as viewed as a commodity and priced according to the New York or London exchanges. This is the dominant trade paradigm for most of the coffee industry; however, a growing group of producers and coffee firms are pursuing strategies that are independent of commodity pricing at the exchanges. Many of these alternatives include some differentiation of the coffee, usually by either quality or cultivation processes. These coffees take on many forms, such as estate coffees or certified organic, and include specialty coffees that typically share the commonality of being well-prepared (processed) with some distinctive attribute in their cup quality and no discernible defects. In a related development, an increasing number of companies in the industry, including some that are household names, are developing purchasing criteria that transparently link their buying to positive socioeconomic and environmental processes in developing countries. Such emerging trade paradigms may offer producers alternative ways to capture the long-term value of sustainability by linking usually superior prices to demonstrable advancements in both the quality of the coffee and to more sustainable cultivation and trade practices. The world's largest coffee traders and other industry leaders recognize an obligation to help their business partners: the producers. They also see that these new trading paradigms can present new marketing and goodwill opportunities for coffee at the consumer level. Commodities Systems and Other Options: Differentiation or Diversification For decades, most coffee-producing countries have passively accepted their role as raw materials suppliers. Although much of the discussion in coffee markets today revolves around the themes of New Paradigms in Global Supply and Demand 95 oversupply and increased production efficiency and their role in the declining producer price, equally important changes have occurred in the relative distribution of industry revenues. The slow recovery of producer prices currently makes coffee production a tenuous pursuit for many. Meanwhile, on the demand side of the market, roasters and retailers have shown a capacity to add considerable value to green beans by targeting increasingly segmented and fragmented consumer markets. Firms in consuming nations and multinationals have been relatively more successful in capturing downstream margins than most producers who, because of the long-run decline in prices, have seen their share of total value decline substantially: from approximately 30 percent of the total to about 5 percent in the past two decades. Given the apparent declining long-term commodity market price trends, many developing countries may not find their participation in these to be very rewarding in the long run (see figure 42). While raw commodity production may be an excellent opportunity for some developing country producers with superior factors of production, many will find themselves competing fiercely (primarily on price) in a race to the bottom. Even though some of the problems of global commodity trade were recognized and addressed in the international coffee agreements, these have not resulted in a lasting difference for producers. In order to get beyond the highly competitive and volatile commodity-based trade, many producing countries are looking toward differentiated and value-based products for at least a portion of their production. But differentiating a product or service or adding value in the country of origin is not an easy task. It can require understanding and managing a set of more complex issues including current market trends, appropriate (though not necessarily state-of-the-art) technology, multiple distribution channels, and the sometimes complex logistical, financial and risk management options of supply chains. The integration and participation of smallholders and the poorest farmers requires that more attention be paid to strengthening organizational and managerial capacities of institutions, such as trade associations and cooperatives. Competitiveness factors such as macroeconomic stability, productivity, cheap land and labor, logistics, and consistent reliability--though still vital--are not quite as important to competitiveness as they once were. Competitiveness in differentiated markets increasingly requires paying attention to a more diverse set of factors: Supply chain integration and distribution capabilities A greater role for new standards and technologies in everything from seedling quality and field productivity measures to postharvest processing equipment. Labor and management skills (harvest and postharvest). Technology added value (processing, packaging, and branding). Affordable credit. Knowledge systems (not just information). More agile policy and regulatory environments. 96 Coffee Markets Figure 42 One hundred years of commodity prices (Real price of a mixed basket excluding petroleum) 140 120 001 100 = 0 80 190 60 Index 40 20 0 1900 1920 1940 1960 1980 2000 Source: World Bank (various issues). Commodity Price Data, Washington, D.C. There are a number of projects, both public and private, working to promote increased value for producers. While many such projects come and go--a product often of uncoordinated donor support-- some, such as the GEF-financed Rainforest Alliance/Salvanatura project in El Salvador, continue to provide valuable support for the producers involved. A few, such as the Internet auctions pioneered during the Gourmet Coffee Project (ICO et al. 2000; Chrispeels 2002), continue (as The Cup of Excellence program) to expand their efforts to educate as well as identify and reward quality producers through credible market-oriented mechanisms rather than ongoing government support. The majority of producers must find their own value-adding or differentiation strategies. Helping them to both assess their capabilities as well as the nature of particular markets, and also gain access to higher value markets is still a challenge for most development projects. Some countries have effectively turned to diversification in rural areas, especially to high-value products, but are often joined by many other producers as production and trade opportunities further globalize and become more widely available. For most farmers, it is not easy to learn new production methods and find new markets. Seeking competitive advantage, a number of them have begun to consider ways to add value to their production and move toward some measure of independence from commodity markets, but this is not an easy path. Potentially viable alternatives, such as processed or roasted coffees, face tariff barriers in many industrial countries that protect their established industries. While a handful of producing countries export processed coffees, the volume is modest, and the vast majority of these exports are of soluble coffee. Highly competitive soluble markets, along with their considerable capital and operating costs, severely restrain new entrants. Roasted coffees and extracts are mostly produced in the consuming markets and account for a very small fraction of producer countries' exports. The primary difficulty in expanding producer country value-added exports is their access to New Paradigms in Global Supply and Demand 97 markets. Increasing concentration at every level of distribution makes it difficult to enter without a partner in the consuming country that can not only help provide access but also the vital and fast-changing market information necessary to remain competitive. Without costly branding and promotion strategies, most vendors would be limited to channels such as private-label and institutional sales. Other difficulties are more readily surmountable. Capital and technology requirements for coffee roasting and packaging are readily accessible, though, for many countries, inputs such as valve lock bags and packaging films must be imported, thereby elevating costs. One challenge that can increasingly be overcome, thanks to fast improving and lower-cost logistics, is the need to satisfy the just-in-time requirements of most distributors or retailers that often require costly warehousing of stocks. It should be noted that these strategies offer little evidence of significant direct benefits for most farmers since, to be competitive, local roasters would usually pay growers the going market rate. A significant hurdle for many countries is the requirement to achieve consistency of both quality and flavor profile throughout the year. In the case of coffee blends, this could require the importation of coffees from other origins, a policy that not all producer countries permit. In some cases select origins, for example, 100 percent Colombian coffee (already selling nearly three million bags), Kenya AA, or Jamaica Blue Mountain could bypass some of these barriers and provide a retailer with their own proprietary or cobranded finished product. The commodity markets (undifferentiated bulk products) typically reward the lowest cost production of increasingly fungible and standardized products. Focusing on operational efficiency and productivity are valuable but are limited approaches to competitive advantage because most producers are pursuing the same goals. Even though operational investments may yield higher productivity, higher quality, and reduced time to market, these improvements do not necessarily translate into perceived advantages that the consumer or buyer would be willing to pay for. A value proposition based on the ability to produce more efficiently is therefore not enough for higher cost producers because lower-cost competitors--as Brazil and Vietnam have recently demonstrated--can imitate or overcome that advantage rather quickly. Efficiency and productivity are certainly important as competitive factors but are not necessarily the only sustainable source of competitive advantage. Instead, developing a competitive position based on processes that are more difficult to match presents another and perhaps more viable long-term solution and a new paradigm. This form of differentiation can present a feasible competitive platform, especially for those countries lacking the necessary factors to be competitive as bulk raw material producers. Such process-oriented strategies, including those for high quality, are not necessarily dominated by large players and lend themselves well to many of the poorer producing countries. Processes, such as organic and eco-friendly certification, present a rare opportunity for rural smallholders to materially participate in global markets while safeguarding their natural resources. Consumer markets for such differentiated coffees are still relatively small but have been growing much more quickly than conventional markets. For example, the SCAA predicts that in just 2-3 years there will likely be a shortage of the coffees they require. Supplying these differentiated markets is particularly important because they represent one of the few growing segments of the coffee industry. Unfortunately, the intrinsic nature of the coffee trade stifles this differentiated development in most of the world. Most small and medium coffee farmers typically bring their sacks of coffee to processors where it is combined with the production of others for bulk processing. These undifferentiated coffees trade as bulk commodities based on either the New York or London exchange prices that do not reward coffees exceeding basic exchange-based grades and standards. For the producer to capture the value from a superior product or a desirable process (for example, an eco-friendly 98 Coffee Markets process) he or she must seek and market their unique selling proposition to trading channels outside of the commodity process. As noted above in section two, there are negative consequences for growers' quality incentives in the common practice of combining different grades of coffees together. In particular, this greatly reduces the incentives for growers to improve quality, inadequately values their efforts, and stifles differentiation. Differentiation and quality improvement efforts must start with a clear understanding of farmer incentives, such as price premiums, extension services, and prompt payment, and then help to structure the supply chains to deliver these benefits to the farmers. Only by addressing the current structures of trade can a new and more equitable trading paradigm emerge. There is evidence that it is already happening as even the larger global traders are increasingly adapting their procedures in order to receive and reward differentiated coffees that can then also be separately traced from the farmer to the roaster. The channels for differentiated coffee often involve a shorter supply chain in which information, financing, technology, and sometimes even risk are more readily transmitted between the participants. The tendency in such closely coordinated supply chains is to develop consistent working relationships that promote continuity and competitiveness as a result of ongoing improvements. These improvements can help producers understand and more readily meet the buyer's demands and participate more closely in the market. By reducing some of the inherent asymmetries that put producers at a disadvantage these channels may improve the sustainability of coffee production. Nevertheless, these alternative trading channels are still relatively new and quite small in comparison to the total commodity flows of coffee. In order to participate, producers require not only a differentiated product but also the ability to both access the buyers for these products and effectively export to them. For many, traders and middlemen still play a vital role. For the process-oriented differentiation of coffees, such as organics, there are ample reasons, beyond their marketability, to justify their adoption, and these are addressed later in this document. In recent years, the mounting downstream concentration of power in the hands of only a few traders, roasters, and retailers likely contributed to a decline in traditional long-term personal relationships and an increase in the commoditization of coffee. In contrast, the differentiated chains must develop closer relationships and include viable incentive structures that support differentiated qualities, certifications, and audit trails. The emergence of strong differentiated channels has begun to shift the locus of power, and some of the coffee industry is beginning to take note. It appears that the most progressive firms are staking claims with better producers in many countries and strengthening those relationships. A number of the most prominent companies in the industry are already adopting Sustainable Sourcing Guidelines that help stimulate demand for sustainably produced coffees by favoring those producers that take active steps toward sustainable practices. A number of major trade and industry buyers increasingly facilitate longer- term trade relationships by increasing the volume of their coffee purchased by long-term contracts with producers. There is also an increasing trend toward contracts that are at least somewhat independent of the commodities market prices and reflect an agreed-upon value for the growers' coffee. These relationship coffees are a positive development that benefits both the grower and the buyer with increased stability and therefore contributes to sustainability. Some forward-thinking producer countries such as Colombia are even attempting to facilitate these arrangements between their producers and coffee buyers. New Paradigms in Global Supply and Demand 99 Definition of Differentiated Coffees Differentiated coffees are those that can be clearly distinguished because of distinct origin, defined processes, or exceptional characteristics such as superior taste or zero defects. In contrast, mainstream coffees are nearly always pre-ground blends that are often unidentified in terms of origin. These are usually, though not always, distributed through mainstream channels such as supermarkets, foodservice, and institutional and they compete strongly on the basis of price. Differentiated coffees are often distinguished by a closer and sometimes direct relationship with a roaster or buyer rather than being traded in bulk or via the commodity markets. Differentiated coffees can help the coffee industry compete with other beverages by leveraging unique characteristics that include: Geographic Indications of Origin (appellations) Gourmet and Specialty Organic Fair trade Eco-friendly or shade grown Private or Corporate standards Flavored and decaffeinated coffees can also be somewhat differentiated. Since they represent value added by roasters and food processors in importing countries, they are very much a downstream phenomenon and much less relevant for the coffee grower.34 There is considerable confusion in the industry about what these "differentiated" coffees actually are. This is in part due to the inconsistent use of various terms such as "specialty" resulting from the failure of a globally diverse coffee trade to define its terms resulting in the imprecise use of terms such as "mountain grown," "shade," and "gourmet" in marketing campaigns. For example, at a recent conference of the coffee industry, there was no consensus among regional and international experts on what is "specialty coffee." Even organic coffee and eco-friendly coffee suffer the same confusion even though these both have clear definitions. Clearly, if the industry itself is unclear, one can only assume that consumers are equally at a loss. Consumer confusion is known to depress rather than stimulate markets; therefore, clarity and consistency could potentially contribute to growth. The following paragraphs offer basic definitions for these coffees. Geographic Indications of Origin Coffees from areas that are specifically demarcated and acknowledged as having distinct physical characteristics such as microclimate, soil composition, and particular varietals have successfully been marketed utilizing their specific Geographic Indications of Origin (GIO). Development of GIOs creates the mechanisms for a new agronomic model, similar to the wine industry. Much like the wine industry, this permits a unique competitive advantage and, if properly marketed, can result in stronger demand and higher prices that may be somewhat more immune to market fluctuations than commodity products. This 34This could eventually change if growers and consumers are willing to accept coffee plants that are genetically modified to produce lower caffeine content or to express flavors such as vanilla hazelnut and if these ever make it to large-scale field trials. 100 Coffee Markets category can also loosely encompass estate coffees. Despite recent setbacks in seeking legal protection for GIO in the United States, this differentiation strategy has been successful for many regions, including Jamaican Blue Mountain, Hawaiian Kona, and Guatemala Antigua whose popularity have spurred global sales far greater than their actual production volumes. The EU, in 2003, proposed international WTO protection for 41 of its GIO products and appears amenable to the recognition of other countries' products protected by GIO. This implies that such initiatives on the part of producing countries will also require investment in monitoring and enforcement. Specialty and Gourmet Coffee The term "specialty" is used in different ways by different people, making it very difficult to either characterize or measur adequately. The use of the term "specialty"--some would say overuse--can be traced to the United States where it was originally used by smaller roasters and retailers to differentiate their offerings from the mainstream offerings of the largest commercial roasters who were often called "the cans" in reference to their preferred packaging style. Specialty coffee has sometimes come to be used interchangeably with "gourmet" coffee although the former still commonly refers to a larger set of coffees. This larger set of coffees, in addition to high-quality, single origin or sustainable coffees, can also include coffees that may or may not be special such as flavored, espresso-based, decaffeinated, and cold, ready-to-drink preparations. The latter coffees can perhaps best be characterized as differentiated and as having most of their value added in the consuming country. Today, the specialty industry itself is searching for a clearer definition of this term to avoid the obvious confusion it engenders. Perhaps the best and most succinct definition goes back to the quality-oriented roots of the specialty movement and defines specialty, in the words of SCAA's executive director as "Great taste, no defects." This category can include estate coffees. These coffees, for which provenance is from well-known farms that specialize in producing coffees with exceptional quality characteristics, often enjoy long-term contracts and premium prices. Gourmet is used to refer strictly to higher-quality and exceptional coffees. Before the term "specialty" lost most of its meaning because of overuse, such coffees were typically sold, often as whole beans in dedicated coffee stores or cafés. Although this term still suggests a degree of exclusivity, such coffees have actually penetrated most marketing channels and are available now even through mass merchants and supermarkets. Market receptivity and strong growth trends suggest that there is room for such expansion given that increasing market fragmentation allows price differentiation even at the mainstream levels. The market expansion for differentiated and specialty coffees, as exemplified in the boom of cafés openings led by some highly visible brands, has been significant in the U.S. markets and is now spreading back to Europe where the café concept originated. In the United States, where coffee imports account for one-fourth of global totals, the specialty coffee industry accounts for nearly 20 percent of the total volume; yet its US$8.4 billion in 2002 sales represent more than 40 percent of the U.S. coffee market's total revenue and an even greater percentage of its profits. It is currently the only segment of the coffee industry that has shown consistent and notable growth.35 According to the ICO and the SCAA, most potential specialty coffee markets are far from saturated, and sales in many global markets continue to expand. 35National Coffee Association (NCA) estimates average annual growth of about 30 percent in last five years to 2002. New Paradigms in Global Supply and Demand 101 Sustainable Coffees The coffees that are often called "sustainable" (that is, organic, fair trade, and shade grown) are predominantly produced by small farmers and characterized as paying farmers reasonable prices, providing incentives toward organic production and rewarding farmers for practicing good natural resource stewardship.36 They tend to promote water conservation and protection, energy conservation, nutrient recycling, and even community/cooperative development. Until recently, their scarce presence in the marketplace caused some confusion about what they each actually represent. Now with both clear definitions and international certification standards, it is incumbent upon the coffee industry and regulatory bodies to help educate consumers and ensure that coffees using these labels are indeed certified by an independent third party. Failure to do so will cost the industry a valuable means of differentiation, and the resulting erosion of consumer confidence will render the terms meaningless and will remove a valuable tool from the repertoire of the small coffee producer who can least afford such a loss. A more complete discussion of sustainability, and other types of coffees that can contribute to it, can be found in the section on sustainability later in this section. Organic coffees incorporate management practices to conserve or enhance soil structure, resilience, and fertility by using cultivation practices and only nonsynthetic nutrients and plant protection methods. Although many producers grow coffee without the use of synthetic agrochemicals, this passive approach is not sufficient to be considered organic for market certification purposes. Organic requires active cultivation practices that are monitored and verified by means of a certification process. Organic certification is also required of the processor and roaster in order to be sold as such. This helps to reduce the risk of organic products being contaminated or mixed with nonorganic coffees. Certification is conducted by a growing number of enterprises throughout the world, many of them private businesses. The most useful in terms of broad acceptance in cross-country trade are those accredited by an umbrella organization known as the International Federation of Organic Agriculture Movements (IFOAM). In exchange for the certification of their sustainable cultivation practices, many farmers receive price premiums. Fair trade coffee is purchased directly from internationally registered and certified cooperatives of small farmers37 who are guaranteed a minimum and consistent contract price, as well as access to some credit from the purchaser if necessary to complete production and harvesting. Fair trade's mechanisms encourage community-driven investment in public goods such as education, healthcare, and infrastructure. It is the only major certification system that requires the buyer rather than the small producer to cover all of the costs, most of which are embedded in the base price. The fair trade market sets a minimum floor price currently US$1.26 for washed mild arabica and US$1.41 if organic certified. This price is a bit less in some countries (see table 19). When market prices rise above this, the fair trade premium is only US$0.05 more than the market price per pound. The price benefit is particularly noticeable during low price markets. Arabica farmers averaged premiums over market prices of US$0.64 per kilogram in 1999 and US$0.95 per kilogram in 2000.38 Though these premiums are 36Partly adapted from Conservation Principles for Coffee Production, available at www.consumerscouncil.org 37Changes are now being considered to accommodate farmers that are not members of cooperatives 38Difference between average annual "C" market prices and FT contract prices. Robusta figures are lower, according to FLO. 102 Coffee Markets considerable, it should be noted that only about 20 percent of the global fair trade production capacity is sold at fair trade prices. Table 19 FLO international conditions for sustainable coffees (U.S. cents per pound) Regular Certified Organic Central America, South America, Central America, South America, Type of coffee Mexico, Africa, Asia Caribbean Area Mexico, Africa, Asia Caribbean Area Washed Arabica 126 124 141 139 Nonwashed Arabica 120 120 135 135 Washed Robusta 110 110 125 125 Nonwashed Robusta 106 106 121 121 Source: FLO, International Conditions for the Purchase of Coffee, partly available at www.consumerscouncil.org A number of institutions exist in most of the developed consumer markets that monitor and coordinate fair trade. Many of these now coordinate through a single European office of the Fair Trade Labeling Organization International (FLO). Among its roles is the registration and monitoring of participants in the fair trade system. For many years fair trade coffees have not met consumers' affinity for environmental issues, though this is beginning to change as almost half of fair trade sales are now also organically certified, and FLO is considering the inclusion of more explicit environmental components into their criteria. Shade or Eco-friendly coffee production systems maintain and enhance wildlife habitat and biological diversity particularly through effective management of the forest canopy on the farm and protection or restoration of surrounding natural environments. The term "shade" is often used as shorthand because this differentiates between the above method and most conventionally produced coffees that are monocropped under full or partial sun exposure and require considerable, often synthetic, agrochemical inputs. Of course, until the 1970s, most coffee producers naturally used rustic or traditional shade production systems. The recent emergence of this category in the 1990s responded in part to the inadequacy of organic certification for biodiversity conservation. Although the spirit of the organic movement embodies harmony with the natural environment and implies the fostering of biodiversity, it does so primarily from the point of view of agriculture that has some biodiversity rather than biodiversity that incorporates agriculture. The difference is evident in the field where some organically certified coffee farms bear a closer physical resemblance to conventional monocrop production than to the integrated forest canopy of most shade-certified farms. Some organic certifiers are now taking up shade certification. There are two internationally recognized certifications in this category: 1. 1. Smithsonian Migratory Bird Center (SMBC) certifies that there are adequate multi-storey shaded forest settings that maintain and support ecosystem biodiversity. Within this, birds are an indicator species of a healthy environment. This type of coffee is also sometimes called "bird- friendly." 2. 2. Rainforest Alliance certification incorporates most of the SMBC criteria apart from organic requirements and adds social responsibility criteria particularly in terms of labor practices and New Paradigms in Global Supply and Demand 103 worker facilities. More specifically this includes requirements for: decent housing, sanitary facilities, potable water, electricity when possible, safe cooking facilities, fair pay (at least the legal minimum, except in emergency situations such as a "food for work" program), access to medical care, and the availability of schooling. This certification encourages organic production methods but only requires the implementation and steady improvement of integrated pest management (IPM) methods. This facilitates the participation of producers, particularly larger scale plantations that are in transition toward organic methods. Coffee farms vary in how much shade they can support without seriously diminishing production. Scientists note that not all shade is equal, and there is spirited debate over how much shade is sufficient to warrant certification. Yet, none of these certifications recognize those cropping systems that incorporate only single species or "specialized" functional shade since these are not considered sufficient to foster biodiversity. The Rainforest Alliance has nevertheless explored a variety of certification options. For example, their scientists elected to certify a 3 thousand acre Brazilian farm in an area of shrub forest where a canopy high enough to shade coffee would be unnatural. Although biodiversity parameters must be flexible enough to adapt to different natural requirements, there is a danger in the increasing number of producers claiming their coffee is "shade grown." This is incorrectly propagated by some of the national coffee promotion councils. Unfortunately, the abuse of this term will eventually lead to loss of trust among not only industry buyers but also consumers. A valuable point of differentiation will have been lost for many producers if the industry does not better disseminate the correct definitions of these terms/criteria and help to foster and enforce their correct usage. Ultimately the only assurance of compliance with these or any criteria is independent third-party certification. Private or Corporate Standards Some corporations and corporate-driven groups are developing their own differentiation around the issues of sustainability. They have developed their own criteria to improve sustainability and to help manage their risk of participation in socially or environmentally difficult situations in countries of origin. The best of these agricultural production standards promote--and pay for--fair labor practices, the minimization of agrochemical inputs, environmental biodiversity management, and traceability. These initiatives are an important trend that ought to be considered seriously because they can quickly introduce some sustainability standards to the mainstream industry that provides most of the world's coffee supply. Since they have the potential to have widespread influence when marketed by large firms, they can serve to educate consumers about sustainability standards and about what the higher price premiums are used for. However, these corporate standards face some critical challenges. For these standards to be credible, they must be independently verified. Lacking such independent third-party certification presents a greater opportunity for misrepresentation or fraud. Some are criticized for setting the criteria so low that they present only a modest improvement for the producer. Indeed most of these corporate-driven standards fall short of the requirements embodied in more established certifications such as organic, fair trade, SMBC, or Rainforest Alliance. By competing with existing standards, in-house corporate certifications can actually be harmful to consumers and growers by confusing them and thereby reducing the market effectiveness of the currently accepted certification systems. These questions pose an ethical and possibly reputational dilemma for the companies involved with private standards and opens them to accusations of free riding on the established market credibility of systems, such as fair trade or organic, and ultimately eroding the ability of these to continue providing benefits for producers. 104 Coffee Markets Some corporations adopting such standards have not yet chosen to make the standards public. Some fear that this could induce consumers to believe that other--noncertified--coffees are unsustainably produced. This is likely to change in the near future as these issues become more public or as some companies act to capture a first mover advantage. These changes are already happening. The Utz Kapeh foundation, originally set up by one of Europe's largest food retailers, has reportedly certified more than 250,000 bags of coffee (15 million kilos) to its "decency standard" in 2003. Major brands are also investing in market tests. It is estimated that the world's third-largest food retailer will claim that all of the coffee they roast for their European stores meets the EUREP-GAP coffee standard in 2004. Companies deciding to pursue private standards face a decisive challenge when investing in this individual pathway: If they adopt a standard that is eventually less accepted or even discredited, they will incur the fiscal and competitive costs of catching up to the rest of the market's dominant standards. An emerging difficulty for producers is the Box 5 Selecting appropriate standards: some sample possibility that buyers demand that elevated questions standards be met as a precondition for doing Are the full benefits and costs of a particular standard business without offering adequate compensation clear to the grower? for achieving such requirements. Some of the Have buyers been identified who require the certifications do not guarantee any compensating standard? What is the market value? premium for meeting their requirements or pay Is technical assistance available to help farmers comply with the standards? prices well below those of the most commonly Are there incentives to meet the standards? known certified coffees. In such cases, these Are the standards comprehensive enough to meet the standards impose a complex and costly burden on desired goals? Do they cover an adequate range of producers without any transparent assurance of a farm-management, conservation, social, certain level of remuneration. The market power environmental and community issues? of the usually larger buyer combined with a How are the standards actually implemented in the producer's often inadequate market information field? Do the farmers see the standards as guidelines to better manage their own farms or as impositions leaves the grower to negotiate this with the buyer from a firm or NGO? from a vulnerable position. This almost certainly Is the certification process consistent, transparent, will diminish the producer's economic and well-documented? sustainability--the very issue that such standards Does the certification program promote continual purportedly support. improvement? How are the audits conducted? How often are audits Judging the different standards' respective values conducted and are there surprise inspections? at the field level can be difficult since they each Who does the auditing, and what are the have some distinct objectives. There is an requirements to be an auditor? Are the auditors increasing demand for effective impact experts who know the culture, agronomy, ecology, evaluation of these sustainability standards and laws, and language? Who does quality control of the auditing? the Sustainable Agriculture Initiative (SAI) is one How useful are the audit reports? Can farmers get of several that is beginning to explore the actual enough guidance from the reports to make a practical impacts on the supply chain of different farm-management plan? sustainable practices. Box 5 lists important Source: Author; Chris Wille, personal communication questions that farmers, policymakers, and businesses alike should ask when considering the different standards options. New Paradigms in Global Supply and Demand 105 The Nature of Differentiated Markets There is great interest in the economic, social, and environmental benefits of differentiated and specialty coffees. The differentiated markets could be one valuable tool with which producers can earn higher revenues and superior market reputation. These markets have been growing strongly for a number of years and, though they are not a simple panacea for all producers, they provide useful alternatives for some. Box 6 Some useful shorthand definitions Differentiated coffees are quite simply those that can be clearly distinguished because of distinct origin, defined processes, or exceptional characteristics like superior taste or zero defects. In contrast, mainstream coffees are nearly always preground blends that are often unidentified in terms of origin. They are often, though not always, bought and sold on the basis of price and distributed through institutional or mainstream channels, such as supermarkets. Differentiated coffees are often distinguished by a more direct relationship with a roaster or buyer rather than being traded in bulk or via the commodity markets Specialty coffee has two characteristics: "Great taste, no defects." (Lingle SCAA 2002) Gourmet is used to refer strictly to higher quality and exceptional coffees. Such coffees are most often sold as whole beans. Geographic Indications of Origin (GIO) apply to coffees from areas that are specifically demarcated and acknowledged as having distinct physical characteristics, such as microclimate, specific varietals, or soil composition that together may impart distinctive flavor characteristics. This category can also loosely encompass estate coffees. The coffees that are often called sustainable (organic, fair trade and eco-friendly or shade-grown) are predominantly produced by small farmers and typically characterized as earning farmers reasonable prices, encouraging community development and providing incentives toward organic production and natural resource stewardship. Such practices are monitored and verified by means of a certification process. Organic coffees incorporate management practices to conserve or enhance soil structure, resilience, and fertility by applying cultivation practices that use only nonsynthetic nutrients and plant protection methods. Although many producers grow coffee without the use of synthetic agrochemicals, this passive approach is not sufficient to be considered organic for market purposes. Fair trade coffee is purchased directly from cooperatives of small farmers that are guaranteed a minimum and consistent contract price, as well as access to some credit from the purchaser if necessary to complete production and harvesting. Part of the proceeds are earmarked for democratically selected community projects. Most are internationally registered and certified. Shade or Eco-friendly coffee production systems maintain and enhance wildlife habitat and biological diversity particularly through effective management of the forest canopy on the farm and protection or restoration of surrounding natural environments. One such system also requires decent working conditions and fair pay. Source: Authors Although they are relative newcomers, the market presence of differentiated coffees has grown dramatically in recent years. This growth has been fueled as much by the industry's interest and support as by consumer demand. These coffees are known to fetch higher prices but are even more important for 106 Coffee Markets the industry because of their high growth rates and their contribution to producer sustainability, as well as their ability to command a price premium. At the far end, of scale this price premium can be considerable--as is the case for Indonesia's Kopi Luwak, which can sell for up to US$75 for one-fourth of a pound.39 Though this is an extraordinary example, it makes the point that many forms of differentiation are possible. Differentiated coffees can access market niches that are competitively different, and often involve direct relationship with buyers. The markets for these products should be approached with caution because they are still limited and can involve considerable farmer effort to adapt to their more stringent requirements. Because differentiation has typically been the realm of smaller producers, it should be noted that even with differentiated products, they can still face difficulties to access markets, including the markets for such products. One promising solution has been civil or public sector support for the structuring of marketing partnerships directly with private sector firms in consumer markets. While these public private partnerships can be very useful, providing producers improved technology, market access, financing, etc., they can also be problematic. If they are poorly structured, they can concentrate benefits for corporate coffee buyers, using public money, but giving farmers only the potentially short-lived benefit of one or two years of sales. The comparative characteristics of differentiated and conventional coffee markets are summarized in table 20. Table 20 Comparison of conventional and differentiated markets Conventional markets Differentiated markets Commodity price pressures Consistently higher prices Reward for quality and Price Reward for quality and process Easy market access Limited market access Intense competition Moderate competition Gov. support: subsidy, extension, R&D Limited government support Broad market size Very limited market size Short learning and cost curve Longer learning and cost curve: certification Source: Authors Although differentiated coffees are still relatively small in terms of volume, they benefit the entire industry in terms of increased sales and greater profits all along the supply chain occupy. Despite their smaller market niche, they offer attractive benefits for several million people, mostly small to medium, farm households. Among these benefits are certain positive externalities that are fostered by several types of differentiated coffees. These benefits can include: Increased use of rural labor and organizational development. Crop diversification and reduced input costs that together minimize financial risk. Better natural resource management. Biodiversity conservation. 39The Luwak, a small mammal that consumes coffee cherries, adds exceptional postharvest processing value, such as flavor through fermentation, via its digestive tract. New Paradigms in Global Supply and Demand 107 Improved crop resilience to adverse weather. Fewer health risks due to potential mishandling of agrochemicals. Traceability. Certain standards in particular offer further benefits such as traceability and process management that can help prepare smaller producers to better compete in modern agricultural trade for these and for other farm products. Sustainability One of the most useful simple definitions of sustainability in the coffee world states that a sustainable producer shall meet long term environmental and social goals while being able to compete effectively with other market participants and achieve prices that cover his production costs and allow him to earn an acceptable business margin.40 The coffee commodity market, like most other agricultural commodity markets, is a purely economic proposition that does not internalize either the environmental or the social costs of production into its pricing. The coffee industry is, however, among the most enlightened in the sense that it recognizes the importance of sustainability in two distinct but interrelated ways. First, economically it makes good long- term business sense. Evidence from successful industrial supply chains highlight the critical importance of every link in the chain to achieving high levels of competitiveness. In this regard, many leaders in the coffee industry understand that they must improve their relationships with the growers who supply their basic raw materials. Second, it fulfills important social needs. Many leaders in the coffee community visit the origins and are personally aware of the difficulties faced by many coffee growers. Many coffee buyers and traders have developed a humane understanding that while their companies are reaping healthy profits. their suppliers are in some cases cutting back on food and are forced to keep children out of school. Leading members of the coffee industry have recently proposed a number of initiatives intended to define sustainable coffee standards. Some are moving beyond the talk to actually putting these standards into operation. The Sustainable Commodity Initiative (SCI)41, under the banner of UNCTAD/IISD, has animated a broad and inclusive dialogue on different market-based approaches for improving sustainability in the coffee sector. Pursuant to demands from stakeholders all along the coffee supply chain, the SCI is currently facilitating the development of a multi-stakeholder platform in the form of a "Sustainable Coffee Partnership". This effort aims to create a transparent, equitable, and inclusive platform for the development of a shared sustainability strategy for the coffee sector based on the experiences and successes of existing industry standards and related sustainability initiatives. In the past, three systems have been pioneering what are arguably the best attempts at fostering more sustainable production in the field. Organic, eco-friendly, and fair trade systems already meet a number of the vital environmental, social, and economic needs of about three-fourths of a million coffee producers. Of course, these three systems of coffee production and marketing neither offer a guaranteed sustainability, nor are they the exclusive path to sustainability in coffee production. Other production 40Adapted from personal communication with Michael Opitz, executive director, E.D.E. Consulting, April 25, 2003. 41Sustainable Coffee Discussion Group: http://www.iisd.org/trade/commodities/sci_coffee_discussion.asp 108 Coffee Markets systems and other coffees may also contribute to sustainable development. Indeed, a number of efforts are underway to develop standards that might be more acceptable to the mainstream coffee industry. It is certainly important to take steps in this direction and to recognize the sincere efforts made by the larger companies to improve production sustainability. It is quite feasible that being the first industry to collectively achieve a high measure of sustainability could have a significant market impact at the consumer level. It can conceivably generate the sort of goodwill for coffee that the industry already seeks through other methods, such as promoting the scientific studies that link coffee with positive health effects. Nevertheless, sustainability is difficult to measure and even more difficult to achieve. Some of the so-called sustainable initiatives set the bar so low as to have very little impact on a producer's sustainability and have been accused of being little more than risk management measures or public relations gambits on the part of the corporations that support them. While far from perfect, organic, eco-friendly, and fair trade systems possess intrinsic qualities that most closely fulfill the balanced social, environmental, and economic requirements necessary for sustainability. They are also among the few that have transparently defined international standards and permit reasonable independent verification of their claims. For these reasons the use of the term "sustainable coffee" is a useful shorthand description used in this and other documents. It is not intended to imply that other noncertified coffees are necessarily unsustainable. Certification Certification occurs primarily around the sustainable coffees: organic, fair trade, and eco-friendly, as well as Utz Kapeh. There is also a growing interest in facilitating the certification of coffees based on their GIO using geospatial information systems. In addition to its traditional role of verifying relevant claims of origin or production methods, certification is now also emerging as a mainstream tool for many forward thinking firms. Private companies increasingly use certification systems to ensure that food safety, labor, or environmental criteria are being met by their suppliers in order to reduce their exposure to legal or reputational risk. Certification systems can also help to provide traceability, improve quality, and can alert them to potential problems in the field. The discussions within the SAI, EUREP, the GTZ-led Common Codes for the Coffee Community project, and the Utz Kapeh Foundation appear to be moving in the direction of independent certification by agencies or through multistakeholder arrangements. Many large companies, although they know that such certifications will be difficult at first, increasingly understand that they may be necessary in the long term. Nestlé's Hans Joehr has proposed a landmark idea about companies working together on precompetitive issues to achieve sustainability at the farm level.42 This implies collaborations that contribute to the overall "public good" or sustainability of the growers and communities and do not alter the relative competitive position of buyers in the playing field. While it is true that many of the industry's large corporations--a handful of which dominate coffee markets--have done little more than sponsor modest projects or adopt soft general guidelines, a number of innovators are already implementing concrete purchasing guidelines that are transparent for verification and are paying farmers to achieve them. Although each of the sustainable coffees has very specific criteria, as defined by their respective certifying agencies, the definitions and distinctions are often unclear to many coffee companies, retailers, 42Hans Joehr, corporate head of Agriculture in Geneva, Switzerland, personal communication, December 9, 2003. New Paradigms in Global Supply and Demand 109 and consumers. This is further complicated by the increasing number of certifications and by some variations in criteria among the certifying agencies as well as distinct bureaucratic procedures in certain countries. Growers face similar confusion at origin. The confusion also allows free riders to take advantage of naiveté and to market coffees that are not what they appear to be. For example, a number of companies sell shade-grown coffee without any verification of this growing standard or in cases where the shade comes only from a single species of tree and therefore does not meet the internationally acknowledged criteria for shade-grown coffee.43 Third-party certification and verification in all of these markets can prevent indiscriminate use of these terms. The alternative may be a loss of consumer confidence when such discrepancies are discovered. Such a reputational issue could have an impact on the entire industry and not just the specifically certified products for the same reasons of consumer confusion mentioned above. Perhaps more importantly, it will also damage some of the few niches that are particularly beneficial for small coffee producers. It is possible that other sustainable agricultural practices for a number of crops will also suffer collateral damage in the marketplace much as meat and dairy products in many European countries suffered heavily during England's mad cow debacle. Organic certification is the most widely recognized and available certification, although in several European markets fair trade coffee is more popular than organic. Eco-friendly, shade-grown, and GIO verification are in their infancy but have strong interest particularly in North American and Japanese markets. It is evident that certification in general still has a long way to go in terms of broad market visibility and acceptance. Nevertheless, it is considered important for at least four reasons: 1. It allows for consistency of characteristics and claims and improves market transparency. 2. It provides marketplace credibility. 3. It captures demand and price incentives of niche markets. 4. It "glues" participants to multiple objectives such as commerce, conservation, and social justice by linking economic success to monitored certification principles. Geographic Indicators of Origin (GIO) identify a crop by its specific growing area that is often defined by satellite aided location or Global Positioning System (GPS) or more traditional demarcations that are sometimes termed "appellations." For GIO coffees the predominant criteria are national geophysical standards that, in some cases, are supported by international agencies helping to map and define the standards. The most effective method is using Geographic Information Systems (GIS) which supplements satellite imagery with on-the-ground verification. Since coffees, like wine, can often carry the distinct characteristics of their particular microclimate, many of the world's finest and most costly coffees have been identified with a particular place. Jamaican Blue Mountain, Hawaiian Kona, Tanzanian Kilimanjaro, and Monsooned Malabar are a few examples that are prized around the world and fetch considerable premiums for growers in those regions. Similar to the wine model, there is ample room in the marketplace for many other appellations especially as consumers become increasingly aware of their flavor variations. The SCAA and USAID are central to many of the GIO efforts with mapping results already achieved in Costa Rica, Peru, and Guatemala. Other countries, such as Colombia and Mexico, have also taken steps to 43The Smithsonian Migratory Bird Center (SMBC) has established criteria that are the benchmark standard used by certifiers. For more information, see www.si.edu/smbc. 110 Coffee Markets more clearly delineate and "certify" some of their growing regions. Efforts are underway to make this information readily available to buyers on the Web and to develop verification systems to prevent mislabeling and fraud, but these are not yet adequately funded. There have been discussions at the WTO level, stimulated by the EU proposals for the establishment of a multilateral system of notification and registration of GIO in order to protect producers and consumers alike.44 Although most of the industry trade associations support this, it will probably be most beneficial if the industry itself actively helps to form and support these GIOs because governmental legislation and bureaucracy tend to be slow and cumbersome. More than two-thirds of the North American specialty coffee industry believes that certification of sustainable coffees will be important to their business in the future (Giovannucci 2001). Similarly, about two-thirds were in favor of a simpler way of communicating sustainability in the marketplace, in effect a "super seal" incorporating criteria from organic, shade-grown, and fair trade coffees. This may be in part because--apart from a core group of "committed ideological supporters"--it is not clear whether more mainstream consumers differentiate much between the claims of different seals (Giovannucci 2003). Retailers and the coffee industry are indicating preferences for more cohesion between these sustainability standards. European buyers also feel that certification is important and that there is some confusion about the different certifications. Businesses are noting a consumer preference for simpler choices that do not require trading off one advantage for another. With shelf space at a premium and market share for these coffees still small, some leading European supermarkets now insist on dual certification especially for their private labels (Giovannucci and Koekoek 2003). In the case of fair trade, in 1996 only one percent was also certified organic, whereas, by the end of 2002, nearly half of fair trade coffees were also certified organic. Each of the NGOs, firms, and nonprofits that manage or support the certifications systems for sustainable coffees are committed to their own particular system and to its value. Harmonization between the major systems would undoubtedly reduce both confusion and costs for coffee producers and perhaps even for consumers as well. There has been some progress in discussions toward certification criteria that harmonizes the best aspects of these independent certifications while not significantly compromising their integrity. One of the challenges in pursuing harmonization is to not lose the benefits of certification as a developmental tool that can help to address some of the social and environmental needs that are particular to smallholders and to the poorest farmers; therefore, any harmonization efforts must be cautious in understanding the potential impacts on them. In the near- to midterm, it appears more likely that individual developments within the fair trade and organic movements will lead each of these to include broader sustainability criteria. Fair trade is developing labor standards for large estates and a more complete set of environmental criteria while the organic accreditation system is now discussing how to better incorporate social standards and biodiversity criteria. The Rainforest Alliance is fast emerging as a major certifier since its standards incorporate social criteria that include plantation or corporate laborers, as well as extensive environmental criteria. They do not set a baseline price, work with some small but mostly larger farmers, and do not require organic certification. On one hand, this could undermine some of the efforts of the organic and fair trade 44According to the European Coffee Federation, the EU has made proposals for the implementation of article 23.4 of the TRIPS agreement relating to this topic. New Paradigms in Global Supply and Demand 111 movements, and, on the other hand, this facilitates the participation of large farms and corporations that might have difficulty meeting organic or fair trade standards. The International Federation of Organic Agriculture Movements (IFOAM), in its recent annual conference, noted a strong push toward social and environmental criteria and has committed to furthering these aspects, as has the international federation of accreditation bodies (ISEAL). IFOAM, in particular, has begun to discuss whether biodiversity shade criteria should be a part of organic criteria since they both share very similar principles. There has been some progress toward a more formal harmonization of the major coffee sustainability criteria under the stewardship of the Consumers Choice Council who coordinated the participation of several major NGOs and a number of experts to create "The Conservation Principles for Coffee Production."45 The German development agency, GTZ, is also developing a set of baseline sustainability guidelines in cooperation with other organizations and members of the German coffee industry. It does not intend to establish new certification standards but simply to set up a baseline benchmark that eliminates the worst ecological and social practices in the industry. The Mexican Sustainable Coffee Council has developed a set of sustainability criteria and is the first producer country body to do so. Ultimately, the only assurance of compliance with these or any criteria is independent third-party certification. Despite the extra cost of such verification, the inherent confidence and traceability are vital for these standards that are still relatively new to most consumers and whose credibility would be seriously damaged by scandal. The costs and even some of the confusion around their requirements can however be daunting for the average farmer. The Social Accountability in Sustainable Agriculture (SASA) project has been launched to capitalize on the commonalities between some of the cause-related or process standards. 46 This initiative explores the possibilities of coordinating their information, training, certification, and inspection in order to reduce the grower's transaction costs. Some organic certifiers, particularly in Mexico, have already been independently trained in eco-friendly and fair trade certification and, by combining certification and inspection visits, have considerably reduced producer costs. Market Awareness In North America, both the industry and consumers are very much aware of higher-value, differentiated coffees, and coffee drinkers, according to several surveys, are aware that there is something beyond the average supermarket can of coffee or the jar of instant coffee (Rice and McLean 1999). The U.S. National Coffee Association's annual surveys consistently indicate a high level of consumer awareness about specialty coffees. An independent 2001 coffee industry survey points out that 95.1 percent of firms were aware of at least one or more types of sustainable coffee:47 98.7 percent were aware of organic coffee. 82.5 percent were aware of fair trade coffee. 45Conservation Principles for Coffee Production are currently the closest thing to joint or umbrella criteria, although these are not certifiable. For more information, see www.consumerscouncil.org. 46Part of the International Social and Environmental Accreditation and Labeling Alliance (ISEAL) seeking to improve the field level efficiencies of standards such as SAI 8000, organic, fair trade, and Rainforest Alliance. 47Sustainable Coffee Survey of the North American Specialty Coffee Industry is available in three languages. For English, see www.scaa.org; For English, Spanish, and French, see www.cec.org/coffee. 112 Coffee Markets 76.4 percent were aware of shade coffee. In a number of Europe's major consuming countries, it is often said that the overall quality of mainstream coffee is superior to that of the U.S. and that there is a high level of differentiation by the roasters themselves. As a result, there has been less of a push toward coffees that producers differentiated by quality. This appears to be changing. Until recently, many countries had a plethora of small roasters who were able to individually brand, and thereby differentiate, their own offerings leaving less room for the differentiation of producers. As these markets consolidate and a few large roasters take over the business, this scenario is changing. The awareness of fair trade, and to some extent organic coffees, is often higher than that in the U.S. market, though this varies somewhat from country to country. Few are aware of eco- friendly coffees, but this is changing as first movers--including a multinational industry giant make a commitment to this certification. In some of the Asian markets, primarily Japan, awareness is increasing, though the level of market penetration is still relatively shallow. This is mostly concentrated among higher income urban dwellers. Availability In North America, differentiated coffees are widely available but primarily through the specialty market channels, though this is fast changing as large retail chains increasingly add upscale products. An overwhelming majority of the coffee firms surveyed in North America carry at least one type. Even some large convenience store chains such as those operated by the Southland Corporation (7-Eleven) and gasoline retailers are offering more differentiated products to their growing numbers of customers. The presence of differentiated coffees is certainly growing but still limited in mass distribution channels, such as supermarkets. Millstone--an upscale supermarket-oriented roasters/distributor owned by Procter and Gamble--offers an example of how this is expanding beyond the traditional quality segmentations: It now has three certified organic coffees in its lineup and is testing the market for certified fair trade and eco-friendly products. It is very difficult to generalize about European markets in this regard. Sustainable coffees tend to have a higher level of visibility and greater sales than they do in North America. A history of social activism has elevated fair trade coffee to the most visible and the most widely distributed of the "sustainable" coffees in Europe, though organics are now growing at an even faster rate while eco-friendly coffees are just beginning to turn up in a few countries. GIOs are much less common, though producer-driven options such as single origins, are now beginning to emerge as the retail landscape changes. Gourmet or specialty coffees are more often visible as branded coffees, relying on the credibility of the roaster or retailer, than just on the certification. Local shops and brands that have been a trusted form of differentiation have traditionally dominated the retail landscape at the expense of other forms of differentiation. Several factors are converging in Europe to probably stimulate a greater shift in this direction: · New café culture. The cultural popularity of Seattle-style cafés--and their diverse coffee selections--is fast increasing. · Quality differences. The reported decline in the quality of some standard commercial coffees opens room for competition. Some standard commercial coffees, used as loss leaders in supermarket chains, may further sacrifice quality to meet promotional price points. · Multiple store retail chains. These are fast changing the retail landscape as they increasingly dominate food distribution channels and are adopting increasingly differentiated product lines, sometimes under their own private label. New Paradigms in Global Supply and Demand 113 · Consumer awareness. A combination of very active NGOs, sympathetic media, and supportive governments particularly with EU harmonization, have greatly elevated the awareness of environmental and social justice issues. Japan's trading system has allowed differentiated coffees to permeate every type of distribution channel, ranging from the highest gourmet quality to common consumption. The Japanese consumers buy many of the world's most expensive differentiated coffees, such as Jamaica Blue Mountain. They also use certified eco-friendly coffee for one of their premixed canned coffee beverages. Large-scale retailers are also increasing their position with differentiated coffees because supermarkets now sell more than 60 percent of the volume. Convenience store chains like Family Mart are promoting more differentiated coffee products, including certified sustainable coffees. High prices appear to prevent more widespread availability of differentiated coffees and stifle demand beyond the more affluent urban areas. At the same time, the consistent stability of major blends means that consumers have less incentive to move away from products that they already know and like. Consumers are particularly conscious of traceability and value the auditable/safe food chains of certified products because of recent high-profile scandals around the mass contamination of both milk and blood products. This may have further stimulated demand for easily traceable products, such as certified organic or eco-friendly coffees. Price Premiums Substantial price premiums are currently earned for all of these coffees. Gourmet coffees are easily earning twice the current market price, as are fair trade coffees. Some industry pundits point out that some premiums, such as those for gourmet quality, are the product of scarcity; they are concerned about what will happen if too many producers start growing the same product. The United States specialty coffee industry predicts a continuing shortage of the coffees it needs, but this can change; it is prudent to de- emphasize significant price premiums as a reason for entering these markets because it is quite plausible that these premiums could eventually diminish. These price premiums should not be discounted for their current impact, particularly in areas where there is a finite supply or where even a modest premium can make a substantial difference toward covering costs. Given the growth rates for differentiated markets in recent years and the predictions of many companies, it is unlikely that premiums will disappear in the near future. One indicator of this confidence is the 75 percent "yes" response of the North American coffee industry when asked if they feel that price premiums for sustainable coffees are reasonable (Giovannucci 2001). The European industry, in a separate survey agreed that premiums--better termed compensation--are justified and was also confident that they would continue (Giovannucci and Koekoek 2003). Some of the differentiated coffees, such as those identified by their GIO, have inherent supply limitations. For them, premiums will probably depend more on their marketing, maintenance of quality, and perhaps policing the market for impostors. Specialty coffee industry associations like the SCAA already claim that there is a foreseeable shortage of supply for specialty or distinctive gourmet coffees and that price premiums for these will likely continue to be substantial. It is likely that those differentiated coffees, for which growing processes can be duplicated, will be most at risk for a decline in premiums. For this reason, it is imperative for any encouragement of sustainable coffee production to be closely linked with corollary measures to improve quality, consistency, and market efficiencies. The industry has already clearly indicated that consistency and quality are even more important for value and premiums in the marketplace than are sustainability principles (Giovannucci and Koekoek 2003; Giovannucci 2001). 114 Coffee Markets There is no consistent data source on the exact value of these price premiums to the producer. It is clear that they vary considerably due to various factors, such as type (gourmet, certified), processing (screen size, washing) region (high-grown, preferred zones), and availability. The most consistent figures are those for fair trade coffee: The mandatory base price for many mild arabicas is US$1.26 per pound with an additional compensation of US$0.15 per pound if the coffee is organically certified. For organic coffees, price premiums have declined considerably over the past decade from highs in excess of 100 percent. In early 2003, some low-quality and remote (far from market) coffees have been offered for fees as low as US$0.10 per pound while established quality-oriented producers could command premiums of nearly US$1.00 per pound. On average, the range for organic certified arabica is roughly US$0.15 to US$0.40 per pound more than the existing market price. Compensation for certified eco-friendly coffees show considerable variability, ranging from almost nothing to substantial premiums depending on individual negotiations. SMBC certification, because it includes organic certification, fetches at least the organic premium. One of the world's largest coffee roasters has reportedly committed to paying up to 20 percent more for eco-friendly certification. "Up to" is the key phrase, and if 20 percent is indeed paid then it would currently be equivalent to about US$0.13 per pound for arabica. Utz Kapeh, using EUREP-GAP as its standard, recommends a differential for fulfilling these sustainability practices but does not interfere in the negotiation between buyer and seller. Utz Kapeh recommends a specific premium of US$0.07 per pound for washed arabica and US$0.04 per pound for unwashed arabica but only when arabica coffee dips below US$0.70 per pound on the New York C market. The suggested robusta premium is US$60 per ton (US$100 per ton if washed) when the market dips below US$650 per ton. For some of these products, the issue of farmer compensation is not clear. For many proponents of sustainability, this represents a distinct danger. Given the inherent asymmetry in negotiations between farmer and buyer, there is a very real risk that farmers will be inadequately compensated for the costs of complying with standards. Historically, industry standards quickly devolved to represent a baseline entry requirement that is necessary for doing business but that is not directly compensated by the buyer. This, of course, raises the requirements for farmers and forces them to absorb additional costs. For example, premiums for meeting EUREP-GAP coffee standards are expected to typically be very low and subject to negotiation between buyer and seller. The failure to have adequate, and widely accepted, discovery of the actual costs of achieving new standards and having these certified makes the recovery of these costs increasingly subject to negotiations in which farmers, because of their often weaker position, may be at a distinct disadvantage. It will, as a result, be critical that the industry jointly define at least the minimum fair compensation for the basic costs of meeting a particular standard and having that certified. It would otherwise be onerous for the producer to negotiate or bear the full burden of these costs. This is especially justified in the case of sustainability standards that represent a clear public good, and they should, therefore, not be entirely subject to the vagaries of market negotiation. If buyer payment of these costs of certification are not a compulsory requirement, then farmers may be unable to recover them. Current research, particularly in the European and Japanese markets, indicates that it is not always clear to both professional buyers and consumers exactly who benefits from the premiums for sustainable coffees, and how much actually reaches the producer. This can consequently limit the appeal of such coffees. Critical Competitive Factors Coffee quality and consistency are found to be the most important criteria for the decisions of both European and North American coffee companies purchasing sustainable coffees (Giovannucci 2001; Giovannucci and Koekoek 2003) (see figure 43). This was even more important than price or customer New Paradigms in Global Supply and Demand 115 awareness/demand. Given that both surveys were conducted during uniquely low price periods, the valuation of price may have been somewhat skewed. Nevertheless, informal extracts from these surveys indicate that this finding would also apply to their purchasing decisions for other differentiated coffees. In Japan, one of the world's largest coffee markets, the poor quality to value ratio has been identified as a constraint to further market growth. In some European markets, quality was not deemed to be a constraining factor. Nevertheless, the increasing competition for a share of slow-growing markets means that quality may be the deciding point in many of the more inelastic markets. Figure 43 Key factors for the expansion of sustainable coffees 70 60 50 tnecrep 40 30 20 10 0 quality consistency price clarity awareness Not at all important Not very important Important Very important Source: Giovannucci and Koekoek 2003 The relatively high value placed on consistency underscores the industry's typical preference for steady and predictable quality given the costs and risks of sourcing from new suppliers. This critical competitive factor has several implications, particularly for smaller suppliers who typically find it most difficult to achieve consistency every year. For small producers to achieve consistency it will be vital to improve basic business practices in their cooperatives and organizations. These improvements range from local supply coordination and accounting to contracting and export procedures because these are key factors that prevent the satisfactory fulfillment of contracts. For many it will be equally important to strengthen their collaborative capacity as efficient and democratically run cooperatives/associations that can take advantage of scale economies and ensure the consistent fulfillment of larger contractual obligations not to mention the vital importance of assuring that the financial benefits reach the individual farmers in an equitable and transparent way. Source Countries Latin America is the leading source of many differentiated coffees. Its long historic focus on quality and the establishment of infrastructure and institutional mechanisms to foster consistency and quality provide 116 Coffee Markets a competitive advantage; however, this advantage does not pertain to all Latin American producers and the region's first-mover advantage certainly can be short-lived as other producers improve. As noted in section four of this report, Ethiopia, Uganda, India and Rwanda are among those already advancing strategies to penetrate higher value markets. The East African countries and Indonesia are among the strongest competitors to the Latin American leadership in this field, while efforts in parts of Africa and south Asia are still relatively underdeveloped. Kenya and the United Republic of Tanzania have struggled with quality and output in recent years, though both are now making concerted efforts to address these problems. This regional advantage is even more pronounced for the supply of sustainable coffees. Organic, fair trade, and eco-friendly production and certification is increasing much more rapidly in Latin America than elsewhere. Mexico, Central America, Columbia, and Peru are the market leaders for organic and fair trade. Even Brazil, the world's leading producer of conventional coffee, is growing its participation in these markets, already producing about 2,000 tons of certified organic coffees in 2002. Certified eco- friendly coffee has its roots in Central America and its certified production is already spreading to Mexico, Uganda, Ecuador, Peru, Brazil, and Colombia. Just as some producers of differentiated coffees have difficulty identifying and accessing the more lucrative trade channels, so do buyers sometimes find it difficult to access differentiated coffees. This is perhaps most applicable to those coffees grown by smallholders including the three common sustainable coffees. In Latin America, one nonprofit organization now offers a directory of Latin American exporters of sustainable coffee. The Centro de Inteligencia sobre Mercados Sostenibles (CIMS)--in English, the Sustainable Markets Intelligence Center--was recently launched to help buyers locate organic, fair trade, and eco-friendly coffees but does not yet offer a listing of potential buyers. 6. Differentiated Markets: Size and Outlook Although individual markets vary considerably, there is an overall consensus that the differentiated coffees have shown a healthy rate of growth in recent years despite the flat or even declining sales in the conventional coffee channels documented earlier in this paper. It appears that these general trends will continue an overall positive growth for the near term, though not necessarily for every type or in every market. Just as important for producers is the fact that many of these coffees trade well above the range of the New York and London commodity contract price, and some have managed complete independence in setting their prices. Currently the markets for differentiated coffees import roughly 6-8 million bags representing about 9-12 percent of the volume--and a larger percentage of the profits--in the most developed markets, such as North America, Western Europe, and Japan. In the United States, for example, where the differentiated coffee markets account for less than 20 percent of actual green coffee imports, they now register more than 40 percent of the coffee sector's profits.48 49 To the extent that some of this higher value is kept by 48This U.S. calculation typically includes other value-added coffees in addition to the expected gourmet and whole bean coffees. These include flavored, decaffeinated, prepared coffees (that is, ready to drink), and some specialty solubles. 49SCAA estimates 2002 U.S. Specialty Industry retail sales figures to be approximately US$8.4 billion. A significant portion of this coffee is prepared or transformed, and much of its total value is captured outside of producer countries. New Paradigms in Global Supply and Demand 117 producers, these markets are breaking the pattern of a declining producer share of revenue as payment for their differentiation. Appellation Coffees Strong sales and limited availability of the appellation coffees with GIOs are stimulating the identification and development of additional appellations in a number of countries. Although there is no cohesive global data for GIO coffees, all indications point to very strong and growing demand in all of the major consuming markets. Jamaica's Blue Mountain coffees still lead this category with export values at about 15 times the ICO average and retail prices typically in excess of US$80 per kilogram. Although there are few producers, they receive more than twice world market rates. Prices do fluctuate, but production has been amply profitable for decades. Blue Mountain's popularity also helps to stimulate the sales and higher prices of other coffees grown in the proximate area. These second-tier coffees have similar monikers, such as Jamaican Mountain or Blue Mountain Blend, and sell in much greater volumes than their close cousins. This famous appellation has led to a thriving domestic coffee industry based on the tourist trade, as it has in other locations, such as Hawaii, Guatemala, and Costa Rica where roasted coffees are attractively packaged and sold locally at prices that are close to those of retail shops in the United States. and EU. The demand for some of the best-known differentiated coffees with their higher prices is so great that, according to industry insiders, considerably more than the actual production manages to be sold. A few years ago, the high demand and high price for Hawaii's Kona coffee resulted in fraudulent sales totaling millions of dollars that were eventually exposed and prosecuted. This demand is not limited to the best-known of these coffees. Uganda's Bugisu and Burundi's Ngoma coffees still fetch a market premium, though few consumers are familiar with them. In Colombia, Nariño coffees are contracted for in advance, but other less recognized regions also have a strong following. Even new appellations can quickly develop a market as happened for the Haitian Blue Mountain production. Specialty and Gourmet In the early 1980s, the specialty coffee industry in the United States was widely perceived to represent a quasifanatical fringe market. Its meteoric rise, especially in the last decade, makes it one of the most outstanding success stories in the coffee world and has stimulated the formation of specialty coffee associations in many other parts of the globe. Although it did not register on anyone's radar screens 20 years ago, it is now a leading segment of the industry. Many experts feel that the differentiated coffees supported by the specialty industry will continue to expand at a much faster rate than conventional coffees. The definition of specialty in the United States is undergoing a shift. It currently includes coffees that may not necessarily be high-quality and are otherwise only differentiated by being flavored (chocolate, cinnamon, hazelnut, etc.) and served as an espresso or milk-based beverage, or by being decaffeinated. This is confusing and certainly complicates a better understanding of this market. This confusion can be particularly perplexing from the producers' point of view; producers find that the difficulty of targeting this market is further exacerbated because most of the added value comes from importing country processes like those mentioned above, over which they have no control. The industry is beginning to redefine "specialty" to reflect more of a quality orientation. If we define the U.S. specialty market as those coffees having no defects then the market size is about 3 million bags; otherwise it is approximately 118 Coffee Markets 4 million bags, according to the SCAA. Overall estimates for the U.S. specialty coffee industry indicate that retail sales reached US$8.4 billion in 2002 while total industry sales were approximately US$18.5 billion (SCAA 2002).50 The U.S. specialty market, in the midst of an overall economic downturn, estimates a 5-10 percent growth rate. Much of this growth is expected to come from the out-of-home or prepared beverage segment where approximately 14,000 specialty coffee shop and café retailers account for about three-fourths of the segment's business value. The European differentiated or specialty industries are more integrated into the overall coffee business than in the U.S. and do not count with separate, verifiable data on market size and development. In recent decades, the overall level of variety and quality readily available to Western European consumers has probably been somewhat higher than in the United States so there was less stimulus for the development of a distinct specialty segment. Even some of Europe's largest roasters have positioned themselves in the differentiated and specialty markets directly or through their subsidiaries. There is nevertheless considerable growth in out-of-home consumption of differentiated products especially espresso-based beverages, a trend that is similarly occurring in the United States. The Japanese differentiated market is distinct from its conventional market and has more in common with the U.S. structure than with Europe's. Although most of the importers are large and very few dedicate themselves exclusively to specialty coffees, they are respectful of the segment and encourage its growth. Many operate through a network of wholesalers and distributors who service the needs of specialty roasters. The trend toward U.S. style cafés increased rapidly in the late 1990s and early parts of this decade, serving to increase the visibility of high-quality coffees although their strong growth has now begun to slow. Because the market is tightly managed through significant branding and market segmentation, it is difficult to introduce individual new coffees outside of existing channels or blends. Japanese consumers pay some of the highest prices in the world for coffee. They are, for example, key customers for the high-value coffees of several countries, such as Colombia's Emerald Mountain preparation, India's Monsooned Malabar, and Jamaica's Blue Mountain. Japan's uniquely successful development of coffee sales through vending machines has led to increased visibility and consumption of all coffee products. One unique and successful prepackaged coffee beverage features their specific regional origins, such as Colombia or the United Republic of Tanzania. This approach is likely to provide some lessons for coffee development in other predominantly tea drinking countries. Other differentiated markets are emerging in Australia, Singapore, Hong Kong, Taiwan, and South Korea, driven in part by U.S. style cafés and rapid chain business and franchising expansion. The same is occurring in several producing countries, such as Brazil, Colombia, Mexico, and Vietnam. Although these markets present interesting opportunities and demonstrate notable growth, they are--with the exception of Brazil and Vietnam--still quite small. Sustainable Coffee Overview The term sustainable coffees has been commonly used to refer to certified organic, fair trade, and eco- friendly coffees, but sustainable is now changing to include new entrants.51 These sustainable coffee 50Jay Molishever, director of communications, NCA, personal communication, June, 2003. New Paradigms in Global Supply and Demand 119 segments are growing in most but not all markets. Although they are often perceived as beneficial for growers, it is clear that sustainable coffees also very much benefit the sellers. The industry is in many, but not all cases, seeing increasing sales and higher prices from the product differentiation and price premiums of these coffees. Furthermore, it appears that the industry is generally optimistic about the future of differentiated coffees and seems to increasingly understand that the future of these is intimately linked with the viability of good quality producers. The demand for sustainable coffees comes primarily from the more developed consumer markets--the United States, Western Europe, and Japan. While these coffees are certainly available in other markets, their volume there is rather small. Total traded volume of certified coffees in 2001 was approximately 600,000 bags. This represent on average between 1 percent and 2 percent of the trade in the countries where these coffees are sold. A more complete figure, including estimates of coffees that were sold with claims of sustainable production practices (that is, ethical, eco-friendly, Utz Kapeh) could add another 500,000 bags for a global total of approximately 1.1 million bags in 2002. This represents nearly 2 percent of all the green coffee imported into the leading consumer countries. Early assessments for 2003 indicate strong and considerable growth fueled by the increasing interest of large industry players. To gain a better perspective of the importance of the sustainable coffees, it must also be noted that smallholders disproportionately produce them: When disaggregated from the mass of conventional quality coffee, sustainable coffees represent a much greater proportion of the production from small producers. Approximately three-quarters of a million coffee producer households, or 3.5 million people, benefit directly from sustainable coffees. Most of these coffees move through higher-value channels and consequently capture substantial premiums, both monetary and otherwise, in terms of competitive advantage. While sustainable coffees may only represent a small proportion of total global trade, they are quite important in terms of their value for smallholders. Organic, fair trade, and eco-friendly coffees have traditionally pursued three divergent markets, even though there is considerable overlap among them. Their acceptance into mainstream consumer channels has meant distribution by larger retailers, some of which are increasingly requiring multiple certifications for one coffee. A small but growing number of firms, particularly in Europe, are finding the various certifications to be confusing and prefer to impose their own seal. This could eventually diminish the power and credibility of international third-party certification and may also stimulate the three distinct sustainable coffees toward a more harmonized or unified set of sustainability criteria. In the U.S. and Canada markets, organic coffees represent the most volume, though fair trade is experiencing faster growth rates. Eco-friendly coffees have even faster growth rates and some distinct niches, including a few mainstream supermarket chains, are still in the nascent stages of development. These certified sustainable coffees are relatively new and are together responsible for green coffee sales, totaling approximately 85,000 bags in 2000 and approximately 147,000 bags in 2002 after estimated strong double-digit growth that is continuing in 2003. The longer history of fair trade in Europe has helped it to have a notable presence in many of those markets. Although fair trade is the most popular of these coffees in Europe and is growing very strongly 51Much of the data in this section is drawn from The State of Sustainable Coffee: A Study of 12 Major Markets, a book jointly published by the International Coffee Organization, The International Institute for Sustainable Development, and UNCTAD (2003), as well as The Coffee Survey of the North American Specialty Coffee Industry published by the CEC and the SCAA (2001). 120 Coffee Markets in some markets, the average overall growth projections are modest. Organic coffees are growing somewhat faster in much of Europe, fueled in part by recent food safety scares. Eco-friendly coffees have been recently introduced but still have small presence in Europe. The overall market share for sustainable coffees continues to grow in most countries. The highest market shares, in the range of 3 percent, have been realized in Switzerland, the Netherlands, and Denmark. The Japanese market has shown an affinity for sustainable Table 21 Volume and share of sustainable coffees despite some upheaval as it adjusted to formal coffees in key European markets, 2001 organic standards in 2001-2002. The recent application of the Japanese Agricultural Standards now regulate organic Metric tons Market coffees so that no uncertified coffees will enter. By the end Country Green Share (%) of 2002, Japan, with approximately 5,000 tons (or 83,000 Belgium 1068 1.65 bags), was the world's third-largest consumer of sustainable Denmark 1685 3.37 coffees, behind the United States and Germany. Some of Finland 214 .38 Japan's leading roasters and coffee retailers have recently France 1338 .40 introduced eco-friendly coffees throughout Japan. While Germany 5945 1.10 fair trade continues to be popular, it is less familiar to Italy 947 .29 average Japanese consumers and most is conducted as part Netherlands 4136 2.92 of a network of informal relations between socially Norway 439 1.06 conscious Japanese buyers and coffee growers; only a small Sweden 1477 1.64 percentage of this is formally registered and shows up in the Switzerland 1610 2.85 fair trade data. UK 2408 1.73 Totals 21,267 1.63* In the United States and in most of Europe (see table 21), sustainable coffees started on a very small scale and often *unweighted average through independent roasters and retailers. Since the Source: Giovannucci and Koekoek 2003 mid1990s, some smaller and specialty supermarket chains have carried these coffees, but mainstream supermarkets are now beginning to incorporate them, as well, albeit in smaller selections and quantities. Sustainable coffees appear to be at a crossroads because they now earn their place on the shelves of large multiple store retailers. If their growth consequently escalates, then the challenge will clearly be to provide a consistent and high-quality supply. In the United States, some major coffee chains tested these coffees successfully and are now giving them considerable visibility through renewed larger-scale commitments as they discover consistent sources of supply. High- profile distribution deals are also helping to dramatically raise the visibility of these coffees among consumers. For example, a leading ice cream manufacturer is now launching a new ice-cream flavor, "Coffee for a Change," using a certified eco-friendly coffee extract. The out-of-home consumption market is expanding in Europe but more slowly than in the United States. Given the increasing importance of out-of-home consumption, the foodservice and café channels could be significant areas of future growth for European countries in particular. In 2000 and again in 2001, most firms reported experiencing either increased or similar sales of sustainable coffees in most markets with some notable country variations. In North America, more than half of coffee sellers queried in 2001 expected sales to increase over the next few years. Although some projected growth to remain flat, almost no one projected decreases. Among those who projected increased sales, estimates of growth were approximately 27 percent and were spread over the next two years--a bit less than 15 percent per year. In Europe, industry growth estimates differ dramatically from country to country, and ten percent per year represents an approximate overall estimate for 2003-2004. New Paradigms in Global Supply and Demand 121 Organic The overall organic food and beverage market has shown remarkable resiliency over the long term, growing at approximately 20 percent per year for more than a decade. The International Trade Commission conservatively estimates that the global retail market for certified organic food and beverages grew from approximately US$10 billion in 1997 to US$17.5 billion in 2000 (Kortbech-Olesen, 2000). For 2001, the less-conservative calculations by the Organic Monitor for global organic retail sales were about US$26 billion. In North America and in Europe, organics are fast becoming mainstream and are gaining new distribution channels through the dominant supermarket chains even in more conservative regions. Certified organic coffees are a relatively new business. They have been on the market for about two decades, mostly in health-food shops and some specialty retailers, but broad appeal and volume sales have only occurred more recently since the mid1990s.52 In the United States, the Organic Trade Association (OTA) has registered rates of approximately 12 percent average annual growth for organic coffee over the past five years among its respondents. The coffee industry's own estimates have been higher. Most industry projections predict continued growth, though the estimated rate of future growth varies from less than 10 percent to nearly 20 percent per year (Giovannucci 2001; OTA 2001; Giovannucci and Koekoek 2003). The Sustainable Coffee Survey of the North American Specialty Coffee Industry estimated organic coffee consumption at approximately 5,000 tons in 2000 (predominantly U.S.). There are clear indications that this is growing according to various supporting sources, including the OTA survey cited earlier, unpublished industry reports, and a National Coffee Association (NCA) survey. This NCA survey noted a considerable increase of consumers purchasing organic coffee at least once--13 percent or 8 million people--just among those who are specialty or gourmet coffee drinkers (NCA 2002). In an informal poll of some North American importers and roasters in early 2003, certified organic coffees were showing growth rates of about 20 percent for 2002.53 In 2001, Western Europe consumed more than 11,000 metric tons certified organic coffee. This is considerably more than the North American volume even when adjusting for the 15 percent greater population in the 11 country European sample. Survey estimates show that Germany led Europe with approximate consumption at nearly 3,500 metric tons. Northern European countries appear to dominate this niche. Denmark's organic coffee has a higher share--2.4 percent of the total domestic coffee market--than any other country. 52The much earlier third-party certification of Finca Irlanda in Chiapas, Mexico (Demeter biodynamic) was the first ever recorded, but very few such coffees were available on the open market at that time. 53Mention should be made that this poll was from a modest starting point. 122 Coffee Markets European organics have positive growth outlooks in most countries with industry Table 22 Organic coffee sales in select European countries estimates of growth and projections averaging about 10-15 percent per year in the Volume 2001 Avg. Annual 5-year period of 1999-2004 (see table 22) Country (green metric tons) Growth,1999-2001 (%) (Giovannucci and Koekoek, 2003). This Belgium 456 15 growth rate will mean a near doubling in Denmark 1448 4 volume over that period. In the EU, organic Finland 103 18 certification has for a decade been governed France 600 18 Germany 3502 17 by regulation 2092/91 and has served to Great Britain 691 18 make the organic trade more transparent. The Italy 641 60 independent application and management of Netherlands 978 15 the EU rules in each country but has meant Norway 230 2 that the organic industry still has to sift Sweden 1477 28 through the confusion created by the various Switzerland 431 15 regulatory agencies in some of the states. This has, according to the coffee industry, Source: Giovannucci and Koekoek 2003 caused difficulties and impeded growth. Beginning in July 2002, more stringent EU import authorization rules for organic products mean that valid transaction certificates issued by recognized certification agencies will be mandatory. Failure to provide the certificates when applying for an organic import authorization for any coffee from outside of the EU will mean that the product will be classified as conventional and cannot be legally sold as organic. The Japanese market participated in the global surge of organic coffee demand and reportedly showed excellent growth rates through the late 1990s but had recently dropped to an estimated 1,700 metric tons of certified coffees in 2001 before picking up again. Two reasons seem to explain this anomaly: First, the recently enacted Japan Agricultural Sector laws governing the certification and labeling of organic products apparently disturbed the markets because many traders were unprepared for the new criteria that replaced much looser organic standards. Second, the Japanese consumer expects the quality levels of organic products to be similar or better than conventional products and, in the past, many of the imported organic coffees have apparently not met consumers' flavor and quality criteria. It appears that the Japanese market is now moving beyond both hurdles and 2002 figures indicate that Japan is the world's second-largest consumer of certified organic coffees with imports in excess of 4,000 tons. By early 2002, the global supply situation was much improved with 26 countries exporting certified coffees. In recent years, producers have seen a considerable reduction in the premiums paid with much more attention paid to quality. Organic premiums range from a low of US$0.10 to US$0.15 for average or lower-quality coffees and can easily reach US$0.40 to US$0.60 for better coffees. Several sources report considerably higher premiums paid in some cases. Although some sources of organic supply can still be poor or inconsistent in quality, many have demonstrated significant improvement as a result of competitive pressures. The recent winner of Brazil's Cup of Excellence, a prestigious internationally judged competition, was certified organic. Hawaii's Kona coffee, one of the world's most prized origins, recognized a certified organic producer as the winner of its annual competition in 2002. One of the world's most popular café chain now identifies enough good quality certified organic coffee to develop a permanent organic blend for its U.S. stores. With this new blend, it expects to initially need at least an additional 300 metric tons of certified organic coffee per year. New Paradigms in Global Supply and Demand 123 Fair Trade The fair trade market has achieved widespread European acceptance since its modest beginnings there in the 1970s (see table 23). It is the most popular of the cause related coffees in the European markets and surpasses the market share of organic coffee. In its brief history, it has provided considerable support to hundreds of thousands of small producers in two dozen countries. Most, but not all, of the fair trade network is now coordinated by the Fair Trade Labeling Organization International (FLO). The clarification and harmonization of policies, labeling, certification, and inspection are proving to be valuable steps forward. This niche is emerging from the earlier stages of its development as a limited network, dependent on a high level of ideological solidarity and toward a more viable market entity with widespread consumer appeal. Globally, sales have averaged about 8 percent annual growth over the past 5 years with 2002 volumes reaching nearly 16,000 tons. Fair trade coffee is sold in about 20 countries and has a market share of about 2.5 percent to 3 percent in the Netherlands, Denmark, and Switzerland. For most other countries, the fair trade market share is less than 2 percent (see table 23). In some of the more seasoned markets, there is concern about the capacity of fair trade for future growth beyond this level. Although it is not yet clear, it appears that in a few countries such as The Netherlands and Denmark, consumption levels may have matured and reached a potential ceiling. There is general agreement, even among some of its proponents, that to move beyond fair trade's apparently limited base of partisan support and increase its reach and volume, that it must position itself strongly in the more mainstream distribution channels. This is just beginning to happen in Europe as various supermarkets take an interest. In the North American markets, fair trade has Table 23 Fair trade coffee in select European countries positioned itself as part of the specialty trade and has not met heavy consumer resistance in Avg. annual this high-end channel. In the four years since Volume 2001 growth,1999-2001 Country (green metric tons) (%) the official introduction of Transfair Austria 503 8 certification in North America, it has generated Belgium 698 11 dramatic growth. The United States posted Denmark 836 0 imports of approximately 4,600 metric tons of France 1134 88 green coffee in 2002, an increase of 45 percent Finland 116 18 Germany 3754 -2 over 2001 when increases were closer to 50 Great Britain 2271 12 percent more than the previous year. The vast Italy 562 14 majority of this, about 83 percent, was also Netherlands 3726 0 certified organic and only very modest Norway 214 78 Sweden 361 27 quantities were certified as shade grown. Switzerland 1554 -2 Canada grew from 190 metric tons in 2000 to 360 tons in 2001 and nearly 600 tons in 2002; Source: compiled from data provided by FLO and author's approximately one-half of this was also certified independent research (Giovannucci and Koekoek 2003) organic. A portion of the North American imports were used in blends or were otherwise not labeled as fair trade. The visible amount of 100 percent fair trade registered coffees sold in stores and cafés is somewhat smaller, but this has little or no effect on the direct benefits that producers receive. The Japanese fair trade market is particularly difficult to gauge because only Transfair keeps statistics, and they currently represent only a small portion of the Japanese fair trade market. Transfair figures show 124 Coffee Markets a 17 percent annual increase to nearly 8 tons in 2001; while total fair trade estimates are more than 500 tons. The three most cited sources of resistance to the adoption of fair trade into the mainstream channels are a) its requirement to make prefinancing available to growers if necessary; b) that the benefits to producers are not clear; and c) what is considered a high price in relation to the current market. The first is partly an issue of mechanics as many large buyers do not deal directly with producers and would have to authorize and track deposits along their supply chains. In practice, this is often a moot point since many producers do not request such financing. A number of firms, including some that sell fair trade coffees, voice concerns that they are not certain about exactly how producers are actually benefiting. This complaint may be surprising to some because buyers who participate in fair trade usually have direct contact with the growers and could have ready access to such information. The fair trade organizations have taken steps to improve inspections and reporting from the field and, perhaps, more can be done to educate the roasters and buyers about their specific impacts in the coffee-producing communities. Some buyers have an issue with the FLO floor price claiming that this price is oriented toward income support without being necessarily reflected in corresponding high quality. They also argue that it is artificially set and not reflective of market realities, and it will not be sustainable in the long run because it could easily send signals to produce more when the market is oversupplied.54 The other side of the argument holds that the minimum fair trade price is only a just compensation and that the market does not fairly value the costs and risks of production. When the world price is above the minimum, the fair trade premium is only US$0.05 more per pound (and, therefore, not onerous). It is expected that producers will respond with competitive quality, and buyers, who have more to choose from, will eschew poor quality. Currently, less than 20 percent of the certified fair trade coffee is actually sold through its channels at the minimum floor price. For fair trade to expand its consumer base and be perennially competitive in mainstream markets, these concerns will have to be addressed. The recent entry of these coffees in a number of EU supermarket channels may determine whether fair trade's offerings will appeal to the masses. If there is a healthy acceptance in these supermarkets, its volume and market share could easily show dramatic growth. There are also other reasons for an optimistic outlook. For example, one fair trade company in only ten years has captured about 6 percent of the ground coffee segment of the UK market and has extended its brand into instant coffee and even tea. The question remains whether mainstream consumers will understand the fair trade message and be willing to pay more than they do for conventional coffee. One of America's largest coffee companies is already testing the concept in supermarkets. Fair trade is managing to grow at a healthy pace in many markets, even in the current difficult price situation in which the difference between the international commodity price and its base price (approximately 100 percent in 2002-2003) is remarkable. More than 24 producer countries currently have fair trade certified producers. These approximately 600,000 producers have the capacity to produce more than 100,000 metric tons. They are led by (in volume order) Mexico, Peru, Colombia, Nicaragua, and Guatemala. Global exports have grown by 32 percent between 1996 and 2001. Most but not all of the fair trade flows through the official FLO system. More than 17,000 tons of exports were officially certified as fair trade in 2001, an increase of more than 12 percent over the previous year, and 2002 showed a nearly 10 percent increase. The unofficial figure, 54Originally based on a modest profit margin added to ICO calculations of production costs for quality oriented producers. New Paradigms in Global Supply and Demand 125 including FLO numbers, could be 10 percent to 15 percent higher. Nearly half of this coffee is also certified organic. Eco-Friendly or Shade This relatively new category is not homogenous and actually includes certifications with some similarities--primarily those of the Rainforest Alliance and the Smithsonian Migratory Bird Center (SMBC)--that share a primary concern for ecological biodiversity. They are known as shade-grown, bird-friendly, and certified by the Rainforest Alliance (formerly Eco-OK). These coffees directly contribute to the conservation of ecologically sensitive areas and respond to a shortcoming of some organic certification standards in this regard. Eco-friendly coffee made its first significant commercial appearance in the late 1990s.55 Although its volumes are much smaller than the more established organic and fair trade segments, it has received relatively quick acceptance. They have recently begun with some modest sales in the UK, but have had very little exposure and awareness elsewhere in Europe. This could soon change the world's second- largest branded food company, begins its commitment to source Rainforest Alliance-certified coffees for four of its European markets. Taiwan has introduced these coffees and they recently achieved national distribution in Japan. North America is the most popular market for eco-friendly coffees where they flow through nearly all of the distribution channels, though still in limited quantities. This category could have the greatest potential for mainstream market success because it appeals to larger-established producers because it does not require strict organic production and, unlike fair trade, is not limited to smallholders. These larger producers often have the market contacts and volumes to more quickly establish a relationship with larger buyers. Approximately 4,000 metric tons of eco-friendly coffee from seven countries were sold in 2001, the bulk of which came from Guatemala and El Salvador. In 2002, sales were considerably higher with the help of large new clients in the United States, Japan, and new markets in the UK. Further expansion to France, Belgium, and the Netherlands will certainly increase the volumes sold in 2003. Brazil, Mexico, Costa Rica, Nicaragua, Panama, Colombia, and Peru are the other producers with certified farms. This is a considerable jump from estimates for 2000 sales of certified shade-grown coffee that were approximately 500 metric tons, though much more was sold uncertified. Premiums paid to producers are often linked to coffee quality and vary considerably from US$0.05 per pound to as high as US$0.80 per pound, with the most common premiums ranging from US$0.10 to US$0.60 per pound. Sustainable Coffees: Helping Producers to Capture Diverse Forms of Value Policy options, especially for smallholders and most especially for growers in remote and environmentally sensitive areas, are usually limited. In these situations there are often very few economic alternatives and a limited scope for diversification. A proactive policy toward sustainable coffees can have notable socioeconomic and environmental impacts for the growers. A shift away from rustic cultivation methods that do not use external inputs to organic methods that incorporate local inputs and actively manage the cultivation cycle can improve yields and incomes with only modest external 55Audubon's modest earlier attempt in the 1990s to launch a bird-friendly ecologically sound coffee was problematic, and the coffee was removed from circulation. 126 Coffee Markets investment and without environmental imbalance, as shown in Mexican, Costa Rican, and Guatemalan studies (Rice and Ward 1996; Moguel and Toledo 1999; Akkerman and Van Baar 1992; Mexican Coffee Council--Certimex unpublished). In comparison to many crops, coffee, as an evergreen crop integrated with other trees, can also be intrinsically advantageous for biodiversity. The downward trend of certification costs is facilitating the access of poorer growers to high-value markets. Even during the transition phase prior to organic certification, coffee can often be sold at a small premium. Sustainable coffees provide one of the few viable opportunities for the smallholders to not only access high-value markets but also do so while maintaining or even improving their natural resource management and their environment. These market options are especially valuable because there are only a few remunerative crops with which smallholders can participate competitively in the marketplace. Today's flooded commodity market is but one instance where many producers earn minimal prices and barely recover their costs while many sustainable or differentiated coffees sell at considerable premiums. Furthermore, a number of other benefits accrue to growers and their communities that follow sustainable growing practices that are somewhat independent of the success or failure of sustainable coffees in the marketplace. These reasons, outlined below, provide a convincing rationale for public support to help promote these market oriented production methods. The most common accusation levied against many sustainable production practices is that their output is relatively low in comparison to intensive, chemically-supported agriculture. According to Brady (2001), Akkerman and Van Baar (1992), and Boyce et al. (1994), researchers documented that, though conventional, chemically oriented sun coffee production provides higher yields, and it also results in lower net revenues per hectare than organic production for smallholders. Sustainable coffee producers often manage their farms using multiple crop production strategies, offering food crops, timber and nontimber forest products with which to augment their income and improve their nutrition. The costly upfront input investments of intensive, chemically supported cultivation are sometimes not available to farmers and when calculated with the costs of borrowing for these inputs can, in some cases, make such intensive production methods less competitive. Application and contamination risks should also be considered especially when inexperienced family labor is used. Sustainable production methods eliminate the risks inherent in not only the upfront investment but can also reduce the dangerous dependence on a single crop. Finally, one or more of these sustainable methods will also typically offer a number of other benefits: · Shade trees help to preserve the soil structure, preventing erosion and protecting watersheds. They also provide nutrients in the form of leaf litter and sometimes nitrogen fixation. · Cover trees offer alternate crops for food security or home consumption and for market, such as citrus, banana, avocado, and lumber. · Organic soils better support microbial life, ensuring a natural control of pests and pathogens. The improved tilth improves water retention and soil stability which can dramatically reduce the impacts of drought and excessive rain. · Species diversity improves both nutrient recycling and on-farm diversification and as part of a total yield strategy, helps to manage risk. · Reduced expenses for external inputs tend to minimize financial risk. New Paradigms in Global Supply and Demand 127 · Increased rural self-sufficiency can be achieved through community or organizational development and the greater use of rural labor fostered by sustainable coffees. · Farmers and their families might benefit from the reduced health risks due to the minimized use of agrochemicals.56 The intrinsic value of sustainable production methods, especially in environmentally fragile or low income rural areas, have made them a popular choice especially for smallholders. 56According to the World Health Organization, at least 40,000 people die from pesticide poisoning every year and another 3-4 million are severely poisoned requiring hospitalization. This is especially in developing countries where the more toxic materials continue to be widely used and easily available (IFOAM 2000). These records do not capture the much larger estimated number of people affected by agrochemicals and who are not formally hospitalized. 128 Coffee Markets Appendix Quick Reference on Coffee Production Table A1 Fifty-five coffee-producing countries by principal type and region Milds Natural Arabicas Robustas Colombia Milds All Natural Arabicas American Robustas *Colombia *Brazil *Brazil Kenya Ecuador Ecuador Tanzania Paraguay Trinidad and Tobago Yemen American Milds Asian Robustas Bolivia India Costa Rica Indonesia Cuba Lao PDR Domincan Republic Malaysia Ecuador Philippines El Salvador Sri Lanka Guatemala Thailand Haiti *Vietnam Honduras African Robustas Jamaica Angola *Mexico Benin Nicaragua Cameroon Panama Central African Republic Peru DR Congo Venezuela Equatorial Guinea United Status (PR and HI Gabon African Milds Ghana *Burundi Guinea Cameroon Liberia DR Congo Madagascar Madagascar Nigeria Malawi Togo Nigeria Sierra Leone Zambia Tanzania Zimbabwe *Uganda Asian Milds *India Indonesia Papua New Guinea *Asterisk indicates leading-producing country by type and region in 03/06 crop year, according to the USDA. Source: USDA, data provided to author This survey of the development of coffee supply looks at coffee by classification then by region. The ICA divides coffee output into four major groups--two groups for washed arabicas, and one group each for natural arabicas, and robustas. The washed arabica group is divided in two--Colombian Milds and Other Milds. In this paper we have further split the discussion of each category into a regional focus. This does New Paradigms in Global Supply and Demand 129 mean that the countries in the Colombian Milds group--Colombia, Kenya, and the United Republic of Tanzania--are separated from the regional overview of washed arabica production. There are a small number of cases where the production of a certain type of coffee is not shown because of its small quantity, and this is reflected in the tables in this document, regardless of data source. Examples include the robusta production of Guatemala and Papua New Guinea. Table A2 Share of export value of commodities represented by coffee Country 1998 1999 2000 2001 2002 Average Burundi 81.36 77.29 77.89 52.10 55.13 68.75 Rwanda 49.79 68.47 67.97 46.14 66.95 59.86 Ethiopia 67.37 56.58 51.66 30.49 33.64 47.95 Uganda 59.02 52.86 27.24 21.44 22.21 36.55 Sierra Leone 57.44 38.15 22.93 0.23 0.71 23.89 Nicaragua 31.67 25.83 26.23 17.78 13.50 23.00 Honduras 28.03 22.00 24.45 12.20 14.29 20.19 Guatemala 22.63 24.48 21.18 12.36 12.09 18.55 El Salvador 19.72 20.80 22.70 9.58 8.52 16.26 U.R. Tanzania 19.31 14.50 11.89 8.00 3.73 11.49 Madagascar 26.80 13.77 3.12 0.90 11.15 Colombia 18.84 12.29 9.17 7.10 7.28 10.94 Kenya 10.84 11.03 8.52 4.97 3.61 7.79 Papua New Guinea 11.85 8.09 5.10 4.26 4.70 6.80 Congo, Dem. 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