1 November 1996

If quota ends, what then?

The dairy industry is at a crossroads. With Brussels due to issue its first proposals for reform in the spring, industry bodies are setting out their stalls. Philip Clarke studies the offerings

DAIRYING escaped more or less unscathed from the 1992 CAP reforms, designed to meet Europes commitments under the GATT agreement.

But existing support arrangements, based on quotas to control output and intervention to hold up prices, come to an end on March 31, 2000.

What will replace them will be the subject of heated discussion in the lead up to that date. The debate will gather momentum next year when Brussels issues its first proposals in the spring.

Some farmers have already pressed for maintenance of the status quo. And looking at the trend in dairy farm incomes since quotas were introduced in 1984, who can blame them? Gross margin a cow has increased from just over £500 to almost £1000, with equivalent gains in net farm income.

But a recent report from the NFU Economics Department on Options for Reform in the Dairy Sector suggests pressures for change on the industry are so intense, that leaving things as they are is a non-starter.

So what are these pressures?

The NFU cites several internal and external factors which will force change.

But the over-riding pressure will come from the next round of international trade negotiations under the auspices of the World Trade Organisation, which have to be completed by 2003.

What form this will take can only be guessed at, but NFU economists predict an extension of the last GATT round. In other words:

&#8226 Lower internal support.

&#8226 Lower export subsidies.

&#8226 Lower import protection.

The US, it would seem, has already woken up to the consequences of a WTO agreement along these lines.

Under the US Farm Bill, more and more policy instruments are being "decoupled" from production, so qualifying for the infamous "green box" of measures exempt from future cuts in support.

But existing arrangements in the EU dairy sector would not qualify in their present form. UK dairy farmers would therefore find themselves at a huge disadvantage if this was still the case when the next WTO round takes effect.

Any attempt to maintain the status quo would set UK farmers on a treadmill of price and quota cuts in order to keep pace with cheaper imports and restricted export subsidies.

The NFU report therefore examines two other options.

Price cuts…

The first of these is "price cuts" to bring the EU in line with world prices, backed up with compensation and the removal of all quota restrictions.

"The size of price cut required is uncertain," says the report. "Over the 1980s and early 1990s, a cut in the region of 50% would have been required in order to reach world prices."

But talk of a 13p/litre milk price is quickly dismissed, with the Union predicting a 25% to 30% cut (to about 19p/litre). It cites three reasons:

&#8226 World dairy prices have already risen in the last couple of years.

&#8226 Lower support would lead to lower world supply and with it higher prices.

&#8226 Liquid milk for drinking within the EU is not affected by world market forces.

If milk prices were cut to world levels in one go and quotas removed altogether, export subsidies would not be needed to deal with any extra output.

Obviously there would be a significant income effect. But compensation would offset this, with the advantage it would qualify for the green box and be protected from cuts under the WTO.

MAFF has already made its view clear that any compensation should fall over time and should not be linked to production or farm size.

Certainly the UK would be vulnerable to compensation linked to farm size. The NFU estimates that, if compensation was paid on the first 30 cows only, then only 38% of the UK herd would qualify, compared with 69% for the EU as a whole.

But it does not dismiss this idea of "modulation" altogether, if it could be linked in some way to the removal of quota. With the UK less than self-sufficient in milk, there could be extra advantages from letting the industry expand.

Two tier quotas…

The second option examined in the NFU report is a system of A and B quota, akin to that which has operated in the sugar sector for over 25 years.

Milk producers would be able to produce a certain amount (their A quota) with full market support. Any further output (B quota) would be unsupported, sold to the world market without subsidies.

A quota would then be reduced in line with any GATT/WTO commitments, while B quota sales would expand.

But there are drawbacks:

&#8226 Increasing quantities of B quota exports would reduce world prices and, with it, farm incomes.

&#8226 Cheaper imports would undermine high prices for A quota milk.

&#8226 A and B quotas would be a nightmare to administer, given the plethora of milk buyers and quota holders.

&#8226 It may not be "GATT compatible".

Another issue is whether two- tier quotas will help some member states more than others. Those countries which are not large exporters of dairy produce, such as the UK, could do less well out of the system than those that have historically high levels of exports.

There are clearly pros and cons to all these options. But while the NFU report does not make specific recommendations, it hints strongly that price cutting with compensation is the only one that offers a long-term solution.

It is GATT-compatible, could maintain producer income and results in lower costs to consumers (but higher costs to tax payers).

And gross margin analysis, based on various assumptions about milk prices, quota levels and compensation rates, suggests this is the better route in the longer term (see table).

"Under the status quo option, gross margins decline because both prices and quotas are cut," it says. "This could only be offset in the short term by a devaluation of sterling or by compensation.

"B quotas would maintain milk production at the industry level…but they appear to offer little protection to gross margins at the farm level. This is because B quota has been valued at 13p – the world price.

"But a sharp cut in price accompanied by partial compensation and the removal of quotas appears to offer the best long-term protection for dairy incomes when compared to a policy of maintaining quotas in the face of declining tariffs and reduced export subsidies."n


Impact of milk policies on gross margins

(£/cow)19962000200320042005200620072008

Status quo890798797758726686653624

Price cuts890798797649658667676686

Price cuts with890798797779788797806816

compensation

A & B quota890800800763732694662629

Assumptions include:

Status quo – price cut 15% and quota 5% by 2008

Price cuts – price cut 25% by 2004, quotas abolished- compensation paid at 10% of the 1996 price

A & B quota – price cut 15% by 2008, most of it on B quota

Yields increase 2% a year

Variable costs increase 2.5% a year