Managing Climate Risk in Agriculture

Hon. Kim Chance,

Minister for Agriculture, Forestry and Fisheries, Western Australia

Introduction

I am delighted to be here today to officially open the managing climate risk in agriculture workshop. I would like to thank Dr Greg Hurtzler of the university of western Australia and the organisers of today's event for their hard work in putting together the program. I believe this workshop will provide a valuable insight into climate risk and the exciting new methods that are emerging for managing those risks. I would also like to welcome to western Australia our national and international delegates and speakers.

As we all know, many farmers and rural communities are hurting because of adverse seasonal conditions. The disastrous 2002 growing season illustrates that climate variability has a very large influence on crop production and farming systems across Australia. Agricultural production in the grain belt of western Australia is primarily limited by the amount of rainfall and its distribution through the growing season. As a result, western Australian farming systems have some of the highest yield variability in the world.

Western Australian research has shown that to farm successfully, climate risks need to be appreciated and managed well. With farm sizes increasing and farm costs continuing to rise, the importance of tools to assist farmers in better preparing for climate risk is now greater than ever. Information is critical for better preparedness and the themes covered today outline "a positive way for the future".

The four main themes of today's workshop are:

1) Better long-range seasonal forecasts that can prepare farmers for extreme seasons;

2) Management tools that can convert seasonal outlooks and soil moisture reserves into crop yield forecasts;

3) New initiatives for crop and weather insurance, and

4) Farmer adaptation to climate risk.

The state government is committed to assisting farmers to manage climate risk. One of the mechanisms by which the commonwealth and state governments handle seasonal risk is through exceptional circumstances programs.

The exceptional circumstances program provides welfare assistance and business support through the provision of interest rate subsidies for affected farmers. The debate about exceptional circumstances efficiency and effectiveness, and suggestions for improvement, has been on going. The key issue for the program is to continue to move towards progress that will enable producers to self manage risk.

In august 2001, as part of our program of activities to assist farmers in developing risk management tools, the state government established a task force to investigate the feasibility of establishing a commercially viable multi-peril crop insurance product in western Australia. The taskforce, made up of industry, government and independent research personnel, has conducted a thorough investigation of multi-peril crop insurance.

Multi-Peril Crop Insurance (MCPI)

The task force was mindful of the realities of trying to establish a crop insurance scheme here in western Australia, balancing the needs of farmers with the commercial situation faced by the insurance industry. The taskforce has recently provided me with a report, which has a range of recommendations for government to consider.

I will not be commenting on the recommendations at this stage because I want the key stakeholders to have some time to consider the complex range of issues that are involved before they are able to advise me of their views.

The report indicates that while a sustainable MCPI scheme may be possible on the actuarial data alone, the combination of September 11 (2001), the HIH collapse and other factors leading to the present turmoil in the insurance industry, as well as the current severe drought nation-wide which is not part of the actuaries we have, mean that such a scheme cannot be underwritten by the insurance industry at this time.

I have looked carefully at the potential for government support (as a subsidy) to improve the viability of the scheme and this is not beyond reasonable realms of possibility; indeed the report indicates that the level of subsidy required could be less than is currently committed to the EC scheme. But even with the matter of subsidy resolved, the fundamental stumbling block of a complete absence of an underwriting capacity still remains. This issue, while hopefully a temporary matter, is so serious that I am informed that insurers had difficulty obtaining re-insurance for fire and hail insurance last year.

I believe the report provides reason for hope that in the future, when a level of confidence is restored in the insurance industry, a form of MCPI may be possible. While it is disappointing that a MCPI scheme is not possible at present, the work that the taskforce has done in alternative risk management areas, including mutual funds and weather derivatives, open some interesting opportunities that go to the core of today's seminar.

WA farmers have for generations been effectively managing climate risk through a variety of strategies such as diversification in farm and off farm enterprises. Today, with increasing climate volatility, new and innovative products are being developed to assist farmers.

Farm Management Deposit (FMD) Scheme

The farm management deposit (FMD) scheme is designed to assist eligible primary producers with their year-to-year cash flow management. It is delivered commercially through authorised financial institutions such as banks, credit unions and building societies. An FMD allows pre-tax income from profitable years to be set aside to help balance short falls incurred in poorer years. Interest on FMD's is earned at market rates, and tax is paid at the rate relating to the year in which the money is withdrawn.

Tax benefits associated with the FMD scheme require that an FMD be held for a minimum of twelve months in order for it to be eligible. It is worth noting that in response to the 2002 drought, the federal government has announced the introduction of amendments to tax legislation to allow farmers in exceptional circumstances areas to access FMD's that are less than 12 months old and keep the tax benefits. The partial withdrawal of FMD monies will also be permitted without affecting the benefits that accrue to the remaining money.

Farmers in western Australia are taking advantage of the risk management opportunity offered by FMD's with $212.3 million held in FMD's in western Australia as at the 30th June 2002, of which around $ 15 0 million was held by grain or grain / livestock enterprises. The FMD works effectively when farmers have had good years to make substantial deposits to see them through the poorer seasons. Without those good seasons to make deposits or with an extended run of bad seasons the FMD no longer acts as a buffer.

Weather Derivatives

Weather derivatives are products based on indexes that closely monitor the incidence of 'normal' weather patterns over a period of time. Once long-term data has been studied, a payment schedule is set, based on the purchaser's anticipated revenues during the option period.

Payments are triggered if there is a sufficient diversion from the norm that exceeds an agreed trigger. For example, farmers could take out protection against a weather event occurring at a designated recording station, such as receiving less that 300 mm of growing season rainfall. They would receive a payout for each millimetre of rainfall below this, usually up to a capped amount. The idea is that in the event of a drought, a farmer could receive a payment to at least partially compensate for loss in yield.

One of the key advantages of weather derivatives is that they can be used to cover low-risk, high probability events as opposed to most insurance products which cover high-risk, low probability events such a floods or fire. Weather derivative markets have grown rapidly, particularly in the United States, since their introduction in 1997. The energy generation industry has been the main user.

Weather derivatives in agriculture offer the farmer the chance to hedge against the major factors influencing crop yields - rainfall, particularly growing season rainfall, and temperature, to hedge against frost. The demand for weather derivatives will depend on the correlation between climatic events such as rainfall or temperature and yield and hence income.

A number of companies such as Macquarie Bank, AXA and SG are offering weather derivatives or are looking to investigate this market. The potential problem with weather derivatives is that at times there can be a poor correlation between rainfall and yield. To circumvent this problem, researchers and the insurance industry are investigating index-based contracts and the development of models that link rainfall to yield. Such models would offer farmers greater surety as they would know the effect of a weather event and would be able to insure effectively.

Crop coverage index based contracts are largely free of adverse selection and moral hazard problems, and have relatively low start-up and administration costs. For the risks facing cropping, two simple index contracts are area-yield and rainfall contracts.

The problem with existing index contracts is that an individual can experience a loss in crop yield, but the index contract is not triggered hence a payment is not made. This is known as basis risk. It may be possible to narrow this basis risk through the use of technology and modelling.

The western Australian government could have a key role in the future in the development of a suitable index model for farmers, sufficient infrastructure to accurately measure the data needed for the index, and monitoring the information to add to its credibility.

Farmer Mutual Funds

An alternative to the finance industry providing risk management products is the concept of farmer mutual funds. Mutual funds usually operate within specific industries. Claims are usually limited by some ceiling or maximum distribution of the available pool.

To insure against an event requires broad participation, either voluntarily through levies or some other rating basis to pool income to protect those included in the mutual fund. Mutual funds work similarly to insurance but generally without reinsurance for disastrous events or catastrophes. The mutual funds usually do not cover events other than along specifically targeted defined circumstances.

Some of you will remember the banana growers in Carnarvon (WA) had such a scheme in place up until three years ago to assist the re-establishment of banana plantations following cyclone damage.

There are a couple of drawbacks in mutual funds: firstly, the need for the fund to cross subsidise high-risk areas. Unless a weighted pooling levy arrangement, similar to that which would be established in the general insurance market prevailed, it would be difficult to attract the broad cross section of primary producers to ensure a viable and stable fund.

Furthermore, systemic risk is also an issue. If all the growers in the same area were subject to the same catastrophic event the pooled income would be drawn on in one major event. Reinsurance, if available, could help overcome this problem. These drawbacks aside, farmer mutual funds could offer growers the opportunity to develop a suite of risk management options.

Conclusion

In conclusion, there is a clear need for further, more detailed, studies on the management of climate risk. I see this workshop as a good forum to enable us to think about other useful strategies.

I wish to congratulate all of those working in this field for the advances they have made and for sharing this work with us in this workshop.