Phasing out supply management in Canada is not that simple

In a previous post, I have highlighted that supply management will likely be phased out within the next 15 years, either because of trade agreements or because of internal tensions which could morph into fault lines. I have been quite critical of some of the arguments used by the proponents of supply management because they don’t pass the test of facts. I will be equally critical of some of the arguments of the adversaries of supply management.

Martha Hall Findlay and Jack Mintz recently published an opinion piece in the Globe and Mail in which they outline a possible scheme to phase out supply management in Canada. Their proposal is to transpose to Canada what was implemented in Australia following the deregulation of the dairy market in 2000, namely a temporary levy on fluid milk sale to finance a quota buyout to help dairy farmers transitioning to an open market. However, one key element seems to be missing there : geography matters to trade patterns.

The Australian domestic market for fluid milk is, well, quite insulated from any competition. Therefore, substitution by cheaper imports was not a threat to Australian dairy farmers on that specific market.

In the case of Canada, the situation will be very different. If a levy was imposed on any fluid milk sale in Canada while the market is totally open, the retailers would have many incentives to substitute Canadian milk by cheaper US milk. One fact to remember here: the US states neighbouring our border produced in 2014 about 5 times more milk than Canada in its entirety (Wisconsin alone produced more than Canada). The threat of substitution will be very real in the aftermath of a brutal end of supply management. Moreover, such substitution by retailers would happen very quickly, much faster than any adaptation at the farm level.

While operating costs are fairly similar on average between dairy farms in these US states and Canada, capital and labour costs are quite higher in Canada, partly due to unrealized economies of scale. Consequently, to have a chance to compete against US dairy farms, Canadian dairy farms must be given time to transition and realize their economies of scale.

In these conditions, I think that an Australian-style levy on fluid milk would have dire consequences on the Canadian dairy industry.

The current debate has been painting supply management as the last Canadian obstacle standing in the way of the TPP agreement. Obviously, this is not true as many other issues are contentious but too often perceptions are stronger than reality. In the meantime, the dairy industry contributes significantly to the Canadian economy. So, we could say that the stakes are high.

Unfortunately, the public debate is rather poorly informed and too many arguments – for or against supply management – are weak, resorting to wishful thinking, twisting facts. What is particularly missing is foresight. Fortunately, the federal government has a group dedicated to such exercise, Policy Horizons Canada. Perhaps, it could be mandated to lead a foresight study of Canadian supply-managed industries, allowing scenarios with and without supply management in different forms.

The phasing-out of supply management in Canada will be initiated before 2030, regardless of TPP.

The current debate about the TPP negotiations and their consequences for the future of supply management in Canada is not about the merits and benefits of supply management themselves. It is about Canada’s bargaining power in negotiations it has been invited to and to which it may not be an essential party. As of now, it seems that Canada has a rather weak hand and will have to commit to open its dairy market somehow or risk being sidelined. I’m not privy to the negotiations and my opinion has been forged on what has been publicly disclosed.

Supply management has undeniably served the Canadian dairy industry very well, allowing among other thing dairy farmers to increase their income and wealth over the years and two dairy processors (Saputo and Agropur) to develop into major global players. Over the period 1998-2014, the number of dairy farms has been almost halved. Production has increased only by 4%, following a sleepy growth in consumption of dairy products driven by demographics and changes in food consumption pattern. Today, the three largest dairy processors control about 80% of the market. The Canadian dairy industry could be said to be relatively mature. However, even if supply management survives the current TPP negotiations, its future is uncertain as adverse forces are gathering strength, threatening the three pillars of supply management (import control, producer pricing and production discipline) from within.

The strongest force is the weakness of growth potential in the domestic market which, because of supply management, will translate into a marginal production increase. On the processing side, maintaining or increasing margin will then require to lower supply cost, which will result in a downward pressure on milk price and concomitantly in an increased use of imported ingredients which in turn will reinforce the former. In the meantime, and considering productivity gains and labour shortage in dairy production, there will be tremendous pressure to realize some economies of scale at the farm level to limit the ongoing deterioration of profitability in many dairy farms. Even so, more voices getting louder may call for increasing market potential by making it possible to export Canadian dairy products, which would antagonize import control.

Now the second significant force, quota mobility. Pressure to further consolidation at the farm level will certainly build up as previously shown. This will require that quota is made available for purchase. However, the quota exchange market has become rather illiquid over the last seven years or so. This change has been most remarkable in Ontario and Quebec after new regulations of quota exchange were introduced in 2007. A trigger is needed to incentivize the sale of quota. Will it be sufficient to decrease milk price? Shall we lower the existing price cap? Shall we let the price be set freely? Shall quota move unhindered between province? All this in a context where there are expectations to maintain as many dairy farms as possible in as many regions as possible. Quite a catch 22, isn’t it. Some unruly producers may end up challenging production discipline.

The third force is indebtedness arising from the cost of capital which in turn stems from the price of quota. Indeed, one must not forget that acquiring quota is just the first step but a costly one. Additional investments (buildings, equipment, farmland, herd genetics, etc.) are needed to maintain consistent dairy production systems. This will be especially critical in Quebec where almost all dairy barns are of the tied-stall type, which is ill-fitted for the automation of milk production processes. Besides, these barns are ageing, which combined with work overload could make it more difficult to maintain good herd health status and consistent milk quality, both being key to the farms’ competitiveness. Consequently, heavy investments will have to be made over the next ten to fifteen years in order to achieve a full-scale modernization of Quebec dairy production. Meanwhile, the sources of capital available to the Canadian agriculture are essentially restricted to debt. Already indebted farms will thus have to carry on more debt, pressuring their profitability further. Quebec dairy farms will be particularly exposed to that risk. Here, it is worth remembering that, for instance, if the current dairy crisis in New Zealand has indeed been triggered by a sudden drop in price, one of the main structural fault lines has been excessive indebtedness. So, the very economic sustainability of many dairy farms will hinge on higher milk price while the most efficient ones may still prosper in this lower-price environment. Consequently, producer pricing will become even more conflictual as increasingly diverging interests are expressed along the value chain and within different groups of stakeholders.

These conflicting dynamics may give enough strength to centrifugal forces,  make one of the, or all three pillars of supply management crumble. Quebec may well be at the epicenter of this quake.

This is why I think the phasing out of supply management will be initiated before 2030, regardless of any trade negotiations.

Supply management as such is a sound policy. However, it cannot pretend to remain unquestionably relevant forever. This is why I think it is time to engage in a comprehensive review of supply management, followed by an open debate over its future, over the why and how of supply management.

About the future of supply-management and the difficulty to debate it.

After some discussions, it appears that my previous post on supply management (here) has been understood as a manifesto for dismantling supply management. Yet, nowhere in that post, did I convey such opinion. What I wrote is that current dynamics, if not addressed, may lead to the implosion of supply management. So, let me just rephrase my rationale and clarify some of its elements.

Before anything else, we must acknowledge the successes of supply-management for the Quebec economy. The average income of Quebec dairy farmers’ families is now above the average Canadian family, as is their net worth (see table below). Saputo and Agropur have become world-class dairy processors with a global footprint. The milk is of the highest standards of quality and safety. But when looking at the future, one can see some clouds gathering.

income and wealth dairy farmers QC

First, the quota market is currently not allowing any meaningful investment to fulfil the potential productivity and efficiency gains at the farm level. For Quebec, this means that the efficiency gap with other provinces will increase. In the meantime, although there has been a unique opportunity to deleverage, debt is still growing in dairy farms as excess liquidity is directed to non-dairy investments such as farmland. So, we see, on one hand, assets that are accumulating within farms waiting for the right time to exit and, on the other hand, farms turned towards the future that are investing in non-dairy assets and taking on more debt.

When the time will come to re-invest in dairy production, the scale of investment will likely be large (modernization, farm transfer, etc.). Do we know for sure that the farms we think will take on most of these investments will be able to do so ? I do not have a definitive answer to that question but I’m sceptic because, from my time in banking, I remember that the most efficient farms have been among the most leveraged. While they will certainly have some spare capacity to invest, I question the adequation of their aggregate investment capacity to the scale of the investment that will be needed.

That inadequation would become apparent if a major event was to happen, resulting in a significant increase in cost (major drought leading to insufficient feed availability) or fall in price (major disease outbreak linked to popular dairy products). Then, the number of exiting farms may jump dramatically requiring the farms left to take on the missing production capacity over a relatively short period of time. Consequently, I think there is a risk to see production below demand long enough that the processors would have no choice but to import from other provinces (the least damaging to supply-management at the national level but not for the Quebec share of quota) or from the US (once the gates are open…).

Leaving the worst-case scenario aside and considering a more gradual exit of the less efficient farms, the capacity of dairy farms to invest will still be mainly determined by their capacity to take on more debt. And that could happen in a context where there will be pressure to temper milk price increase and where interest rate will increase in all likelihood. It is also worth remembering here that any decrease in quota value may make it more affordable but it also may also markedly decrease the net worth thus limiting the borrowing capacity of farms, especially in cases where the quota had been leveraged a bit too much.

Perhaps all this is far-fetched and I may end up completely wrong. Yet, I have not read or heard anything to convince me there is no risk.

If I had to suggest a way to reform supply management in the dairy industry, I would choose one based on the deregulation of the quota market along with the creation of regional markets and with a cost-of-production benchmark excluding a greater proportion of the less efficient farms. I would add another measure to prevent any lasting overpricing of quota (and the related risk of over-indebtedness) that is to set up limitations in the use of quota as a collateral in credit structuring.

Supply management needs to be reformed and that rethinking might also extend to the objectives of supply management themselves. Quebec, Canada and the world have changed, the dairy industry has changed and so will supply management. This is not a question of ideology ; this is a question of being realistic.

I’m asking these questions because I see a risk that could be managed. I would not mind coming to the conclusion that there is a trajectory for supply management to last and be able to support prosperous dairy farms and processors for another generation. But I maintain that these issues need to be investigated more thoroughly in order to better anticipate the coming of the black swan that will provoke the demise of supply management. Here comes to mind the Titanic, unsinkable until it met an iceberg.

Sometimes it feels as supply-management is a dogma and not a public policy that could be debated and reformed. We should remember that history offers plenty of examples of such dogmas relegated to the museum of ideas.