Trade for (some of the Price) Risks has been Soaring - But if the Market for Risks Fails

1. NJF Seminar: Risk and Crisis Management in Agriculture September 16-17, Uppsala Trade for (some of the Price) Risks has been Soaring - But if the Market for Risks Fails Kyösti Pietola MTT Economic Research Helsinki

2. Outline: • The Trends • Price risks • Yield risks • Weather risks • Three Risk Layers, OECD: • - Normal risks (managed within the firm) • - Tradeable risks • - Catastrophic risks • Market Failures => policies ? • Catastrophic risks: the role of private and public sectors • Concluding Remarks on Future Developments and Policy Interventions • More to the layer of tradeable risks: • e.g. Indirect, Index-type approaches • New potential to design Public Private Partnership • to get the incentives right • decrease likelihood for adverse and catastrophic outcomes • ”Protection first and very necessary financial safeguarding threreafter”

3. 1. Trends: Market for Price risks boosting NEWS RELEASE: CHICAGO, August 9, 2010 ”CME Group Wheat Futures and Options Reach Record Volume – CME Group, the world’s leading and most diverse derivatives marketplace, had record volume Friday in its CBOT wheat futures and options on futures listings of 354,169 contracts. The prior record was 294,345 on August 2, 2010. Additionally, wheat futures alone hit a record 316,053 contracts, surpassing the old record of 263,120 contracts traded on February 27, 2008. ” Loaded at CME web page: Sept 7, 2010

4. Price volatility is increasing Implied price volatilities in 2006-2009, monthly prices (CBOT).

5. Euronext; Milling wheat Futures (delivery at Nov 2010) Price: Euro/tonne The role of Speculators? = 1 mill tonnes Volume: # of contracts per day Open Interest (OI) at Sept 7, 2010: 256,000 contracts, 50 tonnes each = 13 million tonnes ~ 10% from the annual production (130 Mill t) in EU Loaded September 7, 2010

6. Euronext; Malting Barley (delivery at Jan 2011) Price: Euro/tonne Volume: # of contracts per day Open Interest (OI) at Sept 7, 2010: 1,250 contracts, 50 tonnes each = 0,6 million tonnes ~ 1% from the annual production (60 Mill t) of barley in EU

7. Euronext, Malting Barley Futures Visited at Sept 13, 17 p.m

8. Market for yield (quantity) risks • -is there a market ? • Yield risk usually about the same size as the price risk (at least in Finland) • E.g. wheat yield variation (std) 25% of the mean • tailored market based insurances exist • e.g. hailing and frost • ”skorp bildning” in spring (Sweden) • Traditional multiperil crop yield insurance require subsidy • Adverse selection, moral hazard and systemic behaviour • The US: farmer receives 1.8$ return to each dollar invested in the insurance • EU: maximum of 65% support to premium rates • But still not utilized broadly in the member states • Low adoption rates in some countries • e.g. the new multperil crop insurance in the Netherlands: • only 600 farmers adopted

9. Market for yield risks (2) • New potential in developing index based products • based e.g. yield index and/or waether index (weather derivatives) • Low transactions costs • no asymmetric information and adverse selection • no moral hazard and maintain the market based incentives • to invest in informal risk management strategies on the firm • - e.g. drainage, irrigation • BUT EU regulations under the CAP (1st pillar) • require at least 30% observed loss for idemnity payments => Double threshold schemes (e.g. the new Dutch crop insurance) • A threshold of the weather event has to be passed first • and then if it results to at least 30% losses the idemnity is paid

10. Market for weather risk: Weather derivatives • ”Hot and Cold Bets” • Idemnity payment (with a face values) based on the observed weather event, • (not on observed damage) • - weather events exogenous • => no adverse selection (asymmetric indormation) • => no moral hazard • (maintain incentives for informal risk mgmt even if insured • One third of all businesses weather related • => Could trade the risks accross the sectors => better liquidity • CME launched weather derivatives in 1999 • contracts for temperature, hurricanes, snowfall and frost • since then market has been expanding • quoted for 52 cities • 10 cities in Europe, • Stockholm and Oslo in Scandinavia • efficiency?? Correlation with the realized damage (Sami Myyrä) CME = Chicago Mercantile Exchange

11. Stockholm Heating Degree Days (HDD) Monthly Future (D5) Visited at CME Sept 13, 2010

12. New York Heating Degree Days (HDD) Monthly Future (H4) Visited at CME Sept 13, 2010

13. 2. Risk Layers (OECD) Probability of the event Normal:within the firm Investments on Risk reducing technologies, Land allocations, Income diversific Marketable between firms Insurances, derivatives Catastrophic Outcome better than expected Outcome worse than expected Larger and more systemic damage Expected Outcome

14. Catastrophic Risks: • What is catastrophic ? • Policy realm: • Damage becomes catastrophic when it has policy implications and • public compensation becomes poltically appealing: • e.g. a damage that distorts immediate well being of communities • Long term horizon? • Policies react when they have to • Race to the Bottom; Ending to a ”Byss” ?

15. Is the probability of an adverse event exogenous ? => Does the market give right incentives to decrease the likelihood for catastrophic outcomes ? => What are the measures? Probability of the event Public Private Partnership Larger and more systemic damage

16. Public Private Partnersips (PPS): the role of private and public sectors • Getting the incentives right: • - to decrease the likelihood for catastrophic and adverse outcomes • - to expand the regime on tradable risks • The first best solutions: • - emission taxes • - tradable emission permits • (if the aggregate amount of emissions set at right level) • The second best solutions: • e.g. subsidies and tax schields to real investments • in sustainable (green) and new technologies • - but if far away at the distance, • when to invest and • how to discount? • Hyperbolic discounting? • + Financial, co-funding arrangements

17. The most urgent cases first. • May I ask mr. Banker to come in.

18. Co-funding deals between the public & private • Mutual Funds • E.g. mandatory levies used to collect a buffer fund within the sector • If the epidemics hits, the sector pays the losses to the agreed level • If the losses exceed the level the government steps in • and covers the rest • Most common in livestock epidemics, but also in crops • While the industries concentrate, the largest firms getting reluctant • Premium supports • EU reg.: • At max 65% under the first pillar of the CAP, subject to modulation • Idemnities only for observed losses of more than 30% • Has to be paid directly to farmers • Can’t support re-insurance premiums, even if could be more efficient • The goverment quarantees in catastrophic events • if jeopardizes the community well being • has political consequences

19. Concluding remarks • New potential to expand market for yield (quantity) risks • through Index based insurance contracts /derivatives • - Europe: • need to get the constraints out from the EU CAP regulations • New potential in Public Private Partnerships to protect against • catastrophic risks and to get the incentives right • - e.g. investments in green technologies • - the next CAP reform will open new possibilities • Protecting against irreversible damage: • ”Protection first and the very necessary • financial safe guarding threreafter”

20. Tack, Takk, Tak, Aitäh, Pateicība, Padėka, Kiitos!