Choices Magazine, 1st Quarter 2005 · CHOICES The magazine of food, farm, and resource issues 1st...

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CHOICES The magazine of food, farm, and resource issues 1st Quarter 2005 • 20(1) CHOICES 1 A publication of the American Agricultural Economics Association 1st Quarter 2005 • 20(1) ©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the American Agricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org. A Statement from the Editors Welcome to our third issue of Choices. We want to make you aware of several things. Choices is a good place to get your work out. During the period November 1, 2004 to January 31, 2005, our Choices website has had about 216,000 total hits, which represent the total number of requests made to our server. Most of these hits came from the United States, but many are also from countries around the world. We need outreach partners. Please help us reach more people with mailing lists who can join in our outreach partner campaign. See our plea and forms to nominate or agree to be a partner on http://www.choicesmaga- zine.org/outreach.htm. In this regard, we are pleased to welcome several new outreach partners, including Cat- tleNetwork.com, that will consider redistributing our web page and email announcements to their 15,000 subscribers. We are trying to get issues out on time. After this issue, we will strive to publish at the end of each quarter of the year. Please send us content. High-quality issues require high-quality content; we would like to see the profes- sion help us by contributing more content. We would really like to see a significant pickup in the number of thematic submissions and an enhancement in the stream of grab bag submissions. For submission requirements, see http://www.choicesmagazine.org/ submissions.htm. Contents of Vol. 20, No. 1: Washington Scene . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Theme: The Changing Face of Agricultural Lending Changing Face of Agricultural Lending . . . . . . . . . . . . . . . . . . 5 Growing Complexity of Agricultural Lending Decisions . . . . 7 History and Unique Features of the Farm Credit System . . 11 Restructuring of the Ag Lending Markets: The FCS Dilemma15 Selling a Piece of the Farm Credit System. . . . . . . . . . . . . . . 19 Are Rural Credit Markets Competitive? Is There Room for Competition in Rural Credit Markets? . . . . . . . . . . . . . . 25 FCSA Sale to Rabobank: Selling What? On Whose Authority? And For Whose Benefit? . . . . . . . . . . . . . . . . . . . . . . . . . . 31 The New Basel Capital Accord: Implications for US Agricultural Lenders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Agri-lending Vision 2020: When Vision and Reality Meet . 43 Theme: 2005 Markets for Environmental Goods and Emissions Markets for the Environment . . . . . . . . . . . . . . . . . . . . . . . . . 49 Lessons Learned from SO2 Allowance Trading . . . . . . . . . . . 53 The Evolving Western Water Markets . . . . . . . . . . . . . . . . . . 59 The Future of Wetlands Mitigation Banking . . . . . . . . . . . . 65 Crunch Time for Water Quality Trading . . . . . . . . . . . . . . . . . 71 Grab Bag Are E-Grocers Serving the Right Markets?. . . . . . . . . . . . . . . 77 The Farmapine Model: A Cooperative Marketing Strategy and a Market-Based Development Approach in Sub-Saharan Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Comment and Reply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 Coming Attractions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

Transcript of Choices Magazine, 1st Quarter 2005 · CHOICES The magazine of food, farm, and resource issues 1st...

Page 1: Choices Magazine, 1st Quarter 2005 · CHOICES The magazine of food, farm, and resource issues 1st Quarter 2005 • 20(1) CHOICES 5 A publication of the American Agricultural Economics

CHOICESThe magazine of food, farm, and resource issues

1st Quarter 2005 • 20(1) CHOICES 1

A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

A Statement from the EditorsWelcome to our third issue of Choices. We want to makeyou aware of several things.• Choices is a good place to get your work out. During

the period November 1, 2004 to January 31, 2005,our Choices website has had about 216,000 total hits,which represent the total number of requests made toour server. Most of these hits came from the UnitedStates, but many are also from countries around theworld.

• We need outreach partners. Please help us reach morepeople with mailing lists who can join in our outreachpartner campaign. See our plea and forms to nominateor agree to be a partner on http://www.choicesmaga-zine.org/outreach.htm. In this regard, we are pleased towelcome several new outreach partners, including Cat-tleNetwork.com, that will consider redistributing ourweb page and email announcements to their 15,000subscribers.

• We are trying to get issues out on time. After this issue,we will strive to publish at the end of each quarter ofthe year.

• Please send us content. High-quality issues requirehigh-quality content; we would like to see the profes-sion help us by contributing more content. We wouldreally like to see a significant pickup in the number ofthematic submissions and an enhancement in thestream of grab bag submissions. For submissionrequirements, see http://www.choicesmagazine.org/submissions.htm.

Contents of Vol. 20, No. 1:Washington Scene . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Theme: The Changing Face of Agricultural LendingChanging Face of Agricultural Lending . . . . . . . . . . . . . . . . . . 5

Growing Complexity of Agricultural Lending Decisions . . . . 7

History and Unique Features of the Farm Credit System . . 11

Restructuring of the Ag Lending Markets: The FCS Dilemma15

Selling a Piece of the Farm Credit System. . . . . . . . . . . . . . . 19

Are Rural Credit Markets Competitive? Is There Room for Competition in Rural Credit Markets? . . . . . . . . . . . . . . 25

FCSA Sale to Rabobank: Selling What? On Whose Authority? And For Whose Benefit? . . . . . . . . . . . . . . . . . . . . . . . . . . 31

The New Basel Capital Accord: Implications for US Agricultural Lenders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Agri-lending Vision 2020: When Vision and Reality Meet . 43

Theme: 2005 Markets for Environmental Goods and EmissionsMarkets for the Environment . . . . . . . . . . . . . . . . . . . . . . . . . 49

Lessons Learned from SO2 Allowance Trading . . . . . . . . . . . 53

The Evolving Western Water Markets . . . . . . . . . . . . . . . . . . 59

The Future of Wetlands Mitigation Banking . . . . . . . . . . . . 65

Crunch Time for Water Quality Trading . . . . . . . . . . . . . . . . . 71

Grab BagAre E-Grocers Serving the Right Markets?. . . . . . . . . . . . . . . 77

The Farmapine Model: A Cooperative Marketing Strategy and a Market-Based Development Approach in Sub-Saharan Africa. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Comment and Reply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87

Coming Attractions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

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CHOICESThe magazine of food, farm, and resource issues

1st Quarter 2005 • 20(1) CHOICES 3

A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Washington Scene New Proposal for Market-Based Programs—The Clear Skies Act.One of the centerpieces of President Bush’s current envi-ronmental program is the Clear Skies Act, which is cur-rently before Congress. The Act includes cap-and-tradeprograms for three of the main pollutants from electricpower generation: sulfur dioxide, nitrous oxide, and mer-cury. Trading is a central component of the proposed pro-gram as a way to achieve these environmental targets at thelowest possible costs. Critics of the program point to thefact that trading can lead to locally high concentrations; inthe case of mercury, this would have serious health conse-quences.

Market-based Trading for Carbon Dioxide Erupting in Europe.Climate change-related greenhouse gas trading is on therise in Europe. With the recent ratification of the KyotoProtocol, the per-tonne CO2 trading price in Europe has

increased from €6.85 on January 17, 2005 to €10.75 onMarch 9, 2005—a 57% increase. Volume traded in 2005has increased dramatically from almost 3 million tonnesper month for October, November, and December of2004 to about 7 million tonnes in January 2005 and 8million tonnes in February 2005. Through the 9th, 4.69million tonnes have already traded in March 2005. Addi-tionally, the Chicago Climate Exchange is starting a Euro-pean carbon futures market, the European Climate Ex-change (ECX), based on the EU Emissions TradingScheme and traded on the International Petroleum Ex-change in London. There is also the European Energy Ex-change (EEX) that allows trades and which held its firstdaily spot auction on March 9, 2005 with 20,000 tonnestraded.

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Page 5: Choices Magazine, 1st Quarter 2005 · CHOICES The magazine of food, farm, and resource issues 1st Quarter 2005 • 20(1) CHOICES 5 A publication of the American Agricultural Economics

CHOICESThe magazine of food, farm, and resource issues

1st Quarter 2005 • 20(1) CHOICES 5

A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Changing Face of Agricultural LendingDavid M. Kohl and John B. Penson, Jr.

The structure and conduct of agricultural lending hasbeen changing rather dramatically over the past twodecades. However, it took the attempted sale of a largeMidwestern agricultural credit association in the FarmCredit System to a foreign bank to refocus attention onthe implications of these changes.

Some of the forces causing change have been occurringat the farm level, where farmers and ranchers are changingthe way they do business. Other changes have been occur-ring in global markets for agricultural and value addedfood and fiber products. Rapidly changing dynamics areoccurring in technology embodied in inputs and manage-ment of resources and the environment. Finally, evolutionis occurring in the credit market serving agriculture andthe regulations that govern institutional behavior.

In this issue of Choices, we examine a broad range ofissues changing the face of agricultural lending. The agri-cultural lending decision making process is becomingmuch more complex as a result of contractual and owner-ship arrangement issues, locational issues, and manage-ment quality and risk management issues. The FarmCredit System, with its unique structure, faces a numberof issues as it attempts to maintain its competitive positionin light of the evolving farm customer base and activitiesof competitors providing loans and services in this market.The degree of competition in agricultural lending willinfluence quantity and quality of loans made.

Particular attention in this theme is placed on examin-ing the recent attempted purchase of Farm Credit Servicesof America headquartered in Omaha, Nebraska byRabobank, an international financial services lender head-quartered in the Netherlands. Already active in otherregions of the United States, Rabobank offered $750 mil-lion to purchase this component of the Farm Credit Ser-vice last summer. Although this deal ultimately was calledoff, it raises a number of policy and structural issues thatwill be debated in the coming months.

The Basel II Capital Accords, scheduled to be imple-mented by the end of 2006, has implications for settingcapital requirements, supervisory review, and market disci-pline at banking institutions. The measurement and man-agement of credit risk, operational risk, and market risk lieat the heart of Basel II. While implementation will beginat the nation’s largest banks, the more advancedapproaches to calculating capital requirements and othermanagement practices will have implications for otherbanks and nonbank lending institutions as well.

With the many forces changing the face of agriculturallending, this is a good time to examine shifting paradigmsimpacting agricultural lending as it evolves over the next15 years from both the customer side of the market as wellas from the lender perspective. Other contributors to thistheme include Danny Klinefelter, Neil Harl, Michael Boe-hlje, Allan Gray, Robert Jolly, Josh Roe, Maureen Kilk-enny, Roger Ginder, Ani Katchova, Peter Barry, and AliciaMorris. Any remaining omissions or errors are the soleresponsibility of the contributors and editors.

Articles in this Theme:Changing Face of Agricultural Lending . . . . . . . . . . . . . . . . . . 5

Growing Complexity of Agricultural Lending Decisions . . . . 7

History and Unique Features of the Farm Credit System . . 11

Restructuring of the Ag Lending Markets: The FCS Dilemma15

Selling a Piece of the Farm Credit System . . . . . . . . . . . . . . 19

Are Rural Credit Markets Competitive? Is There Room for Competition in Rural Credit Markets? . . . . . . . . . . . . . . 25

FCSA Sale to Rabobank: Selling What? On Whose Authority? And For Whose Benefit? . . . . . . . . . . . . . . . . . . . . . . . . . . 31

The New Basel Capital Accord: Implications for US Agricultural Lenders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Agri-lending Vision 2020: When Vision and Reality Meet . 43

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David M. Kohl is a professor emeritusin Agricultural and Applied Econom-ics at Virginia Tech. Choices co-editorJohn B. Penson, Jr. is Regents Profes-sor and Stiles Professor of Agriculturein the Department of AgriculturalEconomics at Texas A&M University.

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CHOICESThe magazine of food, farm, and resource issues

1st Quarter 2005 • 20(1) CHOICES 7

A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Growing Complexity of Agricultural Lending DecisionsDanny A. Klinefelter and John B. Penson, Jr.

The face of agricultural lending has changed dramaticallyover the last several decades from both a demand and sup-ply perspective. Farm numbers are down, but size is up.The distribution of farms is increasingly bimodal; 2% offarms today produce over one half of total sales. Large-sized operations are capital intensive, utilizing the latesttechnologies embodied in variable and fixed inputs toexpand productivity and lower costs. The use of debt capi-tal in agriculture has reached an all-time high. Total farmdebt outstanding today is up almost 50% from 1990 andnow exceeds the peak debt outstanding before the farmfinancial crisis in the mid-1980s. These borrowers areincreasingly sophisticated in their marketing strategies,alliances, and use of available information technology.

There has also been considerable change in the lendersproviding loans to farmers. The Farm Credit System(FCS), which accounts for 38% of real estate farm debtand 22% of non-real estate farm debt, has transformeditself from 12 farm credit districts down to just four FarmCredit Banks (FCBs) and CoBank, which serves coopera-tives nationwide in addition to its affiliation with majoragricultural credit associations (ACAs) on both coasts. Therecent failed attempt by the Dutch banking conglomerateRabobank International to purchase one of the largerACAs in the FCS raised a number of policy issuesaddressed by other papers in this theme. Commercialbanks, the largest commercial lender to farmers, accountfor 33% of real estate farm debt and 49% of non-realestate farm debt outstanding. The credit delivery system atboth lenders has changed considerably in recent years,with credit scoring and information technology playing amajor role in credit decisions and resulting in efficiencygains in terms of decision turnaround and cost of opera-tions. Other lenders to farmers and ranchers are undergo-ing change as well.

This paper focuses on the drivers of change at the farmlevel and emerging credit analysis issues. The remainingpapers in this theme provide background on and discussthe implications of the attempted Rabobank purchase ofan ACA, the implications that the Basel II Accords havefor lending and portfolio decisions by agricultural lenders,and a look at where agricultural lending may be headedover the next several decades.

Drivers of Change at the Farm LevelThere are a number of forces that will drive further changein agricultural lending in the next few years. These driversin turn will influence credit analyses and portfolio man-agement decisions at agricultural lending institutions.

For starters, the next farm bill will likely see severalchanges that will affect agricultural lending. This includesthe potential de-emphasis on commodity safety nets (loandeficiency payments and countercyclical payments) as wellas direct payments and increased emphasis on revenueinsurance for a broad range of crop and livestock com-modities. Continued programs may involve payment limi-tations and needs testing. Other policy-related driversinclude issues related to water rights, zoning, and otherregulations dealing with odor, dust, chemicals, and noisein agricultural production. Finally, macroeconomic poli-cies affecting the general economic health of the domesticand global economies will also affect farm profit marginsand debt repayment capacity.

Environmental, food safety, and bioterrorism concernswill also drive changes in production at the farm level.Regulations governing input use such as fertilizer andchemicals can affect both yields and the cost of produc-tion. Traceability in production processes and other Envi-ronmental Protection Agency (EPA), Federal DrugAdministration (FDA), and Homeland Security regula-tions can also affect the cost of production but could have

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positive effects on demand if theseregulations give consumers greaterconfidence in finished goods.

International competition andglobalization will affect trade flowsand market shares for agriculturalproducts and hence affect the pricesreceived by farmers. Supply anddemand conditions in China alonecan have a substantial impact in theglobal marketplace. Brazil may alsosurpass the United States in terms ofproduction of major commodities inthe foreseeable future. These trendswere happening before NAFTA andrecent WTO rulings. The ultimateimpact on US farmers will dependupon the relative efficiency and com-parative advantage of competitornations, including the United States.Although commodity prices may beglobal, production costs are local.Avocado production in Mexico, forexample, requires no irrigation,whereas irrigated water representsCalifornia avocado growers’ singlelargest input cost. This makes Mex-ico growers extremely competitivewith California growers. Absent ofquality differences between Mexicanand Californian avocados, one wouldexpect declining prices for avocadosin US markets as Mexican growersgain broader access to markets in theUnited States. The general competi-tiveness of US farmers in global mar-kets will also depend on exchangerates, trade agreements, and the agri-cultural policies of competitornations.

Farm involvement in integratedsupply chains will also influence thestability and profitability of farmborrowers. By enhancing the predict-ability of quality and supply to insti-tutional buyers, these relationshipsensure a market, and hence the sta-bility of sales by farmers. Alliances,joint ventures in input use and pro-duction, and new forms of business

relationships will also lead to changesat the farm level.

Finally, other potential drivers ofchange at the farm level include thecost and availability of water, the costand availability of capital, the Inter-net and the availability of decisiontools online, biotechnology and itsaffects on the cost and productivityof crop and livestock production, andfarm operations producing nontradi-tional differentiated products such asspecialty grains.

Lenders will need the expertise tounderstand these drivers of change.Forming expectations of future debtrepayment capacity requires lendersto understand the business relation-ships and environment in which theirborrowers make decisions.

Emerging Credit Analysis IssuesAs farms become larger and morecomplex, a number of issues arebeginning to arise that will challengetraditional agricultural lenders. Themeasurement and assessment of riskevolving from the Basel II CapitalAccords described in the paper byKatchova and Barry (in this issue)implies the need for using moresophisticated probability-of-defaultanalysis tools for large exposures.Furthermore, the growing complex-ity of loan approval and portfoliomanagement means the skills andknowledge lenders need to possess isgoing to change significantly. Theremainder of this article identifiessome of more significant issues we seeemerging in credit analysis.

Alliances, contractual relation-ships, joint ventures, and interlock-ing ownership arrangements arebecoming increasingly common asthe food and fiber system movestoward coordinated supply chains.The analysis process will have to con-sider the terms and conditions of

these arrangements and how risks areshared between the parties involved.Sorting out how costs and returns areallocated and accounted for will alsopresent a challenge. These arrange-ments will also raise questions con-cerning ownership interests, liability,and the methods of legal recourseunderpinning them.

Multiple entities, multiple own-ers, and the various interlockingownership and contractual arrange-ments will also magnify the impor-tance of relationship risks. Inaddition to the previously mentionedfinancial and legal aspects, equallyimportant are issues related to thecommitment to the arrangement bythe parties involved, compatibilityand complementarities of manage-ment styles and philosophies, inaddition to potentially different goalsand objectives. Relationship risks arealso not limited to interfirm arrange-ments. The interpersonal relation-ships within the closely heldmultiple-owner businesses are just assignificant. Family business special-ists frequently refer to preparing forthe four D’s: death, disability,divorce, and departure. Theattributes of and need for buy-sellagreements between the parties,including their spouses, to addresshow different events will be handledwill be an increasingly important fac-tor in assessing business continuityand viability.

Many of the multiple entity rela-tionships will be between agricultur-ally oriented businesses andbusinesses for which agriculture isonly a minor part of their businessportfolio. Many current agriculturallenders do not have the training orexperience to assess the credit risksassociated with these firms’ nonagri-cultural business activities.

Evaluating the creditworthinessand business performance of hori-

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zontally and vertically integratedfirms will be far more challengingthan traditional agricultural lending.The diverse and unique combina-tions of assets found in these firmsare going to involve unique creditunderwriting standards.

Although technical knowledge offarm operations has been a prerequi-site for success of lenders in the past,the successful loan officer of thefuture will need to evaluate the eco-nomic value of alliances, informationsources, and coordination methods.

Historically, farmers have oper-ated in a limited geographic area,which allowed lenders to not onlybecome familiar with the productionpractices, but also to have the abilityto physically monitor performanceand conditions. But that is changingrapidly. Geographic diversification isno longer limited to farming in dif-ferent counties. Many farm opera-tions are now spread over severalstates, and some are even multina-tional in scope. A significant numberof US farmers are already operatingin Argentina, Brazil, and Mexico.Not only are the production andmarket risks different, but the issuesof coordination and control, as wellas different economic, political, andlegal risks, will also need to be con-sidered.

Since the mid-1980s, agricul-tural lenders have placed muchgreater emphasis on cash flows andprofitability; however, most farmloans are still asset-based transac-tions. One of the major changesoccurring in agriculture that willchallenge traditional lenders is theshift from hard to soft assets as theunderlying strength in the bor-rower’s business. In addition to thehuman resources of the business(which we will focus on next), con-tracts, brands, patents, leases, alli-ances, buy-sell agreements, and

franchise arrangements are importantto the overall performance and viabil-ity of the business. These “soft assets”will represent challenges from thestandpoint of both risk assessmentand business valuation.

The implications of this trendwill be profound for agriculturallenders. First, the financial perfor-mance of farm operations willbecome increasingly dependent onmanagement and returns to manage-ment, rather than the ownership ofand returns on assets. Managementwill entail not only operations andmarketing skills internal to the firm,but also successful negotiation oflinkages with suppliers and proces-sors or distributors and having theproper external partners.

The human/management factorhas always been recognized as a keyto the success of any business or lend-ing relationship. But the assessmenthas largely been subjective or basedon measures associated with past per-formance. In the future, the primarybasis for a business being able tomaintain a sustainable competitiveadvantage will be management’s abil-ity to learn and adapt faster than itscompetition. Assessing management’sability and willingness to innovateand adapt, as well as whether thebusiness is structured in a way as topermit sufficient flexibility, will be amajor challenge. This is particularlytrue because managers go throughlifecycles in which their attitudetoward adapting to change and tak-ing on new risks tends to change overtime. A key element here will beassessing the breadth and depth ofthe management team, how decisionsare made, and whether there is a clearsuccession plan and basis for succes-sor selection. Another emerging issuethat will complicate managementassessment is the trend toward out-sourcing and pooling of specific

management services and decisions.In these situations, the evaluation ofmanagement quality will not be lim-ited to the business’s internal capac-ity.

The increasing emphasis on riskmanagement by lenders, regulators,and business owners is also spurringthe development of new risk manage-ment products and strategies. Someare and will be insurance products;others will be various forms of deriva-tives. New futures and options mar-kets and different forms of risk-mitigating contractual arrangementsare appearing or being proposed inalmost every market. Unfortunately,most risk management tools canincrease risk as much as they canreduce it, if the tools are misunder-stood or not used properly. Therewill also be issues related to howthese tools and markets are under-written and regulated. The ability toassess and become knowledgeableabout these emerging developmentswill challenge both farmers and theirlenders.

Historically, most agriculturalproducts have been sold in opencommodity markets. Much of theremainder has been produced undersome form of production or market-ing contract. Developments in bio-technology are just beginning tocreate what will eventually becomesignificant markets in specificattribute raw materials for both con-sumer and industrial products. Whilehomogeneous commodity invento-ries represent a fairly definable levelof inventory risk, these new productswill add a new dimension in terms ofpotential attribute quality deteriora-tion and technical obsolescence. Justas clothing fashions, computer hard-ware, and pharmaceutical productscan experience rapid devaluation inlight of the development of new sub-

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stitutes, the same will be true forthese agricultural inventories.

Most lenders recognize theimportance of evaluating trends andcycles when analyzing agriculturalloans. The increasing emphasis onvalue-added business activities andniche marketing is going to requireeven greater emphasis on the need toevaluate market entry and exit strate-gies. This will be true for both lend-ers and borrowers. Historically, mostanalysis has focused on trends as ifthey were linear. The acceleration inthe speed of information transfer,globalization, and changes in con-sumer tastes and preferences andtechnological developments haveresulted in some trends becomingexponential. Timing has always beenimportant, but the early identifica-tion of tipping points, in terms ofboth getting into or out of a market,is becoming critical. The need forcloser monitoring and recognizingthat much of the impetus for changewill come from outside the businesswill be increasingly important in theanalysis process, the design of infor-mation systems, and the identifica-tion of leading indicators.

Related to the previous point isthe ability of lenders to evaluate stra-tegic risks when assessing both indi-vidual loans and portfolio risk. Theimportance of environmental scan-ning is going to become more impor-tant. Although significant changesand events can be envisioned, theirprobability of occurrence is oftenextremely low and frequently will bethe result of events or developmentsoutside the borrower’s industry. Thescope of the scanning process, theunderstanding of interrelationships,and the identification of leading indi-cators in markets largely unfamiliarto traditional agricultural lenders willpresent new challenges.

Most agricultural lenders areknowledgeable about the details ofthe various farm programs and therules and regulations associated withenvironmental programs. However,as a result of increasing concerns andregulations associated with bioterror-ism, food safety, and developments inbiotechnology, compliance withHomeland Security Administrationand FDA regulations may be associ-ated with greater liabilities than tra-ditional farm programs. These

programs not only will present theneed to be knowledgeable about awider range of regulations, but moni-toring compliance may often be moredifficult and more costly.

Summary and Theme OverviewThere have been major changes tothe face of agricultural lending overthe past several decades. Many of theforces driving these changes haveoccurred at the farm level. Lendershave adapted to these changes inaddition to changes in technologythat permit greater efficiency in theiroperations. Lenders will have to con-tinue to adapt to the increasinglycomplex and uncertain environmentin which their clientele operate. Inshort, the future promises continuedchange to the face of agriculturallending.

Danny A. Klinefelter is a professorand extension economist and Choicesco-editor John B. Penson, Jr. isRegents Professor and Stiles Professorof Agriculture in the Department ofAgricultural Economics at TexasA&M University.

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CHOICESThe magazine of food, farm, and resource issues

1st Quarter 2005 • 20(1) CHOICES 11

A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

History and Unique Features of the Farm Credit SystemNeil E. Harl

The proposed buyout of Farm Credit Services of America(FCSA) by Rabobank in late July 2004, and the subse-quent rejection of the offer by the FCSA board in lateOctober 2004, focused attention on the uniqueness of theFarm Credit System as a national cooperative lender toagriculture, on congressional expectations for the system(inasmuch as the system was created by successive congres-sional acts), and on the very unusual tax status of the FarmCredit System, especially the Federal Land Bank segment.The proposed Rabobank buyout posed the policy questionof whether a buyout of a component of the Farm CreditSystem was inconsistent with the statutory and regulatoryframework of the system.

The matter of expectations of the stockholders of thebuyout target was also highly relevant but the proposedbuyout did not progress to the point of assessing stock-holder positions on the matter.

History of the Farm Credit System

Early HistoryBy 1912, politicians found it universally popular to prom-ise that strong measures to deal with the farm credit prob-lem would be taken by government. In that year, all threepolitical parties (Republican, Democratic, and Progressive)adopted platform planks calling for strong rural credit leg-islation. As early as 1908, President Theodore Roosevelt’sCountry Life Commission had recommended a coopera-tive credit system that would provide agricultural credit tofarmers and ranchers on fair terms.

Compromises or reconciliation of such polarized con-cepts—the one system private, the other public—proveddifficult. Congress tied both plans together and adoptedthem into a single enactment as the Farm Loan Act of1916.

Thus, the Land Banks and their affiliated associationscame into being in 1916, because farmers had an urgentneed for more and better long-term mortgage financing.Money was scarce in most rural areas, and when lenderscould be found, costs usually were high. Every few years,mortgages had to be renewed or refinanced. There was theever-present danger that renewals or a new lender wouldnot be available.

After the wartime prosperity of 1918–1920, Americanagriculture fell into a deep depression, and the Federalland program and its private counterpart, the joint stockland banks, were unable to provide the needed credit.

In the early 1920s, the War Finance Corporationendeavored to establish a program for short-term agricul-tural credit. Congress, responding to the nation’s depressedrural economy, enacted the Agricultural Credit Act of1923, which established the Federal Intermediate CreditBanks to finance and discount the paper of agriculturalcredit organizations, commercial banks, savings institu-tions, and cooperatives, in order to channel funds to indi-vidual farmers for their operating needs.

The Great DepressionThe nationwide depression that deepened in 1929 andcontinued into the 1930s accelerated the problems of ruralAmerica. Upon assuming office, President Roosevelt actedquickly to establish a means to revive financially the farmeconomy. By Executive Order, the President created theFarm Credit Administration, thereby concentrating thesupervision and authority over the foundering rural assis-tance programs.

Thereafter, Congress enacted the Farm Credit Act of1933, establishing a system of production credit corpora-tions and associations, with financing from the FederalIntermediate Credit Banks, to provide operating loans tofarmers on a short-term credit basis. That legislation also

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brought into the Farm CreditAdministration the banks for cooper-atives. In the same year, the Emer-gency Farm Mortgage Act providedfor refunding and revising the opera-tions of the Federal Land Bank asso-ciations to meet the problems of farmforeclosures and debt defaults.

In the late 1960s, it becameincreasingly apparent that the system,which was based on several underly-ing statutes, should be recodified,updated, and made ready for theyears ahead.

In 1985, in the midst of a deep-ening farm debt crisis characterizedby low commodity prices, high farmdebt-to-asset ratios, and steeply fall-ing land values, the Farm Credit Sys-tem banks held some $6 billion inloans in which the face amountexceeded the value of the collateral.Increasing amounts of nonaccrualand other high-risk loans ($10 billionin September 1985), record losses,and increasing acquisition of prop-erty through foreclosure or liquida-tion severely strained the resources ofthe system, with individual banksand associations in danger of col-lapse. In response to the growing cri-sis, Congress passed the Farm CreditAct Amendments of 1985 which (a)reorganized the central administra-tion of the system to make the FarmCredit Administration a more inde-pendent, arm’s-length regulator ofthe System; (b) increased the FCA’senforcement powers; and (c) createdthe Farm Credit System Capital Cor-poration to assist the system as aready source of financial assistance.Although the act did not appropriateadditional funds for the FCA, it didprovide the Department of the Trea-sury with discretionary authority toprovide financial assistance after cer-tification of need from the FCA.

The Agricultural Credit Act of1987 provided for reorganization of

the Farm Credit System in terms ofpowers and capitalization. FederalLand Banks and Federal IntermediateCredit Banks within each districtwere merged.

Under the Agricultural CreditAct of 1987, on consolidated or sys-tem-wide obligations, each bank wasresponsible for obligations issued onits own behalf and jointly and sever-ally liable on other obligations ascalled upon by the Farm CreditAdministration. After five years, theFCSIC fund was to be exhaustedbefore a bank was asked to be liablefor other banks’ obligations.

The Agricultural Credit Act of1987 created an FDIC-type fund forthe Farm Credit System. The newfund was designated the Farm CreditSystem Insurance Corporation(FCSIC). The 1987 legislation alsocreated the Farm Credit SystemFinancial Assistance Corporation(FCSFAC) to provide capital to FCSinstitutions experiencing financialdifficulty.

The Exit FeeThe payment of the exit fee in theproposed Rabobank buyout in 2004was of importance because (a) muchof the capital involved, which washeld as unallocated earnings, wouldflow out of FCSA and, in large mea-sure, outside the four-state area tobenefit other FCS borrowers in otherstates; (b) payment of the fee woulddiminish the amount to which stock-holders would be entitled; and (c) theexpected income tax consequencesmeant that the US government andthe respective states would be majorbeneficiaries of the payment of theexit fee.

Payment of the exit fee, estimatedto total nearly $900,000,000, was tobe paid by FCSAmerica out of unal-located surplus—not by Rabobank.

The exit fee is based on the aver-age daily balances of assets and liabil-ities for the 12-month periodpreceding the termination date withadjustments. To calculate the fee,assets are multiplied by 6%, and thatamount is subtracted from total capi-tal. Thus, the exit fee is all capitalabove 6% of assets.

The exit fee is paid to the FarmCredit System Insurance Fund. Theexit fee could have been avoided if abuyout or merger were to occur withanother Farm Credit System unitwith the full amount of the feeretained within the system.

Income Tax ImplicationsThe income tax implications areimportant because of the impact onthe purchase price (the greater thenegative income tax consequences,the lower the purchase price) and thepotential effect on the amount avail-able for distribution to stockholders.

History of Exemptions from Income TaxIncome earned by the Federal LandBanks (FLB) and the Federal LandBank Associations (FLBA) is exemptfrom federal, state, municipal, andlocal taxation. The exempt status wasprovided for in the original act creat-ing the Federal Land Banks in 1916(the Federal Farm Loan Act) and hasbeen continued in subsequent legisla-tion.

Bonds, debentures, and otherobligations issued by Federal LandBanks are exempt from all taxes otherthan federal income tax. This makesFederal Land Bank bonds moreattractive to the investing public. Theexemption benefits security holdersand also allows securities to be pricedmore favorably.

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Effect of the Agricultural Credit Act of 1987 on FLBThe FLB and FLBA exemptions werecalled into question by the IRS fol-lowing the enactment of authority inthe Agricultural Credit Act of 1987,allowing the merger of Federal LandBanks into an Agricultural CreditAssociation (ACA). The InternalRevenue Service ruled on three occa-sions that Agricultural Credit Associ-ations (created upon the merger ofFederal Land Banks and ProductionCredit Associations under the Agri-cultural Credit Act of 1987) were notexempt from income tax from long-term lending activities previously car-ried on by a predecessor Federal LandBank or Federal Land Bank Associa-tion.

FCSA is listed as an AgriculturalCredit Association. However, a fed-eral district court in Fargo, NorthDakota held that the Federal LandBank exemption from income taxcould continue after 1987. In thatcase, an ACA was formed by themerger of an exempt FLBA (offeringlong-term land loans) and a nonex-empt Production Credit Association(PCA) offering short- and intermedi-ate-term loans. The income from theACA’s long-term land loans was heldto be exempt. The court said that toconclude that Congress intended todeny the continuance of the exemp-tion would be “illogical and absurd.”The court said that no specific lan-guage was needed for the long-termland loan income exemption becauseit already existed and was incorpo-rated by reference. Thus, FCSA hascontinued to enjoy an exemption ofincome from long-term land lending.

Taxation of Other Units of FCSAThe production credit lending ofFCSA has continued to be subject tocooperative taxation rules.

The special tax status of coopera-tives involves patronage refundswhereby a percentage of the patron-age earnings (80%) is retained by thecooperative, with 20% of the earn-ings paid out to the member aspatronage. The income tax on theentire amount is paid by the patron.For earnings not classified as patron-age, the cooperative (other than thoseearning exempt income) pays incometax on the earnings at the corporaterate.

Treatment of the Exit FeeThe proposed buyout of FCSA byRabobank also raised a questionabout the income tax consequencesof payment by FCSA of the exit feethat was expected to total nearly$900,000,000. Inasmuch as earningsfrom the Federal Land Bank (andFederal Land Bank Associations) areexempt from income taxes, paymentof the exit fee out of tax-exemptfunds raises a question of whether thepayment would subject tax-exemptearnings used to pay the fee to federal(and state) income tax. That is thecase under well-established tax prin-ciples.

Because of a 1992 US SupremeCourt case, which held that fees andcosts associated with a merger oracquisition were not deductible buthad to be amortized over a lengthytime period, there would have beenno offsetting deduction.

Taxation of Other Exempt EarningsIt was also unclear how the remain-ing tax-exempt earnings in FCSAwould be taxed and to whom (FCSAor Rabobank) upon completion ofthe transaction or at a later time.

The United States SupremeCourt has long held the view thatwhen a new corporation succeeds tothe rights and powers of an old cor-poration, the new corporation is not

entitled to the old corporation’s spe-cial statutory exemptions, includingexemptions from taxation, in theabsence of an express provision in astatute.

Therefore, it appeared thatRabobank would not have succeededto the tax-exempt status enjoyed byFCSA for long-term land loans.Thus, the remaining tax-exemptearnings would have been subjectedto tax, probably upon takeover.

No Guidance Requested from IRSApparently, a private letter ruling hadnot been requested from the InternalRevenue Service on the exit fee issue,the issue of tax reporting by stock-holders of the purchase price (whichwas payment for the interest of thestockholders in FCSAmerica), andthe issue of taxation of the remainingtax-exempt earnings inside FCSA.

Policy ImplicationsThe question still remains (and willpersist until the Congress revisits theissue) of whether it was the intent ofCongress from 1916 to the present toallow a buyout of part or all of theFarm Credit System by a private-sec-tor lender. This is an important pol-icy issue that deserves a full-dressdebate in Congress with an opportu-nity for all points of view to be heard.If that is not done, the stage will beset for another buyout proposal atsome future time, which will likelyproceed under the assumption thatinaction by Congress indicates acqui-escence in the idea of a private-sectorbuyout. The public interest in thisissue goes well beyond the publicresources that have been invested inthe system over nearly 90 years.

At a minimum, if Congressdecides to allow private sector buy-outs, a clear legislative roadmapshould be enacted showing the

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income tax consequences, whenthose consequences are triggered, andwho bears liability for the tax.

Neil E. Harl is Charles F. CurtissDistinguished Professor in Agricul-ture and Emeritus Professor of Eco-nomics, Iowa State University.

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©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Restructuring of the Ag Lending Markets: The FCS DilemmaMichael Boehlje and Allan Gray

The recent initiative by Rabobank to expand their busi-ness in agricultural production lending in the UnitedStates through the acquisition of Farm Credit Services ofAmerica surfaced considerable debate about the appropri-ateness and desirability of that acquisition. But in reality,the question is much more fundamental: Given the dra-matic restructuring of the agricultural capital markets withrespect to both the changing customer base and the chang-ing competitors, how can the cooperative Farm Credit Sys-tem (FCS) maintain its competitive position?

The Changing Customer BaseFarm and agribusiness firms are becoming increasinglycomplex in their size, structure, organization, and interde-pendent relationships. The financing needs and uses offunds by these more complex agribusinesses are challeng-ing traditional lenders to consider new lending policiesand procedures.

For example, many farms operate farming businessesnot only in different counties than their home base, buteven in different states or different countries. This broadergeographic domain challenges the delivery system of afunding organization that does not match that domain.Likewise, more farmers are entering value-added busi-nesses and new ventures beyond the farm gate. Some ofthese new ventures include such business arrangements asvalue-added production systems in the livestock industry,ethanol and biodiesel plants, and other downstream activ-ity. Farmers are also acquiring assets in the input supplysector of the agricultural industry and even in nonagricul-tural sectors. This increased scope of business activity byfarmers challenges a lender who has limited capacity tooffer financial products and services in other industries.Farmers are also increasing their financial product/servicedemands, including cash management services, asset man-agement services, risk management services, payroll ser-

vices, and so forth; a lender must offer a broader product/service bundle to serve this increasingly demanding cus-tomer base.

An additional change in the agricultural credit marketis how farmers may access their lender. Increasingly, foodcompanies and processors are developing qualified sup-plier or franchise grower arrangements with a limitednumber of preferred producers. These processors are serv-ing as value chain coordinators and in many cases are facil-itating their franchise growers’ acquisition of pricediscounts and preferred customer relationships in the feed,chemical, and equipment businesses. It is not illogical thatsimilar arrangements would be developed with credit orfinancial providers. Thus, a value chain coordinator mayfacilitate access on the part of their franchise growers to anational or global lender who can provide the broader setof products and services their growers need. In essence, thetraditional lenders to agriculture—commercial banks andthe Farm Credit System—may need to compete and col-laborate with value chain integrators to provide total sys-tems solutions including inputs, product merchandising,risk management, and financial products and services togrowers participating in vertically aligned value chains.

In essence, the farm customer base is changing pro-foundly in terms of the traditional domain and boundarieswith respect to geography, line of business, product/serviceneeds, business model, asset control, and utilization andbuying behavior.

The Changing Competitor LandscapeThe US agricultural credit market has been dominated inthe past by domestic commercial banks and the Coopera-tive Farm Credit System, but that dominance is increas-ingly being challenged in a number of importantdimensions. The recent entry of Rabobank into the USfarm production lending market has resulted in a global ag

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lender that is one of the highestcredit-rated banks in the world chal-lenging US-based agricultural lend-ers. Agriculture has suddenly becomea sector attracting global and interna-tional bankers and is no longer theexclusive domain of US-based lend-ing institutions.

Noninstitutional lenders are alsoimportant to the farm sector,accounting for almost 25% of thenon-real estate and real estate creditin agriculture (Ryan & Koenig,1999). Captive finance companies, inparticular, have become much morepermanent in recent years with loanvolumes growing rapidly; it is esti-mated that manufacturers and dealersnow have a 25% market share of theintermediate-term non-real estatedebt market for commercial farmers(Dodson, 1997). The recent expan-sion of captive finance companiesappears to be driven more by per-ceived profit opportunities in financerather than marketing strategies tosell excess inventories, suggesting thatthese companies are more likely to bepermanent participants in the marketthan in the past.

Financial leasing arrangementsare also growing rapidly—estimatesare that one fifth of commercial cropfarmers lease machinery and equip-ment (Dodson, 1997). In themachinery, equipment, and facilitymarket in particular, leasing compa-nies affiliated with manufacturers (aswell as independent leasing compa-nies) are expanding volume at dou-ble-digit rates. The unique financingthat captive financing and leasingcompanies emphasize—along withrelatively efficient origination, servic-ing, and collection procedures—fre-quently enables them to providecredit services at an equal or lowercost and with more convenience thantraditional institutional lenders.

The FCS ChallengesThe aforementioned changes in thecustomer base and competitorspresent challenges to lenders who cannot or do not respond in maintainingtheir market position and presence. Itis essential for any lender to antici-pate and respond to changing cus-tomer needs and expectations, tooffer products and services that arepreferred in pricing, service, andother features to that of the expandedofferings of their competitors, and todeliver that product/service effi-ciently and effectively. Regulations orbusiness policies that limit a lender’sresponses to changes in the market-place clearly put it at a competitivedisadvantage.

The Regulatory/Policy ChallengeA fundamental challenge that will befaced by the Farm Credit System isthat of the regulatory and policyregime that shapes its business focusand activities. This challenge in real-ity involves two interrelated issues:(a) regulations that define thedomain of the Farm Credit Systemwith respect to customer and line ofbusiness focus, geographic bound-aries, and product/service offering;and (b) Government SponsoredEnterprise (GSE) status.

The first issue of focus anddomain of the Farm Credit System ispossibly the most straightforward toassess. If the characteristics of boththe customers and the competitorsevolve as discussed earlier, the FarmCredit System will be increasingly ata competitive disadvantage in servingthat changing customer base. Dereg-ulation with respect to a broader setof loan products and financial ser-vices that would be attractive to bothcurrent and future grower and agri-business customers, as well as otherbusinesses in rural communities,

would allow the Farm Credit Systemto serve its current and prospectivefuture customers more effectively.Furthermore, as will be discussedshortly, a more diversified customerbase would allow the system to moreefficiently allocate its risk capital,thus increasing its competitivenesswith other global financial institu-tions.

However, broadening the scopeof lending and provision of financialservices does not come without acost. First, one of the benefits ofbeing a specialized lender is that ofunderstanding the industry and tai-loring the product/service offering tothat industry. If broadening the focusof the Farm Credit System results inless effective and efficient delivery ofcredit and other financial products toits current customer base, FCS willnot be fulfilling its legislatively man-dated mission, and the cost may off-set the benefits. Furthermore,attempts to expand lending authorityof the Farm Credit System will likelybe met with resistance from otherlenders—commercial bankers in par-ticular. It is highly likely that thequid pro quo required by commercialbankers, if the Farm Credit Systemwere to obtain expanded lending andfinancial service authority, would bethe elimination of GSE status andfavorable tax treatment received bycertain Farm Credit System entities.

The critical issue, then, is howmuch the cost of sourcing fundswould increase without GSE statuscompared to the cost reduction thatwould occur if FCS were a morediversified lender due to reducedequity capital requirements per dollarof loan funds. The costs and benefitsof GSE status can not be adequatelyanalyzed without taking into accountthe prospects of a more risk-efficientuse of capital if the portfolio weremore diversified.

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The Capital Market ChallengeAn increasingly important challengethat must be faced by all financialinstitutions (including the FarmCredit System) is that imposed by thecapital markets to efficiently allocateand utilize risk capital. This chal-lenge will be intensified with thephased-in implementation of theNew Basel Accord concerning alloca-tion of risk capital for all financialinstitutions worldwide. The increas-ingly competitive market conditionsall institutions (including coopera-tives) will face in sourcing equity cap-ital and compensating providers ofequity capital at competitive rates ofreturn on their investment willrequire financial firms to be moreprudent with the use of their equitycapital.

A fundamental tenet of risk man-agement and efficient equity capitalallocation in any financial institu-tion is that of diversification: Riskcan be mitigated and equity capitalmost efficiently allocated when theinstitution has a diversified (in con-trast to a specialized) portfolio ofassets. This tenet is in direct conflictwith the specialized focus of FCSlending that, as a function of regula-tory policy and business practice, hasvery explicit boundaries concerningits geographic, line of business, prod-uct/service offering, and market seg-ment domains. In essence, the FarmCredit System has been and contin-ues to be a specialized lender thatcannot take advantage of diversifica-tion to manage risk. System membersare thus forced to maintain a higherequity capital position to managethat risk compared to a more diversi-fied financial institution. The systemmay need to maintain its currenthigh level of equity capital—almostdouble that of other financial institu-tions—if it remains as a specialized

agricultural lender that cannot diver-sify. However, it is clearly overcapital-ized compared to a diversified lenderlike Rabobank that can loan to manydifferent industries in many geo-graphic locations in the world. More-over, from the perspective of currentborrowers, this equity capital is“locked up,” and consequently haslimited current value.

The “excess” equity capital con-cern is very fundamental—one couldargue that if the Farm Credit Systemoperated without current geographic,line of business, product/serviceoffering, and customer segmentationboundaries, the equity capitalrequired would be reduced withoutincreasing the financial risk andpotential loss exposure of the system.This concern was in fact acknowl-edged by FCS of America when theboard reconsidered and rejected theRabobank offer, indicating it wouldimplement policies to more rapidlyredeem or repay its patron retains,thus allocating retained equity capitalback to the shareholders.

But, a partial redemption of theequity capital may not solve the fun-damental problem of efficient riskcapital utilization—a specializedlender by definition must maintain ahigher equity capital position tomanage the higher level of risk itfaces. Even further consolidation ofthe current FCS entities would notgenerate the risk mitigation advan-tages of more line of business diversi-fication. Over time, if capital marketinvestors, including those who pro-vide equity capital to financial coop-eratives such as the Farm CreditSystem, recognize that they are notand can not receive a competitivereturn on that capital as long as theinstitution maintains its specializedfocus, they will move their capitalelsewhere or support the transition tomore diversification, unless that

institution is clearly providing otherbenefits not available in the marketplace.

With the significant changes incustomers and competitors notedearlier, it is likely to become increas-ingly difficult for the Farm CreditSystem to maintain its competitiveposition under the current regulatoryenvironment that limits its scope. Anexpanded scope could provide for asystem that is more responsive totoday’s competitive environment. Inaddition, a broader scope for the sys-tem may allow for a more risk effi-cient allocation of equity capital thatwould continue to attract investors.However, an increase in scope wouldrequire substantial changes in thecurrent regulatory environment ofthe system, which may lead to theloss of GSE status. In addition, abroadening of scope and reduction inregulatory requirements may lead tofurther consolidation of the system.These costs will need to be weighedagainst the benefits of broader scopeas the system determines its competi-tive strategy moving forward.

For More InformationDodson, C. (1997). Changing agri-

cultural institutions and markets: The farm credit outlook. Presented at USDA’s Agricultural Outlook Forum ’97, Washington, DC.

Duncan, M., & Stam, J.M. (1998). Financing agriculture into the Twenty-first Century. Boulder, CO: Westview Press.

Moss, L.M., Barry, P.J., & Ellinger, P.N. (1997). The competitive environment for agricultural bankers in the U.S. Agribusiness, 13(4), 431-444.

Ryan, J.T., & Koenig, S.R. (1999, February). Who holds farm oper-ator debt? Special article in Agri-cultural Income and Finance, AIS-

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76 Economic Research Service, Washington, DC, pp. 47-52.

Michael Boehlje is a professor andAllan Gray is an associate professor inthe Department of Agricultural Eco-nomics at Purdue University.

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Selling a Piece of the Farm Credit SystemRobert W. Jolly and Josh D. Roe

On July 30, 2004, the Directors of Farm Credit Servicesof America (FCSA), an association of the farmer-ownedcooperative Farm Credit System (FCS), announced thatthey had agreed to a purchase offer from Rabobank, an in-ternational financial services company headquartered inthe Netherlands. This announcement set off howls of pro-test from within the FCS and from some FCSA membersand public officials. It was also greeted with restrained gleeby some bankers and other FCSA members. Three monthslater, the FCSA Board terminated the sale negotiation.Shortly thereafter, their CEO resigned and the board fol-lowed up with several full-page ads in local newspaperspledging their (and management’s) commitment to mem-bers and to the principles of cooperation. In demonstra-tion of their renewed commitment, the Board recently an-nounced patronage programs for 2004 and 2005—thefirst ever by this association.

Unexpected and unprecedented events are generallyinteresting in their own right. But they also give us an op-portunity to examine long-held views and plumb what liesbeneath the surface in markets, institutions and publicpolicy. The Rabobank/FCSA deal is one of those seismicevents.

The Players in BriefSometimes you do need a scorecard to tell the playersapart. Here are thumbnail sketches of the major players in-volved in the Rabobank/FCSA deal.

The Farm Credit System (FCS) is a nationwide farmer-owned and -governed financial cooperative. It currentlyprovides $95 billion in short- and long-term loans tofarmers, ranchers, fishermen, rural home owners, agricul-tural processing and marketing operations, farm-relatedbusinesses, farmer-owned cooperatives, rural utilities, andcertain foreign and domestic entities engaged in interna-tional agricultural trade. Loans are funded not by depositsbut rather through the sale of FCS securities in globalmoney markets. The FCS was chartered and initially capi-

talized by the federal government following passage of theFederal Farm Loan Act in 1916. The motivation for creat-ing the FCS was to provide a source of credit for agricul-tural mortgages at rates and terms that banks would not orcould not meet—whether due to cost or inadequate com-petition. Although the FCS now provides a wide range offinancial services to its designated customer base, slightlymore than 50% of its business still comes from agriculturalreal estate lending. Since the FCS is a creation of the feder-al government, it is both a business and an instrument ofpublic policy. It is privately owned (all public equity hadbeen repaid by the 1960s) and governed by its members.But it is considered an instrumentality of the federal gov-ernment when it sells securities. All income from agricul-tural real estate loans is tax-exempt. The size of the FCS,its collective liability for its debt, and its historical ties tothe federal government result in an “implied guarantee” onits securities if the assets of the Farm Credit System Insur-ance Corporation were to be exhausted. This permits theFCS to borrow funds at a cost only slightly above the fed-eral government. In exchange for these benefits, the FCS isrequired to serve exclusively rural and agricultural creditmarkets. The rationale for this bargain has been to ensurethat credit is available to rural markets that might be aban-doned by banks or other commercial lenders.

The FCS is organized into five regional banks. The re-gional banks fund a variety of associations serving smallergeographic markets. Farm Credit Services of America is anassociation of the FCS. It is funded by Agribank, FCB, lo-cated in St. Paul, Minnesota. FCSA provides approximate-ly $7.7 billion in loans to farmers and rural home ownersin Iowa, Nebraska, South Dakota, and Wyoming. TheFCSA is owned and governed by about 53,000 members.(45,000 have voting rights.) The members are representedby a 17-member board. Following cooperative principles,FCSA is owned by those who use it and is governed on aone member, one vote basis.

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Rabobank Group is a century-oldmember-owned bank based in theNetherlands. Its historical roots re-semble those of the Farm Credit Sys-tem. It was started in response to ru-r a l c r e d i t p ro b l e m s i n t h eNetherlands. Farm and agribusinesslending constitute a long-standingcore competency. Rabobank oper-ates in 38 countries with an asset base(at the end of 2003) of approximately$500 billion. Rabobank has operat-ed in the United States for the past23 years specializing in agribusinesslending. However, in 2002 Ra-bobank began to implement their“country banking” strategy with abroader focus on production agricul-ture and rural credit markets. In fair-ly rapid succession, they acquiredValley Independent Bank in Califor-nia, Lendlease Agribusiness Divisionin Missouri, and Ag Services ofAmerica in Iowa. These acquisitionsgave them toeholds in rural commu-nity banking, agricultural real estate,and agricultural input financing, re-spectively. Rabobank’s country bank-ing strategy has been successfully im-plemented in a number of countries.For example, in 1994 Rabobank ac-quired the Primary Industry Bank ofAustralia (PIBA), an established lend-er with a comfortable loan portfolio.Since acquisition, Rabobank has sig-nificantly expanded its lending activi-ties more broadly throughout thecountry and the agricultural and agri-business sector. Rabobank continuesto finance food and agribusinessfirms in Australia as well. A similarpattern of acquisition and growth inrural, food, and agribusiness financialmarkets has been implemented re-cently in New Zealand and Ireland.Rabobank has fostered a reputationas a committed agricultural lenderwith exceptional safety and sound-ness ratings.

The Farm Credit Administration(FCA) is the regulatory agency forthe FCS. Its primary role in oversee-ing the Rabobank/FCSA transactionwas to ensure adherence to the legalprocess required for an FCS bank orassociation to leave the FCS and toapprove or disapprove the proposal.If approved by FCA, the proposalwould then be submitted to theFCSA stockholders for vote.

The OfferSo, here is the deal. Initially, Ra-bobank offered current FCSA mem-bers a $600 million cash buyout forthe assets of the association—loans,personnel, customer base, and facili-ties. The payment would be allocatedbased on current patronage or out-standing loan balances. This cash of-fer was eventually increased to $750million. An exit fee of approximately$800 million would be paid to theFCS Insurance Corporation fromFCSA surplus. The calculation of theexit fee is specified in the 1987 FarmCredit Act and is based on an associa-tion’s capital relative to its assets. Itcan be viewed as a payment for thebenefits received by the associationfor being part of the system. In addi-tion, Rabobank would need to payoff the $6.2 billion credit line fromAgribank funding FCSA’s existingloan portfolio.

Good Deal or Not?At the time the deal was announced,the directors identified a number ofbenefits for FCSA members:• a broader set of financial services,

including access to internationalmarkets;

• competitive cost of funds due toRabobank’s AAA credit ratingand size;

• a cash payout from FCSA capitalsurplus; and

• an opportunity to slip the bondsof the FCS and to serve a broaderarray of rural households andbusinesses.Opponents to the sale also ex-

pressed concern that:• Most of the financial services that

Rabobank could offer were orcould be offered by FCSA.

• The FCSA could develop apatronage program—as mostFCS associations have alreadydone. Patronage programs wouldserve as an alternative means formember/borrowers to share inthe earnings of their cooperative.

• The cash offer was too low, givenFCSA’s assets and earnings.

• The current members wouldobtain the cash from the sale, butbecause it wasn’t clear how muchof the cooperative’s capital wasdue to the patronage of formermembers, the former memberswould be out of luck.

• The exiting association wouldleave a significant hole in theFCS that the FCA would berequired to fill either by expand-ing the territory of existing asso-ciations or chartering a newassociation. Resources for eitheroption might have to partiallycome from equity contributionsof other FCS banks and associa-tions.

• If FCSA were allowed to secede, amass exodus of other associationscould follow.

• Rabobank, although ostensiblycommitted to agriculture, wouldbe free to follow profit opportu-nities in any market. This com-mitment to rural finance wouldbe much more flexible than thelegislation governing the FCS.

• Finally, many FCSA memberswere concerned about the loss ofcontrol over an organization that

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1st Quarter 2005 • 20(1) CHOICES 21

they had built and relied on fornearly 80 years.

Why Sell When You Can Merge?Shortly after the Rabobank/FCSAdeal was announced, AgStar, anotherAgricultural Credit Association serv-ing parts of Minnesota and Wiscon-sin, presented the FCSA directorswith a merger proposal. The mergeroffer included a cash payout to FCSAmembers of $650 million and con-solidation of administrative offices.Further, because this was a mergerand not an exit, the exit fee would beavoided. However, the FCSA boardrejected the AgStar offer at the sametime as the termination proposal.

What Were They Thinking?The Rabobank and FCSA folks areno dummies. Yet, this deal is vaguelyreminiscent of the introduction ofNew Coke. The negative reactionfrom many members, as well as partsof the agricultural community, wasquick and strong and seemed tocatch the proponents of the sale offguard. Rabobank’s stated objective inpurchasing the FCSA was to enter anew rural credit market. This strategyof enter, transform, and expand hasplayed out reasonably well in othermarkets. In singling out the FCSA,was Rabobank attracted to the mar-ket? The firm? Or was it an opportu-nity for a bargain? The answer, itseems, is all of the above.

Figure 1 traces the current valueof farm operator assets and debt inthe FCSA trade area. Note that sincethe end of the 1980s, nominal creditvolume has grown steadily but slow-ly—around 3% annually. Also notethat outstanding non-real estate debtis nearly equal to real estate debt inthis market. And because the value offarm assets has increased at a muchgreater rate than debt, nominal net

worth (and hence potential collater-al) has grown significantly.

Figures 2 and 3 show the changesin market share for major lendersserving the short- and long-termmarkets in the FCSA trade area.Commercial banks are clearly thedominant non-real estate lender. TheFCS and other (mostly nontradition-

al) lenders have made some inroadsin recent years. One of the moststriking features of the real estatemarket is the gain in market shareachieved by commercial banks—from dead last in the early 1980s tothe top of the heap 15 years later.

A quick perusal of this informa-tion reveals a mature market—slow

Figure 1. FCSA trade area farm assets and liabilities—1961–2004.

0

20

40

60

80

100

120

140

160

180

200

61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03

Year

$ bi

llion

Total assetsNon-real estate debtReal estate debtTotal debt

Figure 2. FCSA trade area non-real estate farm debt market share by lender—1981–2004.

0

10

20

30

40

50

60

70

80

90

100

81 83 85 87 89 91 93 95 97 99 01 03Year

Mar

ket s

hare

(%)

BanksFCSAFarm Service AgencyOthers

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22 CHOICES 1st Quarter 2005 • 20(1)

growth in credit volume with existingfirms battling for market share. Theapparent winners of this zero-sumgame are the banks. FCSA’s totalfarm debt market penetration is rela-tively low—less than 22% in thefour-state area compared with about50% for banks in 2004. This con-trasts with FCS penetration national-ly of 30% and more than 40% insome markets such as Michigan orOhio. Keep in mind, too, that manyof the commercial banks serving thismarket are small closely held busi-nesses. Small size imparts highercosts, loan limits, and a reliance onlocal deposits—hardly strategic as-sets for a mature market.

Was FCSA a plum to be picked?In Table 1 we compare financialcharacteristics of FCSA with twoother associations. Farm Credit Ser-vices of Mid-America serves farmersin the eastern Corn Belt and isroughly the same size as FCSA. Ag-Star is smaller, but has had a patron-age program in place for the past few

years. Again, a quick look suggeststhat FCSA’s performance measuresare generally weaker than the othertwo associations. In particular, notethat FSCA earned a lower return onits assets and member capital. Thelower charge-off rates, while admira-ble for being low, may indicate arather conservative lending philoso-phy. This is supported by the factthat FCSA tended to favor real estatelending. Non-interest expense ishigher, despite the fact that real estatelending is usually a lower cost busi-ness compared to short-term lending.And, FCSA is certainly sitting on apile of capital.

Finally, FCSA could have beenattractive because it was offered at afavorable price. Space doesn’t permita complete discussion of this topic.However, capitalizing earnings cansuggest a value. In Table 2 we showcapitalized values for a range of in-comes and required rates of return.As a reference point, we use $115million (the average income for

FCSA for the past three years) and anominal return of 12%. The analysisis very simple—but it does suggestthat a $600 or $750 million offermight have been a tad low.

SeismologyThere is no question that the Ra-bobank/FCSA deal shook up farm-ers, lenders, and public officials. Anumber of questions stemming fromthis transaction merit considerationand answers:

If FCSA is attractive to a privatefirm, are the various legislative andtax preferences granted to the FCSjustified? Or have changes in farm

Table 1. Average financial measures, 2001-2003 for selected farm credit associations.

FCS A

mer

ica

FCS M

id-A

mer

ica

AgSt

ar

Average assets ($ billion)

$6.99 $7.26 $2.23

Return on average assets

1.77% 2.07% 2.20%

Return on average total capital

10.78% 12.78% 16.30%

Net interest income/earning assets

2.83% 2.27% 3.07%

Net charge-offs/average loans

0.09% 0.20% 0.17%

Real estate loans/total loans

70.2% 35.2% 40.7%

Average loan interest rate

6.06% 6.28% 6.25%

Permanent capital ratio

14.23% 14.90% 12.63%

Retained earnings/assets

16.10% 15.08% 10.68%

Non-interest income/assets

0.74% 0.47% 0.47%

Non-interest expense/assets

1.60% 0.62% 1.06%

Wages/assets 0.85% 0.39% 1.14%

Figure 3. FCSA trade area real estate farm debt market share by lender—1981–2004.

0

5

10

15

20

25

30

35

40

45

50

81 83 85 87 89 91 93 95 97 99 01 03Year

Mar

ket s

hare

(%)

BanksFCSAFarm Service AgencyInsurance companiesOthers

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1st Quarter 2005 • 20(1) CHOICES 23

structure and information technolo-gy moved us to a point where the tra-ditional problems of rural credit mar-kets—distance and information—nolonger require unique institutions orpolicies? The same questions arisesimply from the growth in real estatebacked lending by banks. If deposit-based lenders can profitably make ag-ricultural land loans, is government-sponsored enterprise status still need-ed for the FCS?

Do rural credit markets need in-creased competition? Most lenders,particularly community bankers,would argue that they have to workhard enough as it is to attract depos-its and originate loans. Nonetheless,agricultural lending remains a frag-mented industry, and fragmented in-dustries frequently leave money onthe table. Rabobank’s interest in thismarket suggests there could be somegains from further consolidation.

Organizations generally don’tspend much time working on proce-dures for events that they don’t thinkwill occur. The FCA regulations andthe FCSA’s bylaws that govern exitfrom the FCS appear to be incom-plete. Two major stumbling blocksarose as a result of the FCSA pur-chase. The statutorily required exitfee did not appear to reflect the fullvalue of the benefits an associationderives from being part of the FCS.And, because the association had nothad an earnings patronage programin the past, there was no way to link

property rights of former members tothe capital surplus and the earningpotential of the association.

Some financial cooperatives suchas the FCS (or credit unions, for thatmatter) do not pay patronage (twothirds of FCS associations do pay pa-tronage). The benefits to members inlieu of patronage may appear in otherforms—lower loan rates, more officelocations, or better-trained person-nel, for example. But an unwilling-ness to pay patronage dividends cancreate an unaccountable cash flowthat may result in expense preferenc-es and other managerial mischief. Infairness, following the 1987 bailoutof the FCS, a growing capital surpluswas a goal of the system so that gov-ernment assistance could be repaidand the FCA could be assured thatnone would be required in the future.If some capital is good, perhaps moreis better. However, patronage alloca-tion of at least some earnings can beaccomplished along with goals forcapital growth. It is clear that man-agement of FCS capital and patron-age needs a careful look.

Effective governance is critical inboth cooperatives and investor-owned firms—as the stockholders ofEnron will surely attest. When direc-tors and their hired managers take ac-tions that produce an uproar on thepart of members or investors, boththe governance process, as well as itsperformance, need to be carefully re-viewed and strengthened. Coopera-tive boards, in particular, must workto overcome an inherent conflict ofinterest, because they are memberswho represent members.

Finally, perhaps the time hascome to take FCS off its leash. TheFCS might trade off its tax preferenc-es and instrumentality status for thefreedom to seek opportunities in abroader market. The FCS is uniquebecause it is a financially strong co-

operative with a national infrastruc-ture and reach, 80 years of rural lend-ing experience, and an enviableability to source loanable funds.With those assets and a rural creditmarket that appears to offer some op-portunities, the FCS may be ideallysuited to compete on a leveled play-ing field to the benefit of rural Amer-ica. Such a bold stroke, however,should only be considered if the his-torical mission that underlies the cre-ation of the FCS could be assured—the dependable and permanent sup-ply of credit for all segments of theagricultural sector.

Links• Farm Credit Services: http://

www.farmcredit.com• Farm Credit Services of America:

http://www.fcsamerica.com• Rabobank: http://

www.rabobank.com• AgStar: http://www.agstar.com• AgriBank: http://www.agrib-

ank.com• Farm Credit Services of Mid-

America: http://www.e-farm-credit.com/Default.aspx?2-18

• Farm Credit Administration:http://www.fca.gov/FCA-Home-Page.htm

AcknowledgmentsThe authors would like to thankJohn Moore, Farm Credit Adminis-tration, Roger Ginder and Neil Harl,Iowa State University, and John Pen-son, Texas A&M, for valuable sug-gestions.

For More InformationBarry, P.J. (2004). FCS of America’s

organizational choices: Sale to Rabobank, merger with AgStar or Status Quo? University of Illinois. Available on the World Wide Web: http://www.farm-

Table 2. Estimated bank value ($ million).

Required rate of return (%) Income ($ million)

Nom

inal

Real

110

115

120

9 5.8 1,897 1,983 2,069

12 8.7 1,264 1,322 1,379

15 11.6 948 991 1,034

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24 CHOICES 1st Quarter 2005 • 20(1)

doc.uiuc.edu/finance/publica-tions/FCSA%20Rabobank%20Agstar%20choices.pdf.

Jolly, R.W., Ginder, R.G., & Harl, N.E. (2004). Understanding the proposed sale of Farm Credit Ser-vices of America. Ames, IA: Iowa State University. Available on the

World Wide Web: http://www.econ.iastate.edu/rabobank-buyout/.

Novack, N., & Henderson, J. (2004). Termination of the Rabobank and Farm Credit Ser-vices of America sale. The Main Street Economist. Center for the Study of Rural America, Federal

Reserve Bank of Kansas City. Available on the World Wide Web: http://www.kc.frb.org/RuralCenter/mainstreet/MSE_1104.pdf.

Robert W. Jolly is a professor andJoshua D. Roe is graduate researchassistant in the Department of Eco-nomics, Iowa State University.

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CHOICESThe magazine of food, farm, and resource issues

1st Quarter 2005 • 20(1) CHOICES 25

A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Are Rural Credit Markets Competitive?Is There Room for Competition in Rural Credit Markets?Maureen Kilkenny and Robert W. Jolly

Talk to a country banker these days and the first subjectwill likely be competition—cherry picking by the FarmCredit System, sneaky tax-free credit unions, captive fi-nance companies hawking credit as a loss leader, invest-ment houses siphoning off deposits, and so on. It’s a longlist and an old refrain. But it reveals an important ques-tion: How hot is the competition in rural credit markets?If it’s not hot enough, we could expect credit rationingthat limits economic growth. If it is too hot, there is a riskof declining credit quality and failure of financial institu-tions, which would also limit growth.

Our interest in this topic is motivated, to some extent,by the recent bid by Rabobank into the Western CornBelt. That event suggested that profit opportunities mightexist in rural credit markets. But there is a broader issue aswell. Rural credit markets are often fraught with ineffi-ciencies. Remoteness—frequently in association withpoorly defined property rights, rule of law, and poverty—can make it difficult to extend credit to rural households,farms, or firms. This problem is widespread in developingand transitional economies. And, historically, it has been aproblem in rural areas in the United States—one that hasbeen dealt with by creating unique rural lending institu-tions, public policies, and other interventions.

In this paper we attempt to take the temperature of thecompetitive forces in rural credit markets in 12 Midwest-ern states. A recent review by economists at the USDA’sEconomic Research Service pointed out that the averagerate of return on rural-headquartered bank assets has beensystematically higher than the return on urban bank assets.The review presented a number of indicators suggestingthat rural credit markets may be less than perfectly com-petitive. Rural banks charge higher interest rates on loans,pay lower interest rates on deposits, and take fewer risks.

The authors argued, however, that the small size of ruralcommunities and the low number of rural borrowersmight limit the number of lenders that can profitablycompete in rural counties. And, since 1997, the number ofbank firms has continued to decline.

Bank market structure has changed in recent decades,consolidating from a peak of 14,000 firms in 1983–4 toabout 7,800 today, according to the FDIC. In his reviewof the structural changes in the nonmetro financial servicesector, Lence concluded that the decline in the number ofbank firms has been driven by bank stockholders’ searchfor return on equity (Lence, 1997). Bank consolidationhas been made possible by the relaxation of policy restric-tions against branch banking over the past 20 years. Merg-ers of smaller banks have been driven by the opportunityto achieve economies of size and geographic and marketportfolio diversification. But at the same time we have ob-served new bank branches opening in rural credit markets,along with a host of nonbank lenders. The fact that thenumber of bank offices has increased since the 1980s from55,300 to more than 75,000 in 2004 may suggest that ru-ral citizens have more access to bank credit than ever. Let’stake a look at the landscape in rural credit markets.

Table 1 reports numbers and types of bank offices inthe urban and rural counties in 12 Midwestern states. Thetypes of banks that operate in rural areas are more oftenunit banks (banks with no branch offices outside the head-quarter county) or small community banks with a fewbranch offices all in the same county. On average, there arefive or fewer bank firms operating in strictly rural coun-ties. There are twice that many competitors in larger non-metro counties and more than 30 bank firms competing inthe average central metro county in the US Midwest.

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26 CHOICES 1st Quarter 2005 • 20(1)

Distance insulates rural banksfrom competition, so even smaller,less efficient banks may thrive there.Distance can also insulate high-profitbanks from competition. Even ifthere are no barriers to entry (otherthan fixed costs), space imparts mar-ket power because lenders can affordto charge nearby customers higherrates without fear of losing them tomore distant competitors, becausedistance increases the costs of moni-toring loans. By the same token, theproximity of the lender to the bor-rower, and their participation in thesame social networks or communityinstitutions can improve opportuni-ties for loan origination and makeapplicant screening and monitoringmore efficient. Relationship lendinghas been shown to be essential to abank’s competitiveness (Moss, Barry,& Ellinger, 1997). In addition, be-cause bricks-and-mortar banks arelumpy, sparsely populated countiesmay simply be too small to justify theconstruction of an additional bankoffice. Banks are required to obtainapproval to enter a new market fromthe relevant regulatory agency. Part of

this approval process involves justify-ing that there is a need for additionalbanking services in the local market.

In sum, financial intermediariesin rural areas may be able to price-discriminate without losing their ru-ral customers, because other potentiallenders are effectively too far away(Degryse & Ongena, 2004). Pricediscrimination and barriers to entrymay result in less credit being extend-ed in rural areas than is optimal. Totest if these conditions exist, we canexamine data on commercial banksfor indicators of above-normal profit-ability and indicators favoring entryinto the region’s credit markets. Anobvious shortcoming of this ap-proach is that we are not able to fullyaccount for competition from otherrural financial intermediaries. But itis a place to begin—particularly giv-en the market share dominance ofbanks in rural credit markets.

To determine if rural banks pos-sess exploitable market power, wehave to account for the fact thatmany banks operate in more thanone location. This includes banksthat are headquartered in rural areas

but operate as either as a multibankholding company or simply have sev-eral branches, as well as large money-center banks that branch into ruralareas. To begin, we estimate the mar-ket power enjoyed by a bank byweighting the bank’s share of eachmarket in which they operate by themarket’s share of the bank’s total de-posits. Then we estimate the profit-ability of a bank in a location byweighting the profitability of eachbank with an office in the location bythat bank’s share of the total depositsin the location. A bank may havemarket power, but if it isn’t profitingfrom it, we conclude it is not exploit-able—that the markets are sufficient-ly competitive. Finally, we test thehypothesis that a location’s profitabil-ity is sufficient to induce entry.

We analyzed the data on all thebanks with offices in the Midwest,including more than 4,000 bankfirms and their offices by countyacross five Federal Reserve districts in12 Midwestern states: Illinois, Indi-ana, Iowa, Kansas, Michigan, Minne-sota, Missouri, Nebraska, North Da-kota, Ohio, South Dakota, and

Table 1. Average banks and bank offices by county type (US Midwest, June 2001).

County typea Code # firms% unit bank

% below $100m # offices

% community bank offices

Metro HQ (“urban”) Central metro 0 33 16% 7% 161 32%

Fringe metro 1 11 20% 18% 25 55%

Mid-sized metro 2 14 14% 10% 50 34%

Small metro 3 13 24% 18% 36 55%

Nonmetro HQ (“rural”) Large nonmetro, adjacent 4 12 23% 22% 25 63%

Large nonmetro, nonadjacent 5 10 30% 31% 19 73%

Mid-sized nonmetro, adjacent 6 8 30% 37% 13 76%

Mid-sized nonmetro, nonadjacent 7 7 30% 39% 10 79%

Rural, adjacent 8 5 31% 53% 7 83%

Rural, nonadjacent 9 4 32% 56% 5 86%

a Beale Code definitions are as follows. Metropolitan counties (0–3): 0—central counties of metropolitan areas of 1 million population or more; 1—fringe counties of metropolitan areas of 1 million population or more; 2—counties in metropolitan areas of 250,000–1,000,000 population; 3—counties in metropolitan areas of less than 250,000 population. Nonmetropolitan counties (4–9): 4—urban population of 20,000 or more, adjacent to a metropolitan area; 5—urban population of 20,000 or more, not adjacent to a metropolitan area; 6—urban population of 2,500–19,999, adjacent to a metropolitan area; 7—urban population of 2,500–19,999, not adjacent to a metropolitan area; 8—completely rural (no places with a population of 2,500 or more) adjacent to a metropolitan area; 9—completely rural (no places with a population of 2,500 or more) not adjacent to a metropolitan area.Note. Data from FDIC.

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1st Quarter 2005 • 20(1) CHOICES 27

Wisconsin, as reported to the FDICon June 2000, 2001, and 2003. Wefound significant evidence of roomfor more competition in credit mar-kets. Banks that control larger sharesof the deposits in the counties inwhich they have offices have earnedabove-normal profits. This evidenceis consistent with the hypotheses thatthe market power rural banks have isexploitable. Banks with superiormanagement or production technol-ogies who are insulated from compe-tition by distance, or who differenti-ate their financial products, havebeen able to exercise and profit frommarket power in the Midwest. Thepercent of loans to farmers or backedby farmland also supports higherprofits for commercial banks.

Figure 1 shows the counties withunusually few competitors. The blue-shaded counties are counties wherethe banking market is quite competi-tive and the market power of any onebank is low. The orange-shaded

counties are where one or a few bankshave unusually large shares of the de-posits, indicated by a high Hir-schman-Herfindahl Index. Thesecounties are low on competition. Be-cause our statistical analysis indicatesthat banks with low competition doearn higher profits, it is into thesecounties that a bank may considerexpanding.

Next, we investigated whetherthe profitability of banks in a countyhas in fact been sufficient to induceentry into a county in the recent past.Between 2001 and 2003, the numberof bank offices rose by 1,600; in alltypes of Midwestern counties exceptrural counties adjacent to metropoli-tan ones (FDIC data; Table 2). Thelargest rate of growth in offices was incounties with towns larger than20,000 that are not adjacent to metroareas. Midwestern rural counties con-tinue to be much denser in terms ofbank offices per person than urbancounties. Because there are already

more bank offices per person in non-adjacent rural areas than any othertype of county, there was little expan-sion in those counties. But despitethe emergence of e-banking, theprofitability of being physically closeto one’s customers was apparentlysufficient to justify the existence ofone brick-and-mortar bank office per1,000 persons in the totally rural ar-eas of the Midwest (Table 2).

In our statistical analysis wefound that existing banks did indeedopen additional offices in profitablelocations. But the profitability hasnot been sufficient to entice newbank firms into those counties—justnew offices of existing banks. Bankoffice coverage also appears to be dif-fusing across space. More new officeshave opened in places where officedensity is lower; especially in urbanareas where there were fewer officesper capita, but also in nonadjacentrural areas where there were fewer of-fices per square mile. Nevertheless, in

Figure 1. Low-competition counties.

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28 CHOICES 1st Quarter 2005 • 20(1)

rural counties adjacent to metro ar-eas, there were bank and office clo-sures.

In particular, Figure 2 shows thecounties that display the conditionsthat recently inspired existing banksto open new branches. These arecounties where the rate of return on

bank assets has been unusually highand the number of bank firms is un-usually low. The map highlights the106 Midwestern counties (10% ofthe total 1,047) worth a closer look.These hot spots are colored red.These counties are where the returnson bank assets, weighted by the share

each bank has of all the deposits inthe county, are more than one stan-dard deviation above average. Theblue counties are where the banksthat operate there are not profitable.One may also infer that some ofthose blue counties may be placeswhere there are just “deadbeat”

Table 2. Bank firm and office entry.

2001 2001-2003, % change

County typea Code # firms # officesOffices/ 1,000

cap # firms # offices POPOffices per

capita

Central metro 0 33.0 161 0.27 4.9% 12.0% 2.1% 9.7%

Fringe metro 1 11.3 25 0.35 5.3% 5.0% 4.3% 0.7%

Mid-sized metro 2 13.5 50 0.33 6.8% 5.7% 1.5% 4.2%

Small metro 3 12.7 36 0.35 6.8% 7.6% 1.0% 6.6%

Large nonmetro, adjacent 4 12.0 25 0.38 2.0% 2.3% 0.3% 2.0%

Large nonmetro, nonadjacent 5 10.2 19 0.41 7.8% 10.8% -0.3% 11.2%

Mid-sized nonmetro, adjacent 6 7.6 13 0.50 3.0% 3.3% 0.6% 2.7%

Mid-sized nonmetro, nonadjacent 7 6.7 10 0.59 3.3% 3.4% -0.6% 4.0%

Rural, adjacent 8 5.3 7 0.73 -1.6% -0.2% -0.3% 0.1%

Rural, nonadjacent 9 3.6 5 0.91 1.0% 1.4% -1.4% 2.8%

a See Table 1 footnote for Beale Code definitions.

Figure 2. High-profitability counties.

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banks, whose rates of return on assetsare low because of poor management.Those counties may also be areaswhere more efficient banks couldprofitably open new branches.

Many of the potentially attractivecounties are in South Dakota andNebraska. By the way, those twostates are served by Farm Credit Ser-vices of America, the agriculturalcredit association that Rabobank re-cently bid to acquire. Sixty-five per-cent of the hot spots are completelyrural counties, with no towns largerthan 2,500. Metro counties are out-lined in green. Although only 2% ofthe region’s metro counties look at-tractive for entry, over 13% of thenonmetro counties may be. We con-clude that there is room for morecompetition in rural credit markets.

Further market research is neededto understand if these might be at-tractive locations for bank office en-try, expansion, or takeover. Censusdata indicates that some of these ru-ral hot spots have high Native Ameri-can populations. That makes somesense if banks in casino areas are un-usually profitable. Product differenti-ation may explain their advantages.Our FDIC data also indicates thatthe people in these hot counties aresavers. Bank deposits per capita are25% higher on average. They are alsomore self-sufficient places. The pro-portion of local residents employedwithin their county of residence istwice as high in the hot counties thanin all the other counties. And they are

not necessarily high-growth places—yet. The average rate of populationgrowth over the decade 1990–00 inthe hot counties was only 0.5%,compared to an average populationgrowth rate of 6% in the rest of theMidwest.

All our analyses showed that re-gardless of their size, headquarters lo-cation, or other characteristics, banksthat specialize in farm lending aremore profitable. In the presence ofbarriers to entry, this is consistentwith a hypothesis that banks provid-ing farm credit engage in credit ra-tioning towards farmers and awayfrom nonfarm borrowers, as shownby Turvey and Weersink (1997).Coupled with the evidence in Col-lender and Shaffer (2003) that farm-ing-dependent county incomegrowth is more sensitive to local bankfirm concentration, it suggests a hy-pothesis that agricultural credit de-mands may crowd out nonfarm de-mands for bank loans in farming-dependent rural areas. It also suggeststhat there is room for more of bothfarm and nonfarm lending in the ru-ral Midwest. We hope these tablesand maps have provided the kind ofinformation that helps communityleaders and existing Corn Belt bank-ers to focus their attention on someof these opportunities.

For More InformationCollender, R., & Shaffer, S. (2003).

Local bank office ownership,

deposit control, market structure, and economic growth. Journal of Banking and Finance, 27(1), 27-57.

Degryse, H., & Ongena, S. (in press). Distance, lending relation-ships, and competition. Journal of Finance.

Economic Research Service. (1997). Credit in rural america (agricul-tural economic report no. 749). Washington, DC: U.S. Depart-ment of Agriculture.

Federal Deposit Insurance Corp (FDIC). Financial institution directory. Available on the World Wide Web: http://www3.fdic.gov/idasp/index.asp.

Lence, S. (1997). Recent structural changes in the banking industry, their causes and effects: A litera-ture survey. Review of Agricultural Economics, 19(2), 371-402.

Moss, L., Barry, P., & Ellinger, P. (1997). The competitive environ-ment for agricultural bankers in the US. Agribusiness, 13(4), 431-44.

Turvey, C., & Weersink, A. (1997, November). Credit risk and the demand for agricultural loans. Canadian Journal of Agricultural Economics, 45(3), 201-17.

Maureen Kilkenny is an associateprofessor and Robert Jolly is a profes-sor in the Department of Economicsat Iowa State University.

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©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

FCSA Sale to Rabobank: Selling What? On Whose Authority? And For Whose Benefit?Roger Ginder

Rabobank’s proposed buyout of Farm Credit Services ofAmerica (FCSA) would not, on its face, seem to be a radi-cal event. Buyouts, mergers, and consolidations are cer-tainly not an uncommon event in the US economy. Aren’tbuyouts nothing more than one of the methods firms useto adjust to changes in market conditions? Absent anyegregious anticompetitive side effects, they usually occurwith a minimum of fanfare beyond the press releases of theparties involved.

But in the case of FCSA, there were strong and some-times strident outcries from a number of quite variedsources. Challenges were coming not only from some ofthe current FCSA members, but also from former direc-tors and members, other farm credit institutions, and evensome US congressmen and senators. Just what made theproposed FCSA deal so different from all of the others?

At least some of the differences observed in the Ra-bobank-FCSA case are related to the ambiguities createdby (a) the FCSA charter and its intent; (b) the relation-ships of FCSA to the rest of the Farm Credit System(FCS); (c) the historical background of the FCSA entity;(d) the fact that FCSA is organized as a cooperative ratherthan an investor-oriented corporation (IOC); and (e) theFCSA pattern of retaining its earnings as unallocated equi-ty rather than allocating it to borrowers. These factors notonly create a larger set of stakeholders than would typicallybe the case for an IOC, but they also create a much differ-ent set of claims and expectations.

The CharterThe charter for the FCS banks or Agricultural Credit As-sociations differ from typical commercial bank charters ina couple of important ways. The vast majority of corporatecharters, including those for commercial banking corpora-tions, are issued by the states. In addition, the charter is re-quired to enter the banking business. These banking char-

ters are issued and regulated by either state bankingauthorities, or the Office of the Comptroller of the Cur-rency (OCC) in the case of national banks, and usuallypermit the holder to take deposits from the public. Thecharters issued to the Farm Credit System banks do notpermit depository rights and are issued by the federal gov-ernment in accordance with farm credit legislation passedby Congress. But, there is another key difference. FCScharters are issued in a way that guarantees that there is anFCS bank serving the producers in all geographic areas ofthe United States. Thus, the charters are issued as a meansof meeting a legislative mandate rather than simply en-abling the establishment of a commercial entity. At a min-imum this complicates the question of selling an FCSBank or Ag Credit Association such as FCSA to a non-FCS entity.

After such a sale, the legislative mandate still exists forthe FCS to serve the geographic area. However, the opera-tional means to accomplish the mandate has been sold to anoneligible entity that is beyond the reach of the FCS reg-ulators. There is always the option to charter a new FCSentity and start over. However, it could take years beforethe new entity could develop significant market share, be-come well capitalized, and effectively serve the market.The “new start-up” solution also ignores the question ofwhether there is a genuine need for an additional player inthe market. Just how the intended uniform access to theFCS would be achieved remains an issue in this kind oftransaction.

Whether the current shareholders of an FCS charteredAgricultural Credit Association or a FCS bank have theunilateral authority to liquidate the capital built up whileit was operating under that FCS charter is also an openquestion. In addition to the unique responsibilities man-dated by the charter, there are also unique advantages. Thecharter carries some significant tax and funds acquisition

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32 CHOICES 1st Quarter 2005 • 20(1)

advantages for building equity andreserves that would generally not beavailable to other non-FCS institu-tions.

As long as the FCS-chartered en-tity continues to perform its legisla-tive mandate, these advantages aremore easily defended. But when agroup of stockholders attempt to sellthe Agricultural Credit Associationor bank and distribute its accumulat-ed unallocated surplus and reserves,the special treatment may be less de-fensible. The action would not onlyleave the FCS entity in a poor posi-tion to perform on its legislativemandate, it would also create a morefavorable treatment for the currentset of FCS Agricultural Credit Asso-ciation stockholders than the treat-ment accorded similar sets of stock-holders in other non-FCS lenders.

The Other Banks in the Farm Credit SystemOther banks in the system were clear-ly not supportive of the sale, andsome raised vocal opposition to theirmembers, regulators, and the press. Itwould appear that the stockholdersof FCSA would have the undisputedauthority to sell or dissolve withoutany obligation to the other parts ofthe FCS. All of the Farm Credit Sys-tem banks and associations (includ-ing CoBank, AgroBank, etc.) are in-dependent business entities withseparate balance sheets governed byseparate boards of directors andowned by distinct sets of stockhold-ers. Why should other FCS banksand Agricultural Credit Associationscare if FCSA dissolves itself?

Despite the autonomy of eachFCS bank or entity in most visible re-spects, they have some less obviousinterdependencies and shared respon-sibilities. When FCS bonds are soldinto the financial markets, they are

sold for the entire FCS as a wholerather than individual FCS charteredbanks or associations. This meansthat exit of an FCS entity with signif-icant loan volume has the potentialimpact of reducing the size of issues.Likewise, exit of an FCS entity serv-ing a specific region may marginallyreduce the geographic and commodi-ty diversity of the portfolio behindthe issue. Perhaps even more signifi-cantly, all of the banks and associa-tions in the system are “jointly andseverally liable” for the bonds issued.Stated differently, in the event that anFCS entity fails and cannot meet itsobligations to bondholders, a formalset of loss-sharing procedures definedamong the remaining FCS entities istriggered.

Thus, a portion of the equity inall FCS banks or Agricultural CreditAssociations serves as the first line ofdefense when a system entity cannotmeet its obligation to FCS bond-holders. This procedure was last trig-gered in the mid-1980s during thefarm debt crisis, when capital fromall parts of the Farm Credit Systemwas used to prevent default whensome of the banks began to fail. Sub-sequently, even this measure provedinadequate. Assistance from the USgovernment was required to partiallyrecapitalize many of the entities inthe Farm Credit System to avoid adefault on bonds that had been is-sued.

When it became apparent thatUS government assistance would berequired to avoid default, the FCSbanks and Agricultural Credit Associ-ations did not approach the govern-ment individually. Instead, the FarmCredit System as a whole made a uni-fied request. When the money pro-vided by the government to avoid de-fault was repaid in the 1990s, it wasdone through the system. FCSA ben-

efited from these system-wide activi-ties at a critical point in its history.

Although the individual FarmCredit System entities operate auton-omously with respect to managingand capitalizing their activities, theauthority for an entity to unilaterallydecide to sell or liquidate itself re-mains unclear. The agreements forjoint and several liability and the es-tablished patterns of joint behavior intimes of great crisis for FCSA createssome ambiguity about the true extentof this autonomy. At a minimum,there is a serious question aboutwhether any bank that has benefitedfrom loss sharing and government as-sistance has absolutely no obligationto the rest of the system and is free tobehave in a way that diminishes thestature and effectiveness of the sys-tem.

Organization as a Cooperative Versus an IOCFirms organized as cooperatives sharemany characteristics with firms orga-nized as investor-oriented corpora-tions. Both are state-chartered corpo-rate entities controlled by electeddirectors with a fiduciary responsibil-ity to shareholders who have investedequity capital. Both are subject tomarket forces and may fail unless ex-plicit intervention by governmentprevents it. To the general public,there are few visible differences as thefirms go about their day-to-day busi-ness.

There are, however, a number ofimportant differences between thetwo. Capitalization is one key differ-ence. In a cooperative, the people us-ing the products and services of thefirm usually provide the equity capi-tal required by the firm. In virtuallyall cases, some level of capitalizationis required if the user is to share inthe profits generated from the firm’s

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operation. Some cooperatives re-quire capital to be provided not onlyas a condition for sharing in the prof-its generated by the cooperative, butalso as a prior condition for gainingaccess to the products and servicesthe cooperative produces. FarmCredit System banks impose this re-quirement on their borrowers.

In contrast, the investment activi-ty in an IOC and the access to thefirm’s services are completely decou-pled. A consumer of the IOC’s goodsand services may or may not chooseto be an investor and an investor inthe IOC may or may not choose touse the firm’s products and services.Any melding of the role of investorand consumer is strictly voluntaryand occurs entirely at the pleasure ofthe party involved.

Distribution of net margins orprofits is another important differ-ence between cooperat ives andIOC’s. Net profit margins generatedby IOC’s are distributed to stock-holders based on the amount of equi-ty provided. If the net margins are re-tained in the business instead ofbeing distributed to stockholders, thevalue of the IOC is expected to in-crease. The presumption is thatshareholders will receive more fortheir shares when they sell them andthereby capture the value.

Cooperatives generally distributenet margins based on the level ofbusiness that a member shareholderhas done with the cooperative ratherthan the level of investment themember shareholder has made in thecooperative. The idea is to operate onan “at-cost” basis by returning anyexcess net margins above actual costto those who were charged more thanactual cost when they purchasedproducts and services from the co-op.It is also common for cooperatives todistribute at least a portion of the netmargins as equity rather than cash.

This creates a pool of equity that hasbeen retained to meet the need foradditional equity. However, unlikethe retained earnings in the IOC,these earnings have been identifiedwith individual stockholder names,and there is an expectation that it willbe redeemed in cash at some futuredate. It should be noted that mostcooperatives hold some of the netmargins as unallocated surplus re-serves. It permits some level of oper-ating loss to be absorbed withoutcanceling some of the equity that hasbeen allocated in prior years. (How-ever, it is not at all common for a co-operative to retain virtually all of theearnings as unallocated equity, asFCSA did.)

Because members who do morebusiness with the cooperative receivea proportionately greater percentageof the earnings, they also contribute aproportionately greater percentage ofthe allocated equity under this ar-rangement. Stated differently, theirownership of the cooperative is keptin rough proportion to their use. Aslong as the stockholder’s equity con-tribution is roughly proportional tothe level of business done with thecooperative, there is little quantita-tive difference between what thestockholder would have received hadthe net margins been distributedbased on the amount of equity he orshe held.

This raises the question: If thereis little or no difference, then whynot just organize as an IOC and payout the net margins based on profits?The answer lies in the motivation thefounders have for forming the orga-nization. If the motivation is simplyto maximize return on capital invest-ed, then the IOC is the superiorchoice. Once formed, the IOC is freeto seek out maximum return toshareholder capital as its singular goal

and pursue any legal opportunity todo so.

However, if the motivation is toaddress some sort of market failure(such as providing a product or ser-vice that is underprovided by themarket or providing increased com-petition in the marketplace), the co-operative may be a better choice. Inthat case, the founders want to limitthe activity of the firm to those mar-kets they use and wish to influence.Although it is still important to gen-erate a return on shareholder invest-ment, maximizing return on invest-ment is not the singular goal. A dualgoal of correcting market failure andgenerating an acceptable return oninvested capital is pursued. An addi-tional consequence of the dual goal isa more complex board of director’s fi-duciary responsibility to sharehold-ers.

A third important difference be-tween cooperatives and IOC’s is theway that owners exit the business. Inthe typical publicly traded IOC (andsome that are not publicly traded),the IOC assumes no responsibility toredeem its stock in cash. The stock-holder must sell the shares to a thirdparty in order to receive the value ofhis or her interest in the company.Potential buyers of the stock are pre-sumed to capitalize any undistributednet earnings into the share price;thus, the sale of stock incorporatesthe value of any undistributed netmargins due the shareholder into theshare price.

In contrast to the IOC, coopera-tives typically redeem purchasedshares of stock at the same face valueit had at the time of purchase. Netmargins that have been issued as eq-uity for later redemption are handledin a similar fashion. This creates noproblem as long as the cooperative al-locates all of the net margins to indi-vidually identified users of the coop-

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erative. When a member exits, he orshe has explicit rights to both thepurchased share and the allocated netmargins received while actively usingthe cooperative.

However, if net margins havebeen retained as unallocated surplus(without an identified user’s name at-tached), a serious problem arises inreflecting the increased value of thefirm when the stockholder no longerneeds the co-op and wishes to exit.The share price is fixed and will beredeemed at the same value it hadwhen it was purchased. If the netmargins have been held in unallocat-ed form instead of allocated, theshareholder has no explicit rights tothem. Absent any explicit claims, co-operative members receive the valueof the unallocated surplus only uponsale or dissolution—an extreme mea-sure.

Because few (if any) FCSA earn-ings had been allocated since themid-1980s, this was precisely the sit-uation confronting FCSA sharehold-ers in 2004. Following the farm debtcrisis of the mid-1980s and the pas-sage of the Agricultural Credit Act of1987, FCSA and its predecessorbanks had dutifully repaid govern-ment assistance given, capitalized aninsurance fund, and steadily rebuiltreserves by withholding earnings asunallocated surplus reserves.

Under the leadership of the boardof directors (and most likely at thebehest of regulators), members bor-rowing from the bank during this pe-riod agreed to forgo receiving allocat-ed patronage refunds in order torebuild adequate reserves to providethe bank with enough reserves towithstand another period of disas-trous losses without assistance fromthe government. Apparently, mostborrowers felt that ensuring the exist-ence of a viable Farm Credit Systembank dedicated to providing a consis-

tent source of competitively pricedlong- and intermediate-term credit toagriculture was worthy of the sacri-fice.

Some would argue that FCSAhad gone past the level of reserves re-quired for prudence and could havebegun allocating equity long before itdid in late 2004. Indeed, a largenumber of the sister AgriculturalCredit Associations and FCS banksin the Farm Credit System (includingCoBank) had done so. Perhaps thiswas due to an incomplete under-standing about the differences be-tween cooperatives and IOC’s andthe inability of cooperative stock-holders to access unallocated reserves.Or, perhaps the turmoil experiencedin the 1980s caused the manage-ment and board of FCSA to act withan abundance of caution and to con-tinue to build unallocated reserves.One can only speculate about themotives, but the fact that FederalLand Bank sourced earnings could beplaced into surplus without taxationalmost certainly played at least somerole. It enabled these earnings to beplaced into surplus without a taxconsequence. Had these earningsbeen allocated to members, either themember who received the allocationor the co-op would have had to payincome tax on them.

The Offer From RabobankBy early 2004, FCSA found itselfholding a very large pool of unallo-cated equity with no visible way(short of sale or liquidation) formembers to access it. This made it anideal target for an outside offer topurchase. Sale of the FCSA would re-sult in an inflow of cash; the cashcould then be distributed to currentstockholders who had purchasedshares of stock at a modest cost as acondition for joining. The payout

would be multiples of the relativelymodest price of the shares they hadpurchased. This creates an enormousincentive to sell the cooperative, per-haps even at a bargain price.

The payout to current sharehold-ers would be very lucrative even if thesale price of FCSA were significantlyless than its value as a going concernor its fair market value. Division ofonly half the fair market value (as es-timated by some analysts) among therelatively small number of currentstockholders would still yield a signif-icant sum. Some large-volume bor-rowers would receive sums in five orsix figures. All of this presumes thatthe current members of FCSA holdthe only legal claims to the unallocat-ed surplus reserves and can legiti-mately divide the proceeds amongthemselves. But are the current stock-holders of FCSA really the exclusiveand rightful owners of the unallocat-ed surplus?

The answer for an investor-owned corporation (which pays itsstockholders based on the amount ofequity they hold) is straightforward.It belongs to the current stockhold-ers. Those who have sold their stockand are not currently shareholdershave no claims. Presumably, the valueof retained earnings was capitalizedinto the stock price when they soldtheir shares. Thus, all prior stock-holders received fair market value atthe specific time of the sale, and all ofthe value of the unallocated retainedearnings would be due to currentstockholders.

In the case of FCSA (which is acooperative), the answer is not sosimple. Several key differences be-tween cooperatives and ordinary in-vestor-oriented corporations compli-cate things. (a) Unlike the ordinarycorporation, earnings in the coopera-tive are issued to stockholders basedon their use of the cooperative rather

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than on the amount of capital pro-vided, and in nearly all cases the eq-uity cannot be publicly traded. (b)The decision to invest was not solelybased on generating a return on in-vestment. For FCSA borrowers it wasalso coupled with the right to use thecooperative. The FCSA borrower hadto be a stockholder in order to usethe cooperative. (c) The equity inFCSA is purchased and redeemed atface value. Those who redeemedtheir stock after paying off their loanreceived only face value. This is radi-cally different than what happens inan IOC. For the IOC, the level ofunallocated retained earnings is usu-ally reflected in the share value at thetime it is purchased and at the timethe share is sold.

When the current shareholders ofFCSA bought their shares in the co-operative, the price they paid for theshare did not reflect the capitalizedvalue of the unallocated retainedearnings. But if they sold or liquidat-ed FCSA, they stood to divide thesurplus and receive many times whatthey paid for their share.

So Who Owns the Capital Surplus?The ambiguities that arise from theFCSA charter, its relationship to theother FCS banks, FCSA’s own histo-ry, and its cooperative structure raiseserious questions about who has le-gitimate (if not strictly legal) claimsto the unallocated surplus reserves. Acase could be made that several dif-ferent groups and institutions couldlay claim to at least a portion of thereserves. At least five such potentialclaimants could be identified:• the current stockholders;• the past stockholders who con-

tributed to building the surplus;

• the successor FCS Ag CreditAssociation chartered to replaceFCSA;

• the other Farm Credit Systembanks that provided assistance;and

• the government who providedthe initial risk capital, special taxtreatment, and recapitalized it inthe 1980s.The unallocated surplus in FCSA

represents an endowment generatedby past members for current (and fu-ture members) to use in capitalizingthe lending cooperative. It was notgenerated exclusively by the currentstockholders. Nor was the investmentcost for current stockholders adjustedto reflect the level of unallocated re-tained earnings when they entered.Finally, the decision of individualstockholders to buy or sell was basedon their need for credit rather thanthe level of unallocated retained earn-ings.

So who owns the surplus? Is itthose past member stockholders whogenerated it by forgoing the option toreceive a patronage refund on theirinterest bill? Is it the current memberstockholders who now own and usethe cooperative and will make the de-cision of whether or not to liquidate?Or is it possibly the future memberstockholders who will want to join awell-capitalized Agricultural CreditAssociation? Stated differently,should the surplus be taken into thenew Agricultural Credit Associationthat will be chartered to replaceFCSA after it has been sold?

One possible answer is it belongsto those who generated the surplusover the past 20 years or so. It couldbe argued that those who owned andused FCSA during the critical periodwhen FCSA was being recapitalizedin the mid-1980s have the most legit-imate claims. However, 20 years is along time, and there are numerous

difficulties in looking back that far.More than a few of those membersare now deceased and their estateslong ago settled.

Another possible answer is thatthose who have the most legitimateclaims are the members who used thecooperative over a more recent (albeitstill somewhat arbitrary) period whenmuch of the retained earnings weregenerated. This has in some casesbeen formalized in cooperative stat-utes. Some state statutes (includingIowa, which is part of the FCSA mar-ket territory) designate that unallo-cated retained earnings must be dis-tr ibuted to current and formerpatrons based on the amount of un-redeemed allocated equity they hold.

This kind of provision allowsthose who did business with the co-operative in the past, and contributedto building the surplus, to share inthe distribution—even though someof them may no longer be activemembers. But in the case of FSCA,virtually all the earnings were putinto surplus, and there is no allocatedequity to use as a basis for determin-ing how much each patron should re-ceive. It would be necessary to picksome arbitrary period, look back, andcalculate what the claims would havebeen if the equity actually had beenallocated rather than put into sur-plus.

A third possible answer is thatpeople who are currently owners andusers have the most legitimate claim.They, after all, have undertaken thecurrent fiduciary responsibility forthe assets of FCSA, and they are theones who have the voting rights. But,should the entire endowment be dis-tributed to them simply because theyhappen to be members at this time?Was it really the intent of prior mem-bers (who built the surplus) to createa windfall for the voting members atsome future moment in time?

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A fourth possible answer is thatthe surplus is truly an endowmentfrom past and current users for use incapitalizing a user-owned and -con-trolled cooperative for current andfuture farm borrowers. Upon sales ofliquidation, should at least the ma-jority of the endowment be kept andused toward capitalizing the newFCS Agricultural Credit Associationthat will have to be chartered andformed to serve the region? Could itbe argued that those who built thesurplus did it for that purpose ratherthan for the purpose of distributing itin its entirety as a windfall gain tocurrent members?

Some would argue that the re-maining parts of the system shouldget at least some of the surplus. Allparts of the system assume “joint andseveral liability” for the other parts. IfFCSA benefited from this assuranceduring the period when the surpluswas built, does it not have a legiti-mate claim to at least some of thesurplus? To a degree, the exit fee lev-ied by the FCS does this, but ques-tions can be raised about whether thefee is more or less than adequate toaccomplish this.

Finally, some might argue thatthe US taxpayers have a legitimateclaim to at least part of the unallocat-ed reserves. The portion of the unal-located surplus that was sourced fromland loans was never taxed. Further-more, the system was conceived andstarted by the US government, andthe majority of the capitalizationthrough the most risky periods of itslife came from the government.Some might argue that the taxpayersshould have a claim.

Technically, the government as-sistance was structured as a loan, andit has been repaid in full. But mostwould agree that at least part of thesefunds played the role typically playedby equity capital rather than the role

typically played by debt capital. Is itreasonable that some of the unallo-cated reserves should be returned tothe taxpayers as a return for taking onthe role of entrepreneur and venturecapitalist during start-up and themost perilous times FCSA has sur-vived? If they are not compensatedfor playing these roles, should thetaxpayers at least be compensated forthe untaxed earnings sourced fromFCSA’s land lending activities?

Going Forward from HereThe buyout process was halted beforeit went to stockholders for a vote. Wewill never know how it would haveplayed out. It is still interesting andperhaps helpful to consider whowould have had the most just or le-gitimate claim. Would it have beenonly the narrow legal claims of cur-rent stockholders that counted in theend? Would it have simply been de-cided on the provisions in FCSA arti-cles of incorporation and provisionsin the FCSA bylaws along with boardresolutions? Or have other stakehold-ers weighed in through the courts?Or would Congress perhaps haveweighed in through legislation? Theanswers will never be known. It maybe useful to consider the other stake-holder claims and evaluate their mer-it as a measuring rod for future ac-tions. The FCSA experience implies aneed for some changes going for-ward.

Greater effort needs to be madein differentiating the role of theboard of directors in a cooperativeand from the role of an IOC board.Although there are many similarities,and both IOC and Cooperativeboards serve the same general func-tion, the cooperative board has amuch more complex task. In manycases, this is not well understood bycooperative boards.

IOC commercial bank boardshave a fiduciary responsibility to pro-tect stockholders’ investments andmaximize return on stockholders’ in-vestments. Regulators and insuringagencies such as the Federal Reserve,Federal Deposit Insurance Corpora-tion (FDIC), and the Office ofComptroller of the Currency (OCC)in the Treasury Department placeadded fiduciary responsibilities onIOC commercial banks to protectcustomers.

Cooperative boards have a similarresponsibility to protect the stock-holders’ investments and to earn a re-turn on the stockholder’s invest-ment. Regulators and insurers, suchas Farm Credit Administration andFCS Insurance Corporation, placeadded fiduciary responsibilities oncooperatively owned AgriculturalCredit Associations such as FCSA toprotect their borrowers in much thesame way that the FDIC and OCCdo for IOC commercial banks.

However, the fiduciary responsi-bility of the cooperative board to itscongruent set of owner-users goes be-yond that of the IOC board’s respon-sibility to its noncongruent sets ofshareholders and customers. The factthat the owners and the users arecongruent does not exempt the coop-erative board from earning a returnon it invested capital. It does, howev-er, place constraints on what theboard can do in pursuit of returns oninvested capital. Although the coop-erative board is pursuing return on itscapital, it must also ensure that thestockholder’s investment is applied ina way that benefits stockholders as us-ers as well as investors. Balancing thetwo is sometimes difficult, and itnearly always forecloses some of theoptions for generating a return oncapital that are readily available to theIOC.

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Greater efforts also need to bemade to assist cooperative manage-ment and boards in understandingthe differences in the mechanics thatexist between benefit flows fromIOCs and benefit flows from cooper-atives. Actions that are fair to IOCshareholders will not always be fairfor cooperative shareholders. Be-cause cooperative stock and allocatedequity is redeemed at face value, thefiduciary responsibility of coopera-tive directors could extend well be-yond the contemporaneous set ofvoting shareholders in many cases.Simply copying IOC behavior willnot always lead to a similar result in acooperative. It is important for coop-erative boards to understand this andcommunicate it effectively to hiredmanagement—especially when theprior experience base of that manage-ment has not been in the cooperativesector.

The incentives created by the taxexemption for Federal Land Bankearnings also need to be carefullyevaluated. If the exemption appliesonly when earnings are held as unal-located reserves, it may create futureproblems similar to the ones encoun-tered at FCSA. One possible solutionwould be to permit earnings to be al-located as nonqualified patronagedistributions by the AgriculturalCredit Association with no taxationuntil the allocation is actually re-deemed to the borrower in cash. Thiswould, in essence, leave the Agricul-tural Credit Association in the sameposition it currently holds. However,it would identify the member whosebusiness generated the earnings andcreate an explicit future claim for thatmember—even if he or she had re-paid a loan and exited. By creating aspecific property right, this actionwould eliminate some of the exitingincentive for current stockholders to

sell or liquidate as a means of divid-ing the unallocated surplus.

Finally, there needs to be a clearerspecification of what individual sys-tem banks and associations have theauthority to sell unilaterally. Title toreal estate, vehicles, and fixtures areprobably not in question. It seemsclear that the FCS charter for a re-gional bank cannot be sold to an en-tity outside FCS. However, it is lessclear whether the loans, customerlists, customer history, and other cus-tomer information are the exclusiveproperty of the Agricultural CreditAssociation or the FCS. The proce-dures for exiting the system, and theproperty rights of the stakeholdergroups, need to be much more clearlydefined before the next sale of anFCS entity is attempted.

Roger Ginder is a professor in theDepartment of Economics at IowaState University.

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CHOICESThe magazine of food, farm, and resource issues

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A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

The New Basel Capital Accord: Implications for US Agricultural LendersAni L. Katchova and Peter J. Barry

The first Basel Capital Accord, the current system usedfor evaluating capital adequacy, was implemented in 1988by the Basel Committee on Banking Supervision. Theaccord’s objectives are to ensure the soundness and stabil-ity of the banking system, to achieve greater uniformity incapital standards across countries, and to provide equitablestandards promoting bank competition. The currentaccord, also known as Basel I, sets the minimum regula-tory capital for banks at 8% of the risk-weighted value oftheir assets. The guidelines proposed in Basel I wereaccepted by more than 100 countries. Basel I, however,turned out to be too simplistic to address the needs of thebanking system in a changing environment of new tech-nology and increased globalization and competition.

The Basel Committee on Banking Supervision hasbeen developing a new accord, Basel II, to address theshortcomings of the current accord and to reflect the newdevelopments in the assessment and management of risk.The Committee has developed several proposals for revis-ing the existing accord and has conducted four quantita-tive impact studies related to these proposals (posted at theBank for International Settlements’ website, http://www.bis.org). Basel II is expected to be implemented bythe end of 2006.

Overview of Basel IIBasel II rests on three mutually reinforcing pillars: (1)minimum capital requirements, (2) supervisory review,and (3) market discipline.

Pillar 1 outlines the calculation procedures of the capi-tal requirements for banking organizations. Under Basel I,the minimum required capital ratio (set at 8%) is calcu-lated as the regulatory capital divided by the risk exposure(measured by the risk-weighted assets). The differenceunder Basel II will be that the risk exposure will be evalu-ated as the total of the credit risk, market risk, and opera-

tional risk exposure of the bank, where more refinedmeasures will be incorporated to calculate credit and oper-ational risk.

Pillar 2 addresses the supervisory review process inensuring sound capital management and comprehensiveassessment of the risks and the capital adequacy of thebanking institutions. This pillar seeks to increase the trans-parency and accountability of the banking system and to alarge extent has already been incorporated in the UnitedStates.

Pillar 3 aims at improving market discipline by requir-ing banks to publicly disclose key information regardingtheir risk exposures and capital positions. Because Basel IIgives banking institutions greater discretion in calculatingtheir own capital requirements, it is anticipated that thedisclosure statements will allow market participants to bet-ter assess the safety and soundness of the banking environ-ment and thus exert stronger market discipline.

Basel II will include three options for measuring creditrisk and another three options for measuring operationalrisk. The options for calculating credit risk are the stan-dardized approach and two internal ratings-basedapproaches—the foundation approach and the advancedapproach. The standardized approach is similar to theapproach currently used for categorizing bank assetsaccording to their risk and then weighing them using fixedweights. Under the internal ratings-based approaches,banks will evaluate key elements of credit risk: the proba-bility of default, the loss given default, the exposure atdefault, and the remaining maturity of the exposure.Under the foundation approach, banks will estimate theprobability of default of their loans, but the regulators willprovide the other measures. Finally, under the advancedapproach, banks will calculate all key elements of theircredit risk exposures.

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Likewise, there are three optionsfor calculating operational risk: thebasic indicator approach, the standard-ized approach, and the advanced mea-surement approach, with varyingdegrees of bank-provided versus reg-ulator-provided inputs in the calcula-tions of operational risk. Asincentives for adopting the moreadvanced approaches for credit andoperational risks, banks are antici-pated to experience lower capitalrequirements.

Basel II Implementation in the United StatesThe US banking agencies (the Boardof Governors of the Federal ReserveSystem, the Office of Comptroller ofthe Currency, the Federal DepositInsurance Corporation, and theOffice of Thrift Supervision) havealready initiated the process forimplementing Basel II. These agen-cies have recommended that the larg-est, most complex banks (with totalassets of at least $250 billion or totalforeign exposure of at least $10 bil-lion) be required to implement theadvanced measurement approachesof Basel II to assess credit and opera-tional risks (Federal Reserve Board,2003). Currently, ten banks meetthese size requirements, and anotherten banks have chosen to adopt theadvanced approaches of Basel II.These twenty banks account for 99%of the foreign assets and more than65% of the total assets held by USlenders. It is expected that over timeother large banking and nonbankinstitutions will also choose to adoptadvanced capital calculations.

The banking agencies have iden-tified several areas of concern regard-ing the implementation of Basel II inthe United States (Federal ReserveBoard, 2003). The first concern isthe equitability of a bifurcated

scheme whereby large banks will berequired to adopt Basel II while smallbanks will continue to operate underthe existing Basel I. Small banks thatremain under the current capitalregime would generally have highercapital requirements, which wouldalso be less sensitive to risk. Thus,these small banks would be at a com-petitive disadvantage. However, thebanking agencies predict that Basel IImay not have a large impact on capi-tal holdings, because many smallbanks currently choose to hold capi-tal in excess of the required mini-mum. The second concern is that theadoption of advanced approaches formeasuring credit and operational riskmay be too expensive, especially forsmaller banks. The adoption of theseapproaches, of course, will not reducelosses but rather will better align cap-ital requirements and losses. How-ever, even if not required by Basel II,these approaches may be needed inorder to compete effectively in theexisting banking environment. Thethird concern is the way operationalrisk is treated, either as an explicitcapital charge under pillar 1 or on acase-by-case basis under pillar 2.

Basel II and AgricultureThe New Basel Accord does notinclude any special treatment foragricultural lending. Basel II impliesthat large agricultural loans would betreated as corporate loans and smallagricultural loans as retail loans. Theregulators, however, need to take intoaccount the particular characteristicsof farm loans when setting capitalcharges for organizations involved inagricultural lending (Barry, 2001).Farm businesses are characterized bycyclical performance, seasonal pro-duction patterns, high capital inten-sity, leasing of farmland,participation in government pro-

grams, and annual payments of realestate loans. Because of these charac-teristics, losses in agricultural lendingmay not be frequent, but could belarge due to high correlations amongfarm performances. At the sametime, high capital intensity, especiallyinvolving farmland, offers relativelystrong collateral positions, thus miti-gating the severity of default whendefault problems do arise.

Katchova and Barry (2005)developed models for quantifyingcredit risk in agricultural lending.They calculated probabilities ofdefault, loss given default, portfoliorisk, and correlations using data fromfarm businesses. The authors showedthat the calculated expected andunexpected losses under Basel II criti-cally depend on the credit quality ofthe loan portfolio and the correla-tions among farm performances.These analyses of portfolio credit riskcould be further enhanced if seg-mented by primary commodity andgeographical location. Agriculturallenders could adopt similar models toquantify credit risk, a key componentin the calibration of minimum capi-tal requirements.

Farm Lending InstitutionsAmong agricultural lending institu-tions, commercial banks and theFarm Credit System are the largestproviders of credit. Commercialbanking in the United States has longbeen characterized by a large numberof smaller community banks, manyof which are heavily dependent onagriculture. Deregulation and consol-idations are reducing the number ofbanks, although federal data for 2004indicate that approximately 2,600“agricultural” banks still providemore than 50% of bank loans to agri-culture. However, the share of agri-cultural loans held by banks with

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more than $500 million of assets hasbeen growing rapidly. Such largerbanks likely have the capabilities tomove toward the adoption of theinternal ratings-based approaches torisk assessment and capital manage-ment, whereas smaller banks servingdifferent market niches will probablyremain under the current standard-ized approach.

The Farm Credit System (FCS) isa federated organization of fivemostly wholesale banks lending to90–100 farmer-owned lending asso-ciations, which in turn provide creditand related services to agriculturalborrowers. Autonomy of individualunits of the FCS has been high,although recent consolidations, busi-ness practices, product and serviceofferings, risk assessment, and capitalmanagement have become more uni-form over time. Uniformity helps theFCS to present a more understand-able, coherent structure to thenational and international financialmarkets. Investors in these markets,in turn, purchase securities issued bythe FCS banks, thus providing theloan funds for agricultural borrowers.

In general, the FCS has sufficientsize, specialization, and expertise tomove toward adopting the internalratings-based approaches to capitalmanagement. Initial steps haveinvolved the design of data systemsneeded to compile and store loan-level loss data over time and thedevelopment of dual rating systemsfor categorizing the frequency andseverity of default by borrowers. The

goals are to achieve greater precisionand granularity in risk classifications.These steps will lead to the formula-tion of economic capital models thatcombine measures of credit, market,and operational risks to determinecapital adequacy, risk-adjustedreturns on capital, and risk-adjustedpricing of loans and services.

Essential to the adoption of moreadvanced internal ratings-basedapproaches is the acceptance by fed-eral regulatory agencies—the FarmCredit Administration in the case ofthe FCS and the Fed, Comptroller ofthe Currency, and the FDIC forcommercial banks. Basel II requires aformal approval process for the mea-surement, modeling, and manage-ment of risk-based capital. Thoroughdocumentation, rigorous testing,complete validation, and ongoing useare key elements of gaining andmaintaining approval.

In ConclusionAs occurred under Basel I, the newspectrum of choices for capital man-agement under Basel II will be widelyreflected throughout the financialsystem. The scope and depth of BaselII have followed the “best practices”of the top tier of banks worldwide.Such successful practices typicallypermeate a financial system withmodifications to fit institutional sizeand resource base. Vendors offeringfee-based capital services, furtherconsolidations among financial insti-tutions, data sharing arrangements,

and experience gained by the indus-try and its regulators will hasten thepermeation process and enable com-munity banks—as well as the inter-nationally active ones—to utilizeinternal ratings-based approachesand economic capital concepts intheir risk management.

For More InformationBarry, P.J. (2001). Modern capital

management by financial institu-tions: Implications for agricul-tural lenders. Agricultural Finance Review, 61, 103-122.

Basel Committee on Banking Super-vision. (2004). The new Basel Capital Accord. Basel, Switzer-land: Bank for International Set-tlements. Available on the World Wide Web: http://www.bis.org.

Katchova, A.L., & Barry, P.J. (2005). Credit risk models and agricul-tural lending. American Journal of Agricultural Economics, 87, 195-206.

The Federal Reserve Board. (2003, September). Capital standards for banks: The evolving Basel Accord. Federal Reserve Bulletin, Washington, DC. Available on the World Wide Web: http://www.federalreserve.gov/pubs/bulletin.

Ani L. Katchova is an assistant pro-fessor and Peter J. Barry is a professorin the Department of Agriculturaland Consumer Economics at theUniversity of Illinois at Urbana-Champaign.

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CHOICESThe magazine of food, farm, and resource issues

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A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Agri-lending Vision 2020: When Vision and Reality MeetDavid M. Kohl and Alicia M. Morris

Envision the future of agricultural lending as it evolvesover the next 15 years. By recognizing current trends andlooking toward the future, individuals can strategically po-sition their businesses and people to proactively mitigaterisk in adverse events and capitalize on opportunities. Thispaper will first examine the realities of the agriculturallending marketplace. Second, we will analyze the futurestructure of agricultural products, services, and credit riskassessments demanded, and then conclude with strategicplanning implications for financial institutions serving ag-ricultural producers.

The Landscape of AgricultureFirst, examination of the landscape of agriculture will setthe stage. Agriculture will continue to consolidate main-stream production in North America and throughout theglobe driven by consumer wants and needs and the foodretail sector. Agri-lenders will be providing financial prod-ucts and services to a smaller group of producers that willgenerate a larger share of revenue. This segment will befaced with margin compression created by global competi-tion. On the other hand, a large number of agriculturalistswill be involved in agriculture that will stretch the para-digms of any planner to think outside the box. For exam-ple, financing hunting lodges, bed and breakfasts, or mul-tientity businesses (such as grain farmers who own a carwash or computer consulting firm to fully employ resourc-es) will be common.

As a large share of production consolidates to approxi-mately one million producers worldwide and 150,000producers in the United States, natural and man-made riskpotential will increase. Although large farms tend to man-age risk better, a breakout of pandemic flu or a natural di-saster in an agricultural cluster area can be devastating to alarge share of the portfolio. This will create an environ-ment of extreme earnings and deficits for commercial agri-

business producers, which will test portfolios and manage-ment strategies of the smallest to the largest institutions.

Direct government support for agriculture will declineand shift toward environmental and natural resource man-agement in many developed countries over the next 15years. With more women and minorities operating farms,a lending institution that fails to have a female or minoritystrategy will be behind the curve in meeting a very impor-tant emerging agricultural market.

In a time-compressed environment, producers will dif-ferentiate themselves from competitors through informa-tion and people, rather than production and capital as wascommon in the past. In the workplace, lifestyle issues, liketime management and balancing family and social activi-ties, will drive the business model rather than the businessmodel driving the lifestyle. Leaders’ failure to recognizethis balance imperils long-term sustainability of a custom-er or employee of the institution or business.

Finally, the first of many shots were fired in the sum-mer of 2004 when Rabobank made an offer on a FarmCredit Services entity. This was a wake-up call to a com-placent agri-lending environment, stagnant through gov-ernment supports and high land values. Agri-lending willbe required to evolve into a more fluid and competitiveglobal industry that can quickly but objectively meet achanging environment.

Agricultural StructureThe 2004 Family Farm Report, based upon data from theannual Agricultural Resource Management Survey(ARMS), uses the ERS typology on farm size and organi-zation to define the current state of agriculture. As agricul-tural industry structure progresses toward the year 2020,subsequent hypotheses suggest that it is evolving into sev-en unique business and lifestyle models yet to be defined

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in the research literature or capturedin the databases.

Super Commodity/AgribusinessModel one will be the super commodi-ty/agribusiness operation. Anecdotalevidence suggests this model willgenerate $1.5 million of revenue onaverage in today’s dollars, but willgenerate twice this amount on theEast and West coasts outside the tra-ditional government payment zones.These operations will pocket in 35 to40 regions in the United States andCanada in prime natural resourcebase areas for land and water, withminimal public disruption. Control,rather than ownership, of assets willrequire lenders to revolutionize un-derwriting standards and alter mar-keting, operations, products, services,and delivery systems.

These entities will extend to mul-tiple counties, states, provinces,countries, and (to a small extent)hemispheres. They will be com-prised of multiple entities, some notdefined as agriculture, to provide bal-ance and diversity in their businesses.This model will operate for the mostpart as a multiple family unit or in-vestor under the guise of corpora-tions and limited liability corpora-tions to foster business formality.This segment will stretch the param-eters of government-based lendingentities that are historically slow toreact to change, making them an ex-cellent target for an internationallending institution.

Super commodity/agribusinessoperations will be geographically andpublicly challenged with site selec-tion and location. For example, envi-ronmental, air quality, and animalwelfare issues will be numerous andconstant. Those that finance crop op-erations will find land use, resourcemanagement, and water issues a highportfolio risk factor. This customer,

while dealing with large input suppli-ers on a regional, national, or inter-national basis, will not always be themost profitable relationship for theinstitution despite large volumes.

Moving toward 2020, these enti-ties will utilize very sophisticated in-formation systems, such as global po-sitioning systems and autotrackequipment, allowing them to linkproduction to the bottom line prof-its. Profits on food and fiber productswill ultimately be driven by the de-mands of the consuming public andretailers.

Needs for this model from theagri-lender include growth and stra-tegic management, cash and work-ing capital programs, venture capital,equity management, coaching servic-es, execution of strategies and facilita-tion of acquisitions, mergers, and al-l iances as delivered by a lendermanagement team that handles nomore than 40–50 accounts. Thesespecialists must be adept in theawareness of macro issues, but beable to drill down on specific issuesof the entity as a solutions-based pro-vider.

The five C’s of credit will still ap-ply from the credit side. The chal-lenge to the credit analyst will be todevelop underwriting standards onsoft asset financing, such as humanresources, business best managementpractices, execution strategies, andmetrics, that can be quantified andtested in a volatile marketplace.

Traditional Family FarmThe second model is known as thetraditional family farm, generatingrevenue in the $50,000–600,000range, in today’s dollars. Althoughthis range is large, it encompasses alarge number of farms. Global eco-nomics will produce dramatic changein this segment in the future. TheNorman Rockwell version of the

farm or ranch will evolve by thosewho have the passion to carry on thefarm family legacy. This model willbe particularly important to agri-lenders, because these operationshave traditionally been the mostprofitable customers.

Vision 2020 finds that the num-ber of traditional family farms will bedriven by dynamics of rural commu-nities, lifestyle issues, economies ofscale, and technology. These opera-tions, particularly crop and less in-tensive livestock farms, while large bytoday’s standards, could be operatedon a part-time basis, bringing awhole new mode of ownership andmanagement to the picture.

Ten percent of current traditionalfamily farms will grow to larger enti-ties generating $600,000 and $1.5million in revenue. Thirty percentwill scale down, becoming lifestylefarms and ranches; another 30% willexit the industry because of develop-ment or recreational use opportuni-ties, leaving approximately 30% re-maining as traditional family farms.To any strategic planner, realizing therapid reduction of government sup-ports, the introduction of new tech-nology, information base, or regula-tory standards could radically adjustthese numbers in a five-year period,similar to what occurred in westernCanada, South Africa, Australia, andNew Zealand.

The visionary lender will findnew methods to make this customersegment transition profitable. Theland-based operations will be pur-chased by extended family membersor outside investors for recreational,housing, water, and natural resourcedevelopment. Farm management ser-vices and reverse mortgages to pumpliquidity into a cash-starved older agerural population base could be op-portunities knocking on the door.

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Today’s credit standards will stillwork quite well, but marketing fi-nancial products and services willhave to be adjusted using enhanceddelivery systems involving allianceswith realtors and accountants to beable to gain exposure to absenteeproperty owners. Youth that leave ar-eas to seek higher incomes and excit-ing lifestyles may boomerang back tothese areas in later stages of life toseek balance in quality-of-life issues.

Vertically Integrated OperationVertically integrated agricultural mod-els, such as hogs and poultry, whichhave been the bread and butter of theagricultural finance portfolio in someareas late in the last century, will notbe as large of a growth segment in theportfolio of the future. Large multi-national agribusiness firms will findit more economical and environmen-tally friendly to move a portion ofthis business offshore. These busi-nesses will still be popular with theyounger segment who are technolo-gy-oriented and seek a stable earningbase as an entrance into agriculture;however, more will seek vertically in-tegrated opportunities on a part-timebasis.

Contract AgricultureContract agriculture will be a growthmarket with traditional commoditiessuch as vegetables, beef, milk, and to-bacco, but will also meet the needs ofa more sophisticated affluent con-sumer. Strategic alliances with agri-businesses, medical, and technologycompanies will stretch the paradigmsof what is considered farming and lifesciences. This type of operation willhave the image of a white collar orscientist’s family farm. Contracts,patents, and copyrights will be thecollateral and conditions that willunderwrite these loans and financialservices. This segment will be very at-

tractive to large national and interna-tional financial institutions and equi-ty capital entities. These entities willbe pocketed and isolated in rural ar-eas to protect their products and ser-vices. The contract agriculture seg-m e n t w i l l f r u s t r a t e p l a n n e r s ,regulators, and government policymakers, who will struggle to developpolicies and standards that are flexi-ble and expedient enough to meettechnology and cutting-edge initia-tives driven by the affluent consumer.

Lifestyle SegmentThe lifestyle segment, which shouldnot be referred to condescendingly as“hobby farmers” or “sundowners,” isthe largest segment of producers bynumber and will continue to repre-sent a dynamic marketplace. Ninetypercent of these businesses will locatewithin reasonable driving distances ofrural affluent zones, which have thefol lowing character ist ics : goodschools, hospitals, health care sys-tems, infrastructure, technology, nat-ural amenities, reasonable cost of ar-eas to live, and convenient shoppingand social opportunities.

Some efficient agri-lenders al-ready handle 600–1,000 lifestyleloans. Streamlined, simple under-writing standards will be the norm,with the deeper analysis being con-centrated on the layering of risk, thatbeing industry, community, andeconomy risk. Twenty-four-hour ac-cess to loan services, through kiosks,will not be an option but a require-ment. Again, developing alliances,such as with realtors, and being ableto target specific areas and match theproducts and services to the customerwill be critical. With over 50% ofAmericans desiring to live on 20acres in the country (according toUSA Today), this segment will be dy-namic and profitable to those whomesh credit, marketing, and opera-

tions into a streamlined mode of de-livery.

Value-added AgricultureThe value-added model is alive andwell, particularly outside the tradi-tional government payment zoneswith agricultural enterprises that en-courage and reward outside-the-boxentrepreneurial thinking. These busi-nesses exploit a location, production,servicing, technology, branding, orsystems aspect to give them the dif-ferential advantage. Markets will be80% domestic and 20% internation-al, with a focus on natural and organ-ic foods and emerging energy andnatural resource products, such asethanol, biodiesel, wind power, wa-ter, and mineral harvesting aspects.

Special units or teams will evolveto handle these entrepreneurial enti-ties across institutions and even withcompetitors. This agricultural seg-ment is in dire need of new credit un-derwriting standards that capture therisk and components of a successfulentity. Needs of these enterprisesfrom lenders include business plan-ning, strategy development, growthmanagement, coaching, working cap-ital and cash management, and net-working across markets and sectors.Profits and sustainability, along withrisk, are high as this group takes onthe characteristics of entrepreneurialsmall businesses.

Agri-entertainerFinally, the fastest growing modelwill be coined as the agri-entertainer.Financing of lodges for hunting,pumpkin festivals, bed and break-fasts, the urban farmer’s market,horse trails, or all-terrain vehicle rec-reational sites will become morecommonplace. This model can beeasily integrated into any of the pre-viously mentioned entities as a sideventure. Lifestyle, value-added, and

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the agri-entertainer models will at-tract a new set of youth and adultsbringing needed energy to NorthAmerican agriculture as they seek tofulfill their dreams.

The Future of Agri-lendingThe new models just discussed willbe better defined by their consumer-driven attributes than by demograph-ics. This in turn will change the land-scape of agri-lending institutions. Ag-r i c u l t u r a l c o m m u n i t y a n dcommercial banks that currentlynumber approximately 2,500 willmost likely decline to near 1,000 inthe future. Small community or fam-ily-owned banks will continue toserve the traditional, lifestyle, andnew emerging segments. Their strate-gic advantage will be investors andmanagement teams that do not focuson a maximization of next quarter’sresults to satisfy stockholders, as thelarge institutions tend to do. Quickdecision-making and fast, friendly,human-oriented service with base-line technology will be critical to suc-cess. Government guarantees andspecial program initiatives, such asgovernment liquidity savings ac-counts and reverse mortgages, mayprovide the differential advantage.Being located near rural affluentzones may be critical for the attrac-tion of human resources to providequality service.

The Farm Credit System, whichhas nearly 100 associations and fivedistrict banks nationwide, will mostlikely consolidate down to 25–30 as-sociations or alliance entities withother institutions. GovernmentSponsored Enterprise (GSE) statusmay become a concept of the past, ifthe agricultural environment re-quires the system to expand prod-ucts, services, and authorities to meeta dynamic marketplace. Farm Credit

will find that the “better is better”strategy rather than the “bigger isbetter” strategy is very applicable in acooperative system that operates 364days a year as a business and one dayas a cooperative.

Farm Credit’s strategic advantageas an efficient deliverer of credit mustevolve to become a financial solu-tions-based provider. They must con-tinue to brand the image of not beinga fair-weather lender regardless ofgovernment entity status and havinga well-trained educated staff and cus-tomer.

The Farm Service Agency andFarmer Mac will be critical in eitherguaranteed lending or pooling ofrisk, particularly as agriculture con-solidates. This will be necessary ascommodities such as soybeans andcorn find increased competitive pres-sure from South America, wheat getscompetition from the Baltic States,and cotton and apples move to Chi-na, shutting windows of opportunityand increasing volatility. These pro-grams will be critical in providingstability and opportunities for youngproducers in the agricultural financialsector as well as assisting in farmbusiness transition.

Insurance companies and partic-ularly nontraditional lenders and in-put supply firms will continue tocompete as niche and stealthy com-petition, exploiting the vulnerabili-ties of the larger institutions. Theywill continue to build on strategic ad-vantages of streamlined decision-making and being a total agribusinesssolutions provider to the segmentsthat they target. Some agribusinessfirms may form global alliances withinternational lenders. This will bemore common with the larger pro-ducer and agribusiness segments thatare perceived to be sustainable in theglobal marketplace without subsidiesand supports.

ImplicationsThe following are items that any stra-tegic planner needs on the agenda tohelp envision and plan for the future.The objective is to provoke thought,which may provide the differentialedge for success in the agribusinessand agri-lending industry of the fu-ture.• Data systems must evolve to facil-

itate moving raw data to informa-tion, leading to knowledge that isshared throughout the organiza-tion and with customers. Thiswill, in turn, help anticipateopportunities and provide solu-tions that transform vision toreality. Although leading agri-business firms are currently doingthis, the traditional lender oftoday has yet to see the advan-tages, particularly those of a port-folio made up of the sevenbusiness models outlined above.

• Leadership and boards of direc-tors of institutions and agribusi-nesses must be revamped toreflect the realities of the market-place. Having representation ofwomen and minorities, as well asboard accountability, education,and evaluation, must be arequirement. Businesses will seekhigher levels of expertise in linewith the portfolio concentrationof segments represented by theseven business models. The prac-tice of appointing versus electingdirectors, particularly in coopera-tives, will be re-examined to helpseek this balance.

• Education of employees and cus-tomers must be a high priorityeven in times of tight budgets. Aconcept called “edu-marketing” isan effective differentiation strat-egy by making your customermore knowledgeable and sustain-able through educational pro-

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grams, such as young, beginning,and executive producer schoolssponsored by lenders. Smallerbanks and cooperatives will joinin alliances with agribusinessesand even competitors to providethese opportunities. Programs forboth customers and employeesthat deal with medical, pension,retirement, and transition plan-ning will be a high priority tomaintain a sustainable customerand employee base, as Medicareand Social Security face morechallenges. The concept ofblended education, encompassingInternet-based training guided bymentor experience and oversight,will be critical to combine thecomponents of high tech andhigh touch. Internship and coop-erative education programs thatare organized nationally or inter-nationally can provide an oppor-tunity for red-shirting ofprospective employees—a popu-lar concept in sports—which issimilar to the employee andemployer having an extendedinterview. These concepts willchallenge banks and lending

cooperatives of small-town Amer-ica but will also be a must forboth customers and employees ina global environment.

• CEOs, leaders, and managementof agri-lending institutions mustoperate with a long-term mental-ity rather than a short-term maxi-mization strategy. Agriculture,particularly in the United States,is an industry that does not adjustreadily to large paradigm shifts;those that do not recognize it willbe doomed to failure.

• Historically, technology has beenthe differentiator in the competi-tive marketplace in lending. Inthe future, as the technologycurve flattens, the differentialadvantage will come through ahumanization strategy—combin-ing high tech with a balance ofhigh touch. The challenge will beto train younger employees whoare technology-oriented, butchallenged when it comes toemotional intelligence, involvingworking with people and criticalthinking skills, which are bothvery important for success. Lend-ers in rural areas that don’t have

the quality of life attributesdesired will struggle to find newemployees.

• Products and services must be“customerized.” That is, a cus-tomer could have access to amenu of choices inside and out-side the organization throughstrategic alliances to be custom-ized to meet their needs. This willrequire the 2020 agri-lender toplay the roles of a teacher, coach,and facilitator.Agriculture in 2020 will be an in-

dustry in which one size does not fitall. Being fast, fluid, and flexible, andrealizing the customer drives changeand the business model, will be im-portant. The competitive agri-lendermust think globally—beyond 20miles of their home base—but act lo-cally. Understanding people, philoso-phies, and consumer dynamics, whiledemonstrating a passion for the agri-cultural industry, is the recipe formaking the vision become reality.

Dr. David M. Kohl is ProfessorEmeritus and Alicia M. Morris is anMS student in the Department ofAgricultural and Applied Economicsat Virginia Tech.

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©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Markets for the EnvironmentRichard T. Woodward

Markets are increasingly being used and proposed as away to address environmental problems and manage natu-ral resources. Functioning markets exist for water rightsand sulfur dioxide credits can even be purchased via theInternet. Markets are being developed for trading waterquality credits, greenhouse gas emissions, and many otherenvironmental services. In this paper, I examine why suchmarkets are being widely proposed, give some backgroundon their history, and speculate on their future. The otherpapers in this Choices theme provide an overview of whatis really happening “on the ground,” discussing how wellthe promise of these new markets has been met in reality.

BackgroundMost economists are quite enthusiastic about markets;they make buyers and sellers better off and create incen-tives for innovation. These benefits can also be achievedwhen applied to the environment. Markets can helpreduce the cost of achieving environmental goals andmove resource usage permits to those that value themmost. However, Adam Smith’s invisible hand does notmagically materialize to provide clean air, protect endan-gered species, or even ensure the best use of fresh water. Ifmarkets are to be used to address these issues, then therights to be transacted must be intentionally defined.

The advantages of markets have led economists to lookfor ways to harness market forces for the management ofthe environment and our natural resources. After beingpromoted for decades by economists, this policy tool isbeginning to have some notable successes. Costs of con-trolling sulfur dioxide have fallen dramatically, and waterquantity trading is now routine in some regions. It mighteven be argued that the development and implementationof environmental markets constitutes the single most valu-able contribution of environmental economists to date,having saved billions of dollars in the SO2 program alone.Today markets are being promoted as part of the solutionto an ever-increasing range of environmental problems,

including overfishing, urban sprawl, and global climatechange.

What are the Economic Benefits of Environmental Markets?The theory behind market-based approaches to deal withpollution problems arose in the late 1960s in work byDales (1968) and Crocker (1966). In such a system, rightsto emit pollutants or use natural resources would be dis-tributed to stakeholders but could then be sold. Marketnegotiations between potential permit buyers and sellerswould occur and result in the reallocation of these permitsacross the stakeholders. In the textbook version of such aprogram, a cap is first placed on total pollution emissions.Second, permits equal to the cap are distributed to the pol-luters. Finally, a market develops in which the sellers arethose firms with relatively low abatement costs who endup reducing emissions by more than initially required;buyers are those with relatively high abatement costs whoend up reducing emissions by less than initially required.Regardless of the aspect of the environment being consid-ered, the market-based approach requires that transferablerights be defined and protected (typically by government),an initial allocation is set, and trade in these permits isallowed. The textbook result is an efficient market equilib-rium in which a pollution target is achieved at lowest costor a resource is used in a way that yields the most value tosociety.

At least, that is how it is supposed to work—the sim-plest theoretical models never quite work in practice. For

Articles in this Theme:Markets for the Environment . . . . . . . . . . . . . . . . . . . . . . . . . 49

Lessons Learned from SO2 Allowance Trading . . . . . . . . . . . 53

The Evolving Western Water Markets . . . . . . . . . . . . . . . . . . 59

The Future of Wetlands Mitigation Banking . . . . . . . . . . . . 65

Crunch Time for Water Quality Trading . . . . . . . . . . . . . . . . . 71

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example, Dales’ original proposal wasto use transferable rights to improvewater quality. Coincidentally, one ofthe earliest applications involvedmarkets for water pollution on theFox River in Wisconsin. However,significant barriers to market tradesarose because the difficulty in obtain-ing regulatory authority for tradesand the persistent concerns about“hot spots”—locally high concentra-tions of the pollutants. In the end,the Fox River program, established in1981, did not give rise to a singletrade during the first 14 years of itsexistence.

Challenges to Market DesignAs the Fox River example makesclear, the design of environmentalmarkets is not without challenges.Numerous decisions must be madewhen such markets are put in place.The nature of the rights must becarefully defined so that environmen-tal goals are met but market flexibil-ity remains. The initial allocation ofrights must be established, sometimesbeing handed out based on historicalprecedents and other times beingauctioned by the government. Thesedecisions, and many others, can bepolitically contentious and can affectthe success of the market.

Whether they are used to addresspollution problems or fisheries man-agement, all transferable rights pro-grams require that an institution(typically the government) certify thevalidity and transferability of theproperty right. In addition to defin-ing the rights and obligations associ-ated with the permit, the oversightagency must monitor compliance.This is more difficult than in stan-dard markets. When someone pur-chases an apple at the supermarket,they know the purchase is completewhen they walk out of the store; if

the apple is rotten they can usuallyreturn it for a refund. When some-one purchases a pollution permit,they know that it is legitimate whenthe government informs them thatthey are allowed to increase their pol-lution, but they usually have no wayto know (or reason to care) if theseller of the permit actually reducedits pollution to generate the offset-ting environmental benefit. Compli-ance must be enforced by thegovernment. Monitoring andenforcement is also needed to createdemand for the rights to be trans-acted. Permits will be valued only ifpolluters know that they are requiredby the government. As Dennis Kingputs it in his paper in this series, “the‘invisible hand’ will not work with-out the ‘visible foot’ of a regulatorinsuring compliance.”

Further inhibiting the perfor-mance of environmental markets isthe fact that they usually grow out ofmore traditional regulatory pro-grams and often carry excess baggageas a result. As Robert Hahn (1990)noted, “In the real world, regulatorysystems are rarely discarded andreplaced wholesale. Rather, reform ofregulatory systems proceeds in anincremental fashion.” Hence, the ear-liest transferable rights programs inpollution are hardly identifiable asmarket-based systems at all. In somecases flexibility arises over time, butsuch evolution is not automatic. AsLeonard Shabman and Paul Scodariargue in their paper in this series, thelevel of flexibility that has been intro-duced in the management of ournation’s wetlands is so limited thatthe program can not even qualify astruly market based.

A Brief History of Environmental MarketsThe development of the institutionsneeded to support transferable rightsis more natural in some instancesthan in others. The buying and sell-ing of water rights, which is centuriesold, is a natural improvement overfights that inevitably arise over thisscarce resource. As governmentsbecame more involved in resourcemanagement, however, they oftencreated barriers to trades that madetransactions more difficult. Govern-ment control of water, environmentalregulations, and restrictions on therights to use water often made watertrading quite difficult. However, asRichard Howitt notes in his paper inthis series, in recent years there havebeen efforts to encourage markets bymodifying laws to facilitate trading.Fierce battles are still being fought,but pressed by rising scarcity, therehas been substantial growth in watermarkets.

For pollution and environmentalservices, there is no natural tendencyfor markets to arise; the initiationhad to come from the regulatorybranch. In the 1970s, the US Envi-ronmental Protection Agency starteddown the path toward market-basedinstruments when it began introduc-ing some flexibility into its air qualityprograms. The 1980s saw an expan-sion in the use of this tool: Tradingwas allowed as part of the rules thatremoved lead from refined gasolineand as part of the US approach tocontrolling chlorofluorocarbons.That decade also saw the develop-ment of a number of small-scale mar-ket-based programs to address water-quality: the Fox River program notedabove, programs in Lake Dillon andCherry Creek Reservoir in Colo-rado, and on the Tar Pamlico Riverin North Carolina. By the 1990s, the

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number and scope of market-basedprograms was expanding rapidly. Thenational SO2 program, started in1990, has proven that a program canwork in textbook-like fashion. Cali-fornia introduced an ambitious trad-ing program in air pollutants, andwater pollution programs havesprouted up around the nation.

In addition, it appears that inter-est in market-based mechanisms is asstrong as ever. In fact, it often appearstoday that when environmental pol-icy is discussed in the US, market-based approaches are assumed desir-able unless proven otherwise.

Why this Issue?Today there are many proposed mar-kets, and we can observe a number ofsuccessful and unsuccessful efforts. Itis a good time to take stock of wherewe are. In this collection of articles,Choices explores the reality of envi-ronmental markets in the UnitedStates today. In this package ofpapers:• Robert Stavins reviews the mar-

ket for permits to emit sulfurdioxide, which is widely viewedas an enormous success;

• Richard Howitt and KristianaHansen look at the emergingmarkets for water in the West,where markets remain quite lim-ited despite the fact that thereseems to be great potential forgains from trade;

• Leonard Shabman and Paul Sco-dari look at wetlands mitigationbanking, which, they argue, is sorestricted that it is like any otheroffset program and cannot legiti-mately be called a market-basedprogram; and

• Dennis King looks at the prob-lem of water quality markets andfinds that the potential in thisarena has yet to materialize; andit may never do so unless govern-ment plays a stronger role.

What Do the Papers Tell Us?A constant theme repeated through-out these papers is that details matterand the creation of markets for natu-ral resources and environmental ser-vices is no small task. As we look tothe future, it may be prudent toavoid exuberant predictions of hugeeconomic benefits from trading.Although it is clear that these instru-

ments will continue to be part of thepolicy landscape for years to come,they will also face challenges and set-backs, and markets may not beappropriate in every setting. Overtime, market-based instruments maytake a less prominent place in thepolicy mix, to be seen as one toolamong many that can be used forimproved management of the envi-ronment and natural resources.

For More InformationCrocker, T.D. (1966). The structur-

ing of atmospheric pollution con-trol systems. In H. Wolozin (Ed.), The Economics of air pollu-tion (61-68). New York: W.W. Norton & Co.

Dales, J.H. (1968). Land, water, and ownership. The Canadian Journal of Economics, 1(4), 791-804.

Hahn, R.W. (1990). Regulatory con-straints on environmental mar-kets. Journal of Public Economics, 42, 149-75.

Stavins, R.N. (1998). What can we learn from the grand policy experiment? Lessons from SO2 allowance trading. Journal of Eco-nomic Perspectives, 12, 69-88.

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©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Lessons Learned from SO2 Allowance TradingRobert N. Stavins

The most ambitious application yet undertaken of a mar-ket-based instrument for environmental protection hasbeen for the control of sulfur dioxide (SO2) emissions inthe context of acid rain reduction under Title IV of theClean Air Act amendments of 1990. That Act establishedan allowance trading program to cut SO2 emissions by 10million tons from 1980 levels—a 50% reduction. In thisarticle, I identify lessons that can be learned from thisgrand experiment in economically oriented environmentalpolicy.

The System and Its Performance In Phase I of the allowance trading program, emissionsallowances were assigned to the 263 most SO2-emissions-intensive generating units at 110 power plants operated by61 electric utilities, located largely at coal-fired powerplants east of the Mississippi River. After January 1, 1995,these utilities could emit SO2 only if they had adequateallowances to cover their emissions. The US Environmen-tal Protection Agency (EPA) allocated each affected unit,on an annual basis, a specified number of allowancesrelated to its share of heat input during the baseline period(1985-87) plus bonus allowances available under a varietyof special provisions. Cost-effectiveness was promoted bypermitting allowance holders to transfer their permitsamong one another and bank them for later use. UnderPhase II of the program, which began on January 1, 2000,almost all electric power generating units were broughtwithin the system. Certain units are exempted to compen-sate for potential restrictions on growth and to rewardunits that were already unusually clean.

The SO2 allowance trading program has performedsuccessfully. Targeted emissions reductions have beenachieved and exceeded, and total abatement costs havebeen significantly less than what they would have been in

the absence of the trading provisions. Trading volume hasincreased over the life of the program (Figure 1), and therobust market has resulted in an estimated cost savings ofup to $1 billion annually, compared with the cost of com-mand-and-control regulatory alternatives that were con-sidered by Congress in prior years, representing a 30–50%cost savings.

The allowance trading program has had exceptionallypositive welfare effects, with estimated benefits being asmuch as ten times greater than costs. It is notable that themajority of the benefits of the program are due mainly tothe positive human health impacts of decreased local SO2and particulate concentrations, not to the ecologicalimpacts of reduced long-distance transport of acid deposi-tion. This contrasts with what was assumed at the time ofthe program’s enactment in 1990.

Lessons for Design and Implementation of Tradable Permit Systems The performance of the SO2 allowance trading systemprovides valuable evidence for environmentalists and oth-ers who have been resistant to these innovations. It showsthat market-based instruments can achieve major cost sav-ings while accomplishing environmental objectives. Thesystem’s performance also offers lessons about the impor-tance of flexibility and simplicity, the role of monitoringand enforcement, and the capabilities of the private sectorto make markets of this sort work.

In regard to flexibility, tradable permit experience indi-cates that systems should be designed to allow for a broadset of compliance alternatives, in terms of both timing andtechnological options. Allowing flexible timing and inter-temporal trading of the allowances—that is, “banking”allowances for future use—has played a very importantrole, much as it did in EPA’s lead rights trading program a

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decade earlier. The permit systemwas based on emissions of SO2 (asopposed to sulfur content of fuels),so that both scrubbing and fuel-switching were feasible options.Moreover, one of the most significantbenefits of the trading system wassimply that technology standardsrequiring scrubbing of SO2 werethereby avoided. This allowed Mid-western utilities to take advantage oflower rail rates (brought about byrailroad deregulation) to reduce theirSO2 emissions by increasing their useof low-sulfur coal from Wyoming—an approach that would not havebeen possible if scrubbers had beenrequired.

In regard to simplicity, simpleformulas for allocating permits basedupon historical data have proven tobe difficult to contest or manipulate.More generally, experience showstrading rules should be clearlydefined up front without ambiguity.For example, there should be norequirements for prior governmentapproval of individual trades. Suchrequirements hampered the EPA’s

Emissions Trading Program for localair pollutants in the 1970s, while thelack of such requirements was animportant factor in the success oflead trading in the 1980s. In the caseof SO2 trading, the absence ofrequirements for prior approvalreduced uncertainty for utilities andadministrative costs for governmentand contributed to low enforcementand other program implementation(transactions) costs.

Considerations of simplicity andthe experience of the SO2 allowancesystem also argue for using absolutebaselines—not relative ones—as thepoint of departure for tradable per-mit programs. The difference is thatwith an absolute baseline (so-called“cap-and-trade”), sources are eachallocated some number of permits(the total of which is the “cap”); witha relative baseline, reductions arecredited from a hypothetical base-line—what the source would haveemitted in the absence of the regula-tion. A hybrid system—where a cap-and-trade program is combined withvoluntary “opt-in provisions”—canalso be undesirable because it wouldcreate the possibility for “papertrades,” where a regulated source iscredited for an emissions reduction(by an unregulated source) thatwould have taken place in any event.Relative baselines would have com-plicated the program and could haveled to an unintentional increase inthe total emissions cap.

The SO2 program has alsobrought home the importance ofmonitoring and enforcement provi-sions. In 1990, environmental advo-cates insisted on continuousemissions monitoring, which helpsbuild market confidence. The costsof such monitoring, however, are sig-nificant. On the enforcement side,the Act’s stiff penalties—$2,000 perton of excess emissions, a value more

than 10 times that of marginal abate-ment costs—have provided suffi-cient incentive for the very highdegree of compliance that has beenachieved.

Another lesson involves permitallocation procedures. There areobvious political advantages of allo-cating permits without charge, as wasdone for the SO2 program. But thesame characteristic that makes suchallocations politically attractive—theconveyance of valuable allowances tothe private sector—also makes freeallocations problematic. It has beenestimated that the costs of SO2allowance trading would be 25%lower if permits were auctionedrather than freely allocated, becauseauctioning yields revenues that canbe used to finance cuts in preexistingdistortionary taxes. Furthermore, inthe presence of some forms of trans-action costs, the post-trading distri-bution of emissions—and henceaggregate abatement costs—are sensi-tive to the initial permit allocation.For both reasons, a successfulattempt to establish a politically via-ble program through a specific initialpermit allocation can result in a pro-gram that is significantly more costlythan anticipated.

Finally, the SO2 program's per-formance demonstrates that once atradable system is established, theprivate sector can then step in tomake it work. In the SO2 context,despite claims to the contrary whenthe program was enacted, entrepre-neurs provided brokerage needs,developed price information,matched trading partners, developedelectronic bid/ask bulletin boards,and made available allowance priceforecasts. The annual EPA auctionsmay have served the purpose of help-ing to reveal market valuations ofallowances, but bilateral trading hasalso informed the auctions.

Figure 1. Trading volume in the SO2Allowance Trading Program.Source: Based on data from USEPA "Trading Activ-ity Breakdown" (see http://www.epa.gov/airmar-kets/trading/so2market/transtable.html).

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Lessons for Judging Effectiveness of Tradable Permit Systems When examining the effectiveness oftrading programs, economists havetypically employed some measure inwhich gains from trade are estimatedfor moving from conventional stan-dards to marketable permits. Aggre-gate cost savings are the yardstickbest used for measuring success.

The challenge is to compare real-istic versions of both tradable permitsystems and likely alternatives, notidealized versions of either. It is notenough to analyze the cost savings inany year. For example, the gains frombanking allowances should be con-sidered (unless this is not permittedin practice). It can also be importantto allow for the effects on technologyinnovation and diffusion, especiallywhen permit trading programsimpose significant costs over longtime horizons.

More generally, it is important toconsider the effects of the preexistingregulatory environment. The level ofpreexisting taxes can affect the totalcosts of regulation, as emphasizedabove. Also, because SO2 is both atransboundary precursor of acid rainand a local air pollutant regulatedunder a separate part of the Clean AirAct, local environmental regulationshave sometimes prevented utilitiesfrom acquiring allowances ratherthan carrying out emissions reduc-tions. Moreover, because electricitygeneration and distribution havebeen regulated by state commissions,a prospective analysis of SO2 tradingshould consider the incentives thesecommissions may have to influencethe level of allowance trading.

Lessons for Identifying New Permit Trading ApplicationsMarket-based policy instruments arenow considered for almost everyenvironmental problem, rangingfrom endangered species preservationto global climate change. Experienceswith SO2 trading offer some guid-ance as to when tradable permits arelikely to work well and when theymay face greater difficulties.

First, permit trading is likely towork best where there are wide differ-ences in the cost of abating emis-sions. SO2 trading is such a case.Initially, SO2 abatement cost hetero-geneity was great because of differ-ences in ages of generatingequipment and their proximity tosources of low-sulfur coal. Whenabatement costs are more uniformacross sources, the political costs ofenacting an allowance tradingapproach are less likely to be justifi-able.

Second, the greater the degree ofmixing of pollutants in the receivingairshed or watershed, the moreattractive will be a tradable emissionpermit (or emission tax) system, rela-tive to a conventional uniform stan-dard. This is because taxes or tradablepermits can lead to localized “hotspots” with relatively high levels ofambient pollution. This is a signifi-cant local or regional issue, and it canbecome an issue of overall conse-quence, as well, if damages rise morethan proportionally with increases inpollutant concentrations.

Third, economic theory hastaught us that the efficiency of a trad-able permit system will depend onthe pattern of costs and benefits. Ifuncertainty about marginal abate-ment costs is significant, and if mar-ginal abatement costs are relativelyconstant, but the benefits of abate-ment fall relatively quickly at higher

levels of abatement, then a quantityinstrument (such as tradable permits)will be more efficient than a priceinstrument (such as an emission tax).The advantage of tradable permits isreinforced when there is uncertaintyabout both the marginal costs andthe marginal benefits of pollutionreductions, and these are positivelycorrelated.

Fourth, tradable permits willwork best when marketing and bro-kerage costs are low, and the SO2experiment shows that if properlydesigned, private markets will tend torender such costs minimal. Finally,considerations of political feasibilitypoint to the wisdom of proposingtrading instruments when they canbe used to facilitate emissions reduc-tions—as was done with SO2 allow-ances and lead rights trading—asopposed to using these instrumentsonly to lower the costs of achievingstatus quo emissions.

What about Greenhouse Gas Trading?Many of these issues can be illumi-nated by considering the currentinterest in applying tradable permitsto the task of cutting greenhouse gasemissions—largely carbon dioxide(CO2) emissions—to reduce the riskof global climate change (for more onwhy this might occur, see the Fall2004 issue of Choices). It is obviousthat the number and diversity ofsources of CO2 emissions due to fos-sil fuel combustion are vastly greaterthan in the case of SO2 emissions as aprecursor of acid rain, where thefocus can be placed on a few hundredelectrical utility plants.

Any pollution-control programmust face the possibility of “emis-sions leakage” from regulated tounregulated sources. This could be aproblem for meeting domestic targets

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for CO2 emissions reduction, but itwould be a vastly greater problem foran international program, whereemissions would tend to increase innonparticipant countries. This alsoraises serious concerns with provi-sions in the Kyoto Protocol forindustrialized countries to participatein a CO2 cap-and-trade programwhile nonparticipant (developing)nations retain the option of joiningthe system on a project-by-projectbasis. As emphasized earlier, provi-sions in tradable permit programsthat allow for unregulated sources toopt in can lower aggregate costs bysubstituting low-cost for high-costcontrol but may also have the unin-tended effect of increasing aggregateemissions beyond what they wouldotherwise have been. This is becausethere is an incentive for adverse selec-tion: Sources in developing countriesthat would reduce their emissions,opt in, and receive excess allowanceswould tend to be those that wouldhave reduced their emissions in anycase.

To the limited degree that anyprevious trading program can reallyserve as a model for the case of globalclimate change, attention shouldsurely be given to the tradable-permitsystem that accomplished the USphaseout of leaded gasoline in the1980s. The currency of that systemwas not lead oxide emissions frommotor vehicles, but rather the leadcontent of gasoline. So, too, in thecase of global climate, great savings inmonitoring and enforcement costscould be had by adopting input trad-ing linked to the carbon content offossil fuels. This is reasonable in theclimate case, because—unlike in theSO2 case—CO2 emissions areroughly proportional to the carboncontent of fossil fuels, and scrubbingalternatives are largely unavailable, atleast at present. On the other hand,

natural sequestration of CO2 fromthe atmosphere—such as by expand-ing forested areas—is available at areasonable cost (even in the UnitedStates), and is explicitly countedtoward compliance under the KyotoProtocol. Hence, it could be impor-tant to combine any carbon trading(or carbon tax) program with a car-bon sequestration program.

Developing a tradable permit sys-tem in the area of global climatechange would surely bring forth anentirely new set of economic, politi-cal, and institutional challenges, par-ticularly with regard to enforcementproblems. But, it is also true that thediversity of sources of CO2 emissionsand the magnitude of likely abate-ment costs make it equally clear thatonly a market-based instrument—some form of carbon rights tradingor carbon taxes—will be capable ofachieving the domestic targets thatmay eventually be forthcoming frominternational agreements.

Conclusion Given that the SO2 allowance-trad-ing program became fully bindingonly in 1995, we should be cautiouswhen drawing conclusions about les-sons to be learned from the program’sperformance. But despite the uncer-tainties, market-based instrumentsfor environmental protection—trad-able permit systems in particular —now enjoy proven successes in reduc-ing pollution at low cost.

Market-based instruments havemoved to center stage, and policydebates look very different from thetime when these ideas were character-ized as “licenses to pollute” or dis-missed as completely impractical. Ofcourse, no single policy instru-ment—whether market-based orconventional—will be appropriatefor all environmental problems.

Which instrument is best in anygiven situation depends upon charac-teristics of the specific environmentalproblem and the social, political, andeconomic context in which theinstrument is to be implemented.

For More InformationBurtraw, D. Krupnick, A., Mansur,

E., Austin, D., & Farrell, D. (1998). The costs and benefits of reducing air pollutants related to acid rain. Contemporary Eco-nomic Policy, 16, 379-400.

Carlson, C., Burtraw, D., Cropper M., & Palmer, K.L. (2000). SO2 control by electric utilities: What are the gains from trade? Journal of Political Economy, 108, 1292-1326.

Ellerman, A.D., Joskow, P.L., Schmalensee, R., Montero, J.-P., & Bailey, E.M. (2000). Markets for clean air: The U.S. acid rain program. Cambridge: Cambridge University Press.

Hahn, R.W., Olmstead, S.M., & Stavins, R.N. (2003). Environ-mental regulation during the 1990s: A retrospective analysis. Harvard Environmental Law Review, 27(2), 377-415.

Joskow, P.L., & Schmalensee, R. (1988). The political economy of market-based environmental pol-icy: The U.S. acid rain program. Journal of Law and Economics, 41, 37-83.

Newell, R.G., & Stavins, R.N. (2003). Cost heterogeneity and the potential savings from mar-ket-based policies. Journal of Reg-ulatory Economics, 23, 43-59.

Parry, I., Lawrence, W.H., Goulder, H., & Burtraw, D. (1997). Reve-nue-raising vs. other approaches to environmental protection: The critical significance of pre-exist-

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ing tax distortions. RAND Jour-nal of Economics, 28, 708-731.

Schmalensee, R., Joskow, P.L., Eller-man, A.D., Montero, J.-P., & Bailey, E.M. (1998). An interim evaluation of sulfur dioxide emis-sions trading. Journal of Economic Perspectives, 12(3), 53-68.

Stavins, R.N. (1998). What can we learn from the grand policy experiment? Lessons from SO2 allowance trading. Journal of Eco-nomic Perspectives, 12 (3), 69-88.

Stavins, R.N. (1995). Transaction costs and tradable permits. Jour-

nal of Environmental Economics and Management, 29, 133-148.

Stavins, R.N., & Richards, K.R. (2005). The cost of supplying for-est-based carbon sequestration in the United States. Arlington, VA: The Pew Center on Global Cli-mate Change.

Stavins, R.N. (2003). Experience with market-based environmental policy instruments. (2003). In K.-G. Mäler & J. Vincent (Eds.), Handbook of environmental eco-nomics: Vol. I. (Chapter 9). Amsterdam: Elsevier Science.

United States Environmental Protec-tion Agency. Clean air markets: Acid rain program. Available on the World Wide Web: http://www.epa.gov/airmarkets/arp/index.html.

Robert N. Stavins is Albert Pratt Pro-fessor of Business and Government,John F. Kennedy School of Govern-ment; Director, Environmental Eco-nomics Program at HarvardUniversity; and University Fellow,Resources for the Future.

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CHOICESThe magazine of food, farm, and resource issues

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1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

The Evolving Western Water MarketsRichard Howitt and Kristiana Hansen

Expanding population and environmental protection theworld over are placing additional demands on existingwater supplies. Meeting these demands by traditionalstructural supply augmentation is dogged by increasingenvironmental and fiscal costs, which leave excess waterdemand to be met largely by conservation and reallocationof existing supplies. Water trading clearly has a role in real-locating supplies and stimulating conservation by provid-ing a clear measure of its value for conservation and avoluntary self-compensating mechanism for reallocation.Despite these advantages, traditional markets have beenslow to evolve in the western United States for institu-tional and hydrologic reasons. However, even when insti-tutional, political, and physical impediments preventtextbook water markets from developing, significant gainsin efficiency can result from relaxing restrictions on own-ership, use, and transfer. Most water markets in the west-ern United States fall between the two extremes oftextbook markets in which, on the one hand, price isdetermined by unfettered market forces, and on the other,there is an outright legal prohibition of trading.

Three fundamental reasons probably cause the slowevolution of water markets in the West. First, water hasmany public good characteristics, benefiting not only theowner of a water right, but also the public at large. Publicinterest in water is supported by the fact that most westernstates retain the ultimate property right to water; individ-ual water rights are more akin to use rights than privateproperty rights. Second, fluctuations in water supply resultin periodic “thin” markets with few participants. Third,water transfers often require significant costs, in terms ofboth institutional costs and the cost of physically trans-porting the resource. Even in the presence of willing buy-ers and sellers, trades of permanent water rights are oftennot approved by regulators because they would result insignificant externalities—physical impacts on parties notinvolved in the transaction—and in third party financialimpacts to the exporting region.

A worldwide survey of existing markets makes it clearthat gains in efficiency can occur even in the absence oftheoretically perfect markets (Saleth & Dinar, 2004). Theefficiency gains are achieved by moving water to highervalue uses. To achieve these gains, many states west of theMississippi River have implemented legislation to facilitatewater trading within their borders. However, becausewater has both private and public good characteristics, ithas often been developed with some degree of publicfinancing or subsidies. Hence, its reallocation generatesheated controversy—especially when potential profits areinvolved.

Water Market DeterminantsWhat factors determine whether and how marketsdevelop? Why is trading heavier in some states than inothers? The importance of water’s physical characteristicscannot be emphasized enough. In many parts of the West,the water supply is uncertain; there is tremendous tempo-ral and spatial variation in rainfall. Furthermore, supplyand demand peaks do not generally coincide within thewater year. For example, when snow pack melts in thespring, it is stored in surface reservoirs until late summerwhen farmers’ irrigation demand peaks. These fundamen-tal characteristics of precipitation make water marketdevelopment all the more desirable, but they hinder thecreation of markets in the first place. Transportation andstorage facilities have been constructed throughout theWest, largely at public expense, to convey water acrosstime and space. Not surprisingly, water markets havetended to develop in locations where the Bureau of Recla-mation and state water projects have invested resources increating an infrastructure to facilitate the transportationand storage of water.

Yet obstacles remain. Even though water garners sub-stantial political attention and controversy, its economicvalue at the margin is actually quite low relative to the costof conveyance. For example, the option purchase price for

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water in a 2002 transaction betweenGlenn-Colusa Irrigation District innorthern California and the Metro-politan Water District serving theLos Angeles area was $110/acre-foot.The cost of transport (including amandatory 20% environmental miti-gation requirement and 300-miletransport and pumping fees) isapproximately $143/acre-foot, for atotal delivered cost of $253/acre-foot.Such high transaction costs reducethe number of trades that are finan-cially viable and the geographicalscope of markets.

Water’s mobility also makes prop-erty rights enforcement a challenge.Property rights are easier to monitorin some settings than others. Forexample, annual fallowing transfersfrom rice growers in the north ofCalifornia to urban users in the southof California are relatively easy tomonitor. If the fields are fallowed, thewater must still be in the river andpresumably flows to the purchasers.In contrast, monitoring sales of watersaved by more efficient field applica-tion methods requires the detailedassessment of current and past irriga-tion technologies as well as the levelof implementation.

For trades to occur easily, prop-erty rights must be clearly defined,enforceable, and transferable. Inmost western states, water propertyrights are governed by prior appro-priation, whereby the first to claimthe water in a waterway for beneficialuse has first priority to the water, anda water right not exercised for aperiod of some years is relinquished.When appropriative rights were codi-fied into state laws in the late 19th

and early 20th centuries, state law-makers did not envision widespreadleasing and permanent transfers ofwater rights. As a result, westernrights holders have historically beenreluctant to lease water out, for fear

of losing their right to the water inthe longer term. Further, permanenttransfers of water rights under priorappropriation have usually beencostly and time-consuming. Perma-nent transfers and leases haverecently become easier, as state lawshave changed to facilitate markettransactions.

One water market in the Westwhere property rights are clearlydefined, enforceable, and transferableis a Bureau of Reclamation project onthe eastern slope of the Rocky Moun-tains: the Colorado-Big Thompson(CBT). Water rights in the CBT arecorrelative; shares fluctuate annuallyin response to water conditions, andall shareholders benefit or lose eachyear in like manner. The shares areentirely homogeneous, and transferoccurs with minimal fees and paper-work. However, the CBT system hasthe great advantage of using waterimported from another watershed,thus freeing it from the impacts ofreduced or altered flows on down-stream users or externalities thatcomplicate water trades along naturalrivers. In contrast, California waterrights are far from homogeneous.California continues to recognizeriparian rights (water rights that areattached to the land adjacent to thewaterway) alongside appropriativerights, which makes defining waterrights with sufficient precision to sellthem costly and litigious (Carey &Sunding, 2001). Furthermore, inmany parts of California (as else-where in the West), federal owner-ship of developed water resourcescomplicates market development.

The differential in water valuesbetween current owners and poten-tial buyers is often great enough tostimulate potential trades. However,another complexity is the physicaland environmental externalitiesintrinsic to trading an environmen-

tal resource. Reduced or altered flowson a waterway affect water quantityand quality downstream. Drawdownin an underground aquifer affectsneighbors’ pumping costs. Suchexternalities may be positive or nega-tive. When they are negative, there isa role for regulatory agencies toensure that nonmarket values placedon the waterways by society are takeninto account. The absence of ade-quate protections for those adverselyaffected by negative externalities mayresult in trade volume that exceedsthe socially efficient level. On theother hand, these concerns have tra-ditionally been handled throughlengthy court procedures, which maydiscourage socially beneficial trad-ing. Over time, regulatory agenciesshould develop procedures to addressthese issues in a less costly manner,perhaps through the development ofa body of precedent cases to guidewater traders and through the stan-dardization of environmental impactreports.

Although water trades mayincrease overall efficiency within amarket, there can be negative finan-cial impacts on third parties in thearea of origin through local loss ofincome and employment andthrough impacts on neighboringgroundwater users. Trades are morelikely to occur where impacts onthird parties in the area of origin areminimal (perhaps because the waterdoes not leave the watershed inwhich it originates) or where statelaw does not recognize them. Stan-dard economic theory does not usu-ally consider these third-partyfinancial losses to be legitimate.However, many trades do providesome compensation to third parties,often to appease public opinion. Thisconcern for third-party financiallosses results from fundamental waterproperty rights. In most of the west-

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ern states, the ultimate owner of thewater is the state itself, which isbound to protect the welfare of itscitizens.

Externalities and third-partydamages are likely to become moreimportant as a greater volume istraded. Thus, we expect that thesepressures will induce a higher per-centage of leases relative to perma-nent sales, as negatively affectedparties exert political pressures in reg-ulatory arenas to limit permanenttransfers. Examination of columnsfour and five in Table 1 suggests thatstates where more volume is tradedhave a higher lease-to-sale ratio. Thistension between the benefits to trad-ing partners and the negative effectson third parties is likely to be thedominant influence on future tradingpatterns.

What Do Existing Water Markets Look Like?We were unable to find public sourceof consistent data on western watertrading, so we compiled a summaryof trading from fourteen westernstates for 1999–2002 from backissues of the Water Strategist.Although the Water Strategist maynot record all the trades in westernwater, it is the only comprehensivesource of water trade information. Ifthere is a selection bias in thereported trades, it should be consis-tent across states and thus not influ-ence the comparisons. We classifiedthe trades as sales and leases. In a per-manent sale, the right to the waterfor all time is transferred. Lease trans-actions involve short-term trades ofwater; the underlying property rightremains unaffected by the transac-tion. Table 1 shows that water leasesdominate the market in terms ofwater volume traded. Permanent

sales comprise approximately 10%and leases 90% of the volume traded,although it is important to rememberthat a permanent water rights saleonly appears once, whereas a lease isoften an annual contract that mustbe renewed each year to reflect thesame quantity of water over the longterm.

A majority of the trades reportedin the Water Strategist are from agri-cultural sellers to urban buyers whoare grappling with projected increasesin demand. In Colorado and NewMexico, municipal agencies are pur-chasing permanent rights and leasingthem back to the irrigators fromwhom they purchased in the firstplace until needed to meet antici-pated future demand. The WaterStrategist data suggest that water pur-chases for municipal and industrialuse trade at higher prices than waterfor agricultural or environmental use.

Market purchases for environ-mental use have increased in recent

Table 1. Volume and volume-weighted prices for reported water transactions, 1999–2002.

State

Volume (thousand acre-feet) Price ($/acre-foot, in 2004 dollars)

Lease Sale Total Lease/sale ratio Lease Sale

AZ 1,371 24 1,395 53 73 894

CA 3,127 227 3,354 14 80 1,207

CO 74 242 316 0.3 22 3,451a

ID 692 1 693 692 10 201

KS 4 0.2 4.2 20 51 —

MT 5 — 5 — 5 —

NM 338 10 348 34 66 1,233

NV — 49 49 — — 2,572

OK 10 — 10 — 59 —

OR 532 38 570 14 283 1,045

TX 877 322 1,199 3 81 864

UT 6 3 9 2 6 870

WA 68 13 81 5 53 513

WY 105 — 105 — 40 —

Total 7,211 929 8,140 8 86 1,299

a CBT sales omitted. If included the average sale price is $7,801.Source: Data from the Water Strategist. The authors acknowledge Adams, Crews and Cummings (Georgia State University) for generously providing us with their database of Water Strategist transactions; and Alex Lombardi for assistance.

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years. In California, for example,direct purchases such as those madeby state and federal entities to com-ply with federal environmental regu-lations (primarily augmenting streamflow to enhance fish runs) accountedfor one third of traded volume in2001. By contrast, municipal buyersonly accounted for about 20% ofmarket activity (Hanak, 2002). Thistrend is repeated elsewhere in theWest. In the Pacific Northwest, forexample, water market developmenthas been driven by the need toacquire water for environmental pur-poses (Smith, 1995).

The sale prices reported in theWater Strategist in Colorado, Nevada,and New Mexico over the surveyperiod are markedly higher than inother states, probably reflecting therelative scarcity of the resource inthese locations. Financial theorywould suggest that the price of aright would exceed the capitalizedvalue of a lease for two reasons. First,the purchase of a right eliminates therisk inherent in relying on futurelease markets. Second, given theuncertainty of the value of futurewater rights, rational sellers wouldrequire a premium or hurdle rate inaddition to the capitalized value ofcurrent leases to consummate thedeal. A counterpoint to the risk argu-ment is that leases are more likely tobe concentrated in years of greaterscarcity, whereas the return from thesale of a right should be averaged overall types of water year.

The lease-to-sale price ratios inTable 1 give us the implicit capitali-zation rate over an infinite planninghorizon, which averages 6.6%. Thisis below the standard commercialcapitalization rate of 10%, but itseems a reasonable rate given the riskreduction from permanent sales. It isalso worth noting that high-volumestates, such as Arizona and Califor-

nia, have rates close to 6.6%, whereaslow-volume states exhibit tremen-dous variation in their implicit capi-talization rates. The variation is likelydue in part to thin markets with fewbuyers and sellers.

Permanent Sales, Leases, and Options One striking aspect of the descriptivestatistics provided in Table 1 is thedominance of leases in 12 of the 14states. Permanent trading is onlyclearly dominant in the dry states ofNevada and Utah, where diversionsand permanent trading have alwaysbeen an integral part of settlementand development.

In the presence of supply uncer-tainty, many water agencies in theWest seek to purchase water only indry years when their own supplies areinadequate. This may explain tradingbehavior in Idaho, Oregon, andWashington, where most water trans-fers are leases for environmental and(to a lesser extent) agricultural use.Such leases may be in response toannual water year conditions. Awater rights transfer would be anappropriate response to permanentshortage rather than the year-to-yearsupply uncertainty which often pre-vails. In short, leases are commonbecause temporary transfers of oneyear or less face significantly fewerenvironmental regulations, the costsof defining rights sufficiently to sellthem permanently are often prohibi-tive, and the presence of sufficientsupply in wet years makes permanenttransfers unnecessary and costly inmany cases.

A specific type of leasing—theoption agreement—is gaining cur-rency in California. Under an optionagreement, the purchaser pays anoption cost in the fall before the win-ter precipitation for the right to pur-

chase a specific quantity of water inthe spring, should the water year turnout to be dry. By paying the optioncost, the buyer manages supply riskby avoiding last-minute spring con-tract negotiations for water, whichmay no longer be available at a rea-sonable price. Buyers can furtherdecrease transaction costs by negoti-ating long-run, multiple exerciseoptions. The benefits of options aretwofold.

First, the water remains in thebasin of origin during average andwet water years, lowering third-partyfinancial impacts and making it morelikely that regulators will approve thetransfers. Options undertaken due tothe burdensome regulatory require-ments of permanent transfers are sec-ond best from an economic efficiencyperspective, but are preferable none-theless to no trades at all. Second,given supply and demand circum-stances in California, this is an effi-cient arrangement of property rightsand uses. In California, a typicaltrade might be between small waterrights holders in the North with low-value agricultural use and a largemunicipal water agency in the Southwith relatively high-value use.Because the municipal agency has arelatively high-value use but suffi-cient developed supplies during wetand normal years, the water is mostefficiently allocated to the municipaluser in dry years and the agriculturalfarmers in wet and normal years.

Who should own the water tobest ensure efficient allocationbetween dry and wet years? If weassume for simplicity that the trans-action costs are the same regardless ofwho owns the water, then the waterright should remain with the low-value agricultural use, so that transac-tion costs are a lower proportion ofthe buyer’s final sale price. If transac-tion costs vary depending on who

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possesses the water right (small buy-ers may collectively face higher bar-gaining costs than a single largebuyer), this further strengthens thecase for low-value users to retain theirwater rights.

An option agreement negotiatedin advance of the water year helps themunicipal agency manage its supplyuncertainty. If the difference in valuebetween the buyer and sellers is largerthan the transaction costs, the agri-cultural rights holders can be suffi-ciently compensated for this dry-yearoption contract. To the extent thatwestern states will have to increasewater trading to balance demands,and third-party pressures increase, weexpect the proportion of option con-tracts to increase.

Water Markets in the FutureMarkets as a mechanism for waterallocation are gaining traction in thewestern United States. However, con-cern over environmental and eco-nomic externalities and third-partyimpacts in exporting regions will

continue to be issues with whichdeveloping markets must contend.These institutional impediments towater transfers, combined with theuncertainty of water supply, willprobably lead to a proportionalincrease in the number of lease trans-actions relative to permanent sales ofwater rights. In particular, the risk-sharing characteristics of optionagreements correspond precisely tothe need for flexibility in thoseinstances where supply risk is sharedby both parties or where it is possibleto sell risk between parties.

For More InformationAdams, J., Crews, D., & Cummings,

R. (2004). The sale and leasing of water rights in western United States: An update to mid-2003 (water policy working paper #2004-004). North Georgia Water Planning and Policy Cen-ter. Available on the World Wide Web: http://www.h2opolicycenter.org/pdf_documents/

water_workingpapers/2004-004.pdf.

Carey, J., & Sunding, D. (2001). Emerging markets in water: A comparative institutional analy-sis of the Central Valley and Col-orado-Big Thompson projects. Natural Resources Journal, 41(2), 283-328.

Hanak, E. (2002). California’s water market, by the numbers. Public Policy Institute of California.

Saleth, R. & Dinar, A. (2004). The institutional economics of water: A cross-country analysis of institutions and performance. Cheltenham, UK: Edward Elgar Publishing Limited.

Smith, R. (1995). Annual transac-tions review. Water Strategist, 9(1), 16.

Richard Howitt is a professor of Agri-cultural Economics at the Universityof California, Davis. KristianaHansen is a graduate student in theDepartment of Agricultural andResource Economics at the Universityof California, Davis.

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A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

The Future of Wetlands Mitigation BankingLeonard Shabman and Paul Scodari

Introduction Concern over historic wetlands loss led to a national goalof no net loss (NNL) of wetlands acres and their environ-mental services. In support of the NNL goal, the US ArmyCorps of Engineers (Corps), under authority granted bySection 404 of the Clean Water Act, reviews permits todischarge fill material into wetlands. A permit review pro-cess called sequencing requires a permit applicant (permit-tee) to first demonstrate to a regulator that they haveapplied all practical means to avoid and minimize the fill-ing in of wetlands areas as part of a development project.Then the NNL goal requires permittees to providereplacement wetlands—ecologically successful restorationof former or degraded wetlands or creation of new wet-lands from uplands—to offset the adverse environmentaleffects of the permitted wetlands filling (see Shabman,Stephenson, & Shobe, 2002, for a discussion of offset pro-grams in air and water pollution control programs).

When the replacement requirement was first estab-lished, permittees were expected to provide replacementwetlands (or wetlands “credits”) that were similar to thetypes of wetlands filled (“in-kind”), and that were locatedon or adjacent to the area of the fill (“on-site”). However,over time, program evaluations consistently found thatinferior wetlands restoration and creation practices oftenwere employed by permittees who had little skill (or inter-est) in wetlands restoration. Even when state-of-the-artpractices were applied, the on-site and in-kind require-ment often prohibited long-term ecological success, espe-cially for replacing lost habitat services (e.g., wetlandshydrology was compromised by surrounding develop-ment). Meanwhile, because limited agency resources formonitoring and enforcement had to be scattered amongmany small wetlands credit projects, the quality of thecredits was not assured; in fact, some required creditprojects were never undertaken. These problems moti-

vated interest in new approaches—generally called “wet-lands mitigation banking”—for securing ecologicallyviable credits. One approach to mitigation banking relieson third parties (neither the regulator nor the permittee)to produce wetlands credits that can be used as offsets.Third-party wetlands mitigation banking often has beencited as a successful application of market-like environ-mental policy. After reviewing the experience with wet-lands mitigation banking, we will conclude with acomment on whether this regulatory innovation fits thedefinition of market-like environmental policy.

Mitigation Banking in BriefThe single-user wetlands mitigation bank leaves the respon-sibility for credit production with the permittee. Underthis mitigation option, a large land developer or a stateDepartment of Transportation that expected to receivemultiple future permits develops one large credit project inadvance of and located away from (“off-site”) their antici-pated fills. The credits, once certified by the Corps, aredeposited into a “bank account” that is drawn upon asfuture fills are permitted. The off-site location and largesize of these credit projects increases the chance of ecologi-cal success and allows the Corps to better target its limitedmonitoring and enforcement resources.

Cases where investment in a single-user wetlands bankwas not an option because of the small size of wetlands fills(e.g., parts of an acre) or the infrequent nature for a userled to the development of fee-based programs. In a fee-based program, permittees pay a fee to a third party, certi-fied by the Corps, who produces wetlands credits in one ormore off-site locations. Once the fee is paid, the third-party provider accepts financial and legal responsibility forthe success of the credits. In an in-lieu fee (ILF) program,wetlands credit production occurs when a new project isinitiated, while in a cash donation program the fees are

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used to expand an ongoing wetlandsrestoration project beyond its origi-nal scope. In either case, credit pro-duction does not begin untiladequate funds are collected. Becausefee-based providers are typically gov-ernment agencies or nongovernmen-tal conservation organizations thathave the mission of wetlands restora-tion and creation, there is some con-fidence in the quality of the creditsthat will be produced. Nevertheless,fee-based programs have been criti-cized for inadequate credit produc-tion practices and for setting fees thateither may not recover the costs ofproducing credits, or that may be sohigh that they discourage use of theprogram. Also, there is a temporalloss of wetlands acres and serviceswhile sufficient fees are being accu-mulated (see Scodari & Shabman,2001, for a review of in-lieu fee pro-grams).

Fee-based programs established aprecedent for transferring legal andfinancial responsibility from permit-tees to third-party credit providers in

return for cash payments. That pre-cedent generated incentives for thedevelopment of commercial wetlandsmitigation banks in which privateentrepreneurs make investments inwetlands credit production and thenearn a return on those investments byselling the resulting credits to permit-tees. In developing federal guidancefor certification and use of commer-cial wetlands banks, regulators faceda tension between ensuring high-quality credits and the financial via-bility of commercial wetlands bank-ers. The former could be guaranteedby requiring wetlands credits to beproduced and certified before theycould be sold. However, it may takefive or more years before ecologicalsuccess can be fully judged, and a pri-vate investor typically cannot waitthat long to begin accumulatingreturns. Thus, commercial wetlandsbanks were allowed to engage in lim-ited “early” credit sales (i.e., beforethe credits have been certified as fullysuccessful) in return for the postingof financial assurances that would be

released when credit success wasassured. This compromise facilitatedthe development and use of commer-cial wetlands mitigation banks thathave produced high-quality creditsand reduced time lags for securingoffsets.

Regulatory Conditions and Commercial Mitigation Banking Currently, commercial wetlandsbanks provide only a relatively smallfraction, perhaps 10–20%, of all wet-lands credits, and there are very fewareas where robust credit marketshave developed. This situation can betraced to the rules governing whenwetlands permits are required and theseparate certification rules for com-mercial wetlands banks that raisecosts of credit production and createdemand uncertainty.

First, consider investor costs. Inaddition to investment costs, thereare considerable administrative coststo becoming certified as a commer-cial wetlands bank; the approval pro-cess may stretch over several years.These costs and time delays serve asbarriers to entry and must be addedto credit prices when a prospectivebanker does successfully navigate thecertification process. These increasedcosts restrict supply of salable creditsand at the same time reduce thequantity of credits likely to bedemanded by permittees. (For a dis-cussion of these and other regulatoryconditions on credit prices, see Shab-man, Scodari, & Stephenson, 1998.)

A number of factors worktogether to create significant creditdemand uncertainty. There is marketuncertainty about whether futureland development in an area willintersect with wetlands and thusrequire fill permits. But even whenpermit demand can be predicted, thecredit requirements that will be

What is a wetland? An area that is regularly saturated by surface water or groundwater and is characterized by a prevalence of vegetation that is adapted for life in saturated soil conditions (e.g., swamps, bogs, fens, marshes, and estuaries). However, not all wetlands are subject to regulation under sec-tion 404 (US EPA, "Terms of Environment," http://www.epa.gov/OCEPAterms. Photograph by Lynn Betts, courtesy of USDA-NRCS.)

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placed on permittees—and theresulting demand for credits—ishighly uncertain. In fact, regulatoryfactors are the greatest source of wet-lands credit demand uncertainty. Per-haps most important, the sequencingprocess continues to give regulatorypreference for on-site credits. Onlyafter regulators have determined thaton-site credit production is impracti-cal or environmentally undesirablecan credits from a third-party creditprovider be used as wetlands credits.Then, commercial wetlands banksoften must compete with ILF andcash donation programs that do nothave equivalent regulatory approvalor upfront investment costs. Forexample, ILF and cash donation pro-grams are not typically required topost financial assurances and do notneed to reflect the opportunity costof capital in credit fees, because theyaccumulate funds before they under-take credit production. The result isthat permittees will favor fee-basedcredit options over commercial wet-lands banks when those alternativesare available. Finally, uncertaintyabout the future of the regulatoryprogram contributes to creditdemand uncertainty. For more than30 years, administrative and courtdecisions have rearranged the basicstructure of the federal permit pro-gram. These changes include mattersas basic as what constitutes wetlands,what constitutes fill, and what typesof fills are significant enough to war-rant sequencing review. These shift-ing regulatory principles createuncertainty about future permitdemand as well as the kinds of creditsthat may be required or allowed asoffsets.

Nonetheless, some commercialwetlands credit production hasoccurred in many areas of the countysince the mid-1990s, indicating thatthe private sector will provide up-

front capital for wetlands credit pro-duction if there is an opportunity toprofit from such investments.Explicit or tacit understandings withprospective permittees and regula-tors have offered reasonable assur-ances that there would be a demandfor some of the credits produced, andthe allowance for early credit sales(with financial assurances) has helpedto ensure a competitive return oninvestments. It is in such situationsthat commercial wetlands banks havedeveloped. But, as noted, the amountof credits now supplied by commer-cial wetlands banks is small relative toother mitigation options, and thereare very few areas with multiple com-mercial wetlands banks competingfor business. Moreover, commercialwetlands banks must set credit pricesto recover not only the costs of creditproduction but also the costs of gain-ing bank certification and the riskcosts associated with future demanduncertainty. As a result, the creditprices charged by commercial wet-lands banks may exceed what manypermittees are able to pay.

A New Form of Mitigation Banking The private sector has demonstratedthe capacity to provide quality-assured wetlands credits, in advanceof fill impacts, for use as offsets. Totap this potential of the private sectorand to assure that credit prices paidby permittees reflect the full cost ofcredit production, a new form ofmitigation banking is being discussedand developed. Called a credit resaleprogram, the approach is now in theearly stages of application in theNorth Carolina Ecosystem Enhance-ment Program (NCEEP). For a fur-ther description of the NCEEP, seeShabman and Scodari (2004).

Three interrelated componentscharacterize a wetlands credit resaleprogram. First, funds to capitalize theprogram are provided to a govern-ment agency that has the mission ofsecuring wetlands credits for permit-ted fills. Second, that agency usessome of the funding for planning topredict the near-term wetlands creditneeds of permittees by type and loca-tion. Third, the mitigation agency isgiven the authority to act as both apurchaser and reseller of credits. Inthat role, the agency uses a competi-tive bidding (Request for Proposal orRFP) process to build an inventory ofquality-certified credits from privatesector suppliers. The bidding processcan encourage vigorous competitionamong wetlands credit providers onboth quality and price. The winningbidders immediately begin creditproduction and are paid by theagency on a defined schedule tied tocredit development milestones, theposting of financial assurances, andthe attainment of performance crite-ria. The RFP stipulates credit certifi-cation requirements, and the definedpayment schedule eliminates creditdemand uncertainty, for the winningbidders. The agency then resells thewetlands credits it has purchased tofuture fill permittees at prices thatrecover the full costs of securing thecredits. As the credit inventory isdepleted, new RFPs are issued. Ifproperly designed and administered,this approach can secure the supply,quality, and price advantages of acompetitive market for wetlandscredits (numerous credit sellers com-peting for the business of permittees).

Experience to date with theNCEEP wetlands credit resale pro-gram suggests two design consider-ations for helping such a programwork as envisioned. First, the RFPapplication process can be costly,although not as costly as the process

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for getting certified as a commercialwetlands bank. Over time, qualifiedcredit suppliers will need to be thewinning bidders on some number ofRFPs, or they will not be able toremain in the credit provision busi-

ness. Thus, the credit resale programwill need to issue a significant num-ber of RFPs and then spread thework in some fashion among quali-fied bidders. However, there will notbe enough permitted wetlands fills in

one place to assure this result.Extending the program to providingother forms of mitigation credits(e.g., stream restoration, nutrientreduction, etc.) required by differentpollution control programs couldadd to the number of RFPs issued inany year. Also, expanding the wet-lands credit resale program conceptregionally and across the nationcould increase the likelihood thatmultiple credit providers would beable to prosper.

Second, wetlands offset require-ments, and the resulting RFPs forwetlands credits, should be defined interms of categories of wetlands ser-vices (that include hydrology, waterquality, and habitat) rather than interms of the wetlands asset (i.e., wet-lands area and aggregate services).The water quality and hydrologic ser-vices of wetlands are watershed-loca-tion dependent, and if lost to apermitted fill, often must be replacedon or nearby the fill site. However,the values of wetlands habitat servicesto people and wildlife are less site-dependent, and since wetlands habi-tat services that are replaced on-sitecan often be compromised by sur-rounding development, these servicesare better secured at off-site loca-tions. In the current wetlands mitiga-tion program, a continuing tensionover which services to favor has led tothe requirement that wetlands creditsbe located in the same (usually small)watershed area as the fill permits.However, limiting the location ofcredits to small watersheds has led tothin markets in wetlands commercialbanking (often only one certifiedbank in many areas). A similar prob-lem would confront a credit resaleprogram in which the RFP processwas focused on a very limited geo-graphic area, because this would con-strain the possible sites in a watershedwhere land is suited for a winning

A wetland restoration project at the Phalen Corridor Initiative in St. Paul, Min-nesota, 1996-2001. (1996 and 1997 photographs by Phalen Corridor Initiative (http://www.phalencorridor.org). 2001 photograph by Jessie Deegan.)

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wetlands project. As the availabilityof suitable lands for credit produc-tion becomes more limited, it is lesslikely that competition for creditcontracts can be fostered. If offsetrequirements were stated in terms ofwetlands services rather than for thewetlands asset, then a credit resaleprogram could issue RFPs for wet-lands habitat services at larger eco-region scales. This would increase thepool of land parcels that would besuitable sites for credit production,thus making for more robust compe-tition for credit supply contracts.

If the wetlands credit resaleapproach was used to secure offsetsfor only the habitat services lost topermitted fills, regulators would stillneed to secure offsets for any losthydrologic and water quality services.In determining any needed offsets forsite-dependent hydrologic and waterquality services, regulators wouldappropriately consider whether non-wetlands alternatives required byother regulatory programs could pro-vide the necessary offsets. Site designchanges (e.g., low-impact develop-ment), stormwater ponds, perviouspavement, riparian buffers, and ahost of other methods can be substi-tutes for the water quality and hydro-logic services of wetlands and can beimplemented on or near the sites ofpermitted fills. A variety of local andstate regulatory programs currentlyrequire actions to mitigate for thehydrologic and water-quality effectsof land development. Recognition ofnonwetlands programs would requirewetlands regulators to coordinatewith the relevant nonwetlands pro-grams. The responsibility for assuringthis coordination could fall to themitigation agency charged as thecredit reseller. (See Scodari & Shab-man, 2001, for further discussion ofthe logic of this approach.)

DiscussionCommercial wetlands mitigationbanking and ILF programs are oftencited as examples of market-likeenvironmental policy. The reasonsfor this perception are understand-able. A discharger releases a pollutant(fill) into the environment (wetlands)and in turn must pay a price (creditfee) to make that discharge. Thisappears to be an application of themarket-like concept of an effluentdischarge fee. Or the permittee mustbear the cost of securing an offsettingcredit (a manufactured wetland)from another entity, so the NNL goalis met if they make a discharge. Thisappears to be an application of mar-ket-like concepts of cap and trade.

However, the reality does notmatch the perception. Wetlands mit-igation requirements and mitigationcredit options are not examples ofmarket-like programs. The polluters(permittees) do pay when they makea discharge, but the discharger doesnot have discretion on when it is intheir interest to avoid the wetlandsand when it is in their interest to paythe fee (bear the cost of an offset) andmake the discharge. Regulatorsrequire permit applicants to doeverything the regulator deems prac-tical to avoid wetlands impacts, andregulators determine what kind ofoffsets will be required and wherethey can be located. In this regard,the wetlands offset program is likeany other offset program. Regulatoryreviews drive the permittee towardszero discharge, and then require off-sets for the discharges that remain.Wetlands offset requirements are thusbest understood as a permit condi-tion tied to a traditional commandand control regulatory program.

As with other offset programs,regulators need to have offsets avail-able in a timely fashion and in suffi-

cient quality and quantity to meetthe environmental goal—in this case,NNL of wetlands. It was in seekingto meet these needs that the wetlandsmitigation program has experi-mented with different forms of wet-lands mitigation banking—some ofwhich have been understood as draw-ing on the logic of markets. Certainlyencouraging private investors tocompete for the right to sell wetlandscredits is an application of a market-like idea. In the case of commercialwetlands banking, there is a percep-tion that credit prices are being set bya competitive buying and selling.They are not. And it might seem log-ical that ILF rates are tied to a marketprice from a competitive credit salesprogram. They are not.

The wetlands credit resale pro-gram is an emerging idea that can usecompetitive bidding to meet the par-ticular challenge of securing offsetsfor the wetlands regulatory program.However, unless permittees make thechoice about when it is best to avoidmaking the discharge and when it isbest to make the discharge and buywetlands credits, the wetlands regula-tory program should not be viewed asan application of market-like envi-ronmental policy. This observation isnot offered as a recommendation tochange the current practice of wet-lands permitting. It is only offered tomake the point that applications ofmarket-like environmental policy arerare; at times, what appears to be amarket-like policy may not be that atall. That said, as the wetlands creditresale idea suggests, the benefits ofcompetition—certainly an ideaderived from the logic for markets—still has much to contribute to thedesign of wetlands mitigation pro-grams.

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For More InformationScodari, P., & Shabman, L. (2000).

Review and analysis of in-lieu fee mitigation in the CWA Section 404 Permit Program. Fort Belvoir, VA: U.S. Army Corps of Engi-neers Institute for Water Resources. Available on the World Wide Web: http://www.iwr.usace.army.mil/iwr/pdf/IWRReport_ILF_Nov00.PDF.

Scodari, P., & Shabman, L. (2001). Rethinking compensatory mitiga-tion strategy. National Wetlands Newsletter, January–February, pp. 3-5.

Shabman, L., Stephenson, K., & Scodari, P. (1998). Wetlands credit sales as a strategy for achieving no net loss: The limita-tions of regulatory conditions. Wetlands, 18(3), 471-481.

Shabman, L., Stephenson, K., & Shobe, W. (2002). Trading pro-grams for environmental man-agement: Reflections on the air and water experience. Environ-mental Practice, 4,153-162.

Shabman, L., & Scodari, P. (2004). Past, present, and future of wet-lands credit sales (Discussion Paper 04–48). Washington, DC:

Resources for the Future. Avail-able on the World Wide Web: http://www.rff.org/Documents/RFF-DP-04-48.pdf.

Leonard Shabman is a residentscholar at Resources for the Future,Washington, DC. Paul Scodari issenior economist with the US ArmyCorps of Engineers Institute for WaterResources, Alexandria, VA. Thispaper, based on Shabman and Sco-dari (2004), reflects the views of theauthors and not of the institutes andagencies with which they are affili-ated.

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©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Crunch Time for Water Quality TradingDennis M. King

Economists have been promoting water quality (WQ)trading for decades. Over the past few years, many politi-cal leaders and upper-level government officials have beenjoining them. Money has even started to flow from Wash-ington to local trading organizations to help make WQtrading work. However, enthusiasm about WQ trading isbased mostly on conceptual arguments about its potentialto generate cost savings and ideological arguments aboutthe superiority of market-based solutions over conven-tional regulatory programs. Experiences with actual WQtrading programs have been discouraging. Under currentregulatory conditions, there is simply not enough supplyor demand to support WQ trading. The critical questionnow is whether the regulatory conditions that are inhibit-ing trading will change any time soon.

According to a recent EPA-funded review, the numberof WQ trading initiatives in the United States during2004 was more than 70 (Breetz et al., 2004), which is upfrom around 25 just a few years earlier (Environomics,1999; King & Kuch, 2003) However, this recent review,like previous ones, showed that WQ trading programs arefrozen at an awkward pretrading stage of development—plenty of new guidelines, regional trading institutions, andcomputer simulations of trading, and even some well-developed WQ trading software and websites, but very lit-tle actual trading taking place. Most importantly, point/nonpoint1 trading involving agriculture—the type thatwill be needed for WQ trading to have a significant impactin many watersheds and the type of trading that will beaddressed in this article—has not materialized at all.

Advocates of WQ trading are putting their hopes onthe anticipated establishment over the next few years ofTotal Maximum Daily Loads (TMDLs) for individual

water bodies. These are a kind of total pollution budgetthat could be divided among pollution dischargers as indi-vidual discharge allowances that could be made tradable.The Clean Water Act of 1972 required each state todevelop and implement TMDLs by 1979, but they areonly now being developed in most parts of the country.Eventually, TMDLs may provide the market driver that isneeded to make WQ trading work. (See Boyd, 2000.)However, establishing TMDLs will merely be the first ofmany steps that will all need to be taken quickly if WQtrading is to be given a fair chance to succeed. State andlocal WQ regulators, under increasing pressure to dosomething soon about growing WQ problems, are begin-ning to turn to familiar command-and-control methodsand subsidy programs that often preclude the possibility ofever having meaningful WQ trading.

The three questions that even diehard trading advo-cates are beginning to ask are: Why are there so few WQtrading success stories? Why aren’t the point and nonpointsources who are supposed to benefit from WQ tradingmore supportive? What can be done to improve the situa-tion?

Reviews of regional WQ trading programs reveal themost often cited problems inhibiting regional WQ trad-ing, such as inadequate trading institutions, unclear scor-ing criteria, and high transactions costs of performingtrades, are being overcome in most places (King & Kuch,2003). What is preventing WQ trading is a simpleabsence of willing buyers and sellers. Under existing regu-latory conditions, the supply and demand curves in fledg-ling WQ markets barely exist and certainly don’t cross atany positive price. Moreover, those attempting to makeregional WQ work are usually not in positions to changethe situation. Tighter federal and/or state limits on indi-vidual dischargers will be required before there will be anycommodities (rights) to trade in WQ markets; aggressiveenforcement of those limits will then be needed to bolstersupply and demand.

1. Point sources discharge pollution from a single place, such as a pipeline outflow. Nonpoint sources discharge pollution from many places, such as along the edge of a farm or housing development.

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New Water Quality Trading GuidanceIn November 2004, the Environ-mental Protection Agency (EPA)published a Water Quality TradingAssessment Handbook (EPA, 2004) tohelp regional organizations establish“the necessary conditions for success-ful WQ trading.” This national guid-ance is very general and focuses ontasks such as developing trading insti-tutions, measuring the equivalency ofpollution discharges, establishingrules of exchange, setting baselines,assigning liability, and so on. Most ofthese tasks may be necessary for suc-cessful WQ trading. However, noneof them will provide the buyers andsellers that are really needed for WQtrading programs to succeed. In fact,managers of the existing regionalWQ trading programs that have beenfailing to produce trades have alreadycompleted most of the tasks recom-mended in these new EPA guidelines.What are needed beyond what is out-lined in the EPA guidance are stepsthat will change the incentives anddisincentives facing prospective buy-ers and sellers in ways that will makethem want to trade.

Time PressureDevelopments in the ChesapeakeBay region, especially in the State ofMaryland, illustrate why these stepsneed to take place soon, before WQtrading becomes impossible. Morethan three years of work by a partner-ship of state/federal resource agenciesand stakeholders culminated in 2003with a set of guidelines to supportwatershed-based WQ trading. Atthat time, it was generally assumedthat TMDLs were just around thecorner and that once trading guide-lines were adopted, trading wouldtake place with wastewater treatmentfacilities (point sources) that have rel-

atively high discharge treatment costspurchasing WQ “allowances” fromagricultural interests (nonpointsources) with relatively low dischargereduction costs.

In early 2004, however, Mary-land’s governor and state legislatureresponded to public pressure to dosomething about WQ by establishingan innovative $2.50 per month “flushtax” on water and sewer users (mostlyurban dwellers) to create a fund tosubsidize the installation of state-of-the-art discharge treatment technolo-gies at the state’s wastewater facilities.A similar tax was levied on house-holds on wells and septic systems(mostly rural dwellers) to subsidizethe planting of agricultural covercrops and other agricultural “bestmanagement practices.” Of course,the flush tax all but eliminated theexpected demand for WQ credits bywastewater facilities; and the subsidi-zation of agricultural practices all buteliminated the expected supply oflow-cost agricultural WQ credits.With the stroke of the governor’spen, prospects for WQ trading anytime soon in Maryland evaporated.

Beyond the ABCs of WQ TradingIn principle, establishing an emissiontrading program is a simple three-step process involving: (a) establish-ing an overall cap on pollution dis-charges, (b) allocating portions of thecap as allowances to individual dis-charge sources, and (c) allowing eachsource to meet its allowance byreducing its discharge or by purchas-ing credits from other sources thatreduce their discharges below theirallowances. As long as there are dif-ferences in discharge reduction costs,sources with high costs of meetingtheir allowances will purchase creditsfrom sources with low costs, and amarket will be born. This is the pro-

cess that established the highlyacclaimed and apparently successfulair emission trading programs thathelped reduce SO2 emission (acidrain) problems (see Stavins, thisissue).

However, the land and water usedecisions by nonpoint sources thatcause local water quality problems arevery different than the point sourcesmokestacks that cause regional airpollution problems. Most wateremissions are difficult to measure,change with the weather, have differ-ent impacts depending on where theyoccur, and are the results of ever-changing locally made and locallyregulated decisions. This is a compli-cated problem to attempt to addresswith trading. In fact, two areas ofrecent economic research suggest thatin this type of situation a great deal ofpolitical and regulatory reform maybe necessary to interest anyone intrading.

The first area of economicresearch won two economists—FinnKydland of Carnegie Mellon Univer-sity and Edward Prescott of ArizonaState University—the 2004 NobelPrize in economics. Kydland andPrescott (1977) explained why andhow people “game” regulatory pro-grams; that is, why and how theystrategize to evade regulations andemploy legal and political maneuver-ing to avoid, delay, and reduce penal-ties for violating regulations theycannot avoid. The second involveswork in what might be called “envi-ronmental enforcement economics.”This area of research also addresseshow people “game” regulatory pro-grams, but focuses specifically onthat little benefit/cost calculationthat each regulated entity performs todetermine whether or not to complywith a regulation.

Market-based solutions to WQproblems, despite considerable rheto-

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ric to the contrary, are not substitutesfor regulatory solutions; they rely onand complement regulations. It iswell known, for example, that theacid rain trading program succeededbecause precise individual SO2 dis-charge limits were established andstrictly enforced with 100% moni-toring and severe financial penaltiesfor violators (see Stavins, this issue).For now, at least, most nonpointwater pollution dischargers are eitherunregulated or do not expect thatviolating regulations will be detectedor will be very costly. As a result, theyhave little incentive to get involved inallowance trading. Many of them arealso aware that accepting the notionthat tradable discharge allowances(i.e., “pollution rights”) can be neatlydefined and assigned to individualentities could undermine their long-term political and legal strategies forfending off regulations. Assertingthat they have a credible basis forearning money by selling WQ creditsnow, in other words, means that oth-ers will have a credible basis for justi-fying future restrictions on theiremissions that could result in signifi-cant long-term costs later.

Based on the above-mentionedeconomic research, what is beingobserved in WQ trading programs,in other words, is exactly what shouldbe expected. In the face of weak,rarely enforced emission dischargerestrictions and penalties for non-compliance that are small and easilyavoided, few dischargers are inter-ested in buying WQ credits. Wherethere is no demand for WQ credits,there is no incentive for anyone to tryto supply credits. This is a fairly sim-ple conclusion, but it implies thatstrategies to improve point/nonpointWQ trading should focus ondemand-side and supply-side issues,rather than the institutional and

technical issues that occupy the timeof most WQ trading experts.

Demand-Side IssuesTo appreciate what needs to be doneto stimulate demand, it is useful toabandon the standard economist’soperating assumption that a potentialbuyer’s willingness to pay for a WQcredit is based on that entity’s mar-ginal cost of complying with nutrientdischarge restrictions (e.g., dollarsper pound of nutrient dischargereduction). Instead, assume that thecorrect measure of an entity’s willing-ness to pay for a credit is the expectedcost of not complying with a govern-ment-imposed discharge restriction.If the expected cost of not complyingis lower than the cost of complyingby purchasing credits, there is no eco-nomic incentive to purchase credits.

Virtually everywhere that WQtrading is being attempted, laws lim-iting nutrient discharges (on non-point sources at least) are weak, rarelyenforced, and involve such low pen-alties that the expected cost of non-compliance is near zero. Thecorresponding willingness to pay fornutrient discharge credits, therefore,is also near zero. There is no “natu-ral” demand in regulation-drivenmarkets; demand always depends onwhat regulations are in place and howthey are enforced.

The two 2004 Nobel-winningeconomists examined the deterrenteffects of regulations in considerabledetail and pointed out the impact ofwhat they labeled “time inconsistencyproblems” with many regulatory pro-grams. In case after case involvingfinancial and real estate markets,flood insurance markets, and envi-ronmental compliance, they showedthat people, acting alone and ingroups, significantly discounted theexpected cost (penalty) of not com-plying with a regulation if they

believed that it would not be imple-mented consistently over time andcould be influenced later. Kydlandand Prescott’s work demonstratedthat people tend to believe that ifgovernment yields to one kind ofpolitical pressure to pass laws restrict-ing their polluting behavior now,they can be expected to yield to otherpolitical pressure later that will pre-vent the enforcement of those laws orthe imposition of meaningful penal-ties.

Their research showed that thesuccess or failure of regulatory sys-tems (market based or otherwise)depends overwhelmingly on bottom-up microeconomic decisions regard-ing opportunities to game those sys-tems, and far less on macroeconomicgovernmental decisions about howthose systems are supposed to work.

Based on this research, it seemsthat bolstering the demand side ofWQ markets will require musteringthe political will to establish a credi-ble system for enforcing individualallowances, and imposing meaning-ful penalties for exceeding them.

Supply-Side IssuesThe gaming model (as opposed tothe marginal cost model) alsoexplains what is inhibiting the supplyside of regional WQ trading markets.In watersheds where agriculturalsources are significant, it is usuallyassumed that they will be the primarysuppliers of WQ credits. However,the willingness of farmers to supplyWQ credits depends in critical wayson how it might affect their ability tocontinue receiving agricultural subsi-dies and green payments and to fendoff future environmental regulations.The main problems farmers face here(although they do not refer to themin these terms) are what in environ-mental trading circles have becomeknown as baseline/additionality issues.

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To protect the integrity of tradingprograms, trading guidelines nearlyalways prohibit farmers from sellingcredits for undertaking land use/landmanagement changes that are legallyrequired (e.g., by state regulation) orfor which the farmer has already beenpaid (e.g., green payments). Settingthe baseline for credits in this wayreduces the ability of farmers in mostwatersheds to supply low-cost WQcredits. However, it has other impactson farmers as well. It means produc-ing WQ credits by implementingmanagement practices that gobeyond what they are alreadyrequired to do will require farmers tosomehow validate that these practicesdo, in fact, reduce discharge levels.The need to establish a baseline andshow additionality poses two prob-lems for farmers who are consideringsupplying WQ credits.

First, it requires that someoneexamine and document what farm-ers are already doing to meet theirlegal requirements in order to estab-lish the baseline for measuring mar-ketable WQ credits. Most farmers,for obvious reasons, are not inter-ested in having government represen-tatives or their agents examining,thinking, and talking about the legal-ity of their on-farm land use/landmanagement practices or their justifi-cation for green payments.

Second, farmers know that theirdischarges are not regulated as muchas discharges from most other sourcesbecause, presumably, farm dischargesare too difficult to control or mea-sure, too dependent on the weather,too expensive for farmers to manage,and so on. Selling credits requiresfarmers to provide evidence to vali-date that, in fact, they can reducetheir discharges and document theresults. Many analysts have addressedvalidation requirements in terms oftheir potential to increase transaction

costs associated with completingmarket trades and the likelihood thatthese higher costs could drive awedge between buyers and sellers.However, a more important problemmay be that if farmers show that theycan validate the creditworthiness oftheir on-farm activities, it is bound tocall into question whether theyshould be regulated any differentlythan other dischargers.

There are also other disincentivesfacing farmers. The price farmers willaccept for WQ credits reveals theirdischarge control costs and shows theworld that they are most certainlylower than the discharge control costsof those buying credits. This focusesattention on what many alreadybelieve are inequities in the way dis-charges are regulated and, perhaps, inthe way allocations of dischargeallowances are made to farmers andothers. It also provides evidence thata better long-term cost-saving strat-egy for dealing with WQ problemsmight be to tighten restrictions onfarmers with low treatment costs andrelax them on other dischargers whohave higher marginal treatment costs.

The sources of these disincentiveson the supply side of WQ trading aresimilar to those on the demand side.Weak, vague, and largely unenforceddischarge restrictions inhibit poten-tial suppliers from engaging in trad-ing, just as they inhibit potentialbuyers. However, the strategies thatfarmers can and will use to gamemarket-based environmental pro-grams are intertwined with theirstrategies for gaming other govern-ment programs, so supply-side prob-lems appear to be more complex.

The Immediate ChallengeCareful observers of emerging WQtrading understand that this type ofmarket-based solution is not an alter-

native to WQ regulations. However,this is still not fully understood bymany political leaders and agencyheads. One immediate challenge,therefore, is to convince those whoare using the promise of market-based environmental solutions as ajustification for relaxing regulationsthat this strategy cannot succeed.Another immediate challenge is toconvince those who are introducingnew WQ initiatives, such as manda-tory engineering or discharge stan-dards, that their decisions may makeit impossible to have WQ trading orto realize potential cost savings fromWQ trading. At the same time, itwould be useful for those involved indeveloping regional WQ trading toperform what might be called a “WQenforcement audit” in their region todetermine how much political andregulatory reform will be needed tostimulate supply and demand andmake WQ trading work.

The fact remains, however, thatthe regulatory context that providesthe incentives and disincentives forbuyers and sellers to participate inregional WQ trading is usually notwithin the control of the people whoare attempting to make regional WQtrading work. One useful strategy,therefore, is for those people (and allthe rest of us who want WQ tradingto have a chance to live up to itspotential) to work together to influ-ence state and federal agencies andelected officials who set the legal andregulatory context for WQ trading.Such an initiative could focus on thefollowing five tasks:• Make sure the new EPA guidance

is followed when establishing aWQ trading program;

• discourage command-and-con-trol regulatory programs thatinhibit WQ trading;

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• encourage binding dischargerestrictions on point and non-point sources;

• encourage meaningful monitor-ing and enforcement of restric-tions with stiff penalties; and

• determine gaming strategies thatpoint and nonpoint sources willuse to limit regulation and avoidpenalties and encourage counter-vailing public policies.If these tasks are undertaken

soon, the potential of WQ tradingmight be realized. If not, WQ trad-ing will probably wind up in theoverflowing dustbin of well-inten-tioned economic policies thatattracted attention for a while butnever delivered.

For More InformationBoyd, J. (2000). The new faces of the

Clean Water Act: A critical review of the EPA’s proposed TMDL rules (discussion paper 00-12). Wash-

ington, DC: Resources for the Future.

Breetz, H.L., et al. (2004). Water quality trading and offset initia-tives in the United States: A com-prehensive survey (report for the EPA). Hanover, NH: Dart-mouth College Rockefeller Cen-ter.

Environmental Protection Agency Office of Water, Wetlands, Oceans, and Watersheds. (2004). Water quality trading assessment handbook: Can water quality trad-ing advance your watershed’s goals? Washington, DC: EPA. Available on the World Wide Web: http://www.epa.gov/owow/watershed/trading/handbook/.

Environomics, Inc. (1999). Summary of U.S. effluent trading and offset projects. Report prepared for the EPA Office of Water, Washing-ton, DC.

King, D.M., & P.J. Kuch. (2003). Will nutrient credit trading ever work? An assessment of supply problems, demand problems, and institutional obstacles. The Envi-ronmental Law Reporter. Wash-ington, DC: Environmental Law Institute.

King, D.M. (2002). Managing envi-ronmental Trades: Lessons from Hollywood, Stockholm, and Houston. The Environmental Law Reporter. Washington, DC: Environmental Law Institute.

Kydland, F.E., & E.C. Prescott. (1977). Rules rather than discre-tion: The inconsistency of opti-mal plans. Journal of Political Economy, 85(3), 473-91.

Dennis King is a research professor atthe University of Maryland Centerfor Environmental Science and direc-tor of King and Associates, Inc., anenvironmental economic consultingfirm.

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©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Are E-Grocers Serving the Right Markets?Casie Berning, Stan Ernst, and Neal H. Hooker

Buying Food Online?Prior to 2003, the biggest news in the E-grocery sector hadbeen the dramatic implosion of high-profile operators. Sil-icon Valley and Wall Street saw “dot.bombs” in many sec-tors during the 1990s, but failings in the grocery businessseemed magnified due to unique supply chain relation-ships and, most importantly, strong con-sumer expectations about product andservice quality that do not disappearwhen customers move online. Onlinegrocers like Webvan were among themyriad of startups that failed to balancetrue market potential with their invest-ment in technology and business strategy.Some firms simply subsidized onlineoperations as long as they could as an“experiment” before giving up; reasonsfor these failures ranged from marketselection problems to corporate cultureand commitment. Others simply tried to run before theyhad crawled. Some thought that new technology offset theneed for strategic ways of dealing with known consumerexpectations and industry practices—and failed accord-ingly. The exit of Publix Supermarkets from the E-groceryarena illustrated risks from trying to build such an enter-prise in areas with limited online subscribers or consumersuspicion of online purchasing. Despite these early stum-bles, the E-grocery market rebounded and has grown dra-matically since 2003. New entrants—many of themtraditional grocery retailers venturing into E-commerce—are offering more products and services to broader geo-graphic areas. The question we address here is whether sur-viving E-grocers are entering the right markets—onescontaining enough of the kinds of customers inclined touse this service and generate profits—and what a rightmarket looks like.

Consistent estimates of current market size and pro-jected growth in the E-grocery industry are elusive targets.

In 2002, sales for online food, beverages, and grocerieswere estimated to range between $4.25 billion (KeenanVision) to $6.4 billion (Yankee Group). Forrester Researchcalled 2002 online grocery sales at $5 billion. A morerecent estimate by Jupiter Research predicts that onlinegrocery sales will hit $2.4 billion in 2004, or 0.4% of the

total grocery market of $570 billion. By2008, the estimate grows to $6.5 billion,just 1% of the total forecasted market of$641 billion, but showing an annualgrowth rate of 42%. Clearly this sectorcontinues to grow:• Safeway.com doubled its business in

two years (2001–2003) and expectedit to double again in 2004.

• Ahold-owned Peapod reports that ithas 150,000 active customers in itssystem, which includes Chicago and

parts of the East Coast. By 2006, Peapod expects tonearly double its reach to areas serving 14 millionpotential households.

• In 2004, New York-based pure play Fresh Direct had100,000 active customers—four times the number ofjust a year earlier.

What are the Right Markets for E-Grocers?A major factor in determining the future viability of the E-grocery sector is understanding whether these retailers areentering and servicing the right markets. Based on a com-prehensive literature review and our research group’s previ-ous firm, manager, and consumer research, thecharacteristics of an “ideal” E-grocery consumer can beidentified (see papers and presentations at http://aede.osu.edu/programs/e-agbiz). Age, gender, householdincome, household size, and level of education are keyindicators of willingness to buy food online. Factors suchas computer literacy and access, time pressure, and focuson convenience also play a role. The question becomes

What is an E-grocer?E-grocers use the Internet to sell perishable and nonperishable grocery items. Products are ordered online for delivery or pick-up. E-grocers are divided into two categories: Bricks & clicks are traditional grocers that also offer Internet-based ordering; Pure plays organizations lack tra-ditional grocery stores.

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whether sufficient densities of cus-tomers with ideal characteristicsshow up in the markets in which E-grocers operate. Information wegathered from E-grocery managers in2001 and 2004 indicated they gener-ally recognize the value of these vari-ables but were inconclusive on therole they played in selecting marketsto enter. Marketing managers of gro-cers who were less active onlineappear to discount the importance oftime/convenience and focus more onhousehold income as a potential indi-cator of online grocery acceptance.

Are E-Grocers Targeting Ideal Consumers?To explore the proportion of ideal E-grocery consumers in markets cur-rently serviced by firms, we firstobtained a list of 2003’s top 75 gro-cery stores (based on sales) and iden-

tified their subsidiaries, creating a listof 143 different grocery chains. Tothis list we added all full-service pure-play E-grocers identified in our previ-ous research. Each grocer’s websitewas visited to determinewhether they had full-service E-grocery opera-tions. Of the 143 firms,23 operations offereddelivery and/or pick-upof both perishable andnonperishable items (seeTable 1). These firmsoperate in 26 states andthe District of Colum-bia, with most in largecities such as Los Ange-les, New York, Detroit,and Salt Lake City. Sev-enteen are bricks-and-clicks and sixare pure plays. Some offer deliverywithin 30–40 minutes of placing an

order; others offer next-day deliveryin a temperature-cooled tote.

Service areas for these E-grocerswere determined at a zip code levelfrom their websites, creating a data-

base of 1,371 distinctareas out of the morethan 29,000 zip codesnationally. Using a com-mercial zip code-leveldatabase (MicrosoftMapPoint), a socioeco-nomic analysis was com-pleted for each marketcurrently serviced by oneor more E-grocer (Figure1). This analysis consid-ered key demographicmeasures: age, gender,household income, level

of education, and size of household.Other characteristics, such as numberof households with Internet access,

Figure 1. Zip-code-level distribution of E-grocery service—September 2004.

Ideal E-grocery consumers are:• women, aged 35 to 44;

• college educated;

• in households with income greater than $50,000;

• more likely to have children; and

• looking for conve-nience and therefore less price sensitive.

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adults with a credit card, averagecommute time to work (a proxy for“time-starved” consumers), and theaverage amount that households

spend on food, were also assessed.These data are key to determiningwhether E-grocers are currently serv-ing markets with a large proportionof ideal consumers.

What We See...Initial analysis of our work suggeststhat households in areas serviced byE-grocers have the financial and tech-nical means, tools, and time-starvedincentives to purchase groceriesonline. There also appears to be acritical mass of optimal consumersfor E-grocers to target within thesezip codes, because they contain threetimes more people and householdsthan the national average. Householdincomes in these zip codes are$10,000 greater than the nationalaverage, and households spend about$1,000 more per year on groceriesthan average. These households havethree times more 25- to 44-year-oldsand teenagers, indicating a significantlikelihood of both higher spendingon food and time constraints on rou-tine household activities such as gro-cery shopping. Gender does notappear to play a role, separate of thefact that E-grocery service is offeredin high-population areas having moreof both women and men. Zip codescurrently targeted by E-grocers havehouseholds that are three times morelikely to have credit cards and toadopt E-commerce more generally—other leading indicators of marketpotential. A final indicator of theimportance of convenience is thatwage earners in zip codes targeted byE-grocers are three times more likelythan average to commute 45 minutesor more. These findings indicatethat, to some extent, existing E-gro-cers seem to be targeting the correctgeographic areas. What is less clear to

us, and yet to be clarified by research,is whether these geographic selectionsare truly intentional or merely onesof convenience. Given the nature inwhich this industry has emerged,there is evidence to suspect both sce-narios.

Questions remain as to the futureadoption rate of online grocery shop-ping by consumers. After four yearsof research and observation in thisarea, we can be reasonably confidentthat although analysis typical in loca-tion decisions for traditional grocerystores may have some value in decid-ing where to offer online sales of gro-ceries, other variables are potentiallymore important. Convenience andconsumer comfort with the technol-ogy are logical considerations. Thesefactors are more likely to drive theproportion of households that adoptwithin a service area than to indicatewhich new zip codes are optimal forgrowth. Time-starved consumers, orthose facing other constraints ontheir ability to shop traditionally, areprimary drivers of expansion in thissector. As internet and E-commerceadoption continue to grow, itremains to be seen how much advan-tage is gained by targeting the rightgeographic regions suggested by ourresearch and when such service willbecome sufficiently efficient andaccepted to be seen as a mass marketpractice making the selection of indi-vidual geographic markets lessimportant.

Casie Berning is a former undergrad-uate student; Stan Ernst is an out-reach program manager; and Neal H.Hooker is an assistant professor. Thiswork is part of a broader longitudi-nal study of online food retailing (seehttp://aede.osu.edu/programs/e-agbiz).

Table 1. Number of zip codes serviced by individual E-grocers by type and state—September 2004.

Zip

code

s ser

vice

d

Stat

es se

rvice

d

Bricks & clicks—deliverya

Stop & Shop (Ahold) 80 CT, MA, NY, RI

Giant (Ahold) 21 D.C.

Safeway 16 CA

Vons/Pavilions (Safeway) 178 CA, NV

King Soopers (Kroger) 55 CO

Albertsons 383 WA, OR, ID, NV, TX, CA

Acme (Albertsons) 54 PA

Hy-Vee 226 IL, MO, KS, NE, IA, SD, MN

D’Agostino’s 31 NY

Schnucks 162 IL, MO

Bashas 55 AZ

Bricks & clicks—pick-upa

Lowes 33 NC, SC

Sentryonthego 18 WI

Norkus 14 NJ

Santoni’s 27 MD

Dorothy Lane Markets 3 OH

FarmFreshMarkets 28 VA

Pure playb

Peapod (Ahold) 41 IL

YourGrocer 47 NY

Fresh Direct 58 NY

Whyrunout 57 CA

Xpress Grocer 38 NY

Simon Delivers 55 MN

a “Bricks & clicks/delivery” refers to traditional grocery stores offering E-commerce and delivery or pickup at the store.b “Pure play” firms have no traditional store front.

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CHOICESThe magazine of food, farm, and resource issues

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A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

The Farmapine Model: A Cooperative Marketing Strategy and a Market-Based Development Approach in Sub-Saharan AfricaGodfred Yeboah

Developing countries, especially those in Sub-SaharanAfrica, rely on a few primary commodities and minerals astheir main sources of revenue and foreign exchange.Ghana, a typical developing country, has relied on cocoa,gold, and timber, which together have accounted for morethan 70% of export earnings. There was an urgent need todiversify Ghana’s export base following the persistentdecline in the prices of cocoa and gold in the 1980s and1990s. Efforts to diversify the export base resulted in thepromotion of wood, aluminum, marine products, andhorticultural products—referred to as nontraditionalexports (NTE)—along with tourism (ISSER, 2002).

Horticultural products in general and pineapples inparticular have received a lot of support from the WorldBank and the United States Agency for InternationalDevelopment (USAID; Boselie & Muller, 2002). Thediversification efforts paid off, and pineapple has sincebecome the most important agricultural NTE. Pineappleexports have increased from 2,600 metric tons in 1986 tomore than 42,000 metric tons in 2002, earning the nationover $47 million (FAO, 2004). In addition, pineappleproduction has provided employment and income in thepineapple growing regions. However, the current industrystructure and organization makes it very difficult to realizethe full potential of the industry.

The main focus of this paper is to examine a marketingarrangement in Ghana—the Farmapine model—that hasthe potential of changing the industry structure and offer-ing a means of realizing some of the potentials in theindustry. Specifically, this paper examines the institutionalarrangement behind the establishment of Farmapine and

the inherent efficiencies in the model over existingarrangements. Secondly, this paper seeks to identify anddiscuss factors that will impact replication of the model byother producer groups in Ghana and other developingcountries. To achieve the objectives of this study, 60 small-scale pineapple producers were surveyed, and informationon their production and marketing activities was collectedvia questionnaires. Thirty of the small-scale producerswere selected from the 172-member Farmapine coopera-tives. The remaining thirty were selected from among thehundreds of noncooperative small-scale producers. Inaddition, twelve exporters were surveyed for informationon their export and marketing activities. The twelveexporters were selected from the 16-member Sea-FreightPineapple Exporters of Ghana (SPEG), an umbrella orga-nization for exporters. This organization is responsible forover 90% of all pineapple exports from Ghana.

Pineapple Industry in GhanaThe pineapple industry in Ghana is composed of produc-ers and exporters. There are three categories of producers:large, medium, and small-scale. Large-scale producers areproducers with more than 100 acres of pineapple underactive cultivation. Medium-scale producers have 50–100acres under cultivation. Small-scale producers (also knownas outgrowers) have less than 50 acres under cultivation.The majority, however, have less than ten acres under cul-tivation. Most of the large-scale and some of the medium-scale producers also operate as pineapple exporters, export-ing their fruits mainly to Europe. Exporters buy approxi-mately 40% of their export requirements from outgrowers

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under various arrangements. Thesearrangements are seldom character-ized by formal contracts. An exportermay provide assistance—often in theform of chemicals, planting materi-als, or even cash advances—to anoutgrower with the understandingthat the outgrower sells his produceto the exporter. In most cases, out-growers receive no assistance fromthe exporter. Exporters usuallyapproach outgrowers when they needfruits to meet an export order,whereas outgrowers only contactexporters when their fruits mature.

Most of the producer/exportersusually try to produce the bulk ofexportable fruits from their ownfarms, taking on all the productionand marketing risks. This requireshuge investments in land and equip-ment. They also face severe creditconstraints, as they find it very diffi-cult getting approved for loans(Obeng, 1994). The result is thatthey end up not being able to pro-duce all the fruits needed for export.Thus, exporters are forced to rely onoutgrowers. However, in the absenceof formal contracts, outgrowers canbe unreliable, often reneging on prioragreements and selling to otherexporters offering higher prices. Thisscenario makes it difficult for export-ers to enter into long-term contractswith their European importers. Inaddition, the quality of outgrowers’fruits cannot always be guaranteed, asexporters have no knowledge of theagronomic and cultural practices towhich the fruits are subjected.

Outgrowers, on the other hand,also take all the production and mar-keting risks in their operations. Dur-ing periods of high demand thatoccur during the winter months, out-growers are assured of a ready marketfor their produce. At these times,exporters try to outbid each other forthe outgrowers’ fruits. However,

when European domestic fruitsbecome available in summer (espe-cially June and July), outgrowers findit very difficult to sell their fruits(Obeng, 1994). During such times,some exporters would not honorprior agreements made to buy fruitsfrom outgrowers. In some cases,exporters abscond after taking deliv-ery of fruits. Outgrowers also havehad to contend with delayed pay-ments—sometimes as late as sixmonths after fruits have been deliv-ered. Given the above arrangements,neither the exporters nor the out-growers were satisfied.

The Farmapine ArrangementThe Farmapine cooperatives wereformed as a result of the unsatisfac-tory arrangements between outgrow-ers and exporters. According to thecooperative members, the coopera-tives were formed to enhance theirability to attract help in producingand marketing their produce. Tech-noserve, a US-based developmentagency, has been assisting the cooper-ative members to improve their pro-duction and management practices(Boselie & Muller, 2002). The coop-erative members, however, were stillconstrained by the lack of a reliablemarket source and lack of access tocredit. The prevailing industry struc-ture, coupled with their small sizes,made them helpless in overcomingthese constraints. Stanton (2000) hasidentified small sizes as the underly-ing factor in most of the challengesrural producers face, and suggests theformation of cooperatives as one wayof overcoming this problem.

In 1999, the World Bank, underits agricultural diversification pro-gram, provided $1.4 million for theformation of Farmapine Ghana Lim-ited (FGL). The money was to berepaid in 10 years at a 7% interest

rate. FGL is a marketing concern thatprocesses and exports the farmers’produce. It is owned by members offive farmers’ cooperatives and twoformer producers/exporters. The fivecooperatives have 80% ownership;the former exporters hold theremaining 20%. Once the WorldBank loan is repaid, the cooperativemembers will be able to share in anyprofits resulting from operations.The cooperative members sell theirfruits to FGL for processing andexport. The whole arrangement isguided by formal contracts signedbetween FGL, the cooperatives, andcooperative members. Membershipin these cooperatives was initiallyopen to all pineapple producers.Once FGL was formed, new mem-bers were no longer accepted.

Pineapple was selected for sup-port due to the following reasons. Itis an exportable crop with a readymarket in Europe and has a relativelyshorter gestation period. Moreover,the farmers’ cooperatives were alreadyformed and active. The limiting fac-tors were access to the European mar-ket in the form of reliable importersor buyers and in-depth knowledge ofthe export market. To overcome this,the two former exporters wereincluded as shareholders in the FGLarrangement. Farmapine was incor-porated in March 1999 and com-menced operations in September1999. A managing director hired bythe board of directors oversees day-to-day operations, assisted by threeproduction managers and an exportmanager. The board is made up ofthe presidents of the five farmers’cooperatives, the two former export-ers, the managing director, and a rep-resentative from Technoserve.

The cooperative members receivechemical inputs on credit from FGL,which is repaid when their fruits areharvested. This significantly reduces

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their financing needs, as the cost ofchemicals constitute the single largestvariable-cost item in pineapple pro-duction. The cooperative membersdo not receive any other credit facili-ties. Output price is negotiated at thebeginning of the growing season andreviewed periodically to reflect pre-vailing prices in the industry. Moreimportantly, the price is indexed tothe US dollar, and payment takesplace approximately 2–5 weeks afterharvest. Indexing the price to thedollar offers protection against depre-ciation in the local currency. Thisarrangement guarantees payment tothe cooperatives’ members once fruitsare supplied to FGL.

Additionally, the cooperativemembers receive technical advicefrom the production managers atFGL. The production managers actas extension officers or field special-ists and assist the farmers with anychallenges they face in production.They coordinate the planting andharvesting activities of the farmers toensure that they fit into the overallexport program of FGL. They alsoadvise and monitor the level ofchemical usage by the farmers toensure that they conform to exportstandards. Farmers affiliated withFGL still have to bear the productionrisk. However, this risk is reducedconsiderably due to the advice, inter-action, and monitoring of their farm-ing activities by the FGL fieldspecialists.

Farmapine, on the other hand, isassured of quality fruits to meet itsexport obligations. It is able to nego-tiate favorable prices for its exports,based on its ability to provide asteady and reliable supply of qualityfruits. Although FGL takes on all theprice risk, it is able to sign contractswith importers and thus transfer theprice risk to the importer.

As mentioned previously, Far-mapine supplies chemical inputs tothe cooperative farmers on credit. Inorder to do this, Farmapine usuallyrequires financing from banks andother funding sources. Financing is aconstraint for individual cooperativemembers, but because Farmapine is alarger entity with professional man-agement, it is able to obtain financ-ing from institutions at morefavorable terms. Additionally, it isable to buy larger quantities of chem-icals at significant discounts.

Performance of FarmapineFarmapine has been profitable sinceits inception in 2000 and is the sec-ond largest exporter of pineapplesfrom Ghana. In 2003, Farmapineexported 4,854 mt of pineapples val-ued at $1.52 million. Cooperativemembers are able to consistentlyachieve exportable yields of 65% ormore from their fields, which trans-lates to guaranteed profits of about$1,000 per acre.1 On average, coop-erative members cultivate five acres,and thus earn about $5,000 pergrowing season. This amount is sig-nificant when compared to Ghana’sper-capita gross national income of$320 (World Bank, 2004a). Profitsfor FGL and the outgrowers areexpected to increase further asplanted acreage and exportable yieldincreases.

Outgrowers not affiliated withFGL achieve lower exportable yieldsof 50% or less, translating to profitsof $500 per acre. This profit also car-ries a greater degree of uncertainty,whereas profit for the FGL outgrow-ers is almost given. The non-FGLoutgrowers also face higher variationsin their yield due in part to the lackof technical support in their opera-tions and their inability to strictlyadhere to recommended rates when

applying chemicals. The noncooper-ative farmers have to rely on inade-quate extension support from theMinistry of Food and Agriculture(MOFA). They are also severely con-strained by the high cost of chemicalinputs, which is further compoundedby the absence of loans or credit ofany kind. This causes them to rationthe quantities of chemicals they applyon their farms, contributing to thelow yields and the variation in yield.Both sets of outgrowers sell their“export rejects” on the local marketfor $0.01–0.04/kg compared to theexport price of $0.10/kg.

Total land available for pineapplecultivation is about the same for bothsets of outgrowers. However, plantedacreage by the cooperative membersis higher on average than that of thenoncooperative members. The coop-erative members average five acres,while the noncooperative membersaverage less than two acres. In addi-tion, the cooperative members arevery intent on expanding their farms.This contention is evidenced by themore than 50% of cooperative mem-bers who have leased more land orare in the process of leasing moreland. This clearly indicates that theyare optimistic about the future oftheir operations and the pineapplebusiness in general. The FGL cooper-ative members are mostly full-timefarmers; farmers not affiliated withFGL tend to have other occupations.The cooperative members have onaverage two full-time workers andalso employ temporary workers forland clearing and planting opera-tions.

Replication of the ModelThe apparent success of the Farmap-ine concept begs the question: Howfeasible is it to replicate the model forother producer groups in Ghana and

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in other developing countries? Basedon the working of the Farmapinemodel, four important factors havebeen identified for successful replica-tion of the model. The most impor-tant and fundamental factor is theexistence of cooperatives or organizedfarmers’ groups. In the Farmapinearrangement, the cooperatives wereactive and already working withTechnoserve (Boselie & Muller,2002). This trait contributed to thesuccessful implementation of theprogram. If no entities such as Tech-noserve exist, extension and develop-ment specialists could help organizeinterested farmers or producers intoviable groups.

In addition to an existing cooper-ative, funding is critical for the suc-cessful implementation of any suchprogram. Funding is needed for anyfacility or infrastructure needed toprocess and market produce. Small-scale farmers in developing countriesfind it very difficult to get approvalfor loans and usually do not haveenough equity of their own. One wayout is for governments to providegrants or credit guarantees to pro-ducer groups to establish any suchprogram. Groups relying on govern-ments for support would have tocompete for funds with nationaldevelopment needs such as healthcare, basic education, and so forth. Aworkable solution would be for thesmall-scale producers to join forcesand form cooperatives or producergroups. These groups can explorefunding sources that would not beavailable to the individual members(Stanton, 2000). The producergroups can work with developmentspecialists who can direct them toviable sources of funding and helpthem meet the selection criteria forfunding. A potential source of fund-ing would be donor agencies thatfund and support a variety of projects

in developing countries. In 2002,average per-capita aid for the 688million people in Sub-Saharan Africawas $28.20 (World Bank, 2004b).

Development specialists have alarger role in the success of any sucharrangement. They are especiallyneeded to organize producers intoactive cooperatives. These specialistscould work with producers to formcooperatives where none exist, orthey could help established coopera-tives to embark on productive ven-tures. In the Farmapine arrangement,development specialists from Tech-noserve contributed significantly tothe establishment of FGL and con-tinue to support the outgrowers inmanaging their operations. Similarly,development specialists were veryinstrumental in the success of NewGeneration Cooperatives (NGC)—acooperative arrangement prevalent inNorth America with structures simi-lar to the Farmapine model. Fulton(2001) lists the supporting role ofrural development officers among thefactors that have accounted for thespread of NGCs in the United States.

Finally, successful implementa-tion of Farmapine-like arrangementsrequires a marketable produce—pref-erably one with a shorter gestationperiod. A healthy demand for anyproduct reduces the marketing con-straints and offers the hope ofrecouping any investments made.Pineapple is ideally suited for thiskind of arrangement because of thehuge demand it enjoys in Europe andits short gestation period (12–14months). Based on these require-ments, products such as papaya,yams, cassava (processed into chips orstarch), assorted vegetables, and oth-ers would also be suitable for suchventures.

In addition to the factorsdescribed above, an important andrelated issue that would impact repli-

cation is the organizational structureof the group. The current cooperativestructure of Farmapine may not bean optimal structure for some pro-ducers. To enhance replication, someproducer groups may find it benefi-cial to adopt alternative organiza-tional structures. Fulton (2001)describes the dynamic nature ofNGCs in adapting to local condi-tions as a contributing factor to theirsuccess. One popular option that USproducers have been using in form-ing joint ventures is formation ofLimited Liability Companies (LLC)(Jorgensen, 2005). An LLC offersmore flexibility in organizing a jointventure or business activity. Individ-ual producers could form an LLC asan alternative structure to engage inproductive activities that add value totheir produce. (A more detaileddescription of LLCs and briefdescriptions of other corporate formscan be found in Meehan-Strub andHarris, 2004.)

Concluding RemarksThe Farmapine arrangement hasproved more successful than conven-tional arrangements. Farmapine out-growers make higher profits and facelower risks than outgrowers not affili-ated with FGL. The arrangement hasbeen successful in increasing farmers’income, generating employment, andstemming migration to the cities insearch of jobs. In addition, the coop-erative members have been active intheir communities, funding thebuilding of schools and providingother basic amenities. The Farmapinemodel could serve as a sustainablemodel for rural development in Sub-Saharan Africa.

Replication of the Farmapinemodel is feasible granted that certainfactors previously described are inplace. The key ingredient needed to

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bring all the factors together andenhance replication of the model inthe subregion is government com-mitment. A committed governmentwould serve as a facilitator to bringall the factors together to pave theway for a successful implementationof any such program.

Note1 This is based on average plant pop-ulation of 20,000/acre, average fruitweight of 1.5 kg, output price of$0.10/kg, and a production cost of$1,000.

For More InformationBoselie, D., & Muller, E. (2002).

Review of the impacts of changes in EU pesticides legislation (directive 2000/42/EG) on fresh food exports from developing countries into the EU. Case study: The horticultural export sector in Ghana, Wagenin-gen UR. Available on the World Wide Web: http://www.north-south.nl/webfiles/Mission report Ghana3.doc.

FAO. (2004). Key statistics of food and agriculture external trade. Coun-try profiles for Ghana. Rome, Italy: Food and Agricultural Organization.

Fulton, M. (2001). New generation co-operatives development in Can-ada. Saskatoon, SK, Canada: University of Saskatchewan Cen-tre for the Study of Co-opera-tives.

ISSER. (2002). The state of the Gha-naian economy in 2001. Legon, Accra: University of Ghana Insti-tute of Statistical Social and Eco-nomic Research.

Jorgensen, N. (2005). Leaving home? Reasons vary for co-op conver-sion; critics remain wary of pro-ducers losing control. Rural Cooperatives, 1, 8-11.

Meehan-Strub, M., & Harris, P.E. (2004). Limited liability company: A farm business arrangement alter-native (staff paper no. 473). Mad-ison, WI: University of Wisconsin-Madison Department of Agricultural & Applied Eco-nomics.

Obeng, S.I. (1994). Effect of domestic policies on production and export of non-traditional agricultural com-modities: A case study of fresh pine-apples in Ghana. Unpublished master’s thesis, University of Ghana, Legon, Accra.

Stanton, J. (2000). The role of agri-business in development: Replac-ing the diminished role of the government in raising rural incomes. Journal of Agribusiness, 18(2), 173-187.

World Bank. (August 2004a). World development indicators database. Ghana data profile. Washington, DC: The World Bank.

World Bank. (August 2004b). World development indicators database. Sub-Saharan Africa data profile. Washington, DC: The World Bank.

Godfred Yeboah is a graduate studentin the Department of AgriculturalEconomics, University of Kentucky.This research was sponsored with aSAGA research grant.

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©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Comment and ReplyComment: “Tracking and Testing of US and Canadian Cattle Herds for BSE: A Risk Management Dilemma”

Ed C. Curlett, USDA Animal and Plant Health Inspection ServiceThere appears to be a flaw in the paper by Cox et al. thatwas recently published in Choices (4th Quarter 2004),wherein they presented an estimate of the benefits of beingable to track and test Canadian cattle in the face of poten-tial BSE outbreaks.

Namely, Cox et al.’s conclusions state: “In other words,the benefit from tracking in this case does not come fromavoiding the cost of 100% testing of US cattle, becausethis is costly. Rather, it comes from the assumed reducedloss of US beef sales if the country of origin of a BSE casedetected in the United States is Canada and this can be as-certained and announced.” However, history contradictsthis conclusion. The origin of the cow involved with theDecember 2003 Washington State BSE case was known tobe Canadian within days of its discovery. This knowledgeof the Canadian origin of that US-discovered BSE case didnot lead to the Cox et al. “assumed reduced loss of US beefsales.” Rather, shortly thereafter the US faced, and contin-ues to face, severe trade restrictions on exports of US cattleand beef, which continue today—over a year later. Conse-quently, Cox et al.’s assumption of reduced loss of US beefsales seems to be in error, and this calls into question theirconclusions and benefit estimates related to the trackingand testing of cattle.

Authors’ Reply:

Louis Anthony Cox, Jr., John J. VanSickle, Douglas A. Popken, and Ranajit SahuWe thank Dr. Curlett for pointing out what appears tohim to be an error in our conclusions. However, we believethe example he provides and the facts of the case supportour conclusion. Our model assumed that one of the mainvalues of an adequate tracking program is that it would al-

low cattle of Canadian origin to be reliably and rapidlydistinguished from cattle of US origin and that future risk-management programs would be rational in using this in-formation. Dr. Curlett suggests that even though theWashington State cow was known and announced to be ofCanadian origin “within days,” it did not lead to markedreductions in trade restrictions applied to imports of UScattle and beef. In reality, the USDA announced on De-cember 23, 2003 that BSE had been confirmed in an ani-mal located in the state of Washington. Japan, South Ko-rea, Taiwan, and other countries announced on December24, 2003 they were imposing a ban on US beef and cattleimports. On December 27, 2003, the USDA announcedthat preliminary information suggested the index cow wasimported from Canada. On January 9, 2004, sixteen daysafter US export markets were closed, the USDA providedconfirmation to the World Organization for AnimalHealth (OIE) that DNA testing of the index cow indicat-ed that it was of Canadian origin.

Our export markets closed before the USDA was ableto use DNA testing to identify it as of Canadian origin.Moreover, in the absence of country-of-origin labeling andan adequate tracking program, the discovery that the cowwas of Canadian origin did not create an option for theUnited States to promptly identify and stop exportingsuch cattle. Our model suggests that this risk-managementoption would be very valuable. Under an adequate track-ing program, as we proposed, Japan and the other coun-tries would not have acted on information that a US cowhad BSE—they would have reacted on information that aCanadian cow imported into the United States at the ageof 4 had BSE. Exports of beef from Canadian-origin cattlecould have been promptly halted—precisely what Japansubsequently suggested as a precondition for resuming im-ports of beef from the United States. Thus, more completeinformation at the time of identifying the animal withBSE, and the use of risk management options that such in-formation would have made possible, may have promptedthose countries to reach a different decision, especially in

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light of the fact that Japan had previ-ously been willing to accept US beefwith verification that it came fromcattle of US and not Canadian ori-gin. In summary, the example pro-vided by Dr. Curlett is precisely oneof the considerations motivating abetter approach, as addressed in ouranalysis.

For More InformationCox, Jr., L.A., VanSickle, J.J., Pop-

ken, D.A., & Sahu, R. (2004). Tracking and testing of US and Canadian cattle herds for BSE: A risk management dilemma. Choices, 2004(4), 51-54.

Louis Anthony Cox, Jr. and DouglasA. Popken are with Cox Associates,Denver, Colorado (http://www.cox-associates.com). John J. VanSickle is aProfessor with the International Agri-cultural Trade and Policy Center,University of Florida. Ranajit Sahuis a Risk Assessment Consultant inAlhambra, California.

Page 89: Choices Magazine, 1st Quarter 2005 · CHOICES The magazine of food, farm, and resource issues 1st Quarter 2005 • 20(1) CHOICES 5 A publication of the American Agricultural Economics

CHOICESThe magazine of food, farm, and resource issues

1st Quarter 2005 • 20(1) CHOICES 89

A publication of theAmerican AgriculturalEconomics Association

1st Quarter 2005 • 20(1)

©1999–2005 CHOICES. All rights reserved. Articles may be reproduced or electronically distributed as long as attribution to Choices and the AmericanAgricultural Economics Association is maintained. Choices subscriptions are free and can be obtained through http://www.choicesmagazine.org.

Coming AttractionsConsumers and Markets

Economic Incentives, Public Policies, and Private Strategies to Control Foodborne PathogensNew threats, like “mad cow disease,” are altering globalmarkets. Recent food safety innovations have been spurredby stringent standards demanded by large buyers, domes-tic and overseas, and by regulatory agencies. While HazardAnalysis and Critical Control Point (HACCP) systemsstarted as a private-public partnership to develop saferfood for US astronauts, in the mid-1990s the Food andDrug Administration and the Food Safety and InspectionService in USDA required HACCP for seafood, meat andpoultry, juice, and now shell eggs. Both private and regula-tory HACCP systems are evolving with new scientificinformation, innovative equipment, and new pathogentests and management strategies. Some companies areusing continuous food safety innovation as a competitivestrategy. Not only are global markets at stake, but food-borne pathogens cause acute illness in 76 million US con-sumers, 5,000 deaths, and an unknown number of chroniccomplications annually.

Agriculture and Trade

US in WTOThe United States has initiated numerous regional andbilateral trade negotiations over the last four years and isheavily engaged in multilateral trade negotiations in theWorld Trade Organization (WTO). These initiatives haveimportant implications for US agriculture in terms of mar-ket access and expanding trade. Progress in the WTO willlikely mean not only more open markets, but somechanges in trade distorting domestic support used by theUnited States, the European Union, and Japan. This seriesof articles examines prospects for progress in the WTO,challenges created by recent Dispute Settlement rulings,and the implications of the Central American-DominicanRepublic Free Trade Agreement.

We are working on future theme coverage on supplychains, appraising nonmarket environmental attributes,GMOs, and checkoff programs.

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