Developing a Fairtrade Cocoa Sector in Nicaragua (Paper)


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Barcelona GSE Master Project by Giuliano J. Bandeen, Armen Khederlarian,
Edmund Moshammer, Tommaso Operto, and Christoph Sponsel

Master Program: International Trade, Finance and Development

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Developing a Fairtrade Cocoa Sector in Nicaragua (Paper)

  1. 1. Barcelona GSE Independent Study Project | ITFD ’13 / 14 Developing a Fairtrade Cocoa Sector in Nicaragua Giuliano J. Bandeen Armen Khederlarian Edmund Moshammer Tommaso Operto Christoph Sponsel
  2. 2. Executive Summary This is a policy proposal directed at the Government of Nicaragua. Nicaragua’s cocoa industry achieves a very low export unit value in comparison to global competitors in West Africa, South East Asia and Latin America. Given the promising prospective growth of the cocoa world market and the higher price paid for Fairtrade cocoa, the aim of the present policy memo is to examine whether Nicaragua could benefit if farmers were to switch to certified cocoa production standards. We show that under perfect market conditions this would indeed result in higher profits. How- ever we also identify that there are currently several obstacles preventing farmers from switching. These obstacles include minimum quantity requirements of international buyers, price information asymmetries, a low negotiation power in the supply chain, and financial and technological con- straints. We propose three policies targeting these obstacles which consist of a provision of storage facilities, a credit guarantee and an educational campaign. All of them rely on group forming of farmers with mutual liability agreements. Comparing the net present value profit of selling conventional cocoa with an investment in our proposed policies, which allows selling Fairtrade cocoa, we calculate an internal rate of return. This rate varies between both potential clients, European chocolate manufacturers Ritter Sport and Zotter and is 129% and 20% respectively. This hence encourages our policy proposal. By comparing different scenarios of government intervention we find that the highest average welfare gain results from an intermediate level of intervention. In this scenario the government would pay for warehouse construction and an educational campaign, and would provide a credit line guarantee to avoid that cooperatives pay a high risk premium. Additionally we include several robustness checks where we allow for changes in investment horizon, fertilizer effectiveness, gov- ernment interest rate, farmers’ risk premium and most importantly international cocoa prices. We show that implementing our policies promises high potential gains from switching for individual farmers and the entire economy under a wide range of scenarios.
  3. 3. Contents 1 Introduction 1 2 Potential Profits from Fairtrade Production 3 2.1 Quantifying the Costs and Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 2.2 Consolidated Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 3 A Case of Market Failure? 9 4 Policy Recommendations 11 4.1 Policy I – Storage Facilities Improvement . . . . . . . . . . . . . . . . . . . . . . . 11 4.2 Policy II – Upfront Payment Scheme . . . . . . . . . . . . . . . . . . . . . . . . . . 13 4.3 Policy III – Educational Campaign . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 4.4 Call for Government Intervention . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5 Gains from Government Intervention 16 5.1 Methodological Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 5.2 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 6 Conclusion 20 A Appendix 24 A.1 Policy III – Educational Campaign . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 A.2 Perfect Market – Dynamic CBA . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 A.3 Degree of Government Intervention: Feature Comparison . . . . . . . . . . . . . . 25 A.4 Dynamic CBA including Degree of Government Intervention . . . . . . . . . . . . . 25 A.5 Robustness Checks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
  4. 4. Developing a Fairtrade Cocoa Sector in Nicaragua 1 Introduction World Cocoa Market The world cocoa market has recently attracted the attention of media given increasing chocolate prices and their expected rise in the mid and long term future. The cocoa world market price has indeed seen a steady increment since the beginning of 2013, and has thereby presumably induced the speculation of international investors. Driven by an imbalance between supply and demand, the increase in cocoa prices is assumed to further intensify in the future (Fairtrade Foundation, 2011; Wegner, 2012). While rising income levels and the demand for luxury food goods (i.e., chocolate) in emerging markets such as India and China have gone hand in hand, cocoa production remains highly sensitive to climate variations as well as to geopolitical tensions given the political instability of large production countries (e.g. Côte d’Ivoire). This conjuncture is believed to lead to even sharper price increases of cocoa. It therefore seems crucial to put great importance on stabilizing the future development of cocoa production. Growing concern in Western countries for sustainable development and working conditions in production sites have led global retailers to increasingly certify their chocolate products by various labels that guarantee quality standards in different fields. Price premiums are being paid for the farmers’ produce conditional on the fulfillment of these standards. This has led to the distinction of the so-called sustainable cocoa production. In effect, sustainable cocoa production has grown at a rate above conventional cocoa production and is assumed to increase even further in the future (FAST, 2012). Nicaragua’s Cocoa Production Nicaragua’s cocoa production has only developed after the coffee crisis of 2001 when Asian compe- tition led to a price slump and displaced Caribbean production. This induced the government to promote cocoa production among small scale farmers (Gutiérrez et al., 2008). The industry there- fore stands at a low level of development with low-scale subsistence farmers holding an average of 1.5 ha/farmer (Lanzas Espinoza, 2010), and a great variation in production capacity. Farmers face local, national and international outlet of their harvest. However, one of the main reasons why exports mainly flow to the neighboring countries such as Guatemala and El Salvador is due to its underdeveloped supply chain organization and infrastructure. This is suboptimal as the value of exports to industrialized countries such as Germany is much higher than those of the neighboring countries (see Figure 2). Moreover, Nicaragua’s cocoa processing industry is underdeveloped with only few local and small scale manufacturing sites existent. As a result, Nicaragua’s rate of return Independent Study Project 1 Barcelona GSE
  5. 5. Developing a Fairtrade Cocoa Sector in Nicaragua to their cocoa production is extremely low in comparison to its competitors. Figure 4 clearly indicates that Nicaragua’s cocoa production could yield higher profits. 46%   33%   20%   1%   Guatemala   El  Salvador   Germany   Austria   Figure 1 19%   31%   48%   2%   Guatemala   El  Salvador   Germany   Austria   Figure 2 Cocoa beans avg. export quantity (lhs) and value (rhs) by destination country in 2011 0   0.5   1   1.5   2   2.5   3   3.5   4   4.5   Guatemala   El  Salvador   Germany   Austria   avg.  price/kg  (in  USD)     Figure 3 0.0   0.5   1.0   1.5   2.0   2.5   3.0   3.5   Nicaragua   Cameroon   Côte  d'Ivoire   Indonesia   WORLD   Ecuador   Nigeria   Ghana   avg.  price  /  kg  (in  USD)   Figure 4 Cocoa beans avg. price/kg by destination country in 2011 (lhs) | Export prices for main producing countries and Nicaragua in 2011 (rhs) (FAOSTAT, 2014) Fairtrade Cocoa and its Potential Taking into account the previously mentioned mid to long term trends of the world cocoa markets, the potential gains from further developing Nicaragua’s cocoa sector are very large. Moreover, Nicaragua’s current relative geopolitical stability, its rather young cocoa sector as well as its favor- able climate conditions favor a large growth potential in the cocoa production industry. Indeed, Nicaragua’s cocoa production is estimated to significantly increase throughout the upcoming years from 3’000 tons in year 2010 to 28’000 tons in year 2022 (MEFCCA, 2013). Independent Study Project 2 Barcelona GSE
  6. 6. Developing a Fairtrade Cocoa Sector in Nicaragua One straightforward strategy to increase the unit value of Nicaragua’s cocoa industry is to en- hance the production of sustainable cocoa given its implied price premium. Currently, around 20% of Nicaragua’s cocoa production is sustainable1 , and hence certified. The main certification label operating in Nicaragua is the German Fairtrade (henceforth FT) initiative which partners with German and Austrian manufacturers Ritter Sport and Zotter. Most importantly, certifi- cation under FT guarantees farmers a minimum price and an additional price premium for the accomplishment of organic production standards and investments in the local community. Other potential gains from certification under the FT initiative include greater access to financing for farmers, prohibition of child labor and sustainability of farming land through environmentally beneficial production standards. The compliance of FT quality standards is monitored through regular auditing by local agencies of the regional FT cooperative which also intermediates the trade between farmers and international buyers. Hence, the question is whether the current situation corresponds to an equilibrium outcome or to the existence of market failures which prevent farmers to market their produce through the certified output channel. The aim of the present policy memo is to ascertain whether there are market failures preventing farmers to take up certified production and, if so, define a range of government policies that aim to align incentives toward certified production and hence increase the value of Nicaragua’s cocoa production. In Section 2 we inquire whether the current situation corresponds to an equilibrium outcome under perfect market conditions or not. Section 3 analyzes the potential market failures that prevent farmers from switching to certified production. In Section 4 we define our proposed policy actions. In Section 5 we analyze the welfare gains from our policy proposal and compare it to alternative intervention degrees. Finally, in Section 6, we lay out our main conclusions. 2 Potential Profits from Fairtrade Production The aim of this section is to investigate whether producing FT cocoa is more profitable in compar- ison to conventional production standards at the individual farmer’s level under the assumption of a perfect market. We approach this issue by using a cost–benefit analysis (henceforth CBA). This preliminary analysis is essential for the intended purpose of the policy memo since it determines whether possible policy recommendations intending to dismantle existing market frictions are to be considered in the first place or not. That is, if an individual cocoa farmer in Nicaragua, even in a perfect market, does not have an incentive to switch from conventional to FT cocoa produc- tion, then there is no need for a policy intervention. The underlying assumptions of the perfect 1There exists no precise data on sustainable and conventional production. In order to assess their respective importance, we therefore consider all exports to industrialized countries as sustainable cocoa and to neighboring countries as conventional cocoa. Independent Study Project 3 Barcelona GSE
  7. 7. Developing a Fairtrade Cocoa Sector in Nicaragua market approach are given in Table 1, including the costs and benefits associated with FT cocoa production standards. Costs Benefits Assumptions Certification costs Higher price Equal technologies Yield loss without fertilizer Lower price fluctuations Equal labor cost Transition period No spendings on fertilizer No information asymmetry No environmental damages Constant gap between TS price and int. cocoa price Table 1 – FT cocoa production under complete market approach 2.1 Quantifying the Costs and Benefits Cocoa Prices A central aspect of our CBA for FT cocoa is the comparison of prices, here measured in nominal USD per kg. In total, we have access to five sources of prices available to Nicaraguan farmers: – World Market Price: The price for conventional cocoa once loaded on a cargo ship, traded at the international stock exchanges. As Figure 5 shows, this price has fluctuated from 0.86 USD/kg in 2000 up to 3.53 USD/kg in 2010 throughout the past 20 years (World Bank, 2014). – FLO price: The Fairtrade Labeling Organization (henceforth FLO) imposes a minimum price on FT cocoa. It is currently sold 0.2 USD/kg higher than the world market price, together with a minimum price of 2.30 USD/kg. This minimum price absorbed the harsh price drop during 2000-2002 (FLO, 2012). – Zotter: An Austrian chocolate producer that sources its cocoa from Nicaragua. For the minimum quantity of a container load (18 tons) delivered to an international harbor in Costa Rica, it offers a price of 4.26 USD/kg for FT cocoa. Zotter is neither involved in the transportation process to the port nor in the contract negotiations with the certification agency and therefore leaves the coordination to the partnering cooperatives. The price has been fixed several years ago and was not adjusted according to international market fluctuations (Moshammer, 2013). – Ritter Sport: A chocolate manufacturer from Germany that works in close cooperation with the local cooperative Cacaonica and offers payment directly to the farmers at the various ad- ministration centers of the cooperatives throughout Nicaragua. The price is considerably lower Independent Study Project 4 Barcelona GSE
  8. 8. Developing a Fairtrade Cocoa Sector in Nicaragua than that of Zotter. However, the cooperative assumes the certification of farm land and the transport. Ritter Sport buys FT cocoa at a price of 3.50 USD/kg and cocoa in the transitional phase at 3.25 USD/kg. Although the price is very stable, it was raised several times during the phase of high world market prices in 2010 in order to remain competitive (Bohl, 2010). – Traveling Salesmen (TS): Merchants who are ubiquitous and work decentralized on their own account. Farmers receive regular visits from traveling salesmen (henceforth TS) who buy cocoa at low prices and later sell it either to the national market or to other Central American countries. TS are the main channel through which the few national chocolate production factories source their raw material and conduct trade with the neighboring countries. It is important to note that TS do not differentiate between conventional and FT cocoa, and hence buy both types of produces at the same prices. The price is correlated with the world market price and hence subject to great fluctuation (see Figure 5), but significantly lower depending on the remoteness of the farmers. Asking a sample of fairly remote living farmers in southern Nicaragua in December 2012, they reported an approximate rate of 1.61 USD/kg. Assuming constant transport costs and competitive TS, we assume that they tend to offer a price around 0.75 USD/kg below the world market price. This implies that since 2000 the price fluctuated between 0.11 USD/kg (TSlow) and 2.78 USD/kg (TShigh), and hence 1.45 USD/kg on average (TSavg) (Moshammer, 2013). Throughout the following analyses, we will take these prices as a benchmark of the prices of the most accessible sales channel of farmers. Indeed our policy proposal aims at shifting incentives from selling through the TS sales channel toward selling through a certified sales channel. 0.0   0.5   1.0   1.5   2.0   2.5   3.0   3.5   4.0   4.5   1994   1996   1998   2000   2002   2004   2006   2008   2010   2012   2014   USD  /  kg   FOB   Cocoa  price   FLO  price   Zo9er  FT   Direct  Sale   Ri9er  TransiBon   Ri9er  FT   Traveling  Salesmen   Figure 5: Comparison of cocoa prices Independent Study Project 5 Barcelona GSE
  9. 9. Developing a Fairtrade Cocoa Sector in Nicaragua Transport We have data on the cost of transport as faced by the cooperative ASHIERCA2 operating in the south of Nicaragua, specifically in the region of Rio San Juan. The cooperative delivers its cocoa to the harbor of Puerto de Caldera in Costa Rica. As a result of insufficient storage facilities close to the farmers, cocoa is stored in a warehouse in Nicaragua’s capital Managua. Only when a quantity large enough to fill a container is reached, the goods are transported to Costa Rica (Moshammer, 2013). Cocoa is brought in small quantities from the cooperative’s administrative center in Boca de Sa- balos to Managua at a relatively high cost of approximately 0.24 USD/kg. If there existed storage possibilities near the center, cocoa could be transported in larger quantities (e.g. a truckload of six tons) at a cost of roughly 0.11 USD/kg. In Managua, the farmers are cooperating with a storage firm that offers to hold their cocoa at a rate of 0.26 USD/kg/year. Given that the cooperative has a FT production capacity of 24’277 kg/year, it takes about nine months to fill a shipment container of 18 tons.3 On average we need to store each unit for 4.5 months, resulting in storage costs of 0.10 USD/kg. Transport of the cocoa from Managua to Costa Rica costs 0.21 USD/kg (Moshammer, 2013). Overall, the costs from getting the cocoa from the cooperative’s administrative center to the harbor where it is ready to be shipped are 0.55 USD/kg in the case of small quantity transport, and 0.41 USD/kg in the case of larger quantities when transporting cocoa to the capital. If we were to avoid the storage in the capital altogether by pooling the produce of several cooperatives, the transportation costs would decrease to 0.32 USD/kg. Certification Costs There are multiple certification schemes available to cocoa production. The schemes differ not only in required payment, but they also demand different percentages of certified content within the delivery. FT certification for instance requires 100% certified content for the use of its label whereas UTZ certification only requires 40% of certified content. As FT certification has the biggest market share in Nicaragua’s cocoa production (KPMG, 2012), we will make use of those costs for our CBA. FT requires an initial payment and subsequently an annual fee, both depending on the group size of the cooperative. The initial fee amounts from 1’859 USD for groups of less than 50 farmers up to 4’511 USD for groups consisting of 1’000 farmers and more. The annual 2ASHIERCA is representative in the sense that it unites an average number of 48 cooperating farmers and is located in one of the six main cocoa producing regions in Nicaragua. Despite the remoteness of the region, there is a road leading to the main center (Moshammer, 2013). 3Here, we are making the sensible assumption of evenly distributed crop yields throughout the year. Independent Study Project 6 Barcelona GSE
  10. 10. Developing a Fairtrade Cocoa Sector in Nicaragua fee ranges from 1’521 USD to 3601 USD depending on the same criterion as above. We do not have the exact distribution of the certification fee for each cooperative. However, the size of the cooperatives in Nicaragua is available (Orozco et al., 2012). Together with the payment criterion mentioned above we can therefore compute the average certification cost a Nicaraguan cooperative faces. Approximately 45% of the cooperatives consist of less than 50 farmers and the other 55% reach a maximum of 160 members. We can therefore conclude that the upper bound of 4’511 USD which would be due for cooperatives of 1000 farmers will by far not be reached. We estimate an average initial certification cost of 2’000 USD per cooperative and an annual fee of approximately 1’800 USD. Accounting for the average group size of 70 members (Orozco et al., 2012), an average yearly productivity of 0.34 t/ha/year (Guzmán, 2013), and an average field size per farmer of 1.5ha (Lanzas Espinoza, 2010), we calculate an annual (initial) certification cost of 50 USD/t (58 USD/t) on the farmer’s level and a yearly cooperative production of 70 farmers * 1.5ha * 0.34 t/ha/year = 35.72 t/year/coop. Making the same calculation for conventional farmers and additionally taking into account the production gain by using fertilizer yields (70 farmers * 1.5ha * 0.34 t/ha)/ (1-30%) = 51.03 t/year. Yield Loss without Fertilizer It is important to stress that the assumption made in this section is valid only for FT certification. Other certification schemes such as UTZ and Rainforest Alliance seem to significantly increase productivity of certified cocoa production due to application of good agricultural practices and ef- ficient use of pesticides. Estimations vary between a 20% up until approximately 90% productivity increase after three years, depending on country specific factors, the initial state of productivity and on the size of the producing farm (assuming that before transition the area was completely untreated) (Dammert and Mohan, 2014). Generally, smaller farmers are supposed to profit less from productivity increases (Ruf and Bini, 2012). In fact, 60% of certified producers possess land of less than 1.4 ha (Lanzas Espinoza, 2010). This suggests that using pesticides in Nicaragua would generally not lead to a productivity increase of the same magnitude of West African coun- tries. Moreover, since we focus on FT certification where productivity enhancing pesticides are not allowed, we assume a productivity loss of approximately 30% after the transition to FT cocoa (Mahrizal et al., 2012). Since certifying the production process is generally assumed to lead to a productivity increase, this represents a very conservative estimate and is likely to downward bias our calculations. Independent Study Project 7 Barcelona GSE
  11. 11. Developing a Fairtrade Cocoa Sector in Nicaragua Cost of Fertilizer Based on experiences in Africa, the cost for fertilizers has been estimated to be around 600 USD/t. However, these estimates are associated with productivity increases of up to 90% and are therefore considered high quality input combined with perfect prerequisites of producing cocoa on a large scale (KPMG, 2012; Ruf and Bini, 2012). A more general assumption of fertilizer cost and an estimate which is in line with the productivity loss of 30% when producing FT would be 22 USD/t (Mahrizal et al., 2012). The latter estimate is in line with our field observations in Nicaragua and will therefore be used in our CBA. 2.2 Consolidated Profit The results are summarized in Table 2. Zotter pays a higher price than Ritter Sport. However, the cocoa has to be transported to the next international harbor, whereas Ritter Sport already buys the cocoa from the regional warehouse which is why they have different transport costs. For both certification schemes Table 2 shows that from an ex-post point of view (i.e. not considering the transition period), an individual farmer yields significantly higher profits once switched to FT production when comparing to the average price of the TS (TSavg). Evaluating the example of Zotter, the CBA suggests that even though the farmer faces higher costs and has a lower productivity, the profit almost doubles compared to the average pricing scheme of conventional production. Only if the CBA is evaluated by assuming a high TS price the profit is lower for FT production. On average however, this analysis clearly raises the question on why farmers have not switched to FT production yet. Description Ritter Sport Zotter Non-FT (T Savg) Non-FT (T Shigh) Price 3’500 USD / t 4’265 USD / t 1’445 USD / t 2’780 USD / t Transportation 0 320 USD / t 0 0 Certification paid by Ritter Sport 50 USD / t 0 0 Quantity per cooperative 36 t / year 36 t / year 51 t / year 51 t / year Quantity per farmer 0.51 t / year 0.51 t / year 0.73 t / year 0.73 t / year Fertilizer cost 0 0 23 USD / t 23 USD / t Profit / cooperative 125’024 USD / year 139’119 USD / year 73’738 USD / year 141’863 USD / year Profit / farmer 1’786 USD / year 1’987 USD / year 1’053 USD / year 2’026 USD / year Table 2 – Static CBA under complete market assumption The results of the CBA have important caveats which ought to be outlined. The higher profit is only feasible under the strong assumption of a perfect market. Possible market failures are therefore not taken into account in this step of our analysis. Moreover, the transition period of three years which is needed to switch from conventional to FT production standards is fully Independent Study Project 8 Barcelona GSE
  12. 12. Developing a Fairtrade Cocoa Sector in Nicaragua ignored. During this period the farmer receives a transition price which lies between the price offered for FT cocoa and the TS price (see Figure 5). Taking the lower transition price into consideration might therefore yield different results given the lower incentive of switching, even if ex-post the farmer will have higher profits. -­‐2'000   -­‐1'000   0   1'000   2'000   3'000   4'000   5'000   6'000   7'000   8'000   Low  Interna6onal  Price   Average  Interna6onal  Price   High  Interna6onal  Price   NPV  (in  USD)   Farmer's  NPV  Gain  RiGer   Farmer's  NPV  Gain  ZoGer   Farmer's  NPV  Gain  Intl.  FLO   Figure 6: Individual farmer’s NPV gain with varying int. prices including the transition period In order to take this period into account we will calculate the NPVs of switching to FT production instead of a static CBA in Section 5. For a dynamic analysis of this CBA (taking into account the transition period, but ignoring market failures and government policies), Figure 6 shows how the individual farmer’s NPV gain of switching to FT production is affected by the pricing scheme and by fluctuations of the TS price, including the transition period. In this dynamic analysis, a farmer’s decision to switch will thus depend on the conditions of receiving finance, the interest rate, and the ability of overcoming possible market frictions. We will account for all these variables in the next sections. 3 A Case of Market Failure? As shown in the previous section, Nicaraguan farmers would choose to grow FT cocoa in a complete markets scenario as returns are significantly higher and certification costs could be relatively fast recovered. However, since in reality only few farmers produce FT cocoa, there must be obstacles preventing farmers to switch. We have identified four obstacles, which can be summarized as follows: Minimum quantities requirement (MQR): Global chocolate manufacturers buy FT cocoa beans in standard containers which should be loaded with not more than 18 metric tons weight, Independent Study Project 9 Barcelona GSE
  13. 13. Developing a Fairtrade Cocoa Sector in Nicaragua including dunnage (CMAA, 2012). This is a large quantity considering that an individual farmer on average only produces 510 kg of FT cocoa per year. Hence there is a significant amount of time needed to accumulate such large quantities which implies high storage costs. Moreover, the underdeveloped transport and communication infrastructure in Nicaragua adds to this problem. Cocoa beans need to be stored under dry and cool conditions. Appropriate storage facilities are too expensive to be afforded by individual farmers. Furthermore, external transport services are scarce and expensive. As a consequence, the MQR is hardly reached by cocoa farmers which hence prefer selling to local TS who do not impose any quantity restrictions. Price information asymmetries: An important assumption of the complete market scenario in the previous section was that all relevant players have perfect knowledge regarding the different prices. However, in reality it is observed that farmers do not know at which prices their cocoa beans are sold in the national and international markets. Often they live and produce in remote areas with a poorly developed communication infrastructure which complicates the spread of information. Local buyers (TS) can hence buy at prices far below the price of the international or national markets. Negotiation power throughout the supply chain: As mentioned before, Nicaragua’s cocoa pro- duction is mostly dominated by small-scale subsistence farmers who lack any negotiation power when selling their product. Local buyers could always turn to other neighboring farmers. More- over, these farmers often find themselves obliged to sell their produce at fire sales prices since they need to cover immediate financial needs such as paying for food, schooling of their children or debt which consequently further reduces their negotiation power. Financial and technological constraints: Switching to FT cocoa production requires a range of initial investments such as the payment of certification costs and material needed for sustainable farming techniques. Farmers might be unable to cover these costs given their financial limitations. Also, they might lack the technological knowledge necessary to apply those techniques. These failures of the complete market assumptions reduce the farmers’ incentives and make selling their cocoa to local buyers, in spite of lower prices, more attractive. The aforementioned market failures and constraints currently align incentives toward selling through the TS sales channel. In order to shift incentives toward sales through the FT sales channel, an increased coordination between farmers is required. This would facilitate the meeting of MQR, increase the knowledge about prices through improved communication channels, improve farmers’ negotiation power when facing buyers, and provide mechanisms to overcome financial and tech- Independent Study Project 10 Barcelona GSE
  14. 14. Developing a Fairtrade Cocoa Sector in Nicaragua nological constraints. As Figure 7 shows, the purpose of the policy actions we propose in the following section is to eliminate the red arrows from the supply chain. COCOA PRODUCERS! INTERMEDIARIES! BUYERS! COOPERATIVE! BUYERS OF ! FT COCOA! FAIR LABELLING ORGANIZATION ! TRAVELING SALESMEN (TS)! OTHER BUYERS!CONVENTIONAL FARMERS! FT FARMERS! SUPERVISION! DELIVERY! ! PAYMENT! DELIVERY! ! PAYMENT! DELIVERY! ! PAYMENT! DELIVERY! ! PAYMENT! SUPERVISION! DELIVERY! PAYMENT! PAYMENT! Figure 7: Cocoa supply chain in Nicaragua 4 Policy Recommendations 4.1 Policy I – Storage Facilities Improvement We recommend the construction of adequate cocoa storage facilities in order to increase the time farmers can store certified cocoa before vending. One prime reason why farmers prefer selling cocoa to TS than to the certifying cooperatives is that it is possible to sell small amounts of cocoa to the TS while a sale to cooperatives requires larger quantities for transport reasons. Hence selling larger quantities requires the storage of cocoa in dry and constantly cool storage facilities in order to accumulate the quantity required. Such facilities are often not available to farmers which represents a strong barrier for switching to FT production standards. To overcome this problem we propose the setup of a delivery network where several small local warehouses supply few strategically placed regional warehouses. At the local level we recommend the forming of groups of 10 farmers sharing one small warehouse with limited capacity (ca. one ton) where the combined cocoa production is gathered in short walking distance. In total we aim to build approximately 100 local warehouses to cover the needs of the currently 980 farmers organized in certifying cooperatives (Orozco et al., 2012: p.4). Independent Study Project 11 Barcelona GSE
  15. 15. Developing a Fairtrade Cocoa Sector in Nicaragua Following FT production standards, 10 farmers produce approximately 850 kg per two months4 , which fits the warehouses’ capacity. Once the capacity has been met the cocoa is transported to the regional warehouse. There is a joint liability agreement among the farmers similar to the group commitment concept in microfinance: within the group all farmers are obliged to stick to FT production standards, to store their cocoa in the local warehouse and to not sell to the TS. This is controlled by whether the total capacity of the warehouse has been met or not, assuming that the production capacity of each farmer is generally known. If at least one farmer deviates from this commitment strategy, all farmers of the group are paid a reduced price in the following month which however would still be above the TS price in order to maintain incentives to switch. Hence, there exists group pressure among farmers to respect FT production standards and to sell uniquely toward those cocoa cooperatives. Farmers are not only incentivized to adhere to FT production standards because of the income gains this generates but also as deviating potentially results in a reputational loss and social consequences. If only one farmer deviates from this rule all farmers are sanctioned so that farmers are encouraged to control themselves mutually. In case of repeated deviation, an appropriately elaborated sanctioning mechanism would be deployed by each cooperative. Farmers receive the aforementioned prices depending on the corresponding international buyer. The transport from the cocoa field to the local warehouses is operated by the farmers themselves at negligible costs. Once gathered at the local warehouses the cocoa is transported to the regional warehouses at a cost of 64 USD/t which is the transport cost of quantities up to one ton (Lan- zas Espinoza, 2010). Further transport from the regional warehouses onward occurs as described in Section 2.1. At the regional level we recommend the construction of 14 warehouses spread strategically across Nicaragua in accordance with the 14 currently existing certifying cocoa cooperatives (BioLatina, 2013). Each of these warehouses has a storage capacity of six tons of cocoa which equals the amount of one truckload. One warehouse covers the storage needs of approximately 70 farmers as currently each cooperative holds on average 70 farmers (Orozco et al., 2012: p.4). In these warehouses cocoa is received from the local warehouses and stored until the full capacity is reached so that a full truckload can be delivered to the cooperatives. It seems important to note that these warehouses do not require electricity and are dry. Therefore, maintenance is rather easy and costs are low. The operation of the regional warehouses is delegated to farmers which already have long-term relationships with the certifying cooperatives and are hence trusted. We recommend the positioning of the 14 regional warehouses within the six regions where cocoa 4Productivity: 340.2 kg/ha/year * farm size: 1.5 ha/farmer * 10 * 2/12 (IICA et al., 2009; Guzmán, 2013; Lanzas Espinoza, 2010). Independent Study Project 12 Barcelona GSE
  16. 16. Developing a Fairtrade Cocoa Sector in Nicaragua production is concentrated in Nicaragua (see lhs in Figure 8). As an example, the map on the rhs of Figure 8 (Bohl, 2010) shows the cocoa cultivation region of El Castillo in Southern Nicaragua. The points in different colors show 257 different cocoa farms and their locations. We can see that cocoa farms in this representative case tend to be clustered but often at significant distances from roads (orange lines). The map also shows the potential of strategically placing the regional warehouses at roads where they are easily reachable from the clusters of cocoa farmers in which the local warehouses would be placed (e.g. in El Che Guevara). Policy I: Storage Improvement ! ! !"#$%&$'&($!%# Introduction! CBA I! Coordination! Policies! CBA II! Conclusion! Developing a Fairtrade ! Cocoa Sector in Nicaragua! Figure 8: Construction plan of regional warehouses (lhs), cocoa farms in El Castillo, Southern Nicaragua (rhs) The approximate cost of constructing one regional warehouse is 5’000 USD and of one local warehouse 2’500 USD (Moshammer, 2013). While the maintenance costs of all warehouses are covered by the farmers themselves, the government accounts for the initial construction costs. The received rental payments by the government will cover amortization so that once the warehouse has completed its life cycle, the government can assume the renewal of the same. Annual rental cost thus correspond to the annual amortization of the warehouse (10-year life cycle). Given that approx. 70 farmers use one regional warehouse and that 10 farmers use one local warehouse, the costs per farmer are in total approximately 320 USD/year. 4.2 Policy II – Upfront Payment Scheme By constructing local and regional storage facilities for certified cocoa, the aim is to significantly reduce transportation time and costs of the farmers. Moreover, a successful execution of group forming with joint liability will make it easier for the farmers to meet the minimum quantities Independent Study Project 13 Barcelona GSE
  17. 17. Developing a Fairtrade Cocoa Sector in Nicaragua required in order to sell to the cooperatives. Both these effects are expected to decrease a farmer’s barrier of switching to FT cocoa production. However, one major problem remains. Depending on the chocolate manufacturer (Zotter or Ritter Sport), the certifying cooperatives and therefore the farmers receive their payment only at delivery to the harbor in Costa Rica (Zotter) or the regional warehouses (Ritter Sport). While Zotter buys at a threshold quantity of 18 tons, Ritter Sport buys as soon as the regional warehouse is filled. Given that the yearly production of a cooperative is estimated to be 36 tons, Zotter will only pay twice a year and Ritter Sport every two months. The implication of the given value chain is clear: if local FT farmers find themselves in a situation of acute financial distress they will most likely not be able to wait for the delayed payment from the cooperatives. Therefore it seems likely that they will prefer fire selling their cocoa at a far lower price to the TS, thereby harming the entire group. To tackle this problem, we propose an upfront payment scheme in which farmers receive a payment at every delivery to the local warehouse. To make this possible, the underlying cooperative needs to take on a credit line issued by a private bank. The total amount and maturity of this credit line depends on the underlying chocolate manufacturer the cooperative delivers to, and the price it will offer to the farmers. Taking on a credit line as a cooperative of farmers implies the payment of a risk premium which is estimated to lie around 12% (Moshammer, 2013). In order to avoid such high interest rates, we propose that the government guarantees the repayment of the credit toward the private bank. Hence, cooperatives will be able to borrow at the government’s interest rate, i.e. around 8%5 (Hidalgo, 2014). This mechanism secures that the gap between any TS price and that offered by the chocolate manufacturers is as large as possible. Farmers receive the price currently fixed by the international buyer minus the proportion of the cooperative’s expenses which include transport costs, interest payments, storing, etc. As can be seen in the analysis that follows (see Section 5.2), cooperatives selling to Ritter Sport and Zotter can pay farmers prices between the average and the high TS price under standard assumptions. Thus, this approach will offset a farmer’s incentive to deviate from the FT sales channel and fire sell his produce. For the short peaks in TS prices however it is vital to have the above described group liability and sanctioning concept in place. In order to calculate the cost of the upfront payment financing we need to take both the interest rate charged (i) and number of months between the upfront and final payment (t) into account. Moreover, we need to determine the upfront payment price received at each delivery by farmers. We assume that this is equal to the high TS price. Finally, we calculate the annual cost of the upfront financing by using the compounded interest calculation methodology: Annual cost of upfront financing = yearly Production ∗ TShigh ∗ (1 + i) t 12 −1 5For a detailed description of real interest and risk premium estimation assumptions, see Section 5.1. Independent Study Project 14 Barcelona GSE
  18. 18. Developing a Fairtrade Cocoa Sector in Nicaragua 4.3 Policy III – Educational Campaign Additionally, we recommend an educational campaign to complement the previously discussed policies and to support farmers switching to FT production standards. An important barrier preventing farmers to switch to a FT cocoa production is the farmers’ unawareness of its potential gains and its requirements (see Section 3). We hence recommend enhancing the farmers’ education concerning FT production standards and the required changes along the value chain. Specifically, we propose a non-recurring6 decentralized campaign, led by acquainted and experienced farmers of each cocoa region. An appropriate curriculum needs to be set up in collaboration with the cooperative and some of the acquainted teachers. For example, it should contain how high yields can be achieved without using fertilizers, good weeding practices, appropriate distances between trees, the right time of trimming branches and the right timing of cocoa harvest for optimal taste and quality (KPMG, 2013). It is crucial that these classes are held in the local (often indigenous) language. An additional aim is that farmers gain expertise in specific areas so that mutual support of farmers within their groups becomes more effective. Moreover the teaching farmer should assist other farmers in their decisions, create awareness of the different prices paid by certifying cocoa cooperatives and the TS and help concerning the usage of warehouses and group forming with joint liability processes. In total, the costs associated with this policy would accumulate to 564 USD per cooperative (see Appendix A.1). 4.4 Call for Government Intervention Given that our proposal is based on the profit opportunities of FT cocoa production it raises the question why these opportunities have not yet been used by a private entrepreneur or by the unification of individual farmers. In this section we will show why only the government could implement our suggested policies. Given the fragile situation of law enforcement in Nicaragua it is necessary that the government builds and maintains the warehouses. Any private investor would be reluctant to such investments due to the considerate risk of ex-propitiation as land ownership in Nicaragua (World Bank, 2013)7 has often not been clearly defined and has been subject to various reforms and changes during the last decades. Moreover, any private investor would charge a considerably higher rent (the govern- ment only seeks to recover construction costs) and without this subsidy, the farmers’ incentive to 6We believe that executing the campaign only once is enough to obtain a chain reaction in which trained farmers will share their knowledge and promote FT production standards. 7According to data collected by Doing Business, contract enforcement takes 409 days, costs 26.8% of the value of the claim and requires 37 procedures. Globally, Nicaragua stands at 47 in the ranking of 189 economies on the ease of enforcing contracts (p.83). Independent Study Project 15 Barcelona GSE
  19. 19. Developing a Fairtrade Cocoa Sector in Nicaragua switch would be considerably reduced. Given that this policy requires significant investments it is further unlikely that farmers could organize themselves in groups and proceed independently as mentioned above. Hence only the government can implement the suggested construction of warehouses. Furthermore, the weak law enforcement situation in Nicaragua would prevent any private investor to implement our suggested policy of upfront payments to farmers. Both investor and farmers would not have any security of mutual contract compliance as law enforcement in rural Nicaragua is hardly existent. The resulting mistrust thus makes it unlikely that a private implementation of our policy recommendation would occur. Finally, it is in the government’s interest to implement the policies as a private intervention would yield a comparably lower welfare distribution and would most likely consider social and ecological benefits to a smaller extent. In the case of a government intervention the entire profit of switching would be collected by individual farmers. Although total welfare gain from switching would be equal in the case of a private intervention there would be a reduced welfare distribution as Nicaragua’s tax collection system is inefficient and highly corrupt. Hence, profits collected by a private sector agent could hardly be redistributed to the individual farmers and welfare would be distributed less. Moreover, the share of profit received by individual farmers would be reduced and as a result their incentive to switch at all. 5 Gains from Government Intervention The aim of this section is to analyze the aggregate welfare implications and individual farmer’s gain of our proposed policies. As in Section 2.3, we will weigh the costs associated with FT production standards against its quantifiable benefits. We use a 10-year time horizon approach and apply a net present value (NPV) calculation methodology. 5.1 Methodological Approach Degree of Intervention We calculate the costs and benefits for varying degrees of government intervention in order to compare our proposal to other alternative policy choices. For an overview and comparison of the degrees of government intervention see Appendix A.3. 1. No Intervention – In this case, the government does not carry out any of the proposed policy actions which are therefore fully carried out by the farmers and the cooperatives. The key Independent Study Project 16 Barcelona GSE
  20. 20. Developing a Fairtrade Cocoa Sector in Nicaragua difference of this approach is that the credit line will not be guaranteed and hence the coop- eratives will have to pay a substantial risk premium. As mentioned in Section 4.2, we assume this risk premium to lie around the magnitude of 12%, in addition to the average real interest rate. 2. Proposed Intervention – Our prosed policy intervention consists of guaranteeing the credit line required to implement the upfront payment, building the required regional and local storage facilities and promoting technical knowledge spread through an educational campaign as well as imposing a joint liability concept upon the groups of farmers. Note that farmers still have to assume warehouse maintenance costs. 3. Full Intervention – In this case, the government would not only guarantee the credit line and subsidize the warehouse construction but also all other costs of switching during the transition phase of three years. This includes warehouse maintenance, certification and transportation costs. Scenarios For each of the three policy choices we have calculated the CBA according to the following sce- narios: – Prices: As seen in Figure 5, there are three main purchasers of FT cocoa, namely Ritter Sport, Zotter and the International FLO market. For each purchaser the different prices and certification procedures are considered. For instance, Ritter Sport covers all certification costs, Zotter does not. Ritter Sport buys FT cocoa directly from the regional warehouses while Zotter receives it only at the harbor, on average twice a year. These and other peculiarities give place to different calculations for each of the three sales channels. – Real interests: Given that we use a long term, 10-year time horizon approach, NPV results are highly sensitive to the discount rates. We approach the definition of the discount rate as the sum of the prevalent real interest rate and the risk premium paid by agricultural cooperatives in Nicaragua. With respect the former, we assume the prevalent real interest rate to be equivalent to the yield of 1-year government bonds which currently are of an approximate 8% (Hidalgo, 2014). With respect to cooperatives’ risk premium, since these are currently paying an average of 20% on their credit lines, we consider the risk premium to be the difference between this and the prevalent real interest rate, hence 12%. We then consider three scenarios: low real interest rate of 4% + RP, normal real interest rate of 8% + RP, and high real interest rate of 14% + RP. Independent Study Project 17 Barcelona GSE
  21. 21. Developing a Fairtrade Cocoa Sector in Nicaragua Assumptions We base our calculations on the following assumptions: – No general equilibrium effects: We acknowledge that the implementation of public subsidies that shifts the incentive structure toward switching will create some general equilibrium effects. For instance, we can conjecture that TS will initially cut into their mark-up and offer higher prices. Moreover, we assume that the demand for FT cocoa is exogenous and that an increase in supply will have no effects on prices. We believe this assumption is realistic since the prices offered by Zotter and Ritter Sport are guaranteed, and Nicaragua’s impact on international markets is too small to affect international FLO prices. This argument is supported by an upward trend in cocoa prices in both the mid and long term (see Introduction). – Constant labor costs: Given the gap created by the ban of child labor and the fact that switching to FT production standard leads to increased working hours (Dammert and Mohan, 2014: p.25), it seems reasonable to assume an increase in labor costs. This may be due to the need for hiring additional workers or through the opportunity cost of having to work more hours. However, we assume these costs to be negligible and acknowledge that this might upward bias our results. – Pricing: For simplicity we take the average prices paid by TS and do not calculate different scenarios for variations in the same. Hence, we assume that the gap between FT pricing schemes and the TS price remains constant. This assumption is linked to the prior assumption of no general equilibrium effects. Given our policy proposal it should however be noted that short peaks in international prices can be overcome by the joint liability agreement. – Productivity loss: As already mentioned in Section 2.1, we assume a productivity loss of 30% due to the non-use of fertilizers, in compliance with FT production standards. However, existing literature on the effects of FT production on productivity is ambiguous. In fact, some evidence even points to an increase in productivity, especially in the presence of previously low-developed farming practices (Valkila, 2009)8 . Therefore, we consider that this assumption is likely to downward bias our results. Outcomes of Interest We will analyze the dynamic CBA according the following outcomes of interest: 1. Aggregate welfare gain (AWG): The outcome of the NPV of farmer’s profit through each FT channel minus NPV of government expense implied by policy intervention and the NPV of 8Valkila (2009) points out that there is a continuum of farming practices from those that are low-input and low-yield to those that are high-input and high-yield Independent Study Project 18 Barcelona GSE
  22. 22. Developing a Fairtrade Cocoa Sector in Nicaragua profit obtained by selling to the TS. The AWG is the core decision criterion for the government on intervention on if and how to intervene. 2. Individual farmer’s profit (IFP): The IFP is calculated by considering the NPV per capita of a farmer’s profit of selling through a certain FT channel minus the NPV of profit obtained by selling to the TS. 3. Internal Rate of return (IRR): The discount rate that sets the NPV calculation of the AWG equals to zero. The IRR is usually used in capital budgeting where it is interpreted as the rate of return or profitability of an investment. In this case profitability would refer to the gains accrued by farmers for switching to FT considering the implied costs for the government. 5.2 Results Given the assumptions and scenarios, the calculation of the dynamic CBA yields the following findings with respect to our three outcomes of interest (see Figure 9 and 10): – Switching to FT production standards yields positive welfare gains for both Ritter Sport and Zotter pricing schemes but not for the average International FLO price (FLOavg). This holds for all degrees of government intervention and points toward the necessity of strengthening the cooperation with the two global manufacturers. – For any given degree of intervention gains are substantially larger for Ritter Sport. This is mainly due to the reduction of ongoing costs of certification and transport, and the interest paid due to the financing of the upfront payments as Ritter Sport assumes certification costs and collects goods more frequently than Zotter. This reduction in the implied costs offsets Zotter’s higher price. Our results imply that if international buyers want to encourage certification, a reduction in switching costs loom larger than price premiums. – We consider the magnitude of the AWG and IFP from switching to be large in a real world sense, especially in the case of sales through Ritter Sport. For the proposed policy intervention and the normal case scenario of 8% real interest rate, the AWG and IFP for Ritter Sport are 160’670 USD and 2’553 USD, respectively. For Zotter, they are 62’765 USD and 1’226 USD, respectively. Given the subsistence status of farmers, we believe that a gain in profits of ca. 250 USD per year from producing FT cocoa is rather large. – Within the three studied degrees of government intervention, the one that offers the highest return in terms of IRR is our proposed intervention. As the government guarantee allows for lower interest payments of the required credit line, the IRR is higher than for the scenario with Independent Study Project 19 Barcelona GSE
  23. 23. Developing a Fairtrade Cocoa Sector in Nicaragua -­‐150000   -­‐100000   -­‐50000   0   50000   100000   150000   200000   250000   Perfect  Market   No   Interven5on   Proposed   Interven5on   Full   Interven5on   NPV  (in  USD)   Degree  of  Gov.  Interven6on   Ri>er  Sport  FT   Zo>er  FT   Int.  Avg  +  FLO   Figure 9: Aggregate welfare gain -­‐1500   -­‐1000   -­‐500   0   500   1000   1500   2000   2500   3000   Perfect  Market   No   Interven6on   Proposed   Interven6on   Full   Interven6on   NPV  (in  USD)   Degree  of  Gov.  Interven6on   Ri?er  Sport  FT   Zo?er  FT   Int.  Avg  +  FLO   Figure 10: Individual farmer’s gain no intervention. It is also higher compared to the IRR resulting from full intervention as a higher degree of intervention decreases the discount rate, i.e. the government intervention bears a larger share and thus lowers the risk of the project and hence increases NPV costs. – While the AWG for the proposed and full intervention are almost equal since costs simply shift from farmers to the government, the IFP is significantly higher for with full government intervention. This is due to increased subsidizing of switching costs. – In order to check the robustness of our results we have performed several sensitivity checks by varying some of our assumptions. Our robustness checks yield the following main results: (a) Sensitive only to large increases in international prices (b) Substantial increase in the AWG and IFP for lower productivity loss due to ban of fertilizers (c) Lower sensitivity to changes in real interest rate in the case of Ritter FT compared to Zotter and Int. + FLOavg 6 Conclusion Nicaragua’s cocoa industry achieves a very low export production value of cocoa beans in com- parison to global competitors in West Africa, South East Asia and Latin America. Given the promising prospective growth of the cocoa world market, Nicaragua would benefit highly of an increase in the unit value of its cocoa production. Our policy recommendation targets this po- tential by incentivizing cocoa farmers to switch from conventional to FT cocoa production. FT production guarantees higher prices and would hence increase the produced cocoa’s unit value. Farmers are currently not switching to FT production due to various incentives promoting the production of conventional cocoa. These incentives can be summarized as a coordination problem Independent Study Project 20 Barcelona GSE
  24. 24. Developing a Fairtrade Cocoa Sector in Nicaragua between farmers. This problem includes minimum quantities required by international buyers of FT cocoa, price information asymmetries between farmers and local TS, farmers’ low negotiation power in the supply chain, farmers’ immediate financial needs and a lack of knowledge on how to implement FT farming practices. Our proposed policy aims to redirect incentives toward FT cocoa production in four ways: (i) Developing storage facilities at local and regional level to overcome minimum quantity issues. (ii) Preventing fire sales to TS by allowing upfront payments to farmers on goods delivery, financed through a credit line for FT cocoa cooperatives guaranteed by the government. (iii) Carrying out an educational campaign in order to raise awareness of the program and increase knowledge concerning FT production techniques. (iv) Gathering farmers in joint liability groups in collaboration with FT cocoa cooperatives in order to meet minimum quantity requirements, reduce price information asymmetries, spread FT production techniques and most importantly, to implement a system to enforce adherence to FT production of individual farmers. We balance the costs and benefits of our proposal against those of the current conventional cocoa business model using a NPV calculation with a 10-year horizon. We find that based on prices paid by chocolate manufacturers Ritter Sport and Zotter, the IRR is around 129% and 20% respectively. Therefore, the CBA results encourage our proposed policy. Furthermore, our proposed policies would imply various positive social and ecological externalities of FT production which are not accounted for in our CBA. The most relevant ones are reduced volatility in farmers’ income due to guaranteed minimum prices, increased schooling of farmers’ children given the imposed ban of child labor, environmental sustainability given eco-friendly practices and an increased empowerment of farmers. Moreover, we consider that the proposed policy has a wide and scalable scope. Currently, around 80% of cocoa production is sold through conventional sales channels which leaves extensive growth potential to FT cocoa production. Given the ease of our suggested policies’ implementation their scope could be easily extended toward farmers which are not yet members in FT cooperatives. This is an especially attractive feature of our policy given the prospective growth of the world FT cocoa demand. Independent Study Project 21 Barcelona GSE
  25. 25. Developing a Fairtrade Cocoa Sector in Nicaragua References BioLatina (2013). Lista de operaciones certificadas. Bohl, K. (2010). Sistematización y análisis de las cadenas de valor de cacao en el municipio el castillo, río san juan. Technical report, Canacacao. CMAA (2012). Standard guidelines for shipment of cocoa beans in containers as of 12/13/12. Technical report, The Cocoa Mechants’ Association Of America Inc. Dammert, A. and Mohan, S. (2014). A survey of the economics of fairtrade. Discussion paper no 8167, Institute for the Study of Labor. Fairtrade Foundation (2011). Fairtrade and cocoa – commodity briefing. Technical report. FAOSTAT (2014). Last checked: 25.05.2014. FAST (2012). A brief overview of the sustainable cocoa sector in latin america and the caribbean. Market research for sustainable investment., Finance Alliance for Sustainable Trade. FLO (2012). Fairtrade minimum price and fairtrade premium table. Table, Fairtrade Labelling Organizations International. Fundación CHICA (2011). Centro Nicaragüense de Capacitacion Solar (Cenicasol), Cinco Pinos. Gutiérrez, C., Gutiéerrez, M., and Altamirano, M. (2008). Sub programa fomento de la producción, transformación y comercialización de cacao en nicaragua. Technical report. Guzmán, R. (2013). Nicaragua incrementará su productividad con apoyo del bid. Hidalgo, W. Á. (2014). Bolsa con rédito de hasta el 8%. Technical report, La Prensa. IICA, MAGFOR, and Austriaca, C. (2009). Propuestas para el fomento y desarrollo de la agri- cultura orgánica en nicaragua. Technical report, Instituto Interamericano de Cooperación para la Agricultura. KPMG (2012). Study on the costs, advantages and disadvantages of cocoa certification. Technical report, The International Cocoa Organization (ICCO). KPMG (2013). Moving the bars: Sustainability brought to the forefront in the cocoa chain. Technical report. Lanzas Espinoza, J. J. (2010). Analisis del beneficiado de cacao en fincas de productores de cacaonica, waslala, raan, nicaragua. Technical report, Proyecto Cacao Centroamérica (PCC). Independent Study Project 22 Barcelona GSE
  26. 26. Developing a Fairtrade Cocoa Sector in Nicaragua Mahrizal, Lanier Nalley, L., Dixon, B. L., and Popp, J. (2012). Necessary price premiums to incentivize ghanaian organic cocoa production: A phased, orchard management approach. HortScience, 47(11):1617–1624. MEFCCA (2013). El cacao en nicaragua, situacion actual y perspectivas. Technical report, Ministerio de Economia Familiar, Comunitaria, Cooperativa y Asociativa. Moshammer, E. (2013). Field research within the cooperative ashierca in buena vista, rio san juan, nicaragua. Technical report, Fundación CHICA. Orozco, L., Caceres, S., and Valencia, D. (2012). El cacao: Promesa de futuro para nicaragua síntesis para decisores. Technical report, FENACOOP R.L. Ruf, F. and Bini, S. (2012). Cocoa and fertilizers in west-africa. Technical report, IDH Sustainable Trade. Valkila, J. (2009). Fair trade organic coffee production in nicaragua – sustainable development or a poverty trap? Ecological Economics, 68(12):3018–3025. Wegner, L. (2012). Cocoa fact sheet. Technical report, Wageningen UR Centre for Development Innovation. World Bank (2013). Doing business 2014: Understanding regulations for small and medium-size enterprises. Technical report, World Bank Group. World Bank (2014). Cocoa (icco), international cocoa organization daily price, average of the first three positions on the terminal markets of new york and london, nearest three future trading months. Independent Study Project 23 Barcelona GSE
  27. 27. Developing a Fairtrade Cocoa Sector in Nicaragua A Appendix A.1 Policy III – Educational Campaign The costs associated for this campaign are based on Fundación CHICA (2011) and estimated as follows: – Teaching material and curriculum development: 1’000 USD – Promotion, awareness creation: 500 USD – Rent of school facilities: 300 (Rent per workshop) x 12 = 3’600 USD – Number of paid teachers: seven, one for each of the six main cocoa cultivation regions and one supervisor – Salary per teacher for all workshops: 100 USD – Expenses per teacher for all workshops: 20 USD (4 meals) + 30 USD (3 nights) = 50 USD – Vehicle costs per teacher: seven vehicles rented at 150, using 100 of petrol each = 250 USD – Total costs of all seven teachers: 7 USD * (100 + 50 + 250) = 2’800 USD – Total costs: 1’000 USD + 500 USD + 3’600 USD + 2’800 USD = 7’900 USD – Total costs per cooperative: 7’900 USD / 14 = 564 USD A.2 Perfect Market – Dynamic CBA For this NPV analysis we assume (i) a project time horizon of 10 years, (ii) a fertilizer productivity gain of 30%, (iii) a government interest rate of 8%, and (iv) a farmers interest rate of 20%. We vary the international cocoa price and the pricing scheme. in USD Ritter Sport Zotter Intl. FLO Aggregate Welfare Gain Low International Price 486’643 306’340 159’920 Average International Price 201’031 121’180 -18’160 High International Price -84’581 -63’979 -103’844 Farmer’s NPV Gain Low International Price 6’952 4’376 2’285 Average International Price 2’872 1’731 -259 High International Price -1’208 -914 -1’483 Table 1 – Aggregate welfare gain and farmer’s NPV gain Independent Study Project 24 Barcelona GSE
  28. 28. Developing a Fairtrade Cocoa Sector in Nicaragua A.3 Degree of Government Intervention: Feature Comparison Costs No intervention Proposed intervention Full intervention Warehouse Construction Farmer Government Government Warehouse maintenance Farmer Farmer Government / Farmer Credit Line Guarantee Farmer Government Government Interest on Credit Line Farmer Farmer Government / Farmer Education Campaign Farmer Government Government Initial Certification Cost Farmer Farmer Government Annual Certification Cost Farmer Farmer Government / Farmer Transport Cost Farmer Farmer Government / Farmer No intervention: “As if” farmers and cooperatives would organize themselves Proposed intervention: Credit line guarantee allows to lower risk premium Full intervention: Government assumes ongoing costs during the transition phase Table 2 – Degree of Government Intervention: Feature Comparison A.4 Dynamic CBA including Degree of Government Intervention Here we assume that the farmer’s interest rate is constantly 12 pp higher than the governments (risk premium) and vary the government interest rate (4%, 8%, 12%) to calculate the aggregate welfare gain and an individual farmer’s NPV gain for the different pricing schemes. For this NPV analysis we assume (i) a project time horizon of 10 years, (ii) a fertilizer productivity gain of 30%, and (iii) an international cocoa price of 2’195 USD/t Interest Rate (Gov. / Farmer) Pricing No Proposed Full intervention intervention intervention Aggregate Welfare Gain Ritter Sport 183’792 192’665 190’185 4% / 16% Zotter 71’542 99’009 88’566 Int. FLO -101’288 -73’820 -84’263 Ritter Sport 153’199 160’670 158’167 8% / 20% Zotter 39’361 62’765 52’570 Int. FLO 99’980 -76’576 -86’770 Ritter Sport 129’102 135’476 132’983 12% / 24% Zotter 15’179 35’381 25’475 Int. FLO -98’415 -78’213 -88’119 Ritter Sport 125% 129% 124% IRR (Government) Zotter 15% 20% 17% Int. FLO #INF #INF #INF Table 3 – Aggregate welfare gain for varying interest rates and degrees of government intervention Independent Study Project 25 Barcelona GSE
  29. 29. Developing a Fairtrade Cocoa Sector in Nicaragua Interest Rate (Gov. / Farmer) Pricing No Proposed Full intervention intervention intervention Farmer’s NPV Gain Ritter Sport 2’626 3’010 3’161 4% / 16% Zotter 1’022 1’744 2’406 Int. FLO -1’447 -725 -63 Ritter Sport 2’189 2’553 2’713 8% / 20% Zotter 562 1’226 1’907 Int. FLO -1’428 -764 -84 Ritter Sport 1’844 2’193 2’361 12% / 24% Zotter 217 835 1’530 Int. FLO -1’406 -788 -93 Table 4 – Individual farmer’s NPV gain for varying interest rates and degrees of government intervention A.5 Robustness Checks Taking our proposed policy and our suggested parameters (project time horizon of 10 years, fertilizer productivity gain of 30%, government interest rate of 8%, farmers interest rate of 20% and international cocoa price of 2’195 USD/t) into consideration we re-run our model, thereby individually changing each of our parameters to observe the sensitivity of the aggregate welfare gain and individual farmer’s NPV gain, given our three organic pricing schemes Ritter Sport, Zotter and FLO. Time Horizon In the main line of our policy memo, a project duration of 10 years is assumed. As the duration increases the high initial cost of certification, transition phase and warehouse construction become less relevant and the fruits of high FT prices in comparison to the TS prices becomes more dominant. Given our high discount rate of 20% for farmers and TS, the initial cost of the policy intervention asymptotically diminishes after ca. 20 years. -­‐100000   -­‐50000   0   50000   100000   150000   200000   250000   3   8   13   18   23   28   33   38   43   48   NPV  (in  USD)   Time  Horizon  (in  years)   Ri,er  Sport  FT   Zo,er  FT   Int.  Avg  +  FLO   Figure 1: Aggregate welfare gain -­‐1000   0   1000   2000   3000   4000   3   8   13   18   23   28   33   38   43   48   NPV  (in  USD)   Time  Horizon  (in  years)   Ri+er  Sport  FT   Zo+er  FT   Int.  Avg  +  FLO   Figure 2: Individual farmer’s gain Independent Study Project 26 Barcelona GSE
  30. 30. Developing a Fairtrade Cocoa Sector in Nicaragua Fertilizer Productivity Gain (for non-FT cocoa) Founded by literature and Nicaraguan farmer claims, a fertilizer productivity gain of 30% is assumed throughout our core calculations. Hence, an average cooperative of 70 farmers produces roughly 36 t of FT cocoa (which prohibits the application of fertilizer) or 51 t conventional cocoa per year. As the gain of using fertilizers decreases, FT cocoa production becomes more and more profitable. In the charts below, negative productivity gains hint at the possibility of FT farming practices that even increase the productivity (see Section 5.1). -­‐1000000   -­‐800000   -­‐600000   -­‐400000   -­‐200000   0   200000   400000   600000   -­‐100%  -­‐90%  -­‐80%  -­‐70%  -­‐60%  -­‐50%  -­‐40%  -­‐30%  -­‐20%  -­‐10%   0%   10%  20%  30%  40%  50%  60%  70%  80%   NPV  (in  USD)   Fer/lizer  Produc/vity  Gain   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 3: Aggregate welfare gain -­‐12000   -­‐9000   -­‐6000   -­‐3000   0   3000   6000   -­‐100%  -­‐90%  -­‐80%  -­‐70%  -­‐60%  -­‐50%  -­‐40%  -­‐30%  -­‐20%  -­‐10%   0%  10%  20%  30%  40%  50%  60%  70%  80%   NPV  (in  USD)   Fer/lizer  Produc/vity  Gain   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 4: Individual farmer’s gain Government Interest Rate The government interest rate is relevant for the guarantee the government issues on the upfront payments. While Zotter and FLO prices are paid on average six months after delivery (at the harbor), Ritter Sport pays on average after 2 months (at the regional warehouse). Therefore, Zotter and FLO pricing schemes are more sensitive to government interest rate changes. Throughout the policy memo, an interest rate of 8% is assumed. That is the rate Nicaragua currently pays for government bonds (Hidalgo, 2014). -­‐150000   -­‐100000   -­‐50000   0   50000   100000   150000   200000   1%   2%   3%   4%   5%   6%   7%   8%   9%   10%   11%   12%   13%   14%   15%   16%   17%   18%   19%   20%   NPV  (in  USD)   Government  interest  rate   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 5: Aggregate welfare gain -­‐1500   -­‐1000   -­‐500   0   500   1000   1500   2000   2500   3000   1%   2%   3%   4%   5%   6%   7%   8%   9%   10%   11%   12%   13%   14%   15%   16%   17%   18%   19%   20%   NPV  (in  USD)   Government  interest  rate   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 6: Individual farmer’s gain Independent Study Project 27 Barcelona GSE
  31. 31. Developing a Fairtrade Cocoa Sector in Nicaragua Farmer’s Interest Rate FT only The project profitability largely depends on the assumed interest rate of the farmers, which obviously includes a significant risk premium (12%). Upon asking them, the famers commented that they had to pay an interest rate of roughly 20% approaching the rural banks as a cooperative. In this calculation we hold constant the interest rate for trading with TS at 20% and vary the interest rate of trading with the cooperative. A lower risk premium could be argued for long trading history within the cooperative. -­‐200000   0   200000   400000   600000   800000   1%   4%   7%   10%   13%   16%   19%   22%   25%   28%   31%   34%   37%   40%   43%   46%   49%   NPV  (in  USD)   Farmer  Interest  Rate  (FT  only)   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 7: Aggregate welfare gain -­‐3000   0   3000   6000   9000   12000   1%   4%   7%   10%   13%   16%   19%   22%   25%   28%   31%   34%   37%   40%   43%   46%   49%   NPV  (in  USD)   Farmer  Interest  Rate  (FT  only)   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 8: Individual farmer’s gain FT and Conventional We now bring the interest rate of farmers trading with cooperatives and farmers trading individually with TS together. It is evident that low interest rates significantly more benefit the farmers trading with cooperatives; in fact, the graphs depict an increase in the aggregate welfare gain and individual farmer’s NPV gain as we decrease the interest rate from the currently assumed 20%. A decrease in overall interest for farmers could possibly be achieved through gradually improving the institutions in Nicaragua and thus improve the enforceability of contracts. -­‐200000   -­‐100000   0   100000   200000   300000   400000   1%   4%   7%   10%   13%   16%   19%   22%   25%   28%   31%   34%   37%   40%   43%   46%   49%   NPV  (in  USD)   Farmer  Interest  Rate  (FT  +  Non-­‐FT)   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 9: Aggregate welfare gain -­‐2000   -­‐1000   0   1000   2000   3000   4000   5000   6000   1%   4%   7%   10%   13%   16%   19%   22%   25%   28%   31%   34%   37%   40%   43%   46%   49%   NPV  (in  USD)   Farmer  Interest  Rate  (FT  +  Non-­‐FT)   Ri0er  Sport  FT   Zo0er  FT   Int.  Avg  +  FLO   Figure 10: Individual farmer’s gain Independent Study Project 28 Barcelona GSE
  32. 32. Developing a Fairtrade Cocoa Sector in Nicaragua International Cocoa Price The following graphs indicate the sensibility of the aggregate welfare gain and individual farmer’s NPV gain on international cocoa price changes. We regard Ritter Sport and Zotter prices as exogenous and fixed. The FLO and TS prices are direct functions of the world market price. The FLO price includes a constant price premium of 200 USD/t and a minimum price of 2’300 USD/t. For the TS a price reduction of 750 USD/t for transportation to the harbor is assumed. Throughout the policy memo an average international price of 2’195 USD/t is assumed. If the interna- tional price increases, the TS becomes increasingly more profitable. Only for extremely high international prices Zotter and Ritter Sport pricing schemes lose their edge. For short periods of high prices FT coop- eratives can enforce loyalty through sanctioning and group liability concepts. For longer periods of high international prices Zotter and Ritter Sport would have to raise their prices to remain competitive. The only relevant scenario for which even the FLO price becomes an option is that of very low international prices. While the TS prices keep dropping, the FLO minimum price makes this scheme competitive. -­‐200000   -­‐100000   0   100000   200000   300000   400000   500000   860   1060   1260   1460   1660   1860   2060   2260   2460   2660   2860   3060   3260   3460   Interna'onal  Cocoa  Price  (in  USD)   Ri-er  Sport  FT   Zo-er  FT   Int.  Avg  +  FLO   Figure 11: Aggregate welfare gain -­‐2000   -­‐1000   0   1000   2000   3000   4000   5000   6000   7000   8000   860   1060   1260   1460   1660   1860   2060   2260   2460   2660   2860   3060   3260   3460   Interna'onal  Cocoa  Price  Sport  FT  FT   Int.  Avg  +  FLO   Figure 12: Individual farmer’s gain Independent Study Project 29 Barcelona GSE