Extreme weather events such as floods, hurricanes and droughts can lead to sharp fluctuations in food production in particular regions. They will become more frequent in the wake of climate change.
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What does the future hold?

Food price volatility is both multi-causal and multi-impact. Severe as the 2007–2008 spike was, the 1970s were a period of much greater volatility – yet the future holds new uncertainties that call for novel policy responses.

Volatility in food prices is an entirely natural characteristic of agricultural markets, given that demand is relatively inelastic and that supply is both variable (for example dependent on meteorological factors) and cannot respond in the very short term due to the production cycle of agricultural commodities, and longer-term decisions on investment and R&D. As for any market-traded commodity, food prices exhibit volatility on different temporal scales, for example from day to day, reflecting transaction flows and changes in sentiment, and in the longer term (month to month, year to year) as market conditions and expectations change, or because of the effects of unpredictable events, or ’shocks’, affecting the system. 

High levels of volatility in global agricultural markets have adverse effects on both consumers and producers, through the disruption they cause to the global food system, and, when particularly severe, through the general economic, political and social instability that can occur. These effects will be most severe for low-income countries and the poor, and spikes in food prices can be a major cause of increased hunger (see also article on pages 10–13) They may also distort investment decisions by making returns harder to gauge and incurring costs in hedging risk, with the potential to exacerbate problems of macroeconomic and fiscal management.

 

Looking back

 

The pattern of fluctuations in the price of five major food commodities (wheat, rice, sugar, beef and palm) over the last 50 years shows that food prices can be strongly affected by shocks from outside the food system, such as the oil crises of the early 1970s (see Figure). It also shows that the last 20 years have been a period of relatively low volatility compared with the previous three decades in particular, the spike in food prices of 2007/2008, while receiving considerable political and media attention, was relatively small compared with the fluctuations in the 1970s. 

 

Volatility in the future

 

The number of factors affecting volatility and the levels of uncertainty associated with each make it very difficult to predict whether the magnitude of fluctuations in food prices will fall or rise in the coming decades. Although predicting future volatility is complex, there are several arguments suggesting that volatility may well increase in the future. Also, at least some food price spikes are inevitable. Work commissioned by the Foresight Project The Future of Food and Farming: Challenges and Choices for Global Sustainability analysed the different drivers that will affect volatility in the future (HMG, 2010; Foresight, 2011) and found no strong evidence for either greater or lesser future volatility, but others conclude that although there are factors pulling in both directions, volatility may well increase in the future. Some of the factors include: 

Non-economic factors. Droughts, floods, hurricanes and other extreme weather events can lead to sharp fluctuations in food production in particular regions and are very likely to increase in frequency as one of the first manifestations of climate change.

Wars, major civil strife and breakdown of governance not only affect the nations concerned but also have consequences on the global food system. Although such shocks have declined in frequency in recent decades this trend may reverse due to rising population pressure and greater competition for limiting resources (especially water).

General economic factors. In general, food price volatility will be influenced both by fluctuations in general economic activity and the governance regimes concerning national and international commodity markets. International trade can compensate for regional production shocks and linked financial and capital markets can transmit economic shocks rapidly throughout the world. 

Shocks in some other commodity markets are often correlated with price fluctuations in agricultural markets, as price movements are transmitted from one sector to another. For example, oil prices affect food production through changes in the costs of energy, petrochemicals and fertilisers used in agriculture. Where market forces are driving biofuel production, this could lead to an additional link between agricultural commodities markets and the oil market, amplifying the impact of oil prices on agricultural markets. Where biofuel production is a function of renewable energy policy, inflexible biofuel mandates may exacerbate volatility in grain prices, while flexible mandates could have the opposite effect (the potential to switch production from biofuels to food at times of scarcity has the potential to reduce the fluctuation in food prices). Oil prices also affect transport costs, and hence the degree of international market integration and price transmission.

Factors within the food system. The level of food stocks held by the private and public sector has declined in recent years, in part as a response to reduced volatility, changes in agricultural support policies, a more efficient food system, and increased levels of international trade. Stocks held by governments have fallen relative to those held by private agents, which potentially affects how they are managed in response to changes in market conditions. If stocks are low, agents are less able to cushion the market when supply unexpectedly falls relative to demand, pushing more of the response onto prices. Therefore, levels of future stocks within the global food system will have a significant effect on volatility.

As consumers enjoy higher incomes, they tend to consume food that is more processed and where basic agricultural commodities account for a smaller share of the retail price. This means even large changes in world prices may only have small effects on retail prices. 

Continuing improvements in crop protection and biotechnology may increase yield stability, for example through resistance to new emerging pests and diseases, and through the development of varieties of crops that are resilient to extreme conditions such as drought and flooding. Globalisation and intensification, on the other hand, increase the risk of the emergence and rapid spread of these biotic challenges.

Commodity-specific factors. The  ‘depth’ of the relevant markets – the volume of transactions in relation to the scale of the shocks hitting the system – affects the extent to which international trade can dampen volatility. Some international markets, such as rice, are particularly shallow, and volatility in such commodities will be affected by changes in future levels of trade. 

Certain staple food prices are politically sensitive, leading governments to take steps to reduce domestic price volatility, which can sometimes have the opposite effect on the rest of the world. Rice in South East Asia is a classic example. 

 

Decisions for policy-makers

 

 

Interventions to reduce volatility can be expensive and require resources that could be used elsewhere, and also have a potential risk of both distorting markets, or of interventions being hijacked for political reasons. They may also fail to be effective or make problems worse through unintended consequences. Key issues for policy-makers are therefore:

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  • What levels of volatility are considered ‘acceptable’, and should governments intervene to attempt to keep volatility within defined bounds?
  • How can the negative consequences of volatility be mitigated (and price risk management be facilitated), and which interventions would be most effective?
  • Is it better to develop mechanisms to protect producers or consumers from the effects of volatility and, if so, how? and
  • To what extent should collective action and planning at the international level (for example the G20) occur to protect the poorest from the worst effects of volatility?

 Determination of acceptable levels of volatility in food prices is a political judgement that needs to consider the negative effects of volatility, but also the costs of intervention. Policies to address volatility may take various forms: 

Working markets. Adoption of more market-oriented agricultural policies in individual countries and further liberalisation of agricultural trade would both strengthen the market mechanisms that help reduce price fluctuations in the face of shocks to the food system and improve food security by increasing potential sources of supply. The decline in protectionist agricultural policies seen over the past two decades might be expected to continue in normal circumstances, given the role of the WTO and perceptions of the welfare benefits that could be expected. However, it is in more difficult times, when supply falls well short of demand and strong upward pressure on prices emerges, that market-oriented policies and liberalisation are likely to come under threat. This has been illustrated very recently in the wheat market, with the poor 2010 wheat harvest from drought and fires, and rising prices, which led Russia to ban wheat exports. 

Information on stocks of food and agricultural commodities is relatively poor in most countries. This inhibits the efficient functioning of agricultural markets and the provision of early warning of impending difficulties in supply and increases the potential damage due to ill-informed price formation. The recent proposal by the International Organisations to the G-20 Agriculture Ministers included the creation of an international database of agricultural production, consumption, and inventories to enhance the quality of global food balance sheets. This is to be welcomed.

More action is needed to promote domestic policies that could increase supply responsiveness and encourage market flexibility. Such policies include technical assistance to farmers and measures to improve regulation of land, labour and capital markets, which would enable food production to respond more efficiently and quickly to changing conditions (HMG, 2010).

It is essential that mechanisms are put in place to give governments the confidence in the global trade system to resist what will often be intense political pressures to impose export restrictions at times of high food prices. Improving the functioning of commodity markets can reduce the element of volatility that does not reflect underlying market fundamentals.

Market intervention. There have been calls for a global system of virtual or actual international grain reserves to help dampen price fluctuations on global markets. The Foresight Project did not find the arguments in favour of this strategy to be sufficiently strong to suggest that it be given priority. Indeed, there are grounds for concern that the proposal would be both very expensive and counter-productive. In most circumstances the costs and policy risks of using international food reserves, virtual or real, to dampen volatility (as opposed to protecting the poor directly) will tend to outweigh the benefits. Past experience with international agreements, such as those for coffee and sugar following the 1970s price spikes, were not successful; they broke down when divergent interests of the participants emerged as markets recovered. There is sometimes a case, however, for higher public stock holding at the national or regional level if there are likely to be long lags between the import requirements of a country becoming apparent, and the arrival of such imports (whether because of a poorly functioning private sector, and/or poor infrastructure, and/or because a country is land-locked). 

Mandates from governments to increase the production of biofuels in some countries has the potential to affect market stability for certain grains and oils. Despite being seen by some as destabilising, it could in principle act as a stabiliser of food prices to some degree if production can be diverted to the food supply at times of shortage. Attention should be paid to how biofuel mandates can best be specified in a way that helps to dampen fluctuations in food prices, for example through appropriate linkages to fluctuations in oil prices and avoidance of very long lock-in contracts that reduce flexibility.

Limiting harmful effects. Problems faced by farmers as a result of fluctuations in food prices can be very damaging, and mechanisms are needed for the management of risk, especially covariate risks affecting whole regions rather than just individual farmers. Market mechanisms are readily available in high-income countries, including insurance, options and futures trading, but these are generally not available in low-income countries. As in high-income countries, social safety nets will be needed to prevent the worst effects of temporary spikes in food prices from having severe effects on poor people in low-income countries. Particular problems are likely to occur among the urban poor, who cannot grow their own food or who do not have access to ‘wild food’. Failure to address these problems may lead to social strife and political instability, as seen in 2008. Although social safety nets are the responsibility of national governments, where countries are unwilling or unable to provide safety nets relating to food, it will be important for international bodies, such as the World Food Programme or major NGOs with public support, to continue to provide the safety net of emergency food resources. This would be an essential function of the rapid response international forum for dealing urgently with emerging food crises proposed by the International Organisations.

Area-based index insurance, written against specific perils or events (such as drought, hurricane or flood) and recorded at regional levels, may also have a useful role to play in helping individual farmers. However, challenges include the need to generate sufficient demand for a sustainable insurance market to develop, and a requirement for sufficient weather stations to capture adequately the spatial variation in climatic conditions. A distinction also needs to be made between policies designed to protect poor people from catastrophic losses (which generally require public subsidy) and those designed primarily to promote agricultural development (which are best channelled through private sector intermediaries).

Sir John Beddington
Chief Scientific Advisor to the
UK Government
London, Great Britain
mpst.beddington@bis.gsi.gov.uk

 

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