Friday 13 July 2012

Insurance Markets

Frances Woolley has a few worries about ending supply management in Canada. She's right that it's worth worrying about whether and how we'd compensate those losing their quotas. The rest seems to put a bit too much weight on dairy lobby scaremongering.

But one bit in the comments section seems worth further expansion. "Greg" there wondered why dairy farmers aren't insured against the potential loss of quota rents:
Canada's dairy farmers are in business. They ought to be holding insurance against the loss of their quotas, the same as with other capital. If they aren't, well, they made that decision.
Frances replied saying that such insurance markets are impossible:
Insurance works through risk pooling, i.e. car insurance works because not everybody has car accidents at the same time. The elimination of milk quotas is a correlated risk - i.e. if one farmer loses their milk quotas, everyone will lose milk quotas. It's not possible to buy private insurance against highly correlated risks (which is why, for example, house insurance doesn't cover acts of war, crop insurance doesn't exist without government subsidies, etc).
Let's twist things around. Imagine that ICE Futures Canada defined and started trading a very particular set of futures contracts. The contract would read something like the following:
This contract pays $1000 if, at Dec 31 2013, the average auction price for dairy quota in the previous six months across all provinces was under $5000 or if supply management ceased to exist.
There are a few proposals floating around to get rid of supply management. CD Howe's was to expand the supply of quota over time to erode it; others say do away with it and compensate the losers; others say do away with it without compensation. You'd need to be a careful to define what "supply management" means for purposes of the contract. But the low quota price option is to guard against "erode the rents" plans.

It's pretty easy to imagine people being willing to trade this contract. Suppose that the true value of the contract were $100: a 10% chance that Canada gets rid of supply management by the end of next year. Dairy farmers have a whole lot of wealth tied up in their quota. They should be willing to pay more than the fair-odds price for the contracts. Other dispersed risk-neutral people should be happy to sell at a premium above the fair odds price. Or, you could do it through option contracts.

So long as farmers are willing to pay a premium to lay off risk affecting a good chunk of their asset base, and so long as there are other folks willing to sell them bits of that kind of insurance, this works. No one guy would want to take on all that risk because then he has even more at stake than the dairy farmers. But it wouldn't be a bad small bit of a portfolio for somebody whose other positions don't go south in case of the abandoning of supply management. Or, you could imagine some large corporates who'd do well if Canada got into the Pacific trade deal being willing to short those contracts - if Canada gets rid of supply management and into the TPP, the corporates do better through trade but lose on the contracts; if Canada doesn't, they win on the contracts and lose on trade.

And, if there are enough of the risk-neutral investors, we could start getting some market-based assessments of the probability of doing away with supply management.

I don't know the regulatory framework within which ICE operates. But a few contracts on policy like this could be awfully helpful.


  1. Maybe these contracts don't arise because they would substantially in increase the

  2. Maybe these contracts don't happen because their very existence would substantially increase the chances of losing the rents? (I mean, if "don't hurt the poor farmers" is crucial to the politics of keeping the controls around.)

  3. That we open a market on an event means we're more likely to expect the event to happen, but unless you're making claims about bandwagon effects, I'm not sure how we get from market's existence to there then being higher odds of the event occurring.

  4. Eric - interesting discussion.

    Dairy industry scaremongering or not, there is a simple question that needs to be answered: what would a restructured Canadian dairy industry look like?

    "Just like Australia" or "Just like New Zealand" isn't an answer - Oz and NZ are islands, milk is expensive to transport, Canada is vulnerable to international competition in a way that NZers aren't. We also don't have (small bits of BC possibly not withstanding) the super-abundance of high quality grass lands that NZ does.

    It's very hard to know what conditions in US factory farms are like because of the efforts that are undertaken to shield such farms from scrutiny (e.g. here) - but without any way of distinguishing between milk produced in cruel and milk produced in humane conditions, how can we avoid a race to the bottom in terms of animal welfare standards?

  5. Nobody has a crystal ball. But here is my guess.

    In the short run you'd likely have exit and consolidation to larger barns. The sector would likely shrink with import displacement. Some small producers would jump at the chance to be entrepreneurs but most Canadian farmers hate the idea of selling and marketing their own product.

    In the medium term, some of the smaller producers would start figuring out niche marketing and catering to locovore demand. I also would expect innovation by dairy companies into providing organic and "guaranteed hormone free" options. Most people wouldn't buy them, preferring cheaper factory product, but the option would exist, at a cost.

    You could achieve any animal welfare standard you wanted on domestically produced milk by regulation, but if it increased the price too much relative to imports, domestic production would be a smaller part of the market.

    Frances, I worry about animal welfare too. Why not apply broader standards rather than opposing changes to a system that seems an awfully expensive way of delivering animal welfare? How can we get more animal utils at lowest cost? Pig barns might be a place to start.

  6. We supply the majority of the world's traded milk from here. I'm not sure that distance protects our domestic milk producers from competition.