Securing the long-term sustainable future of coffee supply in Colombia. Track: Supply chains and operations management

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1 Securing the long-term sustainable future of coffee supply in Colombia Track: Supply chains and operations management Key words: coffee, sustainability, supply 1 1

2 Securing the long-term sustainable future of coffee supply in Colombia Abstract The challenges with which Nespresso finds itself to ensure a long lasting commitment from coffee small holder farmers are addressed. Colombia, as one of the top quality producing countries, is a major supplier for Nespresso for which it is of Nespresso s interest to analyze this market. Problems such as migration; land tenure and access to credit; Social Safety Net ; generational change on coffee farms and farm productivity are described in order to provide a starting-point for deeper discussion on strategies in order to move forward into the future. 1. Introduction For nearly ten years, Nespresso has made significant investments and dedicated substantial effort to developing its global coffee supply chain in order to meet growing demand for the high quality coffees on which its reputation and brand depend. 1 During this time, the company has acquired a deep understanding of its supply chain, as well as the economic, social and environmental context of its coffee farmer suppliers. Nespresso believes that both its brand and its ability to grow as a company are inextricably entwined with the success of its coffee farmer suppliers. Despite an unparalleled understanding of its suppliers opportunities and challenges, the engagement and support of industry partners, the expertise of leading economic, social and environmental development experts, extensive collaboration with international and national-level non-governmental organizations (NGOs), and a number of pilot projects showing important advances, Nespresso management has found itself facing a challenge shared by most companies dependent on smallholder agricultural supply chains - how to ensure the long-term economic viability of farming for the tens of thousands of farmers on whom they depend. 2. Colombia Colombia is a large country located in the northeastern extreme of the South American subcontinent. It has a population of approximately 45 million (July 2012 estimate), and an area of more than 1.1 million km2 (similar to South Africa, or 1 This effort is summarized in the accompanying Background on Nestle Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 which can be found at: 2 2

3 roughly twice the size of France or Spain). According to the U.S. Government, Despite decades of internal conflict and drug related security challenges, Colombia maintains relatively strong democratic institutions characterized by peaceful, transparent elections, and the protection of civil liberties. (See Appendix 1 for additional information about Colombia) A four-decade long conflict between government forces and anti-government insurgent groups is entering into its final stages. The conflict also generated a large presence of large, unofficially sanctioned, militia-style organizations or paramilitaries, to counter the leftist insurgents. Both the insurgent groups and the paramilitaries are recognized as having been heavily funded by the drug trade and other illicit sources. The Colombian government successfully disbanded the major paramilitary groups, and has established a presence and general control over nearly the entire country. Colombia is in the midst of demographic transition. The birth rate has fallen from more than 6 children per woman in the 1960s to just above replacement level today as a result of increased literacy, family planning services, and urbanization. Despite this transition, 50% of the population is under 25 years of age. Levels of income inequality are among the worst in the world, and more than a third of the population lives below the poverty line. Rural poverty is particularly high, fueling significant migration to urban areas (and abroad) in search of better economic opportunities and better access to essential services -- particularly education and health care. In general, rural Colombia does not suffer from an acute lack of provision of basic services such as education, primary care, and potable water (according to Ramirez (2007) access ranges from 50-80%). In rural areas, 90% of 6 year olds attend primary school, but only 35% complete it; 16% reach secondary school but only 7% finish. Important reasons for this high drop-out rate include low family incomes, violence and displacement. (Perfetti, 2003) Coffee farming in the Colombian Economy Colombia is the third largest coffee producer in the world, and supplies a substantial proportion of the world s high quality coffee, a segment that has seen a large increase in demand. (Perdomo and Hueth, 2011) Coffee farming contributes about 0.8% to the national GDP (FNC, 2012). There are more than half a million coffee producers in Colombia. 95% of them farm less than 5 hectares (FNC, 2011). Coffee farms employ (as either owners or workers) close to 35% of the entire agricultural workforce (Perfetti, 2009) - making coffee farming the single largest source of rural employment in the country. 3 3

4 Table 1. Farm size distribution Type of coffee grower Size of farm (ha) Coffee growers Percent of total growers Number of farms Farms s area Coffee area (ha) Production (bags) Percent of the total production Coffee growers Small producers Medium producers Large producers <1 278, , , ,346 1,527, to 5 204, ,840 1,628, ,967 6,286, to 10 19, , , ,617 1,957, >10 8, , , ,783 2,845, Total 511, ,613 3,319, ,713 12,618, Source: UNCTAD, High levels of violence and political instability during the most intensive years of the armed conflict affected the rural economy. Many farmers, including coffee producers, abandoned farms. Others chose to switch from coffee to more lucrative crops - licit ones where there were viable options. The switch to illicit crops was largely in remote areas where governmental presence was weak (or non-existent) and coffee supply chains were absent or unsafe. Conversely, coffee has been encouraged by the government over the past 20 years to replace illegal crop cultivation and incentivize the sowing of peace in the countryside. Where basic government services were made available and coffee supply chains functioned, farmers generally abandoned illicit crops and many returned to coffee production. All major areas where high quality coffee is grown are currently under the control of the Colombian government and local public administration. In recent decades, the limited availability of rural jobs, armed conflict, historically low coffee prices, and increasing wages for low-skilled labour in urban areas have resulted in steady migration to the cities. Rural migration had increased consistently since at least 1990, reaching a peak in 2005, when 1.2% of the population is estimated to have moved into urban areas, principally to take up jobs in the dynamic construction sector or in the growing industrial workforce (Botello, 2010). A number of factors have contributed to a general decrease in coffee output since the 1990s. Many coffee farms (and even entire producing areas) went out of business during the 90 s because their farms were not at sufficient altitude to be able to produce the required quality demanded by international buyers. Others left the coffee business rather than cope with the ongoing risks of remaining in a conflict-prone region. Since 2001 the total number of hectares in production has stabilized 4 4

5 (and even increased slightly). However, output in recent years has been greatly affected by severe weather conditions in many important growing areas, low prices and decreased productivity due to years of underinvestment. (ECLAC, 2003) Table 2 below shows the areas under coffee production and yields since indicates particularly low yields. ( See Annex 1 for the complete annual production numbers for the last 50 years). Table 2. Coffee production, productivity and area under production in Colombia. Year Total production (bags)* Average productivity (kg green coffee/ha) Hectares in production (ha) * 1 bag = 60 kg green coffee Source: Ministry of Agriculture, 2004, 2010 & Changing climatic conditions There is clear evidence that changing climatic conditions are impacting coffee farming in Colombia. The effects of more intense El Niño (drier conditions) and La Niña cycles (less sun-hours and more humidity) have both been felt strongly by coffee producers, resulting in reduced production, lower volumes of high quality coffee, and increased pest infestations. The future impact of climate change is as yet unknown, and there is no consensus on the likely scale of its effects. The International Center for Tropical Agriculture (CIAT) has reported that coffee is highly vulnerable to climate change and even questions the viability of continuing to produce coffee in some regions (CIAT, 2012). The Latin American Center for Rural Development (RIMISP, 2012) believes that many coffee regions are at risk of turning into areas no longer suitable for coffee production. Others analyzing the impacts on specific varieties, believe that only about 10% of the coffee areas will be affected. (UNFCCC) 5 5

6 Figure 1. Map with predicted percentage change in rainfall from for the period , compared to (derived from multiple climate models) Source: adapted from Ideam-Ruiz, 2010, from UNFCCC. 3. Coffee farming in Colombia According to the International Coffee Organization, (ICO) 2 coffee was first introduced to Colombia by Jesuit missionaries as early as However, civil strife and the inaccessibility of the best coffee-growing regions hampered the growth of a coffee industry. By the early 1900s coffee production increased dramatically. While larger plantations dominated the upper Magdalena river regions of Cundinamarca and Tolima provinces, determined peasants staked new claims in the mountainous regions to the west. New railways, relying on coffee for profit, allowed more coffee to be grown and transported. The opening of the Panama Canal in 1914 permitted exports from Colombia s previously unreachable Pacific 2 see 6 6

7 coast. Coffee geography High quality coffee production requires relatively cool temperatures that allow the beans to develop the flavor intensity desired by international markets. In Colombia and other tropical countries these conditions are found above approximately 800 meters of altitude which generally means hilly or mountainous areas. This remoteness has historically been a normal part of coffee growing. Most current coffee growing regions have been producing coffee for international markets for decades, and in many cases for more than a century. Figure 2: Map of coffee growing regions of Colombia Source: Café de Colombia, Due to the fact that the economies of scale of coffee growing are quite small 3, farms tend to be small and widely dispersed. Colombia s approximately 500,000 farms are distributed (albeit clustered in preferred growing regions) across nearly one sixth of the country (see map above). Consequently, most farms are located in areas that are at a substantial distance from major population centres. Much of the country s production is centred on small towns and villages, often far from major 3 Productivity and profitability of the farm are not dependent on large size. 7 7

8 road networks. 4 One third of the rural population does not have ready access to the road network, and the average rural household lives 2.5 kilometers from an all-season road. (World Bank, 2005) Poor road infrastructure makes traveling for the average farmer in remote hillside villages long and arduous, compounded by frequent rain and ensuing landslides in winter that can make roads impassable. Coffee Farmers The average coffee farmer is approximately 55 years old, is nearly always a man who grew up in an area near to his farm, and who inherited his farm from his father s or mother s family. The vast majority of coffee farmers, particularly smallholders (less than 5 ha of coffee land), have very limited formal education only 9% of all coffee farmers in Colombia attended secondary school. (Lozano 2009) Cultural tradition has ensured that farms have remained small in Colombia. In the past, the farm was divided among heirs (usually sons). The next generation of coffee growers then had to sustain their own families with the income from eversmaller coffee farms. Farm size is now so small that subdivision for successive generations is no longer viable. While only a tiny percentage of ownership claims are in dispute, and virtually every farmer exerts full legal control over his land, only 36% of coffee growers have formal titles for their land (Presidencia de la República, 2012), As a consequence, farmers have difficulty securing loans, since their land cannot be readily used as collateral (see section overleaf on access to credit). Farm Income Income from coffee farming is usually the primary (and frequently the only) source of cash income for the farmer s family. Under normal conditions, a 3 ha farm requires the full time, year-round effort of an experienced coffee farmer (see Annex 2). Additional labour is required at harvest time. Families with smaller farms (those with 3 ha or less) derive more than 75% of their total income from cultivating coffee, with the remainder of income coming from part-time work for neighboring larger coffee farms. (ECLAC 2003; Perfetti 2009, CIMS 2011). In the areas where it is grown, coffee is widely recognized as the most viable and profitable legal crop. With the ending of the armed conflict, local governments have regained territorial control, and access to international coffee markets has been reestablished for nearly all coffee growing areas. Coca and opium poppy (which grow well on coffee lands) have become much less attractive alternatives to coffee. (Eirienne 2009; UNODC, n.d.) 4 Nespresso s sourcing area (cluster) in Nariño province, for example, sources bags of coffee from an area that is km

9 A very limited number of larger farms with excellent road access and short distances to major airports have found cut flowers to be a higher-income alternative, but this option is quite limited due to the large scale and speed to market required by the industry. Coffee prices Coffee is traded both directly and also via futures markets. Coffee futures are extensively traded in the New York Mercantile Exchange, the Intercontinental Exchange, and the Tokyo Grain Exchange. Trading is based on the International Coffee Organization (ICO) guidelines and indicator prices 5 and governed by ICO s International Coffee Agreement. Each of the coffee origins fall under 4 different reference prices, and Colombian Mild Arabicas have their own reference price. Locally, the FNC dictates a base price by guaranteeing a spot price and the actual purchase of coffee to all coffee growers in the country 6 (Abaunza, 2011). Local buyers use this base price as a reference point for buying coffee, and it is common to have quality and sustainability-related price premiums on top of this reference price. Price premiums Price premiums are traditionally the way most coffee traders reward coffee producers for particular attributes like quality and certifications. Nearly every certification program (organic, Fair Trade, Rainforest Alliance, Utz, etc.) uses this mechanism. Quality is one key differentiation factor and each country has its own classification terminology for quality coffee. In Colombia, coffee is classified by size by using a screen. Supremo 7 (screen 17) and Especial (screen 16) are used to classify high quality coffee. For trading, these classifications are accompanied by more specific conditions and a price premium based on cup attributes. Coffee companies pay a price premium to their buyers who, in principle, pass some of this premium to producers. The coffee trading companies, in turn, pass this higher price to retailers who add their mark-up. The advantage of this approach is clear: the trader pays its buyers for the attributes and the entire value chain works exactly the same as before. The buyers will assume costs of paperwork and traceability, and in some cases (like in the AAA Program) additional implementation costs. With a slim variation (5-15%) driven by supply and demand for certified coffee, the premiums tend to be slightly higher when prices drop, and lower when prices are high (at which point participation in certification programs becomes Internal prices can be found at 7 Used as reference point by Nespresso for its quality assurance 9 9

10 less attractive). Coffee companies can realistically expect to pay 7 to 10 US cents per pound of coffee for each cent per pound that the farmer will receive. Coffee farmers in Colombia are constrained by the inability to scale up, invest or negotiate. This is compounded by considerable uncertainty in future prices and markets meaning small-scale coffee farmers in Colombia are missing out on important opportunities. Among the most critical are investments in post-harvest infrastructure (processing, drying, etc). This is essential for maximizing the number of high quality coffee beans, and is usually the most profitable investment an organized large group of small farmers can make, albeit with substantial risks, given the size of the investment

11 Land tenure and access to credit Land tenure in Colombia constitutes a significant challenge to the viability of coffee farming. As indicated earlier, FNC publicly acknowledged that at the beginning of % of coffee growers did not have formal titles for their land (Presidencia de la República, 2012). As a consequence, without formal evidence of ownership of their farms, these farmers have difficulty securing loans, potentially compromising farm succession further. Nevertheless, initiatives led by the FNC have enabled a degree of access to credit for coffee farmers, through the creation of funds, and assisting producers with the right kind of documentation or ID to apply for loan such as a card that proves farmers are active coffee producers and provides information on incomes. (FNC, 2011; Lozano, n.d.) Currency exchange rate and its impact on the coffee industry The Colombian peso / US dollar exchange rate has a direct impact on the coffee prices that producers receive and the prices they pay for imported inputs. Coffee prices are closely linked to reference prices, and are in US dollars. Locally, the coffee price is set in Colombian pesos. On average the peso strengthens against the US dollar at a rate of about 2% per year. Since 2009, however, it has gained about 12%, adding to the anxiety of an already-burdened farmer population (see Annex 3). The Colombian government and the FNC periodically announce measures aimed at protecting the farmer from this slow erosion; most recently the FNC announced an agreement with banks holding farmer credit to relax loan deadlines by up to 2 years. (FNC, 2013) Social Safety Net The Colombian government s efforts to provide basic support to informal and independent workers have made great advances in the past 10 years. In 2009, 80% of families in rural areas were nominally covered by healthcare, compared to a national average of 86%. (Perfetti, 2009) In July 2012, the Ministry of Health and Social Protection implemented a reform that simplified the health system and promises coverage for all Colombians. However, there is still a significant gap in coverage in rural areas, where a larger percentage of people are poor and the distances and remote communities make the logistics of providing health services coverage extremely challenging particularly for the severely ill. (Quintana 2001) The state pension fund system was designed for those with a formal contract and regular incomes again, a distant reality for the average farmer. As recently as the 1990s there was little or no inclusion of smallholder farmers in that system. By 2011 enrollment had grown to 16% of the total coffee producer population (30% of the general population according to the Labour Ministry) In September 2012, the government initiated a system that aims to support those with irregular incomes and few savings (i.e. most farmers). It will be based on shared contributions that will pay out pensions of between 25-85% 11 11

12 of the minimum wage (Ministerio de Trabajo, Sandoval 2012). The FNC is responsible for enrolling coffee farmers into the program. (Presidencia de la República, 2012) In spite of these efforts, the social safety net for smallholder coffee producers is not strong. Most farmers have access to the national health care system, but are logistically challenged by their distance from those services. Few farmers participate in any national program that would generate retirement benefits of any type when they choose to end their farming career. Private pension fund systems are unheard of in rural Colombia. Generational Change on Coffee Farms Colombia s economy has been growing rapidly for more than a decade. Nearly all of this growth has been in urban areas, or in very specific rural areas where mining or other extractive industries are located. The Colombian government has invested heavily in schools, health care, and infrastructure primarily in urban areas where the majority of the population resides, and to support the large-scale migration from rural to urban areas that has been underway since the 1970s and continues to this day. The younger generation (children of the current farm owners) represents the critical mass of those migrating to cities. Faced with limited job options in the countryside and promising opportunities in urban areas, pressure to migrate increases (ECLAC, 2003). The uncertain economic viability of family farms makes it an unattractive option. Low market prices for coffee (such as the period from 1999 to 2008 when prices fell below 100 US cents/lb), have affected farmers capacity to reinvest in their farms, leading to lower productivity, which in turn, has resulted in progressively lower family incomes. Today the average minimum monthly wage (nationwide) is 566,700 Colombian pesos (Presidencia de la República, 2011), or US$315 (exchange rate of February 2013). Achieving this wage level (or even a considerably higher one) is a near certainty in booming urban areas. However, it is extremely difficult to find a full time, legal job at this wage rate in most rural areas where the unemployment level is estimated at 35% or more. (ECLAC 2013) Generational succession on coffee farms has become a critical issue. Migration to booming urban areas reduces population pressure in the rural areas, which also reduces the pressure to further sub-divide farms for the next generation. It can even contribute economically to the rural areas through remittances. For example, research shows a growing trend in which grandparents in rural areas take care of their grandchildren as young economically active parents head to the cities, sending money home for this care. However, for Nespresso and other coffee companies that see Colombian coffee as a critical part of their business, there are some significant threats in this generational change. Coffee farming is very knowledge-intensive. While much knowledge 12 12

13 is technical and replicable through education and training, specific knowledge about on-farm management such as regional variations, farm management practices, plant adaptations, soil management, water management and many others can often only be passed on directly -traditionally from father to son. A loss of know-how between generations (which is already being observed in some areas) could have important effects on productivity and coffee quality. And, more dramatically, a large percentage of the younger generation of potential farmers may simply choose a different career path if they do not see coffee as a viable one, which would mean fewer farms producing the highest quality coffee that Nespresso and other companies desire. 4. The Coffee Value Chain and Key Actors Value Chain The most common value chain in Colombia involves 3 to 4 local actors. In most cases, farmers are responsible for growing the coffee, wet milling the coffee cherries, 8 and implementing sustainable practices (if participating in certification programmes). Coffee is then gathered by cooperatives, which aggregate the coffee and then sell it to a trader. After dry milling 9 the coffee, the trader will sell it to a buyer/exporter. The buyer/exporter will grade the coffee based on its quality, and sell it to the different international importers of coffee. Cooperatives Colombian coffee producers are grouped into cooperatives that sell their coffee using three channels: a) a branch of the FNC (Almacafé), which consolidates coffee from farmers and sells it to locally-based traders or to international buyers, through the FNC commercial branch, b) second-level cooperatives that commercialize the coffee in international markets, or c) sell the coffee to the private exporters. The FNC s sales account for roughly 35% of total volumes exported, while private companies (including growing volumes from cooperatives) export the remaining 65%. (ECLAC, 2003) Figure 3. Actors and processes in the generic coffee value chain in Colombia. 8 Using water (for transportation and cleaning) and mechanical force, the beans are separated from their skin and the sugar rich mucilage that lies between them 9 A process that uses mechanical force to separate the beans from a husk, known as parchment. The end product is green coffee beans

14 Source: CIMS,

15 The Colombian National Coffee Federation (FNC) The FNC is the main institution of the Colombian coffee industry. It is a private capital firm with public objectives and public funding aiming to assure the growers safety and representation. Within its structure are more than 566,000 coffee growers and it is one of the best-organised coffee institutions in the world. Its democratic structure, divided into different levels, is the basis on which coffee growers elect their representatives within the organisation. This model enjoys international recognition and is said to be the basis for the success of the Colombian coffee industry. (UNCTAD, 2009) The organization also runs complementary organizations that support the coffee industry. From providing broad-based extension services to the most remote farmer, to their Juan Valdez retail stores, the Federation is involved in all stages of the value chain. It also owns research and broadcasting organizations, builds public infrastructure and enjoys a generally positive reputation across Colombian society. A critical role played by the FNC is to guarantee the purchase of all coffee from all producers of coffee in the country at a minimum price 10. This guarantee is widely cited as a crucial factor in simplifying the lives of coffee farmers and protecting them from unscrupulous traders. The FNC also has a branch that is in charge of selling and exporting coffee to international markets. The organization maintains sales offices in several of the most important coffee markets, such as Europe, Japan and the United States. Expocafé a second level cooperative The Sociedad Exportadora de Cafe de las Cooperativas de Caficultores S.A. (Expocafé) was founded in 1985 by a group of cooperatives to create their own export channel. The organization has managed to position coffee in untraditional markets by focusing on specialty markets for coffee, and is now the second largest private exporter in the country. Expocafé is owned by 36 cooperatives that represent more than 130,000 farmers and has 500 purchasing points distributed across the coffee regions. Expocafé differentiates its coffee by focusing on initiatives that range from farm-level to the end consumer. Private exporters Private companies export the largest proportion of Colombia s coffee. Transnational companies like Volcafe (Switzerland), Neuman Kaffee Group (Germany), and Ecom Trading (Mexico) source coffee in Colombia, and account for an important share of the exports. Nespresso sources coffee from all three types of exporters

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17 5. Coffee production and on-farm economics At the most fundamental level it is basic farm economics that determine whether coffee farming can be a sustainable economic activity. Introduction Like most agricultural products, coffee production is a system that transforms inputs like water and nutrients into a consumable output (grains of coffee). The coffee bushes are the means or asset responsible for this transformation, and the energy for the process comes from the sun. The efficiency of this transformation process depends on agronomic variables such as the natural environment and production conditions available to the farmer, soil management, pest management, and a broad range of farm management practices (including pruning, fertilizing, drainage, shading, harvesting, post-harvest handling, among others). The economics of this process are determined by: a) the cost of implementing all farming activities, and b) the income generated from selling the beans. Cost Structure The cost structure of coffee is dynamic and dependent on the variation in fertilizer and labour costs. The specific dynamics of these key drivers are explained below. In 2009, it was found that the average production cost in Colombia was US$ 2,270/ha, with a median of US$ 1,535/ha. However, it is important to note that averages and means can be deceiving, as the range of costs is quite wide, and the corresponding productivity from those costs quite variable (see annex 2). The following chart shows the average breakdown of production costs. Figure 4. Distribution of production costs in Colombia 17 17

18 Source: CIMS, The chart shows that labour is a significant part of the costs, and represents 55% of the total 11. Fixed costs mostly originate from infrastructure (housing for harvest workers, water treatment systems, warehouse, wet mill, etc.) There is a high level of specificity in the plantation s ability to transform its most relevant inputs, such as fertilizer, into coffee. In a study of different origins where Nespresso sources coffee, it was found that each of them had different response to levels of fertilizer input and resulting productivity. Table 3. Average fertilizer input and average coffee production by origin Cluster Fertilizer input (kg/ha) Average productivity (qq green coffee/ha) Caldas-Antioquia Cauca Nariño Huila Source: Crece, 2011; Nespresso. Farm Size The two key factors that determine income for farmers are farm size and productivity (the quantity of coffee produced per hectare of land). However, it is important to note that there is no specific relationship or correlation between farm size and productivity (see annex 4). In 1980, the average farm size was 4.6 hectares (ECLAC, 2003). By % were 1 hectare or smaller (Abaunza, 2011). Today 95% of farms are smaller than 5 hectares and the average (mean and median) farm size in this group is 2 hectares. (FNC, 2011) Farm productivity Productivity is driven by three key factors: the age of the coffee bushes, fertilizer inputs and farm management (agricultural practices). Farm management consists of optimizing the use of inputs and at the same time ensuring that the coffee bushes are in a healthy condition (nutrition, pest control, root system, pruning, age, etc.) so that they can make the best use of inputs and transform them into high quality coffee beans. Sufficient levels of farm investment are critical for supporting this process and securing productivity. (see annex 5) 11 In this study, the labour costs include the farmer s time invested on the farm, and considers a payment equivalent to the salary he would have to pay to an external worker

19 These aspects can also be an important contributor to producing good quality coffee. Other key contributors to coffee quality include picking the coffee at the right stage of ripeness and an efficient wet milling process. Centralizing the milling process, as Nespresso has done as a pilot project with one cooperative in Jardin (Colombia) has also started to bring benefits in improving both efficiency and quality of coffee. All these factors can help the farmer secure better prices. Renovation Under ideal conditions, new coffee bushes will start producing coffee when they are three years old. From that point yield grows steeply and peaks at the age of six. At this stage the coffee bush s production potential will begin to diminish, reaching 45% of its productivity when it is close to 25 years old, falling to as low as 20% of its potential when it is around 35 years old. (see annex 6) Consequently, sound farm management practices recommend keeping the average age of coffee plants within their higher productive potential. Farmers do not renovate their entire farm at the same time, since this would eliminate their income for at least three years as they wait for the new bushes to produce. In practice, the issues involved in replacing older bushes with new ones include optimizing cash from current income, the costs of renovation, and the time to maturity. The FNC has implemented a renovation initiative using two techniques: hefty pruning (with partial results) and replanting. In the beginning the initiative had a limited response from farmers, largely because of the capital cost involved and the short-term implications of reduced income involved in renovating. However, because the new plantlets used are of varieties that resist important pests (for example, the variety known as Castillo is one of the most popular in Colombia) the initiative subsequently became very attractive, particularly after farmers started to see the damage wrought by the fungus known as coffee rust (scientific name: Hemileia vastatrix) in Even when renovation costs vary because of the varieties and densities, the average cost of renovation per hectare is US$2,000/ha in the first year of investment (this includes all the costs of taking out the old coffee bushes, buying and planting new plantlets (5000 plants/hectare), and the maintenance of the plantation during this first year (weed control, fertilization, etc.). By the second year the costs of maintenance are about US$1,000/hectare. The bushes will not start producing until the third year. The FNC s program for promoting renovation involves the offer of a subsidy to each of the farmers that renovate with new varieties that are resistant to diseases. The stimulus in 2011 was of 160 Colombian pesos per plantlet (or US cents 8.9/plantlet; US$445/ hectare). The stimulus program was targeted at severely disease-affected areas, and led to 12,600 hectares being renovated in that year. (FNC, 2011) 19 19

20 Fertilization Fertilizing is also a critical means of securing yields and has the potential to increase productivity. Few commercially grown plants extract as much nutrients from the soil as coffee (de Graff, 1986). Nutrients that are extracted must be returned to the soil in order to maintain a sustainable production system. Additionally, the farmer can achieve higher yields by fertilizing in higher amounts than merely replenishing lost nutrients (particularly with nitrogen). However this practice imposes both economic constraints on farmers due to rising input costs, as well as environmental constraints due to the contamination of water. Additionally, the effectiveness of fertilizer is highly dependent on other farming practices (see Table 3 earlier), such as the amount of organic matter in the soil, timing and technique of application, as well as the health of the bushes root systems. The producer has little influence over his input prices. The price for nitrogen, the element that drives total fertilizer prices, is dictated internationally. Its production is closely linked to that of natural gas, and thus its price tends to follow rising oil and gas prices (see annex 7). As a result, farmers can only seek out the best prices available locally or gain economies of scale by making group purchases a practice that does not tend to be very common in Colombia. Labour In the case of smallholder farmers 12 (more than 95% of the coffee farms in Colombia), the family carries out most farm management work and it is only during the harvesting period that external workers are contracted (Proctor & Lucchesi, 2012; Lipton 2005). However, when hiring labour for the harvest, famers are also price takers. Coffee picking must be done in a short period of time when quality is at its peak. The timing is mostly driven by weather conditions, and therefore complete regions will need to pick the coffee simultaneously in periods as short as 2 weeks. This generates a dynamic that obliges coffee growers to pay a market price that depends on the supply and demand of labour, on top of existing complexities that include a minimum wage dictated by the central government. (Botello, 2010) Responding to the growth in urban populations and inflation, the central government has increased minimum wages, expecting to positively impact the economy. Given the close link between minimum salaries and price of labour during the harvest season (Botello, 2010) the effect in coffee regions has been that urban jobs have become more attractive, and coffee harvesting has become more expensive. Other factors relevant to productivity 12 Estimates based on official statistics in Colombia (DANE, 2005) indicate that, on average, a farm worker is needed for every 3 hectares of coffee year round (excluding the harvest period). However, experts consider that one farm worker could manage 5 hectares

21 Under such challenging production conditions, it is critical that farmers have a good control of production costs and efficiency in the system. However, as research reveals, farmers knowledge of the business aspects of their farms is limited. According to a survey in Caldas and Nariño (two key coffee growing regions in Colombia), more than half of the farmers were unaware of their own production costs (CIMS, 2011). When data was further analyzed there was a clear link between farmer income (revenue) and productivity. CIMS evaluated the correlation between the two factors and found a coefficient of with a p-value of 0.001, meaning that there is a positive correlation with a high level of statistical confidence. While price is frequently considered an important driver of income, this study and other longitudinal studies carried out by CIMS, proved the price is not as strong a driver of income (see annex 8). Added to these factors are the broader issues concerning Arabica coffee productivity. There have been no major technological changes to increase productivity in the past 20 years. The exception is the emergence of new hybrids. New types of coffee plants have been developed that claim to produce higher yields, and some cases, tolerance to common disease. The adoption of hybrids has not yet been sufficiently mainstreamed by farmers, and for this reason it is not possible to see these potentially positive effects at a macro level. As the following chart shows, productivity has in fact been decreasing in most Arabica producing regions, including Colombia. Declining profit margins have slowed re-investment in all the productivity drivers mentioned above, ultimately creating a vicious circle. Figure 5. Coffee productivity in high quality producing countries (46 kilo sacks / hectare) Source: Faostat, In the case of Colombia, coffee productivity has declined severely. Low plant densities, low levels of reinvestment on the farm and renovation plans, above-average rainfall and pests associated with heavy rain have all combined to make it hard for producers to produce enough coffee (see annex 1). However, coffee producers engaged in programs that stimulate sustainable practices like reinvesting on the farm and quality assurance practices (such as those promoted by Nepresso) have managed to lessen the negative impacts on yields, and consequently manage to secure higher incomes. Under ideal conditions, the farmers should be able to produce much more coffee, thereby optimizing input transformation. This would require a range of efforts including progressive renovation, optimized levels of fertilization, training the farmers on farm management and best production practices (pruning, shade and shade management based on weather forecasts, fertilizing - including organic matter - and pest control), optimizing the wet milling process (by central milling where possible), irrigation systems, and financing to implement all those practices. With all these efforts, coffee could be a good 21 21

22 source of income for smallholder farmers, and the value chain would benefit from sustainable, high-quality coffee production. Table 4 below shows farm costs and productivity levels in two Colombia coffee regions from which Nespresso sources. It also shows estimated potential yield levels for these same farmers. The percentage of coffee that farmers could sell to buyers could reach up to 90%. Table 4. Farm size, current and potential yields Farm Size Farm Yield Estimated potential Production costs Portion of harvest Coffee Region Mean/median /Std Dev Mean/median /Std Dev yield Mean/median /Std Dev Mean/median /Std Dev sold as AAA hectares quintals/ha quintals/ha US$/ha US$/ha % Caldas 2.4/1.6/ /12.2/ /773/ /64.5/ Nariño 1.3/1/ /19.3/ /1430/ /79/ Source: Author s calculations based on CIMS, Environmental issues in coffee production Climate change In order to combat the effects of climate change, both short and long-term measurements are required. The Coffee Guide (from the International Trade Centre) and Coffee and Climate, an industry initiative organized as a development partnership, have identified short and long-term strategies for the mitigation of climate change and its effects on small farmers, identified as the most vulnerable group in the coffee industry. Short-term measurements range from climate forecasting (where producers can prepare proactively to reduce or mitigate impacts) to diversification into other crops (in cases of extreme necessity). For the long term, carbon footprint reduction and linkages with carbon and coffee markets for products with reduced footprints are the current strategies that hold currency. (ITC, 2012) To proactively mitigate the effects of these changes in climate conditions, the FNC is implementing a range of interventions including the dissemination of more climate resistant coffee varieties, local initiatives that have contributed to a national proposal for mitigation efforts, and crop forecasting (FNC, 2011). At farm level, the coffee industry is also participating in these efforts. Companies such as Nespresso and Fundación Natura have already implemented projects to reduce carbon emissions caused during the coffee processing

23 Farm level environmental issues Aside from the macro level issues of climate change and weather, over which farmers have far less control, there are a number of farm-level environmental issues that can affect the short and long-term productivity, viability and health of the farm. Many of these have cost implications for the farmer: soil health, tree cover, water and overall biodiversity. For example, if not properly managed, over-fertilization can pollute local water systems (exacerbated by waste water from the wet milling process); insufficient tree cover on steep farm slopes causes erosion and landslips. In the short term, farms can be prepared to resist extreme weather conditions (soil coverage, irrigating systems, general health of the bushes); in the medium term, renovation can ensure more climate-resistant bushes, and for the long term, water pollution issues can be addressed by installing water treatment systems for waste-water from the wet mill. The farmer has a range of interventions at his disposal, but all demand time, effort and means to invest. 7. Farmer succession Currently, a significant portion of the next potential coffee farming generation has chosen to move to the urban areas in search of jobs. Many farmers are over 55 years old and the majority do not have a pension fund. Adequate farmer succession is relevant from a social, economic, and political perspective, but it is also key to the future of the coffee industry in Colombia, and those sourcing high quality coffee in the country. Succession planning for farmers has been studied both in the developed and developing world. Options for farms in generational transition in wealthy countries, or with large farms are: selling the farms, leasing to other producers, hiring a professional farm manager, or involving family members in managing the farm and transferring the farm later (Joerger, 2001). In Colombia the reality looks quite different. The farmers options are: close the business and move into the labour market (either working on a larger farm or moving to an urban area), pass on the undercapitalized business to the next generation (taking a small share to sustain himself and his spouse), or attempt to lease or sell his land to a neighboring undercapitalized farmer. In response to this situation the FNC implemented a pilot project to better understand the needs faced by young coffee farmers 13. The program reached 250 young coffee farmers, yet the costs of such programs are high and difficult to implement on a large scale. Nevertheless, the FNC s findings indicated that the younger generation was overwhelmingly in favour of transforming coffee farming into a more lucrative activity. The key challenges identified in this pilot project were: 13http://

24 access to land for those without it, scaling up to an adequate farm size to generate a decent income, access to credit, production technology (aimed at climate change mitigation and increased productivity) and farm-management training. 8. Nespresso sourcing coffee in Colombia Growth in demand for coffee from Colombia The Specialty Coffee Association of America (SCAA) has been reporting consistent growth trends in consumption of gourmet and espresso coffee in recent years. Demand for high quality coffee is strong, and is growing in newer markets such as China, India and Brazil. As the largest single producer of high quality Arabica coffees in the world, Colombia s coffee production is a critical piece of the commercial and growth strategies for numerous coffee trading companies. Nespresso has been experiencing a healthy growth in the demand for its capsules for more than 15 years. Market analysts predict a growth rate of 10 to 15% annually for the premium portioned coffee sector for the next 3-5 years. Beyond that period, growth is uncertain, but with history as an indicator and the opening of new markets, the company is likely to enjoy continuous long-term demand growth. Nespresso s Coffee Profile According to studies conducted on specialty coffee and product sensory profiling by the internal green coffee experts within Nespresso, only around 1-2% of the worldwide coffee harvest is of the correct quality level, flavor and aroma profile for the Nespresso grands crus. Given this constraint and the significant growth rate of the business, securing a stable, long-term supply of highest quality green coffee will remain a significant challenge for Nespresso. Colombia is an important source of high quality coffee and a key origin for fulfilling demand growth for these grands crus. Nespresso AAA Sustainable Quality Program The Nespresso coffee sourcing program, co-developed with Rainforest Alliance, focuses on helping coffee farmers improve their ability to produce the highest quality coffee whilst addressing on-farm sustainability and farm productivity at the same time. A central ambition of the program is to improve farmers incomes in order to ensure the long-term economic viability of coffee farming. This led to the conceptualization of Real Farmer Income (RFI), a methodology designed to assess farm-level evidence and inform better decision-making. 14 Competitors 14Find more information on the AAA Program and concept of RFI in the Background document on the Challenge website

25 Most of Nespresso s competitors are represented with varying levels of activity in the country, though none appear to have yet reached the scale of involvement and investment that Nespresso has. Competitors actively sourcing include Starbucks, Illy Caffe, Sara Lee, Mondelez, Mars, as well as more niche brands such as Sustainable Harvest and Green Mountain Coffee Roasters. Most share a range of similar approaches: a sourcing model dependent on large intermediary buyers, commitments to work with a certification label or established internal program (Rainforest Alliance, UTZ, Fairtrade, CAFÉ practices), collaboration with the FNC and local NGOs on projects to boost quality, farm management and technical support, and public targets to improve social, economic and environmental wellbeing of the communities from which they source. Most competitors approaches, however, are primarily characterized by a short-term focus on the more immediate challenges of sourcing, with an acknowledgement of broader concerns such as the future viability of smallholder farming for the next generation or climate change, albeit without specific strategies to address these concerns. (see annex 9) The specific demands of Nespresso s high coffee quality together with its premium payments for quality and environmental performance mean that the company does not compete directly for the same coffee with all these competitors in the same regions. However, because high quality coffee is always in demand, competitors purchase coffee from the same cooperatives. Coffee rejected by Nespresso for its AAA premium is still considered outstanding coffee and receives good prices. The market structure allows farmers (usually at the cooperative level) to choose among intermediaries purchasing coffee in their regions. The farmers and their co-ops do not always know which trading company is ultimately bringing their coffee to market. Price and premium structure and distribution process The Nespresso AAA Sustainable Quality Program pays premiums for both quality and sustainability. The premium is paid to their local buyers at an amount around 40 to 50% above the New York ICE futures prices for coffee (NY"C") and 10% to 15% above the general local market price for coffees of similar quality 15. Those funds are transferred by Nespresso to the buyers and will cover technical assistance, training, and an incentive for the quality attributes of the coffee. However, as Karsten Ranitzsch, Head of Coffee at Nespresso pointed out, the program is about more than paying a premium, it is about building a long-term relationship with coffee farmers. 15 Please see Figure 6 for detail on industry price construction and definitions

26 The buyers use this premium, as they determine, to secure the supplies of the high quality coffee, provide technical assistance and advance AAA compliance. The quality of Nespresso coffee is assessed and verified at key points across the value chain. After the buyers purchase high quality coffee from the farmers, it will then be sorted based on its physical attributes, and expert coffee cuppers test batches of coffee to assure the right quality. Buyers also take on significant risk notably the risk of acceptance/rejection by Nespresso due to lack of required quality. Perhaps the most challenging for the AAA buyer s business is to work with farmer to maximizing their AAA quality beans. Buyers routinely purchase the entire farmer s harvest, even when only 35-65% of those beans meet the AAA quality requirements, and therefore qualify for the premium. As a generic description of the pricing structure for high quality sustainably sourced coffee, the price paid to the buyer is based on the New York C price. On top of this there are a number of different premiums as reward of coffee attributes. For example: a) a differential price set by ICO on country differentials, b) the specific quality grade of the coffee, c) implementation of sustainable practices, and d) training of the farmers at the field level. The following chart describes the key elements involved in the price construction for highest quality sustainable coffee in Colombia. Figure 6. Price construction for a premium coffee supply chain in Colombia (US cents/lb) 1617 Source: Intracen, NY "C" price corresponds to price as of March 4th, Country differential "takes into account (i) differences between that coffee and the standard quality on which the futures market is based, (ii) the physical availability of that coffee (plentiful or tight), and (iii) the terms and conditions on which it is offered for sale." For additional information please refer to:

27 9. The Challenge Nespresso has invested heavily in Colombia in recent years in research, local expertise, field personnel, and numerous pilot projects many of which show promising results. The company is committed to Colombia s potential, and has made firm public commitments to maintain it as an important origin for the long term. It has engaged with the FNC, the Government of Colombia, Expocafe, and numerous international and local partners to identify and advance strategies to improve coffee farming and the situation of the farmers who are so critical to the development of its business. The company understands that this commitment means working with partners to address challenges and opportunities and identifying new approaches and strategies. Consequently, Nespresso has decided to engage a new generation of managers to find a way, How Nespresso can ensure that coffee farming is a sustainable economic activity for small-holder farmers in Colombia for the next 25 years?, as stated by a leading manager of the company

28 10. References Abaunza, F Análisis de estrategias de inversión para caficultores colombianos por medio de un modelo de dinámica de sistemas. Tesis de Grado Para Optar al Título de Magister en Ingeniería de Sistemas. Universidad Nacional de Colombia. Facultad Nacional de Minas. Medellín. Asociación Probienestar de la Familia Colombiana (Profamilia) Encuesta Nacional de Demografía y Salud Profamilia. Gerencia de Evaluación e Investigación. Bogotá, Colombia Banco de la República El Mercado mundial del café y su impacto en Colombia. Borradores de Economía. No Bogotá, Colombia. Banco de la República Tasas de cambio del peso Colombiano. Available at: Bernal, R The Informal Labor Market in Colombia: Identification and Characterization. Desarrollo y Sociedad. First Semester, pp Botello. S Jornales cafeteros e integración del mercado laboral cefetero: Revista No Available at: Consulted: January, Café de Colombia Gente de Colombia. Available at: Comisión Económica para America Latina y el Caribe (ECLAC) Colombia: escenario social, económico e institucional de la actual crisis cafetera. Oficina de Cepal en Colombia. Bogotá. Comité de Cafeteros de Nariño Encuentro de gobernadores cafeteros. Oficinal de prensa. Palacio de Nariño. Available at: e3e006a709e?OpenDocument&ExpandSection=6. Consulted: January, de Graff, J The economics of coffee. Center for Agricultural Publishing and Documentation (pudoc), Wageningen, the Netherlands. Departamento Administrativo Nacional de Estadística, DANE Matriz de empleo en la base 2005 de las cuentas nacionales. Dirección de Síntesis y Cuentas Nacionales. Available at: Consulted: January, 2013 Economic Commission for Latin America and the Caribbean (ECLAC) Statistical Yearbook for Latin America and the Caribbean. Available at: Consulted on: February, Eirienne, A USAID's Alternative Development Strategy: A Critical Review of Initiatives in Colombia. Student Pulse. Vol. 1. No. 10. Available at: Consulted: January, Faostat Agricultural Production and Yield Statistics. Food and Agriculture Organisation of the United Nations (FAO). Available at: Consulted: December, Federación Nacional de Cafeteros (FNC) Sostenibilidad en Acción Federación Nacional de Cafeteros (FNC) Caficultural Sostenible. Informe del Gerente General. Federación Nacional de Cafeteros (FNC) Nuevo programa de crédito para aliviar deudas y apoyar la fertilización. Prensa FNC. Febrero 14, Available at: 28 28

29 viar_deudas_y_apoyar_la_fertilizacion/. Consulted: February, Federación Nacional de Cafeteros (FNC). n.d. Protección en Salud. Available at: ano/proteccion_social_en_salud/. Consulted: January, Fitter, R. and R. Kaplinsky Who gains from Product Rents as the Coffee Market becomes more differentiated? A Value Chain Analysis. IDS Bulletin Paper, Institute for Development Studies (IDS). Grupo Diálogo Rural Saldar la deuda histórica con el sector rural. Propuestas del Grupo Diálogo Rural Colombia. Available at: Colombia-Foro-desarrollo-rural.pdf. Consulted: January, International Center for Tropical Agriculture (CIAT) Reporte de avance: Vulnerabilidad al cambio climático en la región Andina de Colombia, Ecuador y Perú. Available at: Consulted on: January, International Coffee Organization (ICO) Statistics. Coffee Prices. Monthly Averages. Available at: Consulted: June, International Trade Centre (ITC) Climate Change and the Coffee Industry (revised edition) Geneva: ITC. Joerger, P Succession Planning: Who s Next? Noble Foundation. Available at: Consulted: January, Lipton, M Crop science, poverty, and the family farm in a globalising world Discussion paper 40. International Food Policy Research Institute, Washington DC. Lozano, A. n.d. Acceso al crédito en el sector cafetero colombiano. Available at: %20colombiano%20-%20Andrés%20Lozano.pdf. Consulted: January, Ministerio de Agricultura y Desarrollo Rural de Colombia (MinAgricultura), Anuario estadístico del sector agropecuario Bogotá, Colombia. 272 p. Available at: < Consulted on: February, 2013 Ministerio de Agricultura y Desarrollo Rural de Colombia (MinAgricultura), Anuario estadístico del sector agropecuario y pesquero Bogotá, Colombia. 262 p. ISBN: Available at: Consulted on: February, 2013 Ministerio de Agricultura y Desarrollo Rural de Colombia (MinAgricultura), Anuario estadístico del sector agropecuario y pesquero 2011: resultados evaluaciones agropecuarias municipales Bogotá, Colombia. 205 p. ISBN: Available at: Consulted on: February, 2013 Ministerio de la Protección Social La promoción social en Colombia. Available at: Consulted: January, National Agricultural Statistics Service (NASS) Agricultural prices. Agricultural Statistics Board, United States Department of Agriculture (USDA). 82 p. Available at: Consulted: January,

30 Perfetti, J. J Crisis y pobreza rural en América Latina: El caso de Colombia. Documento de trabajo Número 43. Programa Dinámicas Territoriales Rurales. Rimisp, Santiago, Chile. Presidencia de la República Decreto número 4919, Available at: Consulted: February, Presidencia de la República En marcha campaña para formalizar la propiedad de 200mil cafeteros. Sistema Informativo del Gobierno. Available at: Consulted: February, Proctor, F.J. and Lucchesi V. (2012) Small-scale farming and youth in an era of rapid rural change, IIED/HIVOS, London/The Hague. Rhenals, R. Es alto el salario mínimo en Colombia?: una comparación internacional. Perfil de Coyuntura Económica. No. 13. August Sustainable Markets Intelligence Center (CIMS) Sustainability impact assessment of coffee farms in 5 countries. Sustainable Markets Intelligence Center (CIMS) Real Farmer Income study. Complete Report. Internal report to Nespresso. Sustainable Markets Intelligence Center Economic analysis results Internal report to Icafe. Trujillo, G Reposición Adictiva No. 20 Cuestionario aditivo a la proposición No.17 de julio 31 de 2012 sobre la problemática actual del sector cafetero de nuestro país. Oficial communication. United Nations Framework Convention on Climate Change (UNFCCC). n.d. Excecutive Summary. República de Colombia. Segunda comunicación nacional ante la Convención Marco de las Naciones Unidas sobre Cambio Climático Available at: Consulted: January, United Nations Office on Drugs and Crime (UNODC). n.d. Alternative development. Colombia. General Facts. Available at: Consulted on: February, World Bank Data by country. Available at: Consulted on: February 23,

31 11. Annexes Annex 1. Total coffee production and trend in Colombia Source: Banco de la República, Annex 2. Net income in sample coffee farms in Colombia, 2011 Source: CIMS, Note: Income includes payment for the time the farmer spends working at the farm year round. The salary is equivalent to what he would pay if hiring an external worker

32 Annex 3. Behavior of the Colombian peso / US$ Source: Banco de la Républica, Annex 4. Scatterplot of farm size and productivity Source: CIMS,

33 Annex 5. Relationship between production investments to yield in coffee producing farms Source: CIMS, Annex 6. Plant potential production cycle Source: CIMS,

34 Annex 7. Price indexes, fertilizer and fuel, United States: = 100 Source: NASS, Annex 8. Correlation coefficient of net income versus price and productivity (yield) Costa Rica Guatemala Colombia (Nariño) Correlation between Net Income and Price Correlation coefficient ,358 0,403 Brazil Mexico p-value <.0001 <.0001 Correlation between Net Income and Yield Correlation coefficient ,742 p-value <.0001 <.0001 <.0001 <.0001 <.0001 Source: CIMS, Annex 9. An overview of competitors sourcing coffee in Colombia Starbucks works globally through its CAFÉ practices model, one that seeks to promote a sustainable approach to sourcing both in a social, environmental an economic sense. It has been purchasing coffee from Colombia since 1973, but its approach has typically been characterized as price-driven, rather than a commitment to long-term support to groups of farmers. However, in 2012 it established a farmer support centre, its first in Latin America, as part of the company's plans to expand in the region. The centre offers farmers agronomic advice and crop management. llycaffè, the Italian brand, entered Colombia in Amongst its initiatives is a quality award to farmers ( Colombian Award for Coffee Quality for the Preparation of espresso ) and UniCaffe Colombia, an informal training program for restaurant and hotel owners aimed at developing interest and skills in producing high quality coffee. It is also working on 34 34

35 climate change issues with Oxford University and the International Coffee Organization to examine the effects of climate change on coffee production. Mondelez (formerly Kraft) has recently launched its global Coffee Made Happy" strategy and has plans to invest a minimum of $200 million to empower one million coffee farming entrepreneurs by 2020 by building sustainable coffee communities; and in doing so, attract new generations back to the small-scale farming sector. However, no Colombia specific activity has yet been identified. Sara Lee works with its buyers to provide technical assistance in the sustainable production of coffee, and around 700 local families are being trained in food security. Housing is being improved, as well as the general social infrastructure, while better management of forests and the natural environment is being introduced. Annex 10.Glossary CIAT CIMS ECLAC FNC ICO ITC NGO RIMISP SCAA UNCTAD UNFCCC UNODC International Centre for Tropical Agriculture Sustainable Markets Intelligence Centre Economic Commission for Latin America and the Caribbean Colombia National Coffee Growers Federation International Coffee Organization International Trade Centre Non governmental Organization Latin American Centre for Rural Development Specialty Coffee Association of America United Nations Conference on Trade and Development United Nations Framework Convention on Climate Change United Nations Office on Drugs and Crime 35 35

36 Appendix 1: Further background Information on Colombia Population: 47,735,000 (July 2012 estimate, ECLAC) Area: 1.13 million km2 GDP 2011: US$ 333 billion million GDP per capita 2011: US$ 7,074 (10,700 PPP) (ECLAC, 2012) GDP per capita 2001: US$ 2,421 (ECLAC, 2012) GDP per capita 1991: US$ 1,726 (ECLAC, 2012) Coffee as percentage of GDP (2011) : 0.86% Economic Structure (2011 % of value added per sector): Agriculture 7%, Manufacturing Industry 14%, nonmanufacturing industry (primarily extractives) 18%, services 61%. (source World Bank 2013). Human Development Index (HDI): 7.1 (Latin American average is 7.3, highly developed countries 7.4). Source: UNDP Health Expenditure Per Capita: US$ (ECLAC, 2012) Poverty Rate: Urban 30%, Rural 46% (World Bank, 2012) Illiteracy (2010): 8.8.% (55-59 years old), 11.8% (50-64 year old) 3% (under 25 years old). (World Bank, 2013) Average Educational attainment (6-15 years old enrolled): Urban 95.8% (male) 96.5% (female), Rural 91.6% (male), 93.6% (female) (World Bank, 2013) Access to water (2010): Urban 91.7%, Rural 60% (Profamilia, 2010) Access to sanitation (2010): Urban 96.8%, Rural 69% (Profamilia, 2010) 36 36

37 Not enrolled in the health care system: Urban 11.9%, Rural 10.9% (Bernal, 2009) Informal work rate: Urban 35.2%, Rural 42.4% (Bernal, 2009) Informal workers with pension fund: 8.1% (Bernal, 2009) 37 37

38 Securing the long-term sustainable future of coffee supply in Colombia Teaching note Abstract This document provides the teaching notes to the Nespresso s Securing the Long-Term Sustainable Future of Coffee Supply in Colombia case. Nespresso faces the challenge to secure a stable, long-lasting supply of highest quality green coffee. The teaching notes render a brief summary of the case, teaching objectives and assignment questions. The assignment questions focus on Nespresso s strategy and Colombia s coffee actual situation; consequently a deeper explanation of the circumstances concerning the supply chain is discussed. 1. Introduction In 2003, Nespresso launched The Nespresso AAA Sustainable Quality Program to look after the future of high quality coffees and secure the livelihoods of farmers that grow them. Since then, the company has build on the know-how and years of knowledge to assure farmers a better income and help protect the natural environment, whilst guarantying the best quality coffee. It is Nespresso s point of view that their brand as well as their aptitude to grow as a company is inseparably entangled with the success of its coffee farmer suppliers. This case takes place in Colombia due to its importance as a major supplier of high quality coffee for the company. Furthermore, Nespresso has decided to maintain a close relationship with Colombia for various reasons; mainly because it has excelled and acquired the know-how; it benefits from national institutions and it enjoys of extensive collaborations with different public and private organizations. All this together makes it an ideal candidate to engage in long term planning and investment. 2. Case use This case provides background information useful in various academic areas such as Strategic Management, Agribusiness, Sustainable Development and Corporate Social Responsibility. The main goal of the case is to familiarize students with Colombia s coffee sector background as well as Nespresso s actual strategy to tackle their supply setbacks and allow them to explore sustainable alternatives to achieve a long-lasting supply of highest quality green coffee

39 The key target audience for this case is graduate students in an Agribusiness Masters, Masters of Business Administration (MBA) or any post-graduate program related to sustainable development. Furthermore this case study might be used on workshops or any seminars with sustainable development. 3. Teaching objectives The case s main objectives include: To be able to recognize the complexity to achieve sustainability, especially regarding economics, in an agricultural supply chain. To understand the role and the different interests of the various stakeholders along the coffee supply chain. To be able to comprehend the limitations of small holder coffee farms to reach a sustainable status. 4. Suggested assignment questions 1. Analyze the factors concerning the Colombian coffee farming sector. 2. Analyze the coffee supply chain and the role of different stakeholders. 3. Study and evaluate the economic profile of coffee smallholders in Colombia and possible future scenarios. 4. How does the AAA program address the challenges mentioned before and what is your judgment on this program? 5. Which strategy would you recommend to Nespresso to achieve an economic sustainable supply chain in the future? 5. Discussion and analysis Analyze the factors concerning the Colombian coffee farming sector. Colombia is the largest single producer of high quality Arabica coffees in the world; therefore is a vital component of the commercial and growth strategies for numerous coffee trading companies. Furthermore the demand for high quality coffee is strong, and is growing in newer markets such as China, India and Brazil. Nevertheless, the world may be currently observing the lowest Colombian harvest in more than 5 decades, struggling to reach their supply (Volcafe, 2012). Various aspects have influenced this general decrease in coffee output; mainly severe weather conditions (extended rains) across the country and decreased productivity due to underinvestment, specifically substandard agronomic practices (lack of fertilization or the interruption of the extremely important pruning cycle) in certain smallholder communities due to economic factors, such as low prices

40 Farming in the Coffee sector (specially for smallholders) is quite tricky and complex, mostly because of years of low market prices (resulting in diminishing family incomes), productivity affected by climate change, no social security, limited education infrastructure, and prospects for far higher wages in urban areas. Not only do farmers have to attend to these issues but they also face difficulties regarding costs and access to credits. In terms of production costs, these have increased over the past years. In comparison to 1995, the costs of fertilizers have quadruplicated, sometimes even more (essentially correlated with oil and natural gas prices). On the other hand, Labour costs have also increased. In view of the fact that chemical inputs generally represent around 1/3 of production costs and labor costs over half profits have been diminishing if not eliminated at all in some cases. Figure 1. Distribution of production costs in Colombia Source: CIMS, 2011 Legacy of farms has been done through successive generational subdivision; nonetheless farm size now is so small that subdivision is no longer feasible. On this issue, while only a small percentage of ownership claims are in disagreement, and practically every farmer exercises full legal control over his land, only a limited percentage of coffee growers have formal titles for their land which leads to difficulty securing loans to most farmers since their land cannot be readily used as collateral. All of these aspects may influence a large percentage of younger generations of potential farmers to choose a different career path if they do not see coffee as a viable one. Not only would these mean a shortage in coffee farmers in the future but also the fading away of the know-how. Since coffee farming is very knowledge intensive, most of its success depends 40 40

41 on the wisdom passed down generation through generation and with no future generations to come, comes a new challenge to the coffee trading companies Analyze the coffee supply chain and the role of different stakeholders. The traditional coffee supply chain in Colombia involves a dynamic relation between producers, cooperatives, the Colombian National Coffee Federation (FNC), traders/exporters or traders/roasters. Typically, farmers grow and wet mill coffee, which means most of the coffee coming from farms, is sold in dry parchment state. This condition occurs after cherries are wet milled (peeled, depulped, and demucilaginated) and then dried (sun-dried or artificially dried); which leaves the seed only covered with a hard and thick skin called parchment (Annex 1). Producers have access to both institutional and private commercialization channels. In the first case, coffee is gathered by cooperatives, where coffee is consolidated and usually dry-milled (parchment and silver-skin are removed). Here, the coffee can take three different (non-exclusive) routes: a) through Almacafe, a commercial branch of the FNC which aggregates coffee and sells it to locally-based traders or international buyers; b) second level cooperatives that sell the coffee directly in international markets or c) sell coffee to private exporters. On the other hand, the coffee producer might choose to sell their coffee directly to a private exporter who will consolidate, dry mill and export the coffee. This option involves a more competitive scenario for coffee producers, of course with the chance of getting higher prices. In both cases, institutional and private commercialization channels, the buyer/exporter takes the responsibility of grading the coffee beans based on its quality and then sells it to the different importers according to their requirements. According to FNC (2012), in 2011 the private channels bought 67% of the production and the remaining 33% was gathered by the Coffee Cooperatives. Key Actors Cooperatives This is the most common Organization type between farmers to sell their coffee. In the Colombian coffee industry there are first and second level cooperatives, depending on the complexity of the members. There are 34 first level Cooperatives with 547 points of purchase along the country that offer a Purchase Warranty ; a service through the Federation s channel 41 41

42 where producers have the guarantee of getting the best possible price in the nearest location. This service is considered one of the main services of the coffee industry in Colombia. Expocafé (Sociedad Exportadora de Café de los Cooperativas de Caficultores S.A) is a second level cooperative founded in 1985 by a group of Cooperatives in order to create their own export channel. They have clearly focused on specialty coffee markets, and nowadays they are the second largest private exporter in the country, encompassing 36 cooperatives that represent more than producers across Colombia

43 The Colombian National Coffee Federation The FNC is a private capital firm with public funding and objectives, which seeks to assure producer s representation and safety. It is the main institution of the Colombian coffee industry reaching more than growers who democratically elect their representatives. Furthermore, it is considered to be one of the best organized coffee institutions in the world. The Federation runs complementary organizations in charge of research and extension services; retail stores and broadcasting services. Part of their offices can be found in strategic coffee market places such as Europe, Japan and USA. Nonetheless, one of the key roles of FNC is to offer the Purchase Warranty ; widely cited as a crucial factor to protect producers business. Due to these reasons, and other social projects (such as building public infrastructure), the FNC enjoys positive reputation across the Colombian society. Private Exporters As mentioned before, private companies account for the largest proportion of the Colombian coffee exports. Neumann Kafee Group (Germany), Volcafe (Switzerland) and Ecom Trading (Mexico) are among the most important transnational companies that source coffee in Colombia. Nespresso s Colombian coffee supply can be sourced from first level cooperatives, second level cooperatives or private exporters; as long as they meet the quality standards Study and evaluate the economic profile of coffee smallholders in Colombia and possible future scenarios. Rural areas in Colombia used to be highly unstable and violent due to drug related conflicts. Many farmers have been displaced or have migrated to urban areas. The political situation is now more stable; nonetheless, living conditions are hard. Coffee farming is still the largest source of employment and the primary source of income in rural area. However, unemployment is high and in coffee departments (group of municipalities), unemployment reaches 13, 4% (Fonseca, 2003). Farmers live in remoteness mountainous regions with strong limitations to move and difficult access to larger population centers due to poor road infrastructure, if any. Rural poverty is higher than in urban areas and in coffee departments such as Cauca and Nariño, over 40% of the population has unsatisfied basic needs, while the national average reaches 28% according to the National administrative department of statistic (DANE) in its 2005 national census. The profile of a typical coffee farmer is a 55 year old man who grows coffee (being this his main income) as a traditional crop production on a farm inherited from his family. 95% of these farmers grow on small size plots (less than 5 hectares), 43 43

44 which leads to low production volume worsen by current low coffee prices; rising labor costs and yields that are often not maximized. The mountainous landscape makes mechanized work on coffee plantation impossible; hence, most of it has to be done manually. Therefore, farmers endure hard manual work on a farm that generates extremely low income and is hardly profitable (Fonseca, 2003). Furthermore, 64% of farmers have no formal land titles which limits access to credit that would allow to potentially invest, renovate or increase land size. Additionally, farmers have low levels of education which limits their business development: 75% have no formal education or have not completed school (Fonseca, 2003). Farmers live usually in a basic house built on their small plot with an average of 4, 3 persons per household in which 47, 6% are less than 20 years old (Fonseca, 2003). An increasing proportion of household heads are grandparents taking care of the grandchildren while their children work in the city. According to (Fonseca, 2003) coffee farmers have similar access to electricity as in the rest of the country. However public services like drinking water and telephone are much more limited in coffee regions with respectively 19, 2% and 2, 9%. Additionally, only 11% of the coffee farmer population is covered by a social security scheme. Possible future scenario: Most of the current farmers will probably stay on their farms for the rest of their life as we can assume that a 55 year old farmer hardly moves from his farm anymore. We can also foresee that they will continue working until they are not able to do so, primarily because coffee farming is more than a job, it is their life and also because they would not get any income otherwise. Productivity is expected to decrease as well as coffee quality thus leading to even lower income for aging farmers with less energy and motivation to properly manage their land. This may be exacerbated if their children are not interested in taking over the farm and decide to look for better job opportunities in the city. Regarding farmers children, a strong urban migration flow has started already and will most probably continue as the younger generation is looking for better quality of life and coffee farming currently does not offer it. If the coffee sector does not undergo structural changes to become more attractive and profitable for farmers with opportunities such as fair coffee prices and access to credit, it can be expected that most farmers children would migrate to the city to improve their socioeconomic status and those staying may be maintained in poverty

45 5. 4. How does the AAA program address the challenges mentioned before and what is your judgment on this program? Co-developed by Nespresso and Rainforest Alliance, the AAA program embraces a series of agricultural, managerial, social and environmental guidelines for coffee farming management. The program was launched in 2003 and focuses on helping producers to enhance their ability to produce high quality coffee in a sustainable manner, considering simultaneously that the main goal of the program is to improve the farmers net income. While Rainforest Alliance and Nespresso built the concept and guidelines of the program, the coffee buyers technicians and agronomists are in charge of the extension services to implement the program in each country. The AAA price premium is a distinctive characteristic of the program; it works as a driver for producers to comply with the specific coffee quality and farm practices standards. The AAA premium is around 30% to 40% above the standard market price for coffee (price paid from NN to coffee buyer) and 10% to 15% above the general local market price for coffees of similar quality (price paid from buyer to producer). This engaging mechanism is considered a key benefit from the farmers perspective, for participating in the Program (CIMS, 2011). The price premium that Nespresso pays to its buyers has two main elements: one corresponding to technical assistance and one that is actual cash paid to the farmers for their coffee. The coffee buyer is in charge of paying the premium directly to coffee producers; therefore, the buyer makes discretional use of the amount of this premium. The Real Farmer Income (RFI ) is a metric that involves taking a closer look at farmers and identifying ways to enhance their business profitability. The results derived from applying the RFI in five countries revealed that in most cases the AAA price premium mechanism was not enough to truly impact the farmer s profit when compared to control coffee farms (Non AAA farms). On the other hand productivity (coffee yield/ha) showed a stronger and significant correlation with famer s economic performance; particularly in Colombia, the correlation between price paid to producers and the net income was really low (though statistically significant), whilst the correlation between coffee yield and income was strong and significant. See Annex 2. Productivity is now a strategic objective of the AAA program and therefore, the agronomists (who offer training and technical assistance) are also focusing on projects that boost this aspect. Certainly, productivity is a complex issue dependent on a number of variables, including farm management (activities like pruning and fertilization), age of coffee trees, varieties, weather and pests. On the other hand, quality has its own set of variables, some of them also linked to 45 45

46 productivity, but also related to the quality of the processing (milling and fermentation stage) and optimal ripeness for harvesting the coffee beans. One key aspect that ensures loyalty from farmers is the commitment to price premiums. Nevertheless, one of the real drivers behind improvement at farm levels is the commitment to farmers extension work, technical assistance as well as building a long-term relationship with coffee producers. Farmer well-being has not been an explicit part of the traditional coffee buying and trading culture. Historically, the relationships between roasters/brands, their trader suppliers and farms have been strictly transactional, and nearly always based on negotiations for the current years harvest. Nespresso developed a 5 point strategy within the AAA program in Colombia. This involved a closer collaboration with institutional partners such as FNC; focused targeting of potential public-private partnerships (PPPs); a focus on yield and quality (QualitivityTM); innovation in addressing water management and a process for measuring and tracking the program s performance. A range of projects in partnership with suppliers show positive early indications of yield improvements (data not shown). As farms move towards compliance with Rainforest Alliance s Sustainable Agriculture Network (SAN) standards, the program is also having a positive impact on environmental aspects, particularly with area of water consumption and wastewater treatment. For instance, the Central milling of Jardin, co-founded in 2010 by Nespresso and other partners (including Cafexport, USAID, ACDI-VOCA and FNC) enables farmers to process their coffee collectively, rather than each individual farm. This facility has resulted in many benefits; the mill has doubled the supply of AAA profile coffee; decreased water use by 63% and eliminated waste water contamination (Annex 3) Which strategy would you recommend to Nespresso to achieve an economic sustainable supply chain in the future? After class discussion, students have a good basis of information in order to suggest a sound strategy for a sustainable supply for Nespresso. Students should have clear at that moment, that through solely a price premium it will be extremely difficult to create an economic environment that inspires farmers and especially their children to continue their farm business

47 Based on the presented information in the case, many students will recommend measures in order to increase productivity. Among the different options to increase productivity, renovation of coffee plantations has the clear advantage since there are no negative environmental side effects to expect at all if compared with increased fertilization. Additionally, renovation is not just a onetime shot, but helps improve productivity for future years. The challenge of a cluster (region) wide renovation program is the high investment need, which hardly can be managed only by Nespresso; therefore it needs the involvement of other stakeholder of the coffee sector, such as the FNC or even the government. In the end, discussion will show very often, that these challenges presented in the case can t be solved by just one actor of the coffee supply chain, but requires a coordinated effort of several members of the supply chain. Nevertheless, Nespresso must play a vital role in order to reach a more sustainable situation for the farmers so that also their children see a future in coffee farming. 6. References CIMS (Sustainable Markets Intelligence Center) Real Farmer Income study. Complete Report. Internal report to Nespresso. CIMS (Sustainable Markets Intelligence Center) Figure: Generic supply chain in the Colombian coffee industry. Prepared by CIMS. Fonseca, A Colombia: escenario social, económico e institucional de la actual crisis cafetera Oficina CEPAL Colombia. Available at: Consulted: October, Federacion Nacional de Cafeteros (FNC) Colombian Coffee Insights: A market perspective from FNC. Available at /supply_chain_designed_to_favor_the_producers_income. Consulted: October, Technoserve, Jardin Central Wet Mill Year 1 Monitoring Assessment. Power point Report. Internal report to Nespresso. Volcafe, Origin: Colombia. Available at: Colombia.pdf. Consulted: October, Annexes Annex 1. Generic supply chain in the Colombian coffee industry 47 47

48 Source: CIMS,

49 Annex 2. Pearson correlation test: Net income vs. Price, Net income vs. Yield Source: CIMS, Annex 3. Impact of the Central Wet Mill on quality and productivity Source: Technoserve, Jardin Central Wet Mill Year 1 Monitoring Assessment,