How Long-Term Contracts Can Help Drive More Sustainable Agriculture
Ed. Note: This is a work in progress. We’d like your input, your examples, your learning. Please highlight and use the private comment function here on Medium, or get in touch at email@example.com.
I wanted to explore the role that long-term contracts (LTCs) can play in reducing the short, medium and long-term risks that are associated with the production of food and soft commodities. LTCs can also play a key role in driving more sustainable agriculture, particularly in the face of climate change and more resilient food systems. They can be a key part of a business strategy that develops value for the buyer as well as the seller by leveraging longer-term investments in more sustainable food production.
In short, LTCs use the market to change it — they tap existing business transactions to leverage investments in more sustainable production — as well as encourage producers to make changes that will allow them to adapt to future conditions. Harnessing the power of markets to change the markets themselves will be the hallmark of of more sustainable supply chain management going forward. Governments do not have the funds or the inclination to help producers adapt to the speed and scale of changes in the food system today. And, producers and buyers have sufficient self-interest to insure the long-term viability of the food system in general and supply chains in particular.
In this discussion, sustainability is broadly defined as including economic, social and environmental performance.
What are Long-Term Contracts? How Do They Differ from Traditional Purchasing or Offtake Agreements?
Long-term contracts are usually established by a buyer for multiple years for food crops, animal production (including dairy) and other soft commodities that will be purchased repeatedly over the life of the agreement. The reach of the LTC can extend all the way to the producer, or it can be with a trader or a value-add processor, such as a coffee roaster, that then works in turn with aggregators or directly with producers.
LTCs are not necessarily a new idea. Because they can influence market behavior, e.g. of producers and processors, and provide buyers a way to create better relationship with their source of supply, they have been used in one form or another for decades. Often, they were more relationship-focused, with a specific aggregator or processor, and were mostly centered around keeping access to supply or for price stability.
LTCs address such issues as relationship-building with aggregators or producers and sound business benefits, but they are much more holistic in their approach to addressing social and environmental issues producers face, and downstream buyers care about or at least see as risks, specifically around sustainability impacts but also around long term supplies of products. These types of LTCs are currently being used in dairy, potatoes, soft oils, banana production, and beef cattle, among others, to address issues specific to their production.
The opportunities explored in this paper include:
- How LTCs are currently being used,
- How LTCs could be used more effectively in the future, and
- How LTCs could be used to enact change for specific food-production systems.
To be most effective, LTCs need to be seen as of mutual benefit to both the buyer and the seller. They are about long-term partnerships. They are also generally developed as a multi-discipline process that produce a number of different tangible results. This includes decision making in the procurement process, demand aggregation, conducting market analysis, and identifying and assessing the specific commercial risks of the commodity. For retailers, brands, traders or aggregators who want to prioritize sustainability or social impacts in the long-term — even if for no other reason than risk mitigation, LTCs are one way to link reduction or mitigation of agreed impacts without either premiums or up-front cash expenditures. These impacts might be, for example, eliminating deforestation or child labor, improving animal welfare, addressing climate change, increasing productivity or efficiency, or adding value locally.
In addition, LTCs generally have a contract-management plan that clearly defines the contract work flow, structure, roles and responsibilities of all parties involved, as well as control and accountability mechanisms.
CASE STUDY: TESCO AND MANAGEMENT
Tesco has established long-term contracts with key value-added processors of agricultural products, who act as volume aggregators. The product categories were chosen by developing a matrix of key factors, including importance to the financial health of the brand, social accountability goals, and brand risk. Each product category that the processors represent is jointly managed by a team of buyers, quality assurance assessors, sustainability experts and agronomists; and, if the commodity requires it, risk managers.
The team meets bi-monthly with the processor(s). Progress in each of the key areas is jointly agreed upon — such as deforestation, proper water usage, and elimination of child labor — are evaluated and adjusted as needed. Once a year, the joint team meets and reports on progress to the VP of Supply Chain and Sustainability.
Why Focus on Long-Term Contracts to Leverage Change?
Most large-scale buyers of agricultural and food products use short-term buying strategies (less than one year). These strategies utilize a combination of spot market purchases or fixed-price agreements for periods as short as a few days or weeks, to periods that are rarely more than one crop cycle. These short-term buying strategies are often thought of by the buyers as a way to “beat the market,” or to hedge in some way the expected rise or fall of the commodity price. In addition, utilizing a shorter-term view allows the buyer to see the cost impact of the buying decision in nearly-real time and as a function of quarterly business reporting. Such strategies also allow purchasers to buy only what they need.
This paper will show that this short-term view drives additional costs into the buying process. Moreover, it is a missed opportunity to support, much less drive, adaptation and change in the agricultural sector. Short-term purchase strategies can also create an adversarial relationship between buyer and seller, a zero-sum game approach. Perhaps most importantly, however, the short-term view does not support the type of investments in sustainability and climate-smart agriculture that producers will have to make if they are to survive long-term. In fact, the short-term view actually undermines the long-term ability of producers to invest in innovation and adaptation. More important for buyers, it undermines their ability to build long-term partnerships to reduce risks in their supply chains as well as to make their sourcing more traceable and transparent.
The impact of more traditional, short-term purchasing is significant for the producer. Short-term purchasing agreements act as an impediment to the producer in developing markets in gaining access to finance, improving yields, adapting to climate change, investing in new production systems that meet changing market demands (e.g., animal welfare), improving product quality and/or adding value, or breaking the cycle of poverty. These are just a few of the issues that can be improved by using LTCs.
Reliance on short-term agreements or spot market purchases puts the onus of long-term investments that would make food systems more sustainable over time squarely on the shoulders of the producers rather than the entire system. Short-term contracts also reinforce producer tendencies to ignore environmental externalities like soil health, weather variability or deforestation. For example, one cause of deforestation is that smaller-scale producers often have no other option to feed their families than to clear additional land for production. In the end, if it comes down to protecting a tree or feeding a child, the tree will lose every time.
What Does the Producer Need?
According to a recent United Nations’ report, the developing world has half a billion small farms, and most of the producers are living in poverty (United Nations Development Programme, 2016). These small-scale producer families account for most of the malnutrition and stunting on the planet. Used correctly, long-term contracts present an opportunity to address this concern directly or at the very least transition the system in a more sustainable direction. The average producer in developing countries faces the following issues:
- Limited access to financing or loans.
- Trouble accessing modern inputs to intensify sustainably yields on land currently in production.
- Inability to invest in infrastructure at scale that could improve irrigation, access to markets, or storage facilities.
- Insufficient access to technology.
- Lack of access to markets and market intelligence. In many cases, retailers and traders may purchase through aggregators, rather than directly from producers. The effects of LTCs could still impact the producer’s knowledge and, over time, access to markets through organizations like grower associations, as is the case in sectors like palm oil (in Indonesia) or dairy (in the UK).
- Lack of resilience or resources to mitigate market-associated risk. Access to crop insurance is one example where producers outside of North America or Europe face difficulties. With impacts from climate change (see below) already being felt, this issue will become even more important.
- Limited ability to adapt to the effects of climate change. The Food and Agriculture Organization of the UN (FAO) calls this concern “critical”:
“Helping smallholders adapt to climate change risks is critical for global poverty reduction and food security. Close attention should be paid to removing obstacles they may face and fostering an enabling environment for individual, joint and collective action … More climate finance tools need to flow to sustainable agriculture, fisheries and forestry to fund the large-scale transformation and the development of climate-smart food production systems.” (FAO, 2016)
LTCs generally have the following elements:
- A specific time-frame (usually more than one year and at times up to 10+ years, as in the case of bananas) and mechanisms to allow the agreement to be extended.
- Specifications on the minimum quantity to be purchased each year, as well as the quality (or other attribute) of the purchased item and/or production practices and impact requirements or good faith efforts. This can include specific requirements such as zero deforestation, what types of pesticides can be used, or sustainable intensification and good faith efforts to double productivity per unit of land, for example.
- Specific non-financial requirements such as sustainability expectations and the adherence to some types of certification or verification are also often conditions of LTCs. This feature will be explored in detail in this paper.
- Binding language between buyer and seller but that can be non-exclusive. The buyer or producer is under no obligation to use the LTC exclusively with a specific party, or purchase/sell more than an agreed-upon amount. Neither party is prohibited from buying from or selling to others, even competitors.
- A price finding mechanism to which both parties agree and neither is disadvantaged by. This can be a “cost plus” calculation at the time of sale, a single or average spot market price or a moving average price of specific markets. For this to work in the long-term, neither buyer nor seller can feel disadvantaged by the price finding mechanism or the system will not work well and certainly will not be renewed.
- A price-adjustment process to maintain economic viability in the case of unexpected cost increases. This process, and the frequency of pricing review, will be different by commodity and production geography. The process is designed to protect each party’s ability to maintain profitability and competitiveness in the marketplace. The specific mechanism will be spelled out as part of the contract.
- An issues resolution or conflict-management process to address problems as they arise.
- Insurance against side selling and non-compliance for whatever reason.
To be cost-effective, LTCs must meet the demand requirements of the buyer. Depending on the commodity, buyers approach producers in different ways. The most straightforward is to work with producers directly. However, with many commodities, this may be impractical due to the number of producers and the need to aggregate production to achieve the desired volumes of product. Another approach is with a co-op or producer organization, as is the case with dairy or potatoes in North America or coffee or cocoa production in many developing countries, or other supply aggregators such as a value-add processors such as slaughterhouses, sugar mills or palm oil processing plants.
Where they exist, producer organizations or co-ops are very practical structures for LTCs. However, since these structures do not exist everywhere, or for all agricultural products, one way of aggregating demand to begin an LTC strategy is the idea of “satellite farms.” Dr. Norton of Texas A&M’s Borlaug Institute describes satellite farms as a variant of contract farming under which a larger (nucleus) farm works directly with the buyer in the LTC and serves as the demonstration farm, and coordinates with the surrounding farms. They all agree to plant the same crop (using agreed crop-rotation practices), utilize the same cultivation procedures and sell to the same buyer per the LTC.
In this case, the satellite approach, along with LTCs, also facilitates consolidated investment to improve producers’ economic standing, infrastructure, access to finance and insurance, and education/training to intensify production sustainably on current land.
Of course, co-ops or satellite farm approaches are not the only path for buyers and producers to come together to implement an LTC. The possibility exists that third-party aggregators, already in place to coordinate the current process of short-term or crop-year purchases between producers and buyers, can also transition to an LTC with a commercial buyer. While there is potential concern about the additional costs associated with these entities, in particular, of having a “middle man” between the buyer and producer, experience suggests that some of the benefits of LTCs do flow through to the producer. One commodity that would serve as an example is coffee, where some buyers have put into place LTCs with the roasters who also act as aggregators. The expectations that the roaster will execute on several initiatives with their producers, like technical training and access to certification, are included in the roaster’s contract.
One large American retailer acknowledges that the company uses LTCs to encourage suppliers to make investments that allow them to comply with the company’s requirements, but that require sizeable investments that cannot be recouped in the short-term. These include a wide variety of animal-protein (e.g., meat, poultry, eggs, dairy) suppliers that need to make investments to comply with the company’s additional animal-welfare requirements. The company is also providing LTCs to cashew-nut producers so they can make the investments required to shell the nuts they produce, rather than sell them to India or Vietnam where the value (and employment) is added and the product is subsequently sold to the American retailer.
A large US brand that sells paper products has long worked through LTCs with its suppliers to make the investments required for larger, more efficient pulp- and paper-processing facilities. These facilities tend to last 30–40 years or more before they in turn become obsolete. The resulting processing plants are more efficient, better for both buyer and seller and more sustainable. However, without the LTC, making investments in state of the art processing plants is a riskier venture for the pulp and paper company. With the LTC, the company can obtain finance at more reasonable rates.
Current State: Traditional Short-Term Purchasing
Most commercial buyers of agricultural goods structure their procurement in time frames of one year or less. In this dominant procurement model, purchasing is often aligned with a crop cycle or based on whether a commodity market can enter into various trading instruments. Purchases of less than one year also tend to align with business reporting on a quarterly or annual basis. Over time, these methodologies are effective, and from a purely financial standpoint, meet a business’s requirement of having the correct amount of a given commodity at an acceptable price to meet their needs over the next quarter or year. There are considerable financial analysis and price-discovery tools available to support this process, from data-service providers like Bloomberg to internal accounting support.
The typical buyer in this model aspires to be a shrewd negotiator whose primary responsibility is obtaining the best possible price from suppliers and producers, and ensuring that minimum quality standards are met. Little or no concern is considered for the producer’s economic health. Risk — be it producer income, sustainability practices or even assurance of access to future supply — is usually not addressed. Typically, buyers take a divide-and-conquer approach to purchasing, buying small amounts from many suppliers and playing one against the other to gain price concessions (Kralkic, 1983). This will often lead to a transactional, adversarial, zero-sum game approach to buying and selling: For the buyer to “win,” the seller must “lose.”
Concerns with Traditional Short-Term Buying
Many companies are now beginning to recognize that in increasingly complex, competitive and global supply chains, short-term strategies cannot adequately address brand and cost-efficiency goals through their supply chains. There is now a growing need among buyers for their suppliers to be partners — not adversaries — to assure supply, address brand concerns, and cut costs.
The traditional short-term purchasing process involves several steps: Requisition, soliciting bids, purchase orders, shipping advice, invoices and payments. This process is now often seen as slow, expensive and labor-intensive. Each transaction generates its own paper trail, and the same process must be followed whether the item being purchased is a single soybean contract or 100 tons of rapeseed for monthly delivery to a crush facility.
A study by two faculty members at Stanford’s Graduate School of Business helps illustrate one issue with current spot-market, or short-term, buying. The model studied by Haim Mendelson and Tunay Tunca shows that by strategically using both fixed-price contracts and open-market trading, supply-chain participants can create greater efficiencies. Both the end consumer and the supply chain organization as a whole will benefit from these efficiencies. Once a buyer has all (or a significant amount) of their needs covered by an LTC, they can focus on other cost drivers like ocean logistics or optimizing their cold chain.
“The more you trade, the more you drive the price against yourself,” says Tunca, Assistant Professor of Operations, Information and Technology.
So, buying only on the spot market raises the risk that you’re going to spend more than you would have in an LTC (Rigoglioso, 2007). This research is based on the idea that moving to a mix of short- and long-term buying strategies will bring a “first movers” advantage in price. In the future it may become less of an advantage in pricing, and more of a driver of new behaviors associated with non-financial advantages.
Moving Beyond Short-Term Purchasing
There is evidence that the state of procurement is changing to reflect new thinking beyond traditional short-term purchasing strategies. Leading supply chain managers are finding enormous amounts of waste with short-term agreements, which they are trimming away to keep working margins. Second, supply chain thought leaders are finding innovative ways to make collaboration work for mutual benefit.
Since the 2008 financial crisis, many companies are turning to new ways of capturing value by moving to longer-term relationships with their key suppliers. It was during this time that many large-scale US companies saw significant impact of other global buyers on price. They realized that they needed to find a way to create long-term relationships with producers to keep everything from simply being sold to Asia and other regions where economies were growing at 5% or more per year.
Many companies credit their survival of the 2008 recession largely to their working relationships with buyers and suppliers. Why? Because successful supply-chain relationships depend upon much more than cost efficiencies and economic conveniences. Factors like access to markets, assured supply and ensuring topics such as social justice and environmental performance are important advantages that are not always apparent to those in the organization with the “sharp pencils.” Dr. Matthew B. Myers, writing in Supply Chain Management Review, has charted the progression of procurement thinking since 2008. This chart from his work shows the movement in thinking about long-term purchasing agreements (Myers, 2010).
The idea that LTCs can and should be part of an overall strategic procurement plan is a current “hot topic” for thought leaders in the procurement space. For many leading consumer-facing companies, establishing strong, mutually beneficial long-term relationships and agreements with strategic suppliers will be a critical step in improving performance across the supply chain, generating greater cost efficiency and enabling the business to grow and realize its sustainability goals. To accelerate the adoption of LTCs, the hard and soft benefits need to be clear — and significant enough — for the buyer and the producer to change current practices and systems.
Are multi-year purchasing agreements a key part of the future of procurement? The evidence points to yes, with a substantial first-movers’ advantage. — Dr. Matthew B Myers (2010)
What Are the Benefits of Long-Term Contracts to Buyers and Producers?
1. Lower total transactional costs and improved profitability. One of the benefits first realized from LTCs — and one that consistently delights operationally oriented managers — is the cost savings that result from routinized procedures over the life of the agreement. When buyers and producers begin a long-term agreement, their interactions can be fraught with inefficiencies and expensive organizational idiosyncrasies, potentially adding to the cost of doing business in year one. In year two and beyond, however, procedures typically become more streamlined, kinks in IT and payments systems (for the buyer) are worked through, and the entire process between buyer and producer becomes more efficient. The longer the agreement, the lower these costs can be. The value achieved can be measured by assured supply in a tight market, stable or improved quality, on-time deliveries, lower price volatility, or some combination of these. The longer the agreement, the more direct and indirect costs are reduced.
These cost savings are often shared by both buyers and sellers, increasing the benefits to both. LTCs can, for example, stipulate that savings achieved by the buyer above a certain target be shared with the producer. This “gain sharing” approach can be used as funding for projects that are mutually beneficial to both parties. The savings can also be passed on to final customers in the form of lower prices, thereby increasing the supply chain buyer’s product in the competitive landscape, and can stimulate additional demand for the producer’s goods.
2. A powerful tool to help achieve sustainability goals. It has become increasingly common — and is becoming expected by consumers — that consumer-facing brands have sustainability goals and aspirations that are reflected in the products they offer. What just a few years ago was seen as a competitive advantage — having sustainability goals — is now seen as green fees for brands to “have permission” to sell their products to current consumers or market access to new ones. Many of the large consumer companies have set near- and long-term targets in areas such as deforestation, water usage, eliminating human trafficking, child labor, carbon footprint and GHG emissions. These goals are often based on a company’s values — year-over-year-reduction of the brand’s environmental footprint or a social justice issue specific to their products, for example.
The actual implementation of these now-published and defined sustainability goals typically falls to the Supply Chain or Procurement Teams. In many cases these teams have already achieved near-term goals that address what the company (and often its direct suppliers) covers directly (e.g., Scope 1 and 2 impacts) through collaboration with industry groups and their own buying efforts. As a brand’s sustainability goals get more ambitious and, hopefully, impactful to lives along their value chain, achieving them will likely become more difficult, and new tools will be required. LTCs can be a key tool for buyers and producers to drive change and set specific dates for completion. As already noted, LTCs often have a built-in mechanism for addressing multi-year issues like sustainability goals. The LTCs suggest that there are increasing expectations of support from the buyer to help the producer in this transition, though the LTC does not require an up-front cash payment.
CASE STUDY: SUSTAINABLE CATTLE PRODUCTION IN BRAZIL
A large buyer of beef trim in Brazil needed to ensure that all its hamburger came from land that was not associated with deforestation, was rebuilding soil health, and was providing tracking of cattle. By entering into a LTC with the slaughterhouse, the buyer was able to join with producers, soil experts, third-party verification experts, and civil society experts to deliver on the goal of sustainable production.
3. They are not an all-or-nothing proposition. LTCs appear to work best when they represent part of a total strategic buying or selling program — think of them as part of a portfolio strategy. For the buyer, contracting 60% of their projected needs in LTCs and 40% in shorter-term, market-based agreements will provide flexibility to reduce pricing volatility and assure supply, while also having the ability to quickly make moves in supply based on short-term needs or other opportunities that may arise. This flexibility to both “trade” a portion of their spend as well as “fix” a portion of their price and costs will have appeal to many buyers. Most importantly, however, it is often difficult for the buyer to predict with great accuracy how much raw material it will buy in any year to meet sales demand, much less over the next 10. Thus, no buyer would want to contract, or lock-in, 100% of what they currently buy going forward.
CASE STUDY: LONG-TERM CONTRACTING OF BANANAS
A large banana trader uses a 70/30 approach in their procurement strategy: 70% of needed volume was in a multi-year agreement, and 30% was left to the spot market. This was done to concentrate their sustainability and production intensification efforts in a specific area to have the most cost-effective impact. Spot volumes are utilized in the “high” season only, driving internal efficiency for the buyer.
For the producer, having a large amount of their production contracted out to a reputable buyer gives the security that they will have a specific market for their product. This can allow them to be more efficient in how they plan their production. They can plan out production, input costs and the other benefits of having the security of access to markets and the capital they can leverage from that. However, no producer would want to plan to produce just the quantity of product for which they have contracts in-hand, given weather variability and other factors affecting production. In fact, the total amount a producer (or aggregator) would contract out may be significantly less than what a buyer may want to contract as a total percentage. LTCs allow for such flexibility.
Producers can, and likely will, produce more with a portfolio strategy. This system would allow a producer to sell the non-contracted portion without the stigma of side-selling. They could sell it to the holder of the LTC, or they could take advantage of price increases that may be short-term and outside the scope of the LTC. Having the security of multiple years of production sold under an LTC brings real benefits in securing financing, insurance and technical training, as already explored.
4. Decreased price volatility. Price volatility is a sensitive issue for many buyers and can have devastating effects on producers. For the buyer, it requires careful weighing of price volatility against the contract length, volumes, determining the right mechanisms and time frames for adjusting pricing between the producer and the buyer, and the importance of the procured product to the buying organization. For many companies, it is vital to establish how much volatility can be absorbed before price must be adjusted (if it can), cheaper product substitutes are found or developed, or the price has to be passed on to the consumer — which usually has a market share or competitive impact that affects the buyer in the short-term, and the producer in the long-term.
Price volatility for the producer can be one the biggest risks they face. Markets can and do “whip-saw” the producers with dramatic changes in demand and price, especially those that are forced to sell at the time of harvest for financial reasons. In reaction, producers can chase the market with different crops for cultivation that are not appropriate long-term to the soil or climate they are in, simply because they were profitable last year.
But it is harder to chase the market with tree crops, some kinds of animal protein, and other production that requires long-term investments.
This “whip-saw” effect is of course a risk for both the buyer and the producer. But, LTCs can be designed to enable producers to commit to more modest and/or flexible pricing models to mitigate this risk, by putting in an open-book policy and negotiated margins (as opposed to short-term fixed contract pricing). This type of “pass-thru” of producer costs requires high levels of trust and a solid understanding of the cost drivers of the product. When it is achieved, it can allow both parties to benefit from fluctuations in the market and pricing.
The actual mechanism for achieving a reduction in price volatility for the buyer and profitability protection for the producer is a very important element for the success of an LTC. There are two generally accepted ways of managing price and profitability for the producer and the buyer in LTCs: Cost-plus contracts and window contracts, also known as “cap and collar.”
Lawrence and Wang (1997) discuss various versions of cost-plus contracts for the pork industry as a representative example. Generally, the minimum price for pork is tied to feed costs — typically corn and soybean meal prices — as they may represent nearly 80% of the cost of raising hogs. The minimum price the processor/buyer pays rises as feed costs rise, and declines as feed prices drop. The processor makes up the difference out of their margins when market livestock prices are below the minimum production costs as agreed in the LTC price.
The hog producer often makes up the price difference when market prices rise by a fixed amount over the minimum feed contract price. Often the feed prices are averaged over part of the production period for the hogs marketed on that contract, as a way to manage these pricing variations. Ad-hoc adjustments to the contract are often included to prevent one party from benefiting tremendously to the detriment of the other party. For example, if one party has accrued a large dollar surplus by the end of the contracting period as a result of the contract, the counter party may elect to extend the contract period.
The cost-plus contract is essentially a contract on producer margins, or spreads — the difference between the input costs and the output price. The long-term contracts manage the risk between changes in input and output prices.
An open-book long-term contract seems to be most useful in those agricultural products that have a longer-term cycle, such as livestock or tree crops. It should be noted this type of pricing has been used with success with an aggregator of canola (rapeseed), a shorter- cycle crop in western Canada.
Window contracts set a minimum floor price and a maximum ceiling (or cap) price that the producer can charge. Conceptually, the producer removes price risk below the window floor in exchange for giving up price gains above the window ceiling. Conversely, the provider of the contract, often a processor or marketing organization, foregoes the possibility of purchasing commodities below the floor price in exchange for removing purchase prices above the window ceiling.
This concept of the producer accepting that they will not be able to capture the entire “upside price” as part of the agreement in exchange for having their “down side” risk removed will take time for some commodity producers to accept. Over time, and with the benefits of LTCs realized, this risk will likely decrease.
Many different risk-sharing agreements are possible with a window contract or with a cost-plus contract. Window contracts are strictly a contract on the market price and only manage the output price risk from the producer perspective, or the input price risk from the buyer’s perspective (Unterschults, Novak, & Koontz, 1997).
Choosing the best method for a commodity to reduce volatility, at least at some level, enables the producer to manage the risk associated with crop selection, hectares planted, and establishing a sound methodology for adjusting price as needs dictate. This is because the buyer has committed to multi-year purchase of some portion of the yearly production, producers are better able to plan in multi-year intervals to purchase inputs, accept training to increase sustainable yields, plan crop rotation, and have the stability to improve income and living standards.
5. Reduced risk. Price and brand exposure are not the only risk in procurement. The lost sales (and profits) when supply of a key commodity is interrupted is a risk all buyers face. The very nature of LTCs and the value they create for the producer significantly reduces the supply risks that are under the producer’s control and increases their incentive to assure supply to the buyer. This increased assurance of supply can translate into a competitive advantage when other competitive buyers are unable to gain access to a preferred producer or area of geographic supply, or are faced with limited amounts available on the spot market.
Long-term contracts provide key incentives for the producer to assure supply, at the correct amount, location and quality. This is beneficial to the buyer, and should be a key driver for its acceptance.
Additionally, increasingly competitive global supply chains are placing enormous pressures on supply-chain managers and buyers to develop new processes that enhance both cost efficiencies and improve production capabilities. Like new product development, new process development can be extraordinarily expensive — and risky. Yet, long-term contracts and agreements often prove to be the most innovative way to develop processes that both reduce costs and add value for all partners (Wetekamp, 2008). As was seen in the previous example of the Canola trader and processor, LTCs can play a key role in reducing the risk of additional investment in a supply chain’s efficiency.
6. Improved ROI (buyers) and access to financing and insurance (producers.) One primary advantage for producers who agree to an LTC is improved access to financing and crop insurance. Traditional forms of funding — typically private banks — have often not been willing to lend to producers because of the boom-bust cycle they face. Lacking access to adequate funding, producers, especially small ones, are not able to invest in those technologies, modern production practices or other infrastructure to better manage the risks of the business cycles that impact them.
LTCs and the demand aggregation necessary for them to work can change this situation to one where banks see LTCs as assets and are able to lend to producers at affordable rates. Here’s one example: Hortifruti is an institutional buyer that consolidates (aggregates) products — in this case flowers — from many producers and then sells the bulked produce to supermarkets. Although there is normally no formal contract between the farmer and the buyer, banks observe the relationship, and infer information about the farmer’s credit-worthiness. This is a form of delegated screening in which the informal contract linking the institutional buyer to the producer is what tells the bank this is a good prospect.
The bank has confirmation of the farmer’s ability and willingness to repay based on the institutional buyer’s need to work with efficient, responsible producers, and market risk is lessened by the guaranteed volume of sales obtained through the (long-term) relationship with the institutional buyer. Imagine the impact of a more formal LTC system.
This same relationship reduces price risk and, because guaranteed sales to the supermarket chain continue throughout the year, it also protects the farmer from losses of liquidity. Thanks to a staggered planting and sales program, based on instructions from the institutional buyer, farmers have liquidity throughout the year. With technical assistance, market information, and other non-financial services offered by the supermarket chain, farmers are able to mitigate productivity risks, environmental risks and quality problems that could lead to product rejection. At the same time, they are broadening their horizons, increasing investment and promoting innovation.
A surprising note on Hortifruti suppliers is how heterogeneous they are — their most important distinguishing features are not easily visible. For example, producer size is relatively unimportant. In Costa Rica, the average farm size for Hortifruti suppliers is nine hectares. This is not a huge producer, and many were much smaller. It was found that some farmers owned no land at all, but met their Hortifruti commitments on rented property. Even lacking land, they could find financial intermediaries willing to give them loans on the strength of nothing more than rented property and a contract and ongoing relationship with their buyer. It should be noted that there are other, equally important benefits the producers gained in addition to access to lending, including training in the use of pesticides, food safety and marketing. Again, imagine if they had LTCs. Most financial institutions require collateral, but it doesn’t have to be land. An LTC or a verbal contract with a buyer like Hortifruti, an exceptionally strong and well-known company, is often enough to make a producer creditworthy, at least for working capital financing (Norton, 2017).
Access to crop insurance is another possible benefit to the producer that over the long-term also benefits the buyer by reducing the risk of assuring supply and protecting their base of producers. In North America and Europe, crop insurance protection is available to nearly all producers, either through government agencies or by private firms. In 2016 it was estimated that 90+% of all ground crops grown in North America had some form of insurance.
In the developing world, access to crop insurance is not the norm. In the same way that LTCs and aggregation facilitate banks lending to producers, there is evidence that private insurance providers are willing to consider expanding some type of crop insurance to producers outside of North America and Europe. For a producer facing losing part or all of a year’s crop due to severe weather, drought, or other climate-change factors, having access to crop insurance is a risk-reduction factor for them, but also for the buyer, because it protects the profitability of the producer without affecting their overall price.
Assurance of access to markets through LTCs, access to capital and reduced capital costs, and potential for new types of insurance for many producers are far more important in this case than small price premiums from buyers for products that are produced more sustainably. In fact, price premiums are getting smaller and are often non-existent. So, LTCs and access to capital can help producers increase their net earnings, and drive improvements to sustainable production.
CASE STUDY: ACCESS TO FINANCING FOR BRAZIL NUT SHELLING FACILITY
An early example of long-term contracts involved the shelling of Brazil nuts in a rubber tapper-owned facility in Xapuri, in the state of Acre. When the nut-shelling factory was first built, it sold its nuts FOB (free on board) to Cultural Survival Enterprises (CSE). CSE in turn imported them to the US and EU and sold them to companies like Ben & Jerry’s, The Body Shop, Dare, IFF and Whole Foods. However, initially neither the cooperative nor CSE had working capital to support the purchase, storage and shelling of the Brazil nuts. What CSE discovered was that if it opened a letter of credit to purchase nuts, then the co-op could borrow up to 50% of the value of the contract from a local bank. At that time (late 1980s-early 1990s), inflation reached 1% per day in Brazil. The contracts not only represented considerable income (and employment) for the cooperative as well as the town, payments were in US dollars rather than Reals. CSE was required to put 10% down on the letter of credit, but that leveraged five times more working capital for the co-op. Today, companies are not required to put any money down for a letter of credit, so this type of arrangement can be used for local processing and other costs, but probably not for more than a one-year commitment.
7. Increased efficiency and communication. As the multi-year relationship develops from an adversarial one between a buyer and a producer/processor-aggregator to a partnership, so does the buyer’s understanding of the producer’s costs, yields and infrastructure needs and shortcomings. In return, the producer will develop an increased understanding of the buyer’s needs and market dynamics, where there is flexibility and where there isn’t. An important by-product of this increased communication and efficiency is the reduction of the real or perceived adversarial, or win/lose, economic environment that is currently the norm. Reduction in the adversarial relationship allows both parties to look for areas of efficiency and consolidation across existing products and services, as well as understanding where the areas are for improvement and investment. As a consequence, it is expected that the product purchased will improve. All parties will become more efficient, with “grey areas” disappearing and any issues which do arise handled more effectively. Better relationships and increased interaction will lead to less incidents of poor performance, which in turn leads to lower costs for managing the relationship and reduced costs for both parties.
8. Innovation through joint planning and long-term collaboration. A key benefit of LTCs is the knowledge that can be gained by the buyer and producer through joint planning. While this may not be a possibility for all crops — some commodity crops such as maize and soy would be more difficult — the potential for other crops and livestock production is an intriguing possibility. Instead of being faceless, the producer-aggregator and buyer now share a more direct connection and common goals, as each party becomes a known part of the value chain. There is incentive for both parties to collaborate for mutual gain.
This collaboration holds the potential for significant opportunity to address the issues producers face, as it is in the buyer’s best interest to support any reasonable action that improves the producer’s ability to control costs, assure supply and have long-term economic stability. Some opportunities for innovation and joint planning are providing the producer access to technical education or expertise to allow for improvement; better access to inputs such as seed and variety improvements, fertilizer, etc.; and improved oversight of farm labor conditions
9. Flexibility. As long-term contracts extend in time, it is critical to remember that, while both partners’ share of the benefit pie will grow, each share will not necessarily grow at the same rate. Too often, a lack of understanding around this point has caused acrimony between supply-chain partners. And because of the unrealistic expectations of both parties, otherwise profitable relationships have deteriorated.
This problem is often referred to as absolute vs. relative gains, with too many firms focusing on the latter. Supply-chain partners should concentrate on the relationship’s absolute benefits to their needs — and whether those benefits would be realized if the partnership did not exist. These benefits may not accrue in equal portions to the participants at the same time. As long as a partnership is mutually beneficial and strengthens the competitive position of the producer and buyer, all parties should gain significantly in absolute terms. The longer the collaborative relationship, the more each player — from raw material providers to retailers — will see benefits. And not just in traditional cost-saving terms, but also through increased capacity (investment by buyers and producers enabled by the establishment of LTCs), and enhanced innovation capabilities (Terra Firma, 2017).
Advantages and Corresponding Risks Associated with Long-Term Contacts
Above, the first point refers to falling prices. Pricing is a pillar for successful off-take agreements. It is key for the success of long term contracts to determine a formula that mirrors market prices, otherwise the agreements could deteriorate. A very significant example can be seen in the liquefied natural gas prices agreed between companies and governments with Qatar that were cancelled or renegotiated to reflect market prices.
It is also important to mention that the contract price of a commodity will likely be the same and vary just against a delivery point (this can be seen through Chicago futures of grains or oilseeds). However, the more specialized the product, the more it will have a premium against the “commodity” - for example single origin coffee or cocoa from hybrid varieties will have a significant pricing variation. Therefore, the premium discovery and an incentive or discount table should be negotiated in advance to allow the contract to survive market price shocks as well as quality issues. The body of the contract will be key for finance and insurance.
Examples of Long-Term Purchasing Contracts in Practice
Long-term contracts are leading-edge thinking in food and soft-commodity procurement as an enabler and driver of change. There are a few examples of their use in the public domain — and with effective change management, more can be expected over time. There are some well-documented, peer-reviewed examples of their use outside of food and agriculture that are important to consider as they shed light on the overall effectiveness of the LTC concept.
In this section, three examples of the successful use of LTCs are summarized in chronological order.
1. A major restaurant chain and potato processor and the development of potato farming in northern India.
In the early 2000s, the restaurant’s global supply chain, working with their largest potato processor, began a program to develop a commercial-level potato processing program in northern India where potatoes were currently being grown. This program was in response to projected growth of the company’s restaurants in India, and the increasing costs to import processed potatoes. Several key challenges were immediately identified:
- While potatoes had been grown in the region for more than a century, the varieties grown were not the best type for processing. Basic issues like access to the correct seeds, understanding of the different inputs the new varieties needed to grow and what techniques were most successful needed to be addressed.
- There was a lack of mechanization in the region; most work in the fields was done by human labor.
- Modern potato storage facilities needed to be built and tractors and harvesters purchased.
- The average farm size was three hectares.
- Water rights were very confusing.
Results and Conclusions
By establishing and executing multi-year agreements with the growers and assisting with financing guarantees, much progress has been made in the region. Over the past decade, multi-year agreements, and in some cases LTCs, were used with producers, organizations of producers and in some cases village associations, to address many of the key issues. New, modern potato storage units have been built. New varieties suitable for local conditions and commercial processing have been introduced and yields have increased. By partnering with the growers, the processor was able to bring in agronomists that worked season-by-season with the small holders to improve yields and water usage, and more efficiently utilize the correct types and amounts of input chemicals to optimize income for the producers.
While water rights issues and yields are still not where they need to be, this program is considered a great success by the growers, state government, and various NGOs in the practical utilization of LTC/multi-year partnerships to drive change in a single region and with a single commodity.
2. The use of LTCs for new investments in clean power generation.
In 2008, the MIT Center for Energy and Environmental Policy Research (CEEPR) completed an in-depth review of the issues preventing quicker adoption of clean power generation in the United States, and what should be done to accelerate investment in the same. CEEPR identified several barriers:
- Without a long-term power purchase contract, the cost of capital escalates, and the new investment is discouraged in favor of other technologies with lower capital costs — that ultimately provide power at a higher total cost.
- Bigger, more capital-intensive projects with a longer time-to-build can promise a lower average cost of power to buyers who can make a long-term commitment.
- Renewable advocates, especially a solar company, said that LTCs are essential to bring adoption forward.
- MIT concluded that LTCs are not the norm in most industries, but should be considered.
Results and Conclusions
Based on the research conducted by CEEPR, state legislatures in Rhode Island and Massachusetts adopted new energy legislation mandating the use of LTCs for renewable energy deals of 10–20 years. Impacts to date include a reduction in price volatility of 22%, proving that larger-scale, more capital-intensive projects with a longer time-to-build can deliver a lower average cost of power to buyers (Parsons, 2008).
3. The Cargill Cocoa Promise Program
In 2013, Cargill, a major purchaser of cocoa across the world, began to change how it approached the entire production cycle of cocoa procurement. They stated their mission as:
“Our ambition is to accelerate progress towards a transparent global cocoa supply chain, enable farmers and their communities to achieve better incomes and living standards and deliver a sustainable supply of cocoa and chocolate products. We believe this will contribute to a thriving cocoa sector for generations to come.”
To realize this mission, Cargill has established a multi-year purchasing program that directly ties progress in several sustainability measures with pricing and third-party verification of results. Cargill believes progress to date has been enabled using LTCs (Cargill, 2016).
Key areas where Cargill is using LTCs to create change
- Establishing farmer organizations so producers can aggregate their own production for sale.
- Providing assistance, including some types of financing, to help small producers make investments to improve their production. This includes equipment, new varieties of trees, and infrastructure improvements like irrigation.
- Bringing technical assistance and training to the producers, directly or through their associations.
- Support for the producer’s communities, including assistance in building schools, clinics and other public infrastructure.
- Empowering women.
Results and Conclusions
While it is still early in this multi-year program, Cargill has documented progress in the establishment of producer organizations and marketing programs. Along with the NGO CocoaAction, Cargill is assisting in sustainability activities that engage the entire cocoa value chain, including manufacturers and retailers, to increase their leverage with the producers (Cargill, 2016). Read more about the Cargill Cocoa Promise.
What Legal Structures Should be Addressed in a Multi-Year Purchasing Agreement?
In most cases, a contract is required in a multi-year purchasing agreement (MYPA). While there are many legal requirements in jurisdictions where MYPA will be used in agriculture, there are several common terms that should be considered in any MYPA. A MYPA based on US law is included as an example in Appendix II.
General Scope. This establishes the basic agreement between the parties for the sale and purchase of products, which will likely be defined in a schedule.
Duration. The start date and initial period of the contract need to be specified. This might be 60 months, with the contract providing for it to be rolled over on a quarterly (or longer) basis until one side gives notice. And since an LTC involves planning ahead, each party should be required to give reasonable notice if it wants to bring the contract to an end. The buyer may need time to find another supplier; and the supplier does not want to find he has committed himself to stock that he cannot sell elsewhere.
Because the producer may have investments or acquired multi-year financing based on the stated duration of the contract, a buy-out schedule for the buyer of these liabilities should be considered. Alternatively, language in the contract could be included that allows the buyer, upon notice of ending the agreement, to transfer or sell the contract to another buyer that would be compelled to honor the agreement with the producer.
Quality Issues. The quality of the products is going to be defined by reference to the specification which will be in a Schedule to the Agreement. If the quality of any delivery does not meet the specification, the contract should make the producer responsible for replacement or a reduction in price, at the buyer’s discretion. Some supply contracts might contain a provision for independent testing of the material. And if the supplier is a wholesaler or aggregator, the contract might require that samples be provided in advance if the aggregator wants to source goods from a new producer.
Additional Requirements. In this section, the buyer will include requirements for certification of production methods, sustainability goals or other “soft” requirements. These requirements can be included and referenced in an Appendix or Schedule that may have different milestones. These requirements might also include a schedule of investments or gain sharing that will be agreed upon as part of the LTC.
Quantities, Forecasts, Orders. It is common to have terms that provide for the buyer to give regular forecasts of quantities, allowing the supplier or producer to better meet purchase orders. Sometimes this involves an annual forecast of quantity, which is then refined to a quarterly forecast and followed by monthly purchase orders.
Sometimes there will be agreed minimum and maximum quantities, and these may be coupled with a “take or pay” provision. In such a case, if the buyer fails to take the minimum quantity, he will pay for the shortfall. Similarly, if the supplier fails to provide the minimum quantity, he may be penalized. In the case of the buyer investing with the producer in order to increase the producer’s capacity, then a more specific forecast or order quantity will be agreed upon. As with the “take or pay” provision, should one party fail to meet the agreed-upon amounts, specific actions or penalties will come into play. The contract will also address requirements for placing an order within minimum time periods and make provisions for delivery dates. A model order form can usefully be included in a schedule.
Pricing. The agreement will usually contain a schedule with details of prices, but since price adjustments in an LTC will usually be necessary, there may also be a formula (e.g., an agreed price-finding formula) that is part of the contract or amended to it to address the issue. This could provide for a spot-market price daily, or a price adjustment at some other interval, by reference to the Retail Price Index published by the government in the supplier’s country, or other mechanism already described in this paper.
Alternatively, prices might be adjusted by reference to the supplier’s price list or, if there is no formula, there could be a three-month period of negotiation. If agreement cannot be reached, either party has the right to terminate the contract. Sometimes there will be agreed discounts on list prices, which may vary depending on the quantities being sold. The ease of termination will, of course, depend on the conditions and investments that the seller has had to comply with up to that point.
Payment. Generally, there will either be payment monthly against invoices or, especially in a cross-border deal, the buyer may agree to open a revolving letter of credit. This will give the supplier greater security and be an asset that the seller can use to get finance for working capital needs.
Payment dates and interest on late payment should also be covered. For example, in the UK the supplier may want to claim interest under the Late Payment of Commercial Debts (Interest) Act of 1998, which allows interest to be claimed at 8% p.a. above Bank of England base rate. The supplier may also be allowed to suspend deliveries if payments are overdue for more than a specific period.
Deliveries, Risk and Ownership. The agreement will specify where deliveries are to be made and when they are to be made. Method of transportation (and who bears the cost) can also be covered. Both ownership and risk in product usually passes from the producer or aggregator at the delivery point. Details of who is responsible for packaging or for the cost of storage if the buyer postpones a delivery date can also be dealt with.
Claims. Depending on the type of products and whether they are to be sold in the retail market or by the buyer, there may be a clause dealing with defective product liability claims from third- party customers. In that case the contract is likely to put primary responsibility on the producer. But, if the buyer has modified any products before passing them on, the issues of liability could be complicated.
If the supply is for raw materials, a sampling and testing procedure may be appropriate, with reference to an industry expert if the buyer claims that the products are defective or sub-standard.
Termination. This is a clause that allows each party to terminate if the other commits a serious breach or becomes insolvent. It will vary based on the laws that the relevant country/ies have in place.
Force Majeure. In an LTC, unforeseen circumstances could disrupt the supply arrangements. It can be useful to include a ‘force majeure,’ or unforeseeable events, clause so that if this occurs the party affected will not be treated as failing to perform the contract. Examples of force majeure events can be included in the wording. As well as war, terrorism, fire, and flood, there might be contract-specific items to be covered, such as closure of a border that prevents the producer from making delivery. If force majeure goes on for more than an agreed-upon length of time, either side can terminate the contract.
Limit of Liability. It might be sensible for the contract to limit liability for both parties. If the producer fails to deliver an agreed-upon quantity of material that is vital for the buyer’s business, he might agree to accept responsibility for paying the extra costs that the buyer incurs with another producer or aggregator, but exclude liability for any loss of business suffered by the buyer. Similarly, if the buyer suddenly cancels an order, he might agree to cover the producer’s loss on that delivery if he must sell it elsewhere at a lower price. Or if the producer has made investments in areas like sustainability and infrastructure improvements the buyer may cover a portion of those costs, but not pay as much as the full cost of the goods.
Disputes and Law. If a dispute occurs, it can be useful to have a three-stage process for dealing with the problem. First, direct negotiation between senior executives. If this does not resolve the matter, the dispute can be referred to mediation. Only after these processes can a dispute be referred to the courts or arbitration.
The form of contract is best put together with a set of terms and conditions plus a series of schedules dealing with the variable items such as details of the products, specifications, prices, minimum and maximum quantities, delivery point, price adjustment formula and a pro-forma order form (Giles, 2013; Terzi & Flores Callejas, 2013).
Cargill, Improving livelihoods for cocoa farmers and their communities (Minneapolis, MN, Cargill, 2016). 4–9
Giles, M. Why You Need A Long-Term Supply Agreement (London, Contract Store, 2012). 1–8
Kraljic, Peter. Purchasing Must Become Supply Management. Page 3. Harvard Business Review, (Watertown, Mass. Harvard Business Review,1983) 3
Lawrence, John D., and Wang, Zhi. “Systematic Hog Price Management: Selective Hedging and Long-Term Risk Sharing Packer Contracts.” (Iowa State University, 1998).
Myers, Matthew B. “Back to Basics — The Many Benefits of Supply Chain Collaboration.” (Supply Chain Management Review 49, no. 4, 2010), 67.
Norton, Roger. The Competitiveness of Tropical Agriculture (New York, Academic Press, 2017), 98–99
Parsons, John. The Value of Long-Term Contracts for New Investments in Generation (Cambridge, MA, MIT Center for Energy and Environmental Policy Research, 2008), 4–6.
Rigoglioso, Marguerite. Strategic Spot Trading and Supply Chains. (Stanford, CA. Stanford Graduate School of Business Insights, 2007), 1–3
United Nations Sustainable Development. Sustainable Development Goals — 17 Goals to Transform our World (Rome, United Nations, 2016), 3
Unterschultz, James;, Novak, Frank and Koontz, Stephen. Design and Evaluation of Long Term Commodity Pricing (Chicago, IL, Conference on Applied Commodity Price Analysis, Forecasting and Market Risk Management, 1997) 35–37
Terra Firma. Effective Vendor Management: Reaping Long-Term Benefits From Your Vendor Relationships (London, Terra Firma Ltd, 2013). 1–10
Terzi, Cihan and Flores Callejas, Jorge. Review of Long-Term Agreements in Procurement in the United Nations System (Geneva, United Nations, 2013). 14
Wetekamp, Jim. Long Term Supplier Relationships Yield Short Term Value for Manufacturers
(Cleveland, OH, Industry Week, 2008), 2