Eroded Coffee Traceability And Its Impact On Export Coffee .

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Eroded Coffee Traceability and Its Impact on Export Coffee Prices for Ethiopia1Development Discussion Paper: 2014-04Leonard LeungDepartment of Economics, Queen’s University, [email protected] December 2008, the Ethiopian Commodity Exchange (ECX) opened a new coffee platformthat has transformed Ethiopia’s coffee trade. The way ECX handles coffee in a commodityfashion has eroded traceability, a characteristic sought after by overseas coffee buyers. Thispaper traces the forces that give rise to the commoditization of coffee. An empirical analysisusing a dataset on export coffee transactions supports the view that eroded traceability suppressesthe export price of non-traceable, ECX-sourced coffee, relative to fully traceable coffee. Thecumulative monetary is estimated to be 280 million USD, equivalent to 26% of farmer’ farmgateincome from coffee.Keywords: Ethiopian Commodity Exchange, Ethiopian coffee, coffee traceability,commoditizationJFL Classification: C12, D80, Q17, Q281This project owes its existence to contributions from many individuals. First and foremost, I wish to thankUSAID/Ethiopia for sponsoring a field study. The collaboration of four team members, Christopher Benett, RichardR. Barichello, Habtamu Fuje and Mikhail Miklyaev, is greatly appreciated. The paper benefited substantially fromdiscussions with Robin Boadway, Glenn Jenkins and Lealand Morin. The author takes full responsibility for theresults and opinions expressed in this study.1

Eroded Coffee Traceability and Its Impact on Export Coffee Prices for Ethiopia1. IntroductionCoffee is the single most important foreign exchange earner for Ethiopia. It accounted for 32 percent (823 million USD) of the total value of exports in 2011 and constitutes a significant incomesource for 15 million people in the workforce (Ministry of Trade 2012). Historically, coffee wasmarketed through an auction system that was fraught with problems. In late 2008, the EthiopianCommodity Exchange (ECX) was replaced the old auction regime as the principal coffee tradingplatform. Critics argued that the way ECX handles its coffee trade operations would lead tocommoditization, whereby coffees with considerable differentiability in cup taste, and spatial orgrower origin would become homogenized. This would erode coffee traceability and concealfrom overseas coffee importers credible information regarding the coffee’s origin. The potentialmonetary loss can be substantial, as Ethiopia has more recognized coffee varieties than anywherein the world, and many varieties enjoy high international repute. Regression analysis using theEthiopian Ministry of Trade’s dataset on export coffee transactions indicates that erodedtraceability reduces coffee export prices by about 12 per cent.The Ethiopian government and international development agencies have invested substantialresources in promoting the coffee sector. Past interventions included sponsoring agriculturalresearch and marketing development. Several studies have been conducted on the coffee sectorthat can inform interventions design. For example, Gebreselassie and Ludi (2008) explain whysome households decide not to participate (i.e., selling outputs) in the coffee market. Boansi andCrentsil (2013) investigate what drives coffee output and producer prices, while Worako et al.(2008) focus on how price fluctuations abroad are transmitted to various levels of the domesticcoffee supply chain. The research that is most relevant to the present study is by Arslan andReicher (2010), which finds that the trademarking of three Ethiopian coffee varieties in 2004increased their export prices by 10 per cent. The absolute value of their estimate is strikinglysimilar to this paper’s findings, although the signs of the estimates are different, since erodedtraceability has the opposite effect of trademarking on export prices, by diminishing coffeedifferentiability from the perspective of overseas coffee buyers.2. Institutional background2.1 A brief history of the Ethiopian Commodity ExchangeECX was officially launched in April 2008 as a trading platform for cereals. It was envisioned asa revolutionizing institution providing many of the services that are ordinarily performed by theprivate sector in mature cereals supply chains. Its operations include an auction floor in AddisAbaba to facilitate cereal trade; a clearing system to settle sales contracts; regional assayingcentres to determine the quality of cereals; regional warehouses to preserve cereal quality; andfree, real-time, multimedia dissemination of price information to local markets. The integratedoperations are meant to assure buyers of the quality of their purchase, protect cereal sellersagainst late payments and defaults, and empower farmers by enhancing price transparency. ECX2

was designed to improve cereals market efficiency by reducing transaction costs for allparticipants (Gabre-Madhin and Goggin 2005).Policy makers planned to incorporate coffee into ECX since its inception, although preparationwas expected to take time. The founding of ECX coincided with the 2007–2008 world food-pricecrisis, when grain prices spiked. In anticipation of price rises, cereals sellers ceased bringingshipments to ECX, greatly reducing its throughput and revenues, and undermining its financialindependence. In December 2008, the ECX authority swiftly introduced coffee (Gabre-Madhin2012) in order to ensure ECX’s financial survival.Whereas trading of cereals through ECX was voluntary, the trading of coffee through ECX wascompulsory under a government proclamation (Proclamation No. 602/2008). In addition tocreating a thicker coffee market, the proclamation in effect guarantees a constant income streamfor ECX, allowing it to capture a share of the value produced by the coffee sector. The mandatoryincorporation of coffee to ECX brought the demise of Ethiopia’s old coffee trade regime, whichhad operated for three decades.2.2 The old coffee trade regimeThe old regime was installed by the communist Derg in 1977 to tighten control over the coffeesector. When the current government came to power in 1991, it initiated limited liberalizationthat permitted greater private participation in the coffee sector, although the reform was partial,for fear that unrestrained liberalization would breed vertical integration.2 The coffee supply chainremained heavily regulated and compartmentalized, both geographically and functionally. 3 Inparticular, coffee growers were required to sell all outputs in auction houses; it was not until2001 that they could engage in direct export if they could find international buyers, bypassing theauction system. 4 However, direct export has historically accounted for no more than 15% ofannual exports. For local traders who purchase coffee from farmers, the auction system remainsthe only legitimate marketing channel.Figure 1 presents a schematic of the coffee supply chain. Two features of the old regime deserveattention. First, the coffee trade was centred on auction houses. Considerable efforts wereinvested in keeping consignments separate in storage. Prior to an auction, samples of theconsignments, along with sellers’ information, were put on display, and sellers were presentthroughout the auction process. Second, before coffee shipments could be transported abroad,exporters had to acquire clearance from the Cupping and Liquoring Unit (CLU), a governmentagency charged with assuring export coffee quality. CLU graded each shipment by cup tasting2LMC International (2000) and Petit (2007) provide detailed summaries of the reform.Each agent in the supply chain fulfils a designated purpose. Sebsabies, or petty coffee collectors, were onlylicensed to buy from farmers; arrabies, or wholesalers, could only buy from sebsabies and sell coffee in auctionhouses; exporters and domestic suppliers in turn could only buy from auctions; domestic roasters could only buyfrom domestic suppliers. All licensees were restricted to stipulated geographic areas (Petit 2007). However,loopholes in the system allowed some exporters to achieve vertical integration to a degree.4Smallholder farmers account for 95 per cent of total production, the balance being from private or state-ownedplantations (Chemonics International 2010, p. 3).33

and physically counting the defects in a sample. Coffee of quality below a certain threshold wasrejected. As will become apparent, CLU’s assessment of export coffee quality is important in theempirical exercise that follows.Figure 1: Coffee flow in Ethiopia before ECXNote: Direct export by coffee producers (farmer cooperatives and plantations) was not permitted until 2001, and even today accounts for a minorshare of total coffee exports.Despite having operated for decades, the old coffee regime was fraught with problems. First,contract enforcement was weak. Buyers could renege on bids with impunity. When bids werehonoured, payments were often delayed and occasionally defaulted. Second, the distancebetween auction houses and local markets, coupled with weak telecommunications infrastructure,prevented local farmers from acquiring information about coffee prices. There was anecdotalevidence that sellers and buyers colluded to suppress the price paid to local farmers and the taxesowed to the government. 5 The regime created an environment that was unsatisfactory toproducers, suppliers and the government.2.3 ECX’s new coffee trade regimeFrom December 2008 ECX replaced the old auction system. Figure 1 is still an accuratedepiction of the coffee flow, except that ECX replaces the auction house. Local traders bringcoffee to ECX’s regional offices, where ECX staff sample the coffee and assign it a geographiclabel and a grade. Coffee shipments are then taken to nearby ECX warehouses where coffee ofthe same zonal label and grade are stored in the same compartment without identity tags or othermeans of distinction. Sellers then sell the coffee on ECX’s trading floor. Unlike the auctionsystem, coffee samples are not put on display, nor is the identity of sellers revealed. Buyersacquire no more information than that provided in coffee contracts, namely, the coffee variety5Despite licensing regulations, some exporters were able to run coffee-collecting businesses (as arrabies) and helddual-seller licences by proxy. Having two licences allowed them to buy back their own coffee in auctions (LMCInternational 2000, p. 22; Mezlekia 2009).4

(indicated by the zonal label), its grade and volume. ECX also broadcasts coffee prices in realtime. Contract settlement takes place within the a few days. 6 ECX adopts a first-in-first-outdelivery system: coffee that is stored the earliest is delivered first to the next immediate buyer. Inpractice, buyers receive from ECX coffee of the agreed variety, grade and volume, but theshipments are almost certainly not those initially offered on the trading floor, which will bedelivered to future buyers in unrelated transactions. Figure 2 presents a schematic of ECX’scoffee trade operations, which closely mimic its cereals trade operations.Figure 2: Coffee trade at ECXECX appears to have made a significant contribution to rectifying problems of the old coffeeregime. Evidence in the literature and the media (Tadesse 2010, p. 15; Bjerga and Patton 2011a;Tefera 2012; AFP 2013), as well as findings from a 2012 field study in Jimma (personalinterviews with farmers and traders in several villages close to Jimma, 1–5 June 2012), attest toECX’s contribution as a clearing house and in enhancing price transparency. The ECX systemwas also designed to thwart seller–buyer collusion. The concealment of seller identity duringbidding is insufficient to achieve this, as colluding parties may identify each other by specificprice–volume signals. Instead, first-in-first-out delivery is the centrepiece. As buyers no longerreceive the specific lots that the counterparty put on sale, the former’s incentive to collude all butvanishes. Given first-in-first-out delivery, it is immaterial which lots the buyers receive, so longas the contract specifications (variety, grade, and volume) match. It is likely that storage withoutidentification has been adopted from the cereals trade operations to reduce operating costs.2.4 Commoditization of Ethiopian coffeeThe ECX coffee regime is marked by a trend towards commoditization, as is evident in the waycoffees are stored and delivered. To store similar coffee in the same compartment withoutdistinction is to disregard the subtle differences in cup taste within a grade category, and specificspatial and grower origin under the same areal label. First-in-first-out delivery has a similar effectof homogenizing the coffee, as buyers will receive a coffee blend from multiple, anonymized6ECX members maintain both pay-in and pay-out accounts in designated banks. ECX transfers deposits betweenaccounts to clear transactions; it boasts a settlement period of one day after transaction (T 1).5

sources. ECX’s plan for storing coffee in silos is also suggestive of this trend (personal interviewwith two senior ECX officials, 8 June 2012). Interestingly, the Ethiopian government alsoendorses commoditization, as indicated in a 2011 directive that all export coffee be shipped inbulk containers. Previously, the industry practice was to keep coffee in 60 kg jute bags, whichhad the advantage that different coffee lots could be transported in a single container whilemaintaining lot separation. Shipment in bulk containers would require large overseas wholesalersto repackage coffee beans, and force out of the market many medium-sized distributors andspecialty coffee roasters who bought small volumes. Faced with strong resistance, thegovernment revoked the directive within a month (Mezlekia 2011).Coffee that passes through ECX thus becomes less distinct in cup taste and is non-traceable inspatial or grower origin. Compared to coffee that is directly exported by producers, ECX-sourcedcoffee is a less differentiated product, although it may be of the same quality at the farm level.While commoditization is the direct consequence of measures taken to thwart collusion, it can beunderstood in a broader historical context. Commoditization and the subsequent weakening oflinkages between coffee merchants actually eased the government’s apprehension about thepredominance of private interests in the coffee sector – historically the most important in theEthiopian economy. In addition, because there was little preparation time in introducing coffee toECX, the coffee regime was modelled on ECX’s cereals trade operations.Ever since details of the ECX regime were announced in 2008, industry practitioners andobservers at home and abroad have continually voiced concerns that commoditization eliminatestraceability.7 The general opinion is that the mixing of coffee beans is equivalent to the blendingof French wines in a “big, nasty cuvée” (quoted in Bjerga and Patton (2011a)). The SpecialtyCoffee Association of America (SCAA) was particularly concerned that ECX ruled out thepurchasing of coffee from a single source. To accommodate overseas specialty coffee buyers,ECX established a second platform, direct specialty trade (DST), that traded fully traceablecoffee. Prior to a monthly DST auction, ECX posted information on individual lots on itswebsite, including the grower, geographic origin and cup profile. Coffee samples were also sentto registered potential bidders upon request. DST was initiated in February 2010 but was quicklydiscontinued after two trading sessions, owing to the small number of transactions.8 Since thenECX has made no further attempt to trade traceable coffee.2.5 The consequence of commoditization7There has been no lack of media coverage. See Allison (2009), Frenette (2010), and Bjerga and Patton (2011b) forexamples.8It is unclear why DST failed to generate as much interest as had been anticipated. One plausible reason may beDST’s rather exclusive nature. On the supply side, only specialty-grade coffee could be traded through DST; on thedemand side, only 30 buyers, all overseas, were registered (ECX 2010a). Sellers at ECX had to demonstrate thatcoffee farmers would receive at least 85 per cent of the free on board (FOB) price (ECX 2010b, p. 20). This left only15 per cent of the proceeds to be divided among other participants in the supply chain, greatly diminishing theattractiveness of DST as a marketing channel.6

Cereals are bulk commodities, and commoditization is suitable as it takes advantage of anyeconomies of scale in their marketing. However, commoditization is inappropriate for coffeebecause of its great product differentiability. Whereas cereals have only a few key qualityindicators, connoisseurs have developed a rich lexicon comparable to that used for wine todescribe coffee’s complex cup taste. Storing homogenous cereals in bulk does not significantlyalter the quality, but storing coffee in bulk would smooth out the distinct characteristics ofindividual lots. Furthermore, cereals and coffee have different consumer groups. Cereals aremostly consumed by locals for subsistence, with little attention paid to their origin. In contrast,coffee drinkers increasingly care about coffee traceability, which is a prerequisite for coffeecertification and a desirable characteristic of gourmet coffee. 9 This information is lost throughcommoditization, and the mandatory trading of coffee through ECX forces much of the exportcoffee to undergo this anonymizing process. Its imperfections notwithstanding, the old coffeeregime preserved coffee traceability – the ability to guarantee the origin of coffee – moreeffectively than does the current regime. ECX has artificially created information asymmetry. Ineconomics, the transition from the auction system to ECX represents a transition from a game ofcomplete information to one of incomplete information from the perspective of the overseasbuyers. Game theory predicts that non-traceability will suppress the price of non-traceablecoffee.3. Empirical EvidenceRecall that there are two legal channels for coffee export. Exporters that do not grow coffee mustbuy from ECX, while coffee producers may export coffee directly. As overseas buyers canestablish direct contact with producers, direct export coffee (hereafter producer coffee) isperfectly traceable. In contrast, coffees that are purchased from ECX (hereafter trader coffee) arenon-traceable by design. Whereas traceability adds value by enhancing product differentiation,commoditization diminishes it. It is hypothesized that, holding everything but the source ofcoffee constant, overseas buyers will pay less for trader coffee in response to commoditization.3.1 Data sourceDuring a field study, a dataset on export coffee transactions was acquired from the Ministry ofTrade (MOT) of Ethiopia which contains enough information to test the hypothesis. Table 1shows five random entries from this dataset.Table 1: Random entries in the MOT 8AprExporter 1Jimma4South Africa200920102011DecSeptJuneExporter 2Exporter 3Exporter 4TeppiLimmuYirgacheffe253BelgiumFranceUnited StatesWeight(MT)7236125The most common certifications include shade-grown, organic and Fairtrade certifications.7FOB value(000s USD)210.791.3915.4

2012AugExporter 5Harar4Japan1689.6Note: Exporters are anonymized in this table; grade is assigned by CLU.Source: Ministry of Trade (MOT), Ethiopia.In total there were around 13 000 transaction entries from 2007 to 2012. The dataset containsinformation on the value, volume and destination country of green (unroasted) coffee exportedby individual exporters on a monthly basis. As explained, export regulations oblige coffeeexporters to acquire clearance from CLU (see Figure 1). The MOT dataset contains informationabout the variety and grade of shipments, as assigned by CLU. Since grading occurs before theactual shipment but afte

In December 2008, the Ethiopian Commodity Exchange (ECX) opened a new coffee platform that has transformed Ethiopia’s coffee trade. The way ECX handles coffee in a commodity fashion has eroded traceability, a characteristic sought after by overseas coffee buyers. This paper traces the forces that give rise to the commoditization of coffee. .

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