The EU deforestation regulation went into effect on June 29, 2023, and immediately after it was implemented, the European coffee stocks started a series of impressive declines amounting to 3.12m bags from Jun to Oct. While stocks had been decreasing in destination markets for the last 2 years based on calendar spread inversions, this large 26.9% reduction in only a few months has placed Europe stocks at historically low levels and highlighted concerns about this new regulation.
Essentially, the regulation restricts commodities like coffee from entering the EU market or being exported from the Union if they have contributed to deforestation or forest degradation. The impending EU Due Diligence Regulation (EUDR) is expected to have cost implications on coffee entering the European market, this means additional disincentive for storing coffee in Europe and likley contributed to the decline in both ECF and EU based cert stocks.
The exact price increase per pound to be in compliance is unknown and likely varies from origin to origin. However, the burden of implementing these measures falls primarily on companies storing coffee in the EU market, as they face the risk of hefty penalties (up to 4% of turnover) for non-compliance. All of this implies a major challenge from implementing these measures in a complex supply chain comprised of millions of smallholder farmers in tropical climates, many of whom have very modest incomes.
Over the next couple of years, while the market digests the impact of this regulation, the threat to European stocks may add a bullish component to the coffee market, as it impacts the certified stocks (97% of certs are in Europe) and the ECF stocks. Others with more knowledge on the subject can highlight or debate the merits of this regulation, but for this blog, we will dive deeper into what the EUDR means for the coffee futures market and its potential implications for prices. First we wil provide some background on the regulation, then we will outline the requirments, and finally we will discuss the impact on the markets.
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Background – How the EUDR was Born?
Deforestation has been in the spotlight of the EU’s attention for some time. According to the Food and Agricultual Organization of the UN, it is estimated that ten million hectares of forest are lost worldwide each year, with almost 90% of being caused by agricultural development, and the conversion of forests into agricultural land. For the EU, the top six commodities — oil palm (34.0%), soy (32.8%), timber (8.6%), cocoa (7.5%), coffee (7.0%), and cattle (5.0%) — account for the largest percentage of deforestation. According to an impact assessment of the EUDR, the European Union's consumption of these six commodities will be associated with ~248,000 hectares of deforestation annually by 2030.
In consideration of this, the EU began considering legislation, and on December 2022, the EU parliament passed the European Deforestation Regulation (EUDR) bill, which entered into force by 29 June 2023. This legislation was launched in an effort to combat the deforestation and forest degradation related to products that are imported by the EU market and those produced and exported out of the union. In particular, the regulatory framework seeks to recognize and address how the Union's consumption and the trade of commodities contribute to deforestation and forest degradation within the EU and Globally.
Currently, the operators and exporters of the (above-mentioned) six commodities are preparing for the implementation of the regulation and are in a transition period lasting from 18 months to 24 months (depending on the size of their company). The regulation requires any dealer or operator that sells these commodities within the EU or exports them outside to prove that the products are not sourced from deforested land (cutoff date: December 31, 2020) or contribute to forest degradation.
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EUDR Requirements
Coffee producers and operators importing coffee to EU are required to demonstrate that the product does not contribute to deforestation and forest degradation. To comply, they need to share the geolocation coordinates of the coffee farm from which the coffee has been harvested. This ensures that the plot has not contributed to deforestation.
To ensure compliance with the regulation, the EUDR prohibits any operators from trading any coffee or derivative coffee products either from or to the EU, until they prove that the coffee has been produced in compliance with the regulation. This restriction will become legally enforceable after an 18-month transition period (30 December 2024 for major operators and up to 24 months 29 June 2025 for small operators).
To document this, a due diligence statement is required for commodities entering the EU market. This certifies that the relevant goods are produced in accordance with applicable national regulations and free from deforestation. The responsibility of proving conformity with the EUDR rests with the "Operator" bringing goods into the EU, and companies that violate the regulations may be fined up to 4% of their EU sales. Moreover, a three-tiered benchmarking system with countries categorized as low, standard, or high risk is planned. The method will enable authorities to concentrate their inspections on commodities from high-risk countries, while operators can perform simplified due diligence on products from low-risk nations.
How will the EUDR affect the Dynamic of the Coffee Market?
The first and more obvious effect of the EUDR is already at play, and it’s the decrease in coffee inventories being held in Europe. This not only affects the totality of the European stocks (ECF stocks), but also the certified stocks (down -58% vs Jun), as most of them (~97%) are held in European ports, such as Antwerp, Hamburg and Bremen.
Some of this reduction in stock levels in Europe may be transitory. It’s likely that the Commercials are avoiding having their coffees stored in Europe until they get more clarity on what the costs (and risks) will be from the regulation. However, some of this might be permanent. If some portion of inventory was historically held within the EU and then later traded to countries outside of the EU that do not have regulations, that portion of inventories may now be stored externally.
There are other factors at work that have reduced inventory in the EU as well. Consumption has been reported weak, from high prices and inflation, high interest rates there (4.5%, near 25Y highs) and the calendar spread inversion in both the Arabica and Robusta markets have also made carrying coffee very expensive. When we add in the deforestation regulation, it adds to a mix of factors that have been pushing stocks to new declines.
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Even though the market is transitioning to a period of global surplus, the lack of stocks in destination is a very visible statistic that can help to drive the market higher. Indeed, ECF and cert stocks have seen a consistent decrease in the past few months, contributing to a rally in Arabica and Robusta from Oct-Dec. If declines continue at a similar rate for a few more months, destination stocks will be at critically low levels and further support coffee prices.
Going Forward
The EU market is expected to shift its focus to producer nations that can keep up with the EUDR and are better prepared to provide traceability and ensure minimal risk of non-compliance of products, such as Brazil and Costa Rica. However, the EUDR is expected to greatly impact coffee origins with a high percentage of smallholder coffee producers, such as Vietnam, Indonesia, Honduras, Ethiopia. These origins are key providers of coffees to Europe, with Honduras being a primary supplier of cert stocks.
ON account of the uneven impact, the EUDR has faced greater resistance from some producing countries. For example, Airlangga Hartarto, Indonesia’s chief economic minister, has called this “regulatory imperialism”. Indonesia is the 4th largest exporter of coffee in the world and exports significant portions to the EU. The concern is that the regulation will not only affect stocks in Europe, but also coffee exports (consequently revenue and GDP) of external sovereign states.
Additionally, countries like Guatemala and Peru, with large coffee productions linked directly to deforestation (according to the RFA reports) are going to face big challenges to comply to the EUDR.
On the other hand, countries like Brazil, with big farms, well-prepared land title data, forest monitoring data, and Polygon data will have an opportunity to increase exports to the EU. Since the EU covers nearly half of the world's coffee consumption, and the other origins may be unable to meet the demand by exporting the same volumes that they used to, countries like Brazil may have a competitive advantage. However, even though Brazil may be able to leverage exports to the EU, the net effect may be negative (meaning, less Europe coffee stocks/imports), if compliance ends up restricting the other origins: it’s unlikely that Brazil alone will be able to cover the losses in exports/stocks from other origins in such scenario.
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How Companies are Acting Towards the EUDR
Many companies from different countries are already reacting by helping farmers and exporters prepare for the EUDR regulation. These initiatives are particularly heavy in origins that have a predominance of smallholder producers, as they are more vulnerable to the regulation.
The IDH, supported by ten coffee companies, is currently supporting producers in the Central Highlands of Vietnam to prepare for compliance to the regulation. Uganda is also actively working to enable the large population of smallholder farmers to prepare for it. Although a little late to the party, the Ethiopia Coffee and Tea Authority is also taking the initiative to support smallholder farmers and predominantly pushing exporters to start registering of out-grower farmers that work in partnership with them.
The 5th largest exporter of coffee, Ethiopia would be negatively affected, since it has a large population of smaller-holder farmers and a significant portion of its coffee exports going to the EU. Importing companies like Nestle and ECOM, that have non-deforestation policies (NDPE) already in place, are so they are expected to have a smoother transition into compliance with the EUDR. Sustainability certifications such as Rain Forest Alliance, Fair Trade, and Organic are anticipated to assist operators in conducting risk assessments. However, they are not directly linked to enhancing preparedness for compliance with the EUDR.
Conclusion
All considered, we can draw some conclusions about the impact of the EUDR. First, the EUDR is likely to reduce inventories as the participants reduce exposure to any coffees that they are uncertain about. While this adjustment period is temporary, as the operators learn the realities on the ground, some coffees may leave the EU permanently for external countries.
Second, the EUDR will unevenly impact producing countries and Companies, with some of the largest and lowest income countries potentially hit hardest.
Ultimately markets adjust to the new realities of new regulations and this regulation will be no different: companies will understand the costs of the regulation and pass those on to the consumers. However, in the short term those trading coffee right now have to conclude that this regulation may add an additional hurdle to certifying coffee at a time when the certified stocks are at critically low levels.
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