Farmers make decisions in a risky, ever-changing environment. The consequences of their decisions are generally not known when the decisions are made, and outcomes may be better or worse than expected.

Variability in prices and yields are major sources of risk in agriculture. Changes in technology, legal and social concerns, and the human factor itself also contribute to the risky environment for farmers. Risky situations of concern are typically those in which:

i. There is a high possibility of adverse consequences.

ii. The adverse consequences, should they occur, would cause significant disruptions.

Some risks are unique to agriculture, such as the risk of bad weather significantly reducing yields within a given year. Other risks, such as price or institutional risks, while common to all businesses, reflect an added economic cost to the producer.

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Types of Risks in Agricultural Production

The following are the major categories of risks in agricultural production:

1. Production or Yield Risk

Any production-related activity or event that is uncertain is a production risk. Agricultural production implies an expected outcome or yield. Variability in outcomes from those expected creates risks to the ability to achieve financial goals.

Production or yield risk occurs because agriculture is affected by many uncontrollable events that are often related to weather, including excessive or insufficient rainfall, extreme temperatures, hail, insects, and diseases.

Technology plays a key role in production risk in farming. The rapid introduction of new crop varieties and production techniques often offers the potential for improved efficiency but may at times yield poor results, particularly in the short term.

In contrast, the threat of obsolescence exists with certain practices (for example, using machinery for which parts are no longer available), which creates another, and different, kind of risk. For decades, agricultural risk has been synonymous with production risk. Reducing variability in expected yields has been a major focus of farm managers.

Over time, improvements in technology and production practices have helped decrease agronomic risks and increase yields. For example, genetic engineering has produced new seed varieties that are disease and drought-resistant, commercial petroleum-based fertilizers have increased yields.

Effective herbicides and insecticides have been developed to control weeds and bugs, and a whole host of improved production and management practices have been disseminated. The same underlying changes that are driving the increase in economic risks are also changing the nature of production risks.

Not only is yield variability still a formidable production risk, but the industrialization of agriculture is impacting the entire agricultural production sector. Changes that initially started in the livestock sector are now starting to revolutionize the crop industry.

These structural shifts mean that farmers are vulnerable not only to the vagaries of weather and Mother Nature but also to economic forces that exacerbate traditional production risks.

Production risk is likely to grow due to climate change and globalization. Indeed, there is an expectation of a higher incidence of extreme weather events. Globalization is also likely to drive an increased frequency of pest or disease outbreaks.

Some consider that cross-compliance measures with respect to agro-chemicals may also increase yield risk, such as the Nitrate Directive or the Water Directive requiring less spraying in the vicinity of water. It can also be argued that these measures will give incentives to use agro-chemicals more judiciously or to find alternatives (e.g., crop rotation), thus potentially reducing yield risk.

Yield risk is smaller in the livestock sector for most producers, as weather has a smaller influence. The risks mainly stem from disease, mechanical failure in confinement operations, and variability in weight gain.

2. Price or Market Risk

Price risk reflects risks associated with changes in the price of output or of inputs that may occur after the commitment to production has begun. In agriculture, production is generally a lengthy process.

Livestock production, for example, typically requires ongoing investments in feed and equipment that may not produce returns for several months or years. Both input and output price volatility are important sources of market risk in agriculture.

Prices of agricultural commodities are extremely volatile. Output price variability originates from both endogenous and exogenous market shocks. Segmented agricultural markets will be influenced mainly by local supply and demand conditions, while more globally integrated markets will be significantly affected by international production dynamics.

In local markets, price risk is sometimes mitigated by the “natural hedge” effect, in which an increase (decrease) in annual production tends to decrease (increase) output price (though not necessarily farmers’ revenues).

In integrated markets, a reduction in prices is generally not correlated with local supply conditions, and therefore price shocks may affect producers in a more significant way. Another kind of market risk arises in the process of delivering production to the marketplace.

The inability to deliver perishable products to the right market at the right time can impair producers’ efforts. The lack of infrastructure and well-developed markets makes this a significant source of risk in many developing countries. Market risk can further be classified into:

i. Input price risk (risk associated with input or factor prices).

ii. Output price risk (risk associated with prices of farm outputs).

i. Input Price Risk

In crop agriculture, input price risk has been considered less substantial than output price risk and yield risk. It does not translate into return variability of the same magnitude.

Moreover, the time window of input price risk is shorter: fertilizer and input costs are usually incurred within a few months of the onset of production, whereas the uncertainty around output price and yield usually remains for at least six months.

However, the magnitude of input price fluctuations can be significant, and there is no system in place to hedge against input prices (although there is the possibility of storing some items on the farm). Input price risk is still significant and may be overlooked.

Variability in fuel prices and fertilizer prices appears to be the main component of input price variability in crop production, partly because fuel and fertilizer amount to most of the input costs in conventional agriculture, and partly because, as commodities themselves, they are subject to price fluctuations like all other commodities.

These variabilities are expected to increase in line with increased volatility of energy prices. With respect to the livestock sector, input costs amount predominantly to feed costs. Changes in the price of feedstuffs can have a significant effect on livestock production.

ii. Output Price Risk

Output price risk arises due to the biological lag inherent in agricultural production. Producers must make production decisions months (even years for tree crops) before they have a product to sell, before the actual crop prices are known.

During this period, output prices may change dramatically in response to shocks in supply and demand. This may put farmers in a difficult situation if commodity prices decrease drastically during the production and marketing cycle.

Many factors are responsible for price changes. These factors include income and population growth, rising energy prices, and subsidized biofuel production, which have contributed to surging consumption of agricultural products.

At the same time, productivity and output growth have been impaired by natural resource constraints, underinvestment in rural infrastructure and agricultural science, farmers’ limited access to agricultural inputs, and weather disruptions.

While speculation has been mentioned as a driver of price increases, the issue has been heavily debated, and there is no conclusive evidence that speculation drove prices up. The consumption of cereals had also been consistently higher than production in previous years, which had reduced stocks.

Stocks play a critical role through their cushioning effect: low levels of stocks are associated with high price volatility. Macroeconomic factors also impact the volatility of agricultural prices, such as variability in inflation rates, exchange rates, and interest rates.

The effect of shocks on the agriculture and food system is compounded by low elasticities of both supply and demand. Since food is an essential product with no substitute (apart from alternative foods), demand responses to price increases are typically low (until, for the poorest, it translates into hunger).

Supply responses are also very low in the short term, until production decisions can be made for the next season or more land is brought into or taken out of production.

3. Institutional or Regulatory Risk

Institutional risk results from changes in policies and regulations that affect agriculture. This type of risk is generally manifested as unanticipated production constraints or price changes for inputs or output.

For example, changes in government rules regarding the use of pesticides (for crops) or drugs (for livestock) may alter the cost of production, or a foreign country’s decision to limit imports of a certain crop may reduce that crop’s price.

Other institutional risks may arise from changes in policies affecting the disposal of animal manure, restrictions in conservation practices or land use, or changes in income tax policy or credit policy.

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4. Human or Personal Risks

Farmers are also subject to the human or personal risks that are common to all business operators. Disruptive changes may result from events such as death, divorce, injury, or the poor health of a principal in the firm. In addition, the changing objectives of individuals involved in the farming enterprise may have significant effects on the long-run performance of the operation.

5. Asset Risk

This is also common to all businesses and involves theft, fire, or other loss or damage to equipment, buildings, and livestock. A type of risk that appears to be of growing importance is contracting risk, which involves opportunistic behavior and the reliability of contracting partners.

6. Financial Risk

Financial risk results from the way the firm’s capital is obtained and financed. A farmer may be subject to fluctuations in interest rates on borrowed capital or face cash flow difficulties if there are insufficient funds to repay creditors. The use of borrowed funds means that a share of the returns from the business must be allocated to meeting debt payments.

Even when a farm is 100-percent owner-financed, the operator’s capital is still exposed to the probability of losing equity or net worth. Price risk and production risks are usually considered the most important in agriculture and are discussed below. Policies are part of the solution in addressing these risks but are also associated with regulatory risks.

Other Classifications of Risks

Apart from being categorized according to their sources, risks can be classified according to the frequency of the occurrence of negative events and the magnitude of their impact.

1. Normal Risk: Risks associated with frequent events that do not cause large losses are known as normal risks. These include risks such as normal fluctuations in prices and production. Normal risks are managed on the farm and by general government policies.

2. Catastrophic Risk: Events that are infrequent but lead to severe damage to a whole region (e.g., floods, droughts, or pest and disease outbreaks) typically fall under the catastrophic risk layer, for which market solutions have played a less important role, mostly due to high public involvement.

In developed countries, financial markets and insurance provide solutions to catastrophic risks, while in Nigeria, the state or federal government provides relief to affected farms/farmers via the national disaster relief agency.

3. Idiosyncratic Risk and Systemic Risk: Risks that affect few farms are known asidiosyncratic risks, while risks that affect a large number of farms are known as systemic risks. Examples of idiosyncratic risks are illness of the owner or laborers, acidic soil, and particular plant and animal pests and diseases.

Risks affecting a large population at the same time, such as droughts, floods, or price shocks, are more difficult to manage within the sector. The high propensity for covariate risk in rural areas is a major reason that informal risk management arrangements break down and that formal financial institutions hesitate to provide commercial loans for agriculture (Jaffee, Siegel, and Andrews, 2010).

In this article, the categories of risks in agriculture have been discussed. These include production risk, price risk, and human or personal risks. Price risk and production risks are usually considered the most important in agriculture.

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