Written By: William M. Fitzgerald, CFA
August 29, 2014
The White House Rural Council announced its plans to start an investment fund called the Rural Infrastructure Opportunity Fund that will give pension funds and large investors the opportunity to invest in infrastructure projects that support the agriculture industry. The purpose of this program is to encourage private investment in the rural communities that are the agriculture sector of the U.S. economy. CoBank, which is a cooperative bank and a member of the Farm Credit System, has committed the first $10 billion to the fund. Capital Peak Asset Management will manage the fund's investments and the Agriculture Department will source projects for the fund. Investors will be able to make debt and equity investments in individual and bundled projects.
Our concern with this program is that it assumes that all that is required to advance the agriculture industry in the United States is to give investors a little nudge to send capital to an "overlooked" investment opportunity. However, policy makers fail to understand that investment capital flows to any sector that offers a competitive return. It is not access to financial capital that is the problem for the agriculture industry, but other factors that unfavorably influence the markets for agriculture products and discourage investments in infrastructure that would support the industry. These factors include (1) the economics of the agriculture sector, (2) the failure of policies to manage the natural capital consumed by the sector, and (3) the lack of synchronicity of policies that could, if properly aligned, encourage investment capital without the need for a "nudge" from government.
Economics of the Agriculture Sector
The first conclusion that investors draw about agriculture businesses is that they are not very profitable. The primary reason is that prices of agricultural products have not increased as quickly as the cost of fuel required to operate machinery and transport products to market. During the twenty years between 1993 and 2003, the prices of corn has increased by 177%, wheat by 128%, cattle by 84% and milk by 54%.1 By comparison a barrel of Brent Crude oil increased by 568% during the same time period. The compression of operating margins of farming businesses is one of the significant drivers of consolidation in agriculture.
Supply and demand in the market for agriculture products in the United States is significantly influenced by federal government policy. In total, the U.S. Department of Agriculture will spend $149 billion in 2014 through 240 subsidy programs2. A number of these programs, totaling approximately $22 billion, encourage the supply of agricultural products to make food affordable to American households, including:
Direct payments to farms that produce crops such as wheat, corn, barley, oats and cotton, typically totaling $5 billion annually; Non-recourse loans up to $7 billion annually to farms that produce these and other crops, allowing borrowers to deliver the crops rather than repay the loan should loan amount exceed the value of the crop; Direct subsidy payments to farms when prices of agricultural commodities drop below specified levels, totaling between $1 billion and $4 billion annually in subsidy depending on prices; Subsidies for crop insurance totaling $4 billion that allow farms to pay as little as one-third the market rate for such insurance; A government guarantee to acquire any excess cheese, butter and non-fat dry milk that a farm produces in a year; and Monthly payments to milk producers when prices fall below target levels.
The effect of this array of policies is to systematically create an oversupply of agricultural products, which inadvertently reduces the pricing power and profitability of farms and small businesses in rural communities that support them. The lack of profitability keeps investors for allocating capital to agriculture businesses.
Failure of Policies That Manage Natural Capital
Water is important to both farms for irrigation and to food processors for production. But the state and federal policies that organize the use of this shared resource have not encouraged private investment. For example, the Colorado River is a primary source of water for agriculture businesses that are located in the seven Western states through which it traverses, and is an important source of drinking water for urban centers that include Phoenix, San Diego and Los Angeles. In 1922, the states of Arizona, California, Colorado, Idaho, Nevada, New Mexico and Utah agreed to an appropriation system that divides 16.4 million acre feet annually, even though only 13.5 million acre feet passes the river in an average year3. The appropriation doctrine states "first in time, first in right," which means that someone with a higher priority allocation must use it for a beneficial purpose or lose the allocation to someone with a lower priority position. While a market exists for selling allocations, the law restricts the sale of excess water to 20% of one’s allocation. This creates a distorted market for a critical natural resource. Water from the Colorado River is virtually free for those with priority rights but can be extraordinarily expensive for those with no or low priority rights (one acre foot was recently bid at $22004).
By underpricing water to the "firs in time," this policy has encouraged excess demand for a finite natural resource. According to a recent study by NASA and the University of California at Irvine, the Colorado River Basin has lost 53 million acre feet of water during the past nine years due to elevated consumption during the recent drought5. Local governments are working to solve the shortage of water by planning infrastructure to store and transport excess water and to treat wastewater for re-use. If a free market accurately valued water from the Colorado Basin, local governments could easily offer an attractive financial return for investments in water infrastructure to those who provide capital in the private market without any incentive or "nudge" by government.
Lack of Synchronicity of Policy
We have seen examples of how local policies for managing wastewater provide disincentive for investors to provide capital. One example is the policies of the State of Wisconsin for managing the waste that food processing plants generate. Food processors commonly produce liquid waste that contains high concentrations of phosphorous, which is a valuable ingredient in fertilizers used to increase the production of many crops. Many food processors receive licenses from the State to spread this liquid waste on farmland, an arrangement in which the food processors merely pay the cost of transporting the waste in trucks. However, when phosphorus is spread on farmland in liquid form, it can run off into local tributaries and lakes and create algae blooms that damage sources of drinking water. The City of Toledo, Ohio recently banned users of its water system because of such an algae bloom in Lake Erie, its source of drinking water.
Alternatively, food processors can dispose of their waste at treatment plants that are able to separate the phosphorus and other contents that may be harmful to the habitat. But unlike the food processing companies, the State imposes specific limits on the amount of phosphorus that may be present in the water that a treatment plant discharges. A treatment plant can remove 90% of the phosphorus in the waste of a food processor and still not meet the standard for the removal and be subject to a fine. Moreover, the treatment plant will have removed and stored a substance that would otherwise harm the local habitat and receive no financial benefit from this activity. Such policies lower an operating expense of the food processing company while increasing the operating expense for the waste treatment plant. By narrowing the operating margin of the waste treatment plant in favor of widening the operating margin of food processing company, the government has encouraged private investment in the food processor at the expense of the infrastructure project. No new government program can "nudge" investors enough to compensate for this type of distortion. All government needs to do is properly align its policies – assess fees to the food processor that threatens the source of drinking water and provide financial benefit to the treatment plant that removes the harmful waste.
Seven years ago, the federal government of the U.S. encouraged private financing of ethanol producers by requiring refiners to blend ethanol into vehicle fuel, creating demand for the additive and offering an incentive to attract investors. Recently, the EPA reduced that mandated blend by 12%, which will cause up to 20 ethanol plants to close6. The economics of ethanol didn't support its use in vehicle fuel, so "nudging" private capital to invest in the industry invited them to lose their money.
We believe that investment in infrastructure must balance the goals of government policy and the underlying economics of industry. It must balance the benefits that local economies produce, such as products and jobs, and the natural resources that they consume, such as water. The examples we describe above demonstrate that a lack of balance leads to the loss of both natural capital and financial capital.
1. Farmdoc, University of Illinois at Urbana-Champaign, www.farmdoc.illinois.edu.
2. Edwards, Chris, "Downsizing the Federal Government," CATO Institute, June 2009.
3. Gelt, Joe, "Sharing Colorado River Water: History, Public Policy and the Colorado River Compact," Arroyo, August 1997, Volume 10, Number 1.
4. "Profiting From California’s Epic Drought," Bloomberg Businessweek, August 11 – August 24, 2014.
5. "Satellite Study Reveals Parched U.S. West Using Up Groundwater," NASA, July 14, 2014.
6. "Ethanol Mills Face Closure as Obama Cuts Target," St. Louis Post-Dispatch, December 4, 2013.