The coming specialty coffee supply crisis How re-incentivizing the value chain can help mitigate the threat

A value chain analysis of the specialty coffee trade (Resumen ejecutivo en español)

Master of International Business Thesis

Submitted by Hayden B. Kwast

August 2010

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© 2010 Hayden B. Kwast

ALL RIGHTS RESERVED

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Abstract

Hayden B. Kwast: The Coming Specialty Coffee Supply Crisis, How re-incentivizing the

value chain can mitigate the threat, A value chain analysis of the coffee trade

(Under the direction of Laurent Jacque)

Specialty coffee in the United States has grown from an $8 billion sales industry in

2001 to $13.6 billion in 2008 and is expected to top $18 billion by the end of 2012.

Sustained growth in demand for specialty coffee at first appears as a positive sign for the

industry. But, as specialty coffee consumption grows in the mainstream, demand is

expected to outpace supply, which is more reason for concern than optimism. This

indicates that there are miss-incentives to produce specialty coffee somewhere along the

value chain. Can a re-orientation of the specialty coffee value-chain help incentivize coffee

producers to invest in higher quality coffee and meet growth in consumer demand?

This study examines recent and forecasted growth in the specialty coffee industry,

assesses research and successful case studies on value-added value chains, and then

reports on over twenty-five interviews conducted with organizations along the specialty

coffee value chain to identify the most critical gaps in efficiency and risk exposure. To help

illustrate the gaps in the value chain system, a system model is specified and analyzed.

Finally, from the results of the research, interviews and analyses, recommendations are

made as to how a new look at the specialty coffee value chain can help mitigate a possible

coming supply crisis.

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Acknowledgements

This study would not have been possible without the invaluable support and insight

from professors and research institutions at The Fletcher School, as well as professionals

within the coffee trade, including farmers, farmer associations, exporters, importers,

roasters, coffee shop owners, NGOs, certifiers and trade associations. It was a pleasure

working with all of you.

In particular, I thank my advisor, Laurent Jacque, The Walter B. Wriston Professor of

International Business, as well as the Center for Emerging Market Enterprises (CEME) at

The Fletcher School, Tufts University. My thanks also go out to those in the coffee business

that participated in this study and candidly shared their passion for all that is good in the

coffee trade and all that could be better. Finally, I appreciate and thank PJ Lamberson,

Visiting Assistant Professor at the MIT Sloan School of Management, for his contribution.

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Table of Contents

Page

I. Executive summary 6

Resumen Ejecutivo (Spanish Translation) 9

II. Introduction 13

III. State of the specialty coffee market 15

IV. Specialty value chain trends and research 19

V. Specialty coffee value chain interview results 24 Producers Exporters Importers Roasters Industry views on value chain gaps

VI. Value chain system analysis 34

VII. Modeling the value chain system 41

VIII. Conclusions and Recommendations 49 Specialty coffee current growth trajectory Target growth trajectory How to achieve the target growth trajectory Where the change is needed

IX. Appendix 54

Companies and individuals interviewed Consolidated interview results Works Cited

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I. Executive Summary

Specialty coffee1

This study examines recent and forecasted growth in the specialty coffee industry,

assesses research and successful case studies on value-added value chains, and then

reports on over twenty-five interviews conducted with organizations along the specialty

coffee value chain to identify the most critical gaps in efficiency and risk exposure. To help

illustrate the gaps in the value chain system, a system model is specified and analyzed.

Finally, from the results of the research, interviews and analyses, recommendations are

made as to how a new look at the specialty coffee value chain can help mitigate a possible

coming supply crisis.

in the United States has grown from an $8 billion sales industry in

2001 to $13.6 billion in 2008 and is expected to top $18 billion by the end of 2012.

Sustained growth in demand for specialty coffee at first appears as a positive sign for the

industry. But, as specialty coffee consumption grows in the mainstream, demand is

expected to outpace supply, which is more reason for concern than optimism. This

indicates that there are miss-incentives to produce specialty coffee somewhere along the

value chain. Can a re-orientation of the specialty coffee value-chain help incentivize coffee

producers to invest in higher quality coffee and meet growth in consumer demand?

The motivation for studying supply chains as value chains is to identify how to

change how actors along the chain perceive relations with each other, i.e. look at how

business relations can maximize value capture collectively, rather than view business as a

zero sum game. Past research on the specialty coffee value chain has provided analyses and

recommendations that target change within certain points in the value chain, as opposed to

a complete re-configuration of the value chain. The specialty beef value chain provides a

good example of a successfully reconfigured value chain.

Interviews conducted for this study reveal that the industry perception is that a gap

between producer value capture and the remainder of the value chain is the dominant

problem facing the industry. The four most commonly cited reasons that producers do not

capture sufficient value include poor market power and access, producers are not

1 “Specialty” refers to any differentiated coffee product. Ways to differentiate and thus capture more value from coffee include, but are not limited to, origin country, region, terroir, plant varietal, and certifications, such as Fair Trade and Organic.

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compensated commensurate with the amount of risk they bear, excessive commodity, or

“C” market volatility, and current efforts to help producers are insufficient. On the other

end of the chain, interview results show there is a gap between end-consumer demand for

specialty coffee and the ability of the entire tail of the chain to meet this demand. To a

certain degree, some see the entire industry as unable to fully capitalize on the value that

could be created from consumer demand for specialty coffees. And a notable number of

actors believe that a significant problem for the entire chain is a lack of IT adaptation.

Building upon the interview results in order to pinpoint how these gaps contribute

to supply and demand disequilibrium, analysis of the value chain, supported with the

illustration of a specialty coffee value system model, shows that the specialty coffee value

chain has two key problems that stifle production while industry demand continues to

grow. First, the current value chain system is a commodity system where actors are

primarily incentivized to buy low and sell high. Such an incentive structure leaves little

value capture for the farmer, which means little value is created to put towards investment.

Second, a long delay exists between producer investment and producer payoff in specialty

coffee production and profits. On the other end of the value chain, roaster marketing and

sales continue, which fuels industry demand and overall market growth. Industry demand

for specialty coffee is growing in a cyclical, accelerating manner and thus, is outpacing

production. This could potentially lead to a supply crisis.

Two outcomes are most likely, given a supply crisis. In one scenario, roasters slow

production even though reinforcing growth circles continue to accelerate consumer

demand. This means inventories are low compared to demand and specialty coffee prices

increase, most likely beyond price inelastic levels and, as a result, the quantity demanded

decreases, which has a stagnating effect on specialty coffee business growth. In the second

and more likely scenario, roasters continue to buy green coffee to meet demand growth,

but the supply of specialty coffee does not keep pace. This means specialty coffee producers

increasingly rely on inferior coffees that tastes badly. As a result, consumers will find it

more difficult to distinguish between commercial and specialty grade coffees, the industry

will become diluted and consumers will no longer believe in the legitimacy of “specialty”

coffee. In turn, they will prefer to buy cheaper, commercial grade coffees.

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Both scenarios lead to a phenomenon called “overshoot and collapse.” Overshoot

and collapse results when reinforcing industry demand loops are not met with

commensurate supply growth. Industries or products generally follow an s-curve growth

pattern in which demand increases slowly, then accelerates and plateaus. Specialty coffee

demand is arguably in the acceleration phase, but supply is reaching a plateau. In this case,

many consumers will abandon the specialty industry all together as they become

disgruntled with the product.

This study suggests that the industry needs to move away from a coffee sourcing

system that is based on a commodity product and, in doing so, decrease the influence of “C”

market price volatility on specialty coffee prices. Reconfiguring the specialty coffee value

chain, which would encourage more investment in specialty coffee and increase specialty

coffee supply, can achieve such a change. Two steps encompass how the specialty coffee

value chain should be adjusted so that supply grows with demand:

Step 1: Identify the value creation drivers for business along the entire value chain,

effectively managing these drivers can incentivize the agents in the value chain to

work together to produce, move, and sell specialty coffee.

Step 2: Reconfigure the specialty coffee value chain around these drivers through

increased partnerships between producers, exporters, importers and roasters that

involve three components:

• Risk sharing

• Information sharing

• Revenue sharing

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I. Resumen Ejecutivo

Café de especialidad2

Este estudio provee un resumen del crecimiento reciente en la industria del café de

especialidad, evalúa las investigaciones y estudios de casos exitosos de las cadenas de

valor, y realiza más de veinticinco entrevistas con las organizaciones a lo largo de la cadena

de valor del café de especialidad para identificar las brechas más críticas en cuanto a

exposición a riesgo. Para ayudar a ilustrar las deficiencias en el sistema de cadena de valor,

se elabora y analiza un modelo del sistema. Por último, a partir de los resultados de la

investigación, entrevistas y análisis, se hacen recomendaciones a cerca de cómo un nuevo

enfoque de la cadena de valor de café de especialidad puede ayudar a mitigar la crisis de

suministro inminente.

en los Estados Unidos ha crecido de una industria de $8 mil

millones en 2001 a $13,6 mil millones en 2008 y está previsto que supere $18 mil millones

a finales de 2012. El crecimiento sostenido de la demanda de café de especialidad en un

principio aparece como un señal positivo para la industria. Pero, como el consumo de café

de especialidad crezca en la corriente principal, se espera que la demanda supere la oferta,

lo cual es más motivo de preocupación que optimismo. Esto indica que no existen los

incentivos adecuados para producir café de especialidad en algún punto de la cadena de

valor. ¿Podría una reorientación de la cadena de valor de café de especialidad ayudar a

incentivar los productores para invertir en café de mayor calidad y satisfacer el

crecimiento de la demanda?

El estudio de cadena de suministro como una cadena de valor pretende cambiar la

manera en la cual los actores perciben relaciones mutuas a lo largo de la cadena, es decir,

analiza cómo las relaciones de negocios pueden maximizar el valor capturado de forma

colectiva, en lugar de ver a la empresa como un juego de suma cero. Las investigaciones

anteriores sobre la cadena de valor de café de especialidad han proporcionado un análisis y

recomendaciones que sugieren que hacen falta cambios en ciertos puntos de la cadena de

valor, en lugar de una re-configuración completa. La cadena de valor de carne de vacuno

proporciona un buen ejemplo de una cadena de valor que ha sido reconfigurada con éxito. 2 “Especialidad” se refiere a cualquier producto de café diferenciado. Algunas formas de diferenciar cafe incluyen certificaciones, el origin, la region, “terroir” y variedades.

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Las entrevistas realizadas para este estudio demuestran que la percepción de la

industria es que la diferencia entre el valor capturado por los productores y el resto de la

cadena de valor es el problema más importante enfrentando a la industria. Las cuatro

razones más mencionadas, y las que explican porque los productores no capturan

suficiente valor, son: falta de acceso al mercado, falta de compensación de acuerdo con la

cantidad de riesgo tomado, volatilidad excesiva del mercado "C" y falta de soluciones

actuales para ayudar a los productores. En el otro extremo de la cadena, las entrevistas

muestran que hay una brecha entre la demanda de los consumidores finales y la capacidad

de la cola de la cadena para satisfacer esa demanda. Algunos de los entrevistados

consideran que la industria entera es incapaz de aprovechar del valor que podría crearse a

raíz de la demanda para cafés especiales. Y un número importante de actores cree que un

problema importante para toda la cadena es la falta de adaptación de IT. Basándose en los resultados de las entrevistas, el análisis de la cadena de valor, con

el apoyo de la ilustración de un modelo de sistema de valor del café de especialidad,

muestra que la cadena de valor del café de especialidad tiene dos problemas fundamentales

que suprimen la producción de café mientras que la demanda de la industria sigue

creciendo. En primer lugar, el sistema de cadena de valor actual es un sistema de

mercancía en donde los actores son incentivados a comprar barato y vender caro. Esta

estructura de incentivos hace que el agricultor capture poco valor, lo que significa poco

valor capturado para invertir en café de alta calidad. En segundo lugar, existe un gran

retraso en la inversión de café de especialidad. Como resultado, lo poco que invierten los

productores sufre de un retraso largo antes que la inversión de fruto. En el otro extremo de

la cadena de valor, la comercialización y las ventas continúan. Es decir, demanda de la

industria de cafés especiales está creciendo en una manera cíclica y, por lo tanto, está

superando a la producción. Es probable que esto a la larga resulte en una crisis de

abastecimiento. Dos resultados son los más probables, dada la crisis de abastecimiento. En un

escenario, disminuirá la producción de tostadores a pesar de que los círculos de

crecimiento continuarán acelerando la demanda de los consumidores. Esto significa que los

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inventarios estarán bajos en comparación a la demanda y los precios del café de

especialidad aumentarán. Es probable que los niveles de precios se sobrepasen el precio

inelástico y, como consecuencia, disminuya la demanda, que tendría un efecto de

estancamiento general en el crecimiento del negocio de cafés especiales. En el segundo y

más probable escenario, los tostadores siguen comprando café verde para satisfacer el

crecimiento de la demanda, pero el suministro de café de especialidad no se mantiene al

ritmo. Esto significa que los tostadores de café de especialidad dependen cada vez más de

cafés de calidad y sabor inferior. Los consumidores tendrán más dificultades en distinguir

entre cafés de especialidad y cafés comerciales, la industria se diluye y los consumidores ya

no creen en la legitimidad de la "especialidad" de café. A su vez, ellos preferirán comprar

café barato y de grado comercial. Ambos escenarios conducen a un fenómeno llamado "rebasamiento y colapso."

Rebasamiento y colapso resulta cuando la demanda sigue creciendo en una manera cíclica

mientras el abastecimiento no se mantiene a paso. Industrias y productos, por lo general,

siguen una curva de crecimiento “s” en el cual la demanda aumenta lentamente y luego se

acelera y mesetas. La demanda de café de especialidad está en la fase de aceleración, pero

la oferta está llegando a una meseta. En este caso, muchos consumidores abandonaran la

industria de especialidades porque se encontraran descontentos con el producto. Este estudio sugiera que la industria necesita alejarse de un sistema de

abastecimiento de café que se basa en un producto mercancía y, al hacerlo, reducir la

influencia del mercado "C" y la volatilidad de los precios. Una reconfiguración de la cadena

de valor de café de especialidad puede llevar a cabo dicho cambio. Una reconfiguración

donde el productor puede capturar mas valor, fomentaría una mayor inversión en café de

especialidad y aumentaría la oferta. Dos pasos se abarcan demostrando cómo la cadena de

valor del café de especialidad debe ajustarse de manera que la oferta crezca con la

demanda: Paso 1: Identificar los controladores de la creación de valor para los negocios a lo

largo de la cadena de valor. La gestión eficaz de estos controladores puede

incentivar la cadena de valor a trabajar juntos para producir, transportar y vender el

café de especialidad. Volver a configurar la cadena de valor alrededor de dichos

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conductores de valor incrementara la captura de valor por toda la cadena, y para

cada actor involucrado en la cadena. Paso 2: Volver a configurar la cadena de valor de café de especialidad en torno a

estos conductores y a través de aumento de las asociaciones entre productores,

exportadores, importadores y tostadores. La nueva configuración de la cadena de

valor tiene que incluir tres componentes importantes:

• Reparto del riesgo

• Intercambio de información

• Participación en los ingresos

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II. Introduction

Sustained growth in demand for specialty coffee at first appears as a positive sign

for the industry. But, as specialty coffee consumption grows in the mainstream, demand is

expected to outpace supply, which is more reason for concern than optimism. There is

debate in the industry that the specialty coffee industry is on the verge of a growth plateau,

yet consumer demand is not the driving indicator for such speculation, instead it is a

supply- driven forecast. This means there are miss-incentives to produce specialty coffee

somewhere along the value chain.

In efficient markets, producers would have access to market information that

foresaw demand and value growth in the consumer market, and producers would make

appropriate investments in anticipation of such growth expectations. Some coffee analysts

attribute supply problems to changing weather patterns that decrease specialty coffee

yields, but available data does not indicate that weather can be the sole or primary

explanatory variable. Another explanation is that there is a limited amount of specialty

coffee production that the industry can support, but this justification seems excessively

simplistic. Closer analysis is required to help determine whether the growing

disequilibrium in specialty coffee demand and supply is a product of a miss-incentivized

value chain, an inevitable market correction, or can be blamed on bad weather.

Coffee is not the only food and beverage market that has experienced a transition

from a commodity to a value-added market in the past few decades, and meaningful

research has been done on the success drivers behind sustainable “value-added” value

chains. “Networked,” “quality focused” and “consumer-driven” value chains are a few of the

innovative terms to describe the revolution in specialty value-chains.i

Can a re-orientation of the specialty coffee value-chain help incentivize coffee

producers to invest in higher quality coffee and meet growth in consumer demand? This

study defines recent and expected growth in the specialty coffee industry, assesses

research and successful case studies on value-added value chains, and then analyzes over

twenty-five interviews conducted with organizations along the specialty coffee value chain

These changes have

been experimented with and implemented on a small scale in industries such as beef, pork,

cocoa and coffee. There are lessons to be learned from these small-scale innovative chains

that can be applied to an industry as a whole.

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to identify the most critical gaps in efficiency and risk exposure. To help illustrate the gaps

in the value chain system, a system model is specified and analyzed. Finally, from the

results of the research, interviews and analyses, recommendations are made as to how a

new look at the specialty coffee value chain can help mitigate the potential coming supply

crisis.

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III. State of the U.S. specialty coffee market

Over the past thirty years specialty coffee has grown from a niche market into an

industry with over $13 billion in sales that is forecasted to grow to $18 billion in by 2012.ii

The growth in relationship coffee has moved coffee ownership stocks from

producers to consumers.

The change is part of a greater consumer demand trend for higher quality food products

and food-chain traceability. Initially, budding demand for coffee quality and traceability

prompted trailblazing roasters and importers to take management of these coffee

attributes into their own hands, so they established “relationships” with producer groups

in coffee origin countries. Today, an industry is growing up around multiple interpretations

of the “relationship” business model.

iii

The commercial “C” market is not an accurate measure of return on investment for

specialty production. “C” market volatility has become as much a reflection of macro

economic market pressures, investment and divestment in agriculture commodities, as it is

a function of the demand and supply of coffee. Speculative institutional investors rather

than hedgers within the coffee industry conduct over 50% of the trades on the “C” market.

This means there is increasingly less stock of specialty coffee in

producer hands to meet growing consumer demand. With many specialty producers

engaged in relationship business models, there is little shared data to determine market-

based prices for specialty coffee differentials. As a result, specialty producers continue to

rely heavily on fluctuations in the commercial commodity, or “C” market to make

investment decisions.

iv

Despite the trend towards relationship coffee, a gap in value capture still exists

between the producers, exporters, importers and coffee roasters. Aggregate data on the

number of producers and the percent of their product tied to relationship models, as well

as the price they receive is not available. In turn, conclusive analysis on the impact that

relationship trade has on producer value capture, whether positive or negative, is not

possible. To better gauge the effectiveness of current value transfer efforts in the specialty

coffee trade, this study takes the pulse in the industry through dozens of interviews with

These institutional investors conduct trades based upon movements within the funds they

manage, which presumably are made by individuals without consideration to the

fundamentals of the specialty coffee trade.

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actors along the entire supply chain. The consensus among coffee producers, exporters,

importers and roasters is that the value gap has not changed measurably. Specialty coffee

producers who are involved in relationship model business contracts continue to shift

production to alternative crops or abandon their farms all together as emerging economies

present more lucrative job opportunities.v

The Specialty Coffee Association of America has used the available raw data on

specialty coffee to extrapolate growth trends, though precise data on specialty coffee

growth trends are difficult to accurately deduce from the disaggregated specialty market

information. The key drivers that the SCAA uses to measure specialty coffee growth include

specialty green coffee imports, the value of specialty coffee sales and the number of

specialty coffee houses. Between 1991 and 2008 the number of U.S. coffee houses grew

from 1,650 to 27,715. This is a compound annual growth rate (CAGR) of 82 percent. During

this period, large chain growth was significant; still, today 53% of all coffee shops are

owned by chains of 3 or fewer stores and 60% are chains of 9 or fewer shops.

These counterproductive trends in specialty

coffee production persist while demand for specialty coffee continues to grow.

Figure 1: Estimated number of specialty coffee operating unitsvi

As mentioned, the current value of specialty coffee sales (retail and online) is

estimated at $13.5 billion in 2008. This grew from approximately $8.3 billion in 2001.

Today, in volume of coffee imported this equates to approximately 17% of all coffee

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imported into the United States, or 3.8 million bags/501.6 million lbs.vii Looking toward the

future, the SCAA 2009 Retailer Survey revealed that 67% of their members reported

increases in whole bean sales (online and retail) and coffeehouse sales increased 3.5% in

the last quarter of 2009. These numbers indicate sustained growth through the

recession.viii

Figure 2: Size of the U.S. specialty coffee market ($ billions)3ix

Weather is a frequently talked about cause of a supply and demand imbalance, but

variance in overall coffee production in the past couple years has been no greater than

year-to-year variance since 2000. Global production decreased 3.9 percent from 2008 to

2009, but larger decreases in production occurred from 2002 to 2003 and 2006 to 2007,

(14.6 and 7.8 percent, respectively). And, all the while, global production increased from

2000 to 2009 at a CAGR of 28.4 percent. Arguably, specialty coffee growing regions are

more susceptible to changes in climate than are regions that specialize in commercial

coffees. Even so, as Central American yields grew only 0.75 percent in 2009, production of

Arabica beans in Africa increased by 300,000 bags. Brazil and Colombia had a bad year in

2009, yet industry experts forecast increased production in Brazil, Colombia and East

Africa in the near future.x

3 Years 2009 to 2012 are forecasts

Taking past, current and future production numbers into

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consideration, weather may well have an impact on the specialty coffee market, but

currently does not appear to be the predominant cause of the specialty supply crisis.

Increased demand for specialty coffee is not unique to the United States; coffee

demand is also growing in emerging markets as disposable income increases, which begs

the question, why are more coffee farmers not making investments in anticipation of

increased demand? One answer is that a market correction in coffee prices is needed

because producers will not make further investments until global market prices increase

enough to keep pace with or outstrip increases in costs of living. Waiting for such market

corrections to occur naturally could be lengthy and painful for the specialty coffee industry.

Furthermore, as mentioned, global commercial coffee prices are not reliable indicators of a

coffee producer’s return on investment in specialty coffee production.

An alternative solution to the possible coming specialty coffee supply crisis is to

look closely at the current specialty coffee value chain. A properly distributed value chain

should incentivize producers to make investments that are consistent with forecasted

growth in consumer demand for specialty coffee. The next section takes a closer look at

current research and case studies on specialty value chains. Then, because hard data on

drivers of specialty coffee production is sparse, the results from dozens of semi-formal

interviews with actors along the entire specialty coffee supply chain will be analyzed for

gaps in value capture and risk exposure.

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IV. Specialty value chain trends and research

Food value chains have seen innovative change over the past twenty years as

specialty markets have evolved in response to increased consumer demand for certain

attributes, particularly higher quality and food traceability. Demand for higher quality food

has grown with heightened health awareness and disposable income among the upper

middle class, while food traceability is a byproduct of increased social consciousness and

concerns over food security. An overview of value chain and value chain systems along

with academic research on their adaptation to specialty markets, along with case studies on

successful re-engineering of entire chains can provide insight on specialty value chain best

practices.

The value chain and value chain system

To structure the analysis, this study builds upon the value chain and value chain

system basics as defined in Michael Porter’s text “Competitive Advantage: Creating and

Sustaining Superior Performance.” In describing value chain analysis, Porter outlines a

method for evaluating company and system-wide operations. At the company level, he

defines primary business operations. The primary business operations are: inbound

logistics, operations, outbound logistics, marketing & sales, and services. See Figure 3 for

an example of the standard value chain used to structure analysis in this report.

Figure 3: The value chain

Next, value chain system analysis looks at the greater business ecosystem in which a

company exists. Porter generally defines a value chain system as having four stages:

suppliers, the company or channel 1, channel 2, and buyers.xi In the case of specialty coffee

and in this study, suppliers are considered the coffee producers, channel 1 includes

Inbound Logistics Operations Outbound

LogisticsMarketing

& Sales Services

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exporters, channel 2 includes importers, and the buyers are roasters. See Figure 4 for an

example of how the value system is defined for this purpose of this report.

Figure 4: The value chain system

The basic methodology for analyzing a value chain has three steps. First the value

chain and value chain system is identified along with the costs and revenues where value is

created. This stage is commonly referred to as “value mapping.”xii Second, the cost and

revenue drivers must be determined. Third, a company’s strategy should be adapted so

that their cost and revenue drivers are more efficient than the competition; alternatively

the value-chain should be altogether re-configured.xiii Understanding where value is

captured typically reveals where market power and chain governance lies. When market

power and chain governance are redistributed, so are value capture and value chain

sustainability.xiv

Value chain analysis can identify gaps between players that negatively impact

internal company operations, specific business-to-business (b2b) relations, or have

inhibiting secondary and tertiary effects across entire industries. Identification of such

inefficiencies and un-protected risk exposures can help business executives, trade

association professionals and policymakers adjust strategy or legislation to create a

sustainable differentiation for their company or industry.

xv Market power and governance

of value chains typically lie with developed country firms, when dealing with global, North-

South value chains. This global value chain characteristic is an underlying cause of

economic inequalities. Value chain analysis carries an industry forward by systematically

identifying the value capture and risk exposure of companies at each point in the chain and

then documenting where shared risk can increase value capture for all parties.xvi

Suppliers• Independent

farmers• Producer

organizations

Channel 1• Integrated

Producer / Exporters

• Private exporters

Channel 2• Coffee

importers

Buyers• Coffee

roasters

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The motivation for studying supply chains as value chains is to identify how to

change how actors along the chain perceive relations with each other, i.e. discover how

business relations can maximize value capture collectively, rather than view business as a

zero sum game. To maximize value capture collectively, actors must look for the optimal

agreement where both parties win, i.e. find a win-win negotiated solution. This applies to

negotiations between points in a value chain within and outside a single firm. The

importance of identifying such win-win solutions has become increasingly important for

value chains to sustain continued growth and avoid collapse in consumer driven specialty

markets.

The emergence of a specialty coffee value chain

Consumer demand for product attributes that suit their tastes and social priorities

has driven growth in product differentiation across the food industry. This trend drove the

growth in the specialty coffee market. In the specialty coffee industry, consumer definition

of quality grew to include social, location and taste attributes. In order to meet demand for

these differentiated tastes, roasters/retailers first attempted to manage the full length of

the coffee value chain to guarantee quality and traceability. Importers quickly followed suit

to meet their roaster customer needs.xvii

More recently, exporters and producers are increasingly reaching upwards in the

value chain to take some of the market power back. As the entire value chain slowly adapts

to consumer demand, roasters should not feel the need to control as much of the value

chain. However, even though more producers are aware of consumer demand for quality

and traceability, investment in these attributes is slow, which perpetuates roaster and

importer need to manage down the value-chain. That said, certification programs have

helped incentivize small producers to organize and vertically integrate in order to gain

more control of the value chain.

Specialty coffee value chain research

Coffee certification programs success at organizing small farmers and enabling them

to vertically integrate are well documented. The most prominent certifications include Fair

Trade, Rain Forrest Alliance and Organic. These certifications incentivize farmers with

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higher prices to organize and take control of value capturing stages in coffee production

such as wet milling and sometimes dry milling and exporting. Much of the research and

recommendations on improving specialty coffee value chain efficiency are focused on

improving coffee certification techniques.xviii Other recommendations include: empower

producer organizations through capacity building, vertical integration, increase producer

organization access to specialty market information, increase access to credit facilities,

invest in more certifications, involve producer groups in lobbying and advocacy, and

develop consumer markets for certified products. The most common agencies through

which these recommendations continue to be carried out are coffee cooperatives, Non-

Government Organizations (NGOs), development banks, as well as roasters that manage

their own corporate social responsibility departments.xix

Past recommendations target change within certain points in the value chain, as

opposed to a complete re-configuration of the value chain. The following interviews with

actors along the value chain will seek to pinpoint continued gaps in the specialty value

chain to help assess whether the problems can be resolved through continued surgical

development projects or if a completely new approach to value chain configuration is in

store. First, the following case exemplifies how another previously commoditized food

industry successfully re-developed a value chain to create a sustainable specialty food

industry.

Still, many years after such

research and sustained investment in programs that supported these findings, consumer

demand for specialty coffee outpaces growth in specialty coffee production.

Lessons from the specialty beef value chain

High quality beef has developed into a large and growing market in the United

States. Change in the beef industry began in the early 1990s when consumer surveys

indicated that beef consumption was on the decline due to varied quality and increased

toughness. This was a result of poor investment in raising cattle, as the industry had

become commoditized. Cattle ranchers were subject to prices decided upon by large

processors that competed on price to the end consumer. As a result, there was no incentive

for cattle ranchers to invest in how their cattle were raised and fed.

23

Recognizing a change was needed, the global agribusiness firm and beef processor,

Cargill, began to negotiate with cattle ranchers, such as Friona Industries, that wanted to

realign price incentives paid for cattle. In this deal, Cargill would work with their

distributors and retailers, including large national grocery stores such as Harris Teeters, to

develop a market for premium beef. On the production end, cattle ranchers would invest in

cattle rearing so that choice parts of beef would taste better. In between, Cargill agreed to

pay cattle ranchers a price based upon predetermined standards for beef quality as well as

upon what Cargill was willing to pay given market price fluctuation at retail. In this way,

the entire beef value chain was re-negotiated so that value capture was shared between

each point in the chain, which incentivized the entire chain to produce, package, and

market high quality beef.xx

Understandably, re-configuring the specialty coffee value chain presents different

challenges than the domestic U.S. beef industry, first and foremost the international aspect

of the coffee chain. Nonetheless, lessons can be learned from how middlemen with large

market power were incentivized through the prospect of increased value capture to

negotiate revenue sharing agreements with their producers. At the same time, the

middlemen turned into self-proclaimed consultants to their buyers/retailers by providing

more detailed pricing information on costs of production and packaging associated with

different cuts of beef, which helped retailers forecast their cost of inputs.

Instead of acting as a purely buy low, sell high commodity middleman, Cargill, with

respect to the beef industry, decided to partner with suppliers and providers through

revenue and information sharing. In this way, a sustainable consumer driven industry was

created based on food quality and traceability. Similar value-driven partnership models

could be taken to the coffee industry and implemented between cooperatives, global

traders (i.e. importers) and roasters. The current cooperative movement is a step in the

right direction, but alone it is apparently not providing enough incentive for production to

keep pace with demand. The next section will report results from interviews with

producers, exporters, importers, and roasters, in which these actors discuss how they

perceive the inefficiencies, risks and solutions that face the specialty coffee industry.

24

V. Specialty Coffee Value Chain Interview Results4

The interview results comprise primary data that was gathered via participant

observation and semi-structured interviews. Participant observation included visits in

Guatemala to three dry mills where day-to-day operations were observed. Observations

were also conducted at two coffee roasting facilities in Massachusetts where day-to-day

operations were also observed. Semi-structured interviews were used to record industry

leaders’ perspective on the most relevant issues that impact company and system-wide

value capture. Semi-structured interviews are guided conversations around specific topics;

however, the conversations are left open enough for respondents to take a topic where

they think it is most relevant. The interviewer is also free to ask impromptu questions that

are pertinent to the structured topics. Semi-structured interviews were conducted with

over twenty-five individuals that included producer groups, exporters, importers, roasters,

as well as coffee sector NGOs, and associations.

5

In the interviews, respondents were asked to identify where their company can

capture value, what risks they are exposed to, and current risk mitigation techniques they

use at the five points on the value chain: inbound logistics, operations, outbound logistics,

marketing and sales, and services. The two questions, “where can your company capture

value?” and “what risks is your company exposed to?” are two ways to identify a company’s

needs. Two approaches to a similar question were used to pull from respondents the

nuanced issues each company deals with. Then the report consolidates these answers to

facilitate the analysis. The complete consolidated results from these interviews are

included in this study as appendices.

At the end of each interview, respondents were asked to talk about the “big picture”

issues that are confronting the specialty coffee value system. These points are considered

“gaps” in the system. In the following value chain system analysis section, the system’s

needs, solutions, and gaps are analyzed to identify the key variables that influence the

system and that should be used in the system model.

4 All conclusions in the following summaries are taken from anecdotal interviews with individuals in the specialty coffee value chain system. 5 See Appendix 1 for a full list of organizations and individuals interviewed

25

Producers: Summary of findings6

The most significant producer needs have to do with operating and marketing

issues, including production costs, expected revenue and market information/access. There

is declining incentive for coffee farmers to stay in the business, as costs are increasing and

doubt and uncertainty surround revenue streams.

With respect to costs, three main areas are cause for concern. First the cost of

inputs, such as fertilizers and labor, are increasing. Many of the farm inputs are imported

from the United States, so their prices also increase as the USD appreciates against the local

currency. Labor costs are increasing as the minimum wage rises and manual labor becomes

scarce due to immigration to the cities or the United States. Second, producers lack

sufficient access to financing, particularly during harvest season, when a producer incurs

70 percent of their costs. Third, the costs required to meet respected certification

standards are high, while the price earned with the certification does not fully reflect bean

quality. Other operating issues are technical expertise on growing practices and weather

related risks. Poor weather can damage a coffee fruit while it is still on the plant or while

wet milled beans are drying and exposed to the elements.

Marketing needs have to do with global and regional market information and

market access to global buyers. Producer organizations lack adequate understanding of

global markets to know when they are receiving a fair price, whether they are negotiating

with middlemen, exporters, or through a direct relationship with roasters. Producers also

expressed concern about receiving constant margins based on region and certifications.

These margins help, but still do not fully reflect quality, which is a function of the different

amounts of time and effort each producer organization invests in their coffee. Producers

and certifiers that were interviewed mentioned that improved market access to global

buyers would help these problems.

Current solutions to these operating needs include financial support from integrated

producer organizations that have easier access to affordable financing. Financing can also

come from variety of partnership models with NGOs, banks and micro-finance institutions.

6 For a full list of the producer needs and solutions identified in the interviews, refer to the producer value chain matrix. The text’s summary covers the most common issues raised in conversations with two producer groups and a certifying organization.

26

A number of programs already exist, but the need is greater. A critique of these programs

from the certifier’s point of view is that the term “pre-payment” is commonly used to refer

to pre-financing. Pre-payment implies a forward payment on a sale, but these “payments”

generally carry interest. As a result, this practice is really a loan that is then paid back when

cash if received for the product.

Solutions to producer marketing needs are becoming more sophisticated as

producer organizations vertically integrate. With vertical integration, producer

organizations are developing marketing departments that hire individuals exclusively to

build sales relationships with importers and roasters. In firms whose marketing

department representatives were interviewed, the majority of sales go to importers.

27

Exporters: Summary of findings

Exporters face significant risks both downstream and upstream, along with

importers, and for this reason inherently put downward pressure on farm gate prices. This

means farm gate prices are depressed not just because of risk generated at the farmer level,

but also because exporters must compensate for upstream risk. The areas of risk that

exporters most frequently identified were quality control, price stability, supplier and

buyer reliability, market access, managing a good reputation while also looking for new

markets and price points, managing full containers and the need to vertically integrate the

origin country value chain.

Quality control is important for exporters to accurately take inventory of the value

of their product and in turn, receive an appropriate price. Price stability allows exporters to

more accurately forecast earnings and take additional risks to accelerate growth. Exporters

must manage their own expectations on what they will receive from producers as well as

what to tell buyers to expect. Increased market access is needed so that exporters can more

easily identify new markets and price points, while managing current relationships.

Exporters are careful when changing buyers because they do not want to be perceived as

disloyal, company reputation is paramount in the coffee trade. Also, a new and growing

need is to manage the logistical difficulties surrounding demand for small, high quality lots.

One effective strategy exporters pursue to minimize risk exposure is moving toward

vertical integration between producer groups and exporters. A number of integration

models are practiced in Guatemala. One model is full integration between producer groups

and a cooperative federation. In this case, the cooperative federation dry mills the coffee

from a number of different cooperatives. The federation also manages quality control, and

reserves the right to reject cooperative coffee if it does not meet the communal standard.

The federation also controls international marketing, price setting, and provides pre-

financing to their producers via partnerships with banks and/or development institutions.

Other vertical integration models include producer groups that hire a common marketing

agent to gain additional international access, and/or partner with an exporter that

provides dry milling at a discount rate. Producers and exporters alike express need for

further market access and the ability to negotiate a price that more accurately reflects

coffee quality.

28

Other solutions include wider establishment of cupping facilities at exporter

facilities so exporters and producers can better manage quality control. Some exporters,

particularly those integrated with producer groups, have taken steps to improve product

traceability in response to growing consumer demand for this information. However, even

integrated producer / exporters admit that the depth and accuracy of the type of

information gathered could and should be improved upon, but the institutions lack the

resources to do this alone. Additionally, some exporters said they had recently hired

personnel to deal with managing small shipments of high quality lots, again in response to

growing demand for such orders. Finally, all exporters mentioned that a lot of effort is

expended managing relations with buyers, while at the same time delicately trying to feel

out the market for new opportunities and better price points.

29

Importers: Summary of findings

Similar to exporters, importers face high risks downstream and upstream in the

value chain, which necessitates them to also put downward pressure on price. Variables

that drive the buy low, sell high mentality are the upstream industry standard to offer

roasters the right to reject coffee shipments and the downstream threat that the quality of

coffee origins changes annually, as is the case with any agriculture product. A compounding

problem is that importers are highly competitive and proprietary with regards to market

information. This makes it difficult for the market to assign a value to highly differentiated

coffees. Instead, the market must rely on inadequate industry norms that assign uniform

regional margins.

Together these market inefficiencies create high risk for importers, along with

exporters. Due to high risk and tough competition importers often continue to treat the

buying and selling of specialty coffee as a zero-sum game. This is reflective of how

commodity products are bought and sold. The commodity market business model puts

downward pressure on exporters and producer groups, which disincentives producer

investment in specialty coffee.

Not only do importers need to maximize gains with zero-sum tactics, they must also

minimize risk. To minimize risk, importers use insurance, quality control standards, and

build strong relations with exporters and roasters. They also offer roasters as many options

as possible, particularly with regards to coffee varieties, storage and freight possibilities. At

the same time, they hire and train personnel that understand commodity trading, customer

preferences, and coffee quality. It is the importer trader and salesperson that are

responsible for best allocating resources based on negotiating prices with exporters and

assessing roaster willingness to pay. Importers do the best they can, given the commodity

nature of their business, to assess demand, negotiate prices, and allocate scarce resources

so that both exporters and roasters are content.

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Roasters: Summary of findings

Like the rest of the value chain, roasters are subject to “C” market volatility and

general market risk, but they must also be most responsive to evolving consumer demands

for certain coffee attributes and the price these attributes receive in the consumer market.

Second to market price volatility, roasters face quality risk, i.e. the risk that a shipment is

spoiled. The causes of a spoiled shipment are varied, but the result is the same, the roasters

are forced to return the coffee, losing valuable time and potentially not meeting customer

demand. The third key roasters’ need, in addition to mitigating price and quality risk, is to

be able to meet rising consumer demand for coffee traceability. Since roaster risks are

directly correlated to consumer needs, roasters prefer not be reliant on intermediaries and

to attempt to control as much of the value chain as possible.

Large roasters continue to experiment with business models that develop long-term

contracts with farmers, while at the same time sourcing coffee via traditional methods in

order to acquire the necessary volume. Small to medium-sized roasters unanimously would

like to source directly, but today it is not economically viable for most to do so. Many small

to medium-sized roasters have experimented with direct sourcing and highly value its

benefits. However, any significant shift towards direct sourcing apparently requires a

complete realignment of a company’s business model around the direct sourcing method.

This is to say, today a small to medium-sized roaster either fully embraces the direct

sourcing business model and uses this to differentiate their company, or direct sourcing is

unsustainable beyond the occasional trip to origin, which is better defined as a passionate

hobby than a serious component to a business model.

As importers re-align how they source coffee in order to meet roaster demand, both

importers and roasters increasingly vie for the same relationships with producers and

exporters. This additional level of competition creates value chain inefficiencies. Roasters

incur high costs building direct souring expertise, which is an importer competitive

advantage. This takes roaster resources away from focusing on immediate customer needs,

while importers are forced to compete with a new competitive force. Also, importers

negotiate prices with producers based on how much they believe they can mark the coffee

up to roasters, while roasters negotiate with producers based in part on how much they

can force importer margins down.

31

In addition to mitigating sourcing risks, roasters must raise market awareness for

their product. Most roasters interviewed mentioned marketing as high risk because the

returns are not calculable, but their industry as a whole is dependent on raising awareness

that coffee can be high quality and socially responsible. The complexity of specialty coffee’s

marketing message and the importance effective marketing has on industry sustainability

and growth further emphasizes that roaster attempts to manage down the value chain are

highly inefficient for the industry as a whole. The roaster’s first priority is to meet the

consumer’s every immediate need.

Given the split priorities between sourcing and marketing risk, it is not surprising to

learn from interviews that the roaster community is split when it comes to industry

solutions. The dividing line is between those who believe that more and stronger long-term

roaster-farmer relationships are the solution, and those that think long-term / direct

relations depress farm gate prices and should be the importers’ responsibility. Whether or

not roasters or importers hold the competitive advantage with regards to producer

relations, roasters seem to unanimously agree that for the value-chain to grow in a

sustainable manner there must be more partnering, revenue-sharing, and improved

producer access to the global marketplace. Roasters also agree that specialty coffee is price

inelastic in small increments and many said they would be willing to increase prices

marginally, if producers were the key beneficiaries and the supply chain became more

sustainable.

This is not new information and many roasters already accept higher prices in order

to transfer more value to producers. Still, there is a supply shortage, which could cause

coffee prices to increase enough to significantly damage roasters’ sales. Efforts to mitigate

specialty coffee marketing risk are proving more effective than sourcing risk mitigation.

Despite industry efforts to improve farmer value capture, why change has not happened

more quickly, in pace with consumer demand, will be the focus of the next section that

analyzes the value chain system as a whole.

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Industry views on value chain system gaps

When asked at the end of each of the twenty-six interviews conducted, respondents

identified four key gaps in the specialty coffee value chain: (1) the producer situation is not

sustainable, (2) consumer demand is outpacing supply, (3) the specialty industry lacks

information technology (IT) and the efficiency gains that come from improved information

and technology, and (4) the industry as a whole is not effectively capturing value potential

of specialty coffee products. Figure 5 identifies these gaps and the percent of times each

gap was mentioned in the interviews as the primary industry gap.

Figure 5: Key gaps in the specialty coffee value chain

Looking at these gaps from a value chain perspective, the overwhelming perception

is that a gap between producer value capture and the remainder of the value chain is the

dominant problem facing the industry. On the other end of the chain, there is a gap

between consumer needs and the ability for the entire tail of the chain to meet this need. To

a certain degree, some see the entire industry as unable to fully capitalize on the value that

could be created from consumer demand for specialty coffees. And a notable number of

actors believe that a significant problem for the entire chain is a lack of IT adaptation.

33

Speaking only about producer sustainability, interviewees most often mentioned

four reasons for producers’ inability to capture a sustainable amount of value from their

specialty green coffee. The four reasons are, in order of the frequency each was mentioned

during interviews:

1. Poor market power and access

2. Producers are not rewarded appropriately for the risks they assume

3. “C” market price volatility

4. Current solutions, such as certifications and direct trade, are insufficient.

One interviewee noted, with regards to improving producer value capture, “any change

that is useful needs to be phenomenal.” Using the research and interview results, the

following section analyzes producer, exporter, importer and roaster needs and the

corresponding solutions currently used to mitigate these needs. This analysis is used to

identify the key drivers that facilitate and inhibit industry growth. A system model is then

specified to help show how reinforcing or changing these drivers impacts the entire value

chain system.

34

VI. Value Chain System Analysis

Power in the specialty coffee value chain is shifting from roasters to consumers, as they

demand higher quality and traceable coffees. As a result, coffee roasters are turning to their

value chain for greater access to high quality and traceable coffees. However, the bulk of the

value chain is not built to properly incentivize high quality and traceability. Nor does the value

chain provide for efficient market access and communication between roasters and

producers. To identify and emphasize the gaps in the value chain that keep roasters from

meeting their needs and that force them to inefficiently manage down the value chain, this

value chain analysis was conducted.

35

Consumer demand drives the value chain

Consumer

Need Current Solution

Gap

Quality coffee

Specialty coffee roasters.

Industry demand is growing 17% annually, but industry experts say that access to quality coffee is declining.

Information on farmer

Specialty coffee roasters offer “terroir” coffee.

Only premium coffees offered at high-end coffee shops and as “reserves” at some large chains occasionally have information on the farmer and the growing practices and environment or “terroir.”

Easy access to great coffee

Buy at a specialty coffee shop, grocery store or online.

Online sales is the fastest growing segment as consumers become more educated on coffee quality and origins and can find this information most readily on specialty coffee roasters’ websites.

Reasonable price

Other than McDonald’s $1 coffee and Starbucks $1.50 blend, prices have not changed much during the recession.

A large drop/rise in price is required to impact the coffee consumer. This means that the consumer is price inelastic in small increments. Consumers do not react to small decreases or increases in price. This is particularly true in specialty coffee, which has actually seen continued growth during the recession.

Consumer Conclusions: The consumer is demanding higher quality and more information. The

consumer is unaware that specialty coffee roasters fear declining quality because demand is

outpacing access to quality coffee sources. These sources, some worry, are even on the

decline. Currently, only the very premium coffee market and large roasters have regular

access to full information on the coffee farmer. If high quality and detailed information were

more widely available, many roasters believe specialty coffee could have greater appeal to the

mass market and be able to capture more value. Consumer awareness of coffee quality and

origins would grow similar to consumer understanding of wine quality and growing regions.

36

Roasters exert upward pressure due to price inelasticity and downward pressure to cut costs

Roaster Conclusions: The roaster needs more information, and greater market access to high

quality coffee beans, consistently. Some specialty importers can provide information at a

price, but have limited market access. A minority of roasters source coffee on their own to

guarantee high quality, but this is expensive, time consuming, and exposes roasters to quality

risk, i.e. risk that quality is affected when coffee is in transit from origin country to demand

country or that the producer has a bad harvest or even decides to stop growing coffee all

together.

Roaster

Need Current Solution

Gap

Quality coffee and service

Source coffee through a specialty importer or the roaster sources coffee directly from producer.

Importer market access and transparency is limited. Those that specialize in full transparency come at a price. Sourcing directly from the producers is costly and exposes roaster to quality risk, i.e. risk that quality is affected during shipping.

Information: coffee traceability

Source coffee through a specialty importer or the roaster sources coffee directly from producer.

Importers that provide good information source from a small number of producers because they rely on close relationships for information. This means they have limited market access. Also, many importers have trouble sharing all information they have because of a limited sales force.

Market access to quality coffee

Source coffee through a specialty importer or the roaster sources coffee directly from producer.

Specialty coffee importers, individually, provide a myopic view of the specialty market. Together, they provide a fairly wide selection of coffees. But, because it is difficult to deal with many importers, most roasters only deal with a few or even just one. Procuring coffee directly from the producer is costly and timely for both roasters and importers. This method provides good traceability, but causes inefficiencies when multiple buyers source from the same producers to sell to different roasters.

Reasonable price

Negotiate price with importers or producer. Price discovery is fragmented.

Through interviews with roasters, many have indicated they are willing to pay more if the coffee meets their quality and origin information needs. This is b/c specialty coffee is price inelastic.

37

Importers are incentivized to buy low and sell high because of a commodity value system

Importer

Need Current Solution Gap Higher quality coffee

Work with NGOs on farmer education. Develop direct relations with producer groups.

These services only reach a small portion of the coffee producer market.

More farmer information

Develop direct relations with producer groups.

Importers can only develop a limited number of relationships.

Greater access to roasters and quality coffee

Word of mouth marketing with roasters. Frequent trips to origin countries to develop relations.

Importers said that word of mouth is considered enough marketing with roasters. Importers can only develop a limited number of relationships. Thus, they cannot grow much faster.

Finance coffee at fixed price w/o guaranteed quality or buyer

Buy low and sell high to avoid risk that quality decreases en route, or they can hedge on “C” market.

Importer incentive to buy low is disincentive for producer to produce high quality coffee. Hedging specialty coffee only covers price risk up to commodity price. Difficult to hedge the full differential that can be earned from quality coffee, which exposes brokers to basis risk.

Importer Conclusions: Importers face similar problems as roasters with regards to sourcing

high quality coffee, gathering farmer information and gaining market access. Furthermore,

importers are required to take high risk moving coffee overseas and financing coffee without a

guaranteed buyer. This incentivizes importers to treat the business as a zero-sum game and

negotiate low prices with producer groups. Larger players with more market power that

negotiate low prices with producers, in order to mitigate quality and basis risk, discourage

producers from producing high quality coffee.

38

Exporters are incentivized to buy low and sell high because of a commodity value system

Exporter

Need Current Solution Gap Higher quality coffee

Provide technical training to farmers.

Exporter scope is limited by the ability to develop relationships with producer groups, so there are still many uneducated coffee farmers

More information on farmer

Build relationships with farmers.

Exporters lack the resources to develop detailed profiles on wide number of farmer groups.

Greater access to buyers and quality coffee

Recruit farmers to supply exporter. Develop relations with importers and roasters when possible.

Exporters are only able to recruit farmers when they can offer farmers a higher price that somewhat reflects quality. Relationship development with importers is via word of mouth. Exporters are rarely able to develop relations directly with roasters.

Finance coffee farmers at fixed price w/o knowing quality

Vertically integrate with farmer groups and sign open profit-sharing contracts with farmers at the start of season.

Farmers have big incentive to sell to the street because exporter price is often not much higher than the street price, and on the street the farmer will get the cash immediately.

Exporter Conclusions: Exporters face similar problems as importers with regards to sourcing

quality coffee, gathering information on producers and gaining access to producers. In

addition, they must find a buyer, usually internationally, for their coffee, and finance some of

the coffee before the harvest season, before knowing the quality. To decrease exposure to the

quality and price risk this creates, some exporters have vertically integrated with producer

organizations, often through cooperative organizations. The exporter then serves as a

marketer and dry mill for the producer organizations and shares with the producer at the end

of the sales season any excess profit. Still, the exporter must consistently offer a higher price

than is offered on the street to keep their farmers from taking the street price and receiving

cash up front. The lure of cash up front is high because the exporter price is not much higher

than the street price. This is due in part because exporters, even those integrated with

producers, do not have much ability to negotiate price based on quality.

39

Producers must accept pre-determined commoditized prices that do not fully reflect quality

Producer

Need Current Solution Gap Produce higher quality coffee

Solicit training from exporters, NGOs, or a government agency.

Still, there are many uneducated farmers.

Share their story + information on the coffee

Exporter shares some info, and the few farmers with direct relations with roasters share their story.

Only a few detailed stories make it to roasters and to their consumers.

Greater access to importers and roasters

Most farmers rely on their exporter’s contacts; very few have direct relations with a roaster.

Producers still have a very myopic view of foreign buyers / importer-roaster market

Receive a price that reflects the quality

Producers are given price differentials for certifications and the region they are in.

Standardized differentials for certifications and regions are an imprecise way to gauge quality.

Producer Conclusions: Coffee producers have very limited access to importers and more

importantly, roasters, who have the highest willingness to pay for quality coffee. Instead,

producers are given standardized differentials based on certifications or simply on the region

where they are located. A producer’s usual buyer is an exporter that sells to an importer, both

of which, when the exporter is not integrated with a farmer group, look to buy low and sell

high. Even when the producer/exporter is integrated, the importer is still incentivized to buy

low and sell high. This pricing structure provides little incentive for the producer to invest in

growing a high quality product. As a result, roasters and importers report they see more and

more producers of quality coffee leaving the industry and the overall supply of quality coffee

stagnating, even as consumer demand for high quality is increasing.

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Value Chain System Analysis Conclusions

Consumers are demanding higher quality coffee and increased information on their

coffee’s origin, which means roasters need better access to quality coffee and information.

However, the current import system for specialty coffee is a commodity value chain, which

inherently creates a pricing structure that incents the producer to grow only a commodity

product. Exporters and importers are incentivized to treat price negotiations as a zero-sum

game. Exporters and importers must push down prices to compensate for the significant

amount of quality and price (i.e. basis) risk they must carry. As a result, producers do not

receive a price that fully reflects quality, so there is little incentive to invest in quality,

traceable coffee.

Additionally, a lack of information sharing between importers, and generally

throughout the industry, leads to inefficient pricing. For importers, specialty prices are

determined as differentials over the commodity exchange. This process is inefficient and

means actors along the specialty coffee value-chain can try to take advantage of

misinformation and engage in arbitrage. As consumer demand for quality and traceability

increases, specialty coffee production will not keep pace and the specialty industry will fail to

capture full value in coffee attributes, unless a systematic change in value transfer and coffee

procurement takes place.

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VII. Modeling the value chain system

With a firm understanding of the variables that compose the specialty coffee value

chain and the areas of greatest inefficiency and risk exposure, as well as some of the current

solutions, an effective way to better understand how these functions are interrelated is to

model the stock and flow of green coffee and value capture. System dynamics parameters are

used to specify the model. System dynamics shows how creating, reinforcing and diverting

flows and stocks of variables can have a chain reaction throughout an entire ecosystem. In the

case of specialty coffee, the two key flows are the physical movement of green coffee and value

capture, i.e. the per pound value earned for green coffee at each point in the value chain.

Below, a series of diagrams show in step-by-step progression the current specialty

coffee value chain. First, the two flows, green coffee and value capture, are explained. Second,

the key variables that influence coffee movement and value capture from producer to

exporter, importer and roaster are identified and described. Third, the drivers behind

specialty coffee industry growth and roaster sales growth are explained. Fourth, the key gaps

are identified on the specialty coffee value system diagram. Fifth, a couple of the current

attempted solutions to the specialty coffee supply imbalance are described.7

Finally, in the

recommendation section, a new approach to the specialty coffee value chain is proposed.

System dynamics primer

System dynamics is a method developed at the Massachusetts Institute of Technology

(MIT) to model private and public policy impacts on business, government or social

ecosystems. In the models, boxes represent stock variables (e.g. value and inventory) and

straight double-lined arrows represent rates of change (e.g. “price” in the case of value

transfer and “sales rate” in the case of physical movement of coffee). Curved, single-line

arrows represent positive or negative impact of variables other than stocks or rates of change.

A blue arrow means the two connected variables positively correlate, while a red arrow

means the two respective variables negatively correlate. An explanation for each diagram is

provided below.xxi

7 The system models are examples of standard specialty coffee value chain formations and are meant to highlight the most influential drivers and gaps that contribute to and inhibit value capture. The two “current solution” models are only a couple of many approaches that multiple businesses have implemented in attempts to make the chain more sustainable.

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Step 1: The movement of green coffee and value capture

To begin, there are two principal stocks and flows in the specialty coffee trade that must be modeled. The first is the

physical movement of green coffee (top line) and the second is the capturing of value (bottom line), which is defined as the

difference between the price paid for coffee, or coffee inputs, and the price received for coffee. The red indicates a negative

correlation between two variables, and blue means the two variables are positively correlated. For example, in the first chain

(movement of coffee), the “Investment rate” is positively correlated to “Producer inventory,” i.e. as the producer invests more in

production, their inventory goes up. On the other hand, “Producer sales rate” is negatively correlated with “Producer Inventory”

because as the producer sells coffee, their inventory falls. In the second chain (value capture), the arrow between “Input Price”

and “Producer Value Capture” is red because as input prices go up, the amount of value the produce can capture goes down.

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Step 2: Producer, exporter and importer value capture

This step shows the key variables that impact value capture for producers, exporters and importers. During the

production cycle, access to credit has a negative correlation to input prices. As access to credit improves, input prices go down

because the cost of financing is cheaper. The contributing variables to “Farmers Price” all have a positive correlation to price

except for production risk. As the “C” market, bean quality and traceability premiums, or the regional reputation increases, then

the “Farmer Price” also increases. As the production risk (e.g. weather) increases, the price paid to the farmer decreases. The

“FOB Price” is a function of, again, the “Quality and Traceability Premiums” plus the service of the exporter, minus any downward

negotiation in price due to quality risk that is associated with shipping coffee overseas. The “Importer Price” to roasters also

considers the quality and traceability premiums along with the service the importer provides. Importantly, at each point in the

value chain there is strong downward pressure on price in order to compensate for high risk and strong negotiating power from

the next actor up in the value chain.

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Step 3: Roaster value capture, industry demand and roaster sales rate

This step shows how the value capture and coffee movement chains connect. Roasters increase marketing expense as they

capture more value. Increased marketing expense raises awareness about specialty coffee, which has two effects. First,

awareness of specialty coffee increases overall industry demand for specialty coffee and a change in demand has an impact on

price. Second, increased awareness about a specific roaster’s product impacts that roaster’s market share, which increases

roaster sales. As roaster sales increase, there is a word of mouth effect, especially important in specialty coffee; this further

contributes to awareness, industry demand and the consumer price. These are both positive reinforcing loops that further

specialty coffee demand growth.

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Step 4: Importer, exporter and importer sales rate and producer investment rate

The “Roaster Sales Rate” has a positive correlation to the “Importer Sales Rate.” As roasters sales increase, roasters

procure more coffee from their importers. Also, “Roaster Value Capture” has a positive correlation to “Importer Sales Rate.” As a

roaster captures more value, they are able to invest more and expand, which means buy more coffee from their importers. This

cycle continues down the chain. Importers buy more from exporters and exporters procure more coffee from producers. But, it is

important to point out the “Delay” at the left end of the chain. As producers’ sales rates increase and they capture more value,

they invest in more coffee production. Often investment in coffee production can take multiple seasons before any difference is

found in the crop. As a result, there is a much longer delay in coffee investment for the producer than any other point in the value

chain. Also, increases in “Inventory” of coffee have a negative correlation on consumer price. As supply increases, price decreases.

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Step 4: The specialty coffee value chain system (key problems and gaps)

The specialty coffee value chain has two key problems that could stifle production while industry demand continues to

grow: The downward pressure exerted on “Producer Value Capture” (shown in red block arrows) and the long delay in the

producer “Investment Rate” (shown with a black block arrow). The current value chain system is a commodity system where the

actors are incentivized to buy low and sell high. This is illustrated with the red double-lined arrows that indicate that, for

example, when “Roaster Value Capture” increases, then the “Importer Price” decreases. Such an incentive structure leaves little

value capture for the farmer, which means little value is created to put towards investment and the little that is invested has a

long delay before the investment bears any fruit. On the other end of the value chain, roaster marketing and sales continue, which

fuels industry demand and overall market growth. As shown, industry demand is growing in an accelerating manner (this is

called a “reinforcing loop”), and thus, is outpacing production. This could eventually lead to a supply crisis.

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Step 5: The Direct-trade and long-term relationship model (a current solution)

In the direct-trade and long-term relationship models, the roaster essentially takes the exporter and importer out of the

value capture equation by negotiating a price directly with the producer and paying the exporter and importer a constant margin.

This model attempts to transfer roaster value directly back to the producer, but it is not clear just how much value is transferred.

With a long-term contract, the roaster assumes the production and quality risk in addition to spending more on procurement

costs due to increased travel to coffee origins. To compensate for these risks and costs, the roaster, too, must negotiate low

“Farmer Prices.” Still, this method does provide increased traceability and perhaps more value to the producer. However,

roaster-producer business development is slow and whether there is net value creation, because importers lose, for the entire

chain is debatable. Ultimately, this solution has not been able to induce producers to invest fast enough to meet demand.

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Step 5: NGO funding model (a current solution)

In the NGO funding model, roasters transfer some of their value capture to NGO / development organizations, or in some

cases their own development or corporate social responsibility departments, to carry out projects in the local coffee

communities. These projects target value creation drivers such as “access to credit,” “farmer production methods,” or

“certifications.” The purpose is to enable the producer to capture more value, which should in turn increase their “investment

rate” in specialty coffee. Many of these programs are effective for the targeted community, however, the need is great and as of

yet the projects do not incentivize producers to produce enough specialty coffee to meet consumer demand.

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VIII. Conclusions and Recommendations

Specialty coffee current growth trajectory

Despite a number of business models that attempt to redistribute value along the

specialty coffee value chain, most notably direct-trade, long-term contracts, and NGO /

development programs, industry demand is outpacing production, which has real potential to

end in a supply crisis. The fall-out of a supply crisis could be disastrous for the industry. Two

outcomes are most likely given a supply crisis. In one scenario, roasters slow production even

though reinforcing growth circles continue to accelerate consumer demand. This means

inventories are low compared to demand and specialty coffee prices increase, most likely

beyond price inelastic levels and, as a result, the quantity demanded decreases, which would

have a stagnating effect on specialty coffee businesses.

In the second and more likely scenario, roasters continue to buy green coffee to meet

demand growth, but the supply of specialty coffee does not keep pace. This means specialty

coffee producers increasingly rely on inferior coffees that taste badly. Consumers will find it

more difficult to distinguish between commercial and specialty grade coffees, the industry will

become diluted and consumers will doubt the legitimacy of “specialty” coffee. In turn, they will

prefer to buy cheaper, commercial grade coffees.

Both scenarios lead to a phenomenon called “overshoot and collapse.” Overshoot and

collapse results when reinforcing industry demand loops are not met with appropriate supply

growth. Industries and products generally follow an s-curve growth pattern in which demand

increases slowly, then accelerates and plateaus. Specialty coffee is arguably in the acceleration

phase, but supply is reaching a plateau. In such a scenario, many consumers would stop

buying specialty coffee all together as they become disgruntled with the product.

Figure 6: Overshoot and collapse

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Specialty coffee target growth trajectory

The target specialty coffee growth trajectory is for coffee supply growth to parallel

consumer driven demand growth. Specialty coffee production begins above demand, but as

demand becomes consumer driven, then producers invest in specialty coffee production

commensurate with forecasted consumer demand for specialty coffee. As seen in the specialty

beef industry, specialty markets require partnerships that take the industry away from a

commodity market and towards a value chain that is collectively incentivized to produce

higher quality products. Growing specialty industries with properly incentivized production

should have parallel demand and supply growth curves.

Figure 7: Target “S” curve growth

How to achieve the target growth trajectory8

The industry needs to move away from a coffee sourcing system that is solely based on

a commodity product and, in doing so, decrease the influence of “C” market price levels and

volatility on specialty coffee prices. Assuming weather is not the sole reason supply cannot

keep pace with demand (see section III, “State of the U.S. Specialty Coffee Industry), then

reconfiguring the specialty coffee value chain can have a meaningful impact on specialty

coffee supply. Two steps encompass how the specialty coffee value chain should be adjusted

so that supply grows parallel to demand:

8 These recommendations are not meant as a substitute to current practices that aim to redistribute value capture, but rather build upon and offer additional solutions.

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Step 1: Identify the value creation drivers for business along the entire value chain,

effectively managing these drivers can incentivize the value chain to work together to

produce, move, and sell specialty coffee.

Step 2: Reconfigure the specialty coffee value chain around these drivers through

increased partnerships between producers, exporters, importers and roasters that

involve three components:

• Risk sharing

• Information sharing

• Revenue sharing

Where change needs to happen

• Producer/Exporter: Vertical integration from producer to exporter needs to continue.

In some instances producers have already integrated with exporters. Through

integration both points in the chain are able to collectively capture and share more

value, instead of competing with one another for value control. Value is captured

through sharing wet and dry mill facilities, as well as sales and financial risk. Other

effective practices include collective marketing departments that help improve market

access, as well as improved credit ratings, so financing is cheaper. A few models for

producer-exporter integration have been successful, amongst others:

o Tiered cooperative system where farmer cooperatives supply a parent

cooperative federation. This model is in place in the Guatemala coffee sector,

in addition to others.

o Farmer cooperatives and a corporate parent structure with senior

management that is accountable to the cooperatives. This model has been

successful in the fruit juice industry in the United States.

o Farmer cooperatives develop their own marketing department, but continue

to outsource dry milling and/or exporting for a fixed per pound cost. This

model can be found in multiple locations.

• Producer/Exporter-Importer-Roaster: Increase information sharing so producers have

better access to information on coffee attributes and availability of certain attributes.

Improved information sharing and market access will enable better forecasts of

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demand trends in the specialty coffee market. This information will help producers

plan future investment in specialty coffee production.

• Producer/Exporter–Importer–Roaster: Roaster willingness to pay for specialty coffee

should decide the price that producers receive. Provided producer and exporters are

integrated, roasters should decide the appropriate price, since they are closest to the

end consumer and have the best idea as to how much the consumer is willing to pay. In

such a system, as consumer willingness to pay for a high quality coffee increases or

decreases, so will the price the roaster is willing to pay. When the roaster is deciding

the price, then the price to the producer/exporter depends first on end consumer

demand and acceptable value capture for the roaster and second on commodity market

price, which measures the greater supply and demand balance across the entire

industry. In turn, the producer will have a better understanding of needed investment

in production and have the means to carry it out.

• Producer/Exporter-Importer-Roaster: Importers should continue to procure and move

specialty coffee for roasters, since importer competitive advantage lies in their well-

developed networks in origin countries. Still, the roaster should have more influence

over the price to the producer and the importer earns a percent, rather than a fixed fee

per pound, on the coffee. This pricing system also incentivizes importers to source high

quality coffee and to recommend these coffees to their roaster clients. For such a

business model to function, importers need to develop close partnerships with

producer/exporter companies and engage in revenue sharing agreements.

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Specialty coffee value chain re-configured

This re-configured value chain system model highlights the four points where partnerships need to improve risk sharing,

information sharing and revenue sharing. In this system, a feedback loop is created between roaster value capture and integrated

producer/exporter price, which directly increases producer value capture. This feedback loop is directly correlated to growth in

consumer demand, which improves efficiency and maximizes value capture for the entire industry.

Roaster decides price based on end-consumer willingness to pay

Price is a % of the value

Producers continue to vertically integrate

Increased value capture increases investment

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VIII. Appendices

Appendix 1

Companies and individuals interviewed (Company, Interviewee, Position; Date of Interview)

• Asociación Comunal de Desarrollo Integral Huehuetenango (ACODIHUE), Héctor Mejía, Manager; January 14, 2010.

• Asociación Unión de Pequeños Caficultores (UPC), Aurelio Gabón Lucas, Presidente; January 14, 2010.

• Barismo, Jaime Van Schyndel, Co-Owner / Roastmaster; March 2, 2010.

• Boston Common Coffee Company, Patrick Mahoney, Roastmaster; February 26, 2010.

• Federación Comercializadora de Café Especial de Guatemala (FECCEG), David Quintero,

Sales Representative / Lead Cupper; January 14, 2010.

• Federación Comercializadora de Café Especial de Guatemala (FECCEG), Juan Francisco González Menchu, Manager; January 14, 2010.

• Cooperativa Agrícola San Pedro Necta (Huehuetenango, Guatemala), Junta Directiva

(Francisco Mateo Ramos, Gerente; Víctor Hugo Herrera Leparra, Presidente de Crédito; Agosto Baudelio Gutiérrez García, Secretario del Consejo de Administración; Fausto Martínez, Vocal de Educación; Eudin Gómez Aguilar, Para-técnico)

• Dean’s Beans, Dean Cylon, CEO; February 5, 2010.

• Federación de Cooperativas de Café de Guatemala (FEDECOCAGUA), José Ángel Reyes,

Técnico; January 12, 2010.

• Federación de Cooperativas de Café de Guatemala (FEDECOCAGUA), Gerardo Alberto de León, Gerente; January 11, 2010.

• Federación de Cooperativas de Café de Guatemala (FEDECOCAGUA), Gustavo Adolfo

Galicia, Gerente de Producción y Exportaciones; January 11, 2010.

• Federación de Cooperativas de Café de Guatemala (FEDECOCAGUA), Ing. Agr. Jesus Adolfo Alvarado T., Director Asistencia Tecnica; January 11, 2010.

• Federación de Cooperativas de Café de Guatemala (FEDECOCAGUA), Luis Alberto, Dry

Mill Manager; January 11, 2010.

• Green Mountain Coffee Roasters, Winston Rost, Farmer Relations Manager; February 24, 2010.

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Companies and individuals interviewed (continued)

• Hogan Brother Coffee, Jim Hogan, CEO; February 5, 2010.

• InterAmerican Coffee, Andrew Sargent, Former Coffee Trader; January 6, 2010.

• Just Coffee Cooperative, Matt Early; March 9, 2010.

• Manos Campesinas, Miguel Mateo Sebastian, Marketing Manager; January 15, 2010.

• Red Barn Coffee Roasters, Bill Trull, Roastmaster; February 9, 2010.

• Red Barn Coffee Roasters, Mark Verrochi, CEO; February 9, 2010.

• Royal Coffee New York, James Schoenhut, CEO; March 4, 2010.

• Specialty Coffee Association of America, Tracy Ging, Director of Marketing and Communications; March 25, 2010.

• Sertinsa, Mario Canon C., General Manager/CEO; January 12, 2010.

• Sustainable Harvest, Katie Gilmer, Communications Manager; February 9, 2010.

• UniTrade Coffee Trading Company, Roberto Stahl, Trader; January 17, 2010.

• Utz Certified, Enrique Abril, Field Representative Mexico, Central America and the

Caribbean; January 12, 2010.

• Volcafe Specialty, Alan Nietlisbach, CEO; February 12, 2010.

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Appendix 2 Producer consolidated interview results

Producers Interviewed: Cooperative Agricola San Pedro Necta, independent farmers in Huehuetenango, Guatemala; representatives from Utz Certified, Guatemala

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Producer consolidated interview results (continued)

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Appendix 3

Exporter consolidated interview results

Exporters Interviewed: Federación Comercializadora de Café de Guatemala (FEDECOCAGUA), Sertinsa, Asociación de Cooperación al Desarrollo Integral de Huehuetenango (ACODIHUE), Federación de Cooperativas Comercializadoras de Café Especial de Guatemala (FECCEG), Manos Campesinas, UniTrade

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Exporter consolidated interview results (continued)

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Exporter consolidated interview results (continued)

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Appendix 4

Importer consolidated interview results

Importers interviewed: Volcafe Specialty, InterAmerican (former employee), Royal Coffee New York, and Sustainable Harvest

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Importer consolidated interview results (continued)

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Importer consolidated interview results (continued)

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Appendix 5

Roaster consolidated interview results

Roasters interviewed: Dean’s Beans, Just Coffee Coop, Boston Common Coffee, Hogan Brothers Coffee, Green Mountain Coffee Roasters, and Red Barn Coffee Roasters

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Roaster consolidated interview results (continued)

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Roaster consolidated interview results (continued)

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Roaster consolidated interview results (continued)

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Appendix 6

Works Cited

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