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Annex 4: Changing the basis of payment

1. The LFASS Stakeholder Group examined ways to refine the basis for calculating payment rates, to fit in with the possible changes in EC rules. It has drawn on a range of existing data sources including the Agricultural and Horticultural Census and the Macaulay Land Capability for Agriculture system. The methodology calculates payment rates for LFASS on the basis of income foregone and additional cost as a result of farming land with natural and permanent disadvantages for agriculture production.

2. The Macaulay Land Capability of Agriculture (Macaulay LCA) classifies agricultural land in Scotland according to a range of factors including soil, climate, relief and vegetation. This provides a basis on which agricultural land in Scotland can be ranked according to its productive potential and cropping flexibility. The Macaulay LCA ranges from Class 1 which represents land of highest quality for agricultural production to Class 7 which represents the land of poorest quality for agricultural production.

3. The Agricultural and Horticultural Census provides data on production activities at holding level. By applying gross margin estimates in the Scottish Agricultural College ( SAC) Farm Management Handbook to the crop and livestock enterprises on a holding, estimates of average gross margin per hectare were calculated for each holding. The data on average gross margin per hectare was then used to assess differences in gross margins across holdings in different dominant ²⁰ Macaulay LCA classes. The differences in gross margin between Macaulay LCA classes can be taken to represent different levels of handicap for agricultural land of different quality or capability for agriculture production.

4. Figure 1 shows how average gross margins per hectare drops from land of better quality (Class 1-3.1) to land of the poorer quality (Class 6.1-7).

Figure 1: Average gross margin by dominant Macaulay LCA class (£ per ha)

5. The variations in gross margin by the Macaulay LCA classes shows that the Macaulay LCA effectively captures the differences in the productive potential for agricultural land. It could therefore be used as a basis for designating LFA land in Scotland. It has to be noted, however, that in addition to land quality, the differences in gross margins shown in Figure 1 could be a result of a range of factors. These factors might include farm size, farm type, and farm management practice.

6. The analysis that has been done by the LFASS Stakeholder Group on the relationship between the Macaulay LCA classes and average farm gross margin provides an evidence base that can be used to construct a weights matrix, which captures different levels of disadvantage for agricultural land falling into different LCA classes. Such a weights matrix could then be used to set payment rates for LFASS post-2010 if the Macaulay LCA is adopted as the basis for designating LFA land in Scotland in the future.

7. By applying gross margin estimates from the SAC Farm Management Handbook to holding data on crops and livestock activities from the 2006 June Agricultural and Horticultural Census, average gross margin per hectare were calculated for all IACS registered holdings. The estimates of gross margin per hectare are presented in Table 1 overleaf for land in different Macaulay LCA classes and fragility tiers.

Table 1: Variation in Gross Margin by Macaulay LCA Class and fragility status (£/ha)

Notes: Q Insufficient number of observation to estimate gross margin

8. The variation in gross margin by fragility status only represents differences in enterprise mix between the standard, fragile and very fragile areas. The estimates do not capture additional differences in gross margin that arise from higher input costs in peripheral areas as a result of higher transport costs. This element of LFA related disadvantages would need to be incorporated into analysis separately.

Constructing the disadvantage matrix

9. Differences in gross margin (£/ha) between land that would qualify as non- LFA and LFA can be used as a measure of disadvantage associated with farming land with permanent and natural disadvantages. In the current analysis it is assumed (for illustrative purposes only) that agricultural land in Macaulay LCA Classes 1-3.1 and in the standard fragility tier would make up non- LFA land. Thus, LFA disadvantage is calculated as the difference between average gross margin per hectare between land in Classes 1-3.1 and all the other classes. For example, the average gross margin in Macaulay LCA 4.1-4.2 (fragile) is £278 lower than the average gross margin in Class 1-3.1, which represents the level of disadvantage relative to Class 1-3.1. Table 2 gives an estimate of the disadvantage in the different Macaulay LCA classes relative to Classes 1-3.1 based on 2006 data.

Table 2: Estimated LFA disadvantage by LCA Class and Fragility Tier

Using the disadvantage matrix to calculate payment rates

10. The disadvantage matrix in Table 2 can be presented as a matrix of indices representing LFA related disadvantage for land in different Macaulay LCA Classes and fragility tiers. In the current analysis it was assumed (for illustrative purposes) that land in the Macaulay LCA Class 3.2 and below would form the LFA. By standardising the calculated disadvantage around land in LCA Class 3.2 and in standard fragility tier, a simple matrix of weights starting from 1 was constructed. This is presented in Table 3.

Table 3: LFA disadvantage weight matrix

As prices of agriculture outputs and inputs changes, relative gross margins between enterprises will also change, which has the effect of changing the relative disadvantages presented in Table 3. This implies that the disadvantage matrix would need to be regularly updated to reflect changes in prices.

11. The LFA disadvantage weight matrix suggests that if LFASS payments are calculated based on income foregone and additional costs associated with natural and permanent handicap for agriculture production, every payment of £1 per hectare of land in LCA class 3.2 in the standard areas would have to be matched by a payment of say £1.8 per hectare of land in classes 4.1-4.2 in the fragile areas. Thus the LFA disadvantage weights matrix simply expresses the relative disadvantage between land in different LCA classes and fragility tiers.

12. disadvantage weight matrix in Table 3 suggests a payment rate of £59 per adjusted hectare for the most disadvantaged land in classes 6.1-7 in the very fragile areas and £29 per adjusted hectare for better quality LFA land in class 3.2 in the standard area. Table 4 shows how the payment rates might look if the above approach is used. (As noted in paragraph 15 of this Annex, "adjusted hectares" are used to reflect levels of activity and avoid over-compensation.)

Table 4: Calculated Payment Rates based of LFA Disadvantage using Macaulay LCA

13. In comparison to the current interim LFASS, the above payments would allocate more money to the relatively more disadvantaged land. It is also important to note at this stage that the gross margin estimates used in deriving the disadvantage weights matrix do not fully reflect LFA disadvantages associated with fragility status. Payment rates would be relatively higher for land in the very fragile areas if disadvantages associated with peripherality were incorporated into the analysis.

14. If the Macaulay LCA were used to designate LFA land in Scotland, the LCA classes would replace the grazing categories at field level that are used under the current scheme. However, since fields will have land in different LCA classes, ways of categorising fields into different classes would need to be identified.

Adjusted hectares

15. As with the current scheme, an adjustment to the eligible forage area would be applied where stocking density is below the minimum of 0.12 lu/ha or above the maximum of 1.4lu/ha, irrespective of location or type. As different land will have different levels of activity, the current interim LFASS payments are also designed to reflect the level of activity on a farm and avoid over-compensation. It is assumed here that hectare values are retained from the current scheme and are used to adjust the eligible forage area for level of activity. Based on stocking densities, the analysis by the LFASS Stakeholder Group shows a close link between existing grazing categories and the Macaulay LCA class groupings. This is illustrated below in Table 5 and Table 6.

Table 5: Stocking Density and Hectare Values for Current Scheme

Table 6: Stocking Density and Suggested Hectare Values for Macaulay LCA Classes

16. There are two possible ways of applying the hectare values to adjust for level of activity; which are:

(a) applying the hectare values in Table 5 to eligible area based on the actual average stocking density for each applicant; or

(b) applying the hectare values in Table 6 to the eligible land in different classes for each applicant.

The following example shows how the two approaches can be used.

Applicant has 100 ha of eligible area all in LCA class 5.1, standard fragility tier and an average stocking density of 0.17

Option (a): Given that the applicant has a stocking density of 0.17, a hectare value of 0.167 will apply to their eligible area. The total payment for the applicant will be equal to:

100ha * 0.167 * £49/ha = £818.30

Option (b): Given that the applicant has land in class 5.1, a hectare value of 0.333 will apply to the eligible area. The total payment for the applicant will be equal to:

100ha * 0.333 * £49/ha = £1,631.70

17. This example shows that the way in which the hectare values are applied will affect the value of payment to scheme applicants. There are advantages and disadvantages associated with each of the two options for applying the hectare values to adjust for level of activity. These are presented below.

Conclusions

18. This Annex illustrates the use of data drawn from the SAC Farm Management Handbook and the Macaulay Land Classification to provide an objective basis for setting rates in accordance with the new rules proposed by the EU (for which implementation has been delayed). Further work is required to refine this approach (eg in relation to costs associated with peripherality); to develop practical implementation requirements (eg in relation to land classification); and to consider the need for degressivity.

19. The key elements of this approach are:

• land categorisation revised using the Macaulay Land Capability for Agriculture as a basis for designation of LFA land in Scotland;
• payment rates designed to reflect the identified production disadvantage of land in poorer quality LCA classes and land in peripheral areas;
• with payment rates set according to the disadvantage matrix there would be a shift in the distribution of payments to regions with poorer quality land, fragile and very fragile areas;
• the disadvantage matrix does not capture the full production disadvantage in fragile and very fragile areas, and may require further adjustment;
• the area of eligible forage land would continue to be adjusted for level of activity. Hectare values could either be applied according to the average stocking density for each applicant, or according to the land category;
• over-compensation is avoided by applying restricted eligible hectares where stocking density is below the minimum or above the maximum as stipulated in the existing LFASS scheme;
• the hectare multiplier, providing adjustment to hectare value according to enterprise mix, is no longer applied.

20. Advantages and disadvantages are as follows:

Advantages

• changing the distribution of payment rates would allow a more targeted approach within the LFASS scheme in line with the relative disadvantage identified from differences in income foregone and additional costs of agricultural production on poorer quality land;
• the change in distribution of payments may act to slow the destocking observed in parts of Scotland;
• designing payments according to the Macaulay Land Capability for Agriculture could provide a basis for re-designation of LFA land in Scotland if the outcome of the EU wide review allows designation on this basis.

Disadvantages

• if a wider range of land categories are used, this could increase the complexity of the scheme;
• at holding and field level, land can comprise of a range of Macaulay LCA classes. An effective procedure for allocating a dominant LCA class would have to be established, avoiding perverse incentives to exchange land between farmers to change category;
• re-designation of land on the basis of the Macaulay LCA would be a large exercise in the short term, including the appropriate revision of data systems and administration of the scheme;
• if hectare values are applied on the stocking density for each applicant, in order to adjust payments for level of activity, the annual cost of scheme administration and monitoring would increase significantly. If payments are linked with current levels of activity, there is also a problem with WTO rules.

In addition, the basis of payment would need to include some element of degressivity if this is required by EC legislation. This could be achieved by setting an upper limit to payments per holding, or by having tapering arrangements to reduce the larger payments per holding.

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