Insurance and Climate Change column

Drought Weakens Links in Supply Chain Metaphor

By | August 8, 2014

The weakest link in the great global economic cog is the gazillion supply chains that bind us all.

At one time these chains were an ironic metaphor. Instead of shackling companies, supply chains were providing ever greater freedom and flexibility as suppliers grew more numerous and global – thus empowering the delivery of goods and services more affordably to even the farthest-flung regions.

The effects of climate change and extreme weather in the past few years have companies looking a supply chains less as instruments of growth and more as potentially fragile clusters that must be evaluated, managed and closely monitored.

There are a growing number of examples where extreme weather is impacting supply chains, and supply chain experts say this should put on notice insurers, agents, risk managers and anyone else who may have to deal with the impending mess.

With California experiencing its worst drought in decades, almond growers face a dire outlook heading to next year, as do the rest of those in the almond-dependent supply chain in a state that accounts for 80 percent of global almond supplies.

In fact, half the nation’s vegetables and fruits are grown in the drought-plagued state, and the USDA is projecting 3 to 6 percent increases in the prices of beef, poultry, dairy, fruit and vegetable products.

At the end of July, 58 percent of the state was declared to be under exceptional drought conditions. The drought has led to worries about future production and sent almond prices soaring to $3.45 per pound at the end of growing season, the highest since 2005.

If recent history is an example, food producers will soon be feeling the effect.

A report from PricewaterhouseCoopers, “Sustaining the supply chain,” offers as an example of supply chain disruption attributed to climate change and the unusually prolonged drought in Russia during the summer of 2010.

“By early August, over one-fifth of Russia’s wheat crop had been destroyed and the government banned all grain exports, contributing to wheat price futures reaching their highest point in nearly two years,” the report states.

The report notes that General Mills was one of many food manufacturers that faced significant price pressure as a result of the rising wheat prices. The Fortune 500 food corporation announced price increases between 4 percent and 5 percent in September 2010.

Agriculture and food producers not only face business interruptions along their supply chains due to drought-related water shortages, but they also face the reality that their products may be affected directly due to lower yields or lower quality products, said Don Reed, a managing director in PwC’s U.S. sustainable business solutions practice.

Reed’s job at PwC is to help companies develop and implement sustainability strategies to enhance brands, improve operating efficiency and manage risks. He has been working to get clients and others to look more seriously at the impacts of these climate changes along their supply chains.

“Most companies that are in the agricultural value chain have doubled down on the risk,” Reed said. “We’re definitely working with some clients in the agriculture and food value chains that have already experienced at least highly volatile commodity costs and in some cases really steady rises.”

Looking forward buyers can expect continued high volatility in pricing, as well as likelihood of higher prices, and they will likely see the prices being charged by their suppliers vary broadly from one geographic location to next, Reed said.

To deal with drought, beef producers have been moving from traditionally robust feeding areas like Oklahoma and Texas to wetter Midwest areas, such Nebraska, which this year for the first time passed Texas as the top cattle feeding state in the country.

“In beef production, we’ve seen beef processors actually closing facilities further south and in the southwest and opening up more in the central and northern Great Plains,” Reed said. “The center of gravity of cattle production has been in motion because of the drought.”

Beef buyers may see shipping costs rise as their suppliers move distribution centers a thousand miles further north, and some of those suppliers may not be healthy enough to survive or big enough to adapt.

“If you’re a small feed lot or a medium-sized feed lot and you don’t have a lot of options to relocate, that’s a pretty big deal for you,” Reed said.

Retailers and grocery sellers globally must take a hard look at their vulnerability to climate change.

British supermarket and retail chain Asada, where more than 18 million people reportedly shop, recently issued a report showing that only 5 percent of the company’s produce won’t be affected by changes in the climate.

The Walmart subsidiary has identified $170.9 million in vulnerabilities in the countries in which it sources, $274.95 million in risks linked to processing sites and product ingredients and $174.13 million in infrastructure disruption risks.

Reeds said buyers like Asada face a series of questions they need to answer to better manage their supply chain risk. Do they look for large suppliers that are more geographically diverse? Is it the best course to concentrate on dealing only with large suppliers? Is using only small suppliers and lots of them that are more distributed around the world the way to go?

There are many variables in play, a lot that can go wrong, and someone will pay when the chain breaks. At least one legal expert sees a storm brewing over business interruption insurance.

The popular burger chain In-in-Out recently made headlines when it cited the drought as the reason it raised its prices on burgers and drinks between a nickel and 15 cents.

Other end-sellers may make similar moves to deal with the rising cost of meat and produce, but if they are unable to recoup their higher costs by asking consumers to pay, they may look at their business interruption policies to recover losses, said Linda Kornfeld, a partner in the insurance group at Kasowitz, Benson, Torres & Friedman.

Kornfeld has dedicated her trial and appellate practice to representing companies in high-stakes insurance coverage litigation for over 20 years. Lately she’s telling her clients: “The specific language of your property/business interruption policy is going to be critical.”

Many insurers include exclusions in their policies for crop damage or losses, so she believes insurers will argue that a lack of water supply, for example, isn’t sufficient cause for a company that relies on strawberries to make strawberry soda to claim business interruption.

Kornfeld said she isn’t aware of any cases in which there is a battle between policyholders who feel climate change has interrupted their supply chain and their insurers, but she expects to see some – especially in California.

“I definitely believe given the extent of the drought and the fact that there’s so many businesses that rely on California agriculture…this conversation is one that is presently happening and I presume there will be disputes,” she said.

Kornfeld is advising clients to purchase trade disruption insurance, which doesn’t require actual damage to trigger coverage.

“Trade disruption insurance provides greater flexibility with respect to the types of losses you may suffer because of something that has happened in your supply chain,” Kornfeld said.

She likens it to data breach coverage. There’s a growing awareness of the need for it, but there are still many companies without it.

“It’s a very important insurance,” Kornfeld said. “It provides a lot of protection that has become more relevant to companies recently.”

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Topics California Agribusiness Climate Change Business Interruption

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