Will Primary Producers Continue to Adjust Practices and Technologies, Change Production Systems or Transform Their Industry—An application of Real Options

Adaptation Research Grants Program
Greg Hertzler
The University of Sydney
Year Started: 
New South Wales

Executive summary from final report:

Agricultural production systems depend upon weather and climate. Current agricultural practices are adaptations to specific characteristics of the prevailing climate (Gornall et al. 2010). Accordingly, Australian agricultural systems have evolved to suit a highly variable environment. Over time, Australian producers improved their understanding of the climate regimes and responded by making appropriate decisions.

Climate change presents a challenge to current understanding and practices. We can think about a prevailing climate as a stochastic system in which decisions have been informed by historical experiences (Antle 1996). Over time, decisions are calibrated to the current regime. Yet climate change, by its very nature, implies that we can no longer assume that the climate we are familiar with will be the climate of the future.

This research project applies recent developments in the mathematics of uncertainty to investigate the optimal choice of production regimes under climate change. In this environment, we need tools such as mathematical real options analysis, which can take the dynamic nature of risks into account. ‘Real options’ is the name of the modern analytical method for modelling the value of flexibility and the timing of action in decision-making under uncertainty (Dixit and Pindyck 1994; Copeland and Antikarov 2001). 

Simulation and scenario testing approaches generally seek to simply understand the impacts of change, whereas the real options approach specifically seeks to show how decision-makers can manage risk. This approach examines the trade-offs between acting sooner versus retaining the option to act later, by taking into account the value of flexibility and the value of new information that can help to resolve uncertainty. 

In this study, we apply the Real Options for Adaptive Decisions (ROADs) framework (Hertzler 2012b) to assess whether farmers in wheat dominant agriculture will continue to adjust practices and technologies, change production systems or transform their industry (Howden et al. 2010; Rickards and Howden 2012). We use transects across space as an analogue for climate change. Producers in one region may look to a drier and hotter region to see what their climate and production systems may look like in the future. Wheat is the major winter crop in southern Australia, and we focus on wheat producing regions of New South Wales, South Australia and Western Australia.

We chose transects in South Australia and New South Wales for their sensitivity to climate change. Because Western Australia is forecast to become hotter and drier throughout the state, we analysed its nine major agro-ecological zones. For South Australia and New South Wales we used APSIM simulations (McCown et al. 1996), with representative returns and costs. For Western Australia we obtained summarised results from actual data on 155 farms in the 9 agro-ecological zones.

We estimated the stochastic dynamics of climate change along the chosen transects and within the agro-ecological zones and entered these estimations into the calculation of option values, thresholds, the expected times of switching and the probabilities of crossing the thresholds. The option values are the amount farmers are willing to pay to keep their options open and before committing to an inflexible decision which may turn out to be costly. The thresholds are the points at which farmers choose to switch cropping or livestock regimes and transform their production systems. The expected time corresponds to how long farmers may wait to resolve the uncertainties about climate change and the probabilities of crossing the thresholds show the likelihood of crossing the threshold in the near or distant future.

The chosen transect in South Australia straddles Goyder’s line, with Clare below the line, Orroroo on the line and Hawker above the line. Currently at Clare, farmers are almost certain to adopt wheat, less likely to adopt merino grazing, with no chance of abandoning agriculture.  At Orroroo, farmers are less likely to be in wheat and somewhat more likely to adopt merino grazing, but probably will never abandon agriculture.  At Hawker, there is a small chance of adopting wheat, a larger chance of adopting merino grazing and a reasonable chance of abandoning agriculture altogether. As climate becomes hotter and drier in South Australia and Goyder’s line moves south, Clare will become more like Orroroo and Orroroo will become more like Hawker. The landscape will change as wheat becomes less dominant, merinos are adopted on more farms and some farms leave agriculture.

Compare this with wheat dominant agriculture in Western Australia. Even though the impacts of climate change are expected to be severe and make the state much hotter and drier, wheat will continue to dominate agriculture in all agro-ecological zones, including high, medium and low rainfall zones. Sheep do not compete with wheat in any zone. There is virtually no chance that wheat dominant agriculture will disappear from any of the zones. Farmers will continue to choose wheat and will not transform agriculture in Western Australia in response to climate change.

The chosen transect in New South Wales may be less affected by climate but more sensitive to climate change. Cootamundra is in reliable country, Temora is intermediate in reliability and Narrandera is the riskiest region in the entire study. As climate changes, Cootamundra will switch to become more like Temora and manage the risks with a mixed cropping system. Temora may become more like Narrandera with the adoption of sheep. Narrandera is likely to adopt sheep only enterprises or abandon farming altogether.

Of course, these results are not forecasts. They are predicated on the assumption that space is a good analogue for climate change and that climate will change significantly. If climate change is moderate, different regions may take on characteristic of other regions, but will never become exactly like its analogue on the climate transect.

The results show, however, that climate change does not translate directly into transformations of agriculture. Farmers’ decisions are just as important in determining the impacts of climate change. For example, Western Australia will become hotter and drier, but is very unlikely to adapt its agriculture away from wheat, let alone transform into other production systems. The Mediterranean climate and limited options for growing crops and livestock will ensure that farmers choose wheat. South Australia is more likely to adapt away from wheat as Goyder’s Line moves south, mostly because sheep are a more viable option and wheat can become unprofitable and very risky. As a counter example, New South Wales may be less subject to climate change, but farmers are more likely to transform their production systems into mixed farming. The favourable climate and good soils give farmers many options to choose among.

Finally, wheat dominant agriculture is important in Australia and has lessons for agriculture in general, but wheat is a highly resilient crop, perhaps the most resilient crop in agriculture. Wheat is bred to grow where other crops won’t but we can’t survive on bread alone. Agriculture is a very diverse industry with many sectors, all dependent on the climate in complex ways. Future research should investigate which agriculture sectors will be most impacted by climate change, taking into account that farmers will decide what those impacts will be.

View the final report