Despite Costa Coffee roasting about 45,000 tons of beans a year, coffee beans are not the British coffee company’s biggest cost. It’s milk.
However, hedging the price of coffee has become an important part of Jill Harrison’s role of treasury manager at Whitbread plc – the UK parent company of Costa Coffee.
“Coffee is the second most traded commodity in the world and inconveniently subject to a lot of price volatility which we need to manage. As treasury manager, that’s very high up on my priorities at Costa,” said Harrison.
There are only two elements to risk when it comes to coffee, Harrison told the Treasury Leaders Summit in London on Tuesday.
“The first is clearly the commodity price. Coffee contracts tend to be in dollars,” said Harrison.
“The second element is exchange rate movement. We are a pound sterling business, predominantly operating in the UK, but we purchase coffee in dollars so we’re exposed to fluctuations in sterling and the dollar,” she explained.
When it comes to hedging risks, “it’s really important to us that the strategy comes from the top,” she added.
“The board must communicate what they see as the key risks and what the most important things to protect are. That information is filtered down and feeds into a finance policy which then feeds into the treasury policy which feeds into our FX strategy,” said Harrison.
“We purchase our coffee ahead of time. We also fix our sterling-dollar rate as well”
It is important for treasury to understand what the overarching considerations of the business are when managing risks day-to-day, she argued.
While admitting that every company is different, Harrison believes that an increased focus on hedging risks is consistent for most treasurers due to the global geopolitical shifts over the last two years and connected currency volatility.
As coffee is the second most traded commodity was in the world, future pricing predictions in the market are often quite reliable
“Basic supply and demand has quite a lot of impact on coffee pricing, such as weather conditions,” said Harrison (pictured).
“There are generally two coffee crops a year; one in December, one in May and weather conditions can really affect volume and good quality coffee beans that are produced in each harvest,” she explained.
Costa Coffee has a ‘green coffee committee’ which includes representatives from treasury, procurement, supply chain and the senior finance department.
The committee meets regularly to assess what is happening in the coffee market, from harvests to weather. It then makes recommendations of the levels of coffee that business should buy.
Costa usually buys coffee two harvests ahead of itself at a fixed cost which helps the treasury team to separate pricing risks from other risks. “We purchase our coffee ahead of time. We also fix our sterling-dollar rate as well,” said Harrison.
How do you hedge FX risks?
After joining Costa Coffee in 2017, one the first things Harrison did was review the company’s foreign exchange (FX) strategy. She looked at how the businesses could formalise and document it’s approach to hedging FX.
The company assessed three main hedging strategies.
The first method was static hedging. This means that, at the beginning of the financial year for example, the treasury sets budget rate for the rest of that year.
“This didn’t work for us because we weren’t looking to protect that budget rate. What we wanted to do is hedge against any volatility,” said Harrison.
The next hedging method the business reviewed was rolling hedging. This means that, for example, a company would hedge in January for April and April for May, etcetera.
“[Rolling hedging] didn’t quite work for us because it was too flat. It didn’t give us a dynamic enough hedging strategy for our purposes,” said Harrison.
The treasury team then decided to use a shorter rolling hedging schedule which considers cash outflows. It closes out existing positions as they near maturity and then concurrently opens new positions with maturity dates further in the future.
“At any point in time, we’ve got hedges maturing that have actually been contracted at different dates”
As cash flows become less certain on dates further in the future, Costa will hedge a smaller proportion of the risk and then reassess its position at a later date.
“At any point in time, we’ve got hedges maturing that have actually been contracted at different dates,” said Harrison.
“We have done a review of how this has worked in the past versus what would have happened if we’d taken a different approach to hedging. The review confirmed that this approach works better for us than the other methods.
“It gives us a blended rate, so it is evolving with time. But it also means that we get really good visibility on what our rate is going to be and not that much volatility,” she argued.
Keeping it simple
“At Costa Coffee, we try to keep everything as simple as possible. It is important that the stakeholders understand what it is we’re doing and what we’re trying to achieve,” Harrison explained.
“If we do anything much more complicated in terms of our contracts for currency and coffee, then we start to have hedge accounting problems which we don’t want to come across.
“Our approach is probably much simpler than the approaches that many of you in the room will have but it’s worked for us,” Harrison told an audience of treasurers at the Treasury Leaders Summit.
Banks and other financial services providers have recently started approaching Costa Coffee with options products, more sophisticated hedging products and more complex financial instruments than they have done historically.
“We are looking at preparing the next stage of our hedging strategy in March . We will be focusing on how different products, such as options, might work for us”
“With IFRS 9 coming in next year and the ability to hedge accounts with new types of financial instruments, we think that this is probably going to be quite interesting for us,” Harrison explained.
She said, despite being at the “very early stages”, the company is considering differentiating hedging methods in the future.
“[Costa Coffee] has had its legacy hedging in place for a good amount of time. That come organically for us,” said Harrison.
“We are looking at preparing the next stage of our hedging strategy in March . We will be focusing on how different products, such as options, might work for us.
It is likely that Costa Coffee will create a portfolio that’s just not just maturity driven, but also product driven, according to Harrison.
“There is a little bit of a stigma around options. I’ve heard comments from colleagues around the premium that you can have on options,” she explained.
When using options, the company must take a position on future currency valuations, which Harrison said was a concern to some, whereas forwards are more simply stating a forward rate ahead of time.
“It is a bit difficult, but we’re certainly viewing it as an opportunity to think more creatively about the way that we approach our risk management at Costa,” Harrison concluded.