BACKGROUND ON NESTLÉ NESPRESSO S.A. AAA SUSTAINABLE QUALITY TM MBA CHALLENGE 2013

BACKGROUND ON NESTLÉ NESPRESSO S.A. AAA SUSTAINABLE QUALITY TM MBA CHALLENGE 2013 This information may be shared freely but the document as such is for use in the context of the MBA Challenge only

TABLE OF CONTENTS 1 INTRODUCTION 01 2 ABOUT NESPRESSO 03 2.1 A unique business model 04 2.2 Creating and sourcing the highest quality coffee 04 2.3 A dynamic and fast growing market 05 3 ISSUES IN THE GLOBAL COFFEE SUPPLY CHAIN 06 3.1 Key facts on coffee 07 3.2 Recent market conditions 08 3.3 Coffee sourcing programmes 09 4 SUSTAINABILITY: A KEY BUSINESS DRIVER FOR NESPRESSO 10 4.1 Creating Shared Value and Ecolaboration TM 11 4.2 The Nespresso AAA Sustainable Quality TM Program 11 4.3 The Real Farmer Income TM Approach (RFI) 13 5 COLOMBIA AS A HIGH QUALITY COFFEE SUPPLIER 15 5.1 Challenges for the coffee sector in Colombia 17 5.2 Nespresso engagement in Colombia 17 5.3 Strategy in Colombia 18 5.4 What s next? 20 6 REFERENCES 21 7 APPENDICES 23 Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 2

21 INTRODUCTION

INTRODUCTION 1 BACKGROUND ON NESTLÉ NESPRESSO S.A. AAA SUSTAINABLE QUALITY TM MBA CHALLENGE 2013 This background document has been co-authored by the Nespresso team and their partners at The Sustainable Markets Intelligence Center (CIMS) and INCAE Business School in Costa Rica. The document is designed to give a broad introduction to the Nespresso business and to explain its commitment to sustainability along its value chain. It also contains more specific information about its coffee-sourcing programme designed to secure a long-term supply of the highest quality coffees (the Nespresso AAA Sustainable Quality TM Program). It explains the work Nespresso has been carrying out in key coffee producing countries as well as some of the challenges it has faced and will continue to face in the future. A specific focus is placed on challenges and programmes in Colombia, a key country of origin for AAA coffee. This intends to provide useful context for the forthcoming MBA Challenge case study that will be published in early 2013. Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 2

2 ABOUT NESPRESSO A unique business model Creating and sourcing the highest quality coffee A dynamic and fast growing market 2.1 2.2 2.3

ABOUT NESPRESSO 2 The Nespresso concept was the brainchild of a Swiss coffee pioneer and inventor who was determined to create an espresso preparation system that would enable discerning espresso coffee consumers to prepare excellent quality espresso coffee at home. 2.1 A UNIQUE BUSINESS MODEL The patented Nespresso system uses a unique extraction method encased in stylish machines to extract consistently high quality espressos from exceptional coffee blends in portioned aluminium capsules. Launched in 1985 Nespresso revolutionised in-home coffee cup quality and gave rise to the entirely new home use portioned coffee category. The company has continued to innovate in various areas, and even developed specific formats tailormade for businesses like high-end hotels, restaurants and offices. The Nespresso business model is based on three pillars: the unique extraction system, an innovative and efficient direct-to-consumer club membership model (whereby those who buy a Nespresso machine automatically become members of the Nespresso club) and 24/7 service that allows club members to order capsules, send machines for repair and ask any questions related to their use of Nespresso products. Nespresso has created a brand that stands for luxury, exceptional quality and a lifestyle experience. The individual coffees in the range are described not as varieties or flavours, but as Grands Crus (a term used most often in the wine industry to denote an excellent quality, and adapted by Nespresso to denote the quality of their coffees). In addition to being able to order capsules online, club members can also shop in Nespresso boutiques, about 300 worldwide at the end of 2012, which are always located in the high-end luxury retail areas of major global cities. The brand s story positions it as ultra premium, justifying (in addition to product delivery) consumer price premiums. In addition to machines and coffee capsules, Nespresso sells espresso-related accessories created by top designers and has sponsored high-end events such as the Cannes Film Festival and the Swiss challenge for the Americas Cup sailing competition. 2.2 CREATING AND SOURCING THE HIGHEST QUALITY COFFEE According to studies conducted on specialty coffee and product sensory profiling by the internal green coffee experts within Nespresso, only around 1% to 2% of the worldwide coffee harvest is of the correct quality level, flavor and aroma profile for the Nespresso range of products. Given this constraint in coffee sourcing options and the significant growth rates of the business, securing a stable, long-term supply of highest quality green coffee became a key priority. Furthermore, there was a growing internal consensus that even if it could secure the coffee it needed, the Nespresso brand would suffer if it did not find a way for producers to benefit more from their relationship with the company. Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 4

ABOUT NESPRESSO 2 2.3 A DYNAMIC AND FAST GROWING MARKET The overall profile of Nespresso consumers is upmarket, slightly older coffee consumers. The home market of Switzerland and other European markets with a tradition of espresso consumption still constitute a significant proportion of total sales, though the brand is also growing in so called "white cup" (coffee plus milk) markets such as the US, Asia and Latin America. The unique features of the Nespresso system and business model have led to high growth rates, making Nespresso one of Nestlé fastest-growing businesses and a so-called billionaire brand. The company has over 7,000 employees and the brand is now available in more than 50 countries. One of the brand's main strategic challenges in recent years and in the future will be to manage this growth, in all areas of the business, including human resources, customer service and supply chain management. Portioned or single-serve coffee is now a fast-growing segment and Nespresso's success has drawn the attention of a range of competitors with currently more than 50 competitive systems and 44 brands with compatible capsules. It is interesting to note that the two first compatible capsule competitors who entered the portioned coffee sector in 2010, have chosen a specific sustainability attribute to challenge the Nespresso position with regard to sustainability. One has focused on biodegradable capsules (as compared to the Nespresso recyclable aluminium ones) and the other is ensuring that 100% of the coffee in their capsules is certified to the European-based certification standard Utz Certified. Figure 1: Growth of Nespresso employees as a reflection of the growth of the business from sourcing to sales 2000 over 330 employees 2012 over 7,000 employees Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 5

3 ISSUES IN THE GLOBAL COFFEE SUPPLY CHAIN Key facts on coffee Recent market conditions Coffee sourcing programmes 3.1 3.2 3.3

ISSUES IN THE GLOBAL COFFEE SUPPLY CHAIN 3 3.1 KEY FACTS ON COFFEE Coffee is grown in many countries. However, only a few countries are significant exporters of coffee. It comes in many varieties, but generally falls into two categories Arabica and Robusta. Robusta is produced in very large volumes and is considered of lower quality than Arabica. Arabica coffee is produced in smaller volumes (frequently on farms of less than 1 hectare, but sometimes on farms of over 1,000 hectares), and is generally of high to extremely high quality. These beans are the nearly exclusive choice for consumers interested in cup quality. Nespresso and its principal competitors are interested in Arabica coffee and generally compete with each other for supply and suppliers. Arabica coffee is traded on the New York stock exchange and its price historically varies between 150 to 200 cts/lb. Robusta is traded on the London International Financial Future and Options Exchange in /MT. Compared to Arabica coffee its price has been fluctuating between 80 to 100 cts/lb. As a result, coffee prices are highly volatile and do not respond exclusively to coffee supply and demand. An interesting aspect of the international coffee market is that although Arabica and Robusta compete in very different segments, they are frequently substituted for each other in blends produced for mass markets. As a consequence, the international market price for Arabica is highly dependent on the supply and demand in the much larger Robusta market (see chart 1 below). The overall result of market conditions for the past 20 years has been decreasing real prices (inflation adjusted) for Arabica coffee. In 1989, coffee markets were made more open when a long-standing producer-country cartel was abandoned. In the following years, producers and producer countries (particularly of Arabica coffees) shifted their emphasis toward more differentiated markets, as aspects of quality and flavour profile became more important for a variety of international markets and trading companies. This market liberalisation opened up new possibilities for traders and roasters. Many companies entered this new market space. In the U.S. companies like Starbucks, Peet s, Green Mountain Roasters, and many other smaller roasters redefined the retail coffee industry. ICO indicator prices, nominal (US$ cents / lb) 300 250 200 150 100 50 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 COLOMBIAN MILD OTHER MILD ARABICAS BRAZILIAN NATURAL ARABICAS ICO COMPOSITE ROBUSTAS Chart 1: ICO indicator prices, nominal (US$ cents/lb) Source: ICO, 2012 Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 7

ISSUES IN THE GLOBAL COFFEE SUPPLY CHAIN 3 3.2 RECENT MARKET CONDITIONS With the increased demand for high quality coffee, many analysts predicted skyrocketing prices for Arabica coffees. However, new entrants in the Robusta market, most notably Vietnam supported by a massive World Bank program, began in the late 1990s, flooded international markets with Robusta coffee (see Chart 2) driving down Robusta prices, and taking with them the Arabica prices. Vietnam thus became the second largest worldwide producer after Brazil. 60 Mb Coffee production (Arabica and Robusta) in bags (million bags) 50 Mb 40 Mb 30 Mb 20 Mb 10 Mb Chart 2: Coffee production (Arabica and Robusta), of six representatives countries, in millions of 60 kg bags Source: ICO, 2012 0 1976 1978 1982 1986 1990 1994 1998 2002 2008 2009 2010 2011 2012 Brazil 48.1 Colombia 9.2 Vietnam 18.5 India 4.7 Indonesia 8.5 Mexico 4.4 The net result of market conditions for the past 20 years has been both volatility and decreasing real prices (inflation adjusted) for Arabica coffee, as the charts below indicate. US$ cents / lb 250 200 150 100 50 0 Real prices for Arabica coffee from sources reputed for quality 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Chart 3: Nominal prices paid to growers for Arabica coffee from sources reputed for quality Source: ICO (d), 2010 2006 2008 2010 Brazil Costa Rica Colombia Guatemala Mexico US$ cents / lb Real prices for Arabica coffee from sources reputed for quality 260 240 220 200 180 160 140 120 100 80 60 40 20 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Brazil Costa Rica Colombia Guatemala Mexico Chart 4: Real prices paid to growers for Arabica coffee from sources reputed for quality. Price index 2005 =100 Source: ICO (d) and OECD, 2010 Unfortunately for the worlds Arabica producers, production costs have also increased. Compared with 1995 levels, fertilisers have increased in cost by a factor of 4 or more (largely correlated with oil and natural gas prices). Labor costs have also increased. Since chemical inputs typically represent around 1/3 of production costs, and labor costs over half profits have been squeezed, and in many cases eliminated. Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 8

ISSUES IN THE GLOBAL COFFEE SUPPLY CHAIN 3 3.2 RECENT MARKET CONDITIONS In other agricultural sectors, prices have also decreased (mostly due to increased supply and flat demand), but producers have managed to maintain profit levels through increased productivity (defined as total output per hectare). However, in the case of Arabica coffee, there have been no major technological changes to increase productivity in the past 20 years or more. In fact, productivity has actually been decreasing in most Arabica-producing regions (see chart 5) as declining profit margins have slowed re-investment in new coffee plants, genetic upgrades, machinery and even chemical inputs. 60 Green coffee productivity of selected countries (46 kilo sacks ( qq ) / hectare) 50 Quintals / ha 40 30 20 10 0 Colombia Ethiopia Guatemala India Indonesia Mexico Vietnam Chart 5: Green coffee productivity of selected countries in quintals (46 kilo sacks) / hectare) 1 Source: Faostat, 2012 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 3.3 COFFEE SOURCING PROGRAMMES Against this backdrop, sourcing high quality coffee has become progressively a more difficult task. About 5% of the world s coffee production is given over to Arabica high quality coffee (Giovannucci et al, 2008), and demand for those beans continues to increase. Companies like Illy Café, Starbucks and Nespresso are all seeking to obtain these beans through their respective sourcing programmes. Issues addressed include those of quality, traceability, as well as environmental and social sustainability concerns that growing numbers of consumers care about, and that are increasingly viewed as important in the securing of long-term sustainable supplies of coffee. Third party certification standards such as Fairtrade, Organic and Rainforest Alliance have emerged as the main response by other companies to some of the most relevant sustainability issues in the coffee supply chain. The response of Nespresso to these issues and other challenges is the AAA Sustainable Quality TM Program, a holistic approach embedded in its own sourcing system. The following section describes the programme in more detail. 1 Production of coffee in Vietnam corresponds mainly to Robusta coffee. Most Arabica coffee producing countries, like Mexico and Colombia have a trend of a declining total production of coffee Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 9

4 SUSTAINABILITY: A KEY BUSINESS DRIVER FOR NESPRESSO Creating Shared Value and Ecolaboration TM The Nespresso AAA Sustainable Quality TM Program The Real Farmer Income TM Approach (RFI) 4.1 4.2 4.3

SUSTAINABILITY: A KEY BUSINESS DRIVER FOR NESPRESSO 4 4.1 CREATING SHARED VALUE AND ECOLABORATION TM We are a part of Nestlé Nestlé has committed to Shared Value as an operating principle. Richard Girardot CEO, Nestlé Nespresso S.A. committed the company to the concept of Creating Shared Value (CSV) This principle, developed by Harvard Professors Michael Porter and Mark Kramer in 2006, maintained that companies had a responsibility to create and share value not just for shareholders but also for the communities in which they operated from farmers through to customers and ultimately consumers. In the CSV approach they advocate companies identifying a "sweet spot" or point of connection between the activities and needs of a company and the activities and needs of society, and call this a process of mapping social opportunities. In this way, business organisations can be much more targeted and efficient in assessing the way their business activities create value that is shared with other stakeholder groups. Informed and inspired by the CSV approach, Nespresso identified its own social opportunities and areas of interdependence with wider society within its value chain. On this basis, the company has launched an integrated CSV framework, "Ecolaboration TM 2 to group together its value chain sustainability efforts in the area of carbon footprint reduction, sustainable coffee farming and spent capsule recycling 3. A customer segmentation study conducted in 2008 identified that 16% of Nespresso consumers are defined as "eco-committed" (described as liking the good things in life but in a responsible way). This group is significantly more interested in the Nespresso AAA Sustainable Quality TM Program than other customer segments. This fact provided further motivation for the company to develop its strategy. 4.2 THE NESPRESSO AAA SUSTAINABLE QUALITY TM PROGRAM By applying the CSV thinking especially in the area of sustainable coffee farming, Nespresso soon realised that its requirement for long-term sustainable sources of green coffee overlapped completely with the farmers own need to improve their long-term economic prospects and a wider societal need to improve the effectiveness of coffee farming in conserving natural resources. This led to the Nespresso AAA Sustainable Quality TM coffee sourcing program co-developed by Nespresso and Rainforest Alliance, originally rolled out in 2003, which focuses on helping coffee farmers continuously improve their ability to produce the highest quality coffee whilst addressing on-farm sustainability and farm productivity at the same time (see Figure 2 above). A central ambition of the program is that AAA farmers improve their net incomes. This has led to the conceptualisation of a farm income focus called Real Farmer Income TM (RFI) by Nespresso (see later section for more details on this). Quality Maintaining highest quality First Sustainability Respecting people and environment Second Productivity Farm management A A A Third Sustainable Value Creation Figure 2: AAA pillars 2 Find more details at: http://www.nestle-nespresso.com/ecolaboration/sustainability http://www.nestle-nespresso.com/ecolaboration/creating-shared-value 3 Find details on the recycling initiatives at: http://www.nestle-nespresso.com/ecolaboration/sustainability/capsules Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 11

SUSTAINABILITY: A KEY BUSINESS DRIVER FOR NESPRESSO 4 4.2 THE NESPRESSO AAA SUSTAINABLE QUALITY TM PROGRAM The key characteristics of the AAA program are to pay premiums to its farmers for quality, incentivise them to comply with the Rainforest Alliance standard (environmental, social and various management variables) and initiate projects to boost yields and income. Nespresso chooses very select coffee-producing regions around the world that provide the unique flavour and aroma characteristics that define its blends. The company then identifies and enters into long-term relationships with experienced coffee buying companies working in those regions that are contracted to provide coffee according to the Nespresso quality requirements. In addition, the buyers assist Nespresso and supplier farmers in advancing toward compliance with the AAA program, mostly through the provision of technical farm extensionist services. From its original inception in 2003 and through its subsequent redefinition and expansion to include Real Farmer Income TM as a metric, the AAA Program has now grown to be a sourcing program that reaches 50,000 farmers in seven countries, including Colombia, and twenty growing regions (referred to internally by Nespresso as clusters ), and is set to grow further in the next three years. The backbone of the AAA program is the large network of agronomists in the field who offer training and technical assistance through farm visits and workshops to help farmers improve performance. As a consequence Nespresso is gradually building ever-closer relationships with its global community of AAA farmers 4. Video: Coffee sourcing in Colombia The Nespresso AAA Sustainable Quality TM Program pays premiums for both quality and sustainability. The premium is around 30% to 40% above the standard market price for coffee and 10% to 15% above the general local market price for coffees of similar quality, a key benefit from the farmers perspective, for participating in the Program. (see Chart 6) 4 For more information, please go to: http://www.nestle-nespresso.com/ecolaboration/sustainability/coffee Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 12

SUSTAINABILITY: A KEY BUSINESS DRIVER FOR NESPRESSO 4 4.2 THE NESPRESSO AAA SUSTAINABLE QUALITY TM PROGRAM One key aspect of the programme that ensures loyalty from farmers is the commitment to price premiums (see below chart). However one of the real drivers behind improvement at farm levels is the commitment to farmer extension work, technical assistance as well as building a long-term relationship with coffee producers. Drivers of satisfaction among AAA Sustainable Quality TM participants PREMIUM 29% BENEFITS RECEIVED BETTER FARM MANAGEMENT 16% 17% COFFEE QUALITY 9% OTHER 7% BETTER QUALITY OF LIFE TECHNICAL ASSISTANCE ENVIRONMMENTAL PROTECTION CONTINUOUS IMPROVEMENT 6% 5% 5% 5% 0% 5% 10% 15% 20% 25% 30% 35% Chart 6. Drivers of satisfaction among AAA Sustainable Quality TM participants (Colombia) Source: Crece, 2012 The price premium that Nespresso pays to its buyers has two components: one corresponding to technical assistance and one that is actual cash to be paid to the farmers for their coffee. One other important aspect of the Nespresso sourcing programme is that usually only a relatively small percentage of each producer s coffee is eligible to receive the Nespresso AAA premium (only this percentage passes the quality test due to size of beans, harvesting approach, and post-harvest handling). Coffee that does not comply with Nespresso's high quality standards will be sold to other buyers. 4.3 THE REAL FARMER INCOME TM APPROACH (RFI) In 2008, Nespresso committed to RFI as one of its strategic pillars. We are committed to increasing Real Farmer Income as the expression of our commitment to create shared value with our key farmer partners. RFI is critical to us, because of our corporate culture, because it maintains the health and vitality of our supply chain, and because it is the right thing to do for the farmers who are such an important part of the Nespresso success. CEO, Nestlé Nespresso S.A. Richard Girardot The Real Farmer Income concept involves taking a close look at the farmer s business model and with this information, identify ways of transforming coffee farming into a more profitable economic activity. While most Nespresso executives saw RFI as a key strategic approach, farmer well-being has not been an explicit part of the traditional coffee buying and trading culture. Historically, the relationships between roasters/brands, their trader suppliers and farms has been of a transactional nature, and nearly always based on negotiations for the current years harvest, although it is not unusual for Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 13

SUSTAINABILITY: A KEY BUSINESS DRIVER FOR NESPRESSO 4 4.3 THE REAL FARMER INCOME TM APPROACH (RFI) farmers to sell to the same buyer for many years. An extensive field study conducted by its research partner, the Sustainable Markets Intelligence Center (CIMS, based in INCAE Business School in Costa Rica) concluded that productivity was the key driver of farmer income, while prices and premiums remained as secondary drivers. Productivity is dependent on a number of variables, including farm management (activities like record keeping, pruning and fertilisation), age of coffee trees, weather and pests. Separately, quality has its own set of variables, some of them also linked to productivity, but also related to the quality of the processing (milling and fermentation stage) and optimal ripeness for picking the coffee. The study, conducted between 2008 to 2010 across 5 countries (Costa Rica, Guatemala, Colombia, Mexico, Brazil) also concluded that while some improvements were seen in social and environmental management of farms, positive net incomes in some regions (clusters) was by no means guaranteed for all farmers in the programme, and that uncertainty for the farmer remained. (please find results on farmer income from the RFI study in Appendix 1) Notwithstanding the company s commitment to having a positive impact on Real Farmer Income TM, it was clear that there are many challenges to the realisation and execution of the RFI approach. Each coffee growing region (cluster) has its own difficulties and each requires a specific diagnosis of its own challenges related to farming culture, scale, social and environmental constraints, effects of climate change and incidence of disease and many other variables. The scale of the challenge is also significant. Many of the farms in the programme are smallholdings of a few hectares. Head of Green Coffee at Nestlé Nespresso S.A., Karsten Ranitzsch, noted some of the important challenges. In practical terms, Nespresso has over 50,000 farmer suppliers, and no two are exactly alike in their strengths or weaknesses. Virtually all will need some assistance to increase their income, most will need a great deal of help and not just in production, but in quality management, and reducing their environmental impact. Video: Coffee sourcing in Costa Rica Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 14

5 COLOMBIA AS A HIGH QUALITY COFFEE SUPPLIER Challenges for the coffee sector in Colombia Nespresso engagement in Colombia Strategy in Colombia What s next? 5.1 5.2 5.3 5.4

COLOMBIA: A HIGH QUALITY COFFEE SUPPLIER 5 COLOMBIA AS A HIGH QUALITY COFFEE SUPPLIER Colombia is the third largest coffee producer in the world, and a significant producer of much of the world s premium quality coffee. Demand has been constant and growing (Perdomo and Hueth, 2011); in particular, high quality coffee has seen a rise in demand, increasingly from growing middle classes in countries such as China, Coffee growers participating in specialty coffee programs India and Brazil. This has 2005 caused - 2009growing pressure on the supply of beans (SCAA, 2012). Total coffee production and exports grew 50% between 1977 and 2007. (FNC, 2007) 80,000 70,000 69,568 74,927 60,000 50,000 40,000 3.0,000 20,000 10,000 24,372 11,567 4,051 2005 2005 2005 2005 2005 Chart 7. Participation of coffee growers in specialty coffee programs, Colombia Source: FNC, 2010 Coffee is an important contributor to the Colombian economy, particularly in rural areas where this labour-intensive crop is produced. Although the significance of coffee to the Colombian economy has declined in recent years the crop still represents 10% of agricultural GDP. Coffee has an even higher share of the cultural and social significance in the country with 500 000 farmers, and the crop employs close to 35% of the agricultural workforce. The country has a long and deep rooted tradition as a quality coffee producing and exporting country. Since 1927 the Federacion Nacional de Cafeteros de Colombia (FNC), a business cooperative, has provided an institutional framework for the coffee sector in Colombia and this focus has enabled Colombia not only to be the second biggest supplier country of Arabicas but also to gain higher prices for quality on the international market. Given the high quality of its coffee, Colombia remains one of the key sourcing markets for Nespresso, and for this reason it has focused considerable attention on its coffee-growing communities. Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 16

COLOMBIA: A HIGH QUALITY COFFEE SUPPLIER 5 5.1 CHALLENGES FOR THE COFFEE SECTOR IN COLOMBIA Colombia has suffered over 40 years of civil war and still bears the scars of this conflict. High levels of violence and political instability affected the rural economy, and coffee was no exception. Farmers chose to switch from coffee to other more lucrative crops, further exacerbated by a drop in coffee prices during the period. This caused a steady loss of knowledge of coffee farming in the country. With the civil war over, and violence much reduced, coffee growers have slowly returned to farming activities. However, more than fifty seven percent of Colombians living in rural areas still live below the poverty line. Life for the average coffee farmer and his dependents is a difficult and uncertain one: years of low market prices (resulting in shrinking family incomes), productivity affected by volatile weather and climate change, no social security, limited education infrastructure, and prospects for far higher wages in urban areas. Data shows that rural migration has been increasing for the last 15 years, reaching a peak in 2005, when 12 in every thousand inhabitants moved mostly into urban areas, many to take up jobs in a dynamic construction sector (Botello, 2010). This situation has caused considerable challenges in the agricultural sector, especially coffee. With the average age of a farmer being around 54 to 56, and little incentive for the next generation to stay in the countryside to tend the farms, the sector faces considerable uncertainty. Some of the consequences are already being felt not least a loss of farming know-how, decline in productivity, and the fragmentation of already small farms. (more than 95% are less than one hectare) In recent years, Colombia has suffered from a significant decline in productivity in its coffee sector; some of this is related to a fungus called coffee rust that affects the coffee trees; continued changes in climate (including severe rainfall) are also to blame. All of these add up to a challenging panorama for coffee sourcing in the country. 5.2 NESPRESSO ENGAGEMENT IN COLOMBIA In the last few years, total volumes of coffee sourced in Colombia by Nespresso have tripled. The company is now engaged in four regions sourcing from more than 37,000 farmers. It has increased its involvement in the country since its entry in 2004 and currently sources AAA coffee from five clusters highlighted in ANTIOQUIA this map below. CALDAS Figure 3: Nespresso coffee supplying regions in Colombia NARIÑO CAUCA HUILA Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 17

COLOMBIA: A HIGH QUALITY COFFEE SUPPLIER 5 5.3 STRATEGY IN COLOMBIA 5.3.1 REAL FARMER INCOME TM STUDY Nespresso has undertaken a number of initiatives in the country in recent years. In 2004 it initially focused on a project designed to improve quality and productivity conducted in the Caldas region of Colombia with the U.S. non-governmental organisation Technoserve. Then, in 2008, as part of its five-country RFI study with CIMS, Nespresso took a closer look at the economic situation of the Colombian producers that supplied them with coffee. CIMS studied 150 farms (both AAA and control group farms) and effectively created new, comparable income statements for farmers, looking at their cost structures, inputs, revenue and profits. The methodology was based on internationally accepted criteria developed by the Committee on Sustainability Assessment (COSA), a consortium of independent research organisations that study the economic, environmental and social aspects of commodity production. (see http://www.iisd.org/standards/cosa.asp) The 2008 study revealed some significant challenges in the value chain. Amongst the most important findings on farm economics included: Not all farmers were profitable, as reference prices are highly volatile, and production costs varied significantly. Nespresso and other purchasers of Arabica coffee could reasonably expect large-scale exit of coffee producers from coffee-producing zones they depend on for their highest quality coffees. Nespresso needed to respond to the likelihood of decreased coffee production in zones it was planning to expand sourcing to meet its strategic goals. Though initial results showed evidence of positive farmer benefits from their relationship with Nespresso (through technical assistance and the pass through of the price premiums), the bottom line impacts on farmer s income were not yet strong enough to be transformative in this short timeframe. Among the drivers of income, it was found that productivity, fertilisation and farm management had the highest impact. In fourth place, the prices and premiums of coffee were found to be less influential drivers for a given market price. (see appendix 3 for details on correlation findings) The RFI study informed a core part of the Nespresso wider AAA strategy and has enabled it to develop further interventions to address its challenges in Colombia. 5.3 STRATEGY IN COLOMBIA 5.3.2 AAA PROGRAM IMPLEMENTATION For the effective deployment of the AAA program in the country, Nespresso has developed a 5 point strategy. This entails a closer collaboration with institutional partners such as FNC, focused targeting of potential public private partnerships (PPPs), a focus on yield and quality (Qualitivity TM ), innovation in addressing water management and a process for measuring and tracking CSV performance. A range of projects in partnership with suppliers show positive early indications of yield improvements (find a complete list of projects in Colombia in Appendix 2). The program is also having a positive impact on environmental outcomes, in particular in the area of water consumption and wastewater treatment, as farms move towards compliance with Rainforest Alliance s Sustainable Agriculture Network (SAN) standards. Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 18

COLOMBIA: A HIGH QUALITY COFFEE SUPPLIER 5 5.3 STRATEGY IN COLOMBIA 5.3.2 AAA PROGRAM IMPLEMENTATION One illustrative example of theses initiatives is a community coffee-processing center in the region of Jardin, co-funded in 2010 by Nespresso and other partners (including Cafexport, USAID, ACDI-VOCA and FNC) enabling farmers to process their coffee collectively, rather than on each individual farm. This effort has enabled greater efficiencies, economies of scale and a number of other social, environmental and economic benefits. The mill has doubled the supply of AAA profile coffee, increased average farmer net incomes equivalent to 17%, freed up to 4 hours of time for farmers per day in the harvest period, decreased water use by 63% and eliminated waste water contamination. (Please see information on the impact of the central mill in Appendix 4) Video: Central mill in Colombia Subsequent research done in Colombia over the past year by a local organisation affiliated with FNC (Crece) has shown indications of improvements in farm sustainability performance suggesting that some investments are beginning to show positive pay offs. CRECE has been measuring AAA farm performance in Colombia against a control a control group of farms using sustainability indicators across the social, environmental and economic spectrum. Their study demonstrates a higher performance for AAA farms with evidence of progress on a range of social, environmental and economic criteria (see below charts). AAA farmers + AAA farmers with Rainforest Alliance (RA) certification had better social conditions AAA farmers + AAA farmers with Rainforest Alliance (RA) certification had better economic conditions AAA farmers + AAA farmers with Rainforest Alliance (RA) certification had better environmental conditions 100 80 60 40 20 0 65 67 54 53 46 2009 2011 CONTROL AAA RA AAA 100 80 60 40 20 0 40 49 2009 39 55 59 2011 CONTROL AAA RA AAA 100 80 60 40 20 0 49 68 2009 48 73 2011 79 CONTROL AAA RA AAA Chart 8: AAA farmers + AAA farmers with Rainforest Alliance (RA) certification had better social conditions Source: CRECE Chart 9: AAA farmers + AAA farmers with Rainforest Alliance (RA) certification had better economic conditions Source: CRECE Chart 10: AAA farmers + AAA farmers with Rainforest Alliance (RA) certification had better environmental conditions Source: CRECE Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 19

COLOMBIA: A HIGH QUALITY COFFEE SUPPLIER 5 5.3 STRATEGY IN COLOMBIA 5.3.2 AAA PROGRAM IMPLEMENTATION After a number of years of commitment to the country, the same local research suggests that AAA farmers have high levels of loyalty to the programme. However, against a backdrop of continued decline in productivity, an ageing farmer base, and remaining wider socio-economic and environmental challenges, the Nespresso ambitious growth targets and demand for Colombian coffee mean that the company needs to build further on its successes to ensure a more secure and ultimately transformative business in Colombia for both the company and its farmer communities. 5.4 WHAT S NEXT? Through its MBA challenge programme, INCAE Business School, CIMS and Nespresso are seeking support from the global academic community to help it develop innovative solutions to the challenges in its coffee supply chain. This document is a background document that aims to help set the scene for the Challenge. The Case Study will be released early February 2013. Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 20

6 REFERENCES

REFERENCES 6 ALDRIDGE, M. 2003 Civil War and United States Involvement in Colombia. Available at: http://www.stanford.edu/class/e297a/united%20states%20involvement%20in%20 Colombia.pdf Consulted on: December, 2012. BOTELLO, S. 2010 Jornales cafetaleros e integración del mercado laboral cafetero: 1940 to 2005. Available at: Consulted on: November, 2012 FAOSTAT 2012 Agricultural Production and Yield Statistics. Food and Agriculture Organisation of the United Nations (FAO). Available at: Consulted on: December, 2012 http://faostat.fao.org/site/567/default.aspx#ancor. FEDERACION NACIONAL DE CAFETEROS (FNC) 2010 Colombian coffee sector outlook. World Coffee Conference, 2010. Available at: http://dev.ico.org/event_pdfs/wcc2010/presentations/wcc2010-munoz-e.pdf Consulted on: December, 2012 FEDERACION NACIONAL DE CAFETEROS (FNC) 2007 Principales cifras de la caficultura colombiana. Available at: http://mailin.cafedecolombia.com/productivo/inscripc.nsf/792337e17cf5a4f6052 56d51008185f3/2c078acdd6d20f830525730200816139/$FILE/B-3-Principales%20 cifras%20de%20la%20caficultura%20colombiana.pdf Consulted on: November, 2012 GIOVANNUCCI, D., LIU, P. AND BYERS, A. 2008 Adding Value: Certified Coffee Trade in North America Pascal Liu (Ed.) Value-adding Standards in the North American Food Market - Trade Opportunities in Certified Products for Developing Countries. FAO. Rome. PERDOMO, J.A. AND HUETH D.L. 2011 Funciones de la producción, análisis de economías a escala y eficiencia técnica en el eje cafetero colombiano: una aproximación con frontera estocástica. Available at: http://www.federaciondecafeteros.org/static/files/jornales_e_integracion_al_mdo_laboral_cafetero.pdf http://www.federaciondecafeteros.org/static/files/funciones_produccion_analisis_economias_escala.pdf Consulted on: November, 2012 SPECIALTY COFFEE ASSOCIATION OF AMERICA Specialty Coffee Facts and Figures. Available at: http://www.scaa.org/pdf/resources/facts-and-figures.pdf Consulted on: November, 2012 Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 22

7 APPENDICES

APPENDICES 7 APPENDIX 1 Farmer income in Nespresso purchasing regions in five countries, in US$/ha (ordered from least to most profitable farm) 4,000 Net income (US$/ha) 3,000 2,000 1,000 0-1,000-2,000 0% 20% 40% 60% 80% 100% Brazil Costa Rica Colombia Guatemala Mexico Source: CIMS (cl. 2010) Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 24

APPENDICES 7 APPENDIX 2 Nespresso AAA Sustainable Quality TM Program. Projects in progress in Colombia OBJECTIVES ACTIVITY EXPECTED RESULTS FOR 2015 1 Coffee growers adopt a Quality System to improve their coffee quality and sustain it. A1 A2 Promotion of a culture of quality leveraging continuous improvement of coffee cup profile. Improvement of postharvest equipment and infrastructure in the farms. 85% average acceptance rate of the coffee at the cooperative as AAA. 10% of the farmers achieved and maintained at least the emerging level under the TASQ TM assessment for Quality. 9,000 equipment installed in the farms to have better productive infrastructure for coffee processing. 4,500 new sun dryers installed in the farms. 4,500 new fermentation tanks installed in the farms. 2 The smallholders adopt an Environmental Model for protection of coffee ecosystems in each production unit. A3 A4 Implementation of good agricultural practices and continuous improvement processes. Implementation of environmental management plans in the farms. 10% of the farmers have achieved and maintained at least the emerging level under the TASQ TM assessment Environmental aspects. 6,000 farms are certified RFA in 4 years. 3 The smallholders adopt a farm management system to increase the productivity in their farms. A5 A6 Implementation of crop improvement management plan. Implementation of self consume plots in the farms for food security. 96.3 millons of plantlets produced (Cenicafe certified). 22,542 hectares are renovated with optimal density for the farm conditions. 4,592 hectares are optimised for coffee production. 14% incentive grant for fertilisers given to farmers. 7,000 samllholder families are trained on food production and good nutrition. 42% of the trained families implemented food security plots. A7 Establishment of community participation mechanisms. 20 producer groups are created. 2 Prospresso Local Participation Committees are created. 4 The Coffee Grower Community engage for a People Development Plan for good governance, empowerment and cohesion. A8 A9 Implementation of Capacity Building Plan for the Coffee Grower Community. Implementation of the next generation program. 100 agronomists trained for assisting farmers. 33,000 smallholders receive technical and social support. 5% of the youngsters of the smallholder families particpate in the "Young Coffee Growers" program. 5% of the children of the smallholder families participate in the School and Coffee program. A10 Implementation of Real Farmer Income TM Model by the Coffee Growers. 35,394 trainings to farmers on Farm Income Model application and interpretation. 10% of the farmers have achieved and maintained at least the emerging level under the TASQ TM assessment for Economical aspects. 5 Enhanced Economic Support System to increase Coffee Farmers loyalty and Real Farmer Income TM. A11 Strengthening of the local coffee commercialisation systems. At least 85% of the coffee produced is delivered by the farmers as AAA (Loyalty rete). 70% of the coffee is commercialised in specialty markets with an over price. 6,000 farmers secured a buying contract for certified responsible coffee. A12 Establishment of Strategic Alliances for the sustainability of the actions. 2 Regional Inter-sector Committees created and operating. At least 2 Private-Public Partnerships for the action are settled. Source: Nespresso Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 25

APPENDICES 7 APPENDIX 3 Correlation between Real Farmer Income TM in its key drivers in five Nespresso supplier countries COSTA RICA GUATEMALA COLOMBIA (NARIÑO) BRAZIL MEXICO CORRELATION BETWEEN NET INCOME AND PRICES CORRELATION COEFFICIENT -0.09031 0.05854 0.06883 0.358 0.403 P-VALUE 0.3691 0.5772 0.552 <.0001 <.0001 CORRELATION BETWEEN NET INCOME AND YIELD CORRELATION COEFFICIENT 0.84257 0.64509 0.70133 0.6100 0.742 P-VALUE <.0001 <.0001 <.0001 <.0001 <.0001 Source: CIMS, 2011 APPENDIX 4 Impact on quality and productivity of the central mill 10 9 8 7 6 5 4 3 2 1 0 Lbs Total Parchment 6 0.4 Before the wet mill 2.1 1.5 2.1 1.1 Physical relection by Coop Laboratory rejections by Expocafé Dry mill loss Green Coffee available for export Parchment required to obtain 1lb of AAA green (2011) Non AAA green 1 AAA green 10 9 8 7 6 5 4 3 2 1 0 Lbs Total Parchment After the wet mill 3 0.1 0 0.7 2.1 1.1 Physical relection by Coop Laboratory rejections by Expocafé Dry mill loss Green Coffee available for export Non AAA green 1 AAA green Source: Technoserve, Jardín Central Wet Mill Year 1 Monitoring Assessment, 2012 Background on Nestlé Nespresso S.A. AAA Sustainable Quality TM MBA Challenge 2013 26

Nespresso Backgrounder Sustainability MBA Challenge This information may be shared freely but the document as such is for use in the context of the MBA Challenge only.