DIRA review nibbles at the status quo and avoids the big questions

The current review of the Dairy Industry Restructuring Act (DIRA) does not address the big decisions that face the New Zealand dairy industry. That may well be a wise decision by Government.

Big decisions will indeed be necessary over the coming years. Clearly, they are difficult decisions. However, trying to make those decisions through the DIRA mechanism would be a brave decision and, in all likelihood, with unintended consequences. So, the Government has stepped back.

Instead, Government is using DIRA to nibble around the edges.  Whether those nibbles are the correct nibbles remains a moot point.

There are three issues where the Government is choosing to nibble away at the edges. The first is the open entry and exit of farmers to Fonterra. The second is provision of Fonterra milk to new processors. The third is the vexing issue of the so-called regulated farm-gate milk price.

I will look at each of those in turn. But first it is important to remind ourselves why we have the DIRA in the first place.

The reason for DIRA is that Fonterra, when set up in 2001, was in conflict with the competition principles within the Commerce Act. Special enabling legislation was needed.

This enabling legislation was justified by the Helen Clark Labour Government of the time because there was seen to be merit in the notion of Fonterra as a ‘national champion’, of benefit both to the dairy industry and the wider economy.

Fonterra was to be the structure that would allow New Zealand to grow its wealth through exports. Fonterra was meant to become a $30 billion company within a few years.

There was some confusion back then as to whether this $30 billion referred to capital value or annual sales. Right now, 18 years later, Fonterra has a capital value of around $6.5 billion. Annual sales, in much depreciated dollars, now approximate $20 billion.

The ‘quid pro quo’ which Fonterra willingly accepted at the time was that it would have particular responsibilities in return for the monopoly powers that it was being granted. In essence, this was to ensure that Fonterra did not become a monopolist bully that prevented the entry of competitors. There was a particular issue that Fonterra should not be able to act as a monopolist in local retail markets here in NZ.

Since then, competitors have emerged, and they now process and market around 20 percent of New Zealand’s milk, up from four percent back in 2001.  The big companies such as Open Company, Synlait and Oceania (Yili) are export focused, but there is also a myriad of niche operators who focus on local dairy products.

There is also the remarkable case of The a2 Milk Company (ATM), still a New Zealand company, but with all of the top executives and most of the shareholders now outside New Zealand. The ‘a2 Platinum’ infant formula, manufactured by Synlait under contract to ATM, uses no more than one percent of New Zealand’s milk, but has led to the capital value of ATM being more than 50 percent greater than Fonterra’s capital value.  It’s what happens when you get value-add to work with a differentiated product.

Nevertheless, in terms of volume and power, there is no doubt that Fonterra is still dominant across all sectors of New Zealand’s dairy industry.

At the farm gate, most farmers still have no option but to supply Fonterra. This is because the other companies only operate in restricted localities and have a full book of farmer suppliers. Some companies have big waiting lists.

In the supermarkets, there are is essentially a duopoly, with Fonterra and Goodman Fielder each with big market shares. However, Goodman Fielder gets it milk from Fonterra under a special regulatory mechanism within DIRA that is to continue, and with an enhanced growth provision.

Some will argue that DIRA has been helpful over the last 18 years, but there is also a belief that there is more to be done. Many are disappointed that Fonterra has not become the national champion that was envisaged back in 2001, having stumbled many times.

The alternative stance that comes from Fonterra is that they have things under control, and they would be pleased if the DIRA would simply go away. In the current no-growth environment, more new entrants would mean that Fonterra risks having stranded assets.

Over the last year, I have been part of a group of so-called ‘lateral thinkers’ set up by the Minister of Agriculture Damien O’Connor to explore some of these issues. Chatham House rules always apply in these situations so I am not going to say who said what, and there were no minutes kept. However, I can say that there was considerable diversity of thought as we wrestled with some complex issues.

I also make the point, and do so strongly, that our ’lateral thinkers’ role was simply to throw ideas around with the Minister and to critique those ideas.  Whether or not we might have influenced the proposals as approved this week by Cabinet, I am not going to say.  We were never meant to be the decision makers.

The open entry and exit conditions are going to remain, with some minor modifications, which means that a farmer who leaves Fonterra for an independent processor can still shift back to Fonterra if that farmer is dissatisfied with the new processor. This reduces the risks for a farmer who is considering leaving Fonterra, and makes it easier for the new processor to attract farmers.

Fonterra thinks this is unfair. However, in other countries where there are multiple processors, farmers can and do shift between processors to get the best deal. It is Fonterra’s monopoly powers that stops that happening in New Zealand, and hence the open entry and exit provisions.

New entrants will still be able to require Fonterra to supply them with milk, but only up until they have their own supply of 30 million litres, and for a maximum of three years. Fonterra does not like this requirement to supply.

The independent processors are also not keen about new entrants continuing to get access to Fonterra’s milk. They themselves were helped by this, but now that they are established, they would rather like to see the gate closed to any further entrants benefitting in that way. That is the way  the commercial game is played.

The third issue, and this is controversial, relates to the so-called farm-gate base milk price which Fonterra uses as the benchmark for paying its own farmers.

The independent processors all believe that the milk-price formula is flawed and that Fonterra pays its farmers too much, thereby gaming the system and making it hard for the independent processors to compete.

The argument goes, according to the independents, and with some cautious agreement from the Commerce Commission, that Fonterra uses a flawed ‘asset beta’ in its calculations and thereby under-estimates its cost of capital.

According to an Open Country submission in 2017, this leads to the cost of capital being under-estimated by 0.9 percent. This in turn would indicate, by my calculations that about 10c per kg milksolids (fat plus protein) is transferred from profits to the milk price. Some would argue that the overpayment, perhaps for other reasons, is greater than this.

The Government is now saying that it wants to keep its eye on what is happening with the milk price and wants to have its own nominee as a member of the panel that calculates the milk price.

Everything to do with setting of the milk price is complex and open to debate.  Government may well be wise to step in with great caution.

The original idea back in 2012, when Fonterra allowed investment units to be bought by non-farmer investors, was that farmers would always be paid the milk price. Since then, we have seen that Fonterra has on two occasions paid less than the milk price when it got scared that its balance sheet needed propping up. So, in reality it is just a benchmark. Also, the current proposal is explicit that the benchmark does not have to be applied if Fonterra has good reason not to.

That ‘let-out’ clause is important, as without it, Fonterra might well lose its financial rating and find its cost of borrowings going up markedly.  It means that farmer payments are subordinated to Fonterra paying the banks.  But it also means there are no concrete rules as to farmer payments versus investor profits.

The reasons I am so cautious about the Government getting too involved in setting the milk price are twofold.

First, the issues around calculation of the ‘asset beta’ are complex and theoretical. Each side claims with some passion that its own perspective is correct. I could easily write an article on that alone.

The second issue is that, regardless of any asset beta, Fonterra has dug a big hole for itself by making a series of disastrous historical decisions such that its balance sheet is now weak. It may be better for Government to leave Fonterra to come to its own decisions about solving this rather than getting involved and becoming the fall guy.

About Keith Woodford

Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington.
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