Report on the state of competition in the New Zealand Dairy Industry

On 2 June 2015, as required by the Dairy Industry Restructuring Act 2001 (“DIRA”) the Minister of Primary Industries requested a report from the Commerce Commission – providing the Minister with an independent view on the state of competition in the New Zealand dairy industry.

In the event the Commission concludes that the state of competition is insufficient, the report will also provide recommendations on whether the market share thresholds specified in section 147 of DIRA should be reset, what the options are for a transition pathway to deregulation, and if any of those options should be pursued.

DIRA contains provisions to ensure contestability in New Zealand’s farm gate and factory gate markets. These provisions are intended to expire when there is workable competition in the domestic dairy market.

The Commerce Commission’s consultation and reporting process is expected to take 9 months.

The Commission published a process and approach paper on 12 June 2015. That paper appears to have created some uncertainty as to when comments on the substantive issues would be sought. By way of response, the Commission has indicated that it would prefer parties to raise any substantive views that they have – early.

Views on substantive matters

The Commission has signalled that it is seeking views on all substantive matters – and provided a non-exhaustive list issues:

• the markets upon which to focus, and the relative extent of that focus;
• how to define the farm gate and factory gate markets;
• what the state of competition is at the farm gate, factory gate and downstream markets;
• the evolution of competition in the relevant dairy markets since Fonterra was established and since the Government’s 2010 review of competition in the dairy industry;
• views on Fonterra’s incentives to, and/or ability to, exercise market power without the [DIRA] regulations;
• the specific changes to the [DIRA] regulations that could make the farm gate and factory gate more efficient and better promote the purpose of the DIRA;
• what economic inefficiencies are caused by existing regulations, and how could these inefficiencies be mitigated;
• whether there are any redundant or ineffective regulations in terms of promoting the efficient operation of the dairy markets;
• the regulations that you would be concerned about being removed or altered, and why;
• how deregulation may potentially impact on downstream markets; and
• any other issues that the Commerce Commission should consider.

Indicative date /steps:
10 July 2015 Submissions on process and approach were due.
24 July 2015 Cross-submissions on process and approach were due.
June – July 2015 Interviews with market participants.
17 August 2015 Submissions were due on substantive matters.
31 August 2015 Cross-submissions due.
Early Nov 2015 Draft report published. This will include findings on the state of competition, and initial views on pathways to deregulation and resetting of thresholds. (On which submissions will be sought).
Late Nov 2015 Submissions due on draft report – it is anticipated that submitters will have 4 weeks to provide their views.
Mid Dec 2015 Cross-submissions due – it is anticipated that submitters will have 2 weeks in which to make cross-submissions.
29 Feb 2016 Final report published.

Why is DIRA under review?

DIRA provided for the creation of Fonterra – with the result that Fonterra started life with a dominant market share within New Zealand. Consequently, DIRA contains provisions to manage the impacts on competition within New Zealand (the ‘pro-competition provisions’) – which are intended to expire when there is sufficient competition in dairy markets within New Zealand.

The DIRA requires an assessment of the state of competition in our dairy industry, to be done either when the amount of milksolids collected by independent dairy processors has reached the market share threshold of 20% in either island in a season, or after 1 June 2015. On the basis of that assessment, the Minister will consider:

• whether the threshold should be reset and the provisions left in place; and
• whether there is an alternative pathway to deregulation that should be followed.

The pro-competition provisions in DIRA require that:

1. Farmers must be able to enter and exit Fonterra without restriction (Fonterra must accept all supplies of milk – with some exemptions, • Fonterra must allow farmers to withdraw from the co-op (Trading Among Farmers (TAF) was introduced in 2012 to provide a more flexible capital structure).
2. Independent processors must be able to obtain raw milk from Fonterra to enable them to compete in dairy markets (Shareholding farmers can allocate up to 20% of their weekly production to independent processors & the Raw Milk Regulations require Fonterra to provide a fixed amount of raw milk to independent processors).

The process for the expiration of the provisions has a number of steps and can take up to 2 years. The process starts when independent processors in either the North or South Island, or both, reach a threshold of collecting 20% of milk solids.

• First the Minister must certify that the threshold has been met.
• Then an Order in Council is required – that the provisions cease to apply to the island where the threshold has been met (the order must take effect no later than the end of the subsequent dairy season).
• The provisions will remain in DIRA and still apply to the other island if the threshold has not been met there.
• Once the provisions cease to apply in both islands, they will expire.

Note that the process to assess the state of competition allows the Minister to make sure that the provisions should be allowed to expire, but it does not affect the timing of the process whereby the provisions cease to apply to either island and then expire – unless the Minister decides to change the legislation.

Concluding comments

This process comes at an interesting time for the dairy industry – particularly in view of the collapse of international dairy commodity prices, and Fonterra’s recent announcement of low payouts for the 2014-2016 seasons.

For example, a finding that that the amount of milksolids collected by independent dairy processors had reached the market share threshold of 20% in either island in a season – and the knock-on impacts of Fonterra being able to do either or both of:

• decline to accept the supply of milk from allcomers; and/or
• reduce the volume of raw milk it provides to independent processors (or possibly change the pricing structure for the amounts it supplies),

could have very big implications for the entire industry.

Amongst other things, it could reduce the impact of Fonterra having to fund new plant to cope with the continuing upswing in production from dairy conversions. In turn, this might cause a serious spotlight to be placed on the economic rationale for (say) milking cows in the McKenzie Country (on either a business basis or that for land/water use) and having to be trucked to for hours to the nearest processing facility.

Whether that means that we see the same sort of impact that has made itself felt in the forestry sector, with very large (overseas) funds with very long time horizons being prepared to accept a lower yield on the basis of long-term views about such matters as security of supply might be an interesting voyage of discovery.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.