The state of competition in the New Zealand Dairy Industry (DIRA review – draft findings)

On 6 November 2015 the Commerce Commission released their draft report on the state of competition in New Zealand’s dairy industry.

The draft report is the first indication of the Commerce Commission’s findings on the state of competition in the New Zealand dairy industry and the Dairy Industry Restructuring Act (“DIRA”).

The draft indicates that the Commerce Commission’s primary concern is that competition in the factory gate market is very limited. Without the DIRA Regulation, Fonterra would be able to increase the price of raw milk it sells to other domestic processors. This would result in higher prices for dairy products in downstream domestic markets.

Because of these concerns, the Commission does not think that there is sufficient competition to remove the DIRA Regulation at this time. This is based on an assessment of the costs and benefits.

The Commission adds that the pathway to deregulation requires the development of a factory gate market – and recommends that options for changing the regulations, in a way that facilitates the development of that market, be considered.

Views on substantive matters

As part of this review the Commission assessed the state of competition under the DIRA Regulation, reviewing two relevant markets:

• the farm gate market, in which processors of raw milk including Fonterra compete to acquire raw milk from farmer suppliers; and
• the factory gate market, in which processors supply raw milk to each other (primarily when they do not collect it direct from farmers themselves).

The Commission took into account the effects of competition in the farm gate and factory gate markets in downstream markets in which processors including Fonterra supply wholesale and retail dairy products.

Under the Raw Milk Regulations, Fonterra is required to supply raw milk to independent processors (“IPs”) including separate provision for Goodman Fielder in the factory gate market (“DIRA milk”).

Fonterra is the only firm with this obligation, and is the monopoly seller of DIRA milk. The DIRA milk price is specified to be the farm gate milk price plus transport costs.

Some IPs acquire raw milk that is not subject to the Raw Milk Regulations either from Fonterra or from another IP (“non-DIRA milk”). The price and terms for non-DIRA milk are typically negotiated between the parties.

• The farm gate market: The Commission considers that Fonterra does not have the ability or incentive to exercise market power (by decreasing prices below competitive levels) in the farm gate market. In particular, as a co-operative, Fonterra is owned by its suppliers and would be unlikely to exercise market power against them.

The Commission also concludes that Fonterra does not have the ability to engage in conduct to prevent or hinder rival processors from accessing raw milk at the farm gate – as a result of a combination of the DIRA Regulation (which helps ensure contestability), Fonterra’s co-operative nature, and constraints from competitors.

• The factory gate market: The Commission reports that there is limited competition at the factory gate but the DIRA Regulation prevents Fonterra from raising prices for DIRA milk above competitive levels. The combination of the requirement for Fonterra to supply regulated volumes of milk to IPs at the factory gate, at a price which is also subject to the DIRA Regulation, may be restricting further participation in the factory gate market.

The exercise of market power against farmer suppliers

The Commission’s draft conclusion is that the DIRA Regulation places some limit on Fonterra’s ability to exercise buyer side market power, such as reducing the farm gate milk price paid to farmers. In the absence of the DIRA Regulation, Fonterra would have greater ability but little or no incentive to use this power to the detriment of its own shareholding farmers.

The exercise of market power at the factory gate

The Commission’s draft conclusion is that, without the DIRA Regulation, it would expect the price of factory gate DIRA milk currently supplied to IPs to increase (reflecting Fonterra’s market power in the factory gate market – with the current market price for non-DIRA milk supplied by Fonterra to IPs being an indicator of the likely price increases).

Fonterra’s ability to prevent IPs from effectively competing in the farm gate or factory gate (foreclosure)

The Commission says that Fonterra would gain no benefit from foreclosing IPs who mainly export (because such foreclosure would not enhance Fonterra’s market power in the export market – where Fonterra is a price-taker and would not be able to raise the price of its own exports). Fonterra may have the incentive but not the ability to foreclose some other IPs which produce for the domestic market, because these IPs have alternate sources of raw milk supply – and IPs without alternate sources of supply could be foreclosed by Fonterra but there is minimal incentive for Fonterra.

Competition in the farm gate and factory gate markets is insufficient

The Commission does not think there is sufficient competition at the factory gate to conclude that the markets would be more efficient without the DIRA Regulation. The factory gate market also benefits from the regulations at the farm gate – particularly open entry and exit. (And the costs / benefit analysis appears to be neutral – but the removal of DIRA regulation involves risks, including the risk of disruption to markets during the transition).

Reset both market share thresholds—no need for additional expiry triggers

The Commission’s draft recommendations are to:

• reset the market share thresholds from 20% to 30% – because, despite having reached the 20% threshold in the South Island, the Commission considers competition is insufficient (and when the 30% threshold is reached in either the North or South Island, this should trigger another report on the state of competition in the New Zealand dairy industry);

• reset the time limit provision of the DIRA to the 2021/22 season (requiring a report on the state of competition, even if the market share thresholds had not been met by that time); and

• not add additional or alternative expiry triggers (on the basis that the current market share thresholds are both suitable and simple measures, sufficient to trigger a future report on the state of competition).

Options for a transition pathway to deregulation

The Commission says that its main concern with full deregulation at this time is that competition is not yet sufficient to prevent Fonterra increasing the price of raw milk at the factory gate above the competitive price, and that this has the potential to adversely affect domestic retail markets.

Consequently a staged approach to deregulation is considered appropriate – with the transition path encouraging market participants to depend less on the regulations over time. A staged approach mitigates the risks associated with deregulation (using a process involving well-signalled, simple glide path for market participants).

The Commission has also considered options for transition pathways for each core element of the DIRA Regulation and, whilst it has not identified any subparts to repeal in entirety, it says that some amendments should be made. To this end, the draft recommendation is to consider amendments to the Raw Milk Regulations that facilitate the development of a more effective and functioning factory gate market.

The Commission adds that, once there is a functioning factory gate market, the risks associated with full deregulation will be significantly lower.

Next steps

The Commerce Commission is now inviting submissions on the draft report until 4 December 2015 – with the final report to be released by 1 March 2016.

The final report will help the Minister for Primary Industries to make policy decisions, in particular, whether or not to allow the default expiry of the pro-competition provisions of the DIRA Act in the South Island (the current expiry threshold was met in the South Island in the 2014/15 season).

Further information

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