The state of competition in the New Zealand Dairy Industry (DIRA review – final report)

The state of competition in the New Zealand Dairy Industry
(DIRA review – final report)

By way of an update to my note last November, the Commerce Commission released its final report, on 1 March 2016, providing the Minister with an independent view on the state of competition in the New Zealand dairy industry.

In that report, ComCom noted that, having considered submissions on the November 2015 draft report, ComCom’s view remains that there is not sufficient competition at the farm gate and factory gate to consider full deregulation at this time.

The final report recommends that a pathway to deregulation would be smoothed by facilitating the development of a factory gate market for non-DIRA milk. In this regard, ComCom said that the options the Minister should consider include:

• reducing DIRA milk entitlements;
• investigating if and when the DIRA milk price covers Fonterra’s opportunity costs; and
• tightening the terms and conditions for DIRA milk supply.

Within 90 days of receiving ComCom’s report (i.e. by the end of May 2016), the Minister must respond to the report, including by giving public notice of his intention to promote changes to the current market share thresholds, or measures that provide a transition pathway to deregulation, or both.

Responses (or likely responses)

In the period since ComCom’s final report, we have seen a range of responses. Predictably because the subject matter is complex and there are no easy solutions to a problem that the media (particularly) appear to see only in terms of a soundbite of the outcomes of the bi-weekly GDT auction – there has been a wide range of views. Some are, no doubt, well-grounded – whilst others strike me as downright scary.

I have no doubt whatsoever that some of the raw emotion being shown at the farmer/supplier level is very real. The difficulties faced by only being able to influence part of the cost of production (and, for example, target the Dairy NZ-type benchmarking) and have no influence whatsoever over the price of the product is not the recipe for a decent night’s sleep for many – particularly the latest generation of younger farmers who will typically be the most indebted. Thankfully, unlike many of the sectors populated by owner-operated SMEs, there is clearly a good layer of sensible and highly experienced advice on hand (some of it provided by industry-good bodies for free or at very modest cost) which will help at a micro-level with much of the decision-making process – albeit at the production/cost part of the equation.

And the media and some commentators seem unable to help themselves. As a result, talk about Fonterra’s management and governance is just so much noise.

Fonterra is likely to continue to see farmers migrate to other (non-co-op) suppliers. On the supply side, its overall market share has reduced from 96% in 2001 (when Fonterra was formed and DIRA implemented) to approximately 85%. For a few, migrating to a contract-only model where they do not have to stump up with the capital for shares in the co-op probably makes sense in terms of lowering their cost of capital – but to put things into perspective Fonterra still has approximately 10,500 farmer shareholders. By the numbers, it remains a very big business. The independent processors are big businesses too. Even getting a toehold in the industry is a $100m+ exercise – but Fonterra has total assets of $15.5bn. This is also part of the reason why some of the vox pop commentary (and some of that from people who should know better) seems remarkably un-worldly.

By contrast, Fonterra’s response gives a clear indication of where the focus of the discussions with the Minister is likely to be. Chair, John Wilson, said immediately after the release of the ComCom final report that Fonterra accepted the importance of having a very robust milk price formula (and the ComCom oversight). It also accepted the requirement to provide milk to small, innovative, domestic companies (my emphasis) manufacturers – provided it is at the right price.

However, John Wilson continued by noting the two things that Fonterra think require further investigation, namely:

• the requirement to supply milk to a new start-up to export in competition with Fonterra in the global marketplace – which he described as being a space populated by well-capitalised investors arriving in New Zealand that do not need a hand up from the Fonterra farmer; and
• (as having moved past its use-by date) the requirement to accept milk from all farms – which he saw as a requirement for Fonterra farmers to underwrite any potential new milk growth in New Zealand.

The requirement to supply milk

Fonterra is signalling that it believes that the market has changed since DIRA was enacted – and it characterises the requirement to supply raw milk to export competitors as “unfair”.

So, the hard conversation with the Minister might come down to a simple line of demarcation – that it is OK to foster the development of small, innovative, domestic brands (think Lewis Road Creamery or Kohu Road ice cream) but the moment they stop being cuddly (and very small) local players – and start hitting export markets, the game changes.

It will be interesting to see the Minister’s response. I don’t know the owners of Lewis Road, but given its strike rate amongst the teenagers in my house – I would bet the farm that their ambitions are not confined to being small players in the local market. They seem far smarter than that.

The requirement to accept supply

The language being used in the dialogue around the requirement, which is presently hard-wired into DIRA, that Fonterra must accept supply from new entrants is interesting. Equally interesting is that it does not highlight the accompanying DIRA requirement that Fonterra must also accept uplifts in the volume of raw milk supplied by existing shareholding farmers.

Unless I have missed something, the framing of that discussion in environmental terms is new. There is what appears to me to be some buy-in to the comments Jan Wright (the Parliamentary Commissioner for the Environment) about the impact of dairy conversions on water quality.

Fonterra chair John Wilson tiptoed around the topic by saying that whilst “we” have to be very careful about where we convert land, the decision-making process is not in Fonterra’s control. And that whilst it is very important that dairy farmers are able to get on and do what they do well (which he saw as meaning to farm productively within the constraints applicable to their relevant area) there is also a sea change occurring in farming systems as they adapt to cope with the changes that are required in environmental outcomes.

Whilst I have no doubt that those comments are well-made, and I wonder out loud about the merits of dairying in (say) the Mackenzie Country – there seems little doubt that issues about water quality and water volume will only continue to increase in importance. As a result, I was quite interested to see that the recent debate about a water bottling plant in Ashburton – and the apparent lack of recognition that the amount of water at stake was roughly the same as that used by a smallish dairy farm in the same region.

Much less prosaically, the requirement to accept supply requires Fonterra to arrange pick-up and continue to build and operate expansive plants must be firmly on the radar. The profitability of some conversions and some increments in volume must be questionable (for the farmer) – and the logistics involved in coping with the march of conversions in remote parts of the country must be financially and logistically challenging.

Next steps

As noted above, the final report has gone to the Minister for Primary Industries to make policy decisions, which are due by the end of May. We await the outcome with baited breath.

Further information

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