Review of the Dairy Industry Restructuring (Raw Milk) Regulations: Options for addressing industry concerns April 2008

Background analysis

The following material provides background into the analysis that went into the development of the three options outlined in this paper.

For ease of presentation, this material is grouped as follows:

  • Industry background
  • Finding a fair and efficient milk price
  • Setting the volume cap
  • Managing excess demand
  • Contractual issues

Industry background

There are exciting prospects appearing in international dairying that New Zealand is well positioned to benefit from. The outlook for high-quality dairy products remains positive as world demand is projected to increase slightly faster than world supply, with consequential impacts on long run prices.

On the supply side, competing land use internationally, especially from biofuels, is likely to result in a cost advantage for pastoral based production systems.

Compared to other pastoral dairy producers such as Australia, New Zealand is better positioned to manage the implications of global climate change and maintain cost-competitive increases in total milk production. Given current annual production of 15 billion litres, a growth rate of only 2 percent per annum implies total production increasing to over 18 billion litres within ten years. This is a significant quantity of additional milk, which has the potential to become a feed stock to a range of exciting new uses and users.

As part of its Economic Transformation policy the Government aims to promote an innovative and vibrant pastoral and food sector, and is supporting this aim with substantial public investment through the New Zealand Fast Forward initiative. The intention behind this initiative is to produce a step change in research and development investment, with the purpose being the production of an ongoing stream of commercially profitable products.

A corollary is that, like a century ago, New Zealand will exhibit a much more heterogeneous sector compared to now. In addition to differences in ownership structure, firms are likely to range from being vertically integrated across entire value chains to a specialised focus on particular value chain niches – either closer to suppliers or close to customers.

In such a dynamic environment it is critical that the firms that have the highest resource use for milk are able to access it in adequate quantities, and that the regulatory system supports this.

Finding a fair and efficient milk price

Key sub-issues

  • What is meant by a fair and efficient price?
  • Should the reserve price be an ex ante or ex post price?
  • What are the options for setting a reserve price?
  • Does there need to be a premium additional to the reserve price that is distinct from transport costs?
  • How can this premium be found?

A fair and efficient price

The default or regulated price should enable independent processors to secure regulated milk at a fair and efficient price – in other words, regulated milk is neither under nor over-priced.

“Cheap” regulated milk is undesirable from a policy perspective as:

  • it has the effect of diverting raw milk to sub-optimal uses (resulting in an efficiency loss);
  • it may reduce incentives for seeking alternative milk supply (especially if there is also an excess supply situation);
  • transition costs may be increased; and
  • it involves a wealth transfer from the seller to buyers.

Conversely, “expensive” regulated milk is also undesirable as:

  • new investment will be discouraged due to a failure to remove or reduce an entry barrier;
  • firms unable to source alternative supply at competitive prices, but otherwise commercially viable, will close;
  • competitive performance pressures on Fonterra would be weakened; and
  • it involves a wealth transfer from buyers to the seller.

The result is the need for a fair and efficient price.

Ex ante versus ex post pricing

Some submissions strongly argued for a switch from ex post to ex ante pricing for regulated milk. The rationale for this was that an ex ante price allows price certainty for independent processors. It therefore follows that an ex ante price would be higher than an ex post price due to the altered risk profile.

Higher price notwithstanding, producing an ex ante price would represent a considerable change from the status quo in addition to posing a substantial technical issue: in an industry based on ex post payout prices the challenge of formulating a transparent ex ante price should not be underestimated (indeed, the debate associated with Fonterra’s unregulated milk price, which is an ex ante price, underpins this very point).

While price certainty is highly valuable for independent processors that sell in the domestic liquid or fresh product market, it is not clear that the potential price premium is useful for all processors. The risk is that switching to ex ante pricing may assist some but hinder many.

The Review has therefore proceeded on the basis that regulated milk will remain an ex post price.

This, however, does not prevent parties independently agreeing to a fixed price contract outside of the ambit of the Regulations should that prove to be mutually beneficial.

Finding X

Given the notion that the Fonterra farm gate price represents a minimum price and X represents what a firm is willing to pay in a competitive market but is not captured by the farm gate price, then the obvious solution is to auction the milk with the farm gate price acting as the reserve. The price that results, by definition, will incorporate X so long as there is not an excess supply situation (otherwise milk will be supplied at the reserve price).

If an auction process is not adopted then finding X becomes considerably more difficult. Given that X is ephemeral in nature (for example, it reflects market conditions and changes across firms and over time), trying to include it in a pricing formula is not without major challenges.

In terms of a calculation, X can be thought of as arising from any one of the following sources:

  • An independent processor premium: This is the “premium” some processors will need to pay to convince a farmer to switch suppliers.
  • A supply chain management premium: This premium is separate from transport costs and can be likened to the fee a broker would charge for providing securing, managing and supplying raw milk.

The independent processor premium can be approximated as follows:

  • Calculate the volume weighted average price for raw milk (VWAP) for each independent processor that sources at least 10 million litres of milk directly from farmers.
  • Calculate the average independent processor VWAP.
  • Subtract the Fonterra farm gate milk price from the independent processor VWAP and any positive difference is taken as approximating the willingness to pay portion of X. This amount is then added to the price that must be paid by independent processors for regulated milk.

The benefit of this approach is that it would give some level of indication of X. However, the disadvantages are:

  • complexity;
  • invasiveness;
  • lack of transparency; and
  • lagged nature of the calculation.

Another potential weakness of this approach is that by applying an average price across all independent processors, the milk will still be under-priced for some processors and over-priced for others, which could end up being a major point of contention.

The “supply chain management premium” (SCMP), defined as:

  • The other costs associated with the management and maintenance of the milk supply chain. These costs are akin to the margin a broker would charge to co-ordinate the supply of milk in the required quantity and quality, including the collection and administration cost, and the costs of managing any risks, for example, under and over- supply of a perishable product and cost of capital.

The SCMP would also need to be estimated by an independent assessor, so would suffer from similar problems in terms of transparency and potential for controversy as the willingness to pay estimator.

Options 1 and 2 pose a tension regarding the desire for a level of certainty as to what X will be for any given season, versus a degree of confidence that X is a reasonable estimator of market realities. For example, certainty would be achieved by simply setting a figure for X in regulations. Alternatively, an annual or bi-annual valuation process could be undertaken to determine X, which would allow some degree of [lagged] adjustment.

While option 3 (the auction) remains the preferred option, in terms of setting X for options 1 and 2 placing an estimator of X in regulations is the Review’s preferred approach. This is for issues of certainty and practicality – if the North and South Island triggers are met as soon as 2013 then annual or bi-annual assessment processes appear overly complex and invasive for the level of accuracy achieved.

Summary

The concept of using a reserve price that is the same as the price that Fonterra pays its own suppliers is a simple and elegant solution to setting a reserve price. However, it does raise the issue that even this reserve price could still systematically under-price the milk, requiring, conceptually at least, the addition of premium X.

The regulatory question is whether X is of such a magnitude that an inefficient result would occur if regulated milk did not reflect this premium.

Given the difficulty associated with a formulaic approach to calculating X, an auction process is strongly preferred as a simple and transparent method to achieve a fair and efficient price.

We would like to know:

  • If option 1 or 2 was adopted do you prefer:
    • setting a figure for X in regulations; or
    • having a yearly or bi-annual review process.

Setting the volume cap

Key issues

  • Submissions indicated that Fonterra and Fonterra suppliers preferred a smaller cap (400 million litres) whereas independent processors generally wanted a larger one (750 million litres).
  • The total volume cap is not independent of decisions regarding:
    • the reserve price;
    • the access rules for individual processors; and
    • the ability to source own supply, whether it is directly from farmers, intermediaries, other processors, and Fonterra’s unregulated milk.
  • All of these factors need to be measured against the objectives of the Raw Milk Regulations.
  • All other things being equal, the higher the volume cap, the greater the risk that dependency on regulated milk becomes an issue.

Current rules

The DIRA provides for the Government to regulate up to five percent of Fonterra’s annual milk supply. Based on the 2006/07 season this represents almost 750 million litres.

A recent amendment to the Regulations put in place interim changes, so that Fonterra must supply:

  • up to 500 million litres at the regulated price in the 2007/08 season; and
  • up to 600 million litres at the regulated price in the 2008/09 season.

In the absence of any further changes to the Raw Milk Regulations, the volume cap will return to 400 million litres in 2009/10.

Different perspectives regarding the volume cap

The submission process revealed almost diametrically opposed views regarding the volume of regulated milk to be made available.

For example, many of the submissions from Fonterra suppliers questioned why there was the need for regulated milk at all, as processors could either seek supply:

  • on a commercial basis from Fonterra; or
  • directly from farmers.

In a situation whereby regulated milk had to be provided, it was argued that this should be limited to 400 million litres per annum as this was the agreed quantity negotiated at the time Fonterra was created. The corollary to this position was the requirement for stricter rules on eligibility (see next section).

Independent processors and food companies had a different view, making the following points:

  • Given that Fonterra has approximately 95 percent of New Zealand milk production, the requirement to provide five percent at a regulated price was considered the minimum amount of milk that needed to be made available.
  • Fonterra's unregulated price was considered uneconomic, forcing firms that would otherwise have considered buying unregulated milk to use regulated milk.
  • Small or niche processors now relied on regulated milk as processor consolidation had removed their ability to contract with alternative suppliers.
  • Fonterra also competed strongly through tactical pricing to retain specific farmers, therefore frustrating the intent of the open entry and exit regime.
  • Regulated milk was absolutely critical for entry purposes, especially if a new processor was yet to establish a track record.

Independent processors and food companies therefore submitted that:

  • the amount of regulated milk made available to be increased to 750 million litres per annum; and
  • the quantity indexed to Fonterra’s total milk supply.

Suffice to say, there is little in the way of common ground between stakeholder groups.

Considerations

As noted previously, all other things being equal, a high volume cap (for example, 750 million litres) increases certainty of supply for independent processors (at least until the competition triggers are met) yet may also weaken incentives to develop alternative sources of supply.

Indexing the total amount of regulated milk to Fonterra’s total milk supply merely reinforces this so does not appear to be consistent with ensuring a smooth transition to the time when the statutory requirement on Fonterra to supply regulated milk ceases.

Conversely, a low volume cap (for example, 400 million litres) is likely to be immediately oversubscribed, which may lead to considerable disruption across the industry (as scaling would need to be introduced immediately).

It could also be argued that scaling represents an additional barrier for new firms due to existing firms having an incumbent advantage and being better placed to seek alternatives.

Options for the volume cap

A volume cap of 600 million litres is considered adequate to establish a functioning auction and is also consistent with the amount of milk that will be supplied for the 2008/09 season. This quantity has the advantage of a small level of excess supply for the initial season (ensuring a smooth start to the new regime) but is soon likely to run into excess demand issues, which will force independent suppliers to seek their own supply (this will be caused either by scaling or increasing price).

A 600 million litre cap is therefore the Review’s preferred option.

Other options such as setting a high initial limit but imposing a “sinking lid” or reverting to a low volume (for example, 400 million litres) were rejected for transitional reasons and workability.

Summary

The Review proposes the amount of raw milk that Fonterra is obligated to supply under the Raw Milk Regulations be set at 600 million litres and stays at this level until the competition triggers are met.

We would like to know:

  • Do you agree with the cap being fixed at 600 million litres?
    • If you don’t agree, why not?
    • If you don’t agree, what is the suggested alternative?
  • Do you agree that the quantity of raw milk available should not be indexed to Fonterra’s total supply?

Managing excess demand

Key sub-themes

  • Whenever there is an excess demand situation there is the need to ration by price or ration by quantity (or a combination of the two).
  • If rationing by quantity:
    • How is this done?
    • Are there any exemptions to rationing?
  • If rationing by price, are there any rules limiting who can bid and/or how much they can bid for?

Current rules

Under the regulations, Fonterra must provide:

  • up to 250 million litres to New Zealand Dairy Foods (now Goodman Fielder
    New Zealand); and
  • up to 50 million litres to “any other independent processor”.

Interconnected bodies corporate rules6 also apply that mean related firms cannot apply for multiple tranches of milk.

When the Regulations were enacted in 2001, they aimed to:

  • protect the position of companies that bought milk from either Kiwi or NZ Dairy Group from monopoly pricing;
  • protect domestic consumers from monopoly pricing; and
  • provide an entry path for new processors into the milk processing industry

Rationing

“Rationing” is a term associated with addressing issues of excess demand, or where the supply of regulated milk is less than what the eligible participants are seeking at the given price.

There are two broad approaches to rationing:

  • •Quantity rationing: Excess demand is addressed through scaling participant’s quotas so that the sum of the milk allocated is equal to the volume cap (for example, if there is 25 percent excess demand then all applications are scaled back by 20 percent). In the case of an administered scaling rule, participants can generally expect to receive some but not all of the milk they request. The price remains insensitive to differences in demand, and regulated milk would be allocated at the regulated price. The efficiency of outcomes therefore is fundamentally dependent upon having a fair and efficient price.
  • Price rationing: Under price rationing the price of regulated milk becomes the clearing mechanism. The price of the regulated milk is determined, most likely through an auction, so that demand equals supply. An auction mechanism is likely to be superior to an administrative mechanism at allocating raw milk to the highest value users due to allocation being based on willingness to pay.

Options 1 and 2 are based on quantity rationing of excess demand, whereas option 3 uses price rationing. As noted previously, the Review strongly favours price rationing.

Imposition of limits

During the consultation process a range of suggestions were made regarding the imposition of limits and/or conditions on access to regulated milk. In the interests of completeness, these are covered below.

“Existing company” status and existence of own supply

It has been argued that the situation of “existing companies” seeking milk under the Regulations is an anomaly as it is inconsistent with any of the three intentions outlined above associated with the Raw Milk Regulations.

The issue is whether “existing companies”7 should be excluded from the definition of “independent processors”.8

This argument is further extended by noting that existing companies already have their own supply and have the ability to seek additional supply, therefore eliminating the need to access regulated milk at all.

A number of suggestions were outlined during the submission process regarding this issue. One submission argued that once independent processors have 10 million litres of own supply then any entitlement for raw milk ceased. Another argument is a variant of the previous approach but is set at 50 million litres rather than 10 million.

Both suggestions pose policy questions: a limit of only 10 million litres of own supply before being disbarred from accessing regulated milk does not appear to be consistent with the current expectation of a viable entrance pathway. Furthermore, a higher limit such as 50 million litres provides huge incentives for gaming: independent processors simply cap their own production at slightly less than 50 million litres and they can continue to draw on regulated milk regardless.

Option 1 incorporates an own supply rule based on 10 million litres.

Entrance pathway and time limits for new entrants

Both during the first round of the current Review and on other occasions,9 new processors have emphasised the critical importance of being able to purchase regulated milk. Indeed, a number of firms have submitted that they would not have been able to enter the industry in the absence of regulated milk as:

  • regulated milk was critical from a credibility perspective and acted as a base on which own supply could be arranged; and
  • access to 50 million litres of milk allowed firms to achieve sufficient scale to make the transition from supplier to processor (and thereby achieve critical mass).

The corollary of this argument was the view that for a medium scale firm (for example, a powder plant with capacity of approximately 200 million litres per annum) the 50 million litre tranches were too small and that a larger amount for a limited period of time would be a better way to manage a new entrance pathway.

Option 2 acknowledges the new entrant issue, where a figure of up to 75 million litres per annum for three years only (either singularly or concurrently) is suggested as a basis for consultation.

Supply of domestic over export markets

In 2001, the protection of domestic consumers from a single seller of milk was an objective behind establishing the Raw Milk Regulations. Many submissions stated that was the most important objective and that regulated milk should be used to assist domestic competition only, rather than to assist firms competing with Fonterra in export markets.

The Review does not agree with this argument for the following reasons:

  • The protection of domestic consumers is largely satisfied by allowing NZ Dairy Foods (now Goodman Fielder) to access up to 250 million litres of regulated milk, thus ensuring a significant domestic competitor to Fonterra brands.
  • Distinguishing between firms that predominantly supply the domestic market or export markets could prove problematic. Indeed, while some firms currently only supply either the domestic or export markets, many firms either do or are intending to supply both.
  • If regulated milk was only available to domestic suppliers, this could stunt the growth of innovative exporters that require an entrance pathway.

The Review therefore does not propose to distinguish independent processors on the basis that they are domestic or export orientated firms.

Food companies and niche firms

Food companies and niche processors arguably fall under the first objective of protecting the position of firms that purchased milk from either of Fonterra’s predecessor companies from monopoly pricing.

It was strongly argued by submitters that the existing caps represent a barrier to further competition and/or a barrier for additional investment. For both reasons it was argued that the individual participation limits should be substantially increased as these could not feasibly seek own supply directly from farmers as:

  • firm speciality was in the food area, rather than the dairy area, which necessitated a “buy” rather than a “make” approach due to lack of “dairy” expertise; and
  • rapid changes in market conditions may mean sudden under or over supply of milk, which is too volatile for firms with own supply that are not internally hedged by being able to switch milk between product lines (for example, fresh and liquid product to powders and vice versa).

Niche processors argued that while a limit of up to 50 million litres was beyond what they required on an annual basis, they felt especially vulnerable as:

  • given that many of these processors never had, or could get, own supply they were largely dependent on access to regulated milk as industry consolidation had progressively removed their ability to contract;
  • the arrival of new entrants requesting 50 million litres from a limited total quantity had the potential to “squeeze them out”; and
  • in a situation of excess demand they could:
    • miss out on getting milk completely under a price based system; or
    • be severely scaled back under a quantity rationed system.

Small processors therefore strongly argued for preferential consideration based at least in part on guaranteed access to 10 million litres of regulated milk per niche processor. Indeed, one submission argued for a progressive pricing regime in that independent processors paid progressively higher premiums for regulated milk beyond 10 million litres.

The net affect of this proposal is guarantee supply for small payers but make regulated milk uneconomic for any processor that seeks more than 10 million litres milk per annum. This appears inconsistent with the size of the existing allocations (up to 50 million litres, up to 250 million litres per annum), principles about producing an efficient price, and all three policy intentions associated with the Raw Milk Regulations.

The common factor between the small processors and the food companies is that for quite valid business reasons they do not have, and are unable to procure, milk directly from farmers. The corollary is whether the regulations need to make some type of allowance for this or whether the emergence of new independent processors nationally means that the ability to contract has been restored to a level that it is reasonable to expect these firms to diversify supply away from regulated milk, especially given that regulated milk will not be available long-term.

With the exception of the allocation for niche processors under option 3 (the auction), the Review does not propose any additional measures to distinguish food companies from other types of independent processor.

The interconnected bodies corporate rule

One submission argued that the interconnected bodies corporate rules seemed to serve no competition purpose and actually hindered entry, as without access to regulated milk, new firms or firms with new plants, would have no choice but to access own supply through the open entry and exit provisions.

It was therefore argued that either the individual processor caps needed to be substantially raised or the interconnected bodies corporate rule relaxed.

The alternative view is that interconnected bodies already have an entrance pathway. Given that the argument for an entrance pathway centres on a need to establish credibility it can be argued that firms with interconnected processors have already achieved that credibility through their relationships with other processors.

The Review does not propose any changes to the interconnected bodies corporate rule.

Summary

The Review strongly favours price based rationing over quantity based rationing as a means for managing excess demand for regulated milk as price based methods are more likely to ensure the milk is allocated to its highest value use.

A corollary is that a price based system is also more likely to produce a fair and efficient price, which questions why one would limit access to regulated milk based on criteria such as level of own supply, type of business model, or location of customers.

We would like to know:

  • In principle, do you favour quantity rationing or price rationing for determining the ultimate allocation of the regulated milk supply amongst eligible processors?

Contractual issues

Key sub-themes

Terms and conditions for getting raw milk should, as much as possible, reflect standard terms and conditions, which includes take or pay provisions.

Transport costs remain separate from the milk price.

Contractual terms

There is merit in structuring the contract terms for regulated milk in line with standard commercial practice, as there are likely to be efficiency reasons for commercial contracts taking the form they do (for example, price volatility, the perishable nature of raw milk and risk management). Proposals to significantly diverge from commercial norms in the regulated milk contract ought to be considered with some degree of scepticism and would need to be justified on competition grounds alone. Moreover, adopting standard contractual terms assists both farmers and processors with assessing the economics of alternative supply options.

This is not to say that independent processors can not negotiate for refinements to the standard regulated milk contract with Fonterra. However, the basis of that negotiation and the amendment to any terms is outside the scope of the Regulations and would be a strictly commercial matter between Fonterra and the processor.

Transport costs and take or pay provisions

Two areas that have not been covered elsewhere in this document are transport costs and take or pay provisions.

Given there are existing legal rulings regarding transport costs the Review does not intend to relitigate these rulings. Furthermore, given the dynamic nature of the industry there is a real risk that any new rule could get overtaken by events (for example, switching to regional transport pricing, etc).

The Review therefore does not propose to make any changes regarding transport costs.

The Review, however, does consider there are good reasons to introduce take or pay provisions into contracts for Raw Milk – especially so if option 3 proceeds.

Take or pay provisions reflects the stranded asset risk otherwise faced by milk suppliers, given the perishable nature of raw milk and the limited scope for transporting raw milk long distances.

Instigating take or pay provisions strengthens the credibility of demand forecasts provided by independent processors for regulated milk. These provisions would also result in a regulated milk contract which more accurately mimics commercial equivalents, thereby further reducing any artificial advantages of regulated milk where alternative supply is available.

The Review therefore favours the adoption of take and pay provision for all three options.

Summary

The Review favours the adoption of take or pay provisions into the contracts for the supply of regulated milk.

We would like to know:

  • Do you agree that take or pay provisions should apply to regulated milk? If not, why not?

6 Any two bodies corporate are to be treated as interconnected if:

  • one of them is a body corporate of which the other is a subsidiary; or
  • both of them are subsidiaries of the same body corporate.

7 An “existing company” is defined as:

  • The Tatua Co-operative Dairy Company Limited;
  • Westland Cooperative Dairy Company Limited;|
  • New Zealand's Premier Dairy Cooperative Limited.

8 An “independent processor” means:

  • a processor of milk or milk solids or dairy products who is not an associated person of new co-op [Fonterra]; and
  • includes New Zealand Dairy Foods Limited [now Goodman Fielder] and any associated person of that company other than new co-op.

9 For example, in 2007, the Regulations Review Committee received a complaint from Open Country Cheese Company about the operation of the Raw Milk Regulations in that the Regulations are not in accordance with the general objectives and intentions of the statute under which it is made.

Contact for Enquiries

Senior Analyst
MAF Policy
Sector Performance Policy
Ph: 04 894 0142
Fax: 04 894 0745
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