Issues Facing the Dairy Co-operatives
22. The dairy co-operatives are also now facing problems with the current legislative structure, partly because of the industry’s success. The key areas are pricing, capital and governance.
Pricing
23. The price paid to farmers per kilo of milk solids is a combination of the value of milk as a raw ingredient, the value added by processing and the value added by marketing. Since milk from new farms or from growth at existing farms is paid this bundled price (which exceeds the marginal value of the milk), there is an incentive to produce milk which costs more than it is worth. This penalises existing farmers and requires ongoing capacity expansion.
24. Changing pricing policy is difficult because of:
· an industry focus on equality that requires cross-subsidisation;
· the type of co-operative structure operating in the dairy industry, (for example, all shareholders are producers with shareholding in proportion to supply and dividend payments vary with production in the same way as payments for milk);
· the absence of outside equity and market-determined share values; and
· the need to change legislation to alter payment arrangements. Commercial flexibility will continue to be limited as long as a specific statutory framework for the dairy industry remains.
Capital
25. There are three distinct problems relating to the industry’s use of capital:
· price bundling means that the limited capital available to rural New Zealand is being diverted into farm conversions where the returns to New Zealand as a whole are less than the costs;
· the Board and co-operatives face few disciplines in borrowing as their debt commitments can be met before paying the residual income to farmers. Farmers conversely face strong disciplines because of their uncertain commitments to provide additional capital and the residual nature of their incomes; and
· as additional capital is required to handle the additional milk encouraged by price bundling, the capital is obtained by either loans (repaid by reducing payouts) or directly by reducing payouts. Equity is not raised externally and the management faces limited incentives to use the capital efficiently.
Governance
26. There are several related problems in regard to governance in the dairy industry:
· as co-operatives have increased in size, the ability of individual farmers to monitor the co-operatives effectively has been reduced;
· monitoring has been addressed by ward systems of election, meaning that any director’s tenure can depend on local political factors more than commercial expertise;
· at the same time, minorities cannot in practice exit the company without exiting the industry;
· although farmers can, and do, challenge directors to demonstrate performance, the size of the companies means farmers have relatively little power to ensure that the promised performance occurs;
· unlike shareholders on standard companies, farmer-shareholders cannot sell their shares and the share price cannot act as a signal of investors’ concerns; and
· external pressures on co-operative management have been further reduced by the declining number of co-operatives against which to benchmark performance.
Conclusion
27. These problems in the areas of pricing, capital and governance combine to restrict the options of industry participants and distort their incentives. As a result, the industry is unlikely to be close to maximising the return on its substantial capital investment (at the farm, processing or marketing levels) or exploiting the full scope for innovation in the face of changes in technologies and markets.
28. It is important to note that these problems do not mean that the co-operative structure is some how inappropriate for the dairy industry. There are good reasons why co-operatives can and do make good economic sense in the dairy and other industries. From a public policy perspective, the problem is the existing legislation mandates a co-operative structure for the dairy processors and puts in place restrictions on the type of co-operatives that dairy co-operatives can be. As a result, the legislation prevents the evolution of alternative co-operatives or other corporate forms that may suit farmer-shareholders better.
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