16 April 2012
John Groot
Chief Adviser
Regulation Branch
Commerce Commission
PO Box 2351
Wellington 6140
By email: [email protected] (marked for the attention of John Groot)
SUBMISSION ON INFORMATION AND EVIDENCE RELEVANT TO THE DRY RUN REVIEW OF THE
2011/12 FONTERRA FARM GATE MILK PRICE MANUAL AND ITS APPLICATION
The following submission comprises Westland Milk Products assessment of the application of the
2011/12 Fonterra Farm Gate Milk Price Manual (the Manual) and the extent to which this is
consistent with the purpose and principles in the proposed DIRA amendments.
The submission sets out Westland Milk Products’ position, concerns and possible solutions under the
following headings:
Introduction
Problems with the Application of the Milk Price Manual by Fonterra
Problems with the Current Model – An Efficient Competitor
Problems with the Current Model-Misprices Fonterra Shares and Results in the Misallocation
of Capital
Suggestions to Fix the Current Model
o Use Fonterra’s real commodity product mix including cheese and casein.
o Use Fonterra’s real sales revenue for the commodity products sold.
o Use Fonterra’s real manufacturing costs including real yields.
o Use Fonterra’s real selling costs.
Impact of Revised Model on Fonterra and Fonterra’s Supplier Shareholders
Impact of Revised Model on Independent Processors
Dairy Industry Restructuring Amendment Bill
This submission is intended for public release
Westland Milk Products requests a copy of draft of the Commerce Commission Review report
referred to in paragraphs 16. and 17. of the Terms of Reference for the dry run review with Fonterra.
Questions or inquiries related to this submission should be directed to:
Antony Michalik
Email: [email protected]
Phone: (03) 371 1617
Introduction
1.
Westland Milk Products endorses the stated purpose of the Dairy Industry Restructuring Act
2001 (DIRA) to promote the efficient operation of dairy markets in New Zealand by regulating
the activities of Fonterra to ensure New Zealand markets for dairy goods and services are
contestable
2.
Westland Milk Products further endorses the purpose of the Dairy Industry Restructuring (Raw
Milk) Regulations 2001 (Raw Milk Regulations) to provide an effective entry for Independent
Processors to the farm gate milk market and support competition in the domestic dairy
market.
3.
Further Westland Milk Products strongly supports the view that proposed amendments to the
Dairy Industry Restructuring Act and Raw Milk Regulations should directly intervene in
Fonterra’s farm gate milk price setting processes in order to support these purposes.
4.
Westland Milk Products disagrees with the purpose statement in New section 150A(1) of the
Exposure Draft Dairy Industry Restructuring Amendment Bill (the Exposure Bill) which provides
that the purpose of setting the farm gate milk price is to ensure it is consistent with outcomes
produced in a competitive market for milk purchased from farmers.
5.
However the restated purpose found in the Dairy Industry Restructuring Amendment Bill
introduced to Parliament on 27 March 2012 does achieve consistency with DIRA and RMR.
6.
In order to create a sustainable and truly competitive market for farm gate milk in New
Zealand Fonterra’s farm gate milk price must reflect the real value of commodity milk to
Fonterra’s business. Therefore the Manual must use Fonterra’s actual commodity product
mix; actual commodity sales revenue; actual commodity manufacturing costs including real
yields; and actual commodity sales and marketing costs in developing the farm gate milk price.
Problems with the Application of the Milk Price Manual by Fonterra
7.
Westland submits that the use of theoretically efficient processing costs, product mix and
sales costs are not appropriate to meet the policy and purpose of the DIRA and RMR because
it:
a.
inevitably introduces an unnecessary and unwarranted upward bias to the base milk
price; and
b.
fails to provide an effective entry for Independent Processors to the farm gate milk
market which in turn fails to support competition in the domestic market ; and
c.
discourages the efficient operation of Fonterra in the New Zealand market for farm gate
milk.
8.
The fact situation which cannot be ignored is that the current market for milk purchased from
farmers in New Zealand is dominated by Fonterra.
9.
The purpose of DIRA is to regulate Fonterra because of the special position it is in – the fact is
that regulators agreed to the creation of Fonterra provided certain measures were put in
place designed to promote competition in the New Zealand market, in particular for farm gate
milk.
10.
Fonterra determines the milk price, by applying the Manual, but that Manual is flawed so that
legislation and regulation must be designed to remedy this to enable a competitive market for
farm gate milk to develop.
11.
The higher farm gate milk price which results from application of the Manual and its use of
theoretically efficient inputs has a number of adverse effects on the policy objective of the
DIRA regulations and the purpose statements of both the DIRA and RMR stated above by:
a.
enabling Fonterra to price milk as if it was efficient, effectively removing the ability of a
competitor to enter the New Zealand milk market to compete on efficiency;
b.
allowing Fonterra to maintain and grow milk supply, against potentially more efficient
competitors, without having to become more efficient itself;
c.
allowing Fonterra to maintain a lower than efficient share price therefore discouraging
Fonterra Supplying Shareholders from leaving; and
d.
subsequently reducing the efficiency of capital in the New Zealand dairy industry.
Problems with the Current Model – an efficient competitor
12.
The Manual employs an efficient competitor model to set Fonterra’s farm gate milk price and
attempts to approximate the price that would develop from the operation of an efficient
market.
13.
The model used is designed for application to output pricing and when applied at that end of
the supply chain the model correctly results in a lower pricing than an inefficient monopoly
would otherwise apply. The model effectively limits the monopoly’s margins to WACC minus
the monopoly’s inefficiency.
14.
However, when applied at the inputs end of the value chain the same model creates an
upward price bias. The model effectively increases the cost of inputs (milk price) to the highest
price that would be available in an efficient market.
15.
If Fonterra were a true regulated monopoly i.e. farmers had no choice but to supply their milk
to Fonterra, and if Fonterra were not a cooperative i.e. not 100% owned by those same
Farmer suppliers, this would be the correct application.
16.
In that case the application of the theoretical model would be to keep prices received by
farmers up and protect those farmers from the monopoly’s price setting power, to drive down
the prices they receive and increase the margins returned to the monopoly’s owners.
17.
It would also act to compensate milk suppliers for being forced to supply a potentially
inefficient monopoly processor.
18.
In fact neither of these is true. Fonterra is not a true regulated monopoly i.e. Fonterra
suppliers have the choice to supply an Independent Processor, and is a cooperative 100%
owned by the same farmer suppliers being paid the milk price i.e. suppliers are the monopoly
owners themselves.
19.
Fonterra actually faces competition for milk supply from a number of Independent Processors
and operates under statute and regulations (DIRA and Raw Milk Regulations) the purpose of
which is to limit its price setting power domestically and facilitate the development of a
dynamic and efficient milk market in New Zealand.
20.
However, the use of the current price setting methodology actually serves to lock in a
monopoly margin for Fonterra’s farmer shareholder owners in the milk price they receive and
consequently to limit the development of a dynamic and efficient milk market in New Zealand.
21.
MAF have estimated, in their latest review of the DIRA and Raw Milk Regulations, the price
setting methodology in the Manual produces an increase in the farm gate milk price above
Fonterra’s actual cost basis, somewhere in the region of 30c per kg of milk solids.
22.
In the case of users of regulated milk this simply results in the transfer of 30c per kg of
regulated milk solids used (of those Independent Processors return on capital) to Fonterra and
Fonterra’s suppliers instead of into the Independent Processors business.
23.
In the case of domestic market suppliers including Fonterra, this cost is born directly by the
consumer.
24.
For example, at 30c per kg of milk solids, a domestic supplier utilising 200M litres of regulated
milk equates to approximately $5.25M annual transferred from the domestic supplier’s
consumers directly to Fonterra’s supplying shareholders.
25.
Since the Fonterra farm gate milk price effectively sets the New Zealand milk price; even
independent processors with their own milk supply are forced to transfer the same value to
their contracted suppliers, in the contracted milk price, to attract and retain milk supply. This
leaves the Independent Processors with no room to compete against Fonterra on the basis of
efficiency of manufacturing or selling of commodity dairy products, without Fonterra actually
having to become an efficient manufacturer or seller itself.
26.
In the case of export focussed independent processors this cost is a direct transfer from the
efficiency of their businesses to their milk suppliers (or Fonterra’s milk suppliers in the case of
regulated milk). In many cases without those suppliers having invested any capital in the
processing businesses.
27.
Whether the supplier of farm gate milk is Fonterra through regulated milk, or independent
contracted dairy farmers, the effect is the same: efficient processors in the New Zealand
market are unable to capture the value of their investment in milk processing and marketing,
this is passed to milk suppliers, as a direct consequence of Fonterra’s farm gate price setting
power.
28.
In the case of all of Fonterra’s New Zealand competitors for raw milk supply, the use of an
efficient competitor model and the locking in of monopoly margins in the milk price model
also removes any ability to compete for milk supply on the basis of a more efficient business
model. This is directly evidenced by the fact that the non-cooperative Independent
Processors, despite often setting up lean and low capital input processing plants and business
models, have made significant losses on milk purchased at Fonterra farm gate milk price
equivalent contracts (including regulated milk) and have regularly required re-capitalisation.
Other problems with the Current Model – misprices Fonterra shares and results in the
misallocation of capital
29.
Fonterra is able to misprice raw milk because its owner shareholders are also its suppliers. The
upward bias in the raw milk price is subsidised by the return on capital portion of Fonterra’s
payout, reducing Fonterra’s distributable surplus.
30.
Since a higher than efficient farm gate milk price therefore directly results in lower dividends it
also directly reduces the dividend return to Fonterra shareholders and therefore the value of
the shares. This effect will become even more relevant after TAF is introduced when the share
price will be driven by outside investors seeking yield.
31.
A lower than efficient share price has two results which are adverse to the development of an
efficient milk market in New Zealand and therefore adverse to the purpose statements and
policy objective of the DIRA and RMR
a. A low share price is a direct disincentive for a Fonterra shareholder to leave Fonterra to
supply an Independent Processor and means that those who leave are unable to realise
the true value of their capital investment in Fonterra. This is a barrier to the principle of
free exit and entry enshrined in the DIRA.
b. This results in an inefficient usage of capital. Capital is captured by Fonterra that may be
better used either in on farm development, in investment with an Independent Processor
or in any other investment option open to the farmer shareholder.
Suggestions to fix the current model
32.
Westland Milk Products believes that setting the farm gate milk price using methodology
seeking to be consistent with the theoretical outcomes produced in a competitive market for
milk actually precludes the development of just such a competitive market.
33.
A model which uses Fonterra’s actual costs of processing and selling commodity milk should
be applied. This would remove the upwards bias of the existing methodology, serve to
provide an effective base for the development of a competitive farm gate milk market,
support competition in the domestic market and promote the efficient operation of Fonterra
in the New Zealand market for farm gate milk.
34.
There also appears no need for Fonterra to develop a hypothetical business model, which
processes all of its milk into a model set of commodity products, to enable a raw milk price to
be developed. The farm gate milk value can more simply and realistically be derived using
Fonterra’s actual commodity business milk volumes, revenues, manufacturing and sales costs.
35.
So long as a per kg milk solids value for commodity production is derived this can be just as
easily applied across the business as the farm gate milk price.
Use Fonterra’s real commodity product mix including Cheese and Casein.
36.
Fonterra has various installed plants and capacities that are the result of the way their
supplying shareholder capital has historically been deployed. Fonterra cannot process or sell
the volume of milk supplied without the use of these plants. If this real product mix is not
optimal then it is a reflection of a historical inefficiency of the deployment of capital within
Fonterra.
37.
Competition from Independent Processors in New Zealand’s farm gate milk market on the
basis of that inefficiency should provide the stimulus for real efficiency gains in both
Fonterra’s and the Independent Processors commodity businesses.
38.
It follows that if Fonterra’s actual product mix were used to set the farm gate milk price then
seeking product mix efficiencies will be a platform on which Fonterra and Independent
Processors will compete for both raw milk at the farm gate and for capital investment in their
commodity businesses.
Use Fonterra’s real sales Revenue for the commodity products sold.
39.
In order to sell the volume of commodity milk New Zealand does globally it has to deal with
some lower value markets and sell products at times when the returns may not meet
optimised pricing expectations. These are simply the realities and drawbacks of selling New
Zealand milk in the Global dairy market.
40.
If the farm gate milk price produced reflects inefficiencies in Fonterra’s actual commodity
sales revenue achievement then competition from Independent Processors in New Zealand’s
farm gate milk market on the basis of that inefficiency should provide the stimulus for gains in
both Fonterra’s and the Independent Processors’ commodity businesses.
41.
Independent Processors in New Zealand’s milk market should have the opportunity to
compete with Fonterra on the basis of sales pricing, market mix and timing – this will drive all
competitors towards selling model efficiency.
Use Fonterra’s real manufacturing costs including real yields.
42.
It is most likely that Fonterra would maintain manufacturing cost models at a level of detail
that would easily allow the business to identify its real manufacturing costs for the identified
commodity product mix.
43.
If there are inefficiencies in Fonterra’s processing costs, for instance due to Fonterra’s
historical plant investment, then competition from Independent Processors in New Zealand’s
farm gate milk market on the basis of that inefficiency, should provide the stimulus for real
efficiency gains in both Fonterra’s and the Independent Processors commodity businesses.
44.
Independent Processors in New Zealand’s milk market should have the opportunity to
compete with Fonterra on the basis of their own investments in efficient processing.
45.
It follows that with a milk price model that includes the real costs of manufacture, seeking
manufacturing cost efficiencies will become a platform on which Fonterra and Independent
Processors will compete for both raw milk at the farm gate and for capital investment in their
commodity businesses.
Use Fonterra’s real selling costs.
46.
Fonterra maintains a sales force internationally selling commodity products in global markets.
The decision to use these sales offices and not simply use GDT to sell the commodity product
Fonterra manufactures is a reflection of the reality of selling such a large volume of
commodity dairy products globally and presumably Fonterra’s belief that higher revenues are
available by maintaining these offices.
47.
If this is actually an inefficient way to sell the volume then Independent Processors in New
Zealand’s milk market should have the opportunity to compete on the basis of their ability to
sell commodity products more efficiently. The full cost of Fonterra’s sales network should
therefore be used in the model to develop the farm gate milk price.
48.
Fonterra should not be able to get the competitive benefit of an optimum sales organisation
without having to develop one.
49.
It follows that with a milk price model that includes the real costs of sales, seeking selling cost
efficiencies will become a platform on which Fonterra and Independent Processors will
compete for both raw milk at the farm gate and for capital investment in their commodity
businesses.
Impact of revised model on Fonterra and Fonterra’s Supplier Shareholders
50.
So long as Fonterra continues to be a 100% farmer supplier owned cooperative, none of the
above changes (the Revised Model) would have an effect on the total return that Fonterra
suppliers receive for their milk.
51.
They would still receive the full distributable amount available to them and agreed by their
board. It would simply remove any subsidies to the Farm Gate milk price from the capital
return (dividend) portion of their payout.
52.
The changes effected by the Revised Model would however ensure there is transparency for
the Fonterra supplier. They would receive the true value of their milk supply in the farm gate
milk price and the return on their capital investment in Fonterra via the dividend received for
shares owned.
53.
This would promote the most efficient decisions to be made regarding the disposition of the
capital invested.
Impact of revised model on Independent Processors
54.
By ensuring the true value of milk to Fonterra is transparent to all (supplying shareholders and
Independent Processors alike) it would also allow an efficient market to develop for New
Zealand farm gate milk supply.
55.
Independent Processors would have a real opportunity to compete with Fonterra for milk
supply based on the efficiency of their business models and capital investments.
Dairy Industry Restructuring Amendment Bill
56.
Westland Milk Products considers that New subpart 5A of Part 2 Dairy Industry Restructuring
Amendment Bill (the Bill) introduced to parliament on 27th March 2012 addresses many of the
problems identified with the model currently employed by the Manual described above and
fixes many of the concerns that Westland Milk Products identified with the exposure draft bill.
57.
However the following sections require further amendment to align these with the purpose of
Subpart 5A:
a. New section 150B(d) “feasible” should be removed and replaced with “approximate
to the average yields achieved by Fonterra’s actual units of processing capacity.”
b. New section 150C(2)(a)(i) ought to read “the actual commodities that new co-op sold
in the season for which the based milk price is being set.”
c. New section 150C(2)(b)(i) ought to read “the mix of commodities that are likely to be
produced.”