Review of the Dairy Industry Restructuring (Raw Milk) Regulations: Options for addressing industry concerns April 2008
Consultation options
The key element of any regime: a fair and efficient price
It is critical that any regime addressing competition concerns ensures that regulated milk is supplied at a fair and efficient price. An obvious starting point for determining the price of regulated milk is the price Fonterra pays its own suppliers for raw milk (“the Fonterra farm gate milk price”). However, until 2006/07, Fonterra bundled its payout which necessitated the need for a formula to “strip out” the dividend component of the payout and arrive at a farm gate price.
The default milk price formula is:
This formula has not been without controversy, which is not entirely surprising given formulaic processes have two potential sources of mispricing, namely:
- errors in the formula itself; and
- formula omissions (for example, inability to capture attributes such as processor reputation, risk management, the costs of managing a supply chain, etc that firms either would or should pay for in a competitive market).
Regarding the first issue, since 2001 there has been litigation associated with:
- retentions (Complaint regarding the Dairy Industry Restructuring (Raw Milk) Regulations 2001: Report of the Regulations Review Committee); and
- the capital charge component of annualised share value (Commerce Commission v Fonterra Cooperative Group Limited SC 39/2006 [17 August 2006]).
Given Fonterra has unbundled its payout into separate milk price and dividend components, the need for a formula to achieve the same end seems superfluous.
The Review therefore proposes that the formula be replaced by the Fonterra farm gate milk price, which becomes the minimum price for regulated milk (in that it is impossible for milk to be sold at less than this price).
Regarding the second issue, one of the weaknesses of the current default pricing formula is that it never attempted to capture attributes such as risk or the costs of managing a supply chain. The corollary is that if the new regulated milk regime only used Fonterra’s farm gate milk price then under-pricing of regulated milk is likely to occur, which is inconsistent with the principle of providing regulated milk at a fair and efficient price.
The Review therefore proposes that regulated milk include a premium X, which is additional to Fonterra farm gate milk price.
A more detailed analysis of pricing issues is considered here. Meanwhile, three options for pricing and allocating regulated milk are set out below. A major difference between options 1 and 2 compared to option 3 is the mechanism used for “discovering” X. The first two options rely on an administered formula to derive X, whereas option 3 relies on a market discovery process by way of an auction.
Options overview
Option 1
Option 1 is based on the regime that existed until the 2006/07 season, but with more targeted eligibility criteria to reflect increasing demand for regulated milk. Key features include:
- a total processor cap of 400 million litres of raw milk;
- individual processor allocations of up to 250 million litres for Goodman Fielder Limited and up to 50 million litres for any other independent processor;
- even scaling of all applications to manage instances of excess demand;
- the addition of an “own supply rule” restricting access to regulated milk.
Under option 1, regulated milk would be priced at the Fonterra farm gate milk price with an allowance for X added, where X is independently calculated (click here for details).
While the Fonterra farm gate milk price would only be known at the end of the season (when the Fonterra payout is confirmed), X will be set in regulations.
The application period for regulated milk would run from 1 to 15 November of the season prior and independent processors would need to provide forecast requirements for the new season at the time of application (applications need to specify the total quantity required). Fonterra would need to confirm by 30 November of the season prior how much regulated milk will be provided to each independent processor with processors needing to accept or reject this offer by 12 December of the season prior.
If accepted, the offer to supply would become a contractual obligation with “take or pay” provisions.
All milk profiles would need to be consistent with the existing “October rule” (that is milk must be taken in October and in other months and independent processors cannot exceed by more than 10 percent the amount of regulated milk taken in October of that season [winter milk notwithstanding]).
The salient feature of option 1 is the 400 million litre cap, which reflects the initial amount of milk agreed to at the time Fonterra was created. However, given that demand for regulated milk is currently greater than 400 million litres, additional tools need to be put in place to manage what is likely to be an excess demand situation.
In addition to ensuring a fair and efficient price for regulated milk (via the addition of X), two additional tools are provided to assist with equating the supply of, and the demand for, regulated milk, namely:
- the ability to evenly scale all applications for regulated milk if excess demand occurs; and
- the addition of an own supply rule, whereby independent processors with 10 million litres or more of own supply would not be eligible for regulated milk.
With regard to the own supply rule, it is intended that there would be a three year transition period whereby independent processors that either are accessing, or will access, regulated milk in 2009/10, will be able to continue to do so until 2012/13.
Potential issues regarding option 1 include:
- The need for considerable scaling of allocations from the 2009/10 season unless X is set at a very high level.
- The formulaic calculation of X may result in legal challenges.
- The scaling process giving rise to the potential for gaming, in that some processors will be able to over-estimate their requirements. This implies that the scaling only really “bites” on those processors either close to or at their respective processor level cap (though this issue could be mitigated to some extent through the imposition of the take or pay clause).
- The own supply rule, while consistent with the ability to manage within a 400 million litre cap, is hardly consistent with current expectations associated with the provision of an entrance pathway for new processors.
Option 2
Option 2 is based upon the 2008/09 regime. Key features include:
- a total processor cap of 600 million litres of raw milk;
- allocations of up to 250 million litres for Goodman Fielder Limited and up to 50 million litres for any other independent processor;
- the addition of a “new entrant rule”, whereby a new entrant is able to access up to 75 million litres for three years only, thereafter reverting to the standard independent processor allocation.
- even scaling of all applications to manage instances of excess demand.
The key difference between options 1 and 2 is the cap size of 600 million rather than 400 million litres, which removes the need for the own supply rule and permits the introduction of a new entrant rule.
As per option 1, regulated milk would be priced at Fonterra farm gate milk price + X.
The application process for option 2 would be identical to that of option 1.
Compared to option 1, option 2 is likely to result in less short-term industry disruption due to the greater milk availability. It also has the advantage of assisting new entrants at what is likely to be a critical time.
Potential issues regarding option 2 include:
- The removal of the own supply rule, which allows independent processors with own supply to continue to access regulated milk on an open ended basis.
- As per option 1:
- the formulaic calculation of X may result in legal challenges; and
- the scaling process gives rise to the potential for gaming.
Option 3
Option 3 is the preferred option.
Option 3 is also based upon the 2008/09 regime. Key features include:
- a total cap of 600 million litres of raw milk;
- up to 15 million litres of raw milk would be reserved for niche processors (that is, processors whose total production is less than 2.5 million litres per annum); and
- the balance (585 million litres) is available to all other independent processors as follows:
- 2009/10: Goodman Fielder (up to 250 million litres) and any other independent processor up to 50 million litres;
- 2010/11: Goodman Fielder (up to 275 million litres) and any other independent processor up to 75 million litres; and
- 2011/12 forward: No processor limits.
Option 3 employs an auction process rather than rationing rules to manage any excess demand. Under this option, independent processors have the right to bid for raw milk “lots” at the Fonterra farm gate milk price – subject to any applicable individual processor cap.
To allow independent processors to secure the quantity of milk they desire, a range of different lot sizes ranging from one million litres to 20 million litres would be provided.
The auction would be conducted annually in the November of the season prior. In the interests of transparency the auction will be conducted on a platform such as that recently announced by Fonterra and run by CRA International. The auction design rules would be set in Regulations therefore making it impossible for any party to skew the auction result.
All milk profiles would need to be consistent with the existing October rule (winter milk notwithstanding) and winning bidders would be subject to take or pay provisions.
In a situation where there was excess supply of regulated milk, processors would secure milk at the Fonterra farm gate milk price, which acts as the auction reserve price. The staged lifting of individual processor allocations is intended to assist with the transition into the proposed system by ensuring that there is likely to be some degree of excess supply in 2009/10. However, the processor limits would be progressively raised to ensure there is competition for the milk.
In situations where there was excess demand for regulated milk, independent processors would have to bid a positive amount to secure the right to buy regulated milk at the reserve price – thereby producing a premium over the reserve that is analogous to X.
Niche processors (defined as processors that process less than 2.5 million litres per annum) would not be required to participate in the auction (but can do so should they wish) as they would be allocated up to 2.5 million litres of milk, for their own use, from within the 15 million litre niche processor allocation.
Historical patterns of demand suggest that 15 million litres is an adequate quantity to satisfy the needs of niche processors.4
The price paid by niche processors would be the volume weighted average auction price. Applications by niche processors would occur concurrently with the auction process.
The key advantage of an auction is that it is more likely to produce a fair and efficient price for regulated milk. Furthermore, as the price starts to increase, some processors may find it more cost effective to seek their own supply directly from farmers. Alternatively, the possibility of other parties – as well as Fonterra – choosing to sell additional volumes of milk via the auction platform becomes a possibility.
The possibility of selling non-regulated milk via the auction process raises another potential advantage: the platform may well continue to auction raw milk after the legal requirement for Fonterra to supply regulated milk ends.
This leads to the final advantage: compared to the other two options, option 3 offers potentially the smoothest transition to a post regulated milk world. Indeed, if the auction was successful, it is possible that an exchange with more sophisticated trading instruments and different products could evolve.
Notwithstanding the above, an auction could raise concerns regarding uncertainty and inability to secure milk either at a price or volume independent processors are accustomed to. Such concerns, however, need to be kept in context:
- As illustrated during the 2007/08 season, the existing system does not provide independent processors with certainty of supply.
- The auction provides no lesser degree of certainty compared to options 1 or 2.
- Compared to options 1 or 2, the auction is more likely to provide a smoother transition when the requirement on Fonterra to supply regulated milk ceases.
There is also an issue of lead time available for independent processors to address their concerns. In addition to being able to secure raw milk at the regulated price in 2008/09 processors would also be likely to secure raw milk at reserve price for the 2009/10 season.
This implies that the auction is unlikely to result in processors paying more than the reserve price for milk until 2010/11.
Answers to potential questions
The following are responses to some questions about the three options outlined above.
Question 1: Why not proceed directly to 5 percent of Fonterra’s milk (approximately 750 million litres) as permitted in the DIRA?
In the short run (for example, the next three years), total demand for regulated milk is unlikely to approach 750 million litres unless:
- the individual processor limits are substantially increased; and/or
- the rules associated with interconnected bodies corporate were relaxed.
No compelling arguments that either rule should be relaxed in order for independent processors to use 750 million litres have been made. No change is therefore proposed.
In the medium term (for example, greater than three years out), there is a real risk that making additional volumes of regulated milk available would increase the dependency of independent processors on regulated milk, when they need to be considering alternative sources of supply to manage the transition to the time when Fonterra no longer provides regulated milk (current and planned industry investment suggests that this could happen as soon as 2013).
This risk would be compounded if regulated milk did not incorporate X into the price, which would imply that regulated milk was comparatively cheaper than milk sourced directly from farmers.
Indeed, simply incorporating X is likely to mean that less than 750 million litres will be demanded (click here for additional analysis regarding the volume cap).
Question 2: Why not auction 400 million litres?
Four hundred million litres is unlikely to be a sufficient volume of milk for a workable auction given likely demand, which could also result in acute transition issues.
Question 3: Why not change the DIRA triggers?
The DIRA triggers were negotiated as part of a comprehensive pro-competition policy at the time Fonterra was formed in 2001. No compelling public policy reasons have been provided that suggests that the triggers need revisiting.
Once the DIRA triggers have been met then competition policy issues come under the ambit of the Commerce Act 1986.
Question 4: Why not give all independent processors without own supply special treatment?
Given that regulated milk is transitional in nature, providing special treatment is likely to increase dependency on regulated milk in addition to blunting incentives to source alternative supply (whether that is directly from farmers or from any other third party).
Question 5: Why are niche processors treated differently regarding option 3 but not treated differently regarding options 1 and 2?
Niche processors are treated differently with respect to option 3 for reasons associated with auction design. Given the asymmetry in milk requirements (some niche processors only require 10 000 litres per annum) it does not make a great deal of sense to auction a range of very small lots or establish a secondary market to break up larger lots. Carving out a tranche of milk appears to be a more practical option.
Given that one million litre lot sizes will be provided, it also seems reasonable that independent processors that require more than 2.5 million litres can bid at the auction the same as any other independent processor (indeed, processors that require one million litres or more could participate in the auction).
Niche players were not differentiated in terms of options 1 and 2 because:
- the own supply rule in option 1 is likely to favour niche processors; and
- niche processors are much better placed to manage the effects of scaling as they are well below the individual processor caps (so have the ability to over-estimate their requirements).
Question 6: Where can independent processors source raw milk once the DIRA triggers are met and the requirement on Fonterra to supply regulated milk has ceased?
Unlike other pasture based suppliers (such as Australia) New Zealand has increasing milk production. Based on a 15 billion litre supply base and annual growth of only 2 percent, an additional 3 billion litres of milk will be available by 2018.
Given an increasing milk supply, processors that have a business model based on securing supply directly from farmers can do exactly this. Alternatively, processors that do not have a business model based on sourcing supply directly from farmers can either:
- enter into a supply contract with another milk processor or processors; or
- contract out procurement and supply chain management issues to a broker.
Given current and planned investments in dairy processing there are very few locations in New Zealand that will not have at least two – and in some cases three or four – processors that have the ability to supply milk on a contract basis. Moreover, future processor capacity might be expected to develop in locations where alternative supply is available.
Question 7: How will winter milk and organic milk be handled?
Under the existing regulations Fonterra is able to pass on “the reasonable additional costs of procuring and supplying” winter milk and organic milk. This implies that if independent processors receive either winter or organic milk then Fonterra can charge the appropriate premium above the price of raw milk for either product. Under all three options Fonterra’s ability to recover these costs would remain unchanged.
The regulations also state that if independent processors require greater than 20 000 litres of winter milk a day, then estimates of supply quantities may be required up to 18 months before the date that the winter milk is supplied.
This timeline is consistent with options 1 and 2 so no change is required. With respect to option 3, two alternatives are outlined:
- Separate “winter milk lots” are created and these are auctioned on a season forward basis (that is, the November auction would be for winter milk to be delivered in the season after next); or
- Winter milk is handled separately from the auction system.
We would like to know:
- What are your views on replacing the current formula with the Fonterra farm gate milk price?
- What are your views on the addition of an X to the Fonterra farm gate milk price?
- What is your view on using an auction process to determine X rather than a formulaic process?
NB: Questions regarding the integration of winter milk into the preferred allocation mechanism are covered in the next section.
Summary table of options
| Option 1 | Option 2 | Option 3 Preferred Option | |
|---|---|---|---|
| Cap | 400 million litres | 600 million litres | 600 million litres |
| Reserve price | N/A | N/A | Farm gate price |
| Price | Farm gate price + X | Farm gate price + X | Auction price |
| Rationing | Equal scaling on the basis of requested regulated milk, capped by individual processor limits. | Equal scaling on the basis of requested regulated milk, capped by individual processor limits. | Action process based on willingness to pay and capped by individual limits (as applicable). |
| Eligibility and limits | Goodman Fielder can access up to 250 million litres and any independent processor can access up to 50 million litres; subject to: The own supply rule: |
Goodman Fielder can access up to 250 million litres and any independent processor can access up to 50 million litres; subject to: The new entrant rule: |
The niche processor rule: Up to 15 million litres set aside Niche processors can access up to 2.5 million litres of regulated milk for their own use at the average auction price from the 15 million litre tranche. Niche processors are not restricted from bidding in the auction should they wish to. All other independent processors would qualify as follows: Year 1 Year 2 Year 3 forward |
| Contract terms | Take or pay October rule applies |
Take or pay October rule applies |
Take or pay October rule applies (subject to winter milk arrangements. Auction comprises: 100 x 1 million litre lots; |
| Notice period | Firms would need to provide accurate delivery forecasts at the time they applied for the regulated milk, otherwise they would be subject to the take or pay rule. | Firms would need to provide accurate delivery forecasts at the time they applied for the regulated milk, otherwise they would be subject to the take or pay rule. | As per auction rules |
| Transition arrangements | Three year transition period for firms subject to the own supply rule. | Nil. | Nil |
| Comments | As only 400 million litres is provided, it is likely scaling would required until the own supply rule applies. In the short term, this would be likely to increase the incentives for securing alternative supply, albeit at the risk of industry uncertainty and potential disruption. |
Given a 600 million litre cap the incentives for generating alternative supply may be blunted until an excess demand situation applies and quantity rationing cuts in. Getting X “right”, is critical as price is likely to be a key driver of whether processors diversify away from regulated milk (indeed, excess demand would be a signal that X is still too low). |
There is likely to be an excess supply situation in year 1, which will aid transition. An auction price above the reserve is likely to result in any of the following:
Transition: Suppliers may continue to supply milk if it is commercially attractive. |
4 Once niche processors expand beyond 2.5 million litres then the expectation is that they could bid for milk like any other independent processor. For example, if a niche processor wanted 3 million litres of regulated milk then they could bid on three lots of one million litres.
Contact for Enquiries
Principal Advisor
MAF Policy
Sector Performance Policy
Ph: 04 894 0128
Fax: 04 894 0745
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