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

Other issues

Winter milk issues
The 20% rule

The following issues were raised during the first round of the consultation process:

Winter milk issues.
The 20% rule.

Both issues are canvassed below.

Winter milk issues

Current concerns

Under the current Regulations, purchases of regulated milk in May, June or July pay an additional cost of winter milk on top of the default milk price and transport component. The additional cost of winter milk is the average premium that Fonterra pays suppliers per kilogram for milk collected during this period.

The objective of the winter milk component of the Raw Milk Regulations is that independent processors who require winter milk face the additional costs associated with winter milk production.

Due to higher milk supply in May, as compared to June and July, Fonterra does not need to pay winter premiums to attract the required amount of milk supply. The inclusion of May’s milk collection in the winter milk calculation therefore dilutes the average additional cost of winter milk, resulting in under-pricing of winter milk.

Alternative winter milk calculations

MAF has considered the following three options as potential solution for calculating winter milk:

Winter milk option A: Retain the May–July definition for winter milk but switch to monthly charging rather than a three monthly average.
Winter milk option B: Amend the regulations and define winter milk months as June and July and average the price over those two months.
Winter milk option C: Amend the regulations and define winter milk months as June and July and switch to monthly charging.

If changes were to be made to the calculation of winter milk, option B is the Review’s preferred approach.

Winter milk option A

One solution to overcome the dilution of the winter milk premium would be to move to a month-by-month calculation.

Under this option, if Fonterra were required to pay a premium for milk supplied in May, then this would still be captured in the additional cost of winter milk for that month. However, as the additional cost of winter milk would be calculated on a per month basis, this would not dilute the potentially higher average winter milk premiums that are paid by Fonterra in June and July.

This option has the advantage of more accurate pricing that better reflects the costs of production for each individual month.

Winter milk option B

Alternatively, the definition of winter months could be amended to exclude May. This would mean that only regulated milk required in June and July would include the additional cost for winter milk.

Implementing this option would have the effect of increasing the price for regulated milk required in June and July and reducing the price for regulated milk in May, assuming that the average premium in June and July is indeed higher than for the combined three-month period. If premiums paid for winter milk supplied are indeed concentrated in June and July then this would be more representative of the true costs of production.

The impact of this option would be that regulated milk required in May would:

be priced at the default milk price;
come under the October rule, that is, regulated milk required by an independent processor in May could not exceed by more than 10 percent the amount of regulated milk required in October of that season; and
not require processors to estimate demand up to 18 months before the date of supply (as currently required by the regulations for winter milk quantities exceeding 20 000 litres per day).

Option B is the preferred option if changes to winter milk rules were made as it is the simplest way to achieve the policy objective.

Winter milk option C

A further option would be to combine the changes contained within option A and option B, amending the Raw Milk Regulations to define winter milk months as June and July and calculating the additional cost of winter milk on a monthly basis.

This option would capture the features of both option A and option B, including all implications of removing May as a winter milk month and changing the additional cost of winter milk to a monthly calculation for June and July to more accurately reflect the true cost of production.

Option C would require more substantial changes to the Raw Milk Regulations as both the definition of winter milk would need to be amended, as well as the definition of the additional cost of winter milk. More substantive changes may potentially increase any risk factors. For instance, this option may have consequences for those requiring regulated milk in May and there may be implementation problems with moving to monthly calculations of the additional cost of winter milk.

Integration of winter milk into an auction regime

The Regulations currently distinguish between winter milk supplied below 20 000 litres per day and above 20 000 litres a day, with the former requiring three months notice (with confirmation one week prior, on a +/-40 percent basis) while the latter requires up to 18 months notice (again, with confirmation one week prior, on a +/-40 percent basis). The requirement of up to 18 months notice is clearly inconsistent with the preferred option of an auction that is conducted seven months prior to the new season commencing.

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).
Winter milk is handled separately from the auction system (this is likely to require an adjustment to the quantity of milk supplied through the auction platform).

The Review does not have a preference regarding the method of integrating the provision of winter milk with the preferred allocation option and actively seeks industry and stakeholder feedback on this issue.

We would like to know:

What are your main concerns in relation to the calculation of the additional cost of winter milk required under the Raw Milk Regulations?
What would be your preferred method of calculating the additional cost of winter milk: option A or option B or option C or retaining the status quo?
What affect would the above winter milk options have on your business?
Do you have a preference whether winter milk is handled within or outside of the auction process? What are the reasons for that preference?
Do you have any alternative suggestions, or wish to raise additional points, regarding the integration to winter milk with the preferred allocation mechanism?

The 20% rule

The 20% rule allows Fonterra suppliers to divert up to 20 percent of their milk, calculated on a weekly basis, to any independent processor subject to the October Rule.

Like open entry and exit, the legal obligations regarding the 20% rule ceases on an island by island basis as the North Island and South Island triggers are individually met.

A recurrent theme from independent processors was a level of frustration regarding the 20% rule as it was seen as being largely unworkable, yet had the potential to be extremely useful.

From a competition policy perspective, a credible and well functioning 20% rule would substantially increase the level of contestability for raw milk. The rule could provide “within season” competition as suppliers need only give 20 days working notice to divert a portion of supply, compared to giving Fonterra notice of an intention to exit the company between December and February of the season prior.

Notwithstanding confusion as to how the rule operates (for example, some stakeholders incorrectly thought that exactly 20 percent had to be supplied [rather than up to 20 percent] on a daily, rather than weekly basis), it has not been easy to identify the precise reason why the 20% rule has not been utilised to date. For this reason, the Review is exercising considerable caution before consideration is given to changing the rules associated with the 20% rule.

A possible reason why the rule has not be used more is that under existing constitutional rules Fonterra farmers need to redeem Fonterra shares to supply under the 20% rule in order to maintain the correct linkage between milk solids supplied and shares held. This is both time consuming and risky.

If this is the case, then a proposal currently being considered by Fonterra shareholders in the context of capital structure changes is potentially helpful in this regard. Under this proposal, Fonterra farmers will be able to hold up to 20 percent dry shares over and above an allocation of “wet” – or supply backed – shares.

The implication is that farmers could divert some milk to independent processors and no shares would need to be redeemed.⁵ In this situation farmers would be consistent with both the 20% rule and Fonterra’s [potential] rule regarding the ratio of wet and dry shares farmers must hold.

In considering methods to make the 20% rule more workable the Review decided against making changes to the rules regarding vat ownership and/or the ability for farmers to collectivise across multiple farms and dedicate the production from a single location as being eligible as supply under the 20% rule.

The reason for rejecting both changes is that it was not at all evident that either change would make a significant difference without a change in share ownership rules, which is outside of the scope of this Review, being an issue for Fonterra and Fonterra shareholders.

No changes are proposed regarding the application of the October rule to milk sourced under the 20% rule.