Keith Woodford assesses the latest DIRA update and concludes it just nibbles with the status quo and avoids the big decisions

Keith Woodford assesses the latest DIRA update and concludes it just nibbles with the status quo and avoids the big decisions

The current review of the Dairy Industry Restructuring Act (DIRA) does not address the big decisions that face the New Zealand dairy industry. That may well be a wise decision by Government.

Big decisions will indeed be necessary over the coming years. Clearly, they are difficult decisions. However, trying to make those decisions through the DIRA mechanism would be a brave decision and, in all likelihood, with unintended consequences. So, the Government has stepped back.

Instead, Government is using DIRA to nibble around the edges.  Whether those nibbles are the correct nibbles remains a moot point.

There are three issues where the Government is choosing to nibble away at the edges. The first is the open entry and exit of farmers to Fonterra. The second is provision of Fonterra milk to new processors. The third is the vexing issue of the so-called regulated farm-gate milk price.

 I will look at each of those in turn. But first it is important to remind ourselves why we have the DIRA in the first place.

The reason for DIRA is that Fonterra, when set up in 2001, was in conflict with the competition principles within the Commerce Act. Special enabling legislation was needed.

This enabling legislation was justified by the Helen Clark Labour Government of the time because there was seen to be merit in the notion of Fonterra as a ‘national champion’, of benefit both to the dairy industry and the wider economy.

Fonterra was to be the structure that would allow New Zealand to grow its wealth through exports. Fonterra was meant to become a $30 billion company within a few years. 

There was some confusion back then as to whether this $30 billion referred to capital value or annual sales. Right now, 18 years later, Fonterra has a capital value of around $6.5 billion. Annual sales, in much depreciated dollars, now approximate $20 billion.

The ‘quid pro quo’ which Fonterra willingly accepted at the time was that it would have particular responsibilities in return for the monopoly powers that it was being granted. In essence, this was to ensure that Fonterra did not become a monopolist bully that prevented the entry of competitors. There was a particular issue that Fonterra should not be able to act as a monopolist in local retail markets here in NZ.

Since then, competitors have emerged, and they now process and market around 20 percent of New Zealand’s milk, up from four percent back in 2001.  The big companies such as Open Company, Synlait and Oceania (Yili) are export focused, but there is also a myriad of niche operators who focus on local dairy products. 

There is also the remarkable case of The a2 Milk Company (ATM), still a New Zealand company, but with all of the top executives and most of the shareholders now outside New Zealand. The ‘a2 Platinum’ infant formula, manufactured by Synlait under contract to ATM, uses no more than one percent of New Zealand’s milk, but has led to the capital value of ATM being more than 50 percent greater than Fonterra’s capital value.  It’s what happens when you get value-add to work with a differentiated product.

Nevertheless, in terms of volume and power, there is no doubt that Fonterra is still dominant across all sectors of New Zealand’s dairy industry.

At the farm gate, most farmers still have no option but to supply Fonterra. This is because the other companies only operate in restricted localities and have a full book of farmer suppliers. Some companies have big waiting lists.

In the supermarkets, there are is essentially a duopoly, with Fonterra and Goodman Fielder each with big market shares. However, Goodman Fielder gets it milk from Fonterra under a special regulatory mechanism within DIRA that is to continue, and with an enhanced growth provision.

Some will argue that DIRA has been helpful over the last 18 years, but there is also a belief that there is more to be done. Many are disappointed that Fonterra has not become the national champion that was envisaged back in 2001, having stumbled many times.

The alternative stance that comes from Fonterra is that they have things under control, and they would be pleased if the DIRA would simply go away. In the current no-growth environment, more new entrants would mean that Fonterra risks having stranded assets.

Over the last year, I have been part of a group of so-called ‘lateral thinkers’ set up by the Minister of Agriculture Damien O’Connor to explore some of these issues. Chatham House rules always apply in these situations so I am not going to say who said what, and there were no minutes kept. However, I can say that there was considerable diversity of thought as we wrestled with some complex issues. 

I also make the point, and do so strongly, that our ’lateral thinkers’ role was simply to throw ideas around with the Minister and to critique those ideas.  Whether or not we might have influenced the proposals as approved this week by Cabinet, I am not going to say.  We were never meant to be the decision makers.

The open entry and exit conditions are going to remain, with some minor modifications, which means that a farmer who leaves Fonterra for an independent processor can still shift back to Fonterra if that farmer is dissatisfied with the new processor. This reduces the risks for a farmer who is considering leaving Fonterra, and makes it easier for the new processor to attract farmers.

Fonterra thinks this is unfair. However, in other countries where there are multiple processors, farmers can and do shift between processors to get the best deal. It is Fonterra’s monopoly powers that stops that happening in New Zealand, and hence the open entry and exit provisions.

 New entrants will still be able to require Fonterra to supply them with milk, but only up until they have their own supply of 30 million litres, and for a maximum of three years. Fonterra does not like this requirement to supply.

The independent processors are also not keen about new entrants continuing to get access to Fonterra’s milk. They themselves were helped by this, but now that they are established, they would rather like to see the gate closed to any further entrants benefitting in that way. That is the way  the commercial game is played.

The third issue, and this is controversial, relates to the so-called farm-gate base milk price which Fonterra uses as the benchmark for paying its own farmers.

The independent processors all believe that the milk-price formula is flawed and that Fonterra pays its farmers too much, thereby gaming the system and making it hard for the independent processors to compete.

The argument goes, according to the independents, and with some cautious agreement from the Commerce Commission, that Fonterra uses a flawed ‘asset beta’ in its calculations and thereby under-estimates its cost of capital.

According to an Open Country submission in 2017, this leads to the cost of capital being under-estimated by 0.9 percent. This in turn would indicate, by my calculations that about 10c per kg milksolids (fat plus protein) is transferred from profits to the milk price. Some would argue that the overpayment, perhaps for other reasons, is greater than this.

The Government is now saying that it wants to keep its eye on what is happening with the milk price and wants to have its own nominee as a member of the panel that calculates the milk price.

Everything to do with setting of the milk price is complex and open to debate.  Government may well be wise to step in with great caution.

The original idea back in 2012, when Fonterra allowed investment units to be bought by non-farmer investors, was that farmers would always be paid the milk price. Since then, we have seen that Fonterra has on two occasions paid less than the milk price when it got scared that its balance sheet needed propping up. So, in reality it is just a benchmark. Also, the current proposal is explicit that the benchmark does not have to be applied if Fonterra has good reason not to.

That ‘let-out’ clause is important, as without it, Fonterra might well lose its financial rating and find its cost of borrowings going up markedly.  It means that farmer payments are subordinated to Fonterra paying the banks.  But it also means there are no concrete rules as to farmer payments versus investor profits.

The reasons I am so cautious about the Government getting too involved in setting the milk price are twofold.

First, the issues around calculation of the ‘asset beta’ are complex and theoretical. Each side claims with some passion that its own perspective is correct. I could easily write an article on that alone.

The second issue is that, regardless of any asset beta, Fonterra has dug a big hole for itself by making a series of disastrous historical decisions such that its balance sheet is now weak. It may be better for Government to leave Fonterra to come to its own decisions about solving this rather than getting involved and becoming the fall guy.


*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. His articles are archived at http://keithwoodford.wordpress.com. You can contact him directly here.

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18 Comments

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Highlight new comments in the last hr(s).

Any comment on the David Chaston sidebar to the DIRA debate, re the GF and Wilmar/palm oil connection? His note was to the effect that letting a company (GF) linked to a 'despoiler' (Wilmar) continue to have privileged access to cost-price Fonterra raw material was a mixed message at best and a fustercluck in the making at worst.

Waymad,
I don't really see it as privileged access.
If GF lose access to milk then there would be almost no competition in the supermarkets.
If people don't like palm oil then they could stop buying products that contain palm oil - a good place to start would be all supermarket biscuits, anything labeled 'vegetable oil', any hair shampoo and so on.
Those that don't like Wilmar could also stop buying the Goodman Fielder products - milk, yoghurt, ice cream, cheese, bread, flour and so on.
Have a look at all of their brands - you may be surprised.
https://goodmanfielder.com/countries/new-zealand/
Most people would be amazed to see this list.
Keith

Not amazed, have known all this ever since Wilmar bought into GF. I've been telling as many people as I can for a long time now, and yes, have avoided all and any product under the GF label since then, even those absolutely iconic brands such as Edmonds, Vogels, Molenburg etc and do my utmost to avoid palm oil in products. Where biscuits go, I simply do not buy as they either contain palm oil or excessively packed in plastic, usually both. I now pass on shampoo and conditioner in plastic containers and opt for local, small businesses producing bars of same, with no plastic packaging on arrival.

I find it absolutely bizarre that Fonterra have had to supply competitors, especially when most of those competitors were from the very country that was one of the largest consumers of the product. What a dumb idea that was.

I was fascinated by the creation of Fonterra back in the early 2000s. At the time I was working in telecommunications sector which was exploding with innovation and a very exciting space to be involved in. I had close ties with the dairy sector in particular, growing up in the Waikato, as you do...I saw plenty of opportunity for what was a perennially struggling dairy sector to emulate that of the telecommunications sector as fonterra was firmed up. But it never happened. I think a critical issue was the enabling legislation was essentially written by the industry itself which is as self serving as it gets, no? The Clarke govt simply rubber stamped it (the act being full of flaws as we have seen for the last two decades) into effect. The effect of this is made worse still by the innate conservatism that riddles the dairy sector leading to the knifing of the highly innovative Craig Norgate by the faction of the cooperative that simply wanted to milk more cows because it couldn't perceive (due to sheer ignorance) how to really innovate and develop the new business the govt had delivered them. The lost opportunity is most likely enormous and incalculable and stands as a glaring lesson in my view, of how not to legislate for privelage nor how to run a sector of any economy. Such is the New Zealand primary sector though....despite Norgates fate during the gfc, I often think fonterra and the economy on the whole, would have been far wealthier had he stayed involved. Thoughts?

The 4th Estate,
Norgate was certainly charismatic and energetic, but also somewhat undisciplined. I observed his career, both first and second hand, with great interest.
I don't think we can blame DIRA for Fonterra's shortcomings, they were all internal. I reflect on whether or not Fonterra's outcomes were inevitable. If Norgate had stayed as CEO for another couple of years then the A2 saga would have unfolded very differently. And if John Roadley had stayed on as Chair for another couple of years then maybe Norgate might have been able to hang on and make some crucial decisions. But Roadley never saw himself as long-term chair. If Ferrier had understood say in 2006 the coming evolution of China, then once again things would have been very different. But it was not only Fonterra that messed things up. For example, Westland committed themselves to A2 back in 2008, but then new CEO Rod Quin (ex Fonterra) reversed that in 2009. Westland Dairy and indeed all of the West Coast could have been a very different place if it were not for that decision. Both companies had supposed 'wise heads' as external directors so one cannot just blame the farmer directors. Organisational culture is also often at the heart of flawed decision making. And over a fifty year horizon, most big companies seem to lose their way.
KeithW

Craig Norgate was definitely a visionary but he needed a solid hand on his shoulder to slow him down, big picture guys still need to fill the details in as they go. And if a man as hard and experienced as Baird McConnon couldn't do that successfully I don't know who could.
Sadly corporates' primary purpose in life is survival, not very exciting nor fun but business reality.
The next stage in our dairy industry evolution, particularly now there is no more production increases, will be the creation of small players who will nibble away at the edges until Fonterra either wakes up or dies. Look at Murray Goulburn - and they had farmer suppliers who liked supplying them!!

Fonterra was meant to become a $30 billion company within a few years. There was some confusion back then as to whether this $30 billion referred to capital value or annual sales.

Well that's just plain silly. Surely it must have been annual sales.

Well actually, much of the discussions were about company value. The value of the company is a reflection of the value that is added by Fonterra, whereas the majority of the revenue reflects the value that has been added on-farm and which is paid for through the milk price.
KeithW

As always, I enjoy you contributions Keith. Thanks. Today I've enjoyed reading the comments also. Thoughtful rather than just anti cooperative.
I experienced the demise of ENZA (NZ Apple and Pear Marketing Board). That period following the launch of ENZA brand was a period of board excess. To this day, growers of that time do not know the per carton cost of ENZA sponsorship of the Americas'Cup or the Jules Verne record attempts. And it's history now, that the returns to growers plummeted in 1993 and did not recover. If Winston Peters had not been reigned in when he became Treasurer, all producer boards would have been dismantled in one fell swoop and we wouldn't be having this discussion about Fonterra. Despite Fonterra's lackluster performance, I can't help recognising that (from the individual farm business perspective) the 2 strongest Ag sectors are farmer cooperatives.
Let's not throw the baby out with the bath water. Fonterra needs to look very closely at how it operates within the frameworks proscribed and ask the hard questions of whether it's salaried staff are truly focused on delivering best return to the farm gate. This opportunity was never extended to pipfruit. Arguably their were some strong, influential vested interests that had little interest in arguing for that to occur. And little motivation to argue to Government that the single desk exporter should be retained.
It is well beyond NZ shores that the dairy industry faces competition. Not within NZ. Weakening Fonterra will lead to a weakening of the NZ economy and profit from dairy product relocated off shore, not back into NZ regional and national economies.
Strong farmer cooperatives remain the best means of maximising value back to the farmers.
But this model precludes investors with no direct link to farms ticket clipping beyond the farm gate and I can understand how this can lead to disgruntlement amongst external observers and opportunists.

Yes, those Board excesses are more common in monopolies where the directors can often get away with indulgences.
I have always believed Fonterra was important and that is why I have written about it so many times. (Articles written since 2010 can be found at https://keithwoodford.wordpress.com) The current problem, however, is that Fonterra is now short of capital as a result of multiple stumbles, and is largely pulling back to its knitting of commodities and some specialised ingredients. And it still has problems to solve in China, Australia and Chile. The notion that Fonterra could in some way be a national champion for which special treatment was merited starts to look somewhat shaky. Looking beyond Fonterra itself (i.e the processor) to the broader dairy industry, where most of the value is added on-farm, then that dairy industry remains a cornerstone of the export economy. It is in that context that it is so disappointing to see how badly Fonterra has performed.
KeithW
KeithW

Dairy remains a cornerstone for the export economy, increasingly for the benefit of foreign owned processors who pocket the value add. This is what DIRA was designed for, hemorrhaging over 100 years of cooperative capital, and reflecting corrupt government and officials, and incompetent industry leadership.

It is a big step to move from claims of incompetence to corruption. Are you sure?
KeithW

I believe there was a continuum between the two. I can't recall the politicians who were founding shareholder directors of 'independent' processors, likewise MPI officials who advised government and subsequently were employed by the 'independents, but I'm sure you do. I won't debate semantics over terminology; corrupt, unethical, immoral, any rhetorical flourish consistent with the reality will do.

I think you may have mis-read the tea leaves. DIRA and Fonterra were set up under the Clark Labour Government.
Open Country Cheese was set up a couple of years later and the ex politicians who drove that were actually from the preceding National Government.
The story of Open Country is a fascinating one - it started off with a focus on consumer cheese, quickly moved to commodity cheese, and then broadened to WMP to reduce risk. Over time the key shareholders also changed. In the early years they did rely on Fonterra milk (50 million litres per annum, purchased at the regulated price) as they built up their supply base. I have not seen any evidence of corruption. Of course both Open Country and Fonterra played a hard game against each other within the DIRA rules.
KeithW

Fair enough Keith, you can interpret the leaves how you chose, as I do. And I don't think DIRA has done anything to increase the value the dairy industry creates for the NZ economy in proportion what it creates for a handful of well healed so called 'independent' processors. It's an interesting strategy of OCD expanding into low value WMP to reduce risk. This illustrates the true colours of DIRA.

Isn’t the real problem the stupidity of the farmers ,the way they borrowed so much money after frontera was formed
Thinking that the government had there back they went on a buying binge and put costs up for all farmers
Banks , local government and Labour loved it but frontera was forced to keep the payout too high and now it’s another kiwi co op that lost its way
lol is funny that Labour deforested the central plateau for dairy and now want to plant the country in pines and no one has picked up on it

Are you sure you dont mean the stupidity of Fonterra for allowing themselves to run such a high debt to equity ratio. Farmers borrowed because they believed the hype as did the banks who were also happy to lend the money and come to think of it there were plenty of investors that were happy to pump the Fonterra share price up.
Everybodys to blame so please dont pick on the stupid farmer, they simply did what everyone encouraged them to do and unfortunately the Fonterra culture was in the wrong space given what we all know now.