Report On GDC From Charles River Associates

AN APPROACH TO ENSURING EFFICIENT PRICE SETTING BY GLOBAL DAIRY COMPANY

6 April 2001
Strictly Confidential

1. INTRODUCTION

The proponents of the Global Dairy Company (GDC) have indicated that they are committed to retention of the co-operative form of business organisation. This means that farmers must invest capital in the ¡§processing¡¨ operations of GDC in proportion to the milk that they expect to supply. Efficiency requires that farmers may enter or exit GDC at the fair market value of their investment but there is no external market mechanism to establish that value. A fair market value for the processing assets of GDC, and for the raw milk that farmers supply is necessary to ensure that the performance of investment in different assets can be assessed. Efficiency also requires that the milk supplied to and the capital invested in GDC earn competitive returns for farmers despite the absence of effective domestic competition in this market. The returns paid to farmers will provide a benchmark against which the pricing of wholesale milk contracts for processing companies may be benchmarked.
In our view, an effective and efficient means of ensuring efficient pricing by GDC is to ensure that GDC has incentives to use that information that it has to establish fair market values, and that the management of GDC bear the consequences of the pricing decisions that they make. As we explain below, open entry to and exit from GDC is a necessary condition for GDC to have the incentives to set and make a market at the efficient prices.

2. THE ECONOMIC EFFICIENCY OF CO-OPERATIVES

Dairy co-operatives in New Zealand currently have the power to decline applica-tions for membership and to inhibit exit by retaining the value of the exiting farmer¡¦s processing capital in the co-operative for up to five years. If dairy farm-ers had a choice of co-operatives then all institutional structures in the dairy in-dustry, including restrictions on entry to and exit from each co-operative, and all prices set within the industry, would be competitively determined. In this case, there would be no economic efficiency issues raised by the institutional structures and pricing policies in the industry. The situation with respect to the Global Dairy Company (GDC) is different because its initial market position will approximate that of a monopsonist (a monopoly purchaser of raw milk and manufacturer of dairy products). This means that whatever the competitive origins of specific practices and institutional structures, these practices have the potential to be used in ways that will reduce efficiency. Under conditions of monopoly, GDC will have the information to calculate the efficient prices for milk and the true value of its equity shares, but it may lack the incentives to publicise and pay these prices.

3. THE USE OF INCENTIVES TO REDUCE REGULATORY COSTS AND PROMOTE MARKET EFFICIENCY

In this section we explore a proposal that creates the potential to create incentives for GDC to set efficient prices even though it will have a near monopoly position in the market.
3.1 IS BUNDLING INEFFICIENT?
We begin by considering whether bundling is, in itself, a barrier to efficiency in the dairy industry (as has often been claimed). The claimed problems with bundling arise from two sources. The first is bundling the return on processing capital in the pay-out to farmers. This is inherent to co-ops in that these entities arise, or result in, situations where there is not a competitive contract market for raw milk and hence no price determined in a thick market. However, this form of (processor) bundling need not predispose economic inefficiency because farmers will consider their supply cost of raw milk and the capital requirements as their (marginal) cost of entry. Entry may be too high, too low or just right depending upon a number of factors that include economies of scale. There is no requirement for products to be sold in competitive (commodity) markets for this result to hold. It remains valid providing that the co-operative is earning a competitive return in processing marketing and product differentiation investment and there is open entry and exit.
The second form of bundling is where the returns from milk in high value markets are bundled together with returns from milk commodity markets and result in a bundled price to farmers that will predispose inefficient over-production. Because milk is essentially homogeneous, the efficient milk price to farmers is the price in its lowest value use (the commodity milk price). Any higher returns from, for example, product differentiation will be included in the returns to processing and marketing and thereby reflected in the valuations of these activities. Co-operative shareholdings are also tied to the milk that farmers supply, but if the value of any excess returns is reflected in the capital required of farmers for entry or exit then efficiency can be approximated under the co-operative structure.

3.2 INCENTIVES FOR GDC TO SET THE EFFICIENT PRICE AND FAIR VALUE
The operation of a vertically integrated dairy company is a complex business requiring knowledge of domestic and international markets. GDC has the most complete information about its business and the markets in which it operates, and therefore is more informed than any other party about the milk price and share value associated with its business.
GDC will have strong incentives to set the correct valuation of processing capital (equivalent to the fair value price) and the efficient price for milk. If it over-values the capital relative to milk there will be a demand for exit by farmers: if it sets this value too low there will be a demand for entry. In short there may be strong incentives for the co-operative to set the ¡§right¡¨ value of process capital however it does the estimation. It is noteworthy that GDC has every incentive to consider future prices, costs and performance in its pay-out and capital valuation, in addition to the demands of the present. The pay-out therefore is to a significant degree forward-looking, and the separation of the milk price and the return on investment in the co-operative will therefore provide the best public estimate of the value of the processing capital.
However, a necessary condition for GDC to have the right incentives in setting the valuations is that entry and exit of farmers be completely uninhibited: farmers have to be able to respond to GDC¡¦s price signals and GDC has to control entry only through the pay-out and exit-entry capital requirements that apply to all farmers. A parallel can be drawn with telecommunications where the incumbent cannot prohibit connection to its network, but the interconnect price remains to be determined. In this case GDC must allow entry and exit but at a price set by GDC, and, we shall argue, with minimal regulatory oversight.
Open exit simply means that the exiting farmers get the value of their capital at the time they exit. Open entry means that GDC has to accept any farmers¡¦ planned supply of milk if accompanied by the appropriate share capital. Despite the limitations resulting from the lumpiness of investment in factory capacity, GDC will be able to manage free entry with near monopoly coverage and planning periods of one dairy season in length. In short, by open entry we mean that GDC should be open to any planned entry by farmers but we do not mean that GDC has to accept milk that a farmer supplies opportunistically (e.g unplanned output expansion) or attempts to supply without supplying shareholder funds.
By the right amount of entry and exit we mean that the last co-operative farmer member just covers its on-farm costs of supply and (annualised) payment for the processing capital it must provide. This will generally be economically efficient given the choice of a co-operative structure.

4. OPEN ENTRY AND EXIT IN PRACTICE

The prices of capital set by GDC and the pay-outs to farmers provided by GDC will be critical factors that will drive farmer entry to GDC and farmer exit from it. The core information required to set the appropriate prices is controlled by or available to GDC. This includes revenue, product and cost information in their internal management database. It also includes knowledge of how to interpret these data and information about demand for entry and exit at the current price. Equally importantly, GDC has the incentives to set the correct price so long as they are required to facilitate entry and exit at that price. Once GDC faces greater competition in the market for the purchase of milk from farmers, it will have to make competitive pricing decisions. The proposal that GDC facilitate open entry and exit will simply require that they develop and implement appropriate pricing and valuation mechanisms before that competition emerges.
4.1 PRICING
In considering pricing we comment on issues to do with price differentiation to GDC farmers. We are not taking a position on this issue, but consider it necessary to recognise the possibility that is, in any event, a consequence of (the threat of) competition in any proposal.
The requirement to accept all entry at the posted price may result in GDC¡¦s costs being increased substantially by farmers in very remote locations attempting to take advantage of the cross-subsidies that currently exist in the single uniform return paid to all farmers. This may mean that it is necessary for GDC to
i) Introduce differential farm pay-outs based upon distance from the co-operative;
ii) Define geographical areas within which GDC must take all farm supply;
iii) Limit supply to farms that do not impose on GDC transportation costs that are greater than the highest transportation cost farm currently supplying GDC in any catchment.
Choosing among these alternatives, we consider that the lowest level of distortion to the operation of an efficient market is provided by free entry only for those farms whose transport costs to GDC do not exceed those of any existing farms. This proposal would, for example, allow farmers who wished to supply GDC from high transportation cost locations the option of paying to transport milk to the nearest point from which GDC was already collecting milk, subject to quality maintenance. This proposal also ensures that GDC is not required to charge farmers their individual cost of transportation for the successful management of the open entry and exit regime.
4.2 ENTRY
In practical terms, it would be reasonable for GDC to put in place mechanisms that allowed free entry only over time frames consistent with planning for capacity adjustment in the dairy industry. It would be inefficient to force GDC to take milk that had to be dumped for lack of capacity, or trucked long distances (e.g. across Cook Strait). This would not be a credible excuse for non-performance of open entry if sufficient planning time were provided. We suggest that GDC be required to accept the milk of any supplier by the beginning of the second season after the application has been received. We consider that this will give GDC ample time to prepare for the additional milk and also to impound the demand for new entry into the milk price and capital value. We note that entry can also take place from existing farmers and that the same rules should apply.
4.3 Exit
Farmer exit from GDC may raise planning and capacity utilisation issues, but these are unlikely to be as onerous as those associated with expansions in capacity. We therefore consider that exit be possible at the beginning of the season following that in which notification is given.
There is in our opinion no reason why GDC should insist on owning any specific asset that is situated on farms. Such ownership ¡V e.g. of milk vats - can lead to hold-up disputes in the event of planned exit. There would seem to be no impediment to achieving quality, access and co-ordination with these assets by means of contracts. Furthermore, the capital commitment to the co-operative for those farmers that choose to supply their own equipment would be lower.
GDC has expressed considerable concerns about proposals to require that GDC pay out cash to exiting farmers. Their concerns are that in a large scale defection of farmers, GDC may be unable to avoid a ¡§fire sale¡¨ of assets to raise cash. To avoid this problem GDC proposes that existing farmers be paid out in capital notes with a market value equivalent to the value of the farmer¡¦s equity interest in GDC. This proposal has the disadvantage that it imposes on exiting farmers a cost associated with the fact that capital notes do not have the transaction and liquidity features of cash. It also removes from the management of GDC the discipline that would be provided by the need to arrange with their bankers to cover the cost of paying out any (net) exit of farmers from the co-operative. We see the preservation and (where possible) strengthening of this discipline as crucial for the ongoing efficiency of GDC.
4.4 Contractual Issues in Entry and Exit
It is essential that farmer contracts with GDC entail commitment by the farmer, just as the farmer requires a commitment by GDC. The period and nature of these contracts should be a matter of farmer and GDC choice. Contracts for periods longer than one year may be economically efficient where they are offered on terms that are economically equivalent to those associated with annual contracts.
4.5 Principles for the Design of Regulations
To ensure the effective operation of the free entry and exit regime set out in this paper, a core set of regulations will be required. In contemplating regulations we would use the following principles:
„h GDC should be required to accept potential entrants where those entrants have essentially the same economic characteristics as some existing members of the co-operative, and those potential entrants should be offered contracts that have terms that are economically equivalent to those of at least some supplying farmers.
„h The regulations should define the minimum conditions required for entry to and exit from GDC to provide incentives for GDC management to set capital valuations, farmer payouts and wholesale milk prices at the efficient level. This requires that there be no entry or exit subsidies.
„h The regulations should be based on readily observable characteristics and behaviours so as to minimise the costs of compliance for GDC and minimise the costs of assessing claims that the regulations have been breached.
„h The open entry and exit regime should be consistent with the co-operative structure of GDC, and take account of reasonable GDC concerns about the management of liquidity and milk processing capacity as well as the transportation costs associated with accepting farmers in remote locations.
It is envisaged that there would be established an independent disputes and enforcement mechanism for dealing with complaints.

5. DO THE INCENTIVES PROVIDED BY FREE ENTRY AND EXIT REMOVE THE POTENTIAL FOR GDC TO ADOPT INEFFICIENT PRICES AND VALUES?

In this section we provide an assessment of the proposition that GDC will have the incentive to set prices for milk and its equity shares that approximate the efficient prices. We do this by proposing a range of scenarios and then considering the implications of each for GDC. Throughout, our analysis assumes that barriers to entry and exit are absent.
5.1 FOUR BASIC PRICING SCENARIOS
First, consider the four basic scenarios for inefficient pricing by GDC and the implications of each one:
1. Milk price is too high and the value of the equity is too low.
This will result in GDC making payments to farmers in excess of its economic earnings, and thus a deterioration in the capital base of the firm. The negative effects of this policy will be exacerbated by the fact that the high milk price and low equity value will attract large amounts of entry (both because of high short-term payouts and the fact that the equity stake is priced below its market value), creating a requirement for more not less equity. For GDC this combination of inefficient prices would be unsustainable.
2. Milk price is too high and the value of the equity is too high.
These prices will result in GDC making payments to farmers that are in excess of economic earnings. The higher payouts will be unsustainable since GDC will be depleting its balance sheet to sustain them. This is also completely inconsistent with the stated GDC strategy of international expansion and acquisition, which will require that GDC have more, not less, capital.
3. Milk price is too low and the value of the equity is too low.
This price will result in an accumulation of profits in the firm, which will be unacceptable to farmers who have immediate needs to service debt and undertake new on-farm investment. The only way ongoing farmers in the GDC can get a return on their farm and processor capital is through the pay-out (milk plus return on capital) price, and hence there will be vigorous pressure to maintain this price. Further, if GDC retains earnings it will have to show a return on these through the future. Retail earnings that increase the pay-out in the future but do not increase entry/exit capital, even if this were possible, would not satisfy current farmer shareholders because it would encourage too much entry.
4. Milk price is too low and the value of the equity is too high.
This price will result in excess exit from GDC as farmers take advantage of the high price of equity and respond to the low payouts. There will be no entry to offset the impact of this exit on the balance sheet of GDC. This policy will be unsustainable.
In two of these four cases free entry and exit are central to the incentives for efficient pricing faced by GDC. In the absence of free entry and exit it may be possible to sustain inefficient pricing policies but in the presence of free entry and exit it will not. In addition, with free entry and exit, GDC will not be able to sustain payouts to farmers that will place any competing manufacturer at a competitive disadvantage.
Note also that the entry of a competitor offering milk supply contracts on competitive terms but not requirement to invest capital would provide a very high level of discipline on GDC. This is because farmers would be able to assess the returns to the supply of milk provided by GDC and its competitor and weigh up the opportunity cost of having capital in GDC by considering the returns to investing outside the dairy industry.
5.2 COMMENT ON BUNDLING
We note that with open entry and exit GDC will have a strong incentive to pitch the milk price at a level at which extra milk is profitable to it. In so doing they will be unbundling any persistent (quota) rents from the milk price, as discussed above.
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6. SUMMARY

GDC has all of the information required to calculate the fair value exit and entry price for its shares. If there are no barriers to entering GDC or to exit from GDC then GDC will also have the incentives to calculate the fair value price and to implement it.
The milk price and capital value posted by GDC will provide the basis for the calculation of a wholesale price that will be the appropriate starting point for the negotiation of contracts between GDC and other firms in the dairy industry.

Paper Prepared by Lewis Evans and Neil Quigley
16 March 2001

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