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Final report on 2014/15 review of Fonterra

Commission releases final report on 2014/15 review of Fonterra’s base milk price calculation

The Commerce Commission today released its final report on Fonterra’s base milk price calculation for the 2014/15 dairy season. The base milk price is the price Fonterra pays to farmers for raw milk and is currently set by Fonterra at $4.40 per kilogram of milk solids for the 2014/15 season.

Having considered public submissions on the draft decision released last month, the Commission’s overall view that Fonterra’s calculation of the 2014/15 base milk price is largely consistent with both the efficiency and contestability purposes of the Dairy Industry Restructuring Act 2001 remains unchanged.

Deputy Chair Sue Begg said the Commission appreciated the engagement and effort from Fonterra and the parties they met with during this year’s review.

“In particular, we want to thank those who made submissions during the review process. We are encouraged that Fonterra and independent processors have indicated they are keen to work with us for future reviews,” Ms Begg said.

The Commission’s final report on the base milk price and related information can be found here.

The final report covers the base milk price calculation for the 2014/15 season, not the forecast 2015/16 price of $3.85 per kilogram of milk solids that Fonterra recently announced.

The Commission is also undertaking a separate review on the state of competition in milk markets in New Zealand. That review is considering issues that are outside the defined scope of our reviews conducted under the milk price monitoring regime.

Background

What does the Commission’s review look at?
The Commission is required to review Fonterra’s calculation of the base milk price each year as part of the milk price monitoring regime in the Dairy Industry Restructuring Act 2001 (the Act). The review assesses whether Fonterra’s approach delivers incentives for it to operate efficiently and whether it provides for contestability in the market for purchasing farmers’ milk.

The base milk price is the average price paid to farmers by Fonterra per kilogram of milk solids (kgMS) for the dairy season that has just concluded. We do not review how price forecasts for the next season are calculated.

The focus of our review is solely on the farm gate milk price and not any other milk price within the milk supply chain. The term used in the Act for the ‘farm gate’ milk price is ‘the base milk price set for that season’. We are required to consider the ‘efficiency’ and ‘contestability’ dimensions of the base milk price calculation.

Efficiency
There are many factors which can, and do, provide efficiency incentives for Fonterra. Our review of the base milk price calculation against the efficiency dimension requires us to focus on only one of these possible factors (i.e. whether the way Fonterra calculates the base milk price provides an incentive for it to operate efficiently).

Our view is that setting independent notional benchmarks for the revenue and cost inputs that underpin the base milk price calculation would be expected to provide an incentive for Fonterra to operate efficiently. This is consistent with the Act which envisages the use of notional values, and involves the assumption of a notional milk processing and collecting business (a ‘notional producer’).

An infographic illustrating what the notional producer’s business looks like for the purpose of calculating Fonterra’s base milk price can be found here.

Contestability
As explained by Section 150A of the Act, the ‘contestability dimension’ is a function of whether any notional costs, revenues, or other assumptions taken into account in the base milk price calculation are ‘practically feasible’ for an efficient processor. Our review therefore considers whether the assumptions adopted, and the inputs and process used in the calculation are practically feasible for:

• Fonterra; or

• another efficient processor.

Consistent with last year’s review of the base milk price calculation, we have assessed the extent to which the components of this year’s calculation are practically feasible on both an individual component and aggregate price basis.

What is the purpose of the milk price monitoring regime?
The milk price monitoring regime is intended to promote greater transparency of Fonterra’s base milk price setting processes, and greater confidence in the consistency of Fonterra’s base milk price with contestable market outcomes.

The regime exists because, without a competitive market for the purchase of farmers’ milk, the price for that milk has to be determined using an ‘administrative’ methodology. As Fonterra determines and applies that methodology itself, there is a risk that Fonterra might have the incentive and ability to set a base milk price that is ‘inefficient’.

In other words, the regime monitors whether the price that Fonterra chooses to set might be ‘too high’ or ‘too low’ relative to the price that would exist if the market for purchasing farmers’ milk was workably competitive or contestable.

What does the overall monitoring regime consist of?
The Act requires us to do two separate reviews of Fonterra’s base milk price setting each dairy season.
As well as a review of the base milk price calculation, we are also required to review Fonterra’s Farmgate Milk Price Manual (Manual review). This manual sets out Fonterra’s methodology for calculating its base milk price for the season.

We published our 2014/15 Manual review in December 2014. In that report, we concluded that Fonterra’s 2014/15 Manual was largely consistent with the purpose of the milk price monitoring regime.
We have commenced work on reviewing Fonterra’s 2015/16 Manual and will be inviting public submissions on our draft report in October 2015.

At the request of the Minister of Primary Industries we are separately carrying out a review under the Act of the state of competition in milk markets in New Zealand. Our review will examine how competition has developed since Fonterra was established, what it might look like in the future and whether the regulations are helping or hindering the efficient operation of the New Zealand dairy industry. We are due to report to the Minister by March 2016.

ENDS


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