Review of Fonterra’s base milk price calculation

Commission releases final report on 2013/14 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 2013/14 dairy season. The base milk price is the price Fonterra pays to farmers for raw milk.

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

The most significant issue in this year’s review has been Fonterra’s decision to pay farmers an adjusted price for the 2013/14 season that is less than the milk price calculated under the company’s Milk Price Manual.

The Commission’s overall findings are that the way Fonterra is calculating and applying its proposed adjustment to the base milk price is not consistent with incentives for it to operate efficiently; however, the approach is consistent with contestability in the market under the Act.

The Commission’s final conclusions are the same as those in the draft report, with two minor points of difference.

“Our draft finding was that it was ‘probable’ that if Fonterra did not make its proposed adjustment to the base milk price, the milk price calculation would not be consistent with the contestability provision under the Act. This finding has changed to ‘possible’. We changed our view based on additional information received from Fonterra in its submission on our draft report,” said Sue Begg, Deputy Chair of the Commerce Commission.

“We have also changed our finding regarding energy costs from ‘not practically feasible’ to ‘unable to conclude’. This is because Fonterra has provided further information which arguably better supports its approach to calculating energy costs. We intend to further review the information received from Fonterra and the opinion of our independent expert for our 2014/15 calculation review,” said Ms Begg.

The final report and related information can be found on the Commission’s website:www.comcom.govt.nz/review-of-milk-price-calculation-201314-season.

Background

What is the ‘base milk price’?

The ‘base milk price’ is the term used in the Dairy Industry Restructuring Act 2001 (DIRA) to refer to the farm gate milk price that is set by Fonterra. The farm gate milk price is the price paid by dairy processors to dairy farmers for raw milk. The purchase of raw milk from farmers at the base milk price is Fonterra’s largest input cost.

What is the milk price monitoring regime?

The milk price monitoring regime was introduced to DIRA in 2012 to provide greater transparency of, and confidence in, the way Fonterra sets the base milk price.
Each year the Commission must undertake two separate reviews of how Fonterra sets its base milk price.

• The Commission must review Fonterra’s farm gate Milk Price Manual for the coming season, which sets out the methodology for calculating the base milk price for that season. Under s 150I of DIRA the Commission must report on the extent to which the Milk Price Manual is consistent with the purpose of the milk price monitoring regime.
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• The Commission must review Fonterra’s base milk price calculation for the preceding season. Under s 150P of DIRA the Commission must report on the extent to which the assumptions adopted, and the inputs and process used by Fonterra in calculating the base milk price, are consistent with the purpose of the milk price monitoring regime.
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The purpose of the milk price monitoring regime, set out in s 150A of DIRA, is to promote the setting of a base milk price that provides an incentive to Fonterra to operate efficiently, while providing for contestability in the market for the purchase of milk from farmers. Section 150A states that: “…the setting of a base milk price provides for contestability if any notional costs, revenues, or other assumptions taken into account in calculating the base milk price are practically feasible for an efficient processor.”

DIRA requires that, in undertaking its review, the Commission must not state the amount of the base milk price according to its own calculations.

The milk price monitoring regime does not relate to the price of processed milk in either wholesale or retail dairy markets (eg, the price of milk in supermarkets).

What obligations does the milk price monitoring regime impose on Fonterra?

Fonterra must establish an independent Milk Price Panel, and it must maintain a Milk Price Manual that sets out how the base milk price is calculated.

The Milk Price Panel makes recommendations to Fonterra on amendments to the Manual, advises Fonterra on the application of the Manual, supervises the calculation of the base milk price, and recommends to Fonterra the base milk price.

Fonterra does not have to amend the Milk Price Manual in accordance with a recommendation of the Panel, and it may amend the Manual without having received a recommendation from the Panel. However, if Fonterra does so, it must make publicly available its reasons.

Fonterra may also set a milk price that is different, either higher or lower, from the milk price recommended by the Panel. If it does set a different base milk price, Fonterra must make its reasons for doing so publicly available.

Each year Fonterra must provide the Commission with its Manual for the coming season, and must provide the Commission with its assumptions adopted, and inputs and process used, in calculating the base milk price for the preceding season.

What is the milk price adjustment for the 2013/14 season?

For the 2013/14 season, Fonterra is proposing to pay less than the milk price calculated in accordance with its 2013/14 Milk Price Manual. As at 31 May 2014, Fonterra calculated a price consistent with Manual of $8.95/kg milk solids (kgMS), adjusted downwards by 55 cents/kgMS, resulting in a base milk price of $8.40/kgMS. The final base milk price for the 2013/14 season will be set by Fonterra in September.

Fonterra’s 1 July 2014 Reasons Paper sets out the assumptions adopted, and inputs and process used, in calculating its 2013/14 base milk price, and includes Fonterra’s reasons for making the 2013/14 milk price adjustment. Fonterra’s Reasons Paper can be found on the Commission’s website at:www.comcom.govt.nz/review-of-milk-price-calculation-201314-season.

What incentives for efficiency are provided by the way Fonterra calculates the base milk price?

There are many factors which provide efficiency incentives for Fonterra. The monitoring regime requires the Commission to focus on only one of these possible factors, ie, whether the way Fonterra calculates the base milk price provides an incentive for it to operate efficiently.

The efficiency incentive provided by setting the base milk price works as a result of the effect it has on Fonterra’s actual profitability. Although Fonterra can increase its profits by improving efficiency, it can also control its profit levels by changing the level of the base milk price. All other things being equal, setting a higher base milk price results in higher input costs for Fonterra, and therefore lower profits.

By choosing to set a lower base milk price, Fonterra can reduce its largest input cost and increase its profits. However, doing so does not represent an efficiency gain. A lower price does not reflect greater efficiencies in producing raw milk. It simply means farmers receive a lower value for that milk, and Fonterra earns a higher profit.

What is the Commission’s process for reviewing the 2013/14 base milk price calculation?

The Commission published its review of the Milk Price Manual for the 2013/14 season in December 2013, as required under DIRA.

On 9 June this year the Commission sought submissions on the Process Paper for its review of the 2013/14 base milk price calculation, and on 2 July it sought submissions on Fonterra’s Reasons Paper.

The Commission has focused its 2013/14 review of the base milk price on the issues listed in Table 2 of its Process Paper. The Commission’s draft report was published on 15 August 2014, and submissions on the draft report were received and considered before finalising this report.

The documents associated with the Commission’s review of the 2013/14 base milk price calculation can be found on the Commission’s website at: www.comcom.govt.nz/review-of-milk-price-calculation-201314-season.

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