Commission releases final report on statutory review of Fonterra’s 2014/15 Milk …

The Commerce Commission today released its final report on its statutory review of Fonterra’s Milk Price Manual (the Manual) for the 2014/15 dairy season. The Manual sets out the rules for how Fonterra will calculate the amount it will pay dairy farmers for raw milk this season. This is called the base milk price.

The Commission is required to report each dairy season on the extent to which the Manual promotes the setting of a base milk price that provides incentives for Fonterra to operate efficiently, while providing for contestability in the market for the purchase of milk from farmers.

This is the first of two statutory reviews that the Commission is required to undertake each dairy season under the Dairy Industry Restructuring Act 2001 (DIRA).

“Our finding is unchanged from our draft decision in October, that the 2014/15 Manual is largely consistent with the purpose of the DIRA milk price monitoring regime,” said Dr Mark Berry, Commerce Commission Chairman.

“Fonterra has made a number of amendments to this season’s Manual that increase consistency with the overall purpose of the regime. These changes have been made in response to issues we raised last year,” said Dr Berry.

“However, some of those amendments introduce flexibility in the application of some aspects of the rules and there are still some unresolved issues. This means that we are unable to conclude on the extent to which four of the rules in the Manual are consistent with the regime’s purpose. We will have a further look at how Fonterra applies those rules in our review of the 2014/15 milk price calculation in 2015,” concluded Dr Berry.

Fonterra has provided clarification in response to some of the Commission’s concerns about this flexibility and has indicated that it will consider amending the 2015/16 Manual to address matters where further clarification is required.

The final report is available on the Review of Milk Price Manual 2014/15 season page.

Background

What is the ‘base milk price’?

The ‘base milk price’ is the term used in 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 dairy ‘season’ that the Manual refers to?

The season that the Manual refers to runs from 1 June each year through to the following 31 May. The 2014/15 season runs from 1 June 2014 to 31 May 2015.

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.

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.”

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).

Each year the Commission must undertake and report on 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.
• The Commission must review Fonterra’s base milk price calculation for the 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 for the season, are consistent with the purpose of the milk price monitoring regime.  However, DIRA requires that, in undertaking its review, the Commission must not state the amount of the base milk price according to its own calculations.

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 Milk Price Manual for the coming season, and must later provide the Commission with its assumptions adopted, and inputs and process used, in calculating the base milk price for the 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.

How is the Commission following up on the extra costs relating to the 2013/14 peak milk flows as noted in the 2013/14 calculation review report?

In our final report on the 2013/14 base milk price calculation, we questioned whether the base milk price methodology adequately provides for costs associated with one-off or difficult to forecast events such as the ‘super flush’ peak milk flows in the 2013/14 dairy season.

In 2015 we will consider, on the basis of the circumstances of the 2014/15 season, whether a more explicit provision for costs of a one-off or difficult to forecast nature is warranted as part of our review of the application of the Manual in Fonterra’s 2014/15 base milk price calculation.