Release of Report
Evaluation of the December 2000 Dairy Industry Merger Package
From The Perspective of Competition Policy
Economics and Law Consulting Limited 11 January 2001
On 21 December 2000, New Zealand’s two dairy companies announced their plan to merge and absorb the Dairy Board. If the
merger proceeds it will create the New Zealand’s largest company and will have profound effects for the dairy industry.
The dairy sector is New Zealand’s largest export earner; it is also a major onshore processor, manufacturer and investor
in research and development.
The dairy companies’ proposal calls for special legislation to exempt the merger from the anti-monopoly provisions of
the Commerce Act, thus avoiding normal Commerce Commission scrutiny and authorisation.
The performance of the dairy sector significantly affects the New Zealand economy as a whole. Before making any decision
on the merger proposal the Government wishes to gather further information and to encourage informed debate on the
costs, benefits, risks and opportunities presented by the merger plan.
The Ministry of Agriculture and Forestry commissioned Economics and Law Consulting Limited to assess the merger from a
competition policy perspective. The work was commissioned recognising that the information currently available is very
limited.
The Government has decided to release this report in the expectation that it will stimulate and inform further debate. I
encourage anyone with an interest in the dairy industry to take the opportunity to read it and discuss its findings.
I emphasise that this is an analysis produced outside government in a very limited time with limited access to
supplementary information. It is not government policy.
If and when similar material comes to hand the Government will endeavour to make as much of it available as possible.
Hon Jim Sutton Minister of Agriculture
Evaluation of the December 2000 Dairy Industry Merger Package From The Perspective of Competition Policy
A Report for the Ministry of Agriculture and Forestry
Final Report 11 January 2001
Economics and Law Consulting Limited 20 Messines Road, Wellington 6005, New Zealand Phone (64) (025) 409 839
Facsimile (64) (4) 463 5436
The Author
This Report was prepared for Economics and Law Consulting Limited by Professor Neil Quigley, Executive Dean of the
Faculty of Commerce and Administration at Victoria University of Wellington. Contents
Executive Summary i
1. Introduction 1
2. A comparison of the Mega-Merger and GDC Proposals 3
3. Public Detriments 6
4. Public Benefits 16
5. Overall Assessment of the Balance Between Benefits and Detriments 19
6. Costs and Benefits of Assessment by the Commerce Commission 20
7. Conclusion 22 Executive Summary
Introduction
On 21 December the Dairy Industry announced a proposal for the merger of the New Zealand Dairy Board, the New Zealand
Dairy Group and Kiwi Co-operative Dairies to create Global Dairy Company (hereafter GDC). The Ministry of Agriculture
and Forestry has requested that Economics and Law Consulting Limited (ELC) provide an initial report on the following
three issues: (i) Of the detriments identified by the Commerce Commission in its draft determination on the 1999 dairy
industry “mega-merger” proposal, which of those detriments appear to be addressed by the GDC proposal (and to what
extent) and which do not appear to be addressed. (ii) Of the benefits identified by the Commerce Commission in its draft
determination of the 1999 dairy industry “mega-merger” proposal, the extent to which the GDC proposal appears to
increase or reduce those benefits. (iii) The costs and benefits of allowing the GDC proposal to be implemented without
requiring it to be authorised by the Commerce Commission.
ELC accepted this assignment with the caveat that it should be absolutely clear that our Report would not be, and could
not be viewed as or used as, a substitute for a full assessment by the Commerce Commission.
The GDC Proposal
The proposal announced by the dairy industry in December 2000 has the following key features: (i) The merger of the NZDG
and Kiwi, and the integration of the Dairy Board with their operations, to form GDC. Other co-operatives will either
merge with NZDG / Kiwi / GDC or sell to GDC their respective interests in the Dairy Board; (ii) The single-desk monopoly
of the Dairy Board is to be removed within one year, but GDC will own all dairy industry quota rights for foreign
markets; (iii) The divestiture of Dairy Foods to create competition in the New Zealand domestic market, with GDC
licensing Dairy Foods to use certain well-known brands within New Zealand and agreeing contracts for the supply of milk
to Dairy Foods; (iv) The creation of mechanisms for the establishment of the fair value of the capital invested by
suppliers of GDC and the use of capital notes to pay out the capital investment of suppliers who wish to switch from GDC
to another manufacturer. There is, however, no proposal to move towards the unbundling of returns on capital invested
from returns on milk supplied; (v) The creation of a Shareholders’ and Suppliers’ Council to protect the interests of
farmers; and (vi) The suggestion that after three years the Commerce Commission will conduct a review of both the
domestic wholesale price charged by GDC to Dairy Foods and any other competitors, and the operation of the fair value
entry and exit price.
The GDC proposal is supported by a rationale for change in the structure of the dairy industry that is more convincing
than the arguments presented in 1999. It argues that the Dairy Board was an effective way to maximise the returns from
international marketing when there were 400 dairy co-operatives, but that now, with a large part of the dairy
manufacturing industry controlled by two co-operatives, this structure is inefficient. The GDC proposal further suggests
that the costs of splitting the operations of the Dairy Board between two competing companies (Kiwi and NZDG) are so
high that a merger of the two large co-operatives with the Dairy Board provides the only practical means of achieving
vertical integration in the industry. The case put in the GDC proposal appears to be that (i) It would be contrary to
the national interest to attempt to preserve competing vertically-integrated firms given that [it is claimed that] there
are very large benefits from size, full vertical integration and industry-wide co-ordination of manufacturing and
marketing strategies, (ii) The [“enhancement” of the] co-operative structure of the industry and the sale of Dairy Foods
will ensure that neither farmers nor domestic consumers are harmed by the creation of GDC. Whatever its merits as a
solution to structural problems in the dairy industry, the proposal to create a dominant vertically integrated firm is
inconsistent with competition policy in New Zealand. The Commerce Commission has taken the view that competition
provides efficient outcomes in the dairy industry as in all other industries, and nothing in the GDC proposal provides
convincing evidence that this view is inappropriate. For any proposal to satisfy the Commission it must therefore take
seriously the need to create markets that are competitive even if effective competition is not immediately present.
Public Benefits and Detriments
In its August 1999 draft determination the Commerce Commission found that the merger proposal had moderate to large
detriments and small public benefits. The vast majority of the detriments were associated with the loss of productive
and dynamic efficiency as a result of the loss of effective competition for the merged entity and not from the impact of
the merger on prices paid by domestic consumers.
The GDC proposal contains the following substantive changes from the 1999 proposal. In each case, the impact on the case
as it is likely to be viewed by the Commerce Commission is indicated in brackets. ;
Specifies, for inclusion in legislation, a method for fair valuation of capital on entry and exit to remove barriers to
switching [positive] ;
Clearer and more credible specification of the gains from the merger [positive] ;
Shareholders’ and Suppliers’ Council [weak positive] ;
Proposal for three-year review by the Commerce Commission [neutral] ;
Allocation of all quota rights to GDC [negative] ;
No proposal for tradable shares and payment unbundling [negative].
This summary highlights the fact that the GDC proposal has introduced a number of positive and negative changes: on
balance we doubt that the changes would have a strong positive or negative impact on the views of the Commission. We
reach this conclusion primarily because the changes that are positive are not likely to have a material impact on the
Commission’s assessment of the detriments associated with the merger. In particular, the proposal does little to improve
the environment for competition: it does little to enhance the likelihood that over a two-year time frame a viable
competitor for GDC can emerge. Of particular concern is the allocation of all quota rights to GDC and the establishment
of Dairy Foods on a basis that precludes use of its major brands in international markets. While the GDC proposal is
based on the proposition that vertical integration is essential for efficiency in the dairy industry, both these factors
limit the ability of potential competitors of GDC to expand into export markets. Equally important from the perspective
of potential competition is the absence of a commitment to unbundling returns to farmers, the absence of a mechanism to
provide for tradable shares, and a fair value mechanism that is likely to set values for equity stakes in co-ops that
are biased against switching. We therefore conclude that the Commerce Commission is likely to find that the detriments
of the GDC proposal substantially outweigh the benefits.
Role of the Commerce Commission
The primary role of the Commerce Commission is to ensure that market structures and market practices are consistent with
competition. We consider that the GDC proposal should be considered by the Commerce Commission for the following
reasons: 1. It would be inappropriate to deny the Commission the opportunity to assess the proposed merger but then to
require it to undertake ongoing monitoring of the operation of the relevant markets. 2. The Commerce Commission plays a
vital role in collecting information, making assessments of net benefits to the public, and in considering any
structural (but not behavioural) remedies for concerns that it might have. The larger are the firms proposing to merge,
and the greater the contribution of the industry to national income, the more important it is that any merger proposal
be authorised by the Commission. 3. Only in very unusual cases (of which the GDC proposal does not appear to be one) is
it possible that the analysis of the Commission will not be consistent with an analysis of the national interest. 4.
With a Commerce Commission decision, it will be clearer if there is a “benefit to the nation” justification for any
behavioural undertakings that may be offered the Government and included in the legislation that will be required to
facilitate change in the industry. 5. Failure to require the proposal to be authorised by the Commission would create a
precedent that proponents of future mergers of large firms would invoke to avoid authorisation by the Commission.
Conclusion
By comparison with the merger proposal put forward by the industry in 1999, the GDC proposal provides a more plausible
statement of the benefits to be derived from the merger than did the 1999 proposal. However, it still does not meet the
key concern of competition policy: the need to create a structure within which viable competition for GDC will be
present within two years. In its current form, our assessment is that the GDC proposal has detriments well in excess of
the benefits, and that this is synonymous with the view that the proposal does not represent the best deal for New
Zealand. It appears to us to be important, however, that the industry seek an authorisation from the Commission and
consider structural means of reducing the detriments as a prerequisite for any legislative action by Government.
1. Introduction
On 21 December the Dairy Industry announced a proposal for the merger of the New Zealand Dairy Board, the New Zealand
Dairy Group and Kiwi Co-operative Dairies to create Global Dairy Company (hereafter GDC). The Ministry of Agriculture
and Forestry has requested that Economics and Law Consulting Limited (ELC) provide an initial report on the following
three issues: (iv) Of the detriments identified by the Commerce Commission in its draft determination of the 1999 dairy
industry “mega-merger” proposal, which of those detriments appear to be addressed by the GDC proposal (and to what
extent) and which do not appear to be addressed. (v) Of the benefits identified by the Commerce Commission in its draft
determination of the 1999 dairy industry “mega-merger” proposal, the extent to which the GDC proposal appears to
increase or reduce those benefits. (vi) The costs and benefits of allowing the GDC proposal to be implemented without
requiring it to be authorised by the Commerce Commission.
ELC accepted this assignment with the caveat that it should be absolutely clear that our Report would not be, and could
not be viewed as or used as, a substitute for a full assessment by the Commerce Commission. This caveat is important
because: (i) Our assessment at this time must be based on the small amount of information that has been made available
to the public. This information is in every respect inadequate as a basis for any full assessment of the public benefits
and detriments of the merger proposal. (ii) The assessment of benefits and detriments to the competitive process relies
on both the availability of detailed (and often commercially sensitive) information about the industry and the
judgements made by the investigation staff and members of the Commerce Commission. In respect of these issues, we note
that ;
The information provided by the Dairy Industry is not in the form or at the level of detail and specificity on
competition matters that would be included in any formal application to the Commerce Commission, and ;
The Commission might legitimately make different judgements from those of ELC about the weighting of different factors.
The approach to the analysis of a merger that is taken by the Commerce Commission is to first consider whether a
dominant position is likely to be created in the relevant markets. If it finds that dominance is likely, then the merger
can only be authorised if the public benefits from the merger outweigh the public detriments. Consistent with the terms
of reference provided for this report, we have not attempted to consider each aspect of the Commission’s 1999 analysis
of dominance. Rather, the main factors relevant to the creation of a dominant position are considered directly in
explaining our views about the likely impact of the GDC proposal on the balance of public benefits and detriments.
Public benefits and detriments are normally assessed against benchmarks provided by one or more counterfactuals. The
Commission based its August 1999 draft determination on two counterfactuals: 1. The status quo in the dairy industry,
with industry-driven structural change, and 2. Deregulation of the single desk export monopoly and the emergence of two
large vertically-integrated dairy processors/exporters. Our analysis is based on the use of these two scenarios as the
counterfactuals against which the benefits and detriments of the GDC merger proposal would be assessed.
The structure of our report is as follows. In Section 2 we review the proposal for considered by the Commerce Commission
in August 1999 and compare it with the GDC proposal announced on 21 December 2000. In Section 3 we consider the
principal detriments identified by the Commerce Commission in 1999, and consider whether and to what extent they have
been addressed by the GDC proposal. In Section 4 we consider the principal benefits identified by the Commission. In
Section 5 we consider the costs and benefits of requiring the GDC proposal be assessed by the Commerce Commission. In
Section 6 we offer an overall assessment of the balance of benefits and detriments in the GDC proposal. In Section 7 we
provide some concluding remarks.
2. A Comparison of the Mega-Merger and GDC Proposals
The current structure of the dairy industry is directed by legislation. Consequently, both the “mega-co-op” proposal put
forward in 1999 and the December 2000 proposal require changes to the regulatory environment for the dairy industry. In
each case, the competitive impact of the proposals will be determined to a significant extent by the changes to industry
regulation that accompany the proposal.
The proposal put forward by the dairy industry in 1999, and approved by the Government subject to Commerce Commission
approval, had the following key features: (i) The merger of all of the dairy co-operatives in New Zealand and the
integration of the Dairy Board into a single vertically integrated entity (a “mega-co-op”); (ii) The divestiture of
Dairy Foods to create competition in the New Zealand domestic market, with Dairy Foods being licensed to use certain
well-known brands within New Zealand and having contracts for the purchase of milk; (iii) Removal of the single desk
monopoly of the Dairy Board and the creation of a company to allocated quota rights but with retention of exclusive
rights for the mega-co-op to export into certain quota markets for up to 6.5 years; (iv) The creation of a structure for
the establishment of the fair value of supplier capital stakes in co-operatives, and for the payment of fair value on
entry or exit. This involved the creation of tradable shares (with suppliers able to trade in a range from 80% - 120% of
the shares associated with their supply) and the unbundling of returns on capital invested and returns on milk supply.
The proposal announced by the dairy industry in December 2000 has the following key features: (i) The merger of the NZDG
and Kiwi, and the integration of the Dairy Board with their operations, to form GDC. Other co-operatives will either
merge with NZDG / Kiwi / GDC or sell to GDC their respective interests in the Dairy Board; (ii) The single-desk monopoly
of the Dairy Board is to be removed within one year, but GDC will own all dairy industry quota rights for foreign
markets; (iii) The divestiture of Dairy Foods to create competition in the New Zealand domestic market, with GDC
licensing Dairy Foods to use certain well-known brands within New Zealand and agreeing contracts for the supply of milk
to Dairy Foods; (iv) The creation of mechanisms for the establishment of the fair value of the capital invested by
suppliers of GDC and the use of capital notes to pay out the capital investment of suppliers who wish to switch from GDC
to another manufacturer. There is, however, no proposal to move towards the unbundling of returns on capital invested
from returns from milk supplied; (v) The creation of a Shareholders’ and Suppliers’ Council to protect the interests of
farmers; and (vi) The suggestion that after three years the Commerce Commission will conduct a review of both the
domestic wholesale price charged by GDC to Dairy Foods and any other competitors, and the operation of the fair value
entry and exit price.
The GDC proposal is supported by a rationale for change in the structure of the dairy industry that is more convincing
than the arguments presented in 1999. It argues that the Dairy Board was an effective way to maximise the returns from
international marketing when there were 400 dairy co-operatives, but that now, with a large part of the dairy
manufacturing industry controlled by two co-operatives this structure is inefficient. The costs of vertical separation
of marketing and manufacturing are represented as follows:
These costs arise primarily from the interface between Dairy Board and dairy companies. In pursuing the interests of
their shareholders (as they should) parties are sometimes encouraged to make decisions that merely shift costs to other
parts of the industry or to pass up opportunities that would add to the wealth of all dairy farmers. Further, the
parties’ often conflicting interests result in lengthy and costly decision-making processes. [Business Case for Global
Dairy Co Ltd: Executive Summary at 2]
Current arrangements create delays in the ability of the New Zealand industry to respond to opportunities in the
marketplace. It takes time to decide which company will manufacture product to meet orders, creating risk they will be
lost. It takes time for decisions to be made on international acquisitions or joint venture opportunities when these
arise, creating the risk they will be missed. Shareholder value is eroded while the industry debates the ownership of
intellectual property rather then immediately applying that intellectual property to new products for overseas markets.
[The Merger Package at 8]
The GDC proposal further suggests that the costs of splitting the operations of the Dairy Board between two competing
companies (Kiwi and NZDG) are so high that a merger of the two large co-operatives with the Dairy Board provides the
only practical means of achieving vertical integration in the industry.
While these arguments are not presented in the detail that would be required by the Commerce Commission, we consider
that they are intuitively plausible. As a result, they provide important insights into the benefits that we should
expect to flow from legislation that makes it possible for vertically integrated companies to emerge in the industry.
In respect of its approach to competition in the dairy industry, the GDC proposal shares with the proposals put forward
in 1999 the view that competition is costly and that the maximisation of benefits to farmers requires that the industry
as a whole be planned by a single company. For example, it is claimed that
When new plant is required, an industry-wide perspective can be taken rather than two competing companies duplicating
that investment. This will lead to greater specialisation across the industry’s infrastructure and more efficient use of
capital. [The Merger Package at 8]
And
If the merger doesn’t happen there will either be industry stagnation with the current structure or chaos as competing
companies go their separate ways and fight over the bones of the board. [Key Questions and Answers at 1]
The case put in the GDC proposal appears to be that (iii) It would be contrary to the national interest to attempt to
preserve competing vertically-integrated firms given that [it is claimed that] there are very large benefits from size,
full vertical integration and industry-wide co-ordination of manufacturing and marketing strategies, (iv) The
[“enhancement” of the] co-operative structure of the industry and the sale of Dairy Foods will ensure that neither
farmers nor domestic consumers are harmed by the creation of GDC. In contrast, the Commerce Commission has taken the
view that competition provides efficient outcomes in the dairy industry as in all other industries. In its August 1999
draft determination the Commission took the view that the merger would create the potential for the exercise of monopoly
power and that the market structure proposed created very limited scope for the entry of new competition. The Commission
found that neither the need for the dairy industry to compete in international markets nor the co-operative ownership
structure of the industry mitigated the costs that the absence of competitive pressure would likely create for domestic
consumers, dairy farmers, and the industry as a whole. For any proposal to satisfy the Commission it must take seriously
the need to create markets that are competitive even if effective competition is not immediately present 3. Public
Detriments
3.1 Findings of the Commerce Commission
The Commerce Commission’s analysis of public detriments provided in its draft determination of August 1999 may be
summarised as follows: ;
A reduction in allocative efficiency in the range from $1.4 million to $6.0 million resulting from the exercise of
monopsony power by the merged entity to reduce the raw milk price by 5 – 10 percent. ;
A reduction in allocative efficiency in the range from $1.0 million to $4.0 million resulting from the exercise of
monopoly power by the merged entity to increase consumer prices in the domestic market by 10 – 20 percent. ;
A reduction in productive efficiency in the range from $75.5 million - $151 million against the status quo
counterfactual and $96.0 million - $192.0 million against the deregulation counterfactual as a result of less efficient
operation of the merged entity in those aspects of its operations where competition is absent. ;
A reduction in dynamic efficiency, resulting from less efficient decision-making about product innovations and new
investments in the future, in the range from $60 million to $300 million for the status quo counterfactual, and $65
million to $325 million against the deregulation counterfactual. Overall, the Commission suggested the detriments
resulting from the merger would be likely to fall in the range from $138 - $461 million for the status quo
counterfactual, and $163 - $527 million for the deregulation counterfactual. While the Commission devoted some attention
to the potential costs of the merger for domestic consumers, the magnitude of these costs was little influenced by the
impact on domestic consumers. Productive and dynamic efficiency losses in the dairy industry resulting from the absence
of competitive pressure on those aspects of the merged entity that would not be subject to direct competition in
international markets made up by far the largest part of the total detriments.
3.2 The Price of Dairy Products in the New Zealand Market
At paragraph 513 the Commission expressed concerns about the impact on the domestic market that are directly relevant to
the current merger proposal.
The Applicant argues that competition between [Dairy Foods as an independent competitor to NewCo’s domestic operation
(i.e. Mainland)], combined with both [Dairy Foods and Mainland] accesing raw milk, butter and cheese from NewCo on equal
terms, will ensure that competition would prevail….[T]he Commission has reached the preliminary view that Dairy Foods
will not be a constraint on NewCo. Even if it were, however, the Applicant’s argument overlooks the point that NewCo
would remain dominant in the supply of those inputs. NewCo would thus be in a position to extract any monopoly profits
available in the downstream markets for final goods through the prices it charges both Dairy Foods and Mainland for the
inputs.
In effect, it was the Commission’s view that NewCo would have the power to set the monopoly price in the domestic market
through its power to set the wholesale price faced by Mainland and Dairy Foods.
The effectiveness of the competition that GDC faces from Dairy Foods will depend on whether its new owners have the
ability develop the technology, marketing and distribution needed for long-term viability, and whether the market
structure is permissive of the development of a competitor. In respect of the proposal for the divestment of Dairy
Foods, there is little in the GDC proposal that is different from the proposal considered by the Commission. Under the
GDC proposal Dairy Foods would not have the opportunity to export to quota markets since the proposal is that the quota
market rights should stay with GDC. The proposed structure severely limits the potential for Dairy Foods to become a
viable independent competitor of GDC for two reasons. First, the fact that key brands will be licensed to Dairy Foods
for use only in New Zealand will restrict the ability of Dairy Foods to develop a viable export business within the
two-year time frame considered by the Commission. Second, and given that the GDC proposal is based on the claimed
efficiency of fully vertically integrated firms in the dairy industry, it is difficult to see how Dairy Foods will be
able to pay competitive returns to build its own group of direct suppliers unless it can establish a viable export
business.
Proponents of the proposal to create GDC might argue that the suggested 3 Year Review by the Commerce Commission and the
potential for the Commission to recommend that the Government “implement a procedure for establishing and administering
an independent milk price” will deal with this concern. But the potential to invoke price control is one that is always
available to the government as a response to the exercise of market power. There is nothing in the explicit recognition
of this power in the GDC proposal that would change the view of the Commerce Commission about the likely efficiency
losses that would result from the exercise of market power that might provoke the introduction of price controls. 3.3
Ability to Exit and Calculation of the Fair Value of the Farmer’s Interest
Suppliers to dairy co-operatives have a share in the capital of the co-operative that is based upon the amount of milk
solids that they supply to the co-operative. The value of the capital invested in the co-operative is part of the value
that is purchased when dairy farms change owners, and there is no reason not to assume that in these transactions the
true market value of the capital invested in the co-operative is received by the vendor.
The Commerce Commission identified two factors that provide barriers to competition and efficiency when farmers switch
co-operatives. It took the view that these barriers increased both the monopsony power of the merged entity and reduced
the ability of suppliers to vote with their feet to sanction inefficient management. First, farmers who switch
co-operatives currently do not receive the fair market value of their equity and are not charged the true value of the
equity stake they acquire when they enter a new co-operative. Capital shares in dairy co-operatives are not traded
independently, and the return on the capital invested in the co-operative is bundled into the price that farmers receive
for the milk that they supply. This means that new members of co-operatives may receive a much higher return on their
capital investment than those farmers who have been members (and made a substantial contribution to retained earnings)
over a long period of time. Equally, farmers who increase or decrease supply are required to increase or decrease their
share of the capital at the nominal rate set by the co-operative. Second, under the Co-operative Companies Act, a
co-operative may withhold the capital of a farmer who leaves the co-op for up to five years, even though that farmer
will be required to make an immediate capital contribution to any new co-operative that they join.
In its draft determination of August 1999, the Commission took the view that the terms on which capital could be
withdrawn by farmers who wished to switch co-operatives was a barrier to competition. In particular, it noted (at page
56) that: 1. The merger proposal before it contained no mechanism that would ensure that fair value entry and exit were
established, or that the new dairy conglomerate would implement the proposal to introduce some form of share
tradability. 2. Fair value entry and exit terms would also require that the fair value of the capital in the Dairy Board
should be included in the value paid out to a farmer who switched to supply a dairy company that was not part of the
Dairy Board structure. 3. The proposal to limit share trading to members of the dairy co-operative might not be
effective in creating a true market value for the shares.
Section 3 of the GDC proposal addresses these issues. Because of its significance it is set out in full below. 3.1
GDC will be established as a co-operative and its capital structure will address both the dilution effect of new
shareholding and the cost of new capacity. GDC will have fair value shares to be issued and surrendered through GDC.
Capital will be held both in proportion to a supplying shareholder’s total supply over a season and that shareholder’s
peak supply. 3.2 For the purposes of issue and surrender of such shares, GDC’s shares will be valued, at least
annually, by an independently qualified person or firm. The valuer will be appointed on an annual basis by GDC’s
Shareholders’ and Suppliers’ Council. 3.3 The valuer shall determine a fair value per share. GDC’s constitution
will provide that the valuer must determine which is the best method, or combination of methods, for determining the
fair value per share, having regard to GDC’s business at the time the valuation is undertaken and valuation best
practices. For example, the valuer at its discretion may take into account such factors as sustainable projected cash
flow to the supplying shareholders of GDC and sustainable earnings of GDC before interest, tax, depreciation and
amortisation. The valuer must take into account the impact on GDC of the end of season re-adjustment for surrenders and
issues of shares. In every case, the valuer must apply consistent methodology from year to year except where: (a)
exceptional circumstances require a different methodology in any year; or (b) a different methodology is
required on an ongoing basis, in which case the valuer must advise the Board of the change in methodology and its
impact. 3.4 The valuer will be required to recommend a value per share range to the GDC Board. The value range
can not exceed plus or minus 7.5% of the mid point of the value range. The Board will be required to determine a value
within that range and disclose its reasons for selecting the value but need not disclose confidential information if
that disclosure may adversely affect GDC’s business. In determining that value the Board must seek to avoid: (a)
disadvantage being suffered by a shareholder who wishes to cease holding shares in, and supplying milk to, GDC, and to
re-invest the surrender value and sell milk at a competitive price to a competitor of GDC; and (b) disadvantage being
suffered by a prospective shareholder who wishes to commence supplying milk to GDC and cease selling milk at a
competitive price to a competitor of GDC. In doing so, the Board of GDC may take into account the sustainable terms and
conditions on which milk is bought by its competitors at different times and different locations in New Zealand. 3.5
Public notice of the valuer’s preliminary value will be given at, or just before, the commencement of each season. A
final valuation will be given towards the end of the season. Issues and surrenders of shares will generally occur at the
end of the season and will be on the basis of the final valuation. 3.6 When shares are surrendered, the surrender
price will be satisfied by the issue of variable interest rate notes issued by GDC, with a total market value equal to
the fair value amount of the shares being surrendered. GDC will seek quotation of those notes on the New Zealand Stock
Exchange (or any successor to that exchange). 3.7 If a shareholder, or a person whose application for supply has
been accepted by GDC, wishes to acquire shares as a result of new or increasing milk supply, that shareholder may
convert any notes held to shares in GDC at a rate of conversion which reflects the face value of these notes and the
then current amount determined by the Board of GDC to be the fair value of GDC shares.
This proposal does provide credibility to the claim that GDC will provide a mechanism for fair value entry and exit. In
this sense the GDC proposal does reduce the magnitude of the public detriments associated with the merger. We do,
however, have some concerns about specific aspects of the proposal.
This proposal represents an administrative rather than a market mechanism for the establishment of fair value, and there
is no mechanism by which a market check on the valuations is established. Such a market check can only be provided by
tradable shares. Even if shares are tradable only among suppliers, the price established by this trading activity will
provide some check on prices established by administrative means. From the perspective of efficiency and the potential
effectiveness of future competition in the industry, we consider the absence of any commitment to unbundling returns
from shareholding and returns from milk supply and to the creation of tradable shares as a serious weakness of the GDC
proposal.
The proposed mechanism for the establishment of fair value does provide the potential for continued bias against
switching. This is because the interests of the members of the Shareholders’ and Suppliers’ Council will be to choose
valuers who will set conservative valuations of the shares. Conservative valuations will ensure that (i) farmers who
leave GDC will be taxed for the benefit of those farmers who remain in GDC (and who only realise their capital interest
in GDC through the sale of their farm) and new entrants, and (ii) there is a subsidy available to new farmers joining
GDC. It is likely that the Shareholder’s and Suppliers’ Council will see their personal interests as being strongly
aligned with this position. This conclusion is reinforced by the proposal to assess equity participation on the basis of
both total and peak milk suppliers. The use of peak milk supply creates the opportunity for GDC to design two-part
pricing strategies that maximise the penalty for switching and the benefits of staying with or joining GDC.
The proposal to pay out equity stakes with variable rate capital notes rather than cash requires further elaboration
before we can comment on it in detail, but it appears to us to have a number of features that are at least unusual. 1.
Farmers switching to another co-op receive payment from GDC only via the issue of capital notes, but farmers wishing to
join GDC may purchase a capital stake either through converting capital notes or with cash. 2. The value of these notes
will be determined by the relationship between the variable interest rate and the market rate of interest on similar
corporate debt. The market value will reflect the performance of GDC in so far as this performance impacts on the risk
premium required by investors purchasing the notes. This impact may be quite large given that the notes are perpetual
(do not have any fixed date of maturity) so the holders of these notes will be required to closely monitor the
performance of GDC. 3. The issue of notes rather than cash requires that the farmer bear the transactions cost of
selling the capital notes into the market to obtain cash. 4. The ability of shareholders to convert capital notes owned
to shares in GDC at the market rate is without value, since cash can also be used to purchase shares in GDC at market
value.
It has been suggested to us that the issue of capital notes is designed to substitute for a market for shares in respect
of those farmers who switch to a manufacturer other than GDC, and is designed to allow GDC to manage the any “runs”
(large scale switching). In the former case, the capital notes appear to us to be a poor substitute for tradable shares
in GDC. Only a small number of capital notes will be issued while switching remains limited, and since they confer no
rights other than the right to receive interest they will be traded as a pure commercial debt instrument. In the latter
case, we think that it is at least arguable that GDC should issue capital notes directly to the market, using the funds
to pay cash to any switching farmers and (potentially) using the funds raised to finance new investment. This would
allow GDC the advantages of the creation and management of a much larger and more orderly market for its debt.
3.4 Competition Between Co-operatives
In its draft determination of August 1999 the Commission identified three important elements of the existing competition
between co-operatives: 1. Switching – the threat that farmers will transfer from low-performing to high-performing
co-operatives, 2. Benchmarking – the ability of farmers to assess the performance of co-operative management by
comparing returns with those achieved by other co-operatives, and 3. The threat of take-over – the ability of
higher performing co-operatives to take over those with poorer performance, thus removing weaker management from the
industry. To these factors we would add the positive impact of diverse strategies. There is clear evidence that the
dairy industry has in the past benefited from the diversity of strategies pursued by different co-operatives and the
competitive tension that these different strategies have created. The creation of GDC will mean, in effect, that the
entire New Zealand dairy industry has only one strategy, and that will be the strategy of GDC.
All of these benefits of competition, and in particular the benefits arising from the strong competition between Kiwi
and NZDG will be lost through the creation of GDC, as they were with the 1999 proposal. 3.5 Potential for
Competitive Entry
In its draft determination of August 1999 the Commission noted that
Development of significant competition from a consumer operation would be possible, especially if Dairy Foods is sold to
a company with access to the product technology, marketing and distribution needed. At this stage, however, the
Commission cannot assume that this will occur. Dairy Foods has not been sold, and the likely purchaser will not be
evident until after the completion of this authorisation process.
In considering remedies for mergers to monopoly such as that set out in the GDC proposal, competition authorities
normally look for divestment of an entity that either is from the outset, or can become over a two-year time frame, a
viable competitor. We have already indicated that the terms proposed for the divestment of Dairy Foods do not make it
possible to consider Dairy Foods as a viable competitor for GDC over any short time frame.
The question then is whether any other competitive entry into any of the relevant markets in New Zealand is likely to
emerge in response to the more rapid removal of the single desk export monopoly. Niche entry will occur, but this is not
likely to have a significant impact on competition in the market as a whole. As the Commission concluded in 1999, the
barrier to large-scale entry by an international company looking to acquire milk and export dairy products from New
Zealand is in their ability to acquire any large number of suppliers. Even with fair value exit, we consider that it is
unlikely that over the two-year time frame considered by the Commission any viable new competitor could acquire
sufficient suppliers in New Zealand to provide viable competition for GDC.
3.6 Farmer Scrutiny of GDC activities
In its draft determination of August 1999 at paragraph 524 the Commerce Commission expressed concerns that in the light
of limitations on farmers’ ability to vote with their feet by switching co-operatives, productive efficiency might be
reduced because:
NewCo will become so large, and cover such a diversity of geographic regions and farmer interests, that the voice of the
individual suppliers or groups of suppliers is unlikely to be heard or heeded. Moreover, the organisation would be so
large and complex that it would be even more impossible than it is now for suppliers to monitor and assess performance.
It is not clear exactly how much weight the Commission gave to this factor in reaching its overall assessment of the
range of likely losses in productive efficiency that would result from the proposed merger. It may in addition be
significant in determining the extent of farmer support for the proposal.
The GDC proposal provides a comprehensive attempt to address the problems raised by the Commission in this respect. In
particular, the merger agreement states: 5.1 GDC’s constitution will contain the following provisions, which may be
changed only with the consent of the Minister of Agriculture: (a) GDC will have a Shareholders’ and Suppliers’ Council
which will have the following functions: (i) working with the Board to develop GDC’s co-operative philosophy; (ii)
receiving quarterly reports from the Board reporting on performance measured against key performance indicators; (iii)
ensuring the voice of supplying shareholders is heard by ascertaining the views and concerns of shareholders and
suppliers and reflecting these to the Board and monitoring GDC’s actions in resolving those concerns; (iv) calling a
special meeting of shareholders if the Council has serious concerns about the Board’s compliance with the co-operative
philosophy or achievement of GDC’s performance goals; (v) appointing a Milk Industry Ombudsman; (vi) appointing the fair
value valuer; (vii) acting in accordance with any regulations governing the Shareholders’ and Suppliers’ Council. (b)
GDC may not discriminate between suppliers of raw milk. This would require that, when exercising discretions under the
constitution and any milk supply agreement, GDC would be required to act on commercial principles, and not arbitrarily
favour one supplier or purchaser of milk over another; and (c) the Shareholders’ and Suppliers’ Council shall be
required to appoint a Milk Industry Ombudsman who shall consider any concerns or complaints by shareholders or suppliers
of GDC about the manner in which GDC is operated or exercises its powers and discretions in its constitution or milk
supply agreement. The Milk Industry Ombudsman will be entitled to enquire into those complaints and make non-binding
recommendations to the GDC Board. If the Board decides not to implement those recommendations, it will report to the
shareholders on its reasons.
In its draft determination of August 1999 the Commission expressed skepticism about the potential for internal
mechanisms such as those proposed above to provide effective substitutes for choice and competition between
co-operatives. It is likely that they would take a similar view of these arrangements. In addition, it is not clear to
us that the benefits associated with the Shareholders’ and Suppliers’ Council will outweigh the complications that are
created by introducing it into the governance structure of GDC. We therefore do not expect that these arrangements will
reduce the estimate of productive efficiency losses.
4. Public Benefits
4.1 Introduction
We have been provided with a copy of a document titled “Business Case for Global Dairy Co Ltd: Executive Summary”, in
which is an outline of the sources of the $310 million dollars in benefits that are claimed to be associated with the
merger. The claimed costs savings and revenue enhancements are summarised as follows:
Annual cost savings in the order of $120 million. These savings arise from elimination of duplicated facilities and
activities and are achievable from the first year of GDC. But the immediate impact of the savings is offset by one-off
costs of around $100 million.
Annual revenue enhancements and productivity improvements in the order of $70 million. These benefits are expected to
arise from the second year of GDC and represent enhanced economies of scale and scope if manufacturing activities are
integrated with marketing and distribution functions.
Further benefits arise because the merger will enable the harnessing of synergies between different parts of the
industry, provide fresh strategic impetus and broaden options to exploit new market, technology and biotech
opportunities. The estimated impact on GDC’s net earnings is an additional $120 million per year from the third year of
the merger.
While this outline is couched in the most general terms, it is possible to offer some high level comparisons based on
the views expressed by the Commission in 1999.
4.2 Promotion of Industry Change
In a paper presented to the Commission in support of the merger the NZIER suggested that the 1999 proposal would promote
industry change by providing for a cessation of the bundling of payouts to farmer/shareholders and by facilitating the
integration of manufacturing and export marketing. The Commission was not convinced that the merger was necessary to
obtain these benefits, and in respect of industry change it assessed the benefits of the merger as being in the order of
$5 million - $15 million.
4.3 Promotion of Processing and Structural Efficiencies
The annual cost saving claimed in the NZIER paper supporting the merger proposed in 1999 claimed benefits of $136.6
million as a result of the potential to reduce duplication in ancillary facilities, plant production flexibility and
rationalisation. Of these claims, the Commission accepted benefits in the range from $21 million to $41 million against
the status quo, and $46.5 million to $71.5 million against the deregulation counterfactual.
We note that annual savings of $120 million per year are claimed in the statement cited above, and thus that the
industry claim for public benefits under this category has not changed materially. In the absence of further
information, we must therefore conclude that the benefits accepted by the Commission under this heading are unlikely to
increase.
4.4 Preservation of a Single Seller Market
In addition to the claimed benefits of the GDC proposal noted at the beginning of this section, the “Business Case …
Executive Summary” at page 2 claims that if the single-seller framework was replace by two major competing New Zealand
companies, then “The experience of NZDG, NZDB and Kiwi suggests that market premiums of around $110 million annually
would be lost ...”.
The premium associated with single desk selling was considered by the Commerce Commission. It noted that the Dairy Board
claimed that outside of the quota markets it is able to wield market power in some product and geographical markets by
virtue of its market share and the premium associated with New Zealand dairy products. It is argued that these market
premiums would be eroded as two competing New Zealand companies attempted to increase their share of the markets in
which those premiums above the world price are extracted.
The evidence that such premiums exist is contentious. In a study commissioned by the Dairy Board, the NZIER (1998)
estimated that the premiums totaled $40 million per annum. In a critique of the NZIER study commissioned by the Producer
Board Project Team, Economics and Law Consulting Limited (1998) demonstrated that the conceptual basis of the NZIER
study was implausible and both the methodology and conclusions were flawed. There is nothing in the material provided as
part of the GDC proposal to indicate the basis of the claim of single desk premiums of $110 million.
In considering the evidence in 1999, the Commission was reluctant to endorse the claim the market premiums are obtained
through single desk selling, and it did not agree these premiums would be lost completely if there were two or more
competing New Zealand exporters. The Commission assigned a range from $0 - $20 million for the public benefits
associated with the retention of single desk premiums. Despite the higher amount claimed by the proponents of the GDC
merger, in the absence of quality empirical evidence in support of the amount claimed, we consider it unlikely that the
Commission would recognise public benefits larger than the $0 - $20 million range.
4.5 Industry Development
In its August 1999 decision the Commission considered a range of claims about intangible benefits associated with a
consolidated dairy industry. These included the benefits of the adoption by the industry as a whole of best practice
from each co-op, the structure for funding industry good research (from Dairy Board revenues), the benefits to New
Zealand of having a large multinational firm based in this country, and the claim that the industry could grow its
revenues from US$4 billion to US$30 billion in a relatively short time frame. As the Commission noted, there was no
evidence that this growth in revenues of the merged company would produce tangible benefits for farmers or consumers in
New Zealand. The Commission declined to include any tangible benefits associated with these factors in its analysis.
The GDC proposal contains little detail on any of these factors. The supporting material provides a high profile to the
fact that GDC would be the 14th largest dairy company in the world, and that it would retain New Zealand ownership of
the organisation. It is not, however, clear, that there are any tangible public benefits associated with these factors.
In respect of these factors we therefore see no reason to expect that the Commission would find tangible benefits in the
GDC proposal.
5. Overall Assessment of the Balance Between Benefits and Detriments
In its August 1999 draft determination the Commerce Commission found that the merger proposal had moderate to large
detriments and small public benefits. The vast majority of the detriments were associated with the loss of productive
and dynamic efficiency as a result of the loss of effective competition for the merged entity and not from the impact of
the merger on prices paid by domestic consumers.
The GDC proposal contains the following substantive changes from the 1999 proposal. In each case, the impact as it is
likely to be viewed by the Commerce Commission is indicated in brackets. ;
Specifies, for inclusion in legislation, a method for fair valuation of capital on entry and exit to remove barriers to
switching [positive] ;
Clearer and more credible specification of the gains from the merger [positive] ;
Shareholders’ and Suppliers’ Council [weak positive] ;
Proposal for three-year review by the Commerce Commission [neutral] ;
Allocation of all quota rights to GDC [negative] ;
No proposal for tradable shares and payment unbundling [negative].
This summary highlights the fact that the GDC proposal has introduced a number of positive and negative changes: on
balance we doubt that the changes would have a strong positive or negative impact on the views of the Commission. We
reach this conclusion primarily because the changes that are positive are not likely to have a material impact on the
Commission’s assessment of the detriments associated with the merger. In particular, the proposal does little to improve
the environment for competition: it does little to enhance the likelihood that over a two-year time frame a viable
competitor for GDC can emerge. We therefore conclude that the Commerce Commission is likely to find that the detriments
of the GDC proposal substantially outweigh the benefits. 6. Costs and Benefits Of Assessment By the Commerce Commission
The GDC proposal suggests a role for the Commerce Commission in monitoring the actions of GDC in the domestic market,
but that the Government rather than the Commerce Commission should make the decision to implement the proposal (or not).
This appears to us to undermine the basic principles of competition policy, and to reverse the primary and secondary
roles of the Commission. The primary role of the Commission is to ensure that market structures and market practices are
consistent with competition. If there is a competitive process at work in a market, ongoing monitoring is not necessary.
Only where the Commission has not had the opportunity to impose structural remedies to achieve a competitive process is
it appropriate to consider other actions by the Commission such as price control. In our view it would be inappropriate
to both deny the Commission the opportunity to assess the impact of the GDC proposal and then require the Commission to
make an assessment of the outcome.
The GDC proposal emphasises that time is a crucial issue. The timing of events in the proposal is built around the
suggestion that the merger should be implemented for the 2001 – 2002 milk season, which means in practice by June 2001.
While there is some logic to the proposal that the merger be implemented for the 2001 – 2002 milk season, the short time
frame is one that has been created by the dairy industry. Further, we can not rule out the possibility that the timing
of the announcement was the result of a strategic choice to attempt to create the perception that the Government must
act in an extremely tight time frame.
In our view, the time frame need not and should not be used to justify the avoidance of a Commerce Commission decision
on the proposal. The proponents of the merger would be imprudent if they had not spent the period since 21 December 2000
preparing an application for the Commerce Commission. In any event, it should be possible to submit such an application
to the Commission within two weeks of an indication from Government that this is required. Having considered the
“mega-merger” proposal in 1999, the Commission should not require more than the normal 60 days to make a decision on a
new proposal that clearly addresses the issues that were raised in their 1999 Draft Determination. This means that a
Commerce Commission decision could be available at or soon after the end of March. Provided that the Commission approves
the proposal, the timeline set out in the GDC proposal would still be feasible.
The Commerce Commission plays two crucial roles in the assessment of any merger. First it has statutory responsibilities
and powers to collect information and consult market participants, and a track record for maintaining the
confidentiality of commercially sensitive information that it acquires. The Draft Determination of the Commission dated
29 August 1999 built on past decisions relating to the dairy industry, provided new data about the industry and
identified significant issues associated with the competitive impact of the proposed merger that could only be addressed
on the basis of such a detailed study. Second, the Commission may broker and accept structural undertakings which
resolve concerns that it might have. The Commission is the optimal agent to consider such “deals”. Both roles are
crucial for the achievement of the best outcome for the industry and for New Zealand consumers.
It may be claimed that the Commerce Commission’s mandate is not sufficiently broad to consider all of the issues raised
by the GDC proposal, but in our view there is only one special case in which this might be true. If deregulation of the
dairy industry created the optimal structure of the market from the perspective of dynamic efficiency but this market
structure was unlikely to produce effective competition inside the two-year horizon used by the Commission, it is
possible that the Commission’s approach could be improved by implementing the proposal with the Government finding some
mechanism to accept some behaviourial undertakings for the period in which effective competition is absent. In our view,
for this approach to be considered by the Government, it must be true that (i) the structure of the industry and the
market that is created is optimal from the perspective of facilitating competition in the future, and (ii) there is a
mechanism by which the Government can accept and monitor compliance with short-term behavioural undertakings. The GDC
proposal appears to be far from optimal in terms of its creation of a market structure that will facilitate future
competition, and its failure to include price unbundling will increase the difficulties of monitoring any behavioural
undertakings.
Without an assessment by the Commission it will not be clear where the major concerns with the GDC proposal actually
lie, and it will be more difficult to identify those concerns that can be addressed by undertakings given to the
Government. Thus with a Commerce Commission decision, it will be clearer if there is a “benefit to the nation”
justification for undertakings that are accepted by the Government and included in the legislation that will be required
to facilitate change in the industry.
6. Conclusion
By comparison with the merger proposal put forward by the industry in 1999, the GDC proposal provides a more plausible
statement of the benefits to be derived from the merger than did the 1999 proposal. However, it still does not meet the
key concern of competition policy: the need to create a structure within which viable competition for GDC will be
present within two years. It is hard to reconcile the claim that the GDC proposal will allow retention of single-desk
seller advantages in export markets with the claim that a market structure is being established that will allow the
emergence of viable competition in the supply of the purchase and processing of raw milk, the supply of milk products to
the domestic consumer market and the export of dairy products from New Zealand. The failure to establish Dairy Foods on
a basis that would allow it to emerge as a viable competitor of GDC, the failure to provide for price unbundling and
tradable shares, and the allocation of all quota rights to GDC represent major impediments to the development of
competition. In addition, the proposal could be improved if it was developed or clarified in respect to the proposal to
issue capital notes and the proposal for dealing with the Dairy Board stakes of the small independent co-operatives.
In its current form, our assessment is that the GDC proposal has detriments well in excess of the benefits, and that
this is synonymous with the view that the proposal does not represent the best deal for New Zealand. It appears to us to
be important, however, that the industry seek an authorisation from the Commission and consider structural means of
reducing the detriments as a prerequisite for any legislative action by Government.
ENDS