Draft report on review of Fonterra’s 2017/18 base milk price

15 August 2018

Draft report on review of Fonterra’s 2017/18 base milk price calculation

The Commerce Commission has today released its draft report on Fonterra’s base milk price calculation for the 2017/18 dairy season.

The base milk price is the average price that Fonterra pays farmers for raw milk, which was set at $6.75 per kilogram of milk solids for the season just ended.

The report does not cover the forecast 2018/19 price of $7.00 that Fonterra announced in July.

The Commission is required to review Fonterra’s calculation at the end of each dairy season under the milk price monitoring regime in the Dairy Industry Restructuring Act (DIRA).

Commission Deputy Chair Sue Begg said this year’s review revealed no new areas of concern.

“We’re satisfied that Fonterra’s calculation of the 2017/18 base milk price is largely consistent with both the efficiency and contestability purposes of DIRA, though we have retained our emerging view that the asset beta that Fonterra applies is not practically feasible,” Ms Begg said.

The asset beta is used in calculating the estimated cost of capital of financing milk processing operations, and in turn affects the milk price Fonterra pays its farmers. It reflects the extent to which the assets associated with processing milk are more or less risky than the stock market as a whole. A higher asset beta would put downward pressure on the milk price Fonterra pays its farmers.

Through its reviews the Commission has now seen declining seasonal milk solids volumes from Fonterra for three consecutive years. Understanding if this is a temporary or permanent volume adjustment and the implications of this on the milk price will be a focus area for next season’s reviews.

The Commission invites comments on its draft report by Friday 31 August 2018. The final report will be published on 18 September 2018.

The draft report and related information can be found here.

Background

Milk price adjustment
On 10 August 2018, Fonterra announced it had reduced its 2017/18 forecast milk price payment from $6.75 to $6.70. This forecast reduction is a discretionary decision by Fonterra’s board that is separate to the milk price calculation. The forecast milk price under the Milk Price Manual and DIRA remains $6.75 and Fonterra’s announcement does not impact on our review. As noted in Fonterra’s statement to the NZX, the confirmed final milk price payment is scheduled for 13 September 2018.

The Commission’s review
Each year the Commission reviews and publishes a report on the calculation of the base milk price for the dairy season that has just concluded. The base milk price is the average price Fonterra pays to farmers per kilogram of milk solids (kgMS). The focus of the review is solely on the farm gate milk price and not any other milk price within the milk supply chain. In the review, the Commission is required to consider whether the base milk price calculation provides an incentive for Fonterra to operate efficiently and if it is consistent with contestability in the market for the purchasing farmers’ milk.

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 there is not yet a competitive domestic market for the purchase of farmers’ milk and the milk price is therefore set by Fonterra using an ‘administrative’ methodology. As Fonterra determines and applies that methodology itself, there is a risk that it might set a base milk price that is ‘inefficient’ - either too high or too low relative to what it would be in a competitive market. A price that is too high could act as a barrier to efficient entry by processors. The regime therefore also monitors whether the base milk price Fonterra sets might be too high relative to the price that would exist if the market for purchasing farmers’ milk was contestable.

DIRA review requirements
DIRA requires the Commission to conduct two separate reviews of Fonterra’s base milk price setting each dairy season. As well as the review of the base milk price calculation at the end of each season, the Commission is also required to review Fonterra’s Farmgate Milk Price Manual (Manual review) after the start of the season. Fonterra’s Manual sets out its methodology for calculating its base milk price for the season.

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