Final report on its review of Fonterra’s base milk price

Commission releases final report on its review of Fonterra’s base milk price

The Commerce Commission has today released its final report on Fonterra’s calculation of the base milk price it will pay farmers in the 2020/21 dairy season.

The Commission found that Fonterra’s forecast price of $7.45 - $7.65 per kilogram of milk solids for the season is calculated in a way that is likely to be consistent with the requirements of the milk price monitoring regime under the Dairy Industry Restructuring Act (DIRA).

The key areas of the Commission’s focus in this year’s review were two components of the cost of capital (the asset beta and specific risk premium), the appropriateness of provisions for asset stranding, and the inclusion of instantised milk powder as a reference product in the calculation of the base milk price.

Fonterra sets its base milk price according to rules set out in its Farmgate Milk Price Manual. DIRA requires the Commission to review Fonterra’s methodology for calculating the price and to conclude on whether the calculation is consistent with the purpose of DIRA.

The Commission’s final conclusion is that Fonterra’s calculation is likely to be consistent with both the efficiency and contestability purposes of DIRA. This conclusion takes into account issues identified by stakeholders with the estimate of the asset beta that warranted a change from the Commission’s draft conclusion on this matter. The Commission notes that in practice the methodological issues with the estimation of the asset beta identified in submissions do not have a material impact on the base milk price for this season.

The Commission’s role does not extend to setting or recommending the base milk price, nor does it extend to monitoring or setting the retail prices for dairy. The prices Fonterra receives for processed commodity milk products are generally set on the global marketplace.

DIRA has recently been amended by Parliament, with a change reducing Fonterra’s discretion in setting the asset beta. This change will come into effect for next year’s review.

The final report can be found on the Commission's website.

Background

The milk price regime is designed to provide Fonterra with incentives to set the base milk price consistent with efficient and contestable market outcomes. The regime exists because there is not yet a competitive domestic market for the purchase of farmers’ milk and the base milk price is 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.

Under DIRA, the Commission is also required to review Fonterra’s Manual, which sets out Fonterra’s methodology for calculating its base milk price for the season.

Asset beta

The asset beta is used in calculating the estimated cost of capital of financing the operations of a ‘notional’ milk processor and reflects the extent to which these operations are more or less risky than the stock market as a whole. A higher asset beta would put downward pressure on the base milk price Fonterra pays its farmers.

Specific Risk Premium

The specific risk premium is intended to compensate investors, if appropriate, for downside risk associated with stranded assets that is not otherwise covered in the base milk price calculation methodology.

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