In the first of a two-part series Gareth Morgan and Geoff Simmons warn of private profit at a public cost.

Our rivers are stuffed, and getting worse. The Parliamentary Commissioner for the Environment's report on water quality released late last year fingered the steady expansion of dairying as the culprit. The Commissioner covered the environmental issues in her report, but not the economic ones. In our view this scandal is New Zealand's version of the Global Financial Crisis (GFC), where profits of a few are leaving debts for generations to bear.

Let's be clear up front; we aren't blaming the farmers. Like the bankers in the GFC they are just responding to the incentives the market presents them. And nowadays most farmers try to contain the environmental damage, many taking more remedial steps than they are required to. But just like the GFC, this is a massive failure of the regulatory regime. While rules around dairy conversions and intensification are emerging, they are simply inadequate to offset the rising environmental damage - unfortunately way too little and way too late to avert a crisis. Our lax taxation of the income earned on capital - a benefit that all landowners enjoy - also inflates the after-tax return to farming. The gap between what farmers actually earn and what they would if they paid their fair share of tax and paid for the environmental damage they cause, has become so large that the costs of cure are forbidding.

This is a complex issue, so we need to break it into bite-sized chunks. This first article will explain the concepts and set out the basic problem. The second piece will set out the good stuff farmers are already doing, and what needs to happen if we are serious about tackling this crisis, saving our rivers and averting mass contamination of ground water that threatens public health.

It all starts with cow pee. Sure fertiliser can be a problem if applied excessively or at the wrong times, but in the main it's not the culprit. Rather it is cow pee - a simple urine splash from a cow is a massive concentration of nitrogen, equivalent to 1000kg of nitrogen per hectare. This is too much for pasture plants to take up by far. Given dairy cows pee a lot and over time the nitrogen seeps down through the soil to find its way into rivers and groundwater, the consequence from higher stocking rates are obvious.


Like any nutrient, too much nitrogen in a river, lake or groundwater encourages algae to bloom. When all that algae dies and rots it sucks oxygen out of the water, rendering it unfit for life. This is how our rivers and lakes are dying.

We have what economists call an "externality" - where the actions of a producer create costs they don't pay for but leave others to pick up the tab. Until those costs are sheeted back fully to producers, in this case the farmers, their personal profits will be inflated at society's cost. And of course the higher the profits, the more new dairy farms get set up, making the problem worse. A circuit-breaker is needed.

It gets worse - as intensification increases farmers are removing more and more water from the rivers, which concentrates the nutrient leeching even more. Some naively take the view that every drop of water that makes it to the sea is a waste, ignorantly overlooking the benefits that rivers give to us and their unique contribution to our environment - places for fishing, kayaking, swimming and a haven for rare plants and animals.

Politicians assure us that our rivers are a common resource, one that we all own. While Maori would argue the toss, we won't get into Treaty issues here but, regardless, farmers don't own the rivers. So why are they able to deplete and contaminate at will? Yes they require a permit but that gives them a permanent right to freely use (and abuse) what is a common resource. They pay for the irrigation schemes but they don't pay for the water itself - they should, just as they should pay for the nutrient leeching.

The Commissioner for the Environment's report showed that more conversions is the main problem facing our rivers - far outweighing any benefits coming from farmers' remedial efforts such as riparian management, effluent management, nutrient management, and water use management. Despite all this, the problem is getting worse.

About 283,700ha of land were converted to dairy between 1996 and 2008, an increase of 23 per cent. It projects that by 2020 another 370,300ha will be added to the dairy estate, another 25 per cent increase. Canterbury has had the highest conversion rate with 122,500ha, an increase of 170 per cent, with another 100,000ha likely to convert to dairying between 2008 and 2020.

This rate of conversion will continue to have a telling impact on our waterways. Based on the projections above, nitrogen loads in New Zealand rivers would increase by 6 per cent by 2020. Canterbury alone has already seen a 27 per cent increase in nitrogen loads between 1996 to 2008, and given the conversion rates above will see a further 15 per cent rise by 2020. Many of our rivers are already unsafe for swimming in.

As always it comes down to economics and the profit motive.

The high price for milk drives the strong incentive for more farmers to convert to dairy. It's not just the free rider profits emanating from lax environmental protection, there exist tax loopholes that advantage investors in capital and amplify the effective subsidy from other New Zealanders to dairying. Dairy farms are hugely capital-intensive businesses and becoming more so as the price of land is driven ever higher.

The financial incentives are strong - converting land to dairy leads to a huge increase in the land price. Many sheep and beef farmers have sold or converted to cash in on this bonanza, capitalising the public subsidy to dairying as they exit. Thanks very much.

The test of whether market protection is being afforded is very simple.

After taking full account of all costs does the income yield on the asset provide an adequate return for risk? In the case of farming generally the answer is no, the income yields are derisory, it's all about farming for the tax-free capital return. And when the milk prices rise fast enough to boost the income yield, not long afterwards farm prices rise to get rid of any income yield margin. And we wonder whether the agricultural sector is over-invested on-farm?

The GFC analogy of private profit at public cost is more and more the story of New Zealand dairy farming.

Gareth Morgan and Geoff Simmons research and write at the Morgan Foundation. Their second article on dairying appears tomorrow.
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