Advisory firms that looked into the 'asset beta' Fonterra Cooperative Group uses to determine the farmgate milk price say it may be too low, meaning its farmer-shareholders are receiving a bigger payout than warranted under the company's enabling law.
The Commerce Commission hired Cambridge Economic Policy Associates (CEPA) and Freshagenda to establish whether Fonterra's proposed approach to estimating the asset beta for a "notional processor" - as set out in the Dairy Industry Restructuring Act 2001 (Dira) - is appropriate.
The Act sets out an approach to calculating the farmgate milk price paid by Fonterra, to ensure New Zealand's dairy markets are efficient and contestable in the face of Fonterra's market dominance.
A lower asset beta allows a higher milk price to be calculated. Last month Fonterra lifted its forecast farmgate milk price to $6.55 per kilogram of milk solids from the $6.40/kgMS it projected in December, reflecting the improvement in global dairy prices since then.
Under Dira, the commission conducts an annual review of the milk price 'manual' that Fonterra uses to calculate its base milk price each season. The regime was put in place when Fonterra was created because there wasn't a competitive market for the purchase of farmers' milk.
In the past two years, the regulator has concluded that the manual is largely consistent with its statutory purpose under the Act but has been unable to reach a conclusion on whether the asset beta is consistent with the Act.
Beta is a measure of the volatility, or systemic risk, of a security or a portfolio in comparison to the market as a whole, according to Investopedia.
A beta of less than 1 suggests the security is theoretically less volatile than the market.
Utility stocks typically have a beta of less than 1, which is important for Fonterra because the beta it advocates, of 0.38, is based on a sample of electricity lines businesses.
Its adviser, Auckland UniServices, argues that the systemic risk for the notional processor is lower than for companies in the same broad sector as "as the cash flows, and therefore asset beta, of the business are more similar to that of a price capped/revenue capped business such as an electricity lines business," the report says.
Fonterra makes a large downward adjustment to the commission's asset beta estimate on the basis that the notional processor has lower exposure to systemic risk because it can pass on commodity price risk to its farmers, paying them from the residue of revenue after its notional and actual costs are taken out, including its weighted average cost of capital (WACC).
"The estimate of the asset beta is a crucial determinant of the WACC, and thus the farmgate milk price," the report from CEPA and Freshagenda says. Its analysis indicates other dairy companies "are a reasonable proxy for asset beta in the dairy industry in general, and the notional processor in particular," and indicates an asset beta range of 0.45 to 0.58.
"We have not seen sufficient empirical support for an asset beta below the bottom end of this range," the report says. It does acknowledge that the risks faced by the notional processor are limited given that the Dira price risk is passed on to farmers via the farmgate milk price.
"This might suggest that the business is very low risk compared to comparator companies that may face commodity price risk," the report says. "However, our analysis indicates that dairy price variation is not correlated with general stock market movements, and so may not be systematic."
The report says the argument that a sample of electricity utilities is the best proxy for the notional processor "is unconvincing." It says in a mature economy such as New Zealand, drivers of electricity lines business revenue is somewhat decoupled from economic growth and is more influenced by factors such as changing patterns of electricity demand and supply.
The commission monitors the milk price manual but has no powers of enforcement. For 2017-18, the regulator's "primary focus of our calculation review for this year will be the estimate of the asset beta and estimated cost of capital used in the calculation," it has said.
"While our recent reviews have found the way Fonterra sets its milk prices is largely consistent with the Dira, we continue to be concerned that Fonterra has not provided sufficient evidence to support using an asset beta lower than that of comparable processors," commission deputy chair Sue Begg said in a statement released today with the report.
The commission is seeking feedback on the report by 5pm on May 9 and will then confirm the next steps for its review of this year's milk price calculation, it said.
The government has put on hold an amendment to Dira that had been prepared by the previous National-led administration and in February, Primary Industries Minister Damien O'Connor said the move would allow a broader review of New Zealand's dairy sector and whether it is adding enough value to the nation's biggest export commodity.
The legislative amendment followed a Commerce Commission review triggered by Fonterra's share of South Island milk falling below a Dira threshold which concluded Fonterra's market dominance still warranted regulation.
Units in the Fonterra Shareholders' Fund, which are entitled to dividends from Fonterra's ordinary shares, last traded at $5.73 and have fallen 5.5 per cent in the past 12 months while the S&P/NZX 50 Index rose 17 per cent.