Crying over milk prices

CEO Andrew Ferrier denies Fonterra is to blame for rising prices. Photo / NZ Herald

The price of milk. Imagine, by some clever sleight of hand, dairy monopoly Fonterra artificially inflated the price it pays to farmers by say, 24c a kilogram of milk solids.

Could Fonterra do that? And if that did happen, what effect would it have on competitors and consumers?

These are the questions our Commerce Commission is considering following complaints alleging that Fonterra is "setting a notional milk price, which is anti-competitive in nature". If the allegation is true - and let's be clear, at this stage we don't know if it is - then a hypothetical increase of 24c a kilogram of milk solids (fat and protein) roughly translates into 2c a litre of milk.

If you're a competitor of Fonterra like Open Country, Tatua or Westland, two cents a litre can have a big effect - especially when you're buying 900 million litres a year as Open Country does. That's an extra $18 million - hardly small change in an industry typified by high volumes and wafer-thin margins.

For the consumer, an extra 2c a litre at the farm gate could be expected to end up - after processing, distribution and marketing costs, plus margins - at something like an extra 6c a litre on the retail price. Again, it doesn't seem a huge amount - maybe 60c a week for a family drinking 10 litres a week. So that's $31.20 a year per family - hardly worth worrying about. But multiply that by, say, 1 million households and you arrive at $31.2 million which, from the country's point of view, is quite a lot of money that might be better spent elsewhere.

The bigger cost to consumers however would be the chilling effect on domestic dairy competition. If competitors' chief cost (the price of milk) can be artificially inflated by Fonterra, then local competition and the prospect of greater choice and better prices doesn't stand a chance. It also indicates a fundamental failure of the regulations put in place to allow the formation of Fonterra in 2001 - an entity designed to make New Zealand's dairy production "strong against the world" but not at the expense of local competition.

The Herald has obtained information about some of the complaints and spoken to some of the complainants on condition of anonymity. The crux of their concerns is Fonterra's market dominance in both production and distribution - controlling not just the competitors' costs but also their revenue.

Competitors argue Fonterra's New Zealand manufacturing division, Fonterra Brands, is intertwined in a web of "toll processing" - packaging and bottling contracts - with Australasian food manufacturer Goodman Fielder and the two supermarket chains' house brands. One way or another, Fonterra dominates 95 per cent of the New Zealand dairy cabinet. Independents trying to compete against such might are simply worn down or burned off by the monopoly's ability to undercut any competing product on supermarket shelves.

The Commission is now investigating whether a price control inquiry into the price of milk is warranted. Price control inquiries have been used only twice - in 2003 to regulate gas pipelines services, and in 2002, when it recommended the supply of airfield activities at Auckland, Wellington and Christchurch international airports should be regulated, but the Government declined to do so.

That the Commission is now entertaining the idea of rolling out its big guns is surprising. A week earlier, in response to calls by Consumer New Zealand and others, Commission chairman Mark Berry told Parliament's commerce select committee. "At this time we see no reason or circumstances to commence a price control inquiry into the price of milk."

The Commission's blind eye to dairy market complaints is not new.

In 2008, when former deputy Prime Minister Wyatt Creech complained that increases in dairy retail prices - particularly cheese - went far beyond the increases in international prices, the Commission said: "A correlation between domestic and international price trends is to be expected, and this reflects the Prices are on the rise. Milk and butter are at an all-time high with cheese not

far behind. operation of competitive market forces rather than necessarily being an indication of the exercise of domestic market power."

The Ministry of Agriculture and Forestry (MAF), tasked with overseeing the Raw Milk Regulations, also sees nothing wrong: "Rising international food prices can mean increased returns to the New Zealand economy." it said its March report on the dairy market.

Not in dispute is that, yet again, dairy prices are on the rise. Milk and butter are at an all-time high with cheese not far behind. For the March quarter of this year the average consumer price index for a 2 litre bottle of milk was $3.66 and 500g of butter was $4.28. A 1kg block of mild cheddar was $10.58.

In response to consumer concerns Fonterra Brands unilaterally imposed a price freeze for the rest of the year on the wholesale price of milk it provides to retailers. It was a freeze that seemed to rapidly thaw because it doesn't apply to other dairy products such as cheese or butter. Last week Goodman Fielder increased butter and cheese prices by around 9 per cent and yoghurt by around 6 per cent. Fonterra Brands put butter up an average of 5.5 per cent and cheese went up an average of 5 per cent.

Goodman Fielder said the price rise was because Fonterra has increased its farm gate milk price from $6.90 to $7.50 per kilogram of milk solids. Fonterra's chief executive Andrew Ferrier said the dairy giant was not to blame. "The world price sets the price Fonterra sells milk in New Zealand," he told Newstalk ZB. "The world prices have gone up."

It's a familiar mantra, but omits a few key points. The price of regulated milk which forms the basis of domestic milk supplies is actually set by Fonterra rather than the Government. It wasn't always that way. In the past the price was set by a formula outlined in the Raw Milk Regulations.

It is true that world prices play a big part in New Zealand prices. But the formula now used to arrive at the farm gate figure is complex and known only to Fonterra. At its simplest level, it involves converting the price paid for several export products - whole-milk powder, skim-milk powder, cheese, butter and caseinates (milk protein) - back into the liquid milk form picked up by tankers from the farm gate.

The equation is essentially one of revenue minus costs. Which would be fine if it was entirely based on actual revenue and actual costs. But it's not.

The Fonterra formula uses modelled, theoretical revenue and cost lines as though it was a perfect company with all the milk in New Zealand. Throw other factors into the mix - such as foreign exchange hedging gains, non-dairy derived gains such as selling off an overseas business, fixed contract prices negotiated by large companies such as Nestle - and you begin to see how complex the formula can get.

Competitors say the formula is anti-competitive and forces them to pay a milk price which doesn't reflect actual market returns, leading to paying uneconomic prices and taking unacceptable risk.

The bad situation is made worse by the milk price paid to farmers being confirmed at the end of the year. That means local competitors having to sell goods in a market not knowing what the final cost of goods sold will be. A common thread among the complaints is a call for greater transparency in setting the farmgate price and the need for and independent milk price regulator to oversee the process.

Though the Commission's preliminary investigation will begin at the farm gate - the watchdog has asked Fonterra to provide a copy of its highly confidential Milk Price Manual and the calculations it uses to set the milk price paid to farmers - it will also look further afield. That includes making inquiries of the two main milk retailers - Foodstuffs and Progressive Enterprises. It expects to make its decision in two months.