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Draft report on review of Fonterra’s 2016/17 base milk price calculation

15 August 2017

The Commerce Commission has today released its draft report on Fonterra’s base milk price calculation for the 2016/17 dairy season. 

The base milk price is the price Fonterra pays farmers for raw milk, which is set at $6.15 per kilogram of milk solids for the 2016/17 season just ended. The report does not cover the forecast 2017/18 price of $6.75 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 with the exception of the asset beta component of the cost of capital estimate, Fonterra’s calculation of the 2016/17 base milk price is consistent with both the efficiency and contestability purposes of DIRA. 

“The draft report builds on our previous reviews of Fonterra’s base milk price calculation. This year our review has focused on Fonterra’s decision to include sales outside the Global Dairy Trade auction platform to inform prices for whole milk powder, skim milk powder and andryhous milk fat in the calculation, as well as the practical feasibility of the asset beta component,” Ms Begg said.

“We are satisfied that the inclusion of sales outside the Global Dairy Trade is consistent with the purposes of DIRA. Fonterra is now selling a larger proportion of its products outside the Global Dairy Trade and the calculation now reflects this trend.” 

“For the asset beta, we are unable to conclude on the practical feasibility of the estimate chosen by Fonterra with the information currently available. This is a complex area and we have invited technical input and further information from interested parties to assist us to reach a conclusion."

The Commission invites comments on its draft report by 1 September 2017. The final report will be published on 15 September 2017.

The draft report and related information can be found here.

Background

The Commission’s review

Each year the Commission reviews 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. The term used in DIRA for the ‘farm gate’ milk price is ‘the base milk price set for that season’. In the review, the Commission is required to consider the ‘efficiency’ and ‘contestability’ dimensions of the base milk price calculation.

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, without a competitive market for the purchase of farmers’ milk, the milk price is set by Fonterra using an ‘administrative’ methodology. As Fonterra determines and applies that methodology itself, there is a risk that Fonterra might have the incentive and ability to set a base milk price that is ‘inefficient’. The regime also monitors whether the price Fonterra chooses to set to buy milk might be ‘too high’ or ‘too low’ 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, the Commission is also required to review Fonterra’s Farmgate Milk Price Manual (Manual review). Fonterra’s Manual sets out its methodology for calculating its base milk price for the season. In the report on the 2016/17 Manual review in December 2016, the Commission concluded that the Manual was largely consistent with the purpose of the milk price monitoring regime. The Commission’s review of the 2017/18 Manual will begin shortly.

Asset beta component in the calculation

The asset beta component is used to calculate the weighted average cost of capital for the milk price. The asset beta is a measure of exposure to systematic risk. Systematic risk measures the extent to which the returns on a company fluctuate relative to the equity returns in the stock market as a whole.