Commission's preliminary determination says 'no' to dairy 'mega-merger'

The Commission's preliminary view is to decline to grant authorisation to the proposed merger of the Dairy Board and up to eight dairy companies.

The conclusion reached in the Commission's draft determination is based upon information provided to the Commission to date. It should also be appreciated that the Commission's deliberations have been against a background of uncertainty about the:

• final form of the proposed legislation,
• proposed constitution of NewCo, and
• proposed contractual arrangements between NewCo and Dairy Foods.

The Commission will now proceed as follows:

• interested parties may make submissions in response to the Draft Determination by 17 September (the Commission has invited responses on 48 questions in the Draft Determination)
• a public conference will be held in Wellington from 5-8 October 1999.

The Commission's final decision will take into account all further information provided through the submission and conference processes.

A key concern of the Commission is that the proposal will give the merged company, NewCo, potential control of all milk produced by farmers.

Under the legislation as currently proposed, and under NewCo's current draft constitution, farmers would be potentially locked in to NewCo. Under both the legislation and constitution there is no requirement that NewCo provide fair value entry and exit opportunities for farmers.

As a result, the Commission's current view is that dominance is likely to arise in a number of domestic markets including those for:

• the acquisition and supply of unprocessed milk in the North and South Islands, and
• the processing and wholesale supply of town milk in the North and South Islands.

The concerns the Commission has in these markets point to significant detriments for dairy farmers and domestic consumers.

The application provided little assessment of detriments, except to state that there would be checks and balances in place to help prevent economic inefficiencies arising. Limited information or explanation has been provided on these checks and balances. Further, NewCo's constitution is in draft form only and has yet to be adopted by the dairy farmers.

With NewCo having control of the flow of unprocessed milk from farmers, the Commission considers that potentially there will be detriments including the following:

• NewCo will be under less pressure to allocate its resources efficiently, and to keep its costs down,
• NewCo will be under less pressure to respond quickly to changes in the industry,
• NewCo could reduce pay-outs and quality of service to farmers, and
• NewCo could increase prices and reduce quality of service on domestic consumer markets (such as those for town milk and cheese).

The applicant has claimed that significant benefits will arise from the merger.

In this preliminary assessment of the proposal, the Commission has not accepted many of the claimed benefits because it was not convinced that they could not be gained in the absence of the proposed merger.

The Commission's assessment in this Draft Determination, based on information currently available, is that detriments could be between $138 - $527 million a year, while benefits likely to flow from the proposal could amount to between $26 - $92 million a year.

As earlier mentioned, we now invite submissions in response to our Draft Determination. Some 32 parties have already indicated that they will attend the conference in October and we look forward to hearing their views on this proposal.

Acting Chairman

Mark Berry

Copies of this media release, the backgrounder that accompanies it and the draft determination will soon be available on the Commission's website,

Media contact:

Commerce Act Manager Geoff Thorn

Phone work (04) 498 0958

Communications Officer Vincent Cholewa

Phone work (04) 498 0920

Commission media releases can be viewed on its web site www.comcom.govt.nz

Background to dairy "mega-merger" draft determination, 27 August 1999

Market dominance 1

The counterfactuals 2

Detriments 2

Benefits 3

Balancing of benefits and detriments 4

List of 48 questions from the draft determination 5

The Commerce Act prohibits business acquisitions that result in dominance being acquired or strengthened in any markets.

Parties to an otherwise prohibited acquisition can apply for an authorisation. The Commerce Commission will grant an authorisation if it is satisfied that public benefits from the proposed merger would outweigh its detriments to competition.

To compare benefits and detriments, the Commission must determine the likely effects of granting the determination and compare those to what would happen in the industry if it declined the authorisation.

Market dominance

In this case, the Commission has identified 11 relevant markets covering the acquisition of unprocessed milk from farmers in the North and South Islands; the secondary markets in both Islands for the wholesale trading of unprocessed and near-milk; the markets in both Islands for town milk; the domestic markets for the supply of various dairy products (cheese, consumer spreads, cultured dairy products, and dairy ingredients); and the market for the acquisition of manufactured dairy products for export.

The Commission's preliminary view is that Newco would be dominant in all of these markets except that for consumer spreads (where butter faces competition from margarine and blended spreads).

Dominance would arise because Newco would control virtually all of the milk produced by farmers; it would be the only major supplier of domestic dairy products; it would be the only acquirer of dairy products for export; and it would little potential competition from new entrants because of the high barriers to entry into all of those markets.

The Commission has discounted the competition in the domestic market for dairy products from the divested Dairy Foods company - Dairy Foods, a subsidiary of the New Zealand Dairy Group - because that company would be totally reliant upon Newco for supplies of unprocessed milk and dairy products such as butter, cheese and milk powder. Also, under the Commerce Act the Commission can only accept undertakings to divest assets or shares, and not behavioural undertakings - in this case, the proposed supply contracts for those products.

The counterfactuals - what would happen if the authorisation is declined

Because of the uncertainty as to what would happen in the event that the proposed merger were not to be authorised (or was not ultimately accepted by the dairy industry at large), the Commission has used two counterfactuals to assess the impact of the proposal on the various markets. These are firstly, a continuation of the status quo with no deregulation but ongoing efforts within the industry at structural change (the "status quo counterfactual"); and secondly, the deregulation of the single seller export desk by the Government with ongoing efforts within the industry at structural change (the "deregulation counterfactual").

However, the former is considered to be the most likely outcome at this stage.

Detriments

The sizes of the detriments which might arise in the markets where Newco would acquire dominance, and competition would therefore be severely weakened, were assessed using standard economic efficiency tests. The Commission concluded that detriments would fall into three categories:

• allocative inefficiency (inefficiency arising from the misallocation of resources between markets);
• productive inefficiency (inefficiency arising from the wasteful use of resources in production); and
• dynamic inefficiency (inefficiency arising from a sluggishness in innovation by the industry, in terms of devising and adopting new products and new technologies).

The Commission has reached the preliminary view, based on the limited information currently before it, that the potential detriments from these three forms of inefficiency would each be likely to be moderate to large, although their actual magnitudes are uncertain. These preliminary calculations are summarised in the table below.

Summary of Preliminary Estimates of Annual Detriments ($M)

Overall, the table suggests that the detriments would be likely to fall in the range between about $138 million and about $461 million against the status quo counterfactual, and between about $163 million and about $527 million against the deregulation counterfactual.

Benefits

As part of the proposal, the Applicant has identified four groups of public benefits which it claims would flow from the proposed merger. These are summarised under the following headings:

• Promotion of industry change
• cessation of pay-out bundling
• integration of marketing and processing stages
• Promotion of processing and structural efficiencies
• reduction of duplication in ancillary activities
• plant production flexibility and rationalisation
• deferral of capital expenditure
• Preservation of single seller marketing
• Industry development
• best practice transfers across dairy co-operatives
• funding of "industry good" research

In addition, one further item - "overseas competitive advantages" - has been added by the Commission under the "Industry development" category on the basis of its understanding of the motivation for the proposal, and of information provided by the Dairy Board.

The Commission could not accept on a preliminary basis many of the claimed benefits, on several grounds: it was not convinced that they would not be gained in the absence of the proposed merger; insufficient information was provided to substantiate the argument; and some were likely to be pecuniary economies (or wealth transfers) to Newco and therefore not public benefits.

As a result of the review of the information currently available, the Commission has reached the preliminary view that the benefits from the proposed merger are as shown in the "accepted" columns for the two counterfactuals in the table below. These show that the accepted benefit is likely to fall between $26 million and $56 million when assessed against the status quo counterfactual, and between $46.5 million and $91.5 million when assessed against the deregulation counterfactual. These can be compared with the corresponding "claimed" benefits, which are also shown.

Summary of the Preliminary Estimates of Public Benefits per Year ($M)

Notes: ^*Annuity equivalent over a six-year period.

N/Q = benefit not quantified.

Balancing of detriments and benefits

A summary of the Commission's preliminary views, based on currently available information, on the ranges within which the detriments are likely to fall, and the benefits which can be accepted, under each of the counterfactuals, is shown in the table below. As can be seen, the accepted benefits fall well short of the lower end of the detriment range for both counterfactuals. The Commission notes that even if the Applicant's benefit claims were to be accepted in full, they would still fall only towards the lower end of the detriment range provisionally established.

Summary of Preliminary Estimates of Detriments and Benefits

List of 48 questions where the Commission seeks further information or clarification

Question 1:

The Commission seeks comment on any omissions, or any material inaccuracies in the preceding sections of the Draft Determination.

Question 2:

The Commission seeks comment on the appropriateness of the markets as defined.

Question 3:

The Commission seeks comment on whether any additional markets require consideration.

Question 4:

The Commission seeks comment on the degree of overlap that currently exists between competing dairy co-operatives.

Question 5:

The Commission seeks comment on the degree of switching, to existing or new dairy co-operatives or companies, that might occur if the industry was deregulated.

Question 6:

The Commission seeks comment on the degree of overlap that would be needed to affect a dairy co-operative's performance, should significant switching occur.

Question 7:

The Commission seeks comment on the impact of transport costs on the potential for suppliers to switch dairy co-operatives, both currently and in a future deregulated market.

Question 8:

The Commission seeks comment on the factors that might affect a dairy company's ability or willingness to accept new supply.

Question 9:

The Commission seeks comment on how the factors referred to in Question 8 might change following industry deregulation.

Question 10:

The Commission seeks comment on how the fair value of dairy co-operative shares is likely to be established, and how this relates to current nominal value shareholding.

Question 11:

The Commission seeks comment on how the fair value of Dairy Board shares is likely to be established.

Question 12:

The Commission seeks comment on the suggested share trading mechanism and redemption system currently being contemplated for NewCo, and the impact of the proposed system on the potential for fair value to be realised on entry and exit.

Question 13:

The Commission seeks comment on the likely impact of deregulation on the ability of companies to target the most attractive suppliers and supply areas.

Question 14:

The Commission seeks comment on any additional factors it should be aware of when considering the current potential for switching between dairy co-operatives.

Question 15:

The Commission seeks comment on any additional factors that could impact on the potential for switching between dairy co-operatives following deregulation of the industry.

Question 16:

The Commission seeks comment on the impact of benchmarking between co-operatives on the management and efficiency of dairy co-operatives, and on the extent and nature of competition between.

Question 17:

The Commission seeks comment on the extent to which the threat of takeover currently imposes management discipline on dairy co-operatives.

Question 18:

The Commission seeks comment on the extent to which the continuation of bundled milk pay-outs might impair competitive entry into the New Zealand dairy industry.

Question 19:

The Commission seeks comment on the extent to which ownership of quota rents remaining within NewCo for at least six years might impair competitive entry into the New Zealand dairy industry.

Question 20:

The Commission seeks comment on the extent to which failure to implement fair value entry and exit from NewCo might impair competitive entry into the New Zealand dairy industry.

Question 21:

The Commission seeks comment on the type of fair value entry and exit conditions that would need to be implemented to facilitate contestability in the markets for the acquisition/supply of unprocessed milk.

Question 22:

The Commission seeks comment on the likelihood, timing, nature and scale of potential entry under the proposed regulatory environment.

Question 23:

The Commission seeks comment on the degree of constraint imposed on NewCo by the co-operative structure of the industry.

Question 24:

The Commission seeks comment on the impact of the proposed changes to NewCo's co-operative structure, when compared to traditional dairy co-operatives, on the degree of constraint imposed on NewCo.

Question 25:

The Commission seeks comment on the degree of constraint imposed on NewCo by the potential for substitute uses of dairy farm land.

Question 26:

The Commission seeks comment on the likely status of existing equity relationships of town milk companies and their suppliers should the proposed merger proceed.

Question 27:

The Commission seeks comment on the likely impact of the proposed merger on future entry into the town milk markets.

Question 28:

The Commission seeks comment on the likely impact of the proposed merger on trade in fresh dairy inputs.

Question 29:

The Commission seeks comment on the viability of existing or potential town milk operations to find alternate methods of disposing of flush milk supplies following the proposed merger.

Question 30:

The Commission seeks comment on the potential for new entry on a significant scale to either or both of the North and South Island town milk markets.

Question 31:

The Commission seeks comment on the extent to which the development of UHT and other extended shelf life milk technologies have the potential to change the nature of competition within the town milk markets.

Question 32:

The Commission seeks comment on the extent to which the countervailing power of retailers will be able to constrain NewCo.

Question 33:

The Commission seeks comment on the extent to which major retail chains might be able to facilitate new entry into the town milk markets.

Question 34:

The Commission seeks comment on the potential for entry into the market for the production of bulk cheese.

Question 35:

The Commission seeks comment on the viability and practicality of importing of bulk cheese in New Zealand.

Question 36:

The Commission seeks comment on the ability of current or potential competition to constrain NewCo in the market for cultured foods in New Zealand.

Question 37:

The Commission seeks comment on the viability and practicality of importing dairy ingredients into New Zealand.

Question 38:

The Commission seeks comment on the suitability and availability of non-dairy substitute products that might compete in the New Zealand dairy ingredients market.

Question 39:

The Commission seeks comment as to whether there are any legal impediments to the Dairy Board accessing overseas milk, and the extent to which that may impede its ability to form joint ventures.

Question 40:

The Commission seeks comment as to the likely counterfactual should the proposed merger not proceed, and the various features of that counterfactual.

Question 41:

The Commission seeks comment on the potential for losses of allocative efficiency to arise from the proposed merger in the relevant markets. Comments on any of the points raised above, and any other relevant points, are sought.

Question 42:

The Commission seeks comment on the potential for NewCo, in a dominant position in several domestic markets, to suffer from an erosion of productive efficiency over time; the cost areas which would be susceptible to inefficiency; and the likely sizes of the inflated costs against the two counterfactuals.

Question 43:

The Commission seeks comment on the recent dynamic efficiency of the New Zealand dairy industry, including its research intensity, and the extent to which its dynamic efficiency might be impaired by NewCo gaining a dominant position in the various markets indicated.

Question 44:

The Commission seeks comment on the extent of dynamic efficiency by the dairy industry, and the extent to which that innovation might be eroded by dominance in the various domestic markets, relative to the counterfactuals.

Question 45:

The Commission seeks comment on the extent to which the proposal would promote changes in the dairy industry as compared to the counterfactuals, in terms of the cessation of pay-out bundling and of the integration of marketing and processing stages, and the quantification of the resulting public benefits.

Question 46:

The Commission seeks comment on the extent to which the proposal may promote processing and structural efficiencies in the dairy industry, and the generation of public benefits, relative to the likely counterfactuals. The efficiencies potentially include a reduction of duplication in ancillary activities; enhancement of plant production flexibility and rationalisation; and deferral of capital expenditure.

Question 47:

The Commission seeks comment on the public benefits to be gained from the preservation of single seller marketing of dairy products overseas, relative to the likely counterfactuals.

Question 48:

The Commission seeks comment on the potential industry development benefits that might be brought by the proposal, relative to the counterfactuals, and their possible quantification. These benefits might include best practice transfers across dairy co-operatives; the funding of industry good research; and overseas competitive advantages.