In a decision issued yesterday, the Supreme Court has affirmed the Commerce Commission's view on the way that Fonterra should calculate the default milk price.

The default milk price is the price at which independent dairy processors can require Fonterra to supply raw milk.

The Supreme Court affirmed the Commission's view that Fonterra should use a cost of equity capital when it calculates the "discount rate", an input into the default milk price. Fonterra have been using a weighted average cost of capital (WACC) rate.

The decision will require Fonterra to charge independent processors a price for raw milk which more accurately reflects the price Fonterra pays its own shareholding farmers for their raw milk. This will enable independent processors to compete with Fonterra on a level playing field.

"By allowing competitors to operate on a level playing field, this decision will contribute to competitive dairy markets, and potentially to lower prices for consumers of dairy products," says Commerce Commission General Manager Geoff Thorn.

"A competitive and innovative independent processing industry is also in the long term interests of dairy farmers as it will, over time, encourage competition with Fonterra, and so place pressure on Fonterra to operate more efficiently."

Mr Thorn said the Commission would be talking to Fonterra about the implications of this decision for the default price of raw milk that it has previously charged independent processors.

"These provisions are plainly directed towards creating a level playing field for all processors in relation to their raw milk costs. They form an important part of the legislative context in which the Raw Milk Regulations were made and against which the crucial provisions in those regulations must be interpreted."

Background

The default price of raw milk is the price pursuant to the Raw Milk Regulations at which independent processors can request raw milk from Fonterra.

The default price of raw milk is calculated under the Raw Milk regulations by "unbundling" the payout to shareholding farmers. The payout comprises both the value of raw milk supplied and the shareholding farmers return on equity in Fonterra. By subtracting the annualised share value (which represents the return on equity capital) from the payout, the Raw Milk Regulations determine the amount of the payout which represents the value of the raw milk supplied by the shareholding farmer, therefore "unbundling" these two aspects.

It is the unbundling of the payout that ensures that independent processors are able to purchase raw milk from Fonterra at the same price that Fonterra purchases that raw milk from shareholding farmers.

Under regulation 9(1) of the Raw Milk Regulations the discount rate used in calculating the annualised share value must be the same as the 'cost of capital rate' used in calculating the price of a co-operative share. The dispute between Fonterra and the Commission concerned the meaning of 'cost of capital' in regulation 9(1).

The Commerce Commission appealed to the Supreme Court after the Court of Appeal ruled on 4 May 2006 that reading "cost of capital" as "cost of equity capital" would be straining the words of the Regulations.

Before the Supreme Court the Commission argued that a weighted average cost of capital ("WACC") rate, which Fonterra used to calculate the discount is not a "cost of capital rate" within the meaning of regulation 9 of the Raw Milk Regulations. The only cost of capital rate that makes sense in the context of regulation 9, which is all about fixing a discount rate in order to calculate Fonterra's annualised share value (i.e. its annualised cost of equity), is a cost of equity capital rate.

The Commission further argued that Fonterra did in fact use a cost of equity capital rate as an input into calculating a weighted average cost of capital, which in turn was used to calculate the enterprise value and then the price of a co-operative share. The Commission says this is the "cost of capital rate" which is referred to in regulation 9 and should be used as the discount rate to calculate the annualised share value.

Fonterra contended that the plain meaning of regulation 9(1) requires the use of the WACC rate as the discount rate, because the WACC rate was in fact used by Fonterra in its share valuation.

The Supreme Court has decided that the proper interpretation of regulation 9(1) cannot rest solely on the use by Fonterra of the WACC rate as Fonterra had used three different cost of capital rates in determining its share value. The Court considered that the phrase "cost of capital rate" must have a particular and fixed meaning and noted that it would make no sense to calculate annualised share value using a rate that pertains to anything other than equity capital, as farmers only provide equity capital.

This proceeding is one of two relating to the price of raw milk. In the other proceeding, which concerned the effect of retentions on the raw milk price, the Court of Appeal upheld the Commission's interpretation of the regulations, and there was no appeal to the Supreme Court by Fonterra.