Andrea Fox: Is there any use crying over auctioned milk?

As ministerial media statements go, it was about as bland as cauliflower, but there were interesting messages behind last week's "Milk auction for 2010/11 deferred" notice from Agriculture Minister David Carter.

On the face of it, Carter was simply advising that he was deferring the introduction this year of an annual auction for regulated milk - up to 600 million litres of raw milk that Fonterra is required by law to make available to its competitors each year as the trade-off for being a near-monopoly.

MAF had run out of time this year to bring in necessary legislative change for the auction, he said.

By all accounts that appears to be true, but the deferral shows the difficulty MAF is having fashioning a strong leash for Fonterra for when sunset clauses in the regulations trip - probably before 2013.

Any delay in resolving the vexed and industry-distracting issue of regulated milk has implications for the much more important national issue of Fonterra's capital structure reform.

Why a national issue? Because Fonterra is New Zealand's biggest company, responsible for 27 per cent of the country's export earnings, an economic experiment that eight years after its Government-blessed creation cannot be allowed to stumble. Created from a huge industry merger, Fonterra is a farmer-owned co-operative. It is the engine of the $10 billion a year dairy export industry, and it needs growth capital which its 10,000-odd farmers cannot provide indefinitely. It also needs a new structure to address the ever-present risk of its farmers cashing up their shares and hot-footing it to the emerging, non-share requiring, competition, thereby weakening its balance sheet.

The industry signed up to this arrangement with its eyes wide open in 2001 in the last light-handed industry legislation this country can remember, but the structure doesn't serve them, or New Zealand Inc, well for the future.

Fonterra leaders had a bash at capital structure reform last year, which involved listing some shares, but were shouted down by shareholders appalled at the prospect of losing control of their co-operative.

A second plan is likely to be unveiled later this year, and is bound to include some sort of externally sourced capital injection proposal.

But how can Fonterra leaders have a sensible discussion with shareholders about reform with the controversial regulated milk issue unresolved? And how can Fonterra put a price on its shares for potential outside investors when its regulatory landscape is uncertain?

Carter's ministry is trying to solve three problems identified last year after a major review of the dairy industry restructuring raw milk regulations. An annual auction in which independent processors would bid for forward supply of regulated milk from Fonterra seemed a neat answer to them all. Trouble was, the Business Herald understands, it had no fans in the industry and Fonterra's biggest regulated milk customer, domestic market food giant Goodman Fielder, buys its milk straight from Fonterra under contract anyway. Why would it bother with an auction?

But back to MAF's three problems.

The review, in which the Commerce Commission took a vigorous part having been denied the chance to do its job back in 2001, found Fonterra's irate contention that it is being forced to subsidise its competitors - selling them milk at a lower price than it pays its own farmers - was to some extent, justified. The review found the current pricing formula was "under-pricing" regulated milk. (Fonterra has made a meal of the regulated milk issue over the years, telling the review that "subsidisation" cost its farmers around $29 million a year, hence the difficulty directors will have progressing a capital restructure discussion with shareholders until the regulated milk issue is resolved to the Government's satisfaction.)

Second, the review found the regulations did not manage situations where independent processors, in this case start-ups, needed a heap of milk in one year. (The recession has resolved that problem for now.)

And third, there is an "unmanaged transition risk" associated with the ending of the statutory obligation on Fonterra to supply regulated milk.

As things stand, Fonterra's governing legislation, the Dairy Industry Restructuring Act 2001 (DIRA) says when Fonterra's control of raw milk control hits 87.5 per cent in the North Island, it no longer has to provide diddly to anyone. That can't be too far off.

Judging by Fonterra's ungracious attitude to having to sell up to 600 million litres of milk to competitors out of its 13 billion litre total collection, there is cause for concern about future access to milk supply.

Fonterra has always been emphatic the concern is unwarranted. "We totally understand, given our size, the importance of having arrangements that ensure there is fairness in the domestic market. We just don't think it's fair that we have to supply milk to people who have their own supply base (farmers) or who are taking the milk and competing with us in our overseas markets - usually with ownership by foreign companies," said senior executive Barry Harris.

But the Commerce Commission isn't comfortable. It wasn't in favour of an auction, or changing the current regulated milk pricing formula, and wants even more regulated milk made available to new entrants while a secondary milk supply market builds.

Nor does Carter sound comfortable.

"I am determined to ensure that the independent processors can get access to the milk they need, but that Fonterra farmers get a fair return on the product they provide," he said.

The auction seems a neat solution. Not only would it defeat Fonterra's argument about unfair pricing, but it would serve as a bridge over an otherwise difficult and clunky transition from a redundant DIRA to the Commerce Act if the Government is given cause for concern about dairy market concentration or pricing issues.