Dialogue: Milking the system for fair shares

By LEWIS EVANS and GRAEME GUTHRIE*

Lumping together the payment to farmers for milk production and the return from processing the milk - known as bundling - has a controversial history in the co-operative dairy industry.

However, the gradual introduction of fair value share pricing in the 1990s, combined with Fonterra's valuation processes, has separated payments for off-farm processing from those for milk supply in a way that should significantly improve the economic performance of the dairy industry.

Bundling was a problem when shares in a co-operative were fixed at a nominal value. The arbitrarily low price of shares meant that when a supplier entered the co-operative the shareholding was bought cheaply, and if a supplier left the co-operative the shares were sold cheaply.

Suppliers had no right to the full value the shares represented.

The value of the full dairy processing business less the nominal shares is the value of unowned capital. Farmers referred to this as socialised capital because, when starting as suppliers, they had the benefit of the processing capital without having to pay for its full value.

The problem with bundling is that it can lead to excessive dairy production.

This is because it is not obvious how much of the payment is a return from on-farm production of raw milk and how much is a return on farmers' investment in off-farm processing, marketing and distribution facilities.

The return on these assets will include returns on commodity production and any other potentially value-added activity.

When the bundled returns are distributed to suppliers, the payment per kilo of milk solids will exceed the wholesale price of milk, which induces suppliers to produce more than they would if they received only the commodity price. This is economically inefficient because the return the country (and the co-operative) gets from this milk is the commodity price.

This method of payment encourages resources being applied to dairying in excess of the returns generated. The profit of the industry as a whole - on-farm plus off-farm profit - is lowered.

The economic cost of this method of bundling is significant. But the extent of the inefficiency was limited in the past, because co-operatives restricted suppliers and the expansion of the milk supply. Fonterra, however, must enable ready exit and entry of suppliers while its share of the wholesale market is above a specified threshold of market share.

The effect on input values in the dairy industry has also been estimated to be large. Some argue that excess returns on milk will be discounted into the value of land in any farm purchase and the unimproved value of dairy farmland therefore will be too high.

We consider too much emphasis has been placed on this because the effect is tied to milk and not to any particular input into its production. It is also necessary to consider the relative scarcity of land, labour and management.

It may be that the practice has meant a higher return to dairy-farmer management and labour, including sharemilkers, and that this has improved performance.

In any event the situation is entirely changed by the fair value share pricing system used by Fonterra. Fair value pricing entails:

* Estimation of the commodity (wholesale) price of milk by a valuer appointed by Fonterra's Shareholders Council. If New Zealand had a domestic wholesale market the price of milk in that market would almost certainly be used. Instead, the valuer takes a combination of the major commodity dairy products, prices them at levels received in freely contested international markets, and subtracts the cost of production.

* Calculating the value of shares as the discounted value of Fonterra's net revenue from all sources after deducting the cost of milk at the valuer's commodity price.

* Calculating the dividends as the actual net revenue in the relevant period, less retained earnings.

* Paying suppliers the commodity milk price for their milk and the dividend on their shareholding.

Implementing this approach entails important issues of detail, but the outcome can be expected to approximate the separation of on-farm and off-farm activity.

The upshot of fair value pricing is that all current and expected net returns of Fonterra will be encapsulated in the share price.

The full value of these shares is owned by suppliers. If they leave, they are due to be paid the full value of their shares. Suppliers who enter or expand production must buy shares at their full valuation. In this way unowned capital will be eliminated.

Fair value pricing also affects potential and existing suppliers' incentives to produce milk.

In any year a supplier is paid the commodity milk price for a kilo of milk, plus a dividend which, because shares are held on the basis of milk supplied, will also be paid out per kilo.

In considering how much extra milk to supply, a farmer will balance the benefits of the commodity price plus the dividend plus any change in share value against on-farm production costs and the cost of holding shares in Fonterra.

Under fair value pricing, the farmer should base the decision of how much to produce on a comparison of the commodity milk price and on-farm production costs, which is what economic efficiency requires. It is notable this is achieved without de-linking share ownership and milk supply.

The shift to fair value pricing affects industry input values in ways that are virtually impossible to measure, but the profitability of the industry as a whole will improve. Much of that improvement can be expected to lie within Fonterra as a business.

* Lewis Evans is Professor of Economics and executive director of the Institute for the Study of Competition and Regulation. Dr Graeme Guthrie is with the School of Economics and Finance, Victoria University of Wellington, and is research principal with the ISCR.