Dialogue: Why the mega merger is good for New Zealand

In the second article of a series on the dairy industry, ALEX SUNDAKOV* argues that GlobalCo will ultimately boost domestic competition.

Since the release of the Government's decision on Monday, the debate about the creation of Global Dairy Co (the new company's working title) has focused on its effects on competition in New Zealand's domestic diary product markets.

Unhelpfully, the release of the decision coincided with an unrelated increase in the price of milk, suggesting a link that is not there. In addition, the media appear to be in thrall to the fact that Global Dairy will account for about 96 per cent of New Zealand milk, forgetting that only a very small proportion of our milk production is consumed domestically.

Over time, the package of reforms which goes alongside the creation of Global Co will, in all likelihood, enhance competition. The removal of the Dairy Board's export monopoly will most likely add to the competitive choice available to supermarkets and other purchasers of dairy products for domestic consumption.

It is true that many of the prices of dairy products in domestic markets will remain linked to international returns. This is inevitable when nearly 95 per cent of production is sold internationally. High international returns for New Zealand dairy products will drive up domestic prices. Dairy producers will not sell cheaply into the domestic market if they can earn more by exporting.

That situation occurs now.

At present, we essentially have two major suppliers of consumer dairy products in New Zealand, supplemented by a range of smaller and niche producers and importers. Once Global is created and the regulatory package implemented, we will have almost exactly the same situation, except that the growth prospects of smaller players will not be limited by export restrictions, and it is likely that a range of new participants will enter the market.

In a small economy such as ours - where a high degree of market concentration is a by-product of the need to achieve economies of scale - the key to ensuring that consumers are not exploited is to remove barriers to new competition. This is recognised in the Commerce Act. It is also recognised in the Government's decision to support and facilitate the dairy industry's restructuring proposal.

The industry will be deregulated and opened up to the full range of competitive entry. This, of itself, should benefit consumers in the medium term. But, additionally, the proposal that the Government has agreed to with industry players preserves domestic competition in the short run by incorporating the sale of what would otherwise be Global's 50 per cent interest in Dairy Foods.

Dairy Foods markets a range of milk, cheese, butter and other dairy products under the Anchor, Fernleaf, NZ Fresh, Fresh 'n' Fruity, Primo, Swiss Maid, Cloverlea, Country Goodness and Royal Tasman brands. All of these are valuable, established brands familiar to New Zealand consumers. Depending on the particular products involved, an independently owned and controlled Dairy Foods will have a 30 per cent or more market share. In some cases, such as with butter, Dairy Foods will have a bigger share of the domestic market than Global.

Even in the context of its preliminary decision declining to approve a previous merger proposal, the Commerce Commission concluded that the previous merger would not cause market dominance in the cheese or spreads markets.

In relation to town milk, the competitive constraint from new entrants and niche operators is even stronger. The size of the investment required to produce milk for domestic consumption is modest compared to other parts of the dairy industry. Already, before the Global merger was approved, we have seen an alliance between the Foodstuffs supermarket organisation and a new milk processor. Supermarket house brands already account for 17 or 18 per cent of supermarket sales.

Clearly, one of the key issues is the ability of New Zealand Dairy Foods to be an active competitor in the domestic market, given that initially it will depend on Global Co for its raw material inputs. This is precisely the issue addressed by various elements of the regulatory package that goes with the creation of Global Co.

In particular, the package enhances the ability of Dairy Foods to obtain an independent supply base should Global try to charge uncompetitive prices for its raw milk. The package facilitates the exit of farmers from Global Co through fair value exit rules and by requiring that, in any year, 33 per cent of all supply contracts in a given area can be cancelled without a penalty.

In addition, the regulatory package ensures that even Global's shareholder suppliers can allocate up to 20 per cent of their production to a competitor. A second tier of protection is put in place by creating regulatory powers, which can be used if necessary to prevent Global from unfairly discriminating among suppliers and require it to supply milk to competitors in the domestic market at fair market prices.

But in any event, current market shares do not tell the full story. There are few incentives for new participants at present. They are obliged to export through the Dairy Board or operate in small niches. The single desk exporting arrangements limit the profits that are available to new market entrants. With the creation of Global, these restrictions are terminated in 12 months. At that time, new companies, and major international dairy manufacturers, are free to enter New Zealand.

New Zealand's domestic markets for dairy products are not perfectly competitive today, and they will not be after the creation of Global Co. One will always be able to identify areas of concern and complaint. The key challenge for policymakers is to come up with a package which enhances New Zealand's position in the overseas markets by making Global a stronger force, but protects New Zealand consumers by preventing Global from exercising that full force domestically.

This is a difficult balance to achieve. But when we consider the full package - the merger together with the new regulatory regime - it appears to do just that.

Inevitably, effects of a merger or a regulatory change are to some extent uncertain. In the case of the dairy industry, the combination of the merger and the proposed regulatory reforms provides a high degree of confidence that domestic consumers will be at least as well off as at present, and some likelihood that they will enjoy additional competition.

* Alex Sundakov is the Director of the New Zealand Institute of Economic Research.

Herald Online feature: Dialogue on business

Herald Online feature: Dairy Merger