Peter Fraser: Fonterra's milk-buying regime cops unfair flak

Fonterra collected approximately 96 per cent of New Zealand's milk supply - and farmers only had two regional processors as alternatives. Photo / NZME

Criticism from farmers about the cost of supply rules ignores built-in protection.

Peter Fraser is a Wellington-based economist who specialises in agricultural issues with particular reference to the dairy industry.

Should Fonterra be legally obliged to remain an 'open' co-operative and accept all milk supplied?

This has remained a vexed issue since Fonterra was formed by special legislation in 2001.

Indeed, Herald columnist Fran O'Sullivan noted on March 21 that "the Government should facilitate major changes to the regulatory environment which requires [Fonterra] to accept supply from all farmers. It just doesn't make sense commercially".

A similar argument is often made in farmer circles where it is claimed Fonterra must take milk from all and sundry so is forced to spend hundreds of millions of dollars on building additional processing capacity - thereby increasing debt and hindering it from investing in 'higher value' products.

At best, this argument is a half-truth; at worst, it is just plain wrong.

Sure, under the Dairy Industry Restructuring Act (DIRA) Fonterra is obliged to take all milk supplied by farmers, but the same act also gives Fonterra the ability to make farmers buy shares to 'back' the extra supply.

This is critical as it means new milk is, in essence, self-funding. It's also how co-operatives have funded supply growth since time immemorial.

To put it another way, share purchases are akin to development contributions levied on new home owners to fund drains and roads in a new subdivision. So if an increasing milk supply was not self-funding then that is an issue for Fonterra rather than the Government.

There is a further nuance associated with farmer choice and constructing a credible competition policy - which is hardly a trivial issue given the dairy industry sought, and was granted, an exemption to the Commerce Act.

At formation, Fonterra collected approximately 96 per cent of New Zealand's milk supply - and farmers only had two regional processors (namely Westland and Tatua) as alternatives.

Fonterra was therefore a monopsony (which is a single buyer), meaning most farmers were locked into Fonterra.

To protect farmers, the Government of the day therefore established a competition policy based on farmer switching, known as the open entry and exit regime.

In practice, this means farmers can leave Fonterra (open exit), but can also return again should they wish (open entry).

This last point is critical, because farmers are unlikely to leave in the first place if it means burning their bridges - thereby nullifying the entire notion of farmer switching.

So the irony is that a regime designed to give farmers choice is often unfairly criticised by farmers for largely specious reasons.

The issue of coercion also needs to be considered because it defies belief to claim Fonterra has been forced to take unwanted milk when a key component to Fonterra's much vaunted V3 (Volume, Value, and Velocity) strategy remains volume growth.

Also, the standard response from Fonterra in the face of competition from independent processors is to vigorously defend its share of the New Zealand milk supply and fight to retain its supplier base.

A final point to note is that farmer switching was always assumed to occur in a world of an increasing milk supply - meaning milk for all.

However, in a world of a static or even declining domestic milk supply, it means processors now face a win/lose outcome as milk supplied to an independent means less milk for Fonterra (and vice versa).

In this situation, Fonterra's shiny new plants risk resembling the meat industry, where there is excess capacity for the supply that never came, implying Fonterra may well end up swapping a redemption risk for a stranded asset risk.