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The Effectiveness of DIRA in Fostering Competition and Economic

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The Effectiveness of DIRA in Fostering Competition and Economic PUBLIC VERSION The Effectiveness of DIRA in Fostering Competi tion and Economic Efficiency in New Zealand Dairy Markets Robert D. Willig Meg Guerin -Calvert Andres V. Lerner Compass Lexecon 20 July 2011 PUBLIC VERSION TABLE OF CONTENTS I. Introduction and Executive Summary ................................ ................................ ............. 1 A. Introduction ................................ ................................ ................................ .................. 1 B. Executive summary ................................ ................................ ................................ ...... 2 II. Economic Objectives of the Dairy Industry Restructuring Act (DIRA) ....................... 6 A. Competitive concerns addressed by DIRA ................................ ................................ 6 B. Principa l components of DIRA ................................ ................................ ................... 6 1. Provisions that facilitate switching between Fonterra and rival processors ............ 7 2. Raw Milk Regulation ................................ ................................ ............................... 8 III. The Farm Gate Milk Price ................................ ................................ ................................ 8 A. Fonterra’s incentive s to set a competitive farm gate milk price .............................. 9 1. Fonterra’s incentive to set a farm gate milk price that is “too low” ........................ 9 2. Fonterra’s incentives to foreclose rival processors by setting a farm gate milk price that is “too high” ................................ ................................ ........................... 11 B. The farm gate milk price that would arise in a competitive market ..................... 16 1. Economic framework for assessing the farm gate milk price that would arise in a competitive market ................................ ................................ .......................... 16 2. In principle, the Milk Price Model methodology replicates the farm gate milk price that would arise in a competitive market ................................ ...................... 17 IV. The Price of DIRA Milk to Independent Processors ................................ .................... 21 A. Fonterra’s incentives and ability to raise the DIRA milk price ............................. 21 1. Constraints on Fonterra’s incentive to increase the farm gate milk price in order to increase the price of DIRA milk to independent processors .................... 21 2. The empirical evidence indicates that the price of DIRA milk to independent processors is low relative to the farm gate milk price ................................ ........... 22 B. The efficient component pricing rule (ECPR) ................................ ......................... 25 1. The ECPR framework ................................ ................................ ............................ 25 2. The principles on which the Milk Price Model is based are consistent with ECPR ................................ ................................ ................................ ...................... 26 V. DIRA Has Been Successful in Fostering Competition in New Zealand Dairy Markets ................................ ................................ ................................ ............................. 31 A. Processing market ................................ ................................ ................................ ...... 31 1. Dairy processing capacity ................................ ................................ ...................... 31 i PUBLIC VERSION a) Independent processors have entered and expanded processing capacity ....... 31 b) Fonterra also continues to expand processing capacity ................................ ... 34 2. Independent processors have been able to compete for supply of raw milk directly from farmers ................................ ................................ ............................. 34 a) The DIRA regulations hav e created contestability in raw milk purchases ...... 34 b) Large processors that export milk powder into global markets have sourced in creasing quantities of raw milk directly from farmers .................... 36 c) Independent processors have been able to compete for dairy farmers by matching or beating Fonterra’s farm gate milk price (and/or total payout to farmers) ................................ ................................ ................................ ............ 41 3. Profitability of independent processors ................................ ................................ .42 4. Smaller processors that supply domestic markets have not been constrained by the DIRA supply. ................................ ................................ ................................ ... 47 B. Domest ic dairy retail markets ................................ ................................ ................... 48 1. Domestic dairy prices have been driven primarily by the global market for dairy products ................................ ................................ ................................ ......... 48 2. Domestic dairy prices have increased less than the global prices for dairy product. ................................ ................................ ................................ .................. 50 C. Dairy exports ................................ ................................ ................................ .............. 51 D. Dairy farming industry ................................ ................................ .............................. 55 ii PUBLIC VERSION I. Introduction and Executive Summary A. Introduction We have been asked to conduct an economic evaluati on of whether the Dairy Industry Restructuring Act (DIRA) of 2001 has been successful in providing for competition and economic efficiency in New Zealand dairy markets. 1 In this report, we address a number of questions related to this topic, including: 1. Do es Fonterra have appropriate incentives to set a farm gate milk price tha t is consistent with competitive markets ? 2. Does Fonterra’s methodology for setting the farm gate milk price yield a milk price that is consistent with competition? 3. Is the framework f or setting the price of the raw milk supplied by Fonterra to rival independent processors under DIRA consistent with economic efficiency? 4. Is the empirical evidence consistent with DIRA achieving its intended goal of promoting competition in the dairy proce ssing market? 5. What does the economic evidence show with regard to competitive constraints posed by independent processors via entry, capacity expansion, and their ability to compete for raw milk supply from farmers? 6. Are increases in domestic dairy prices in recent years the result of Fonterra’s methodology for setting the farm gate milk price? Our analysis and conclusions are preliminary, and are based on the information we have received to date and our current understanding of the facts, regulation, and competitive dynamics. In addition, there are several issues that we do not address in detail in this draft report, including (1) a detailed analysis of broader issues of competition in downstream domestic dairy markets; (2) the specific details and implem entation of Fonterra’s Milk Price Model; (3) the Trading Amongst Farmers (“TAF”) program, and its implications for efficiency and competition in the dairy processing market; and (4) the competitive implications (if any) of eliminating all or part of the DI RA regulations. 1 We would like to thank Jonathan Bowater, Emmett Dacey, and Janin Wimer for providing excellent research assistance. 1 PUBLIC VERSION B. Executive s ummary We provide an economic evaluation of whether the Dairy Industry Restructuring Act (DIRA) of 2001 has been effective in ensuring competitive and economically efficient dairy markets in New Zealand. A p rimary goal of DIR A is to foster a competitive environment in which Fonterra faces effective competitive constraints both in the purchase of raw milk from dairy farmers and in markets for dairy outputs. Concern s regarding the efficacy o f DIRA in achieving its goals have b een reflected in a recent submission by the New Zealand Ministry of Agriculture and Forestry (“MAF”). The submission articulated concerns by competitors that Fonterra has set the price it pays farmers for raw milk (the “farm gate milk price”) at a level t hat is inconsistent with competition and economic efficiency in dairy markets . The theory underlying the se concerns (to the extent that it can be ascertained from the material provided ) is that Fonterra, as the dominant buyer of raw milk and the dominant dairy processor, may have inhibited competition from rival processors by setting the farm gate milk price higher than the competitive level, thereby raising the costs of these rival processors. The views summarized in the MAF submission seem to suggest a theory that Fonterra’s cooperative structure, i n contrast to an investor -owned business , diminishes the constraints on Fonterra’s incentives and ability to set a farm gate milk price higher than the competitive level . The theory seems to be that because the cost to Fonterra of increasing the farm gate milk price is largely offset by a decrease in dividends paid to the same farmers, Fonterra effectively faces a lower cost of raising rivals’ costs than would an investor -owned business . We find such a theor y is misguided for a number of reasons. The total payout that farmers
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