Rod Oram: Dairy review risks missing big picture

It’s far from clear that the Government’s dairy industry review announced this week will really get to grips with the sector’s opportunities and challenges, let alone recommend legislative and policy change that will help it with its next great phase of development.

Agriculture Minister Damien O’Connor seemed to have a big picture in mind when he launched the review:

“The review will allow us to take a strategic view of issues facing the dairy industry. In particular it will look at open entry and exit for farmers, the raw milk price setting process, contestability for milk, the risks and costs for the sector, and the incentives or disincentives for dairy to move to sustainable, higher-value production and processing. The whole dairy sector needs to look ahead to see what trends and potential disruptions are coming our way and get ahead of consumer trends.”

However, the last sentence is the most important. The urgent need for much more food, much healthier food and much better environmental outcomes from farming are driving radical changes in technologies and practices worldwide. Farming and food globally will change more in the next few decades than they have in the past few generations, as I described in this column last September and this column last December.

But instead of focusing on this rapidly shifting demand side of the equation, the Minister’s list of priorities led with factors affecting production. These factors are right at the heart of the Dairy Industry Restructuring Act of 2001, which enabled the creation of Fonterra as the near-monopoly milk processor and created regulations to help foster some competition to it.

The review’s main focus is on how the Act should be updated to reflect current and future conditions in the sector in terms of incremental rather than radical change. The danger is it will focus narrowly on those while generating insufficient insight into the megatrends in the sector globally.

Financial performance and sustainability are examples of two critical factors determining the sector’s future that are insufficiently integrated into the review. Its terms of reference specifically state that the number one subject outside the scope of the review is the “Financial, environmental, and animal health and welfare performance of dairy farming in New Zealand”.

These, it says, will be handled by the Ministry of Agriculture’s Farm System’s Change Project. While it does good work, it focuses on improvements in current systems rather than on the big leaps in technology and practices that are coming. Moreover, it’s doubtful its financial and performance data will generate much insight into the sector’s ability to respond to and benefit from radical change.

Similarly, the review is very caught up in the regulatory regime of DIRA itself and the important linkages to the wider regulatory system. This “includes, but is not limited to, the Resource Management Act, the Animal Welfare Act, the Health and Safety at Work Act, the Immigration Act, the Overseas Investment Act, the Financial Markets Conduct Act and the Commerce Act,” the terms of reference say.

Yet, the Resource Management Act has plainly failed to prevent the adverse impacts on water and land from the boom in dairying in recent decades. Environmental regulations are already tightening thanks to the freshwater regulatory regime introduce by the previous government and will be strengthened by the current Government.

To be credible the review will have to factor in even more stringent environmental regulations. If dairy farmers achieve only slow improvements to conventional practices in the decade or two ahead they will find their operations and profitability greatly constrained. But if they pioneer dairy systems that deliver deeply sustainable uses of land and water, while significantly reducing farming’s greenhouse gas emissions, they will prosper.

Another big test of the review will be its analysis of Fonterra. The Commerce Commission was opposed to the creation of such a near-monopoly. But the dairy industry argued that such an entity would become a major global player that could maximise New Zealand’s dairy potential. The Labour Government of the day bought their argument, and created DIRA to regulate aspects of milk supply to encourage competition.

The second part of that proposition has worked to some extent. Fonterra’s share of milk processing has fallen from 96 percent to 82 percent as some new competitors such as Synlait and Open Country have flourished. It will fall to 78 per cent by 2020, TDB Advisory, a consultant, forecasts in its recent report on the sector.

The start-ups were helped by fast-growing milk supply, which rose 52 percent 2001-17, adding on average 470m litres of new milk a year to the sector. Thanks to the new competition, Fonterra’s supply rose more slowly at 37 percent, which still added an average of 300m litres a year to its processing.

Given dairy farming has run into environmental constraints, it will have only modest, if any, volume growth in the years ahead. The competition for milk supply will become more intense so competing processors will still need some protection from Fonterra under a revised DIRA.

Fonterra has delivered some of the potential its backers promised. It is a much bigger and more sophisticated processor than its predecessor co-ops and more international and capable in sales and marketing than the Dairy Board was.

Yet, despite some successes in ingredients, consumer and other higher value products, commodities such as whole and skim milk powders still account for some 57 per cent of its volume, roughly the same as seven years ago. Coping with the surge in milk supply has been the main factor in its failure to shift more of its production mix to higher value products.

As a result, Fonterra’s financial performance has failed to deliver on its backers’ promises. Its milk payout averaged $5.90 per kilogram of milk solids over the past seven years. This was up 45 cents per kg over the previous seven, but that mainly reflected international commodity prices rather than Fonterra factors.

Likewise, its dividend which is paid out of the profits it makes from non-commodity products, averaged 30 cents a share. The fact it was unchanged over the average of the previous seven years shows the serious short-comings of Fonterra’s value add strategy.

Consequently, Fonterra has underperformed its small processing competitors. Its return on assets in recent years has averaged 7 percent, while Synlait earned 9 percent from having a higher proportion of ingredients and consumer products than Fonterra, Open Country earned 11 percent from being a pure commodity player, and Tatua, a small co-op with the most specialised product mix in the sector, earned 18 percent, according to TDB Advisory.

Fonterra’s balance sheet tells an equally disappointing story to its shareholders. Despite raising some $4.5b of capital in the five years to 2012, thanks to booming milk supply, its gearing remains at the upper end of its self-imposed range, and its shareholders equity was virtually unchanged 2011-2018.

Most disturbingly of all to its farmer-shareholders, their equity in their co-op fell from 42 percent of total assets in 2011 to 33 percent in January.

Fonterra has long called for easing of the DIRA regulations. There is a case to be made for relieving some of its obligations to supply competing processors and to process all the milk offered to it.

But the terms of reference for the review, and the Minister’s comments on them, suggest the review will focus intently on these near term regulatory issues. Thus preoccupied, it will fail to deliver insight into the performance of Fonterra and its competitors, let alone the sector’s opportunities and threats as dairying globally embarks on great change.

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