In a regulatory moo-d

The latest Auckland seminar from LEANZ - the Law and Economics Association of New Zealand - brought together a panel of experts on the theme, 'What's Right and What's Wrong with New Zealand Dairy Sector Institutions?'

An important issue at any time, but especially on the money right now with the current review of the regulatory Dairy Industry Restructuring Act (DIRA). So far (according to the Review website) it's reached the stage where it's analysing the submissions on the discussion document it put out last November, and the Review team is now working on policy recommendations for regulatory change. Unless I've missed it, there doesn't seem to be a master list on the site of all the submissions received, but google a bit and you'll find some of the main players' views. Fonterra's are here.

The LEANZ panel was a battle-hardened bunch of dairy experts: in alphabetical order Tony Baldwin, business consultant, A E Baldwin New Zealand; Phil Barry, Director, TDB Advisory (his LEANZ slides are here, well worth a look); Alex Duncan, Consulting Economist at Finology; and Alex Sundakov, Executive Director at Castalia.

It would be nice to say I came away with all the moving parts neatly analysed and clarified and put into a tidy box, but - in the nicest possible way - I didn't, and that's fine. As Mencken's Law says, "For every complex problem there is an answer that is clear, simple, and wrong".

That said, I can't say I was totally disabused of the notions in my head before I went into the seminar, either. 'National champion' strategies are to my mind poor plans (see here and here) and I think the Commerce Commission got the right end of the stick when it proposed in 1999 to disallow the merger that ultimately (via DIRA) became Fonterra (I dug out the details here).

They may not have settled down into a coherent whole, but some of the ideas I took away from the seminar were:

• I liked Tony Baldwin's exploration of deep-seated, long-standing cultural norms in the dairy industry (including worship at the altar of 'white gold', dislike of competition, a wariness of markets in general and outside capital in particular, a strong desire for government involvement/support) and which, he argued, are still in play today and will continue to shape wherever we go next. Tony tells me he's polishing up his slides with extra commentary, and I'll post a link (and maybe some discussion) once they're ready. Alex Sundakov wasn't greatly minded to traverse 'old history' and suggested we should focus more on what's in front of us today, and there is that, but Tony's story still seemed highly relevant to me. Tony also concluded that the current regulatory structure can't deliver the strategy it's committed to, which I'm leaning towards as well. On similar lines Alex Sundakov also argued that existing institutional mechanisms aren't able to accommodate necessary market adjustments

• Alex Duncan, who I last encountered when he took the Commerce Commission for its first walk through the intricacies of the milk price manual, made an intriguing point. The mantra in dairy has been 'value add': he questioned that. He felt that the ingredients business - your powders, your casein - could be the real money-spinner, because it has the production flexibility to turn out whatever pays best on the day, especially if a deeper futures market develops and enables it to lock in transient opportunities or sell-off existing positions if better ideas turn up

• The seminar was largely free of entrenched  'pro Fonterra' and 'anti Fonterra' attitudes but still accommodated some discussion of Fonterra's calculation of the farmgate milk price. In  principle Fonterra could raise the input costs of competing processors via a high price. In practice, that's hard to square with evidence of profitable new entry (see for example Phil Barry's Slide #7) or with the potential discipline from investors in the Fonterra Shareholders' Fund who have an interest in making sure the dividend is not disadvantaged by an overly high farmgate price. Though, as someone said at the seminar, what effective recourse do they have other than to sell out of the FSF? 

• Alex Sundakov was somewhat bemused by the Kiwi predilection for froofrooing over whether regulation is necessary and what form it should take, and said that the Aussies tended to go "Bang! You're Regulated!" (my summary). Fair point - policy analysis in New Zealand has typically been, let's charitably say, exhaustive (don't get me started on reform of s36 of the Commerce Act). But I'm not sure he's right in this case about the Aussies' pace. The ACCC proposed a mandatory code of conduct for the processors who buy the Aussie farmers' milk back in April 2018, itself the outcome of an 18 month inquiry started in 2016. The draft code surfaced in March this year: who knows when (or if) the regulation will go live. And in any event, ditherers or not, Aussie code or not, dairy farmers in New Zealand are much better protected from oligopsonistic market power than their counterparts across the ditch.

A fascinating evening. If you're not on the LEANZ mailing list, subscribe. If you're yet not a member, join up. And thanks too to Richard Meade who organises the Auckland events, and to Bell Gully for the generous hosting that makes these seminars viable.

Wazzup?

For a while there, it looked as if the dairy sector was going to be one of the quieter stretches of the regulatory front line: our regulatory regime was running smoothly along a pre-planned route.

The regulatory scheme of the Dairy Industry Restructuring Act - DIRA, pronounced "dye rah" if you've been lucky enough not to encounter it before - had, sensibly, included provision for a review of the Act if it looked as if it might no longer be needed. If at least 20% of the market for collecting milk from farmers was in non-Fonterra hands, North and South Islands considered separately, DIRA triggered a review of the state of competition. That review could then recommend whether regulation was still necessary, could re-address the 20% threshold, and could suggest routes to deregulation. In default of any new bright ideas, parts of DIRA would automatically lapse.

The 20% trigger was reached in the South Island in 2015 and the Commerce Commission duly published a competition review in March 2016 (the full thing is here and there's a handy summarised briefing here).

Overall, the Commission judged DIRA should be left much as is, but with limited recommendations for improvements, which were mostly around some modest deregulation of "DIRA milk". That's the milk Fonterra is required to supply, at a regulated price, to domestic processors of raw milk (cheese makers and the like), a requirement intended to counter what would otherwise be Fonterra's ability to ramp up the input price to processor buyers. The Commission also said that the 20% threshold for adequate non-Fonterra market share was too low, and suggested 30%, and recommended another look at the Act in any event by 2021-22, or when the 30% threshold was reached if it was triggered earlier (the Commission expected it wouldn't be).

All this looked sensible and it very largely was, though I'm not convinced about one proposal giving Fonterra the discretion not to accept new large dairy conversions as shareholder suppliers. The government of the day thought the package looked sensible too, and it consequently introduced the Dairy Industry Restructuring Amendment Bill in March 2017 to implement it. The Bill had gone nowhere, however, by the time the general election came round.

Which left room for the incoming Minister of Agriculture Damien O'Connor to say, on December 19, forget all that, nothing's getting deregulated, there'll be no change for dairy conversions, and no bits of DIRA are going to lapse for the time being. The Minister's statement is here (it includes a helpful Q&A) and the replacement Dairy Industry Restructuring Amendment Bill (No 2) is here.

The stated rationale was that "The Government wants to take a strategic view of the dairy industry", and limited changes now might get in the way of a big picture rethink later: "The intention is simply to prevent expiry at this time, and then take a holistic approach to all other dairy-related issues. There is little merit in taking a piecemeal approach to parts of the 2017 Bill, as opposed to a comprehensive review of all interrelated issues". There will be "a comprehensive review of the DIRA as a matter of priority" carried out this year.

So my question is, wazzup? It's fair enough to want to review how one of our major industries is performing, but it's still not clear exactly what's bothering the government about DIRA.

It could be that Fonterra's set it off.  For example it pursued a doomed attempt to discriminate, in breach of the 'open entry, open exit' regime, against former suppliers who'd rejoined Fonterra, and over 2015-17 lost all the way to the Supreme Court. And it decided to slow down payments to its trade suppliers  which got it bad press in 2016 and 2017 and suggested that, despite regulation, it still possessed the ability and the incentive to give less and take more. It looked as if they were reading from my DIY playbook,  'How to get regulated'. More recently Fonterra has woken up to playing a more strategic regulatory game, and has been running a charm offensive with its TV ads, but the harm may already be done.

Or it could be that the government is having a rethink about the big regulatory bargain struck at the start. Left unregulated, the merger that created Fonterra would have been bad for New Zealand: the Commerce Commission, in its draft decision in 1999, said there would be a net cost to the economy. The numbers are highly squishy but, the Commission said, there would have been a cost to the country ranging from around a smallish $75 million to around a sizeable $450 million. The overall Fonterra/DIRA deal was consequently an attempt to bank the benefits while containing the costs, turning the combo into a net plus for the economy. And irrespective of the net benefit calculus, it also got the support of those infected by the National Champion virus.

But did the benefits eventuate, were the costs contained, and did the National Champion sweep all before it? There's certainly room for a rethink on the benefits side. In 1999, for example, the Commission noted at para 624 that "The goal is to expand the present business, which currently has revenues of $8 billion per year, to one of $30 billion in ten years, an ambitious target which some have argued lacks specification of the means by which it is to be attained". Quite. In the event, 18 rather than 10 years on, Fonterra's revenues have reached $17.9 billion.

And still on the benefits side, why has the biggest financial payoff from marketing innovation come from outside the Fonterra stable? A2 Milk, currently worth $9.5 billion, is roughly equal to the value of Fonterra. If you take the view that one of the downsides of creating monopolies is a loss of dynamic efficiency, the value of A2 is a chunky bit of circumstantial evidence.

If they'd known then what they know now, it would be an interesting question what dairy farmers would have gone for back in 1999. Would the industry behemoth still look as good an option, compared (say) with creating two decent sized entities, each competing for the farmers' custom, and each with its own approach to product innovation, marketing, and overseas investment? But even if with hindsight some alternative might have been better, it's hard to see how that particular cake can now be unbaked.

All that said, there have been positives from the current regime. Fonterra has come up with some good ideas: Trading Among Farmers for one, and the listing of the Fonterra Shareholders' Fund for another. And DIRA has handled some issues a good deal better than the Aussies have been able to manage theirs. The ACCC's draft report last November on the Aussie dairy industry found that Aussie dairy farmers were at the bottom of a totem pole with the supermarket duopsony at the top and the processor oligopsony in the middle: "Unlike others in the supply chain, most dairy farmers have no bargaining power and limited scope to reposition their businesses to mitigate this ... Imbalances in bargaining power between processors and farmers result in practices that reduce competition for raw milk and transfer disproportionate levels of risk onto farmers" (pages 12-13). Kiwi farmers, with their right to join Fonterra and get a price policed by the Milk Price Manual, are in a better place.

It's also unfair to see everything that happens - good or bad - as down to what Fonterra did or didn't do. The reality is that Fonterra is a middleweight player in a big global market: what it can do is heavily circumscribed by global demand and supply factors. Rather than assuming that Fonterra is an unconstrained free agent, and playing the blame game New Zealand is so good at, the better questions are, has it played the hand it's been dealt as well as it might have? And has it worked the strategic angles so that the next deal of the cards falls more its way? I've no idea, and without good evidence people shouldn't be jumping to any premature conclusions.

In any event we'll know what precisely was on the government's mind when we see the terms of reference for the dairy review, which can't be far away. And the whole episode, by the way, is yet another example of why we need a 'market studies' power for the Commerce Commission. The last government, in what had become sadly typical of its too little too late approach to competition policy, had reached the point where it was prepared to give the Commission some circumscribed powers to look at how industries were travelling. This new government is more friendly to the idea, and rightly so: if there are competition issues in any industry, the specialist in the competition game should be able to take a proactive look and come up with some fixes.