Review of Fonterra’s 2016/17 Base Milk Price Calculation

 In reaching its final view, the Commission considered submissions received on its draft report which was published on 15 August 2017. The Commission’s overall conclusion on the consistency with the Dairy Industry Restructuring Act 2001 (DIRA) is unchanged from its draft report.

Commissioner Dr Stephen Gale said with the exception of the asset beta component of the cost of capital estimate, Fonterra’s calculation of the 2016/17 base milk price is consistent with DIRA.

Dr Gale said: "We are satisfied with the inclusion of sales outside the Global Dairy Trade auction platform in the milk price calculation. We welcome Fonterra’s commitment to disclose additional information to support this. However, we will continue to monitor the effectiveness of these disclosures for interested parties.

"On the basis of the information provided so far, it is not clear that Fonterra’s asset beta estimate meets the contestability test under DIRA. Further information is needed if we are to reach a conclusion in future reviews. In particular, we seek additional evidence from Fonterra on the degree of risk sharing between processors and other participants, implicit in the costs of capital of listed dairy companies."

The final report and related information can be found here.

Background

DIRA requirements

The Commission is required to review Fonterra’s milk price calculation at the end of each dairy season under the milk price monitoring regime in DIRA. The base milk price is the price Fonterra pays farmers for raw milk, which is set at $6.15 per kilogram of milk solids for the 2016/17 season just ended. The Commission’s report does not cover the forecast 2017/18 price of $6.75 that Fonterra announced in July.

The focus of the review is solely on the farm gate milk price and not any other milk price within the milk supply chain. In the review, the Commission is required to consider the ‘efficiency’ and ‘contestability’ dimensions of the base milk price calculation.

As well as the annual review of the base milk price calculation, the Commission is also required to review Fonterra’s Farmgate Milk Price Manual. The Manual sets out its methodology for calculating its base milk price for the season. The Commission’s review of the 2017/18 Manual will begin shortly.

Purpose of the milk price monitoring regime

The milk price monitoring regime is intended to promote confidence and transparency in Fonterra’s base milk price setting processes, consistent with contestable market outcomes. The regime exists because, in the absence of a competitive market for the purchase of farmers’ milk, Fonterra uses an ‘administrative’ methodology to set the price itself.

Asset beta component in the calculation

The asset beta component is used to help calculate the weighted average cost of capital for the milk price calculation and is a measure of exposure to systematic risk. Systematic risk measures the extent to which the financial returns of a company fluctuate relative to the equity returns in the stock market as a whole. Fonterra has used an asset beta of 0.38, which is below the average of 0.47-0.53 observed for a range of other dairy processors identified by Fonterra. Fonterra has not been able to justify the lower beta used to calculate the milk price relative to the average dairy processor.

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