Federated Farmers & Fonterra's proposal for staged removal of statutory 'open entry requirements'

June 12, 2017

As many of you will be aware, there are changes to the DIRA in front of Parliament and you are probably wondering where this is at.  At this stage it is likely that the DIRA will not be debated or considered by the Select Committee until after the 2017 General Election.

BACKGROUND
Why are you talking to farmers about the DIRA and about ‘open entry’ right now?

The Government has been reviewing the Dairy Industry Restructuring Act 2001 (DIRA) over the past couple of years and legislation (the ‘DIRA Bill’) is now before Parliament. Both Fonterra and Federated Farmers will be making submissions to the select committee and talking to Government.

One of the fundamental objectives of the DIRA, commonly called the ‘pro-competition’ measures, is to promote competitive dairy farm gate and factory gate markets in New Zealand by regulating the activities of Fonterra to ensure New Zealand markets for dairy goods and services are contestable. 

Both organisations have a keen interest in the future success of the dairy industry and have come up with a plan for modernising DIRA and, in particular, for transitioning away from DIRA’s ‘open entry’ provisions.

What are the main parts of DIRA and what changes is the Government proposing?

The three main pro-competition parts of the DIRA are:
  • the milk price regime
  • the Raw Milk Regulations
  • ‘open entry and exit’

The Government’s current proposals are:
  • to leave the milk price regime as it is
  • to make some changes to the Raw Milk Regulations (removing entitlements for large export focussed exporters and reducing forecasting flexibility for processors purchasing regulated milk), and
  • to remove ‘open entry’ for new dairy farm conversions.

Fonterra and Federated Farmers are broadly comfortable with these proposals.

However, the Government is planning to retain ‘open entry’ other than in relation to conversions (although there would be a further review beginning in mid 2020). 

Fonterra and Federated Farmers have come up with a joint approach for moving away from open entry as part of the current legislative review process, in way that will support the dairy industry’s future success and provide reassurance to dairy farmers.

What is ‘open entry’?
Open entry is the requirement in the DIRA that makes it mandatory for Fonterra to accept all new milk supply from existing and new dairy farmers. 

There are some current limits to open entry. Notably, applications to supply Fonterra must be submitted within a designated application period each year (to assist with planning) and Fonterra is not required to take small volumes of milk or milk which is more expensive to collect due to farm location (e.g. parts of the West Coast and Gisborne). 

The open entry requirements were included in the DIRA legislation in 2001. These requirements are unique to the NZ dairy industry.  They did not exist at any time prior to 2001 and were a condition of enabling Fonterra to be formed because in 2001, Fonterra’s predecessor companies, and hence Fonterra, collected approximately 96% of New Zealand’s milk production.  Only two other large dairy companies, Westland and Tatua, competed for farmers’ milk in 2001.  There are now numerous dairy companies competing for farmers’ milk - Fonterra now collects approximately 84% of New Zealand’s total milk supply, but less than 80% of milk supply in the South Island.

Open entry gives:
  • Fonterra farmers the confidence to supply other processors (including start-ups), knowing that Fonterra is required to accept them back if they want to return
  • dairy farmers supplying other processors the confidence that Fonterra would accept their supply should they wish to switch to Fonterra
  • new dairy farmers confidence that they could supply Fonterra if they were purchasing or converting a farm.

What are Fonterra’s main concerns with open entry?
Competition and investment is going to continue with or without open entry. The dairy industry has changed enormously since open entry was put in place in 2001. The industry is now very competitive, there are many new players in the market, and there are powerful incentives bringing off-shore dairy companies to invest in New Zealand and to compete for supply. There is nothing stopping a new entrant with a strong business case from entering the industry with the normal business risks that entails. 

Open entry distorts investment decisions and undermines value creation. It requires Fonterra to build additional capacity and leaves Fonterra and its farmers underwriting risk on behalf of competitors that are able to choose which farmer suppliers to accept. 

THE TRANSITION PLAN 

What is the approach for moving away from open entry that Fonterra and Federated Farmers have agreed?
  • Farmers would have a transition period during which to fully consider and take into account the impact of any changes on their operations and business planning
  • From 1 June 2018, Fonterra would no longer be required under the DIRA to accept supply from new conversions (as currently proposed in the DIRA Bill); and then
  • From 1 June 2021, Fonterra’s remaining requirements to accept supply under the DIRA would fall away (meaning Fonterra would have normal commercial discretion to accept milk from that time);

BUT
Fonterra would commit to continue to accept applications to supply after 1 June 2021 in relation to farms that are at the time of application supplying the Co-operative on a share-backed basis (full or part), until the remainder of the pro-competition provisions in DIRA fall away (that is, all of Subparts 5 and 5A). 

That is, Fonterra’s commitment to accept supply would continue to apply in the event of a change in ownership of a farm that supplies Fonterra - as long as supply from that farm to Fonterra is continuous, share-backed and the new supplier meets the normal terms and conditions of supply.

How did this approach for transitioning away from open entry come about?
Fonterra has been advocating strongly throughout the review of DIRA that open entry has passed its use by date and is now an obstacle to Fonterra and the industry maximising value for farmers and success for the co-operative. 

Federated Farmers, however, has had concerns about the implications of removing open entry right now or in the immediate future.  The Federation was of the considered view that a number of farmers were not aware of the full implications the removal of open entry could have on their businesses. Of particular concern was the effect this could have on the sale and purchase of farms.  Without some sort of ‘commitment’ from Fonterra there might be no guarantee that a Fonterra supplying farm could continue to supply Fonterra after being sold.
    
Given both organisations’ strong interest in the open entry issue, Fonterra and Federated Farmers have spent considerable time exploring options for addressing their respective concerns – and come up with a plan for transitioning away from open entry as part of the current legislative process, as outlined in this document.

When would Fonterra’s commitment come into effect?
The commitment would come into effect if the open entry provisions of the DIRA fell away as a result of this transition plan being accepted into the current legislative process. Note that this will require changes to the DIRA Bill currently being considered by Parliament. 

How long would Fonterra’s commitment remain in place?
This commitment would remain in place until the time that all the pro-competition provisions of the DIRA (being all of Subparts 5 and 5A) fall away (that would include the Commerce Commission’s oversight of the milk price). At this point Fonterra would have the option to review its commitment.

There is no timeframe for these provisions to lapse and no stakeholder, including Fonterra and Federated Farmers, is seeking the repeal of all these provisions in the foreseeable future.

THE IMPLICATIONS FOR DAIRY FARMERS

How would this plan, if adopted, make a difference to me if I currently supply Fonterra as a shareholder?
As long as you continue to supply Fonterra as a shareholder this plan will not make any difference to your supply relationship.  Fonterra’s commitment would apply if you chose to sell your farm, or change the ownership structure of your farm.

Would the commitment apply to farm expansions and amalgamations?
Yes, unless more than 50% of the new farmland is new to dairy as that would be considered a new conversion. In this case, the supplier would need to apply to Fonterra in the normal commercial manner.  This will be the case anyway, if the current Bill before Parliament is passed.

What if I am a MyMIlk Supplier?
The commitment applies to Fonterra’s share-backed suppliers, so would not apply to farmers who supply MyMilk after 1 June 2021. Until 1 June 2021 MyMilk suppliers could transition their supply to Fonterra under the ‘open entry’ regime.   After 1 June 2021 MyMilk suppliers would need to apply to supply Fonterra in the normal commercial manner - keeping in mind MyMilk was set up as a pathway to becoming a Fonterra shareholder

What if I, a current Fonterra supplying shareholder, wanted to sell my farm to somebody else, or to a Trust, or pass it on to my children? Will they still have a right to supply Fonterra?
Under this approach, Fonterra will be committed to continuing to accept milk from a supplying shareholder’s farm even if it changes ownership (until such time as all the remaining pro-competition provisions in DIRA fall away). 

How would this plan, if adopted, make a difference to me if I am currently supplying an independent processor, or opt to supply an independent processor in the future, and then want to switch to Fonterra? 
Until 1 June 2021 it would make no difference. Beyond 1 June 2021, if you want to supply Fonterra you would have to apply to do so in the normal commercial manner, i.e. without a legislative requirement that Fonterra must accept your application.

What happens if I, a Fonterra supplier, buy another farm that is suppling an independent processor, and I want to switch that supply to Fonterra?

Until 1 June 2021 it would make no difference. Beyond 1 June 2021, if you want to supply Fonterra you would have to apply to do so in the normal commercial manner, i.e. without a legislative requirement that Fonterra must accept your application.

What if I am a former Gisborne Milk supplier who supplies Fonterra on a non-share backed contract supply basis?
The commitment applies to share-backed suppliers, so would not apply to the former Gisborne Milk farms that supply Fonterra on a non-share backed basis. This reflects the current position - as Fonterra is not currently required to take milk from these suppliers, but has chosen to do so for many years on a non-shareholding contract basis. There is no plan or intention to stop taking milk from these farms. 

Would this plan make a difference to transport charges?
No. Fonterra is already able to charge transport differentials if it chooses to do so. As a Co-operative it has so far chosen not to do so.  

Would this plan make a difference to the milk price?
No.  The process for determining a base milk price is part of Fonterra’s Constitution as well as the DIRA.  The Government’s proposal is to leave the Commerce Commission oversight of the milk price in place, and Fonterra is not advocating for any changes. 

The basis on which that milk price is allocated to the milksolids you supply (for example, fat and protein) is determined by Fonterra’s Board, and there is no proposal for that to change. 

How long will Fonterra’s commitment remain in place?
Fonterra’s commitment will remain in place until such time as all of the pro-competition provisions of the DIRA fall away (including the milk price regime, the 20% rule, the Raw Milk Regulations and the open exit provisions). 

There is no timeframe for these provisions to lapse and no stakeholder, including Fonterra and Federated Farmers, is seeking the repeal of all these provisions in the foreseeable future. 

If at some future point the Government deems that no special competition legislation is needed in the dairy industry, then it would make sense for related commitments to also be reviewed. 

Does this transition plan have the support of the Government?
The Government, in the DIRA Bill, is proposing to retain open entry indefinitely.  However, the DIRA Bill now before Parliament is not yet confirmed. It now seems likely it will be considered by select committee and Parliament after the 2017 General Election.

Both Fonterra and Federated Farmers will be making submissions to the select committee and talking directly to the Government and MPs across Parliament.

How would this plan affect the 20% rule (which allows Fonterra suppliers to divert up to 20% of their weekly production to another processor), the 160 km rule (which requires a third of Fonterra contracts within a 160 km area to expire annually) and the requirements regarding the sale of milk vats by Fonterra to departing suppliers?
This plan would not affect these provisions.  No changes are proposed.