ComCom argues Fonterra's support loans should be included in milk price calculation

The Commerce Commission has signed off on the way Fonterra Cooperative Group [NZX: FCG] calculates its milk payout this season but warned it will be keeping an eye on issues such as its cost of capital calculation and interest-free support payments to farmers.

Under the Dairy Industry Restructuring Act, the commission has to report annually on whether Fonterra's Milk Price Manual promotes setting a base milk price that incentivises the dairy cooperative to operate efficiently while providing for contestability in the market for purchasing milk from farmers.

Fonterra, the world's largest exporter, collects 85% of New Zealand's milk each year. The manual covers only the cost of raw milk at the farmgate rather than any other price component within the milk supply chain.

Commission deputy chairwoman Sue Begg said having considered submissions on the draft report released in October, the commission still holds the view that the 2015/16 manual is largely consistent with the purpose of the milk pricing monitoring regime under the act.

"Overall, we are pleased with the steps Fonterra has taken to improve the manual's consistency with the overall purpose of the regime. We will continue to encourage Fonterra to keep improving the clarity of information on the rules and how it interprets and applies them," she said.

As part of the process, the commission also reviews Fonterra's base milk price calculation at the end of each dairy season.

Ms Begg said there were a number of issues it will be following up next year, with the biggest issue in dispute whether Fonterra takes into account the cost of support payments – such as the 50c  per kilogram of milk solids loan for farmers shareholders, in the milk price calculation. For example, the commission believes the financing costs of interest-free loans to farmers should be included and clearly described when calculating the base milk price, it said.

Fonterra chief financial officer Lukas Paravacini told unitholders in the Fonterra Shareholders' Fund at its recent annual meeting that the loan support package taken up by 75%  of its farmer suppliers would cost the group $390 million and there was a further $20 million lost opportunity cost from the amount that could have been saved on interest paid for its borrowings if it had used the money to reduce debt instead.

Waikato-based milk processor Open Country Dairy submitted that Fonterra's interest-free loans should be part of the base milk price calculation and the manual should provide for that process. It had the "firm belief" that an efficient notional processor would have done what Fonterra has – support its farmers through difficult times.

The commission said Fonterra submitted the costs associated with the interest-free loan will be funded from earnings, in particularly working capital savings from its transformation programme, and it won't be making any provisions or adjustments in the base milk price calculation.

But the commission said "at a high level, we consider that, regardless of how the loan scheme is funded, it raises a potential issue for practical feasibility of the manual and the milk price calculation because it provided an economic benefit to farmer suppliers in difficult circumstances for a longer term benefit of stability of supply."

Competitive aspects of Fonterra's loan scheme will be addressed separately in the commission's report to the minister on the state of competition in the New Zealand dairy industry.

Ms Begg said questions were also raised by interested parties about the cost of capital calculation Fonterra uses to set the capital charge.

Open Country Dairy said the commission had to "maintain pressure on Fonterra to urgently improve the practical feasibility of the capital charge" while rival processor Miraka's submissions questioned whether the commission should more comprehensively review the weighted average cost of capital used to determine the base milk price.

The commission said that, having considered the submissions, it will be publishing a process and issues paper for the 2015/16 milk price calculation shortly that outlines specific areas of focus, including the WACC used.

(BusinessDesk)