Chair, Cabinet

Executive Summary

1. On 23 January 2001 Cabinet agreed that the government's objective for the dairy industry should be to maximise the returns from the industry to New Zealand while protecting the interests of New Zealand dairy farmers and consumers.

2. The dairy industry is unusual in that it is highly regulated in terms of structure, marketing and commercial arrangements. This structure is unsustainable because of the emerging dynamics of both the domestic and global dairy markets.

3. Government has been asked to legislate to authorise the proposed Global Dairy Company (GDC) merger. The merger would provide the most expeditious way forward from the current unsustainable situation. However, it would also result in the formation of a large virtual monopoly that, without an effective regulatory regime, would face strong incentives to use its power to minimise the overall level of contestability in the domestic markets for raw milk, dairy ingredients and dairy consumer products. This would result in risks to innovation, export earnings, farmer incomes and New Zealand consumers.

4. An alternative to the proposed approach would be for the government to actively lead a process of dairy industry reform with the objective of facilitating the evolution of two or more vertically integrated export companies operating within a normalised regulatory environment. The benefits from such an approach would be potentially larger, but achieving them would take longer and would carry greater uncertainty, particularly if the benefits were partly contingent on each company securing offshore merger partners.

5. The available evidence indicates that the proposed GDC merger would produce greater net benefits than the current unsustainable industry structure. The trade-off is between the short-term certainty of the GDC merger and the potentially larger benefits of the alternative, which would almost certainly take longer to achieve and would carry greater uncertainty of achievement. The alternative would require active Government leadership to secure industry support in a context where there may be initial industry and farmer resistance.

6. If Ministers decide to facilitate the merger, the accompanying paper seeks agreement to the method for exempting the merger from the Commerce Act and the package of regulatory measures intended to mitigate the likely detriments of the merger. The detail of this regulatory package has been developed by officials in consultation with GDC proponents and has involved negotiations between the Minister of Agriculture and GDC on several key elements of the package. The Minister of Finance has considered the tax implications of the merger.

Proposal/summary

7. This paper:
   • advises Cabinet on:
     • the proposed merger of New Zealand Dairy Group, Kiwi Co-operative Dairies Limited and the New Zealand Dairy Board;
     • the public policy issues that would arise from the merger proceeding;

   • seeks Cabinet decisions on:
     • whether or not to facilitate the proposed merger;

   • seeks Cabinet agreement to:
     • a communications plan to ensure that farmers and other stakeholders are aware of the Government's decisions on the proposed GDC merger; and
     • a timetable that would result in the detail of any required regulatory package being completed in May, the introduction of legislation into parliament by the end of May and its enactment by the end of September.

8. New Zealand Dairy Group (NZDG), Kiwi Co-operative Dairies Limited (Kiwi) and the New Zealand Dairy Board (NZDB) propose a mega-merger to form a new dairy co-operative - Global Dairy Company (GDC). Proponents of the merger have sought the Government's facilitation for it by way of a Commerce Act exemption and other necessary legislation.

9. The merger, as originally proposed, would have resulted in a number of detriments that would have had implications for Government's broader objectives for the dairy industry and competition law. In order to address these issues, if Ministers decide to facilitate the merger, a package of regulatory measures has been developed.

10. The proposed package of regulatory measures is presented in the accompanying paper entitled Dairy Industry Merger Proposal: Paper Two: Regulatory Package and Tax Provisions. This paper also describes the detriments and public policy issues that the regulatory measures are designed to address.

Background

11. GDC would be a near monopoly that would account for around 7% of GDP, around 20% of total exports, around 96% of dairy exports, around 96% of the New Zealand raw milk market and around 50% of the domestic dairy market. Associated with the proposed merger would be the cessation (after one year) of NZDB's single-desk exporting functions.

12. The merger proponents sought legislation to:
    • facilitate the merger;
    • remove NZDB's statutory powers as the single desk exporter of dairy products (effective one year after the legislation is enacted);
    • provide GDC with certain (concessionary) tax provisions;
    • provide GDC with exclusive access to tariff quota markets; and
    • exempt the merger from the business acquisition provisions of the Commerce Act 1986, thus avoiding the need for normal Commerce Commission authorisation.

13. On 23 January 2001 Cabinet agreed, inter alia, that (CAB Min (01) 1/3 refers):
    1. The government's objective for the dairy industry should be to maximise the returns from the industry to New Zealand while protecting the interests of New Zealand dairy farmers and consumers;

    2. In considering whether to pass special legislation to authorise the GDC merger, the government needs to be satisfied that:
       1. Options for refining the GDC merger proposal (including options for regulatory controls) to increase its benefits and/or mitigate its detriments, have been explored with industry;
       2. The benefits and detriments of a proposed merger have been accurately determined;
       3. A proposed merger is consistent with the government's broader objectives for the dairy industry and its relevant policies;
       4. A proposed merger is a better outcome than other outcomes likely to emerge should the merger not proceed; and
       5. Farmers have had access to sufficient objective information regarding a proposed merger to make informed decisions on its merits or otherwise.

14. Officials subsequently worked with GDC proponents to explore and develop a package of regulatory measures to mitigate the public good issues arising from the proposed merger. Extensive agreement has been reached with GDC proponents on the overall shape of a regulatory package to support the proposed merger.

15. There were a small number of issues on which agreement was not reached between officials and GDC proponents. The Minister of Agriculture subsequently met with GDC proponents to negotiate these issues. The Minister of Finance also considered a number of outstanding tax issues. These matters are now resolved between Ministers and GDC, and the outcomes of their negotiations are reflected in this and the accompanying paper.

Comment

Should the Government Agree to Facilitate the Merger?

16. Regardless of whether or not the proposed GDC merger is to proceed, the dairy industry's regulatory environment is widely regarded, by those within the industry, as unsustainable and in need of change. The industry is highly regulated in terms of its structure, marketing and commercial arrangements. For instance, only co-operative companies are allowed to hold shares in the NZDB, it has an export monopoly, and the Board's pricing behaviour is exempt from the Commerce Act.

17. There is considerable pressure mounting within the industry for the removal of the NZDB single desk. Both NZDG and Kiwi are currently moving offshore through acquisitions in Australia. Tatua, a small co-operative, has for a long time pursued its own niche market and high value strategy. These companies are all attempting to expand into new markets. However, under the current regulatory environment, none can adequately control their overseas marketing, a key element of each company's business. The proposed GDC merger is a direct response from Kiwi and NZDG, who have previously competed against each another, to the constraints of the current regulatory environment.

18. On balance, the GDC merger and the associated regulatory package is better than a continuation of the current status quo, a view supported by research commissioned by officials into the dynamics of the global dairy industry. The main benefits of the merger proposal are:
    • Moving within a relatively short time frame to allow dairy food processors to directly manage their overseas marketing and exporting (and all of the associated costs, risks and potential benefits). This could be expected to result in the rapid expansion of the niche dairy product sector, which includes manufacturers, marketers and exporters such as Tatua and Kapiti Cheeses;
    • exposure of the industry, once the merger has concluded, to all of the commercial disciplines of the Commerce Act;
    • the early integration of processing and marketing activities, which will facilitate improved market signals in the industry and some potential for rationalisation; and
    • broad shareholder and farmer support for the proposal, including the removal of the single desk.

19. The proposed merger also has detriments. The main ones are:
    • risks to the earnings of farmers and the nation arising from the continued management of almost all of New Zealand's dairy exports by a single entity with a single business strategy and set of business tactics (all the eggs in one basket);
    • the continued under performance of innovation, including the evolution of new and higher value products, through insufficient diversity and competition in the production, marketing and exporting of New Zealand dairy products;
    • the creation of a large monopoly that, without an effective regulatory regime, may use its dominant market position to reduce the overall level of contestability in both the domestic consumer product and raw milk markets. This might reduce pressure on the industry to be efficient in its processing of raw milk. If so, it would over time result in losses of export earnings, lower farmer incomes, and price increases for consumers; and
    • the creation of a large co-operative without a cornerstone shareholder, or major competitor, capable of maintaining pressure on management to perform. The shareholder council allowed for in GDC's constitution is unlikely to have the resources, specialist knowledge or influence to do this.

20. While a regulatory package has been developed to help mitigate the above risks, it needs to be noted that there is always the risk that elements of the package may not work as intended. This has been the experience in other markets. While GDC is not a natural monopoly, in the same way as an electricity or telecommunications company, it will have considerable market dominance, especially in the domestic raw milk market, and may behave in ways unanticipated by law makers and regulators. It may also attempt to change the rules to maintain its dominant market position.

21. The key question for Government is whether or not it wishes to facilitate the proposed merger.

22. Officials consider it likely that the evolution of two or more strong export-focussed co-operatives operating under a regulatory environment subject to the full provisions of the Commerce Act and other relevant commercial law could provide greater long-term gains than the proposed GDC merger. This is because:
    • two or more companies will compete on the basis of two or more different business strategies. This spread of strategies should result in less risk to the earnings of farmers and the nation;
    • two or more competing companies are more likely to encourage innovation and best practice in production, marketing and exporting; and
    • two or more competing companies are likely to result in greater disciplines on the industry as a whole to be efficient. Over the long run, this should result in better earnings for farmers, lower prices for consumers and increased export earnings.

23. While officials believe that the industry would approach Government to facilitate such a reform if the GDC merger did not proceed, the timing of such an approach is very uncertain. If the government decided not to facilitate the GDC merger, the onus would probably be on it to lead a process of regulatory reform in order to address the significant issues that are currently impeding the performance of the industry. Although the long-term outcomes might be better than those associated with the proposed GDC merger, this might take some time to achieve (which could impose significant costs on the industry), and might involve considerable effort by the Government, especially if it encounters initial industry and farmer resistance. The uncertainty of this alternative is exacerbated given that its larger benefits are likely to be contingent, to some extent, on each company securing offshore merger partners, such as in Australia.

24. It should be noted that there is an outside risk that the merger may not proceed even with Government facilitation. It requires 75% support from the shareholders of each of Kiwi and NZDG. While such support is likely, it cannot be guaranteed. If farmer approval was not obtained, the onus might fall on the Government to facilitate an alternative approach to industry reform in order to reduce the economic costs of adjustment given the current problems with the industry's regulatory environment.