Chair, Cabinet

DAIRY INDUSTRY MERGER PROPOSAL: PAPER TWO: REGULATORY PACKAGE AND TAX PROVISIONS

Proposal/Summary

1. This paper details a possible regulatory package and tax provisions to apply if the Government decides to authorise the proposed Global Dairy Company (GDC) merger. It is to be read with Paper One on the Dairy Industry Merger Proposal, which sets out the overarching decisions required.

Background

2. The regulatory package was developed by officials, and has been agreed with proponents of GDC as a package that could apply if the Government decided to legislate to authorise the merger.

Main Features of the Package

3. The main aspects covered in the regulatory package are:
   • regulating for open entry and exit of farmers to GDC;
   • regulating raw milk markets, and providing regulation making powers for other dairy markets;
   • New Zealand Dairy Foods divestment;
   • arrangements for non-participating co-operatives;
   • regulation of exports - single desk transition and quota;
   • Commerce Act deemed authorisation;
   • termination of restrictions on GDC;
   • industry good issues;
   • GDC ownership and corporate form.

4. These are discussed below, and the detail is set out in Annex 1. Also discussed are the tax implications of the merger proceeding.

5. Regulating for open entry and exit of farmers to GDC is the heart of the regulatory package. Because of GDC's near monopoly status and its associated market power it may have both the incentive and the ability to create barriers to new milk suppliers joining the co-operative or switching from GDC to other processors. One of the possible mechanisms available to GDC for this purpose would be manipulation of the milk price and its own share value. It could, for example, use returns from equity investments to cross-subsidise the New Zealand milk price, making entry of a competitor more difficult and discouraging suppliers from switching to another company. This in turn would give GDC's management a degree of protection from competitive pressures.

6. To mitigate this risk it is proposed to regulate for open entry to GDC for any farmer wanting to supply GDC at its posted share price, as well as open exit from GDC. Under this proposal GDC would face strong incentives to set fair milk prices and share prices. If GDC set the milk price too high or share price too low it would face an influx of milk. If it set the milk price too low or its share price too high, it would face a loss of suppliers to its competitors (or out of the industry).

7. The main measures to ensure open entry and exit are:
   • requiring GDC to publish milk and share prices;
   • requiring GDC to accept applications from farmers to supply (with the ability to defer for a season if GDC has insufficient processing capacity);
   • requiring GDC to give entering and exiting farmers a degree of certainty about the price they will pay or receive for their shares; and
   • providing for an enforcement mechanism such as a disputes body (not yet developed).

8. See section 1 (para 1 onwards) of Annex 1 for more detail.

Raw Milk Market and Other Dairy Markets

9. GDC could attempt to stop its farmers switching their supply of milk to its competitors through the terms of its milk supply contracts with farmers (eg long contracts with long notice provisions). The package contains provisions to address this, including a requirement that in a given area at least 33% of contracts can be terminated without penalty by suppliers in any year. GDC would also be obliged to offer one-year contracts to all farmers who want them.

10. GDC would control almost all of the New Zealand wholesale milk market. Unless farmers switched their supply from GDC, other processors would need to source their milk from GDC. The terms and conditions of these trades would be important to the ongoing viability of other local dairy processors, including NZ Dairy Foods. Potentially, GDC could use its overwhelmingly dominant position to control the supply and/or price of raw milk, cheese, powders and other ingredients to third party processors.

11. GDC would face access obligations to supply certain volumes of milk to other processors on particular terms. At this stage it is not proposed to regulate markets for other dairy products, but to provide regulation making powers in case it becomes necessary in the future.

12. See section 2 (para 21 onwards) of Annex 1 for more detail.

New Zealand Dairy Foods Divestment

13. In order to provide for some level of domestic competition, NZ Dairy Group's 50% shareholding in NZ Dairy Foods would be divested. The merger authorisation would be conditional on the divestment taking place within one year.

14. See section 3 (para 28) of Appendix 1 for more detail.

Arrangements for Non-Participating Co-operatives

15. Tatua and Westland may or may not join the merger, although Tatua in particular seems unlikely to join. In order to protect their commercial interests, it is important that if they reject the merger they can quickly access payment for their shareholding in the NZ Dairy Board. The package provides for the rapid initiation of procedures for paying out non-participating co-operatives.

16. With respect to their other concerns (as discussed in Paper One), it is proposed that the government reserve the right to intervene if reasonable agreements are not negotiated between GDC and the co-operatives within a defined timeframe. The ultimate sanction on GDC is to delay the introduction of legislation.

17. See section 4 (para 29 onwards) of Annex 1 for more detail.

Regulation of Exports - Single Desk Transition and Quota

18. The orderly disestablishment of the single desk operation of the Dairy Board would result in one of the main benefits of the merger - the introduction, over time, of competition to New Zealand's export marketing of dairy products. The package provides that:
    • there would be a one-year transition period for the single desk, mainly to allow time for the Dairy Board to renegotiate contracts; and
    • during this transition period, existing export permit holders and Westland would be able to export dairy products (deleted under OIA section).

19. Successive governments have negotiated quota rights for dairy products to overseas markets. These quota rights were negotiated for the benefit of the industry and New Zealand as a whole. (deleted under OIA section).

20. The regulatory package provides for:
    • an initial exclusive allocation of quota to GDC for six years (to 2007), phasing out over the following four years as a new allocation mechanism is phased in; and
    • the legislation to state principles of:
      - maximising capture of quota rents for New Zealand; and - ensuring that the beneficiary of the rents should be the dairy industry.

21. In addition, it is proposed that:
    • terms of reference for the policy development process to develop a quota allocation mechanism be considered by Cabinet prior to the introduction of merger legislation in May 2001;
    • Ministers agree to announce decisions on a future quota allocation mechanism by the end of 2001, with a view to enacting legislation in 2002, to give certainty to exporters; and
    • the 1999 QuotaCo model but with the company being a co-operative (ie a company that would allocate quota access on a competitive basis and return quota rents to farmers in the form of dividends) would be the fallback position for a future allocation mechanism if another mechanism were not identified that both the Government and GDC preferred.

22. See section 5 (para 31 onwards) of Annex 1 for more detail.

23. If the Government decides to exempt the merger from the requirement to obtain Commerce Act authorisation, the package provides for this to be achieved by means of a deemed authorisation. Certain clauses of the GDC constitution and merger transactions would be deemed to be authorised under sections 58 and 67 of the Commerce Act. Following the merger the Commerce Act would apply in full.

24. See section 6 (para 38 onwards) of Annex 1 for more detail.

Termination of Restrictions on GDC

25. The regulations restricting GDC's activities would be lifted on an island by island basis where practical, once GDC's market power was reduced. In general, regulations that are intended to mitigate GDC's market power would be lifted, while ongoing arrangements such as quota allocation would remain in force. For the North Island, the threshold would be independent manufacturers collecting 12.5% of milksolids per year. For the South Island, the threshold would be independent manufacturers collecting 65 million kg of milksolids per year, of which at least one manufacturer east of the Southern Alps was collecting at least 25 million kg of milksolids per year. For comparison, Westland processes about 28 million kg of milksolids per year.

26. See section 7 (para 40 onwards) of Annex 1 for more detail.

Industry Good Issues

27. The Livestock Improvement Corporation owns the national dairy herd database, and provides breeding and farm advisory services. Under the package it would become a co-operative owned by users (farmers and sharemilkers only). GDC would be able to contract with it for non-exclusive access to the database. The contract would require Government approval if it was concluded prior to the LIC becoming fully independent of NZDB and GDC.

28. Other industry good provisions include:
    • the Dairy Research Institute, which undertakes dairy processing research, would transfer into GDC;
    • an incorporated society called Industry Good Inc would apply to collect levies for industry good activities and commission providers of that work. This would maintain separation between funding and provision of industry goods. Interim and ongoing governance has yet to be agreed. GDC/NZDB would provide transitional funding for industry good activities for a fixed period;
    • Dexcel (an industry good provider contracted by Industry Good Inc) would be maintained as an independent entity outside GDC ownership and control; and
    • the need to continue regulating herd testing and the collection and dissemination of data for the national breeding objective and/or for animal traceability will need further consideration.

29. See section 8 (para 43 onwards) of Annex 1 for more detail.