The Dairy Industry Restructuring Act 2001 (DIRA) was a piece of legislation that was passed by Parliament when the Labour Party was government. The main reason this piece of legislation was introduced, was to allow then New Zealand Dairy Group to merge with Kiwi Co-operative Dairies along with the New Zealand Dairy Board. At the time of the proposed merger, the New Zealand Dairy Board was the only organsation that was permitted to export dairy products out of New Zealand. In order to create this monopoly (the combined organsation would be collecting about 90% of all milk produced in New Zealand), the laws needed to be changed. Initially the Commerce Commission declined the application under anti-competitive behaviour. However, the government came to the party and changed the law to allow the merger. But there was conditions around the collection of milk.
The first significant act was the compulsory collection of milk from any producer who requests to supply the new company. As Fonterra was collecting such a large volume of milk, there was no other option for a supplier if Fonterra was allowed declined their request to supply. The effect this had on Fonterra will be felt for many more years. In order to process this huge supply of milk, Fonterra set about building dairy factories that processed raw milk into milk powder. Milk powder is the lowest value product they could make. But their hands were tied. Fonterra could not turn away any supply of milk and unlike almost any other commodity, fresh milk has a very short shelf life until it is processed. It has to be processed within three days to avoid it spoiling. Milk powder was a safe bet. It is also the lowest return.
The second and equally onerous rule imposed, required Fonterra to supply up to 500 million kgs of raw milk solids to competitors at a below market price. This price was calculated using a complex formula that would provide a fair price and allow competition to access raw milk without their own milk collection infrastructure. While the price that was calculated using the special formula was above Fonterra's costs to collect this milk, the actual risks around a volatile fresh product as well as its seasonal supply fluctuations were not fully appreciated or worked in to this equation. The vast majority of milk is produced in the spring (this also adds to the above paragraph requiring production capacity to be built based on a peak that is only reached for 1-2 weeks a year) with very low volumes during the traditional 'dry' period of April-July. However, Fonterra still has an obligation to supply milk to its competitors over this time, up to the limit. In addition, if a competitor no longer requires the milk, they can simply make the call to delay or cancel the future deliveries. This risk is all Fonterra's. They need to have the capacity to process every drop of milk they collect, knowing that their competitors may or may not take their full allocation. Fonterra is legally obliged to have a constant excess production capacity. This reduces the return to their shareholders.
Like all government policy there is unintended consensuses. In the case of the DIRA, the cost of this policy lies squarely on Fonterra and its shareholders. Observers could argue that this is the 'cost' of forming Fonterra. I disagree and would instead argue that this make the entire dairy industry in New Zealand less competitive. Without government support, the merger would have never taken place and this is the way it should have been for the better of New Zealand dairy farmers. The quicker the entire DIRA is thrown out the better it will be for the industry.
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