The ACCC view - dairy from a competition perspective

Speakers: 
Mr Mick Keogh, Commissioner
Conference: 
Trans-Tasman Dairy Leaders Forum
6 May 2019

ACCC Commissioner Mick Keogh delivers an address to the Trans-Tasman Dairy Leaders Forum on the dairy industry from a competition perspective.

Transcript: 

Check against delivery

Introduction

Good morning, and thank you for the invitation to speak today.

The Australian dairy industry is facing some significant challenges at the moment, which I am sure is not news to anyone in this room.

In fact, it’s probably fair to observe that decisions made in response to some of the current challenges will be as strategically important to the future of the sector as were the decisions made in the run-up to deregulation in July 2000.

Those decisions will need to be made by those participating in the industry, be they the processors represented here, or the 5500 dairy farmers dealing with the current challenges at an individual farm business level.

That said, decisions by government and regulatory agencies provide a framework in which the industry operates, and therefore can also be of some significance in setting strategic directions for industry.

As I am sure you are aware, the dairy industry has been a focus for the ACCC in recent times.

At the direction of government, we examined it in great detail through our Dairy Inquiry, and a number of issues that came to light during that process have been the subject of further ACCC activities.

Our focus has been and remains on competition issues in the sector, and in my talk today I will expand on these, and our recommended responses.

However, before doing that I think it is useful to stand back and consider the bigger picture in relation to the domestic and international market environment in which the Australian dairy industry operates.

The first point to note is that for Australian agriculture more generally, the ability to compete purely as a “least cost supplier of generic product” is rapidly diminishing.

Australian farmers and processors cannot ever hope to experience energy, labour, transport and regulatory costs as low as those experienced by many of our major global competitors, so even with sustained productivity growth through all levels of supply chains, trying to beat global competitors purely on price is not a sustainable strategy.

A second point to note is that economic growth in developing nations is producing a growing group of middle class consumers with rising levels of disposable income. These are increasingly making purchase decisions based on provenance and credence factors and not just price, and many Australian food exporters are successfully responding to these changing consumer demands, at premium prices.

One only has to observe the international demand for premium Australian baby formula to see an example of this, and there are plenty of similar examples in other agricultural sectors.

In relation to the dairy sector in Australia, it is my observation that the mainstream directions being taken in response to both these factors are questionable.

Many farmers are being encouraged through payment models to move to feed-based non-seasonal production systems, which increases their costs and risk, especially when water and feed costs are high as is the case at present.

At the same time, some major processors do not have strong retail brands, and instead focus on supplying low-cost generic products such as private label drinking milk and cheddar cheese, and bulk milk powder for export.

It should be noted that these comments are somewhat generalised, and I am well aware that some processors and farmers have successfully adopted alternative strategies.

However, as a general observation, there seem to be real questions about the potential for sustainable growth in the sector over the longer term, especially if farmers are being pushed into high-cost production systems by processors that are servicing price-sensitive, generic markets, and need low farmgate prices to remain profitable.

The current exodus of farmers from the industry is because of a number of factors including drought, but low and unresponsive farmgate prices are certainly an additional factor.

The ACCC Dairy Inquiry was not required to consider these broader issues, but they provided an important backdrop to our deliberations. Our inquiry was required to focus on the health of competition in the Australian dairy sector, and to recommend ways that it could be improved to create a better environment for investment and economic growth in the sector.

In my talk today, I will discuss three topics. These are:

  1. The ACCC’s perspective on competition more generally,
  2. The key observations from our Dairy Inquiry, and
  3. Why we think changes are needed in the industry.

How the ACCC looks at competition

Before I talk about competition in the dairy industry, I want to start by providing a broader outline of the ACCC’s views on competition more generally.

Competition law and policy are essential underpinnings of our free-market economy.

As Australia’s competition regulator, the ACCC is tasked with protecting competitive processes by taking action against unlawful anti-competitive behaviour and highlighting practices that can inhibit these processes.

The threat of competition encourages:

  • firms to produce and offer products most valued by consumers (allocative efficiency)
  • the most productive firms to prosper and inefficient firms to decline (productive efficiency), and
  • firms to innovate and invest to build productive capacity (dynamic efficiency).

Competitive markets are the most effective mechanism known for encouraging the efficient use of resources and promoting economic growth.

When assessing competition, agencies such as the ACCC commonly look at the structures and dynamics of markets across the entire supply chain.

First, it is necessary to look at the degree of horizontal competition in a market, where suppliers of similar types of product compete against each other for sales to customers (or to purchase from suppliers).

We often also consider the vertical arrangements in an industry—that is, the relationships between suppliers and customers at different points of a supply chain (for example, between a farmer and processor, and a processor and supermarket).

The horizontal and vertical dimensions of the industry are often interrelated, and they influence competitiveness and overall performance of an industry.

Across an industry, all players at different stages of the supply chain are jostling for a share of profits. If horizontal competition in the processing sector is strong, the opportunity for one processor to dictate trading terms (either with farmers or supermarkets) is limited because they can simply switch to a different processor that offers better terms. In this way, horizontal competition affects the nature of vertical relationships and influences the distribution of the available profits across the industry.

The time dimension is another important consideration for competition issues.

When assessing the degree of competition in a market, the ACCC will distinguish the short-term effects of market behaviours from longer term impacts.

Firms will generally be deterred from raising prices, and prevented from capturing an excessive share of industry profits for a sustained period of time, when effective competitive constraints exist in a market or are likely to become effective in a period of one to two years.

However, if constraints do not appear likely to develop in this sort of timeframe, then intervention may be required to prevent conduct such as mergers or other practices that are likely to substantially lessen competition.

Key observations from the ACCC Dairy Inquiry

Against that background, I would now like to talk about the key observations arising from our Dairy Inquiry.

The ACCC conducted a detailed examination of the sector at all levels from farm to retail, which was enabled by powers to mandatorily obtain information and to cross-examine industry participants.

I am aware that many organisations represented here today were subject to information requests or had staff cross-examined. The ACCC recognises the burden this can impose on businesses, and I want to acknowledge the high level of cooperation we received from processors and thank you all for your forbearance.

That said, the information arising from these processes was critically important in ensuring we obtained a full and objective picture of how competition operates in the sector.

The dominant picture that emerged was one of significant imbalances in bargaining power at each level of the dairy supply chain.

We found that the relative bargaining strength of supermarkets, processors and farmers plays a key role in determining who receives the greater share of the profits.

Supermarkets clearly have strong bargaining power relative to processors. However, dairy processors are also typically large companies with some countervailing bargaining power, and are armed with market information for their negotiations with retailers.

Many processors also have the genuine alternative of supplying products into export markets.

The bargaining power imbalance between dairy farmers and processors is even greater than the imbalance between retailers and processors.

Even in milk-producing regions where dairy farmers can sell to a number of processors, all but the largest dairy farmers lack bargaining power relative to processors.

Processors who actively compete for raw milk have the option to negotiate with a large number of farmers who are mostly substitutable for each other. In contrast, the average farmer has only a few alternatives, and in some cases just one option, for selling their milk.

It is also very difficult for dairy farmers to switch to alternative farm enterprises in response to low milk prices, especially in the short term. This further weakens their bargaining power, and hence horizontal competition among processors.

The presence of $1 per litre milk (and now $1.10 per litre milk) clearly affects confidence within the dairy sector, but we concluded that it is not a key factor driving the overall profitability of most processors and farmers.

For processors, dealing with supermarkets presents challenges across the range of dairy products they produce, and we found that processor margins vary significantly by product. Supermarkets naturally pressure processors to supply products at wholesale prices that enable the supermarket to obtain desired retail margins.

Broadly speaking, the supply of private label milk is not of itself very profitable for processors, but it can result in efficiencies that reduce average processing costs for some processors.

Further, while we observed strong competition between processors for private label milk contracts, processors are not required to enter into these contracts, and the ACCC also found evidence of processors electing not to participate in private label tenders they did not consider would generate acceptable margins.

It is also worth observing that trading arrangements between processors and retailers are governed by the Food and Grocery Code, which has been the subject of a separate review in recent times.

For farmers, outside of uncontrollable factors such as climate and drought, the key issues affecting their costs and profits are:

  • an inability to engage in any real contract terms or price negotiations with processors
  • poor information including opaque and untimely pricing guidance
  • transfers of risk that go well beyond what they can reasonably manage (such as step-downs and loyalty bonus mechanisms)
  • cost transfers (such as seasonal incentives), and
  • barriers to switching.

These factors are all a result of processors’ ability to leverage their far superior bargaining position in determining contract conditions.

Processors’ bargaining power advantage over farmers’ manifests as:

  • the softening of competition between processors for the acquisition of raw milk. Processors do not have a strong incentive to provide farmers with desirable or innovative contract terms, and use contract terms that restrict farmers from switching to competing processors.

As the Dairy Inquiry reported, examples of these contractual barriers include unreasonably long notice period requirements, and loyalty bonus payments that are paid in respect of one dairy season but require ongoing supply into a new dairy season

  • risk being transferred from processors to farmers. Dairy farmers may face significant commercial risk from exposure to unexpected changes in milk prices and input costs, which challenges their ability to make informed production decisions and to operate profitably.

This is exacerbated by processors’ ability to transfer risk to farmers. The 2016 step-downs were the clearest example of this risk transfer in recent times. However, other examples are common in milk supply agreements, such as processors’ ability to unilaterally vary Handbook terms, variable pricing, and seasonal pricing incentives that require farmers to manage the risk associated with seasonality

  • information asymmetries. Processors hold better information than farmers, including wider market knowledge at the farm, wholesale and retail levels, and have discretion over when and how this information is disclosed. Processors often communicate price and contract information in complicated formats. Further, announced prices do not necessarily reflect actual prices.

Processors typically make uniform pricing offers to farmers and announce a single farmgate price at the start of the season. However, the prices received by farmers vary significantly from the announced price. Consequently, farmers are more likely to settle for an average offer rather than a better offer that might be available if they were better informed.

While factors such as international dairy commodity prices obviously have a major role in determining farmgate milk prices, especially in southern markets, there is some confirmation of the relatively weak bargaining position of Australian dairy farmers provided by the observation that prices paid to dairy farmers in Australia are lower than in any of the major dairy-producing countries in the world (Australian dairy industry in focus 2018).

These manifestations of farmers’ lack of bargaining power discourage productivity-enhancing investments by farmers. This is because they add unnecessary risk that deters farmers from making worthwhile investments, to the detriment of the dairy industry.

The ACCC response: why things need to change

As those of us here know, agriculture industries have been subject to a reduction in regulation over the past three to four decades.

Broadly speaking, deregulated markets are more efficient and promote better overall economic outcomes. However, markets that are free of regulation do not always deliver the best outcomes.

This is because some market failures, such as imbalances in bargaining power and information asymmetries, cannot typically be addressed by existing competition and fair-trading laws.

A range of tools can be used to address market failures, and the ACCC strives to identify interventions that do not distort the operation of a market.

In most cases, a suite of interventions is required, which is what we suggested for the dairy industry in our Dairy inquiry final report.

Overall, the ACCC found that change is needed in the dairy industry. Our recommendations point to a number of critical areas of reform, including:

  • the need for clear, simple and written contracts that are acknowledged by both processors and farmers. This will assist to clarify the commercial relationships between farmers and processors, as this has not always occurred in the past
  • the removal of barriers to switching that limit farmer choice between processors, and soften competition in the market for acquiring raw milk
  • ensuring that contract and price information is available to farmers well before the start of a new dairy season. This will increase transparency and ensure farmers have the necessary information to make supply decisions before they have committed to supply a particular processor
  • the need for processors to publish information identifying how their pricing offers apply to individual farm production characteristics to enable better farm income forecasts.

Finally, we considered that a mandatory code of conduct is needed regarding the relationship between processors and dairy farmers.

We noted the significant positive change achieved in some areas in association with the industry’s voluntary code. However, as we have seen in other sectors with voluntary codes, the lack of compulsion and adverse consequences arising from a breach of a voluntary code erodes its value over time, and means that backsliding on improved competition will be inevitable.

Reinforcing this, our enforcement work with dairy processors over unfair contract terms during the past 12 months has highlighted significant definitional variation, and the lack of adverse consequences for those who breach the voluntary code.

A mandatory code will assist to implement a number of the recommendations discussed above, and is, in our view, the only long-term way to address the bargaining power imbalance and problematic contracting practices in the industry.

The Australian Government announced in March that it is advancing the mandatory code, following a number of rounds of consultation.

The ACCC has been pleased with much of the progress made in relation to the proposed mandatory code, but continues to advocate to ensure the code is strong enough to address practices in the industry that we consider problematic.

The ACCC considers that the code should include an outright prohibition on step-downs, regardless of whether they are prospective or retrospective.

Step-downs unfairly transfer the risk of global commodity fluctuations from the processor to the farmer, whereas the processor is best placed to manage this risk for the duration of a contract.

As such, we consider that step-downs, in all forms, should no longer be a feature of the industry.

Conclusion

The problems facing the industry as identified in the Dairy Inquiry present an indisputable case that change is needed.

In this instance, the implementation of a mandatory code to govern the relationship between processors and farmers is the appropriate means of reducing the effects of the bargaining power imbalance between these parties.

We look forward to working with government to deliver the mandatory code of conduct and to enforcing the code to improve practices in the dairy industry.

This code can improve the allocation of risk and enhance competition in the industry, creating better outcomes for market participants and consumers, which is at the core of what we do at the ACCC.

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