Competition Policy Review of Victoria's Dairy Industry

Submission to the National Competition Policy Review of Victoria's Dairy Industry Act 1992

SUMMARY

We note that parts of Australia, particularly the Gippsland region of Victoria and Tasmania, are ideally suited to dairy production.  The industry has achieved high levels of efficiency.  But deregulation will allow producers to improve their efficiency and bring about rationalisation to the benefit of those regions best suited to the industry.

The present regulations entail dual price structures for market milk and manufactured milk and discourage inter-state trade.  These measures prevent efficient industry development by creating price structures that differ on a State jurisdictional basis.  The regulations are inconsistent with commitments by the Victorian and other governments contained in the competition policy agreements and in the regulation review policies that preceded them.

Aside from creating industry structure inefficiencies, the regulations impact on the consumers of fresh milk, who are required to pay twice the price for the product ex-farm than other customers.  They also impact on certain product categories that compete in the broad beverage market, like flavoured milk, by artificially raising input prices.

The Victorian dairy industry and the State generally will gain from increased efficiency and activity in processing that will result from deregulation.  It is unlikely that other States could continue with their present regulatory measures if Victoria were to deregulate.

The industry has sought compensation for agreeing to deregulation.  Whether such compensation were to be a direct payment from the Commonwealth Treasury or a levy on certain products it is not warranted.  Almost all other industries have been subjected to competition and the compensation has generally been confined to some phasing arrangements.

INTRODUCTION

The Industry's Characteristics

Milk production is critically dependent on natural inputs.  Unlike most industries -- and even an increasing number of agricultural industries -- milk is best produced where natural climatic factors are propitious and land is relatively cheap.  Rainfall, a temperate climate with a long growing season for grasses are critical.  Hence, parts of Australia, along with New Zealand, are ideally suited to the industry.

Traditionally, fresh milk has not been able to be stored for long periods and its production close to major markets has enjoyed natural barriers to competition.  These are changing somewhat with the higher market acceptance and improved taste characteristics of UHT milk, but are likely to remain significant.

The industry's derivative products -- butter cheese, powdered milk etc. -- account for half its production and are readily preserved and traded.  The entry of Parmalat into the Australian industry and resurgent activity by other majors like National Foods and Bonlac is likely to transform what was once (and largely remains) one dominated by producer co-operatives.

The Industry's Output

Of the Australian output, over half is exported with the remainder split evenly between drinking milk and manufactured products.  Australia, with some 12 per cent of the world export market, is a major supplier.  Our market share is achieved notwithstanding the protectionist policies of other countries and the considerable export subsidies of the European Union.  According to the Australian Dairy Corporation, production costs in Australia are less than two thirds of those in the EU and three quarters of those in the USA.  New Zealand has a slightly lower cost structure than Australia.

Australian average costs tend to be boosted by production in areas not well suited to the industry.  The parts of Australia ideally suited to milk production, happen to be predominantly located in Victoria -- specifically the Gippsland region, which dominates the industry -- and Tasmania.

Both in terms of herd size, averaging about 150 dairy cows per farm, and production per cow, output per farm has been increasing.  Average herd size is considerably below the level at which economies of scale are exhausted.  This is believed to approach a herd size of 2,000.  Production per cow has increased by 40 per cent over the past twelve years.  The number of dairy farms has halved to about 14,000 over the past 25 years, over 8,000 of which are in Victoria.

Victoria's share of national production is currently 62 per cent and has been increasing.  This is a reflection of some liberalisation that has occurred and the trend away from fresh milk consumption.  That latter trend may partly reflect Australia's changing population age profile but is also a reflection of health concerns regarding cholesterol.  The industry's response has been to increase output of reduced fat milk and to find new fresh milk markets, especially flavoured milk.  These product categories have grown from 10 per cent of fresh milk to almost half of the total during the past 12 years.  Their growth is itself attributable in large part to the increased competition in the industry.

The industry has also increased exports of liquid milk, largely in the form of UHT, though these still comprise only 3-4 per cent of domestic fresh milk sales.

Export production, which accounts for half of raw milk production, is valued at close to $2 billion.  Exports are dominated by cheese, powdered milk and butter and are largely to Asia.  Having hit a low point in the early 1980s, Australian exports have digested the loss of markets resulting from Britain's accession to the European Union and have been increasing rapidly over the past 15 years.  The Asian crisis has not markedly reduced export growth.

The figure below illustrates the trends in production and utilisation.

Figure 1

Source:  Australian Dairy Industry Corporation

REGULATORY ARRANGEMENTS

The Measures in Place

Across Australia, the dairy industry has been closely regulated over many years.  Regulations have set prices at the farm gate, for cartage and in the retail outlets.  The key aspect has been a dual price system with fresh milk receiving a high price and other milk usages being left to market forces.  In States with a quota system, (NSW, Queensland and WA) the high price is dependent on owning quota (which can be traded).  The other States pool the milk with farmers receiving the premium price for the fresh milk sales.  These regulatory arrangements have been supplemented by formal and informal measures preventing inter-state sales.

The dual price system differs from state to state.  The market milk price varies:  it is 58 cents per litre in Queensland, 51 cents in NSW and 49 cents in Victoria.  Milk for manufacturing purposes commands a price of about 24 cents per litre.  This price differential is moderated somewhat by levies on fresh milk (about 1.9 cents per litre) and on manufactured milk for domestic consumption (around 3.7 cents per litre).  The funds from these is directed to farmers for the milk they supply to manufacturers of dairy products.

Milk is, of course, a homogenous product and there is no difference between the product directed to the fresh milk market compared with that going to manufactured products (or going to the fresh milk market without a quota for the premium price).  As a result of these factors, the producers receive markedly different prices for their output.  Those farmers in States where fresh milk comprises a high share of output receive much higher prices.

Based on the NSW Dairy Corporation estimates, without allowing for the moderating influence of the levies, the average price received by Victorian farmers was 64 per cent of that received by those in NSW and Queensland (Tasmanian milk producers fared even worse, receiving only 59 per cent of the NSW/Queensland price).  Figure 2 below illustrates the average prices received.

Figure 2

Decomposed into their two sub-parts, these prices are as shown in the table below:

	Market Milk	Manufactured Milk
NSW/ACT	50.9	25.1
Vic	48.1	22.7
Qld	58.9	24.0
SA	51.1	21.8
WA	53.3	25.6
Tas	54.9	20.4

This price disparity, as well as bringing about a considerable inefficient distortion in the industry nationally, represents a considerable burden on the Australian consumer.  Milk producers, through the monopoly arrangements they have persuaded governments to underwrite, are engaged in price gouging of the Australian fresh milk consumer.  Such actions almost certainly result in reduced consumption of milk products.

Within Victoria the Dairy Industry Act (1992) governs the industry.  Sale of dairy products has been progressively liberalised.  The key regulation remaining is the dual price system which was ostensibly intended to ensure sufficient supplies of market milk while offering "equitable" returns for farmers.  The market for milk products is (and probably always was) sufficiently mature for no economic regulation to be necessary.  As for the need for "equity" for producers, the search for the "just price" outside of the forces of demand and supply has a long and ignoble history.

General Government Regulatory Policy

The regulatory arrangements that allow the vast price dispersion of dairy products to occur are not compatible with those agreed to by premiers in instituting the national competition policy reforms.  Under the Competition Principles Agreement -- 11 April 1995, Governments agreed:

5.(1) The guiding principle is that legislation (including Acts, enactments, Ordinances or regulations) should not restrict competition unless it can be demonstrated that:
(a) the benefits of the restriction to the community as a whole outweigh the costs;  and
(b) the objectives of the legislation can only be achieved by restricting competition.

These matters complement the regulation review procedures that are in place in most States.  The Victorian Subordinate Legislation Act 1994 requires economic analysis and public scrutiny of all substantive regulations via a Regulatory Impact Statement ⁽¹⁾.  This applies to all existing regulations, which expire ten years after their enactment, and to new regulations.  The Act draws attention to the possibility of regulatory failure and seeks to ensure that any regulation that is deemed necessary is the most efficient solution to the identified problem.

Incentives for the Government to Meet the Obligations

Governments have a general incentive to allow increased application of market forces simply because this allows greater wealth creation.  The regulation review procedures that pre-dated the competition policy are testimony to the recognition of this.

Further disciplines to review competition within the deadlines set by the competition policy have been established by competition payments.  These recognise that there is a national dividend from competition reform and that, at a governmental level, the Commonwealth rather than the States obtains the greater share of this because of the structure of Australia's tax system.

Hence, under the NCP Agreements, the Commonwealth agreed to make special payments to States and Territories that made satisfactory progress in implementing the national competition policy reforms.  If a State or Territory does not take the required action within the specified time, its share of the payments will be withheld.  The National Competition Council (NCC) program is to assess whether the conditions for payments to the States and Territories, have been met.  The first formal assessment was made prior to 1 July 1997, and basically required only that at program be in place.  The next assessments are to be made prior to 1 July 1999 and 1 July 2001 and will examine the outcomes of reforms in greater detail.

The money which has been allocated to these special payments is set out in Figure 3 below (estimated nominal $ million).

Figure 3:  Competition Payments

Source:  National Competition Council Brochure (October 1996)

Victoria's share of the $16 billion total is about 25%.

The NCC has indicated the matters that can be taken into consideration in establishing interventions in the public interest.  The criteria for doing so adopt a deregulatory approach but make clear the ultimate objective is not competition per se but using competition and deregulatory measures to enhance the community's living standards and employment opportunities.

Under Clause 1(3) of the CPA, several issues may be taken into account in determining what constitutes the "public interest".  These cover a wide range of matters including:

• (d) government legislation and policies relating to ecologically sustainable development;
• (e) Social welfare and equity considerations including community service obligations;
• (f) government legislation and policies relating to matters such as occupational health and safety, industrial relations and access and equity;
• (g) economic and regional development including employment and investment growth;
• (h) the interests of consumers generally or of a class of consumers;
• (i) the competitiveness of Australian businesses;  and
• (j) the efficient allocation of resources.

The NCC noted ⁽²⁾ that there were no weightings to these particular provisions.  It argues that the onus is on those promoting an exemption of an arrangement to demonstrate that it will be a superior approach.  In this respect, the NCC draws attention to the "net public benefit" test applied by the Australian Competition and Consumer Commission (ACCC).  The ACCC approach is that, unless there are clear arguments to the contrary, competition is to be enhanced in order to meet the objectives of the Trade Practices Act (TPA) on which the competition reforms are largely predicated.  The TPA's objective is to "enhance the welfare of Australians through the promotion of competition".

As well as controlling price within Victoria, the Dairy Industry Act allows the Victorian Dairy Industry Authority to control exports out of Victoria and promotional activities.

The dairy industry regulations are clearly out of step with those required to generate efficiency and cause resources to be maintained in farming activities that would otherwise be non-viable, while preventing expansion in areas that are well suited to the activity.  It would be exceedingly difficult to make a persuasive case for an exemption from general competition rules on any of the public interest grounds of the Competition Principles Agreement.

IMPLICATIONS OF DEREGULATION

Different State Effects

The relative efficiency of milk production can be gauged by the share of premium priced milk on a state by state basis.  This is illustrated in the Figure 4 below.

Figure 4

Market milk, according to the latest NSW Dairy Corporation estimates, accounts for only 7.6 per cent of Victorian production, and 10.2 per cent of Tasmanian and 26.7 per cent of South Australian.  The other States' producers are heavily dependent on the regulated premium price.

Victorian farmers benefit in the short term from the regulated price which doubles their revenues on 7.6 per cent of their production.  They also benefit (by about $6,000 per farm) from cross-payment by inter-state farmers and manufacturers.  Nonetheless, Victoria as a whole is in a strong position to benefit from deregulation.  The immediate outcome will be both a reduction in price in fresh milk, with some increase in the price paid by manufacturers, which are lower than in the other two eastern States.  The reduced price of fresh milk would be expected to boost demand.

The state reviews in Queensland and NSW have acknowledged that their state industries would be forced to follow Victoria's lead in the event of deregulation.  Although transport costs are an impediment to inter-state trade in fresh milk, some sales would be made by a Victorian industry fully unleashed to sell in markets where the price is double that available within the state.  These pressures will force reductions in the regulated prices and undermine the two price system.

Hence, even if other States resisted deregulation (and forfeited competition policy payments as a result) the subsidies their dairy farmers obtain will be eroded.  The size of their industries will contract and, especially in the manufactured products, production will migrate to Victoria and Tasmania.  The cautious political announcements on deregulation in other States recognises that it may be better to grasp the nettle of deregulation once Victoria has done so and have the industry rationalise in an ordered manner rather than be gradually choked.

Deregulation will also bring milk inputs into line with their real price.  The anomalies created by the dual price system are apparent in products like flavoured milk, where producers are obliged to source their inputs at fresh milk prices.  Milk generally, and especially flavoured milk, competes in the general beverage market.  Although these product lines have been growing strongly, with a 20 cent per litre reduction in their input prices resulting from deregulation, their growth would accelerate.

Compensation to the Industry

The industry is seeking restructuring assistance, one way or another underwritten by the Commonwealth Government.  There is a case for such assistance where suppliers have quotas that enable them to earn premium returns.  That case exists notwithstanding the fact that the quotas should not have been present in the first place.  After all, quotas have created a property right and these rights should not lightly be abrogated.  Estimates as to the sums involved vary between $1 billion and $1.5 billion.

That said, there are many reasons why no compensation should be offered.  Not the least of these is that buying out quotas is a highly unusual procedure for the Commonwealth Treasury and one that they rightly resist.  Such action sets considerable precedents.  We have seen with analogous cases on the waterfront that the money dispersed to powerful bodies has had little effect in bringing about the necessary rationalisation.  Moreover tradable quotas are present only in three of the States.

The normal process by which an industry is eased into a more deregulated structure is to offer a phase-in of the competitive gales.  All manufacturing industries have faced a gradual reduction in tariff assistance over the past 25 years.  Average tariffs on manufactures have been reduced from 28 per cent to about 3 per cent.  The means by which the impact of these measures has been softened is through gradual reductions in assistance.  The dairy industry would be best advised to explore such measures rather than seeking direct assistance.

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ENDNOTES

1. See Regulation Impact Statement Handbook, Office of Regulation Reform, Department of State Development, Government of Victoria.

2. Considering the Public Interest under the National Competition Policy, National Competition Council, November 1996.