The Future of the New Zealand Dairy industry.

The future for New Zealand dairy products remains providing ingredients to global markets. Consumer goods and the so-called “high value” those products offer remains a fanciful destination for our dairy industry as it is currently structured. We have long been a high volume producer of pasture-fed milk whose competitive advantage lies in low costs – low enough to outweigh the tyranny of distance from our main markets.

All of which makes the doubling of milk volumes since 2008, a stunning achievement, but one with some undesirable consequences. The growth is partly due to conversion of land to dairying and partly to irrigation, intensification and supplementary food. Despite these recent developments the facts of dairy life here remain unchanged: We are too far away from markets to deliver fresh milk products which is where the margins are for consumer milk products. We can only deliver long shelf life stuff - dehydrated WMP, UHT, cheeses and increasingly the suite of "antioxidants and unique nutritional compounds” which can be delivered by combining our milk ingredients with some novel third party products into nutritionally-beneficial consumer products.

When it comes to milk, the reality is that the global consumer will pay more for fresh, more for less additives. For New Zealand dairy exports, we remove the water to overcome the transport barrier our distance from markets presents. We have to be viable.

Back here on-farm in New Zealand then our competitive advantage remains the low cost of pasture – a considerable advantage compared to the economics of cut and carry or imported supplementary food. Yes New Zealand milk volume has doubled since 2008 but there’s two things about some of these new milk producers need to appreciate;

(a)  they aren’t paying for the additional environmental damage they’re imparting from intensification;

(b)  neither are they paying for the essential water that their irrigated supply provides.

These new sources of milk then currently enjoy artificially low costs. Their current economics are quite false, dependent upon them getting a free ride on pollution and on access to water. If the environmental damage alone was fully costed and levied on the farmers this intensified pastoral cost of milk production (currently $US3 per kg MS) may well not be as cheap as US barn fed ($US5.50 per kg MS).

And then there’s the cost of water (99% of which is for irrigation, the amount cows use directly is negligible). In some of our catchments water is over-allocated and so the market price is well above zero, in other catchments it’s not, so the price per litre is negligible, even zero. So this cost is not the same for all farms that‘s for sure.

In summary, there is evidence that at least some of the expansion in our dairy industry is based on totally false economics – no costing of the environmental damage, no costing of the water required. The solution to such an economic  distortion is to establish markets for both, to ensure users pay the market price for each. The Opportunities Party intends to follow such a strategy and remove the market distortions that are conferring privilege on this activity.

Our environmental strategy is to adopt a “polluter pays” mechanism (whether we’re talking urban or rural activity we don’t differentiate on that matter). Such an approach delivers significant benefits to the best practice dairying that imparts minimal environmental degradation. Correspondingly it will raise the costs faced by the most polluting of industrial practices – whether farming or any industry in fact. It is reassuring that farming leaders have undertaken to make New Zealand rivers swimmable again. While they don’t have any strategy let alone any that’s credible, at least the industry acknowledges the problem. That is a major advance on years previous when denial was all that sector’s leaders could manage.

We shouldn’t forget that pollution in the rural sector is not all about water either. The soil under intensive operations like un-irrigated market gardens and horticulture operations have all manner of contaminants from the various sprays used over time that are another type of “polluter pays” problem to be resolved, as the residues they are leaving will be around for a long time if not permanently. For sure the issue is far wider that nutrients, toxic residues are a major in some areas as well.

For the separate issue of water allocation we take the view that the global demand for fresh water will continue to increase as industrialization and climate change conspire to squeeze the supply/demand balance. We have already seen this in New Zealand as the international demand for our freshwater bottled, lifts. Together with the far greater demand from irrigation for water needed to expand horticulture, cropping and livestock production it is clear that water needs to be priced if it is to be allocated to production that confers the greatest benefit to the source of that water – our environment. Not to do so will see a continuation of over-allocation and arbitrary access to The Commons – the classic free-rider problem that creates a privileged class of producers and damages the economics of others.

It follows then that dairying should line up with all other commercial users and pay the market price for that freshwater that’s available for commercial use. Our “Clear Water Action Plan” does exactly this. Catchment by catchment it determines what the market value of water is and ensures users pay that. The proceeds are applied to our Nature Investment Fund that is responsible for ensuring the sustainability of our freshwater sources and the quality of the fresh water they produce.

Implications for Dairying from User Pays

By pricing environmental degradation and commercially allocated freshwater properly, the new wave of intensive, industrial-scaled dairying will be on a level playing field with alternate natural resource uses – cropping, drystock, horticulture, forestry, tourism, grass-based dairying. This is essential if New Zealand is to maximize the economic benefit from employing our natural capital.

For dairying specifically, it may well be that full user pays for natural resource usage will lead to at least part of the industry’s recent expansion proving uneconomic. Once the environmental subsidy is removed we’d expect investment to switch more toward raising productivity from existing resource use,  and as well more toward extracting more profit from the consumer end of the supply chain (ie; toward production of those unique nutritional and medical products aforementioned). For the farmer/owners the percentage of return coming from dairy company dividends as opposed to dollars per kg of milk-solids would correspondingly rise.

Of course to realize those returns the industry will need to invest in technologies, production and distribution. For an industry that is structured to reward its shareholders primarily through the milksolids price (and by so doing incentivize farmers to produce a greater volume of raw milk) that remains a challenge. The industry will require investment capital – from retaining earnings and possibly from raising new capital (equity and debt) – if it is to be in a position to chase the returns available from downstream value-add. It is here that TOP’s restructuring of capital markets will be of significant benefit to our dairy industry.

The benefits of restructured capital markets and R&D revival

There are two of our policies which have substantial positive impacts on the economics of dairying – and indeed all innovative, competitive business activity. They are

(a)  our tax reform that sees the closing of a major loophole in our income tax regime that currently bestows a tax privilege upon some forms of income to capital.

(b)  our reform of NZ Superannuation that frees up the tax accumulated in the NZ Superannuation Fund ($34bn) to be applied to R&D, technology and science research that bestows greatest rate of return to New Zealand

Tax Reform

Our tax reform – that will close the loophole that rewards mere ownership of capital and encourage that capital be put to productive use – will change dramatically the deployment of investment capital in New Zealand. It will end the decades long over-investment in property as a store of value and lead to property being a desirable asset class solely for its productive capability.

For dairy farm ownership this implies the price per hectare will be directly related to the profit potential of the land, not necessarily the kgs of milk solids that such land produces. With inputs fully priced, the profit maximizing position will no longer necessarily be the same as the milk solids volume-maximizing one.

Our tax reform will have no impact on businesses already earning and declaring a taxable income above the minimum deemed rate for businesses. Let’s say that minimum deemed pre-tax income is 5% on balance sheet net equity. Then a farm yielding above that today will become more valuable than one that yields less (the after-tax income of the former will be unchanged, while that of the latter will reduce). For farmers earning a pre-tax return on net assets of 5% or more then not only will there be no additional tax due on equity, the staff will enjoy the lower tax rates on PAYE income and the owners of the farm will have a lower tax on profits. This arises because the total tax take is unchanged by our tax reform – what we gather in additional revenue from closing the loophole, we give back by a cut in tax rates.

Business is cyclical and loss years can occur. While the tax impost on deemed income on capital applies every year, there will exist a limited ability for cyclical businesses to defer payment of tax during loss years (with appropriate use of money interest).

Innovation, R&D and technological change

One of the consequences of reforming NZ Superannuation – an important component of our taxation and social security reform – is that the $34bn NZ Superannuation Fund becomes redundant. This provides New Zealand with the opportunity to restore its investment in innovation and R&D to levels appropriate to an affluent economy pursuing high income-based economic growth. TOP’s plan is to apply that fund in part to public/private partnerships that extend New Zealand’s competitive advantage in technology.

The NZ dairy industry has a competitive advantage in its herd breeding, on-farm production and in selected manufacturing processes. It is well-placed to extend this advantage into the development of antioxidants and unique nutritional compounds for which there is global demand. The National Innovation Fund would seek to participate in exploitation of those opportunities.

Conclusion

The dairy industry is an important one for New Zealand, it has a long history, several unique comparative advantages and over the decades has developed competitive advantages in some aspects of the dairy product supply chain. For the future of the industry and the investment New Zealand has made in it, it’s essential that it expands on a sustainable basis, that false transitory successes do not send it down blind alleys with undesirable consequences – either to the industry or to other New Zealand sectors.

For that to be the case it must grow on a full cost recovery basis free of subsidies, subject to market signals that encourage investment in truly profitable activity. On the other hand, because of its importance the State needs to recognize that strategic national investment in R&D includes capitalizing on the IP and technological advantage that has already been accumulated over many decades by this industry. TOP’s business, taxation and investment policies ensure this will be the case.