2 August 2011

24 minute read

Background to the Milk Package proposals

The suggested measures aim to improve stability in the dairy sector. The impetus for the Milk Package was the sustained period of low dairy prices in 2008–09 resulting from decreased demand for dairy on the global markets and increased dairy production in third countries following exceptionally high prices in 2007. Average EU dairy farmgate prices fell by 30 per cent between 2007 and 2009. The European Commission concluded that: ...the sharp decline in dairy commodity prices failed to fully translate into lower dairy prices at consumer levels, generating a widening in the gross margin of the downstream sectors for most milk and milk sector products and countries, and preventing demand for them to adjust to low commodity prices, slowing down price recovery and exacerbating the impact of low prices on milk producers.

In October 2009, the Commissioner created a High Level Experts’ Group (HLG) on Milk to “work on a regulatory framework to be put in place for the medium and long term, which can contribute to stabilising the market and producers' income and enhance transparency, while respecting the outcome of the Health Check [of the Common Agricultural Policy]”. The HLG, having taken evidence from organisations across the dairy supply chain, identified several problems in the dairy industry. These have been carried forward in the Commission’s proposed regulation (Box 1).

The European Commission’s analysis of the problems in the dairy sector

• There is a problem of price transmission along the chain, in particular as regards farmgate prices.
• Value-added in the chain has become increasingly concentrated in the downstream sectors, notably with dairies.
• The volume which will be delivered during the season is not always well planned and there is a potential lack of adaptation of supply to demand as farmers are obliged to deliver all their milk to their co-operative and the co-operative is obliged to accept all the milk.
• The use of formalised, written contracts containing even basic elements made in advance of delivery is not widespread.

The HLG on Milk produced a report on 15 June 2010 accompanied by seven recommendations. Of these, the first four are intended to be addressed by the Milk Package (Box 2). An additional recommendation on origin labelling will be covered by the Commission’s ‘Quality Package’ and those on market instruments and research will be considered as part of a wider debate on the future of the CAP.

• Member States may opt to make it compulsory for dairy producers and processors to have written contracts that specify a price or price formula, the delivery volume, the duration of the contract and the timing of collections (Article 185f).
  • Dairy producer organisations shall be allowed to establish that can jointly negotiate contract terms, including price, as long as they do not exceed more than 3.5 per cent of EU production or 33 per cent of national production by volume (Article 126a).96
  • Interbranch organisations can be set up across the supply chain to improve transparency and promote best practice, without distorting competition (Article 123).
  • An explicit legal basis for Member States to collect information from processors on raw milk deliveries on a monthly basis (Article 192).
  • The new rules will apply only until 30 June 2020 (Article 196b).

The European Parliament Agriculture and Rural Development Committee reached its position on the Milk Package on 27 June 2011. It made several amendments to strengthen the Milk Package in favour of dairy producers including increasing the size of Producer Organisations to 40 per cent of national production and requiring that written contracts, specifying a milk price for no less than one year, are compulsory across the EU.97 The Agriculture and Rural Development Committee’s report, drafted by UK MEP James Nicholson (European Conservatives and Reformists group), is expected to be put to a vote by the European Parliament by the end of 2012.

Raw milk contracts

Nearly all milk producers in the UK already have a written contract with their buyer, but these generally do not meet the standards stipulated in the Milk Package. The AHDB told us that the vast majority of contracts do not have clear pricing; buyers are able to change price at short notice, or even retrospectively while farmers are locked in by long notice periods; and contracts often do not specify volumes, which reduces the predictability of supply for processors. Farming groups felt that the existing contracts allowed processors to transfer the risks of market competition and price volatility onto farmers. The NFU added that “you would not sign those sorts of contracts in any other walk of life”. However, Dairy UK argued that “whilst these type of arrangements may not accord with notions of ‘fairness’, they are unquestionably appropriate to the dairy industry”. We heard during an evidence session into the draft Groceries Code Adjudicator Bill that it is also standard practice in the horticultural sector not to have written contracts specifying price or volume.

There are two key issues surrounding the proposals on raw milk contracts: first, whether the proposed elements to be included in standard contracts are necessary and sufficient; and second, whether Defra should make standard contracts compulsory. The NFU, NFU Scotland (NFUS) and AHDB supported the inclusion of either a static price or price formula, as well as volume, timing and duration in standard contracts. The NFU and AHDB proposed that termination clauses should be included to enable farmers to exit the contract if price variation exceeded the agreed limits. NFUS suggested a particular pricing formula, based on commodity market indicators, that could be used as the foundation of producer contracts.106 Dairy UK said they had no difficulty with the idea of contracts covering the four elements proposed by the Commission.

The NFU additionally requested that contracts not include exclusivity clauses, as these reduce opportunities for competition.108 Dairy UK agreed that “non-exclusive contracts may become more practical as producers grow larger and contractual arrangements are developed that give purchasers predictability in the volumes of milk collected”. Moving away from the current system where processors are required to take all the milk from a farm could help farmers make the transition away from a quota-based system and help processors manage their capacity.

Representatives of processors and retailers raised some concerns about stipulating particular elements in contracts. Christine Tacon, the Managing Director of the Co-operative Farms, argued that flexibility on volumes protected both sides, for example if adverse weather conditions prevented a farmer from delivering on his commitments. Dairy UK did not accept that the contract should have to be renegotiated if the price was changed. They argued that this would increase the commercial risk faced by processors of potentially uncompetitive raw material costs, and Mark Taylor of Dairy Crest said processors would drop the farmgate price as a result.

The Tesco Sustainable Dairy Group (TSDG) provides one example of how a contract specifying a price formula might work in practice. The TSDG contract commits Tesco to paying a milk price that is above the average cost of production of TSDG Members and also includes a market tracker that takes effect if commodity market prices exceed the cost of production. Andy Bloor, the Chairman of the Wiseman TSDG noted that production costs had exceeded market prices since 2009. Andy Bloor extolled the benefits of their production cost based system, stating: What we found within the first year, or probably three years, of this group was that farmers were in the position to start reinvesting, which was something they had not done for a number of years. So it was a dream initially that you would be able to ride around the countryside and be able to pick out a Tesco farm, and that is already happening within four years.

With the exception of the Ulster Farmers’ Union, farming organisations called on Defra to make written contracts compulsory.117 The NFU told us that compulsory contracts specifying a price or price formula would “give much greater certainty, clarity and transparency for dairy farmers and thereby build more confidence in the future”.Dairy UK were strongly opposed to the regulation of contracts, stating that they would undermine trust between farmers and processors and increase instability. We were not persuaded by this argument. The Co-operative Group said a prescriptive, EU-wide approach to contract negotiation risked “stifling innovation and efficiency”. The Minister did not like the idea of compulsory contracts, but undertook to consult the industry if the Milk Package was agreed. He added that “I do not share the industry’s optimism that it is the panacea to some of their problems”, claiming the industry did not appreciate “how little information could be forcibly put into the contract”.

We conclude that contracts should provide certainty and clarity to give both parties the confidence to invest—the current system fails to achieve this. Our view is that the Commission’s proposals offer considerable scope for Defra and the industry to jointly establish a more effective system of raw milk contracts. We support the recommendations of the Farming Regulation Task Force that regulation should be the last option, not the default. The majority of producers already have written contracts, however, processors have thus far resisted providing clarity on pricing in contracts (except where required by retailers). Dairy UK’s evidence does not suggest they are likely to rethink their approach. We therefore consider that a regulatory approach is justified in the absence of voluntary action. The Groceries Supply Code of Practice already sets a precedent for regulation of terms and conditions between food suppliers and buyers in cases where there is deemed to be an imbalance of bargaining power.  

We recommend that raw milk contracts should include the four elements specified by the Commission—price, volume, timing of deliveries, and duration. In addition, the contract should make it clear under what conditions the contract can be terminated by either party. Exclusivity clauses should be discouraged to allow farmers to respond to market signals following the abolition of quotas. We realise that in an era of increasing price volatility, imposing prescriptive approaches to price or volume is unlikely to be in the long-term interests of producers or processors. However, if farmers are to be tied into long contracts, which benefits processors, they should know the basis on which their milk price will be calculated and be able to adjust their business model to respond to market signals. If a processor is unwilling to commit to this degree of certainty, the farmer could opt for a shorter notice period instead. We do not suggest that all contracts must contain an explicit price or price formula as these could be overly restrictive, but contracts should set out the principles underpinning price and mutually agreed tolerances. Given that the majority of dairy contracts do not contain these elements, in order to effect the change that we think is needed, Defra should make it compulsory for producers to be offered a written contract containing the elements specified above.

The European Parliament Agriculture and Rural Development Committee’s proposal that milk contracts should stipulate a milk price fixed for no less than one year is, in our view, overly restrictive and could hinder processors and producers from responding to market signals. We recommend that the UK Ministers and MEPs do not support this proposal.

Producer Organisations

The High Level Group on Milk found that the concentration of raw milk supply is low with a resulting imbalance in bargaining power in the supply chain between farmers and dairies. The processing sector in the UK is highly consolidated—87 per cent of milk output comes from just five companies and 78 per cent of cheese output from eight companies. This results in an effective processor monopsony in some regions: one third of dairy farmers in LFA regions in England have only one buyer to supply. The NFU argued that: Milk is a perishable product, that has to be collected every day, and dairy farmers have no choice but to agree to these contracts, thus there is no ‘freedom’ to contract from a farmer perspective.

Producer Organisations (POs) are associations of farmers that must be formally recognised by the Member State and can carry out a restricted range of activities. No formally recognised dairy POs currently exist in the UK. Agricultural co-operatives differ from POs in that farmer members of the co-operative transfer ownership of all their milk to the co-operative and become joint owners of the co-operative (although agricultural co-operatives could also register as formal Producer Organisations). The Commission proposes to grant a derogation of current competition law to enable dairy POs to negotiate contract terms including price (i.e. allowing price-fixing agreements), jointly for some or all of their members' production subject to limits expressed as percentages of EU and national milk production.

EU and national law already enables co-operation among dairy farmers, particularly in the form of agricultural co-operatives. The Office of Fair Trading (OFT) noted that “[co- operatives] have generally been recognised as pro-competitive structures which allow farmers to better compete with other milk suppliers, thus contributing to the modernisation of and rationalisation in the agricultural sector and improving efficiency, to the ultimate benefit of consumers”. If farmer associations do not involve an obligation to charge identical prices, they would not normally be in breach of EU competition law. On the other hand, the High Level Group found that: If the farmers wish to market and sell their milk jointly and also agree on a common price for their milk, when an agreement between competitors involves price fixing and affects trade between Member States, this would normally be considered as a form of cartel prohibited by EU competition rules.

The exception to this provision is that farmer associations may be allowed to jointly agree a price if this is deemed absolutely necessary for the agreement to work; generates substantial efficiencies; and the association does not command more than 15 per cent or 20 per cent of the relevant market share for a joint commercialisation and a joint production agreement respectively. Above this threshold, there is no presumption of illegality, but this will have to be assessed on a case-by-case basis. Dairy co-operatives are more likely to meet these criteria while POs might have more difficulty proving that joint price-setting was required, or else risk breaching the law.

Defra did not support the Commission’s proposal, arguing that “clarifying that it is already possible for producers to collaborate within existing competition law would be a quicker and less risky way of achieving balance”. The Minister told us “there is absolutely nothing in competition law today to stop up to 20 per cent or 25 per cent of dairy farmers from working together as a cohesive group and demanding the price they want”. This is not entirely correct as dairy Producer Organisations are currently only permitted to jointly agree a price if they can prove that this is essential for their operations. The Commission proposed that the threshold size of a PO be specified as a percentage of national or EU milk production, rather than as a percentage of the relevant market. Their rationale was that the relevant market was not always easy to define, and that therefore setting a national limit would be clearer. The NFU concurred that “whilst there might be some indications out there that suggest that up to a certain level you can have a degree of collective bargaining, nowhere are they set out in absolute, clear terms”.

Dairy farmers are particularly disadvantaged in that they are selling a perishable product in a highly consolidated market with often little choice, at regional level, to whom they sell. We welcome the Commission’s proposals, which will make it considerably easier for dairy farmers to collaborate over prices and so increase their bargaining power, without fear of investigation from competition authorities.

The industry was divided over the proposed size limit of Producer Organisations at 33 per cent of national production. NFUS emphasised that POs needed to be sufficiently large to enable dairy farmers to negotiate effectively with buyers, while Dairy UK argued that “to permit one segment of the supply chain to create a dominant monopoly is flatly at odds with the concept of a market led industry striving for competitiveness”. The European Commission did not agree “because with 33 per cent you have an option, for any processor, to negotiate a price with three different producer organisations”.

Competition authorities also expressed concerns that the proposals could lead to distortion of competition. A Resolution of the Meeting of Heads of the European competition authorities “strongly warned against any legislative proposal that would enable dairy farms to jointly fix milk prices” without appropriate limits based on the relevant market and without requiring POs to carry out additional efficiency-enhancing activities. The OFT were concerned by the proposed size limit, stating that “a measure based on quantities of production risks permitting strong distortions to arise in the UK (and EU) dairy markets”. As British processors are generally restricted to sourcing raw milk domestically, the risk that POs distort competition is arguably greater here than in the rest of Europe where a processor might conceivably source from several countries. The OFT recommended that competition authorities should be able to define the relevant market on a case-by-case basis, rather than the presumption that the relevant market was national. However, in the case of the First Milk-Milk Link merger it was accepted that Great Britain was the relevant geographic market. The OFT also warned about the stringency of the conditions under which national competition authorities would be able to intervene, namely, only if they believed competition was being excluded.

The impact of the Milk Package proposal on existing co-operatives is not clear. First Milk warned that co-operatives might be required to negotiate contracts with Producer Organisations (POs) that form amongst their membership, arguing that: This proposal would put members and their co-op in an impossible position if a co-op member was also a PO member, and the PO was undertaking a contract negotiation that may directly undermine the value and security of the same farmer’s investments in the co-op. The last thing we need is anything that undermines farmer confidence in investing in their company’s own value-added activities.

However, the OFT said that a co-operative could defend against internal POs by becoming recognised as a PO itself for its milk brokering operations and for negotiating the sale of any of its members' milk to a third party processor.  

We note concerns that the proposed size limit of 33 per cent of national milk production risks creating regional producer monopolies. On the other hand, lack of a clear threshold size risks creating uncertainty and deterring participation among farmers. To clarify the situation and bring it in line with existing competition law, we recommend that Producer Organisations be able to cover up to 20 per cent of national milk production and above that limit, be subject to a case-by-case analysis by the National Competition Authority until the 33 per cent limit is reached.

  The Co-operative Group were supportive of greater collaboration in the industry, but warned that Defra’s attempts to implement the Fruit and Vegetable Producer Organisation scheme in England had been “absolute chaos”. In April 2011 the European Commission announced that the UK was being fined £23.8 million due to weaknesses in the administration of the Fruit and Vegetable PO scheme. The NFU warned that the criteria for recognising POs had not been set out clearly in the Commission’s proposal. In light of the substantial disallowance incurred through Defra’s misadministration of the Fruit and Vegetable Producer Organisation regime, Defra must ensure that the criteria for recognising Dairy Producer Organisations are clearly and unambiguously agreed between itself, its agencies and the European Commission, before implementation.

Transparency

The Food and Drink Federation (FDF) and Defra called for greater transparency on dairy stocks and production; the FDF said this was needed to “mitigate speculation which results in market volatility”. Farming organisations argued for greater transparency on supply chain margins, the NFU said “clearly we have to be careful about infringing commercial confidentiality, but equally it is important that farmers understand the market environment they operate in”. The European Parliament Agriculture and Rural Development Committee’s report also calls for greater transparency, including on average prices paid for raw milk and the establishment of a Market Monitoring Agency.

The Commission’s recommendation for improving transparency is limited to collating the volume of raw milk delivered to dairies. The UK is far advanced in terms of market information through the wealth of data published by the DairyCo Datum, including weekly raw milk deliveries to processors. Therefore the Commission’s proposals do not offer any benefit to the UK, but equally are unlikely to pose additional costs. The Commission’s proposals on transparency offer little benefit to the UK as the relevant data is already published. We encourage the Government to pursue greater transparency across the dairy supply chain to improve market awareness and reduce volatility.

Quotas

The evidence that we received demonstrated no desire to alter the plans to phase out quotas by 2015. The impact of ending quotas on the UK dairy sector is still unclear—on the one hand, it could provide opportunities for expansion, on the other hand, it could expose the domestic industry to greater competition. Tom Hind of the NFU believed “we need to watch what happens in Ireland very closely, because the Irish Government and the Irish food industry has a very ambitious export strategy, which includes increasing its scale of dairy export by [...] between 50 per cent and 100 per cent”. The Minister also felt strongly “that we have to fight back against this import penetration by developing our own products and investing in processing so that we can compete at price”. The forthcoming lifting of quotas adds weight to the argument for proactive action to bolster the industry before the window of opportunity to expand production has passed.

Conclusions and recommendations

The state of the UK dairy industry

We are confident that the future prospects of the UK dairy sector are positive, but this depends on Government and the dairy industry resolving certain issues. Despite having one of the most efficient production systems in the world, UK dairy farmers are unable to cover their costs and dairy processors are outcompeted by imported products. Farmgate prices have recently become decoupled from both commodity market indicators and farmers’ production costs, indicating that farmers are not consistently able to recoup sufficient value from the supply chain. We conclude that Government action is justified as the substantial drop in the number of dairy producers that would be required to increase farmgate prices through market forces alone would have undesirable consequences for rural communities, landscapes and tourism, and consumer choice. Consolidation in the industry must be driven by confidence, innovation and investment. (Paragraph 28)

We call on Government to take action to resolve this situation through addressing the structural imbalances that result in low farmgate prices; encouraging increased investment in processing, particularly in value-added products; and exerting influence on retailers to establish dedicated supply chains for processed dairy products, such as butter and cheese. (Paragraph 29)

European Commission proposals for the dairy sector

Raw milk contracts

We conclude that contracts should provide certainty and clarity to give both parties the confidence to invest—the current system fails to achieve this. Our view is that the Commission’s proposals offer considerable scope for Defra and the industry to jointly establish a more effective system of raw milk contracts. (Paragraph 40)

We recommend that raw milk contracts should include the four elements specified by the Commission—price, volume, timing of deliveries, and duration. In addition, the contract should make it clear under what conditions the contract can be terminated by either party. Exclusivity clauses should be discouraged to allow farmers to respond to market signals following the abolition of quotas. We do not suggest that all contracts must contain an explicit price or price formula as these could be overly restrictive, but contracts should set out the principles underpinning price and mutually agreed tolerances. Given that the majority of dairy contracts do not contain these elements, in order to effect the change that we think is needed, Defra should make it compulsory for producers to be offered a written contract containing the elements specified above. (Paragraph 41)

The European Parliament Agriculture and Rural Development Committee’s proposal that milk contracts should stipulate a milk price fixed for no less than one year is, in our view, overly restrictive and could hinder processors and producers rom responding to market signals. We recommend that the UK Ministers and MEPs do not support this proposal. (Paragraph 42)

Producer Organisations

Dairy farmers are particularly disadvantaged in that they are selling a perishable product in a highly consolidated market with often little choice, at regional level, to whom they sell. We welcome the Commission’s proposals, which will make it considerably easier for dairy farmers to collaborate over prices and so increase their bargaining power, without fear of investigation from competition authorities. (Paragraph 47)

We note concerns that the proposed size limit of 33 per cent of national milk production risks creating regional producer monopolies. On the other hand, lack of a clear threshold size risks creating uncertainty and deterring participation among farmers. To clarify the situation and bring it in line with existing competition law, we recommend that Producer Organisations be able to cover up to 20 per cent of national milk production and above that limit, be subject to a case-by-case analysis by the National Competition Authority until the 33 per cent limit is reached. (Paragraph 51)

In light of the substantial disallowance incurred through Defra’s misadministration of the Fruit and Vegetable Producer Organisation regime, Defra must ensure that the criteria for recognising Dairy Producer Organisations are clearly and unambiguously agreed between itself, its agencies and the European Commission, before implementation. (Paragraph 52)

Other elements of the ‘Milk Package’

The Commission’s proposals on transparency offer little benefit to the UK as the relevant data is already published. We encourage the Government to pursue greater transparency across the dairy supply chain to improve market awareness and reduce volatility. (Paragraph 54)

The forthcoming lifting of quotas adds weight to the argument for proactive action to bolster the industry before the window of opportunity to expand production has passed. (Paragraph 55)

Actions for Government

Defra’s domestic action programme for the dairy sector offers little of real benefit for dairy farmers. We are surprised and disappointed that the Minister was not able to offer more concrete and proactive suggestions to improve the situation in the dairy sector. We trust that Defra’s response to this report will set out how their commitment to support and develop British farming will be realised for the dairy sector in time for the abolition of quotas in 2015. (Paragraph 57)

Increasing the profitability of the dairy processing sector

The Government should facilitate investment in dairy processing as part of its wider strategy to promote growth in the manufacturing sector and increase exports and Defra’s business plan commitment to promote increased domestic agricultural production. We recommend that Defra review the accessibility to the dairy industry, particularly SMEs, of existing private and public funds for increasing growth and competitiveness and take steps where necessary to improve access. The review should include finances available through the Common Agricultural Policy, but also funds that are not specific to agriculture, such as the Business Growth Fund and Enterprise Capital Funds. (Paragraph 61)

Defra should develop a strategy with UK Trade and Investment and the Foreign and Commonwealth Office to promote UK dairy products and increase exports. (Paragraph 62)

Other than that conducted within commercial concerns, dairy-related research in the UK is focussed on animal welfare and environmental sustainability. This has resulted in a lack of research into innovative ways of adding value in the dairy sector through novel processes, markets or uses. Defra should use the Dairy Supply Chain Forum to identify who is best placed to deliver this research and how it should be funded, which should include the retail and processing sectors, with the ambition of establishing a new research arm within one of the existing industry or government- sponsored programmes. (Paragraph 65)

Reducing production costs on dairy farms

We welcome the assistance with business management provided by DairyCo’s Planning for Profit workshops, but note that the cost may deter the businesses that are most in need from attending. Defra should proactively encourage this project and investigate whether workshops can be provided at a lower or no cost through funding from retailers and the Rural Development Programme. We recommend that Defra set an ambitious target of 30 per cent dairy farmer participation in the programme and report back within one year. (Paragraph 69)

Stimulating technological development in the dairy production and processing sectors through business-led innovation would be a useful focus for the Technology Strategy Board’s Sustainable Agriculture and Innovation Platform. Defra must make the case for directing funds to this area to the Platform’s steering group. (Paragraph 70)

Anaerobic digestion (AD) on dairy farms has considerable potential to reduce costs and greenhouse gas emissions, yet uptake so far has been negligible. The Government’s Anaerobic Digestion Strategy and Action Plan were published after our evidence sessions had been completed, preventing us from giving it full consideration. We recommend that Defra review its plan and explain how it will achieve the targets on AD uptake set out in Dairy Roadmap. (Paragraph 73)

 Stimulating co-operation and collaboration

We heard that increased co-operation among farmers was hindered by a lack of awareness of the available opportunities. Defra and the Office of Fair Trading should update the guidance on co-operation among farming businesses following the principles set out by the Farming Regulation Task Force. Defra should review the utility of the Office of Fair Trading’s ‘short form opinions’ tool to agricultural businesses. (Paragraph 77)

We request an update on the following commitments set out in the Government’s Response to the Environment, Food and Rural Affairs Committee’s 2010 report on Dairy Farmers of Britain: a Financial Services Authority-led code of best practice for co-operatives; an examination of ways to overcome constraints on capitalising UK co-operatives; the implementation of the Legislative Reform (Industrial and Provident Societies and Credit Unions) Order 2010, and its implications for agricultural co-operatives. (Paragraph 78)

Large-scale Dairying

It is absolutely essential that the environmental, animal health and welfare, and social impacts of large-scale dairy farms are quantified and we welcome the fact that research is currently under way. We conclude that large-scale dairy farming presents an opportunity whose potential merits further exploration. The Government has significant power to disseminate the evidence-base on the impact of particular technologies, and if appropriate, to promote them. We do not accept that approvals for large-scale agricultural holdings are purely an issue for planners. As soon as evidence on the impacts of large-scale dairying is available, Defra must establish its policy position on this issue and then take a proactive stance in explaining the rationale behind its decision. (Paragraph 84)

Conclusions on the European Commission’s proposals

We welcome the analysis presented by the European Commission and the High Level Group on Milk, which has successfully highlighted the problems facing the European dairy sector. We support the key elements of their proposals but conclude that more will need to be done to address the structural problems in the UK dairy industry and have set out what additional action is needed. We were disappointed by the weakness of the Department’s proposals to improve the state of the dairy sector and call on Defra to take more a more proactive stance, commencing by implementing the recommendations set out in this report. (Paragraph 87)