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Executive Summary

Reforming Dairy Supply Management: The Case for Growth

by Michael Grant, Richard Barichello, Mark Liew, and Vijay Gill

Supply management is among Canada’s most contentious public policies. The policy is designed to manage the market risk faced by farmers of supply-managed commodities. But it does so by generating higher prices for consumers and closes off growth opportunities in domestic and international markets.

In this report, we highlight the case of dairy supply management to demonstrate these forces at play. We review the reform literature and offer some ideas for reform paths that create a win-win solution for dairy farmers, consumers, and Canada.

Strong interest in policy circles has resulted in numerous reports on supply management over the decades. This report’s unique contribution is that it links farm-level financial analysis—micro analysis—to macro policy. This allows us to show how different policy actions play out in terms of farm viability and transition paths for the industry. We clearly demonstrate that it is possible to grow Canada’s dairy sector by reorganizing assets under the most efficient producers. And Canada’s most efficient producers will provide Canadians and the world with low prices and high-quality dairy products.

Why Reform Supply Management?

The report evaluates dairy supply management against public policy criteria of equity (fairness) and efficiency, and it finds the current policy wanting on these criteria. Dairy supply management operates by setting target prices based largely on average costs of production. But since the average costs include many inefficient dairy farms, it generates prices that are higher than if Canada organized its dairy farm assets under the most efficient dairy farms. The Organisation for Economic Co-operation and Development (OECD) estimates that this market price support cost Canadian dairy consumers an average of $2.6 billion per year in the decade to 2011: roughly $200 thousand per dairy farm per annum and around $276 per family every year.1

The policy is questioned on equity grounds because dairy farmers are generally wealthier than the average Canadian. The policy effectively transfers resources from poorer Canadians to wealthier Canadians. This is especially pertinent given concerns about food security, particularly among low-income Canadians. The 2008 National Nutritious Food Basket suggests a nutritious food basket should include “milk and alternatives” consumption of between 3.59 and 7.19 litres per week. Children and pregnant and lactating women are among those at the high end of the suggested consumption. Yet Canada’s highest rates of poverty are realized by families headed by a lone female parent. Unlike the harmonized sales tax (HST), the transfer engineered through supply management does not include any compensating low-income tax credit to assist low-income dairy consumers.

The policy is challenged on efficiency grounds because it constrains dairy assets from being organized under the most efficient dairy producers. We estimate that the top 25 per cent of dairy farms produce almost half of Canada’s milk supply. But the other half is produced by medium- and low-efficiency farmers, who drive milk target prices. These farmers rely less on operational efficiency and more on market restrictions. Supply management policies are valued in their quota, which resides on their balance sheet. The enterprise value of less-efficient producers is derived mostly from the value of quota restrictions.

We estimate that 25 per cent of dairy farms produce almost half of Canada’s milk supply. Medium- and low-efficiency farmers produce the other half.

The funding of quota results in annual debt-servicing costs of several hundred million dollars. Under the current system, there is an annual leakage from the industry to debt issuers of hundreds of millions of dollars that could otherwise be used to fund tangible dairy assets.

Moreover, the policy effectively cuts Canada off from a burgeoning world demand for dairy products. Global dairy export volumes have continued to grow by more than 7 per cent per annum over the past three years.2 The most significant exporter is New Zealand, which exports around 97 per cent 3 of its milk production and accounts for close to 30 per cent of dairy products traded globally. Australian students are hired to purchase hundreds of tins of milk powder to smuggle to China, where a $24 tin sells for more than twice that amount ($54) online on Taobao, the Chinese version of eBay.4 The Dutch government recently launched a probe into a nationwide shortage of baby formula after sales in early 2013 spiked 50 per cent over 2012 levels without a corresponding increase in births; most of the formula had allegedly been re-exported to China.5

Yet the Canadian dairy industry is unable to take advantage of global demand. A 2002 World Trade Organization (WTO) panel ruled that the price gap between Canadian and world prices was a subsidy.6 This limits Canada’s exports to the WTO export subsidy limit. So instead of Canadian skim milk going to Chinese babies, it is converted into low-priced animal feed.7

Current global trade flows actually suggest that dairy could be shipped relatively cheaply from Canada to Asia. Westbound Pacific freight rates are 20 to 40 per cent less expensive than eastbound freight rates, depending on port location, which favours Canadian producers. Canadian producers are also favoured because competitor exporting countries, like New Zealand, are starting to see their production costs rise considerably.

As the policy limits Canadian producers to the domestic market, the Canadian dairy industry continues to shrink, consolidating into fewer and fewer farms serving a slow-growing Canadian market. At 12,500, the number of Canadian dairy farms is about half as many as 20 years ago.

Toward Reform

Canadians can define a new strategic vision for dairy based on growth and efficiency. This path has been trod by New Zealand and Australia and is starting to be realized by the United States.

For Canada’s dairy industry to succeed internationally, the Canadian dairy market would have to look more like the dairy industry in competing jurisdictions. Farms would likely become somewhat larger, although by standard business definitions most would continue to be small businesses and would remain predominantly family-owned. We estimate that even with larger herd sizes and lower prices, dairy farms would realize sales of around $1.4 million. To put this in a small business perspective, this is about the same revenue as a typical Tim Hortons franchise.

Canadians can define a new strategic vision for dairy based on growth and efficiency.

We summarize the growth potential in three scenarios—status quo, modest growth, and aggressive growth. The moderate growth scenario sees Canada grow at a cumulative annual growth rate (CAGR) of 5.8 per cent, while the aggressive growth sees Canada grow at a CAGR of 9.6 per cent. The moderate growth scenario would see Canada add around 6 billion more litres of milk annually by 2022 to meet international demand, whereas the aggressive growth scenario sees Canada produce about 12 billion more litres annually.

Should Canadian dairy achieve significant success in the export markets (over the next decade), reaching export volumes half that of New Zealand, Canada’s annual production would grow from 8 billion litres to 20 billion litres. Canadians would benefit to the tune of $1.3 billion from efficiency gains. Under this scenario, the number of dairy farms would actually increase by 2.1 per cent over 10 years, with the average herd size simultaneously increasing to 187.

Additionally, a harmonization of Canadian prices with world prices necessary for export trade would result in current excess profits of approximately $2.39 billion transferring from producers to consumers. Low-income Canadians, in particular, would benefit disproportionately from lower prices because a higher portion of their income (along the lines of the National Nutritious Food Basket) is allocated to dairy products.

We estimate potential employment gains from these growth scenarios. The 150 per cent growth scenario, which we believe to be achievable, would see industry employment expand by around 14 per cent, with over 5,000 jobs created in primary production and around 3,000 in processing for a total gain of over 8,500 jobs.

We show that reform is possible by focusing on Canada’s experience with for-hire trucking. This was an industry that was also supply-managed and comprehensively liberalized in 1987.

Approach to Transition: It’s in the FEED

Any reform option must address issues of funding, efficiency, equity, and duration (FEED) in a comprehensive manner. The more funding available, the shorter the transition duration and the more opportunities for equitable redistribution. There are two issues: dealing with existing quota and reforming prices.

On quota, late entrants are exposed the most because they have yet to realize a return on their quota. Therefore, overnight liberalization with no buyout severely punishes late entrants (or anyone who holds recent vintage quota). Second, a market value buyout is extremely generous for all quota vintages. Book value8 buyouts, depending on how one depreciates the asset, are much more reasonable, especially when compared with the returns on alternative investments like 10-year Government of Canada bonds.

A book value buyout program could, for instance, focus on quota acquired over the last 10 years and adjust buyout compensation according to the fraction of 10 years remaining. Based on values on provincial exchange transfers and different types of transfers (exchange, in-family, and consolidation) over the past 10 years, we estimate this type of buyout would cost between $3.6 billion and $4.7 billion. This could easily be funded through a temporary levy or even through public debt issuance.

The administrative realities of supply management point to using the price mechanism to gradually unwind quota. This would likely be matched by an unwinding of Canada’s trade restrictions. The only problem with this gradual approach is that it continues to constrain the efficient producers from gearing up to service export demand. If Canada announces a long transition period of gradual price liberalization, our competitors are likely to take steps to secure their existing export market dominance.

In that event, Canada may be better off buying out quota under equitable terms and moving to a relatively quick reorganization of the industry.

1    OECD, Producer and Consumer Support Estimates. There were roughly 9.4 million Canadian census families in 2011, according to Statistics Canada, “Distribution of Census Families.”

2    Fonterra, Global Dairy Update.

3    Ministry for Primary Industries, New Zealand, Dairy Facts and Figures.

4    News.com.au, Black Market.

5    BBC News, Dutch Government.

6    Goldfarb, Making Milk, 29.

7    Dairy Farmers of Ontario, “Surplus Hits All-Time High.”

8    Book value is the value at the time of purchase. Market value is determined by valuing quota at current market prices.

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Michael Grant Michael Grant
Research Director
Industry and Business Strategy
Richard Barichello Richard Barichello
Mark Liew Mark Liew
Vijay Gill Vijay Gill
Director
Policy Research

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Funding Food report coverThis report shows how to reform dairy supply management using a growth paradigm. Our approach results in greater industry output and employment. Growth creates the resources to compensate farmers equitably.

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