Agricultural emissions policy has been in the news recently (see here and here), with the National Party in favour of pricing agricultural emissions in such a way that there is "no leakage". What do they mean by leakage? As this RNZ article explains:
...Aotearoa is already one of the most efficient producers of meat and dairy products globally. If we reduce emissions here, will that not simply lead to other, less efficient countries picking up the lost production, while our farmers pay the price?
This idea is known as "carbon leakage" and is often used as an argument against any domestic policy that could result in reduced agricultural production. The issue is important as New Zealand depends heavily on agricultural exports. In 2022, of all merchandise trade, 65 percent were agricultural commodities.
How plausible is carbon emissions leakage as a result of reducing agricultural production in New Zealand? Let's focus on New Zealand production of dairy products [*]. We'll use a basic supply and demand model to explain what is happening. The diagram below shows the domestic market for dairy products [**]. If the market were left alone with no emissions price, it would operate at equilibrium with a price of P0, and Q0 dairy products would be traded. When the emissions price (effectively a type of excise tax on dairy products) is imposed, we represent that with the new curve S+tax. The price the consumer pays for dairy products increases to PC, but the effective price for the seller decreases to PP (which is the consumer's price PC, minus the amount of the emissions tax paid to the government). The quantity of dairy products traded decreases to QT. And, because less dairy products are traded, fewer cows are needed, and agriculture-related emissions are decreased.
Notice that there's no emissions leakage in this model. Nothing else is going on. That's because we're only looking at a model of partial equilibrium. We are looking at the domestic market for dairy products, in isolation. New Zealand is producing less dairy products, but the world still wants lot of dairy products. So, the argument goes, other producers will increase production to fill that demand.
However, that ignores the fact that New Zealand is a huge producer of dairy products for export. Higher prices of New Zealand dairy products (because of the agricultural emissions tax) will increase the global price of dairy products. When the global price goes up, dairy consumers will demand less dairy products. So, we can expect fewer dairy products to be produced globally.
Even that conclusion is incomplete though, because it ignores the dynamics. When the price of dairy products is high, profits are higher, and that might encourage more producers to enter the market, increasing supply. That would lower the global price of dairy products, and increase the quantity of dairy products demanded.
We're still not done though. Those new dairy products manufacturers will be higher-cost than New Zealand producers (if they weren't, then they would be producing dairy products already). So, the increase in global supply won't fully offset the reduction in New Zealand supply. And, an increase in global supply of dairy products must mean a decrease in the global supply of some other agricultural commodity that those new suppliers were previously producing. To understand emissions leakage, we need to get a handle on these general equilibrium and dynamic effects.
And finally, we get to the question of whether the new global dairy product suppliers have higher carbon emissions than New Zealand producers, as well as whether producing dairy products has higher emissions than whatever it was that they were previously producing.
So, you can see, the question of whether pricing agricultural emissions in New Zealand leads to emissions leakage doesn't have a straightforward answer. It requires a substantial understanding of global and local agricultural markets, agricultural supplier response to price changes, and the substitutability of agricultural land between different uses, and the carbon emissions of different land uses, both in New Zealand and overseas.
Some smart economists are working on understanding this though. As the same RNZ article notes:
It's difficult to know exactly what might happen in agriculture, as emissions pricing on agricultural products has not yet been used elsewhere. There is no historical evidence to draw on.
International modelling studies present a mixed picture of the likelihood of leakage: an OECD study estimated 34 percent of agricultural emissions would be leaked, mostly to developing countries.
Recent modelling for New Zealand examines a series of scenarios of domestic pricing on its own as well as international pricing. The results show that for the current proposal where only 5 percent of emissions are priced to begin with, with a 1 percent increase each year, New Zealand's production of meat and dairy products could decline by 2050...
This shows leakage may occur, with reductions in production of New Zealand dairy products. But global meat and dairy production by 2050 would be considerably lower than without the policy, which would have a positive overall impact on the climate.
Perhaps we can take away from the evidence so far that there is some emissions leakage, but it's not complete. Not all emissions reductions are leaked overseas. So, pricing agricultural emissions in New Zealand would likely lead to lower global emissions in total. Clearly, there is more research needed in this area, but based on what we know so far, I think it's ridiculous that we give one of the largest emitting sectors a free pass on contributing to climate change. If anyone tells you that all of our emissions would simply move overseas, you should probably examine their motivations for doing so.
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[*] The case is much simpler for the production of other agricultural products, where New Zealand production doesn't affect the global price. If a reduction in New Zealand production is so small that it doesn't affect the world price, then it doesn't create any incentive for other countries to produce more. So, there is unlikely to be any emissions leakage of note.
[**] For simplicity, I'm ignoring two things in this market diagram. First, the diagram doesn't show a negative externality, for example the impact of dairy emissions on the climate. So, the supply curve shouldn't be equal to marginal social cost (MSC), as MSC should also include the social cost of the emissions. However, correcting for that wouldn't change the general conclusion, that taxing agricultural emissions would increase the domestic price and decrease the quantity of dairy products traded. It would simply move the market closer to the socially-optimal quantity. Second, the diagram doesn't include international trade, which has important effects on the New Zealand domestic market for dairy products. However, including trade in a diagram of the dairy products market for New Zealand is not as simple as including the world price (as in this post, for example), because the world price of dairy products is directly affected by New Zealand production. One way of solving that problem is to assume that demand in the New Zealand market reflects global (rather than just domestic) demand, and then the diagram looks much as we have drawn it. Again, the omission of trade doesn't affect the conclusions we draw from the model, that taxing agricultural emissions would increase the domestic price and decrease the quantity of dairy products traded.
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