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One of the cornerstones of Canada's tightly regulated dairy regime is that it's sealed off from the rest of the world.

A massive tariff wall keeps most imports out. Canada, in turn, is largely prohibited from selling its dairy products to the rest of the world.

The cloistered nature of the Canadian system is the main reason Canadian negotiators say that dairy should be spared from the free-trade rules of the Trans-Pacific Partnership deal, now being negotiated. The argument goes something like this: Our milk and cheese doesn't disrupt your markets. So leave us alone to do our own thing.

But the world is rapidly closing in on the Canadian dairy business, in spite of the industry's best efforts to keep it out.

Senior Canadian dairy industry officials now bluntly acknowledge that the only way to save Canada's supply management system is to get into the export game, according to a confidential report presented last week to a Dairy Farmers of Ontario (DFO) policy conference.

The briefing paper, obtained by The Globe and Mail, lays out a stark and surprisingly unvarnished assessment of the dairy industry's prospects. A flood of imported designer dairy ingredients is rapidly displacing Canadian milk in products such as cheese and yogurt. That, in turn, is creating a growing glut of unwanted milk, which must be diverted into animal feed, or worse, dumped. And the industry faces "waning government support" for supply management, according to the report, prepared by top DFO officials.

"The industry is approaching a crossroads beyond which the existing policy framework is no longer sustainable," the report concluded. "A policy environment, which levers export potential within existing trade agreements and enables the marketing system to be operated with more milk and larger growth allowance, is essential."

The trigger for all this trouble is the rise of designer dairy ingredients, including highly concentrated milk protein. The paper notes that imports of milk protein isolates, which come in duty free from the United States and Mexico, have exploded since 2005. And once the European free-trade deal is in place, European Union producers will add to the flood.

"If milk protein imports continue to grow, the industry will no longer be able to sustain itself," the report said bluntly.

The only way to sell growing volumes of expensive, but unwanted milk is to displace these cheaper imported ingredients, export more dairy products, or both, the DFO says.

The industry sees its salvation in creating a new "world-price ingredient class" of milk – milk priced at the lower world price, rather than the inflated Canadian price. This would give Canadian dairy processors access to lower-cost domestic milk and create an incentive for them to invest and export high-margin dairy products.

Success depends on tricky negotiations between farmers, processors and the federal and provincial governments.

If it works, problem solved, the DFO says.

Here's the catch: Canada's trading partners won't be too happy about a secret scheme to boost exports and save supply management, while the country remains closed to most imports.

Trade lawyer and former Canadian trade official James McIlroy warned the pricing plan is unlikely to survive a trade challenge because it would be deemed an illegal subsidy.

It's a desperate attempt to win over major Canadian dairy processors, such as Quebec's Saputo, which have been investing massively offshore because demand is stagnant at home and exports are prohibited, according to Mr. McIlroy.

"This is a Hail Mary," he said. "The farmers are very concerned about losing the support of the government. The processors have already abandoned them."

Just as importantly, the proposed "world price" scheme won't do anything for consumers, who will continue to pay inflated prices at the grocery store so farmers can sell their milk more cheaply to processors.

Other Canadian agricultural sectors risk losing lucrative export opportunities if Ottawa won't budge on supply management in trade talks.

The industry is right to embrace a future of growth and exports.

But it smacks of farmers wanting to have their cake and eat it too – keeping a protected home market while magically getting all the benefits of open trade.

Canadians may wonder why they continue paying the price of a system that even farmers acknowledge is broken.