Carbon Forestry: A New Concept for New Zealand Forestry Investment

The New Zealand Emissions Trading Scheme

A New Concept for in New Zealand Forestry Investment

The following is a very broad outline of the Emissions Trading Scheme and the potential of the scheme to positively impact on investment in new or recently established commercial timber forests in New Zealand. The article is not intended as a substitute for qualified project advice on ETS or forest investment and the views expressed are purely those of the author. As in any significant commercial venture, unless the investor has substantial experience and expertise then expert independent advice by a recognised qualified forestry consultant will be an essential early step before undertaking any specific venture. In New Zealand capable, qualified and very experienced forest consultants are readily accessible. The writer is able to refer potential investors to sources of expert independent project analysis and forest project management.

The Emissions Trading Scheme

For decades investment in the New Zealand forest industry by comparison to almost any other land based primary industry has in practical terms equated to an investment for an uncertain reward – in a distant future (about 25 to 30 years in respect to New Zealand pine forests). From 2008 much has changed. From that time the Emission Trading Scheme (ETS) offers investors an entirely new, exiting and financially rewarding form of timber forest investment.

NZU’s for an early cash flow

Traditionally, forest investment has involved substantial capital sums for land purchase, forest establishment and ongoing forest tending (tree pruning and thinning), with a subsequent revenue stream only at the time of harvest for a net return dictated by log or pulp prices at that time. From 2008 however new forests (together with existing forests that were established after 1989) can offer their owners not only future timber production, but also from an early growth stage generate credits (NZU’s) for the carbon naturally sequested by the forest. NZU’s may be sold on national markets or converted to AAU’s (Assigned Amount Units) for sale overseas to participating Governments so  generating of an early, substantial and reliable cash flow.

ETS legislation

The ETS legislation was passed in New Zealand in 2007 and came into effect on 1 January 2008. It allows  owners of forests that were established after 1989 on un-forested land, together with subsequent new forestry investments to join the ETS scheme and claim to carbon credits (termed New Zealand Units or NZU’s) for carbon naturally sequested by their forests. In the scheme one NZU is the equivalent of one tonne of CO² sequested which may be sold for cash, or alternately held for offsetting a carbon liability.

Principals of the scheme

The operating principal of ETS is that carbon emissions which are a primary cause of global warming, are taken up or sequested by trees over their lifetime. NZU’s are issued from a pool to forest owners who have joined the scheme to benefit from their ETS certified forests (audited by a recognised forestry consultant).

NZU’s may be sold to businesses within New Zealand who may use these to offset their own polluting industries or activities or alternatively sold by conversion of NZU’s to AAU’s (Assigned Amount Units) to other Annex 1 Kyoto member countries who actively purchase AAU’s to meet their obligations under the treaty.  There is a cap on the number of NZU’s which can be converted back to AAU’s being 10% of total number of AAU’s which were assigned to New Zealand in our first allocation under the Kyoto Accord allocation.

Cash flow and viability

Of critical significance to forest investors is the fact that depending on the open market prices achieved for the sale of their NZU’s, their forest operation should create a positive income stream following the first thinning operation in the fourth year from planting. Subsequent NZU income in well managed forests planted on suitable land will pay for ongoing operations and indeed is likely to provide an income over and beyond this, increasing substantially as the forest trees mature and grow. Analysis (PF Olsen) of the financial viability of Pinus radiata forestry investment for both carbon and timber suggests that conservatively, a return under satisfactory management on suitable land should be 12% on capital before taxation. The main variable factors in determining such return are actual prices received for NZU’s over the growth cycle of the forest, the price paid for NZU’s which are required to be returned to the ETS pool and the value of the logs at harvest.

NZU’s issued – and on harvest, accounted for

An important aspect of the scheme is that on harvest or clear felling of the forest, carbon sequested is considered to have been released (in the form of logs) and a liability in the form of NZU’s which were issued is created and must be accounted for. In calculating the forest owners liability the scheme recognises that approximately 75% of the CO² sequested during the life of the forest is removed in the form of logs but that approximately 25% remains on site bound in vegetation and organic matter which slowly decays, but is replaced by the carbon sequested by a new forest if the land is replanted to trees. NZU’s equivalent to the carbon removed in the form of logs not held by the forest owner (i.e. up to 75% of the total) will need to be purchased at their current price and returned to the pool for the forest owner’s obligations under the scheme to be satisfied. Approximately 25% may be retained by the owner – but only if the forest is to be replanted. If the forest is not to be replanted then the entire number of NZU’s claimed and issued will need to be returned.

 Retention of NZU income

The forest owners ability to retain income from 25% of the NZU’s issued within the first planting and growth cycle means that providing the owner does in fact replant the forest, this first forest cycle will inevitably be more profitable than the second cycle. Over the second cycle the forest owner is able only to claim 75% of the first cycle, or in practical terms; the difference between carbon at the beginning and end of the second cycle, following which all credits or NZU’s must be returned. Never the less carbon/timber forestry in the second cycle is significantly more profitable than timber alone. The second cycle creates the opportunity to retain 25% of NZU’s issued in the first cycle and achieves much better use of the capital used for initial land purchase.

 It should be noted that while the scheme is applicable to existing forests planted after 1989, forests planted after that date but prior to 2000 are unable to retain any portion of NZU’s issued on harvest, irrespective of replanting. In this instance the value of the NZU’s issued is in the positive pre harvest cash flow and time value of the money received. 

Summary

In summary, the over riding principal of carbon forestry as it affects any new (or post 2000) forest planted for timber production is that NZU’s are issued from the ETS pool for carbon sequested by living forest trees but ultimately are reclaimed when carbon is released in the form of harvested logs. Therefore income generated can not be treated as a direct return on capital or income earned for retention at the owner’s discretion as in almost any conventional business operation, but rather a substantial positive cash flow through the growth cycle of the forest having a substantial positive impact on the overall financial viability of the investment. In a well managed forest established on suitable land, logging income at the end of the growth cycle should more than pay for  repayment of NZU’s issued and liable for repayment. Financial analysis by PF Olsen for Pinus radiata based on a an estimated price of $25 paid for NZU’s has forecast a real rate of return (IRR) at 12% before tax. The eventual net return is of course reliant on the timber (stumpage) value at harvest and the price of NZU’s both received through the life of the forest and accounted for at harvest.

Investing for the future in New Zealand forestry under ETS

In New Zealand forestry is New Zealand’s third largest industry with exports exceeding NZ 3 billion annually. New Zealand has long experience, considerable management expertise, good infrastructure, research and marketing skills supporting the forest industry; all readily available to new investors. While forest investors have found the industry to be only marginally profitable over the past 15 years, even at conservative current price projections under ETS the economics of forestry in New Zealand change significantly for the better. Add to this the fact that studies (Aspey & Reed and UN – FAO) forecast that due to world population increases coupled with the depletion of natural non-renewable world timber supplies from deforestation, an international demand to supply shortfall for timber will reach 25%, or 2 billion cubic metres by 2050. If future timber export prices follow normal patterns dictated by supply and demand it is more than reasonable to suggest that new forest investment incorporating ETS is an outstanding long term prospect for prudent investors.

The potential for viable carbon and timber forests in New Zealand

As with any primary land based agricultural or horticultural investment anywhere in New Zealand or internationally, the primary requirement is good land that is physically and climatically well suited to its intended purpose – in this instance commercial forestry. While New Zealand has a large exotic forest industry (relative to its overall size and economy) spread over both Islands, it is also very true that growth rates as well as timber quality vary considerably from one region of New Zealand to another, largely through the influence of climate. Growth rates and quality directly affect both the economics of timber production and volume of carbon sequestion for which NZU’s may be claimed and so directly affect the economic viability of commercial forestry and for this reason forest site selection is of critical importance. The following extract from lookup tables published by Ministry of Agriculture and Fisheries (MAF) demonstrate regional variations in growth rates.

Carbon stock per hectare for Pinus radiata by region expressed as tonnes CO² per Ha

The potential for viable carbon and timber forests in Hawke’s Bay

Carbon stock figures published by MAF demonstrate the favourable relative viability of timber and carbon forests in Hawke’s Bay and lower North Island (Wairarapa & Wellington), particularly in relation to South Island regions. However these figures do not tell the whole story as the figures are averages over a broad region and there are wide climatic variations and consequently considerable growth variations within that area. As a broad generalisation, wide areas of Hawke’s Bay south of Napier City as far as the Wairarapa District are affected by a “rain shadow” caused by the central North Island mountain ranges. Here is a typical Mediterranean climate typified by relatively low summer precipitation and low overall rainfall averaging perhaps 650mm to 750mm, conditions not suited to optimum carbon and timber production. Smaller localised areas in the region closer to the mountain ranges, areas having higher altitude and a few coastal areas are exceptions.

 North of Napier and from the Tutira Plateau in particular, Northern Hawke’s Bay and the Wairoa District in general enjoy a significantly higher and wider spread of rainfall. Where accessible land with suitable soils and terrain is available at a viable price the potential for commercial carbon timber forestry is excellent. The neighbouring Gisborne District immediately north of Northern Hawke’s Bay enjoys similar growing conditions and is also an important region for commercial forestry.

 The figure given for carbon sequested between 14 and 15 years for Hawke’s Bay and Southern North Island forests is 35 tonnes. A recently audited 15 year old well managed forest in the Wairoa District of Northern Hawke’s Bay was calculated to achieve 53 tonnes, a 47% improvement on the average given in the table.

Acknowledgments

The following have been sourced for information on ETS and impact of the scheme on commercial forestry.

 The New Zealand Emissions Trading Scheme:  Climate Change New Zealand

Forestry in a New Zealand Emissions Trading Scheme: Ministry of Agriculture and Fisheries

Permanent Forest Sink Initiative:  Ministry of Agriculture and Fisheries                             

Forestry for timber and carbon (Full article reproduced below): 7 December 2009  P F Olsen

PF OLSEN                                              

As at 7 December 2009

Reproduced here with kind permission of PF Olsen

Forestry for timber and carbon

 Introduction

A new form of forestry

Planting and managing forests as an investment for the production of both timber and carbon credits makes forestry more profitable under the Emission Trading Scheme (ETS). When growing forests, the main capital requirements occur during the years of establishment and tending (pruning and thinning). In traditional timber-only forestry the revenue occurs only at the time of harvest some decades after the project s establishment and tending costs are incurred. With carbon forestry, on the other hand, annual revenues can be generated. This is a much more attractive cash flow for most people.

 Analysis based on radiata pine

This technical note is based on radiata pine for a carbon forest. Whilst other species may be suitable, at this stage we consider radiata pine to offer the best prospects for following reasons:

• It is a proven timber species with wide marketability.
• It is easy to establish and has fast early growth.
• The large body of knowledge and technology about the species makes it more reliable to forecast timber and carbon volumes.

Other species enthusiasts, however, should not be deterred as adding carbon credit revenues into the project cashflow will increase overall returns and reduce the reliance on timber only.

 Significant change to investment profile

Adding carbon credits to the product mix significantly changes the investment profile of forestry giving the forest owner the potential for:

• Near-term and annual carbon credit revenue either for more planting to create a multi-age forest, or for other uses.
• Producing carbon credits for offset against other carbon emitting activities such as livestock farming.

 The Emissions Trading Scheme

In September 2007 the NZ Government announced details of an Emissions Trading Scheme (ETS) which came into operation for forestry on 1 January 2008. Owners of post-1989 forests, planted on unforested land, have the opportunity to join the ETS. When joining the ETS, these forest owners are able to claim carbon credits, termed New Zealand Units or NZUs, for the carbon sequestered on this land from 1 January 2008; one NZU for every tonne of CO2 sequestered. These NZUs can be sold for cash, or held for some other use such as offsetting a carbon liability.

The ETS relates to the New Zealand government commitments in relation to the Kyoto Protocol. These international commitments took effect on 1 January 2008. International markets for carbon credits to date have been limited to those related to projects undertaken under the Clean Development Mechanism (CDM – developing countries) or Joint Implementation (JI – developed countries). From the 1 January 2008, Assigned Amount Units (equal to a New Zealand NZU) can be traded internationally, resulting in a market with significantly increased supply and demand.

Financial evaluation of timber and carbon forestry

PF Olsen has analysed the financial viability of plantation forest grown for carbon and timber including the costs and revenues associated with joining the ETS. Using our best estimate of costs and a conservative estimate of $25 per NZU (based on the prices paid for CDM and JI credits), we forecast a real rate of return (IRR) from a carbon forest on suitable land in New Zealand at 12% before tax.

 The following table shows the sensitivity of the assessed IRR of an example investment to both log revenue and the NZU price. The IRR is shown in real terms, over and above inflation, before tax.

Managing the liability for carbon emissions at harvesting

At the time of harvest, approximately 75% of the CO2 sequestered during the life of the plantation is removed in the form of logs. The remaining 25% of the CO2 sequestered remains on site and slowly decays. When replanted, this decay is offset by CO2 that is sequestered by the growth of the new crop.

The portion of NZU carbon credits that need to be returned at the time of the harvest is a liability that can be off-set all, or in part, by harvest revenue. While the IRR of timber and carbon forestry is not sensitive to timber stumpage revenue (as shown in the Table above), the timber stumpage revenue is important for covering the carbon emission liability at harvesting.

Cash flow turns positive following thinning

Forest owners who elect to join the ETS in respect of their post-1989 forests and/or plant additional forests on post-1989 forest land, depending on the price of NZUs, are likely to find that their forest cash flow turns positive following the thinning operation. The NZU carbon credits pay for the annual costs and, based on our current estimates, there is net revenue available then to pay for an expansion of the forest area, or use for other purposes.

Cash flow for forestry project with and without carbon credit revenue ($/ha)

 Net Present Value

The graph below shows the Net Present Value (NPV) curve for both the with carbon and the without carbon credit scenarios. The key point here is that the with carbon scenario has a positive NPV from day one (because the IRR is higher than 10%). The early revenues and increasing carbon liabilities provide an offset for the revenue at harvest age.

First rotation more profitable

Forestry with carbon credits and liabilities is more profitable for the first rotation than for any subsequent rotations because approximately 25% of the CO2 sequestered during the first rotation remains on site following harvesting. The amount of CO2 sequestered in the second rotation, and the associated NZU revenue, is reduced by about 25% compared to starting from a pasture base as in the first rotation.

The second rotation, if assuming similar log and carbon credit revenues, is financially less attractive. In the first rotation all CO2 sequestered from 1 January 2008 can be claimed and about 25% of these credits do  not need to be returned as these are retained on site at harvest. For the second rotation only the difference between the CO2 at the beginning and the end of the second rotation can be claimed and assuming the same amount is retained at harvesting then all credits claimed need to be returned.

 Please note, however, that despite the second rotation being less profitable it still shows a higher IRR than for timber only. Also, and importantly, the second rotation supports the first rotation s profitability by not requiring the surrendering of all the carbon sequestered during the first rotation.

Risk in carbon price fluctuations

The potential financial returns are excellent compared to alternative investment opportunities and the fact that the investment returns become less sensitive to changes in log revenue is also very welcome. The catch is the exposure to the price of carbon. In the example investment we have assumed that the NZU price remains constant over the life of the investment, but in reality this price may go up and down.

 If the price of the NZU goes up during the project life, then the increased NZU revenue is likely to compensate for the increased emission liability at the time of the harvest, but it is possible that if this increase was to happen just before the harvest, the impact on profitability could be significant.

 If the price of the NZU was to decline during the project life, then the profitability of the project is likely to decline, but this decline would be off-set by a decline in the liability for carbon emissions at the time of harvest. The impact very much depends on the extent of the price changes and when they occur.

Mitigating risk

The key to maximising the profits from growing timber and carbon credits is getting in early and spreading the risk of fluctuating carbon credit prices. This spreading of risk can be achieved in a number of ways:

• Selecting a regime that has a long and stable maturity profile.
• This means that harvesting can occur over a very wide period of time, and perhaps, under certain conditions, not at all.
• Creating a multi-age forest. This option is discussed below.

Should I Join the ETS with my Existing Post-1989 Forest?

Should I join the ETS?

Whether to join the ETS with my existing post-1989 forests depends on a number of factors including:

(1) Size of forest

There are joining and annual administration fees which may financially preclude very small forests and conversely economies of scale for larger holdings. The Government has kept its fees low with the intention to recover the direct costs of administering the scheme.

(2) Age of forest

Post-1989 forests planted prior to about 2000 will have no CO2 net of liabilities and all the carbon credits claimed during the growth of the forest will have to be accounted for at harvest time. Therefore, the benefit of the carbon credits is only the time-value of money (like an interest free loan if the credits are cashed up). Forests planted after about 2000 will have up to 260 tonnes per hectare of CO2 net of liabilities at harvest time (the younger the forest, the greater the amount of CO2 net of liabilities). This CO2 net of liabilities does not have to be accounted for provided replanting is undertaken. Therefore, the carbon related boost to IRR for forests planted after 2000 will be greater than for those planted prior to 2000.

 (3) Attitude to risk

This relates to the risk/return trade-off. Adding carbon to your forestry project does add risk (along with increased returns). The main risk relates to the price of carbon. A high price of carbon at harvest time could mean that the cost of purchasing NZU carbon credits for the carbon loss associated with harvesting is higher than the revenues received from selling the NZU carbon credits during the crop rotation and could also be higher than the net stumpage revenue from harvesting the timber.

 (4) Age mix of forests

Creating a forest with a mix of age classes spreads the carbon price risk and allows greater flexibility. It allows you to defer harvesting when the carbon price is high and log prices are low and bring the harvest age forward when the carbon price is low and log prices are high.

 (5) New planting capability

Additional planting to create a mixed-age carbon forest gives you the potential to leverage the greatest benefit (at lowest risk) from existing forest holdings, and get a very favourable return on investment from additional planting. Also, forests that are established on the basis of producing quality timber and carbon (rather than carbon alone) are lower risk as timber revenue provides a contingency in the event that the price of carbon plummets or the ETS ceases.

The right decision depends on individual circumstances

Whether to join the ETS and undertake new plantings for both timber and carbon is a complex decision and the right decision depends very much on each individual s situation. It is recommended that forest and land owners discuss their situation with PF Olsen prior making any commitments to joining the ETS or additional planting.

 Carbon pool PF Olsen is working on forming a carbon pool or fund to provide forest owners with the upside for carbon and mitigate the downside risks. This scheme is not available at present and there is no guarantee if and when it might be available. Such a pool, or fund, may particularly suit existing post-1989 forest owners who cannot plant additional forest. For those that can plant additional forest, some of the options below may be more attractive.

Investment Strategies New Planting

High IRR

Our analysis shows that the IRR for new carbon forestry projects is in the range 8%-16% pre-tax, depending mainly on the price of NZU carbon credits. This is achieved by planting radiata pine in an unpruned regime with a single thin-to-waste treatment. The optimum rotation age appears to be about 35 years although the IRR is not very sensitive to changes from age 30 to 50. Please note that these returns are for a specifically designed carbon forest regime from establishment to maturity and do not relate to joining an existing forest into the ETS.

 Next, we are going to discuss two investment strategies:

1) Planting single-age carbon forests to maximise annual revenues.

2) Planting multi-age carbon forests to hedge the price of carbon.

Planting singleage carbon forests to maximize annual revenues

Planting a new forest on post-1989 forest land as per our example scenario is forecast to yield an IRR of 12% real before tax. In this instance the regime is an unpruned radiata pine stand with a high final crop stocking. The rotation age is modelled at 35 years but such a forest is expected to be merchantable to at least age 50 years. This long maturation profile goes a long way to reducing the risk of fluctuating carbon prices and also maximises the generation of carbon revenues that can be used for other purposes.

Planting multi-age carbon forests to hedge the price of carbon

As mentioned above, a multi-age carbon forest has the advantage of further reducing the risk of fluctuating carbon prices. A multi-age forest can be achieved by either planting to complement existing post-1989 forest, or by embarking on an entirely new planting programme over several years.

Planting and complementing existing post-1989 forests

Planting to complement existing post-1989 forests will more readily achieve a good forest age spread (at least between the existing post-1989 forest and the newly planted forest). Also, the cash from the carbon credits from the existing post-1989 forests can be used to fund the new planting programme. Risk is lowered because the newly planted forest will be generating carbon credits at the time of the carbon liability from harvesting the post-1989 forest. This last feature is particularly important as the harvesting window of the existing post-1989 forest is likely to be relatively narrow (say 5 years) especially if it is a typical pruned regime on a relatively fertile site. This relatively narrow harvest window relates to pruned butt logs getting too large for market and/or developing too high a proportion of heart wood.

 Entirely new planting programme

   A planting programme whereby areas of land were established every few years would also produce the multi-age forest with lower risk associated with fluctuating carbon price. Such a progressive programme may also better suit some people s cash availability and there is the added benefit of being able to use carbon-based revenues from prior plantings to fund subsequent planting. This approach, however, will lower overall returns as establishment of the carbon forest will be slower.

Conclusion

Forestry for both timber and carbon improves the financial viability of forestry investments on land that qualifies for entry into the ETS. This investment opportunity is particularly attractive to those forest owners who have existing post-1989 forests as the credits from the new forestry plantings can be used to off-set the liability for emissions of the older

post-1989 forests.

Planting a single-age forest on pasture land is projected to yield excellent returns and the risk of carbon price fluctuations can be mitigated by growing quality timber.

Planting a multi-age forest over a period of time will yield lower returns in the short term but has the benefit of better spreading risk and lower cash demands. Returns are still forecast to be much better than timber only and most alternative land uses.

 Next Steps

 Individual circumstances need to be evaluated

Because each situation is different, solutions need to be tailor made. PF Olsen can assist you with the important steps to evaluate a possible carbon forestry project:

• Mapping and classifying your land.
• Developing a number of possible scenarios.
• Modelling the scenarios to forecast profitability, carbon and cash flows.
• Evaluating risk/return profiles for the various scenarios.
• Guidance on deciding on the best option.
• Costing and budgeting.
• Project planning and implementation.

First mover advantages

There will be first mover advantages in carbon forestry and interest in carbon forestry is starting to build up. Our expectation is that tree stocks and planting labour will become very scarce for the next few years. This scarcity is expected to be particularly acute for several reasons:

• Very low new planting rates last year means low tree stock propagation levels.
• Few tree stocks grown on spec these days.
• Limited seed available.
• Long lead time to propagate from cuttings.
• Current low level of silviculture means access to skilled labour for planting will be limited.
• Historically low unemployment levels will limit build-up of skilled worker capacity.

How to contact PF Olsen

To find whether the exceptional opportunity of carbon forestry is right for you contact your local PF Olsen representative, or phone PF Olsen on 0508 PF OLSEN (0508 736 5736) or email us at info@pfolsen.com

Disclaimer

The information contained in this technical note is based on “A guide to Forestry in a New Zealand Emission Trading Scheme – October 2009” . The actual impact on post-1989 forest land owners may differ from that outlined in this technical note and these differences may be material. We suggest you check with your PF Olsen forestry advisor before you act on any information contained on this technical note to ensure that the advice you receive is current and specific to your particular situation.

Filed under: Forestry, Hawkes Bay