David Brand’s Speech at Carbon World Finance

October 14-16, 2008, Sydney Harbour Marriott Hotel
Good Morning. Thanks to the organizers of the conference for the opportunity to speak to you today on the role of forests in emissions trading regimes. This is a relatively broad and complicated topic, so I will try to move through the various aspects and considerations in a fairly organized fashion.

Let me start with a brief introduction to our company, New Forests. New Forests is a forestry investment management and advisory services firm. Our business includes investment management focused on forestry assets with exposure to environmental markets—and particularly carbon markets, which we see as an emerging opportunity for forestry investors. We also provide advisory services to companies seeking to establish commercial strategies around the buying or selling of land based carbon credit products.

Forestry has always been a difficult issue for negotiators and scheme designers of carbon emissions trading markets. We all recognize that forest ecosystems contain more carbon than the atmosphere and that the loss and degradation of forests have been responsible for 20% of global greenhouse gas emissions in recent years. Forests need to be part of the solution to climate change.

We also understand that forest conservation and reforestation are among our most cost effective activities in reducing emissions in the short term, especially while new technological solutions are emerging.

Yet forestry has been controversial and difficult and we have largely failed to create workable approaches to incorporating forestry offsets into carbon trading markets to date.

Let’s start by looking at why the incorporation of forestry in emissions trading regimes is controversial.

The main criticisms of forestry are that it is not equal to avoiding an emission elsewhere, that it is difficult to accurately account, and that it will flood the market with cheap tonnes that distract from the priority of reducing fossil fuel energy use. After 10 or so years of policy and technical work, there are answers to these questions, but it remains a somewhat complex and specialist area of the carbon market. Those who don’t understand forestry often have a tendency to put it into the ‘too hard basket’.

So let’s now work through the technical issues and how they are likely to be addressed in the Australian ETS.

The first element is the question of accounting for the carbon position in forests. Forests are biological systems and respond to a myriad of factors including rainfall, soil conditions, management systems, insect attack and wildfire. In terms of a carbon trading system we look at the forest as carbon stock—that is the biomass of forests is about 50% molecular carbon so we can calculate how much carbon is in a forest at a point of time. If the forest grows and increases its carbon stock it is in a credit position. If the forest is cut down for timber or burned in a wildfire it will be in a debit position.

The Kyoto protocol rules are based on this stock change accounting, and Australian ETS rules will use the basic Kyoto approach.

A few more key elements in the accounting:

  1. The 1990 baseline year: Kyoto and the Australian ETS will use a 1990 baseline year. That means that if a forest was planted after January 1, 1990 it could qualify for incorporation into the Australian ETS via stock change accounting after the commencement point of the scheme—so that could be 2010.
    Land Use Change: Qualifying forests must have been planted on land that was non-forested on January 1, 1990. In other words you can’t cut down a native forest, replant it and expect carbon credits.
  2. Carbon Pooling: Normally the cost of incorporating a single plantation of trees into an ETS would be prohibitive, so it is likely that aggregations of forestry plantations will be accounted for as a kind of pool. This provides significant flexibility to manage the risks, timber harvesting and regrowth profile of individual stands. It can also substantially reduce transaction costs.
  3. Credits and Debits: There are a few ‘devil in the detail’ issues in forestry accounting. For example if a forest is three quarters mature, and sells carbon credits up to its point of harvest, the normal liability is only to what has been sold—not the whole amount of carbon harvested. There is some confusion about this in the Australia ETS.
  4. Wood products store up to half of the timber harvested, often for periods of decades. Yet the current accounting methods ignore the carbon stored in wood products and treat a harvest as a total emission to the atmosphere. This is likely to be changed as better systems are developed for forecasting the storage of carbon in wood products.

 

There are a couple of more concepts to explain.

  1. Additionality: In some cases forestry credits needed to prove a test of additionality—that is to prove that the forest would not have been commercial without a carbon price signal. The Australian ETS will not include this concept of financial additionality, as it is difficult to prove. In any event. if two areas side by side were each planted with trees and one was for timber and the other for carbon credits the atmosphere couldn’t tell the difference. The Australian ETS will therefore include a mix of commercial and non-commercial plantation forests.
  2. Permanence: When a tonne of greenhouse gas is emitted to the atmosphere it stays there a long time. Therefore when a credit is sold from a forest, the expectation is that it will be kept out of the atmosphere for a long time. Effectively the sale of a forest carbon credit becomes a perpetual (or at least multi-decadal) obligation on the seller to keep carbon stock in identifiable forests behind the tonnes that have been sold—a bit like the gold that was held in Fort Knox behind the US money supply in days past.
  3. Another note about what forests qualify: the Kyoto protocol allowed countries to account for additional carbon stocks in forests other than reforestation projects. This could include re-vegetation with shrubs, improved forest management , etc. It appears that these additional classes of credit will not be allowed in the Australian ETS, so we are looking at a plantation forestry based scheme.

 

There are a number of other nooks and crannies in the accounting rules, but I won’t go further to avoid the risk of people’s eyes glazing over.

With that basic accounting approach, the question then becomes what strategies should be pursued around forest carbon stocks in an ETS.

The first key point is that forest carbon is a fairly specialized sub-set of the carbon market and will be driven by some unique considerations that do not affect other economic sectors.

  1. Because forestry credits sold incur a retention liability, the decision to sell will be based on the capacity to mitigate the liability associated with selling the carbon. That could be via commercial structures like carbon pools, insurance products, or what I call ‘no regrets’ strategies. A no regrets strategy might be to sell carbon credits from fast growing blue gum forests and then buy remote land for re- vegetation projects to hold the liability. If the price of carbon is high enough this would become effectively no-regrets. Another strategy is to take areas of poor plantation productivity, riparian zones and other conservation areas and convert them to carbon projects. In some cases this can recoup investments that would otherwise be lost.
  2. Another important concept around forest carbon stocks is that of a kind of reserve bank of carbon. In all the emissions markets to date, including Sulphur Dioxide, the EU ETS, the NSW ETS and the Chicago Climate Exchange, prices have been highly volatile. Forest stocks could play an important role in buffering volatility. This would occur by carbon pool managers selling into high market prices and then buying their position back from the market when it dips. If large pools with several million tonnes went in and out of the market, then this could dramatically reduce overall market volatility.
  3. The other factor in forestry is that the carbon price produces a kind of economic margin on timber production. If we look at a large number of forests, they will have a range of opportunity costs in switching from say, maximizing timber production to an integration of timber and carbon stock management. Forest managers will need to use simulation models to understand how different carbon market prices affect returns from alternative management strategies. Our modeling suggests that between 100 and 400 basis points can be added to forestry returns by correctly understanding the commercial parameters affecting different forests.
  4. Finally when we think about forestry in a world where both the carbon credits and the physical timber supply have exposure to market prices there is a potential arbitrage between the two markets over time. While we would expect both Timber pricing and Biomass Energy products to rise in line with an emissions trading regime, there may not be perfect correlation between the two markets. I often think about a 2 by 2 matrix with the four quadrants being:
    • High timber price, low carbon price.
    • Low timber price, high carbon price.
    • High carbon price, high timber price.
    • Low carbon price, low timber price.

 

We could easily see how management strategies would differ in these different quadrants.

While timber prices are robust a manager could safely ignore the carbon market and optimize returns on a timber-only basis. However, if timber prices fell and carbon markets surged it would make sense to reduce harvest, sell carbon, and potentially hold a financial reserve against the carbon obligation. If both carbon and timber prices rise, the manager would essentially undertake a variety of commercial analyses to optimize asset management performance. If both timber and carbon were low, there would be the option to simply sell out of the assets.

So the right strategy needs some thought and some understanding of option theory, volatility, risk management and risk transfer.

I might now turn to some of the potential future opportunities in the forestry sector.

One of the hot areas of discussion internationally is the area of forest conservation or Reductions in Emissions from Deforestation and Forest Degradation (REDD).

In the original Kyoto Protocol discussions in the late 1990’s there were proposals to pay countries that would preserve tropical rainforests from conversion and degradation. There was a backlash against this proposal primarily because of the view that cheap rainforest tonnes would collapse the market. It is interesting to note that instead of cheap rainforest tonnes the world got cheap industrial gas tonnes from China.

After rainforest conservation was thrown out in the Marrakech accords, a body of scientists and some NGO’s continued to push for forest to be integrated to a future global carbon regime. Studies began to be released showing that deforestation was accelerating, and the wholesale conversion of forests to soy bean, beef, palm oil and other crops was leading to the loss of species like the Orangutan and loss of huge swathes of the Amazon. There emerged around the time of the Bali COP last December a renewed consensus that forest conservation needed to be brought back into the process.

There has been significant new discussion around the REDD issue. There is an expectation that an agreement will be reached at the Copenhagen COP in 2009. Yet there remain large issues in how forest conservation will be addressed. Some are arguing for a separate market that allows forest conservation credits to trade in a parallel market with only some limited convertability. There is also debate about whether the forest carbon market should be project based like the CDM or based on national baselines. These are threshold issues that will influence the attractiveness of investing in forest conservation.

In the meantime, the Voluntary Carbon market has surged forward and we now have a very strong move towards a single Voluntary Carbon Standard. This standard provides a set of project types around forests, including avoiding unplanned deforestation, avoiding planned deforestation, reducing mosaic frontier deforestation, converting logged forest to protected forest, etc. Each of these will have one or more methodologies that project proponents can use to develop projects for validation.

We are involved in a couple of projects in Indonesia at the moment, and VCS appears to be a very robust route to market. There is substantial unfulfilled demand for this type of credit in the voluntary and retail markets. The challenge at the moment is getting the VCS panel to function efficiently. Much like the CDM executive board, most of the members are volunteers and there is a lack of resourcing for the work of the VCS. They are quickly becoming grid-locked by the volume of process to oversee.

Nevertheless, the general approach on REDD will be a baseline and credit approach. That is, we must demonstrate what would likely happen to the forest in the absence of the project, then what the difference in carbon stock in the forest over time would be with the project. So, if we take our project in Papua, it is under an HPK designation for conversion to oil palm. We will negotiate to establish a carbon and environmental services license over the area and conserve the forest. The carbon stock profile under oil palm will be based on logging and burning followed by oil palm plantation. We can then model the carbon stock difference year by year to determine the credit release schedule from the project.

The REDD projects appear to have lower cost per tonne than reforestation-based deals, but the economics are driven by the competing economics of conversion to other land uses. We have modeled some of the frontier regions of Indonesia, the Congo and the Brazilian Amazon, and it appears that pricing of $5 to $10 per tonne could draw significant supply from economically marginal areas.

The World Bank to date suggests that it is paying about $4 per tonne for REDD credits destined for voluntary markets, but they are also paying for the accreditation process. The World Bank effectively creates value by developing the project and buying the first tranche of tonnes. The remaining tonnes can then be sold into the voluntary market at a higher price, as the pedigree has been established.

Would REDD credits really flood the market? I don’t think so for a few reasons.

  • Most governments will put some cap on the volume of REDD credits that can be imported, much as the EU did on CDM credits.
  • Host country governments are likely to tax windfall profits much like China did on industrial gas deals.
  • Many of the REDD deals are in areas with complex community land ownership, and achieving prior informed consent will take significant time and effort.
  • The verification process will likely be onerous with considerable pressure on project developers to prove the threat to the conversion of the forest. In many cases what we expect to happen can’t be categorically proven. This will also put a drag on project validation.
  • So the REDD situation is very fluid, but could become an important second leg of the global forest carbon market in the next four or five years. Some pundits are already suggesting that it will draw investments of $30-40 billion per annum after 2012.

 

Nevertheless, even before the REDD scene is finalized, we are likely to see a lot of innovation around the forestry carbon space. The incorporation of forestry in both the Australian and New Zealand emissions trading regimes is very important. The reticence of Europe to include forestry means that much of the commercial learning will occur down under, and if we figure out the various strategies and commercial models we will be able to export them into the US, Canada, Japan and the emerging REDD markets.

Thanks very much, and please feel free to catch up with me afterwards if you have any questions