Financial contracts and the management of carbon emissions in small scale plantation forests.

1. Financial contracts and the management of carbon emissions in small scale plantation forests. Andrew Coleman March 2012

2. Introduction The Emissions Trading Scheme has the potential to transform small scale forestry investment in New Zealand. It allows investors to change the cash flows associated with forestry investments. Without the ETS, long term forestry investments only provide a cash income upon harvest after 25-50 years With the ETS carbon units are received as forests grow, and can be sold. When forests are harvested, forest growers have to remit back their carbon units. If they have sold them, they can use the harvest proceeds to buy them back.

3. Forestry with ETS CO2 CO2 Cash from harvest minus carbon units remitted carbon units earned 30-50 years

4. Introduction A one ha pine forest grows approximately 20 m3 wood per year, 20 carbon units per year $500 worth of carbon units per year at $25 tonne (But only $200 at $10 per tonne) 500 units (worth $12500) by harvest

5. Introduction If a forest grower sells these units, they have to repurchase at harvest This exposes them to the risk of increases in the price of carbon. Each dollar change in carbon exposes them to $500 in revenues at harvest per hectare.

6. Introduction Forest growers may find this risk sufficiently off-putting that they do not sell the units as earned Coleman 2011 discusses various ways of managing this risk: Forward markets Future markets Carbon debt markets.

7. Introduction He argued that carbon debt markets were the most attractive permutation for small scale forestry, for while forward and futures market managed carbon price risk, they create unacceptable levels of counterparty and liquidity risk.

8. An agreement to borrow or lend carbon units at a carbon unit interest rate. Carbon Debt markets

9. An agreement to borrow or lend carbon units at a carbon unit interest rate. Forest growers would lend carbon units as they are earned, and get them back with interest at harvest Raises total return compared to simply holding units in registry Could sell some as earned Allows grower to obtain limited cash as forest grows, with no price risk at harvest time Carbon Debt markets

10. There is counterparty risk that the bank defaults on the loan But no counterparty risk that forester defaults, hence very low transactions costs (similar to making a deposit versus borrowing a mortgage) =>converts price risk to limited counterparty risk. Carbon Debt markets

14. Commodity debt markets analysed by Keynes (1936), Williams (1986) Some exist eg uranium Logically “isomorphic” with forward markets, but the most convenient form typically exists Carbon Debt markets - detail

15. Cronshaw and Kruse (1996), Rubin (1996), and Kling and Rubin (1997) analysed what would happen under conditions of certainty if the Kyoto agreement allowed permits to be banked or borrowed. Marland, Fruit and Sedjo, 2001; Sedjo and Marland, 2003; Chomitz and Lecocq, 2003)considered the use of carbon rental payments for permits issued against sequestered forestry carbon, to take into account the possible lack of permanence Esuola and Weersink, 2005; Bigsby, 2009analysed how carbon lending markets might be useful to agents such as forest growers that earn credits from sequestration Existing literature

16. Natural borrowers and lenders Foresters are natural lenders as they temporarily have units that they need back at harvest time. Could sell and repurchase Could simply lend. Firms wishing to invest in carbon reducing equipment are natural borrowers Carbon Debt markets - detail

17. Example – a forester lends units After 15 years, a forest grower with 20 ha would have 6000 carbon units. At 3%, this is 180 units per year, ~$4500 (at $25/unit) This is much better than not entering the ETS Of course, the carbon units could be sold for cash when earned, providing the forester $150000 – tax = $100000 However the units would need to be repurchased, exposing the farmer to risk. Carbon Debt markets - detail

18. Example – a firm borrows units A firm can invest $1m to save 5000 carbon units yr for 15 years. exposed to the risk that the carbon price falls If carbon price is $25, borrows 40000 units, sells them and buys plant Repays the loan with the carbon units saved. Natural hedge: no price risk Worth doing if carbon interest < 9% Carbon debt market provides perfect way to obtain funds for carbon reduction investments Carbon Debt markets - detail

19. Carbon interest rates Carbon interest rates should equal money interest rates adjusted for expected growth rate in carbon price If carbon price schedule is flat through time, carbon interest rates = money rates If carbon price is expected to rise, carbon interest rates < money rates In equilibrium, carbon rates cannot fall below zero if price is expected to rise, as can be held at the registry. Carbon Debt markets - detail

20. Existence Calton (1984) and Williams (1986) examined necessary conditions for a commodity forward market/ debt market. Need natural users (borrowers and lenders) Need the commodity price to vary in a manner that is uncorrelated with other prices. Need low transactions costs (a) and (b) hold for carbon. (c ) is major issue: will there be sufficient volume for transactions costs to be low? Carbon Debt markets - detail

21. 4. Welfare consequences A carbon debt market has the potential to be pareto improving. Fundamentally, it shares risk between Foresters who are concerned that the future price of carbon is high Industrialists (or new forest growers) who are concerned that the future price of carbon is low. By sharing risk, it means carbon reducing investments will take place ( and more forests may be grown) Carbon Debt markets - detail

22. 5. Transactions costs Arbitrage means anything you can do with debt contracts you can do with forward contracts Forward and futures markets already exist. So why debt markets? Carbon Debt markets - detail

23. Current markets are not aimed at forestry Wrong horizons Large scale Counterparty issues Debt markets easy for retail non-specialists Financial sophistication: lending is easy to understand Earnings easy to understand: just interest No “roll-over” issues Minimal tax issues. Carbon Debt markets - detail

24. A bank could Offer current forest growers additional income (interest on carbon) for merely enrolling in the scheme Offer industrialists a reason to invest in carbon reducing technology even if they are uncertain whether the scheme will exist in the future. Make a margin in the middle. A version of this programme has been started by New Zealand Carbon Farming, that offers to lease carbon from established forest blocks > 100ha. It pays $200 per ha per year and uses the money to plant new forests. Rental price seems high….have they got the interest rate correct? Carbon Debt markets - detail

25. (1) For banks/ NZ Carbon Farming to be able to offer these services, transactions costs need to be low. Carbon Debt markets – role for Government?

26. (2) The Government could set up a programme to remove industry concerns about uncertainty about the carbon price, and encourage carbon reducing investments amongst industrial users. It borrows from existing foresters not in the programme, offering “free money” (additional carbon units) for participating. The Government can make it completely straightforward, profitable, and riskless to foresters to participate in the ETS Carbon Debt markets – role for Government?

27. It uses these units to offer industrialists loans for carbon reducing investments whose repayment is tied to the price of carbon The government removes their carbon price risk Important if a main concern amongst industrialists is the longevity of the NZ system Government does have counterparty risk, but this can be managed Government would earn the interest margin between lending rate and borrowing rate Carbon Debt markets – role for Government?

28. A win-win situation is possible because there is a “free lunch” from sharing risk. If the Government were allowed, it could create new Carbon units to lend to industrialists and would not need to borrow from forest growers. It is not allowed to create these units, however. The forest programme gives it the opportunity to lend to industrial users/ new forest growers and encourage real carbon reducing investments. Since the industrialists sell the borrowed units immediately, the programme works much better when the spot carbon price is high, as fewer units need to be borrowed to finance any future carbon reduction. Carbon Debt markets – role for Government?

29. Forward, future,or debt markets can all be used to offset price risk if units are held The risk is converted into another form Debt market is a natural form for forest growers Increases overall return Eliminates price risk Can provide modest improvement in cash flow Low transactions cost Debt market has natural borrowers => potential for win-win solution to take advantage of natural carbon risk sharing between foresters and industry Conclusion