Forestry investments have gained popularity with the endowment and foundation investors because of the sustainable benefits and stable returns. What set forestry investments apart from traditional asset classes like stocks and bonds and their alternative investment counterpart, commodities, is their independence of political and economic forces, which have no bearing on tree growth.
Biological tree growth is the driving force behind forestry investments, with traditional returns depending on timber sales and land appreciation. Another emerging new source of returns is carbon emission trading which relies on the ability of forest to photosynthesise greenhouses gases (GHGs).
Although the carbon emission market is still in its infancy, trading has, in fact, commenced. Incorporating this type of trading into forestry portfolios will not only improve investment returns while allowing investors to be ecologically responsible in combating global climate change.
It is CO2 among GHGs that causes the rise in atmospheric temperature leading to global warming. Carbon emission trading has evolved from a growing awareness the potential problems associated with the climate change - floods, droughts, food and water insecurity and extreme weather – which lead to high social costs.
Formation of CET
The environmental benefit of growing forests is pervasive. The process of photosynthesis plays an important role in absorbing carbon dioxide and reducing GHGs. The ability of trees to internalise the carbon absorbed and to store it in plant matter and soil is known as carbon sequestration. This process forms the basis for carbon emission trading.
Carbon emission trading is market driven with the objective of rewarding participating parties - the sellers and buyers of carbon credits, the latter being air polluters - for being socially and ecologically responsible. Solid legal and accounting frameworks are crucial for the formation the infrastructure for this type of trading.
Given that forestry assets are highly fungible it is important to define legal ownerships and clearly lay out the participants’ obligations and liabilities. Forestry assets can split into three groups - carbon rights, forestry rights and land ownerships. Once the position of carbon right owners is established, they are obliged to take over the carbon accounting responsibility. Owners are responsible for having carbon sequestration verified against a standard for registration. Upon registration, tradable certificates can be issued and sold in the market place. This marks the beginning of carbon credit trading. One carbon credit is traded for one ton of GHG, which is often expressed in carbon dioxide equivalents. For example, carbon credits can be bought by a utility to offset its emission levels from a commercial forest grower in Peru.
Regarding legal obligations, the sale of carbon sequestration credits creates a contingent liability over the assets. Should a forest be cleared, carbon owners would be required to discharge their obligations and buy back previously sold credits, in order to balance their books. It is the carbon registrar’s responsibility to audit participants’ carbon books to ensure the balances. The rotation of plantations or having large carbon pools can mitigate the liability issues.
Arbitrage opportunities may arise between fluctuations in timber prices and prices of carbon sequestration credits over time, especially in a large carbon pool.
David Brand, director of carbon programmes at Hancock Timber Resources Group in Sydney, says: “The ideal situation is when timber prices are high and carbon prices low. Managers can sell timber and buy back the carbon credit positions on the market. However, when the prices go in opposite directions, managers can sell carbon credits and keep growing the forest for future logging provided the correlations exist.”
Since the late 1980s, the UN has led a series of multilateral discussions on global climate change issues. In December 1997 the Kyoto Protocol was agreed. Participating states were grouped into Annex 1, consisting of 41 industrialised countries, and non-Annex 1, which are the non-industrialised countries. The industrialised countries are considered the major contributors to GHG emissions.
Under the protocol, Annex 1 parties are obliged to cut emissions by 5% below the 1990 level during the first compliance period from 2008 to 2012. The average of these five years’ emission shall not exceed the mandatory level of each country. “In the event of a failure to meet the mandatory levels, shortfalls will simply be added to the following compliance periods. No financial penalty will apply” says Nathalie Roth, director of GHG services at Evolution Markets LLC, in White Plains, New York.
The protocol will become effective when ratified by countries that collectively emit 55% of global GHG emissions at the 1990 level. Non-ratifying countries like the US and Australia will not be bound by the emission requirements and cannot participate in protocol trading activities.
At present only 44.2% of the emission level has been ratified pending agreement on the part of Russia, which in May expressed an interest in ratifying subject to gaining EU approval of its bid for WTO entry.
Emission trading has the potential for exponential growth. Unlike forest plantation, its activity is not geographically bound. The rapid growth is evidenced by the increase in emission trading volume to 71m tons in 2003 from 29m tons in 2002.
The Kyoto protocol trading mechanisms have also set the stage for the emergence of other trading mechanisms such as EU directives due in 2005 and the Chicago Climate Exchange in the US.
Trading under the clean development mechanism (CDM) has already commenced. Evan Ard, vice-president of Evolution Markets, says: “Although certificates under CDM are quoted in US dollars, buyers are largely domiciled in Europe hence they are settled in euros”. Current transactions under international emission trading (IET) and joint implementation (JI) are forward trades with emission reduction units to be delivered during the first compliance period between 2008 and 2012.
Totally separate from the protocol, the soon-to-be-launched EU directives are modelled on the IET mechanism. Only allocated units are traded. Utilities and large manufacturers are assigned emission allowances and caps on GHG outputs. When emission reductions are lower than the caps, the excess can be sold for a profit. Conversely, when reductions are higher than the caps, the emission shortfall will be bought to meet the set requirements.
As the carbon trading volume is on the rise, managers who can unlock the potential returns derived from the intrinsic attributes of their forestry assets are on the right path to enhance their portfolio returns. Incorporating forestry investment as a diversifier into investment portfolios will certainly improve the risk and return profiles while being ecologically responsible.
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