The Global Forest Resource Assessment 2005 finds that forests4 cover 30% of total land area, two thirds of which occurs in just 10 countries.
Figure 2: Global distribution of forest by country. Thirty countries contain more than 84% of global forests. Some countries additionally have 'Other Wooded Land' (5-10% canopy cover),
Tenure and ownership of the world’s forests have recently come under scrutiny as the link between investment in sound forest management and secure property rights has become clear. The questions around access, claims to ownership and who should own the world’s forests are contested in many areas around the world (White and Martin, 2003). While governments still own much of the global forest estate, several hundred million people directly depend on forest resources for their livelihoods.
Forest-Backed Bonds Proof of Concept Study Forum for the Future & EnviroMarket Under pressure from international conventions and local political movements, governments increasingly recognise land-use and ownership claims of indigenous groups and local communities. The conservation movement also recognises the positive contribution of indigenous people’s traditional management practices to ecosystem maintenance, which may be enhanced by devolution of forest ownership from governments to local communities (Wunder, 2001). Furthermore, governments and their agencies generally appear to have a poor track record at managing their resources, triggering a re-evaluation of the types of private/institutional arrangements best suited for the task.
In their detailed analysis, White and Martin (2003) concentrate on tenure data for 24 of the 30 most forested countries as identified by FRA 20017, and make the initial distinction between public and private property, recognising that the statistics do not identify unrecognised claims by local peoples, and that ownership does not necessarily imply control, especially in Africa and Asia. Public property, (defined as all lands owned by central, regional or local governments) is further divided into two subcategories (1) land administered by government entities and (2) land reserved for local communities, but where any rights are not secure, and may be revoked. This second group lacks the important ability to sell or raise finance against land, or claim revenues from ecosystem services sold. Countries with these arrangements include Brazil, US, India, Thailand, the Philippines, Indonesia and Zimbabwe. Private ownership, defined as a right which cannot be extinguished without some form of compensation by government, is divided into land owned by (1) private individuals or firms and (2) local communities or indigenous groups.
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In summary about 2.8 billion ha are managed by governments, 131 million ha are reserved for communities, 246 million ha are owned by community and indigenous groups, and 443 million ha are privately owned by individuals and firms. These numbers, though probably underestimates of the non-government categories, imply around 77% of the global forest estate is administered by governments.
Managed forests currently make up about 34% of total global forest8. Management activities are undertaken by a wide variety of public and private entities, with a similarly diverse range of operational objectives and criteria. They span everything from (industrial) plantations that increasingly feed the raw material needs of major forest product corporations to protected areas of natural forest held by leading NGOs and conservation groups.
Effective policy and regulation are essential cornerstones of forestry management on a national level, but the ability of governments to successfully implement these measures, and of individual forestry operators to survive and develop, requires access to finance. Ownership structures have implications for the way in which the forests are managed, their social and environmental costs and benefits, and the access to capital.
Key arrangements for management of tropical forestry are as follows:
8 Global Forest Resources Assessment 2005 - Production of wood and non-wood forest products is the primary function for 34% of the world’s forests, while more than half of all forests are used for such production in combination with other functions, such as soil and water protection, biodiversity conservation and recreation.
Forest-Backed Bonds Proof of Concept Study Forum for the Future & EnviroMarket
The above list, although non-means exhaustive, provides a useful snapshot of existing tropical forest management. A fraction of these operators are currently recognised as sustainable forestry managers by stakeholders in the international process. Each of these operators faces different challenges and constraints in the day-to-day execution of their businesses. Regulatory policies/enforcement and competition at local, national and international level (in that order) establish the framework within which these businesses operate.
Below we explore the activities of these forest managers in more detail, and provide a snapshot of commercial and financial realities for each.
Although it is clear from the analysis above that governments own most of the forest estate, access rights and management authority are traditionally transferred to large-scale private forestry firms through logging concessions in return for royalties and other fees. In White and Martin’s (2003) analysis of data from 16 countries for which data was publicly available9, some 400 million ha were allocated to concessions. There arrangements typically involved a small number of private firms and allegations of illegal logging and corruption in these concessions were commonplace. Generally, few profits or government revenues from forest concessions tended to be reinvested, and uncontrolled or unsustainable logging led to boom bust cycles of local development. In the case of heavily indebted, vertically-integrated multi-national concessionaires, tax-revenues are low and profits tend to accrue to shareholders in foreign countries; as a result, this model of forest resource ownership and use has fared poorly in comparison to small to medium forest enterprises in countries like Guinea and Ghana (Mendes and Macqueen, 2006).
The Conservation Concession is a novel approach that seeks to directly reconcile resource protection with development.
Under a conservation agreement, national authority or local resource users agree to protect natural ecosystems in exchange for a steady stream of structured compensation from conservationists or other investors. In its simplest form a conservation concession might be modelled after a timber concession; rather than log the concession area, the conservation investor would pay the government for the right to preserve the forest.
A conservation concession requires a negotiated agreement between an investor and a government or other resource owner.
The Heart of Borneo (HOB) covers some 220,000km2 of equatorial rainforests (equivalent to the size of the UK) and about 1/3rd of the island of Borneo the 3rd largest island in the world. The area straddles the transboundary highlands of Indonesia and Malaysia, and reaches out through the foothills into adjacent lowlands and to parts of Brunei. Borneo's biodiversity is unique, being the source of 14 of the island’s major rivers, harbours up to 6% of the world’s total biodiversity and inhabited by 13 species of primates and over 15,000 species of plants. The Declaration on the Heart of Borneo initiative, signed on 12 February 2007, represents a commitment between the three countries to conserve and sustainably manage the Heart of Borneo.
Forest-Backed Bonds Proof of Concept Study Forum for the Future & EnviroMarket By way of example, in July 2002 Conservation International signed a 30-year agreement with the Government of Guyana to establish a conservation concession protecting 80,000 hectares of pristine forest. Conservation concessions can offer an attractive stopgap – an opportunity to support key ecosystems until such time as more permanent arrangements can be made in the form of national parks and protected areas. In this context, conservation concessions offer:
Although governments still dominate forest ownership, this situation is changing. Driven by political and legal reforms, the rights and legal title of land are being transferred to the communities and indigenous groups that have historically occupied them. As an indication of the scale of change in forest ownership, the Amazon basin countries have transferred 1 million km2 of forest estate to community ownership since 1985. Similar changes on a smaller scale are occurring in Africa and Asia. Australia, Bolivia, Colombia and Peru together now recognise 103 million ha of forest as owned by communities, while Bolivia, Brazil, India, Indonesia, Peru, Sudan and Tanzania together recognise 113 million ha as reserved for community administration. As a result, community groups have been able to successfully challenge logging concessions.
Associations often arise as an attempt to increase awareness or representation in government, but could potentially provide access to a resource base of sufficient scale to support a forest-backed bond as an alternate means of raising finance for SFM. However, there are significant challenges associated with community forests, as shown in the study of the Matto Grosso area of Brazil
The Matto Grosso region of Brazil provides an example of the mixture of cultural/political context within which different associations form, often with similar economic aims. Of the 12 associations surveyed, the stated goals of all included (1) securing tenure and (2) securing credit for their members in their stated goals. Although micro- (less than 10 employees) and small to medium forest enterprises (< 99 employees) comprise 98 % of businesses and are responsible for 75 % of the timber produced in the area, they are not supported by favourable public policies, and some reasons contributing to high failure rate (only 50 % survive beyond the third year) of SMEs in the Matto Grosso were listed as:
Companies with inadequate access to raw materials may enter a wide range of relationships with individual growers or cooperatives which vary in regard to the extent to which risks, costs and profits are shared between the parties (). In some plantation-based cases, forestry companies are closely involved in most of the steps from planting to harvest, including arranging finance and training11.
Green Economy can recognise four broad classes of out- grower arrangements:
Classical forest management models focused exclusively on the generation of timber as the primary (if not only) harvestable commodity to be obtained. The extraction of other products, whether marketable or for subsistence purposes, could be considered as a constraint on the model, or a competing use of the land base. There has been increasing recognition, however, of the value of Non-Timber Forest Products (NTFPs) in terms of income diversification and sustainable community development. The production of edible products has also come to be recognised as a valuable component of resource management systems, be it marketable commodities or locally consumed produce.
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The UN’s 2007 report into sustainable bioenergy21 claims that even ‘sustainably’-produced energy crops could have negative impacts if they replaced primary forests, “resulting in large releases of carbon from the soil and forest biomass that negate any benefits from biofuels for decades”.
The main demand and largest production potentials do not geographically coincide. Whereas the largest demand for biofuels is concentrated in industrialised countries, the largest production potential is found in tropical countries (in South-America, sub-Sahara Africa and East-Asia) as well as countries with relatively low population density such as Canada and Russia22 The biofuels industry is still heavily dependent on government subsidies in most countries, which has helped cushion the US and Europe against market prices. The market has been spurred by the increasing emphasis on energy security in the US, which announced plans in early 2007 to reduce petrol usage by 20 per cent within a decade, largely through an increase use of biofuels.
In response to climate change, markets have been developed to effect reductions in carbon dioxide emissions. Forestry projects can generate carbon reductions in one of two ways. Firstly, new trees can be planted and grown to absorb (‘sequester’) carbon from the atmosphere. Secondly, action can be taken to slow or halt deforestation. As there are vastly more natural forests in the world than plantations, and ongoing destruction of these has already been identified as one of the major source of emissions of carbon dioxide worldwide, the potential to generate reductions through this approach are considerable. However, the challenges of creating a market for carbon reductions generated from forests are also significant, stemming primarily from a lack of permanence; leakage; and issues around quality and ownership.
Because forestry carbon is not static, forestry carbon projects need to adhere to exceptionally thorough methodologies to ensure the environmental integrity of the credits they generate. The wide range of social and local environmental benefits, while of interest to a high proportion of potential buyers, add another layer of complexity around measurement and monitoring of impacts.
Forestry carbon credits are generated and traded both in the regulated carbon market, where rules are established and mandated by legal authority and buyers face binding compliance targets, and in the voluntary markets, where projects are undertaken according to independently established standards, and buyers engage largely to demonstrate corporate social responsibility and protect/enhance brand value.
The regulated carbon market dominates the global market, with an estimated value of $30bn in 2007. The vast majority of this activity is related to the trading of EU Allowances within the EU Emission Trading Scheme. The most significant regulated market for project based reductions – of which forestry projects are a variety – is the Clean Development Mechanism, authorised under the Kyoto Protocol, which accounted for $5bn in 2007 (World Bank, 2007). Under current rules the CDM can be utilised for forestry projects involving afforestation and reforestation, but CDM excludes emissions reductions delivered through avoided deforestation. Kyoto Protocol caps the use of carbon credits from forestry by Annex 1 countries in its first commitment period, limiting import to 5% of 1990 levels. Partly as a result of this delay, forestry projects have been excluded from the first phase of the European Union’s Emissions Trading Scheme (EU-ETS), the trading scheme which has been the engine of growth for the global market. Land Use, Land Use Change and Forestry (LULUCF) projects currently account for just 1% of project based emission reduction under the Kyoto Protocol.
The Clean Development Mechanism (CDM) accommodates the non permanent nature of forestry projects through the creation of two types of expiring Certified Emission Reductions (CERs) – a short term credit referred to as a Temporary Certified Emissions Reduction (tCER), and a long term credit referred to as an lCER. tCERs are issued against validated forest carbon stocks, and remain valid for one Kyoto commitment period of five years. At the end of the period, a new batch of tCERs are issued on the basis of stock at the end of each verification period. tCERs can only be used in the commitment period in which they are issued and must be replaced at expiry with another tCER, a permanent CER, Emissions Reduction Unit (ERU), Removal Unit (RMU – a carbon credit derived from a carbon sink) or Assigned Amount Unit (AAU – the unit of measure for a country’s allocated emissions under the Kyoto protocol) ). By contrast, once issued an lCER is valid until the end of the crediting period for the project itself, which could be 30 years. At expiry an lCER must also be replaced, but this cannot be with another lCER, not a tCER. An important feature is that, unlike tCER, lCER do create a liability for replacement in the event that verification shows the total biomass has decreased since the last verification.
The temporary nature of tCERs generated by a CDM AR forestry project means that these credits should trade at a discount to permanent CERs. As they have to be replaced or expired at the end of their 5 year term, the net effect of buying a tCER is to delay the need to purchase (a) another tCER, (b) a permanent CER/ERU/EUA or (c) reducing emissions. A sensitivity analysis of the factors influencing the theoretical financial value of tCERs from the prospective of a potential buyer shows strong correlation with discount rate and duration. The longer the duration of the credit and the higher the discount rate (applied to the deferred action), the higher the current value of the tCER.
Forest-Backed Bonds Proof of Concept Study Forum for the Future & EnviroMarket Although the on-going exclusion of Temporary Certified Emission Reductions from the EU Emission Trading Scheme continues to be a significant cap on overall demand from major corporate buyers, some governments and carbon funds are beginning to emerge. At present the World Bank BioCarbon Fund is by far the most significant buyer of forestry CDM credits.
At $100m, the voluntary market is far smaller than the regulated market (World Bank, 2007), but a greater proportion of projects undertaken are forestry related. Historically a range of different methodologies has been employed, and the inherent flexibility of the voluntary market has been considered one of its unique strengths. However the general proliferation of offset suppliers in the voluntary carbon market has led to concerns over the environmental integrity of some voluntary carbon offsets.
As with certification of timber, mechanisms for capturing revenue for carbon reduction entail up-front costs. These can become particularly significant for smaller and medium scale operators interested in accessing the regulated markets. To comply with the need for environmental additionality, operators are required to demonstrate on paper that the generation and sale of carbon credits is a commercial prerequisite for their project to go ahead. In this context, the costs associated with developing, registering and monetising carbon credits are very important. As a consequence, projects need to be of significant scale to cover these costs and meet the required financial hurdle rate.
Woeking along side us at Green Economy, we recognise the potential barrier that start up costs may present, the Clean Development Mechanism
Typical transaction costs under the CDM
The key sources of transaction cost for regular size projects under CDM are as follows:-
Project based carbon mechanisms require that revenue-generating opportunities in these areas be considered at the outset or earliest stages of a project. An assessment of carbon as ‘the icing on the cake’ suggests a fundamental misinterpretation of how these innovative mechanisms might yield value. Fundamentally carbon credits are intended to extend the range of sustainable forestry projects that can be undertaken, rather than increase the profitability of commercially viable operations.
Plants and trees play a vital role in the global carbon cycle, sequestering carbon dioxide from the atmosphere through the process of photosynthesis as they grow. Some of this carbon is transferred to the soil through roots and as leaves falls, leading the creation of relatively discrete ‘pools’ of carbon. When soil is disturbed, or when trees die and decay or get cut down, stored carbon eventually oxidizes and returns to the atmosphere. In total, across different carbon pools, global forest ecosystems are estimated to contain 4.5G tCO2e53.
The greatest proportion of carbon uptake occurs during the growth phase of trees. The rate of uptake is proportional to the rate of growth, which itself depends on multiple factors including tree species, location, and weather and silvi culture practices/management regime.
These variations, coupled with need to ensure the environmental integrity of project based carbon credits, makes the methodologies for development of forestry based carbon projects considerably more complex than those for projects based on emission abatement through clean technology. Theoretically carbon credits can be generated for reducing the rate of deforestation in natural, old growth forest (e.g. through introduction of sustainable management or conservation) and for planting new forests. The general approach to carbon trading in forests therefore varies depending on the general objective of forest management:
Natural forests are dynamic and highly complex ecosystems, through which CO2 cycles on a continual basis. Discounting any major external natural and/or anthropogenic perturbations, the process is considered to be in balance over time54 with roughly equal quantities of absorbed and emitted - the key significance of natural forests is their role is a vast global store, or ‘sink’, for carbon. In this context emissions occurring as a result of net deforestation are highly significant globally, accounting for more than 18% total emissions55. Carbon credits generated in natural forestry are therefore based on actions that avoided deforestation.
Plantations are man-made forests, and as such can be designed, developed and managed in a highly controlled fashion. Unless planted on ground recently occupied by natural forest56, plantations add to the total size of the global forest estate, resulting in a net removal/sequestration of CO2 from the atmosphere. Carbon credits generated in plantation forestry are based on actions that sequester carbon.
Large tracts of natural forest considered to be of high conservation value have been set aside by governments around the world, and designated as Protected Areas. Without significant financial resource/incentives to address the underlying causes of deforestation in these areas, poorer countries face an uphill struggle to enforce and develop these protected areas. Carbon credits generated in conservation are therefore also based on actions that avoid deforestation.
The extent to which forestry-based carbon credits, whether voluntary or regulated, could be incorporated in a Forest Backed Bond will be influenced by the underlying security and quality of the cash flow they offer.
The key factors currently determining the market for carbon credits generated by these forests are - Lack of Permanence
The lack of permanence associated with forestry, and subsequent temporary nature of any carbon reductions claimed, is a key concern for potential buyers of forestry based carbon credits57. The CDM accommodates this by creating two varieties of non-permanent carbon credit: temporary Certified Emission Reductions (tCER) and long term Certified Emission Reduction (lCER). Non-permanent CERs support the environmental integrity of forestry carbon projects but are effectively a different class of credit from the point of view of a trader or compliance buyer. An alternative approach applied in voluntary markets such as CCX, is ‘self-insurance’. This entails projects putting aside an additional buffer of forestry carbon over and above that used to back credits. The CCX methodology for forestry carbon projects stipulates a buffer size of 20% of total issued volume.
Third party insurance against loss of income from carbon credit generation is also possible by combing insurance against physical loss due to biotic (pests etc) and abiotic (wind, fire) perils, with more recent schemes that enable projects to insure against CDM related institutional risks, including failure or delay in project approval, certification and/or issuance of
A key requirement in the design of forestry carbon projects is to ensure that emissions reduced or avoided within the project boundary result do not lead to an increase in emission elsewhere. Regulated markets catch this through rigorous assessment of initial project design. Voluntary projects for afforestation and reforestation are likely to benefit from the emergence of standards such as CCBA and VCU. Discussions around use of avoided deforestation in regulated markets have centred on the use of national baselines, primarily because of difficulties with assessing leakage at project level. The treatment of leakage in voluntary projects dealing with avoided deforestation is therefore likely to come under close scrutiny.
Forestry carbon projects have been subject to a high degree of scrutiny from NGO and civil society players regarding permanence and perceived support for industrial plantations, which are perceived to have far lower developmental and biodiversity benefits than natural forest.
Following best practice in design of forestry projects is likely to increase the appeal of the credit to buyers, and therefore increase demand, and also reduce the risk of project failure (There is evidence to suggest that 40% of potential buyers for forestry carbon credits will pay a premium for credits from projects certified to the Climate and Community Biodiversity Alliance Standard (CCBA)58
A lack of clearly defined ownership over forestry carbon rights, in particular with regards to local communities, remains a key issue for the NGO community. Given that one of the key benefits of forestry carbon, especially in the voluntary market, has been social and developmental co-benefits this issue should be one of concern for both offset buyers and investors.