This category of risk includes various risks associated with technical and financial management of the forest plantation project and it includes elements such as the following:
· the risk that there will be inadequate capacity to implement specific silvicultural activities;
· the risk that the investor will not be able to meet unforeseen financial obligations due to changes in financial markets (e.g. changes in interest rates);
· the risk of fraud or malfeasance; and
· liquidity risks (i.e. the inability to generate revenues in the short-run to cover unforeseen costs).
Liquidity risk is one of the most important deterrents to forest plantation establishment, particularly in the case of individuals and groups that are not very wealthy. For example, even if an investor establishes a forest plantation with a short rotation (for pulp production), this usually requires the investor to wait for around 10 years before they will make any income and there is very little scope for them to make money from the forest plantation in a shorter period of time. Consequently, investment in forest plantations can generally only be considered by individuals or companies that have secure access to other sources of cash that they can draw upon. In developing countries, therefore, there are strong incentives for smallholders to grow annual crops (such as food crops) rather than trees, even if the potential returns from forest plantations are extremely high. In these instances, the risk of investing in an asset with poor liquidity overwhelms the higher returns that might be made.
Liquidity risk can be overcome if there is a market for immature plantations or if there is a policy framework that supports innovative market arrangements to overcome this risk. Examples of the latter might include legislation to support the establishment of joint venture partnerships, forward sales of future cutting rights, or even the development of futures markets for roundwood and forest products. Generally, these conditions are currently quite rare and can only be found in developed countries.
Market risk refers mainly to the risk that future prices, costs and market conditions will vary from those assumed when the initial financial appraisal of the forest plantation project was prepared. This includes the more obvious risk that the prices of outputs (i.e. roundwood) or inputs (e.g. plants, machinery and labour) may change. However, it also includes the risk that less obvious, but equally crucial, market factors may change (such as: interest rates; exchange rates; and market size). For example, markets can collapse due to the failure of one or a number of potential buyers, as has recently happened during the Asian financial crisis (this is closely related to systemic risk - see below). Market risk also includes the risk that the markets for a particular type of roundwood may shrink due to changes in product specifications, manufacturing technology or competing products. (For example, see Box 2 on page 40 for one company's view about how markets for sawlogs might change in the future and their response to this risk).
Due to the long time-horizon involved in any forest plantation project, it is quite likely that costs and prices will change in during the rotation and that this might have a significant effect on profitability. Ideally therefore, the risk associated with each cost and price figure should be identified and evaluated. In general, this can be done by calculating the variability (i.e. variance) of each cost or price based on historical data.
Much work has been done in the financial sector to develop measures and means of assessing and managing market risks. The most widely used approaches are based on the Capital Asset Pricing Model (CAPM), which examines the relationship between expected risks and expected returns. Similar methodologies could be more widely used in the financial appraisal of investments in forest plantations (particularly outside the corporate sector) and publication of such analyses might be a useful way of promoting investment in the sector.
Political and systemic risks are largely macro-level concepts related to the probability of large-scale political or economic changes taking place that may affect profitability. The most extreme political risks include the risk of wars, revolutions, nationalisation and major changes in political and economic regimes. More normally though, political risks are associated with policy and legislative changes that will affect the general environment for business and investment in a country.
In terms of investment in forest plantations, political risks will generally affect one or more of the following: the overall conditions for investment; market conditions; or regulations governing forest management and harvesting. Specific examples might include changes in the following: roundwood export regulations; harvesting regulations; taxation of forestry activities; tariff structures; regulations governing the repatriation of profits; capital requirements; and environmental regulations. A major concern to any investor in forest plantations is that, at some point in the future, one or more of their activities may become illegal (e.g. roundwood export bans or bans on harvesting in particular areas). Governments in some countries have attempted to reduce these risks by offering joint venture partnerships in forest plantation projects. It is unclear, however, whether this is actually perceived by investors as reducing or increasing risk.
In many developing countries, another important aspect of political risk concerns the security of land tenure. Many developing countries have conflicting or generally unclear legislation governing land tenure and security. In such cases, companies and individuals are reluctant to invest in forest plantation projects for fear that their ownership or rights to use the land may be questioned in the future.
Systemic risk is the risk that an entire system may collapse due to the failure of one particular component. If, for example, one company owns all of the facilities used to process the roundwood from forest plantations, the whole production chain may break down if that company goes bankrupt. Similarly, the closure of a just a single processing plant may cause a more widespread failure at a local or regional level. As noted above, many of the recent difficulties in Asian economies have been ascribed to systemic problems and partial systemic collapse (most notably in the banking and securities sectors in these countries).
Ecological risks are those associated with biological, climatic and site factors. These include risks of catastrophic loss from factors such as: fire; wind; snow; unseasonable frosts; drought; insects; pathogens; and damage by animals. They also include questions concerning the effectiveness of silvicultural treatments, seedling survival rates and yield estimates.
In general, in developed countries, most of the catastrophic risks can be reduced by buying insurance or, for large-scale investors in forest plantations, by diversifying their investments (e.g. by planting many different species in different locations). In developing countries however, insurance against ecological risk is often unavailable or neglected (often because of the cost but also, more generally, because the principles of appropriate risk management may be poorly understood or ignored). In all instances, ecological risks can be minimised by effective forest management (e.g. by paying careful attention to plant storage, handling and planting, species selection and fire monitoring and control).
It should be evident from the preceding discussion that risks vary throughout the duration of a forest plantation rotation. For example, the risk of poor plant survival is generally low once a forest plantation has survived the main ecological hazards present in the first few years after planting (e.g. damage by animals, drought, frost, poor plant handling and competition from weeds). Other risks can rise or fall throughout the rotation (e.g. market risks), although these risks are sometimes predictable.
For some types of risk, it is possible to reduce risk in a number of ways (e.g. by purchasing insurance, through diversification or by using other types of risk management tools). However, this is often not possible or, at least, many investors in forest plantations do not seem to take such measures. Indeed, it seems to be generally true that investors in forest plantation projects do not pay as much attention to the assessment and management of risk as investors in other sectors. Better information and further analysis of risk-related information may be an effective way of reducing the total risk associated with investing in forest plantations and could lead to improved performance in the sector. One way in which market risk is sometimes analysed is within the context of an overall investment strategy and this is briefly discussed below.
Because of the long time period involved in many forest plantation investments, detailed knowledge about the current state of roundwood markets is of relatively limited value to investors. Rather, the most successful investors will be those that most accurately predict long-run trends and may, therefore, have some idea about what the market will look like when they come to harvest the final crop. In particular, trends in end-uses (i.e. trends in final forest product markets and technological changes in the processing sector) are likely to be very strong indicators of what the future market might look like (see Box 7 for some examples of where end-uses have not been considered very carefully). Such information should be used to develop an overall investment strategy that guides investment and improves the management of forest plantations from a financial point of view.
While it should be fairly obvious that it is important to know what the roundwood from a forest plantation will eventually be used for, there are frequent examples of forest plantations that have been established with little idea about future end-uses. In some instances forest plantations have been established as sources of roundwood supply for planned processing plants that have never been built. In such cases, the roundwood eventually produced often has to be sold into lower value markets. More often, end-use problems have arisen because forest plantations have been established with only a vague purpose in mind or in the hope that a market will develop during the rotation. This has frequently resulted in sub-optimal silviculture and poor species selection. If the management objectives underlying a forest plantation investment are unclear or change during the rotation, then the forest manager or owner is often confronted with the question of what to do with all of the roundwood that will be produced later on.
A number of examples of this problem can be cited. In Malaysia, for instance, the Compensatory Plantation Project established around 35,000 hectares of forest plantations of Acacia mangium in the period 1985-1987. These were funded by loans from the Asian Development Bank and were supposed to produce "general utility timber". However, the species proved unsuitable for this purpose and the financial returns from the forest plantations were insufficient to cover loan repayments. Similarly, several thousand hectares of Gmelina arborea were planted in Sabah in the 1980s. When these forest plantations were harvested, however, no market could be found for this roundwood. Eventually, the roundwood was sold to Taiwan for the production of crates at a price that only covered the cost of harvesting and transportation. In Pakistan, the production of industrial roundwood from forest plantations of Eucalyptus camalduensis and E. citriodora proved unsuccessful because the high rates of growth reduced the amount of industrial roundwood that could be recovered to less than 25 percent of the total harvest. Furthermore, due to unstable burning properties, the roundwood was not even well suited to the production of wood fuel.
Source: W Killmann (pers comm).
To take industrial forest plantations for the eventual production of sawnwood and panels as an example there are, in very simple terms, two broad views about general trends in end-use that might be considered. One view is that solidwood products (i.e. sawnwood and plywood) will continue to dominate these markets, while the other is that fibre-based and engineered wood products will gradually increase market share. The first view would suggest that forest plantations should be planted with high quality timber species, probably on long rotations and with high levels of investment in silviculture (e.g. thinning and pruning). The second view (a technology-based future) would suggest utilising fast growing, high yield species to maximise fibre production while minimising maintenance costs. Careful consideration should be given to trends in end-use markets, processing technology and the current status of end-use markets, to identify which of these futures seems the most likely.
The development of a long-term investment strategy can be useful to guide the management of industrial forest plantations for pulpwood production or even for the management of non-industrial forest plantations. For example, when establishing forest plantations for the production of wood fuel, consideration should be given to what are the long-term prospects for other sources of fuel (price and availability) and whether the species can be used for alternative end-uses if the eventual demand for wood fuel fails to materialise.
Government policies cover a wide range of economic, social and environmental issues, many of which can have an impact on forest plantations. However, three policy areas seem to be most relevant to the outlook for forest plantations:
1. policies to encourage forest plantation development by the private-sector (incentives);
2. policies of direct forest plantation development by the government; and
3. privatisation programmes.
Government incentives are a means of encouraging the private-sector to take actions that are viewed as being socially desirable or to prevent undesirable outcomes. In some instances, governments may also create disincentives to attempt to produce the same effects. Direct forest plantation development by governments occurs where governments wish to retain more direct control over the development of the forestry sector. This often occurs where the government is technically the owner of significant areas of land (as is often the case in many developing countries). Privatisation programmes have become increasingly important in recent years in many sectors and for a number of reasons. Such policies are of interest because they result in a shift from direct control over forest plantations, to a system whereby market forces play a greater role in forest plantation development. Where such policies have been introduced, governments have to consider the introduction of incentive systems to achieve objectives that they might previously have achieved through direct control.
A major topic of interest, from the point of view of future roundwood production from forest plantations, is the impact of policies in each of these three areas on rates of new forest plantation establishment and on forest plantation management. Where governments still dominate forest plantation ownership and management, national forest plantation establishment targets are likely to be determined (at least in part) by the state of government finances. Although governments may not necessarily achieve their original targets for forest plantation establishment and management, they generally have some sort of planning mechanism in place that can give a reasonable indication of future plans. Conversely, in purely market-based economic systems, it is generally much more difficult to project what might happen with respect to forest plantation establishment and management.
This section discusses how policies in each of these three areas can have an impact on the outlook for forest plantations. A final section also briefly discusses issues related to the establishment of non-industrial forest plantations.
The introduction of incentives for any economic activity in the private-sector is usually justified where the economic returns to that activity are greater than the financial returns.32 Thus, in the context of forest plantations, incentives may generally be justified where the financial returns from forest plantation establishment are lower than the returns from alternative land-uses, but where the economic returns (i.e. including social and environmental costs and benefits) from forest plantation establishment would be higher than with the alternative land-use.33 Net environmental benefits (including soil and watershed protection and carbon sequestration) are often quoted as reasons to support forest plantation development, although social and broader economic reasons (e.g. job creation and regional development) may also be given.
However, many historical forest plantation incentive schemes have been severely criticised, especially at the global scale. Indeed, incentives have often been "perverse", in that policies aimed at enhancing environmental or economic values have often resulted in environmental degradation or inefficient industrial development, either nationally or internationally. For example, from an environmental point of view, a major criticism of some incentive schemes is that they have encouraged the clearing of natural forests and their replacement by forest plantations. While incentives for forest plantation establishment and management have generally been relatively small compared with the incentives available in other parts of the forestry sector (and, in particular, in other land-use sectors such as agriculture), these criticisms are, nonetheless, highly relevant in most cases and forestry policymakers would be well advised to consider them very carefully.
In very broad terms, most of the World's forest plantations have been established in one of the following four ways:
1. directly by government planting (including local governments) financed out of the national or local government budget;
2. directly by governments with support (finance and technical assistance) from international or multilateral donor agencies;
3. by the private-sector with incentives from the government (sometimes these incentives are financed by donors); and
4. by the private-sector without any incentives.
A very high proportion of the world's forest plantations has been established under one of the first three regimes. As noted above, in most of these instances, non-financial objectives (e.g. environmental, social or, sometimes, political objectives) have been given as reasons to justify government support, rather than purely financial objectives. On the other hand, private-sector investment in forest plantation projects (without any incentives) is relatively uncommon. This is generally due to the comparatively low financial rate of return on forest plantation projects in most countries. Incentives are, therefore, generally required to encourage investment in forest plantation projects in almost all countries.
The fundamental difficulty created by governments providing incentives to the forestry sector (and to other sectors) is that they create distortions in the economy, both at a national level (across all sectors) and in terms of the forest sector globally. Incentives create artificial competitive advantage and thus distort the efficient allocation of resources across sectors and between countries. As already noted, incentives are necessary to achieve social or environmental goals that market forces will not otherwise deliver, but they can also result in the survival or weak or unviable (i.e. economically inefficient) companies in the forestry sector and the continuation of inefficient forestry practices. In a few cases, incentives have been simultaneously economically inefficient, environmentally damaging and socially inequitable.
Despite all of the above problems, a wide range of incentives can commonly be found in the forestry sector in most countries. Examples include: artificially low stumpage rates set by governments (i.e. subsidised roundwood prices); afforestation grants; grants for investment in transport and roading infrastructure; energy subsidies; preferential tax treatment of forestry investments; grants to promote investment and exports; bans on exports of certain types of forest product; and distorted tariff rates. In almost every instance these mechanisms have resulted in the undesirable effect of promoting inefficient and superfluous forest processing capacity and poor forest practices. Thus, at present, the global forestry industry can be characterised as one where many "uneconomic" forests continue to be logged to supply large numbers of inefficient mills.
The cumulative effect of all of the distortions caused by these incentives is that stumpage prices are often artificially depressed in many countries. Furthermore, the impact of incentives in some cases could even be so strong as to artificially depress forest product prices. One consequence of this is that the artificially low prices for outputs pushes down the rates of return that would be achieved on investment in a forest plantation project. This is why it is often necessary to provide incentives for forest plantation projects, to "level the playing field" between forest plantations and (heavily subsidised) harvesting in the natural forest. A similar situation also arises with respect to the comparison between forestry more generally and the (often heavily subsidised) agricultural sector.
Historically, a wide variety of different types of incentive has been offered for forest plantation establishment and management in various countries. The most obvious type of incentive is a direct subsidy whereby the government gives financial assistance to individuals and companies investing in a forest plantation. Such subsidies may take the form of flat-rate grants per unit of land planted or may be set as a proportion of costs. Alternatively, subsidised inputs such as fertiliser or fuel may be provided. Another variation on this theme is the provision of free materials, such as the provision of free tree seedlings in the 20 Points Program for Afforestation in India.34
Generally, the highest levels of subsidy for forest plantations can be found in developed countries (see Box 8 for an example of forestry incentives currently available in the European Union). Due to high levels of income, combined with a strong tax base and relatively effective government institutions, such countries can generally afford to pay the private-sector directly to carry-out activities that are deemed to be in the public interest. Developing countries, on the other hand, tend to favour schemes that are perceived to have lower costs (such as tax incentives).
The EU aid scheme for forestry is based on both economic and environmental considerations. The scheme was implemented as one of the accompanying measures of the 1992 CAP agricultural reforms and aims to control agricultural production and contribute to long term improvement of forest resources by assisting afforestation. In 1994 around 650,000 hectares of regional and national afforestation, and an additional 130,000 hectares of woodland rehabilitation was approved for funding for the period 1993-1997. The EU contribution to Member States' expenses ranges between 50-75 percent of costs and the contribution to above programmes is estimated at ECU 1.2 billion. Direct afforestation payments are presently available to a per hectare maximum of ECU 2,415 for eucalyptus plantations, ECU 3,623 for conifer plantations, and ECU 4,830 for broadleaved or mixed plantations comprising at least 75 percent broadleaved species. Additional payments are available, as a premium to compensate for income losses on previously worked agricultural land (ECU 724 per hectare), for maintenance costs (ECU362 per hectare per annum maximum), and for forest roading (ECU 21,735 per kilometre).
Source: EC Council Regulation (EC) No 2080/92.
The United States of America has offered reforestation incentives to smaller landowners since 1978. Under the Forestry Incentives Program (FIP), the government will share up to 65 percent of the costs of tree planting, timber stand improvement and related practices on non-industrial private forest lands. Incentive payments are limited to $10,000 per person per year with the stipulation that no more than 65 percent of the cost may be paid. In 1997, US$ 6.3 million was paid under the FIP.
One developing country that has had a forest plantation subsidy scheme similar to those above is Chile (between 1974 and 1994). The main subsidy available during this period was a grant to cover 75 percent of the costs of reforestation. In addition to this, other payments were also available to cover part of the costs of other silvicultural activities. The Government of Chile is estimated to have paid around US$ 50 million in reforestation subsidies during this period (Uribe and Franzheim, 1999). The government also granted exemptions on property and inheritance taxes on reforested land and established a special line of credit for reforestation with the central bank.
More recently, Ecuador and Colombia are reported to have adopted the incentive model developed in Chile. In Colombia the main objective of this support is to improve the environment, whereas Ecuador has given economic objectives (such as the bringing marginal land into production, creating new jobs and increasing the exports of forest products) as the reasons for such support. Similarly, Brazil has used a combination of subsidies and taxation incentives to encourage forest plantation establishment in the past.
Tax incentives have been used to stimulate forest plantation development in a number of countries, particularly in Latin America. As noted above, governments generally view tax incentives more favourably than subsidies, because they reduce tax revenues (often many years in the future) rather than requiring current government expenditure. In Panama, for example, reforestation incentives were introduced in 1992 that allowed reforestation activities to result in favourable tax treatment for the purposes of income tax, real estate and land transfer taxes. Similarly, in Costa Rica, reforestation costs qualify for tax refund certificates, which may be applied toward any national tax. Argentina is also presently in the process of developing legislation to offer tax-breaks and subsidies to finance up to 80 percent of land costs.
Amongst developed countries, the United Kingdom has a long history of favourable tax treatment for forestry activities. Income from timber sales has been exempt from taxation since 1988. Before this, tax treatment was even more favourable and investors in forest plantations were able to offset their establishment and management costs as losses against other sources of personal income (see Box 6 on page 70).
The third popular form of government incentives is the provision of loans with easy repayment terms for forest plantation establishment. The Philippines continues to provide Industrial Forest Plantation Loans and tax exemptions to forest plantation investors. New Zealand used Forestry Encouragement Grants and Loans to facilitate small-scale forest plantation establishment by the private-sector and local authorities until 1984.
32 By this, it is meant that the net economic benefits (i.e. taking into account financial, social and environmental costs and benefits) from that activity are greater than the net financial benefits alone.
33 A similar argument could also be made for incentives for improved management of forest plantations, if improved management would lead to net environmental or social benefits that do not result in net financial benefits.
34 Indeed, some would say that the provision of extension services is also a form of subsidy, although it can be argued that the dissemination of information about best practices can be of greater value than just being seen as a subsidy to the private-sector.