What this chapter covers:
Government officers in charge of deciding contracts with entities of the private sector have the responsibility of ensuring that the implementation of those contracts will lead to a chain of events that would produce the most beneficial results for the nation. Thus, the Public Forest Administration granting forest concessions to a private corporation must make sure that the operation of that concession will produce the maximum possible benefits for the country. Therefore, the questions the decision-maker must answer in the event of a decision are: Do the benefits to the nation justify changing the use of the forest? Or should the present use remain instead?
The analysis required to make this decision is carried out by measuring and valuing all changes expected to arise from modification of the use of forest resources, a timber concession for example. Thus, the responsible government officer must have an account of the positive and negative quantitative impacts of granting a forest concession as well as a way to translate all those impacts into a common measure for comparison. The most convenient measure for that comparison is the monetary value of impacts. The study of the balance of advantages and disadvantages for society in the terms described is dubbed “economic efficiency” analysis.
Box 8.1: Appraisal steps in financial and economic analysis
|
Financial and economic analysis | |
|
Financial analysis |
Economic analysis |
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1. Identifying and quantifying physical inputs and outputs | |
Direct inputs and outputs with market prices are included |
Indirect effects are included with no market price also included |
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2. Valuing inputs and outputs | |
Market prices are used Transfer payment such as taxes are added as costs and subsidies as revenues |
Consumers’ willingness to pay is used as the basic measure of value. In cases where market prices adequately represent willingness to pay, such prices are used. In other cases “shadow prices” must be estimated |
|
3. Comparing costs and benefits | |
Calculate commercial profitability |
Calculate economic worth |
|
4. Dealing with uncertainty | |
Carry out sensitivity analysis |
Carry out sensitivity analysis |
Since the government contract in all probability will be with a private party, the government decision-maker will also need to estimate the commercial value of that contract, i.e. how much is the forest concession worth in commercial terms? This is essentially the same type of analysis that private concessionaires interested in the contract will carry out. This type of analysis is normally called the “financial” analysis and is concerned with monetary flows resulting from the change in use. Because the financial analysis provides a profile of monetary flows resulting from the contract, it is a key factor in negotiating the agreement between the government and the private party. Another reason why the government decision-maker will also require a financial analysis is because there will be a need to determine what the impact of the change in use will be in terms of money flowing to or leaving the treasury. Financial analyses always have to be done from the point of view of an interested party – the government forestry administration, private corporations, etc. In contrast, in the “economic analysis” only the perspective of society counts.
There are two other fundamental differences between financial and economic analyses and these relate to, first, what costs or benefits (or positive and negative impacts) are included in the analysis and, second, how those costs and benefits (impacts) are valued.
There is a host of impacts from forests that have no market value and in consequence do not affect private contractors’ natural interests in maximizing commercial profitability. These impacts are, however, of interest to society as a whole. Thus, for example, forests are a repository of biodiversity wealth. They also contribute to conserving water and soil resources and sequester carbon. These are all forest services of local, national, or even global, importance but, since they do not have established markets and prices, they are of little or no financial interest to private entrepreneurs and do not enter into their financial analyses. However, they are of importance in the analysis of “economic” impacts and worth of forests.1
Furthermore, even in those cases in which market prices do exist, they may be flawed, in the sense that they may not reflect the true value of goods and services to society. Monopolies and other market imperfections make this possible. Policy interventions such as taxes or prohibitions to export also affect the economic value of resources, inputs or outputs. Society is interested in the “real” value of resources while commercial enterprises focus on existing market prices, independently of the fact that these may be affected by market imperfections or policy interventions.
Another dimension of value differences between these two types of analysis derives from the fact that impacts – benefits and costs – occur at different points in time. Since costs and benefits have to be reduced to a common denominator, impacts happening at different points in time must be “weighed” in different ways. A dollar today is not the same as a dollar will be ten years from now. The technique to render these values homogeneous is called “discounting”. The future is relatively less important than the present and therefore a dollar ten years from now (be it cost or benefit) is “discounted” as compared with a dollar today. Society must provide for future generations and therefore it should discount the future less drastically than commercial entities, such as concessionaires, who have a shorter time horizon. In other words, the economic analysis should value the future more than the private operators’ financial analyses.
The process described below may be used to answer the questions related to the value to society of a change in forest land use as well as the commercial or financial impacts of such decision. In the following discussion, it is assumed that the change in the use of forest resources will be a forest concession but the same method may be applied to any other change in the use of forest resources. The appraisal steps in a financial or economic analysis are essentially four (see summary box 8.1)
Step 1. Identifying and quantifying physical inputs and outputs associated with the forest concession. Here the analyst attempts to measure all physical changes that will occur over time as a consequence of the change in use arising from the initiation of operations of the forest concession. In performing the financial analysis, only those inputs and outputs that have market prices will be included (i.e. those effects that generate financial outlays and revenues). In contrast, the analysis of the economic impact of the concession will also identify and quantify all non-market inputs and outputs.
The economic impacts of the contract are defined by the difference between two situations: with the contract and without the contract. The estimated variation between these two situations can be legitimately attributed to the contract. The “with and without” scenarios are basic to the economic appraisal and should not be confused with the “before and after” the contract situations. This is because certain changes are bound to occur even if the contract were not implemented and, therefore, those changes cannot be attributed to the contract. Only changes arising from the contract must enter the appraisal. For example, let us assume that a certain forest is suffering from pressure from illegal logging and that it is estimated that over the next 20 years, and despite efforts by the government, 20 percent of all valuable woods will be illegally logged. Now, the analyst in charge of appraising the costs and benefits of a prospective 20-year concession contract estimates that “with” the concession 100 percent of the volume of valuable timber will be exploited. However, in the economic appraisal of the concession contract, the analyst must attribute only 80 percent of all valuable woods as an impact of the contract. Twenty percent would be lost anyway, with or without the timber concession. Were the analyst to compare the before and after situation in the economic analysis he would be attributing 100 percent of the loss of valuable timber species to the contract. This would be wrong because the logging of 20 percent would take place even if the concession contract were never signed.
Step 2. Valuing inputs and outputs. The next step is to develop unit values for inputs and outputs with due consideration to the probable evolution of these values over time. In the case of the financial analysis, market prices will be used. Market prices arise because of the coincidence between consumers’ willingness to pay for a given input or output and the producers’ willingness to sell that input or output. Thus, in perfect markets, the market price could be used in both financial and economic analyses. However, this coincidence may be altered by imperfections in the market, by the lack of markets altogether or by policy interventions. In the economic analysis, inputs and outputs are valued in terms of the consumers’ true willingness to pay for them. When market prices do not adequately reflect a willingness to pay, shadow prices must be developed for use in the economic analysis. Furthermore, taxes and subsidies are treated differently in both types of analysis. In the economic analysis taxes are not entered as costs or subsidies as benefits whereas the private operator’s financial analysis would. The reason for this differential treatment is explained later in the text.
Step 3. Comparing costs and benefits. This is a necessary step to derive a total value of the change in use. This step aims at answering the basic questions raised above. Does the change in use of forest resources represent on balance the best possible use for society as a whole? What would be the commercial implications and the impacts on the government budget? What is a “fair” price the government may charge for the concession? This step implies comparing costs and benefits occurring at different points in time and therefore these costs and benefits must be adjusted or discounted to a common point in time, usually the present, in order to have a common measure of value.
Step 4. Dealing with uncertainty. The three steps above provide most, but not all, of the elements for deciding whether the change in use - the forest concession contract - is the best way to proceed with the management of resources and what may be a reasonable price of a contract with a private sector entity. There is still another and final dimension of the analysis of the worth of the concession contract and a dimension that is very relevant to its negotiation. This is the value of uncertainty associated with the calculations carried out during the three steps above. Since the financial and economic analyses look into the future, identifying impacts and future values accurately and precisely is always a problem. For this reason a major task in the assessment of the concession contract is now a test of the sensitivity of results to possible variations in some of the key assessment variables.
These steps are discussed below. The whole process is complex and faces various obstacles and special situations. Thus, the description below is only a synthesis of the main concepts. For an in-depth treatment of the subject it is highly recommended that the interested reader consult the following FAO publications: Gregersen and Contreras, 1992; Gregersen et al., 1993 and Gregersen et al., 1995.
A change in forest use such as that derived from the implementation of a forest concession contract produces a number of varied outputs and requires several inputs.
There are many analytical ways to classify inputs and outputs. A popular one is to differentiate them into direct and indirect. Direct effects are those that would enter into the financial analysis, while indirect ones do not. These classifications do not matter much except to remind the analyst to look beyond the financial analysis in the estimates of the economic value of changes in use.
For the purpose of economic analysis, any effect that results in an increase in desired goods and services is an output while the opposite is an input regardless of whether outputs or inputs are traded or not. Circumstances vary. For example, fuelwood may be traded in a market while in another it may be produced and distributed free. In the former case, fuelwood is relevant to the financial analysis but not in the latter. However, since fuelwood is a good that has value to society, the economic analysis will consider it even if it is not traded in markets and its market price is zero. The important point to remember is that almost any of the products produced by forests may or may not be traded in a specific situation. Thus, ideally, the analysis of the value of forest use must be carried out in the context of each particular case.
Consumable goods and services produced by forests that normally have a market price include timber products, fuelwood and other biomass fuels, fruits, nuts, leaves, medicinal products, fodder, genetic materials, animals from the forest, skins and so on. Other goods are not necessarily consumed but may have a market value. These include scenery and recreational uses of forests, and soil and water protection services. In some cases, the economic activity associated with the forest concession contract involves training of labour and increases in its productivity. This is clearly an effect of interest to society although it is difficult to quantify and value it. Finally, other services so far are not paid for through market transactions, such as protection of biodiversity resources, gas exchange and carbon storage.
It needs to be emphasized that inputs and outputs are sides of the same coin. For example, reduced water siltation resulting from the existence of forest cover reduces the loss of storage capacity of dams, which in turn results in reducing downstream losses which may be caused by the decreasing water availability from the reservoir. If the forest concession contract reduces these benefits of the forest, because of the reduction of forest cover, this is clearly a cost to society.
Besides direct inputs accounted for in the financial analysis, there are various other inputs associated with the forest concession that are not directly traded in markets. For example, the operation of logging machinery and portable sawmills may pollute water and reduce air quality. Heavy machinery can cause substantial damage to soils and remaining vegetation and fauna. Roads can create opportunities for illegal penetration and subsequent deterioration of the remaining forest. All these effects represent negative occurrences for society as a whole but generally the private contractor does not have to pay for the damage caused because these effects are not traded in markets. Thus, while they are of importance for the economic analysis, they are negligible in the case of the financial analysis.
Finally, some analysts argue that some outputs of forests that today may not be very important may become of great importance in the future. For example, a new drug derived from a forest plant could be discovered to cure cancer. If current forests are converted to other uses, such plant may be irremediably lost. The option of keeping these potential but currently unknown benefits should somehow be included in the economic analysis, because obviously they are of importance to society. Individuals may be willing to pay to preserve these unknown options. In other cases, the mere existence of a forest is a service that many people appreciate.
From the above, it is clear that, although many of the goods and services produced by forests may be very real, often they are difficult to quantify in order to arrive at an estimate of whether a change in use is the most desirable thing for society to do.
This often represents a challenge for the analyst. The relief is that in most cases there is no need to have a detailed and complete list of inputs and outputs and how they occur over time to arrive at a meaningful decision about whether granting a forest concession is socially desirable or not.
In financial analyses, the procedure is relatively straightforward and will not be treated here in detail, as there are many excellent guides on the subject. In financial analyses only inputs and outputs that have market prices count. Market prices are useful because they are observable and objective, no matter how esoteric their use. So long as there is a well functioning market, prices define economic value and thus the financial analysis may serve as the foundation for performing the economic analysis. However, a few considerations are in order.
As already mentioned, rarely do market prices adequately reflect the true economic value of forest goods and services. This is due to several market failures such as imperfect information, the dominance of a large concessionaire, monopolies, “externalities” and so on. Furthermore, it has also been mentioned that market prices are influenced by government policies such as taxes, trade regulations, etc. For the private contractor, a subsidy increases revenues and taxes increase costs. However, these transfer payments from and to the government do not represent a change in society’s value of the input or output. In the case of a subsidy, the government simply shares part of the cost of production, and this in itself clearly does not diminish the real cost to society. In the case of a tax, the government takes a proportion of the value of the outputs produced but this does not change the value of those outputs. Simply, their value is shared between the entrepreneur and the government. This is the reason why, in the economic analysis, taxes are not computed as additional costs and subsidies are not part of additional benefits. Government may also introduce other policies that affect prices, such as price controls, log export prohibitions or subsidies in other sectors such as agriculture that distort forest prices in many direct and indirect ways.
Besides the complications introduced by market failures and policy intervention, there is another aspect of using market prices in the economic analysis that requires clarification. Since the impacts of the forest concession will occur in the future it will be necessary to predict their future changes. It is recommendable to operate with prices free of inflation unless changes in relative prices may be expected. For example, the price of a scarce precious wood extracted from the concession may change in the future relative to other prices because of growing scarcity. The procedure for calculating these relative changes over long periods of time is a specialized task and involves so many imponderables such as future trends in consumers’ preferences and technological change that some argue that results often lack credibility. Thus, this specialized task will not be discussed here. Moreover, all prices are expected to change at the same speed in the long run, and thus, unless there is compelling reason to the contrary, it is advisable to use current prices in the economic analysis.
Market prices may be used in the economic analysis to the extent that they reflect economic values. This will happen if markets are efficient, with many buyers and sellers all operating with adequate levels of information. No buyer or seller is large enough to be able to control information or to influence the market price. Since international markets tend to represent the options for society as a whole, some analysts prefer to utilize border prices for all those goods that can be traded. Border prices cannot be used in the case of non-tradeables, i.e. all those goods that have a domestic price that is lower than the import price (cif) but higher than the price on the international market (fob). Fuelwood often falls into this category.
In all cases where a market price is inadequate or non-existent, some indirect ways need to be used to determine consumers’ willingness to pay, which is the source of economic value. In the case of inputs, the term opportunity cost is often used. This is because using an input in the forest concession diverts that input from other uses and this represents a sacrifice or cost in the economic analysis. However, that value, being foregone in the unrealised alternative use, is also measured in terms of willingness to pay and therefore, in the end, willingness to pay is the basis for measuring both benefits (outputs) and costs (inputs).
While this is an adequate conceptual definition of economic value, it is necessary to be more specific with regard to the various procedures that may be used to apply the concept in practice.
The figure 8.1 provides a general overview of valuation approaches used in the economic analysis.
Figure 8.1: Overview of valuation approaches used in economic analysis
Ideal and perfect markets seldom exist. But frequently it is possible to use market prices for one good or service to infer the economic value of another good or service. On this theme a word of caution is in order. Techniques for calculating economic values are sometimes utilized in arbitrary ways that seem to be geared to intellectual window dressing to justify a particular decision rather than objective analysis. Second, the assumptions and data required behind some of the techniques are such that they are of dubious application particularly in developing countries where basic information is weak. These problems will become apparent in the following paragraphs when the difficulties of utilizing indirect pricing techniques are described. For this reason, the following text does not present an exhaustive inventory of the many techniques that are available.
All methods discussed so far rely directly or indirectly on market prices or using related market prices to obtain estimates of willingness to pay. An alternative procedure is simply to ask consumers to state their preferences assuming theoretical markets and the amount of money they would be willing to pay for some services or goods.
Contingent valuation. The procedure estimates the consumers’ willingness to pay for a specified good or service or to accept compensation for receiving an unwanted good or service (this could be losing an area of forest, for example). The method assumes that the amount the person has stated as being willing to pay for the service would in fact be paid if that situation were to arise. The procedure is useful in all those cases where there is little possibility for estimating non-use values employing other methods such as those that depend on substitutes or surrogate goods. For example, the procedure has been used to estimate how much people would be willing to pay or contribute for conserving biodiversity in the tropics. Critics point out the possibility of bias in the preparation of questionnaires or in interviews as well as the fact that respondents may not be completely honest in stating their preferences and willingness to pay. This is because respondents know that the situation described in the survey is only a theoretical one and that in reality they will not have to pay the values they stated they would be willing to pay (for a discussion of variations of this method, see Bishop, 1999).
Once inputs and outputs resulting from the forest concession have been established, and their physical flows over time and values estimated, it is now possible to begin conducting the comparison of benefits and costs with the purpose of determining the net result of the proposed use change (the concession in this case).
And as previously mentioned, the further into the future a given forest use will occur, the less the value of that use when compared with the same use in today’s terms. This is the concept of the “time value” in economics. Thus, establishing the net economic or financial result of the change in use is carried out in three steps:
This procedure consists of combining physical input and output information with their value (market prices or shadow prices) to construct tables describing values taking place over time.
If a financial analysis is being conducted, this is the cash flow table and it will include only inputs and outputs with market prices and their respective prices. In the case of the economic analysis, the term is value flow table. This table includes market and non-market inputs and outputs and shadow prices.
As previously mentioned, the cash flow and the value flow tables differ in the sense that the cash flow treats some transfer payments such as taxes, subsidies and loan payments in different ways. Other considerations apply. In the financial analysis, costs occur when payments are made and this may be at some time other than when the inputs are used. For example, an input may be used today but paid in instalments over the next three years in the cash flow table. Each one of these payments in those three years is entered as a cost in the respective year. In the value flow table, it is the actual use of the input that matters, not when payment takes place. Thus, if the input is used today, that is the cost to the economy. A parallel reasoning is valid in the case of outputs that materialize today but the value of which is paid by purchasers over a period of time.
If all impacts were to occur at the same time, then the analyst could just add up benefits and costs and derive the balance without further work. However, a forest concession typically spans several years and costs and benefits occur over a long period. As mentioned, values occurring at different times cannot be directly compared. This is because value is associated with time. Impacts occurring in different years must be “homogenised” to a common denominator. An adjustment factor must be introduced. This is the discount rate and thus the process of adjustment is called discounting2.
In the financial analysis, the prevailing market discount rate is utilized. This rate is supposed to represent what resources could generate in the best possible alternative at the margin, the opportunity cost of capital. In reality, this rate varies from situation to situation. In imperfect markets, for example those facing a smallholder, it may be very high. If the contractor participating in a timber concession has good credit, the rate may be considerably lower. Thus, in most cases, an average bank-lending rate may be appropriate. There is no single formula to determine a unique rate. Since the financial analysis is performed from the point of view of a specific party, for example a potential forest concessionaire, the discount rate to be used is the one that that concessionaire will face in the market. If the financial analysis is being carried out from the point of view of the government treasury, then the prevailing rate for treasury bonds may be used, and so on.
The situation is even more complicated in the case of the economic analysis, because in this case the rate to be used should be the value that society as a whole attaches to time. Most people prefer to receive benefits as soon as possible and to postpone costs. The intensity of this desire depends on society’s preferences for present consumption as opposed to postponing consumption to the future. But it is widely believed that society’s discounting of the future is lower than that of private entrepreneurs, partly because society (and government) must provide for generations yet unborn.
There is no easy solution to this problem. Certainly, it is no solution to let different analysts, examining various economic options, use different rates of discount. For this reason, planning offices normally apply one standard rate for all economic analyses. Thus, the analyst should obtain the appropriate discount rate from the central planning unit. Should that rate not be available from the planning office, the analyst can pick up a rate, say 8 or 10 percent, and use it in the main analysis and then test the sensitivity of results to alternative rates, 7 or 11 percent for example, and determine whether these alternative rates will substantially change the conclusions of the analysis. This is the subject of the next section.
At this stage the analyst can provide the decision-maker with most of the information needed to decide whether the idea of entering into a forest concession contract with a private party is a good one for society as a whole. The analyst can provide a measure of the net economic value of the timber concession proposal and, if a financial analysis has been carried out from the point of view of potential contractors, information on how much the concession’s market price may be, i.e. how much potential contractors may be willing to pay for the contract. Finally, if a financial analysis has also been carried out to examine the implications for government, the analyst could provide information about the government revenue effects of the contract.
However, there is still a set of considerations that may affect the bargaining position of the parties involved and the desirability of the forest concession. As is now obvious, all the calculations above refer to events that will occur in the future and thus are uncertain. In the case of a forest concession contract, uncertainty may be high because uncertainty increases rapidly as the planning horizon expands. Concession contracts may well reach 30 or 40 years and many of the effects generally go beyond that period of time.
If there are abundant observations of similar past events, of past estimates and trends, the analyst may have enough information to be able to estimate probabilities of some events actually occurring in the future. For example, a range of variation of future prices of certain species of wood could be calculated within certain probable limits. This is referred to as risk. When there is little or no basis for deriving probabilities, there is a situation of uncertainty. In most cases situations fall in between and analysts can resort to sensitivity analysis to test the robustness of their conclusions. If such analysis reveals some parameters that change drastically the results of the analysis, then more analytical work on those parameters is advisable. Consequently, the sensitivity analysis provides useful information about priorities for further research on those aspects of the analysis that may be the weakest and the most critical.
In summary, establishing the value of forests and the consequences of a change in use are not simple tasks. They require long-term and uncertain projecting with and without the change scenarios (as opposed to before and after), and identification and quantification of a number of goods and services, inputs and outputs, many of which have no markets or imperfect markets. A serious error is to attempt to value everything in economic terms, particularly when the basis for deriving values is shaky. It is advisable to start by measuring and estimating the easier-to-measure impacts. After all, values are only needed to make decisions. If enough information can be collected, based only on the most important impacts to make a sound decision, no further work may be required. The cost in time and scarce human resources needed to reach a detailed analysis needs to be taken into account. In many cases, running a sensitivity analysis for key variables will help in deciding whether further work is needed and, if so, on what aspects of the analysis.
This section covers the choice and design of forest levies and presents an overview of the alternatives available for setting levies for resource use granted under contracts. Levies on forest resources are frequently referred to as royalties, stumpage, rent, tax, revenues and user fees3.
The data obtained through the appraisal of values described in the section above are used by the government as one of the main elements to determine the levies to be raised from forest contracts in public forest lands. Other factors such as political priorities, equity considerations, poverty alleviation, regional development objectives, and so on, may also influence such decision. Thus, levies may have a variety of objectives including the sustainable management of the forest under contract, raising public revenue and guiding private action in the direction of society’s other multiple objectives.
Levies normally are charged per unit of timber volume (cubic meter of wood) or per area of forest under the contract (hectares or acres), or a combination of both methods.
Standing timber in developed and most developing countries is sold based on the volume of timber (Gray, 1983; Grut, Gray and Egli, 1991). Hence the term “stumpage” fee.
They are used in almost every Canadian province, in the United States, Indonesia, Malaysia, the Philippines, in various countries of Africa and many other countries around the world.
Stumpage fees can be tailored to species and dimensions of wood and, of course, may be supplemented with other fees to refine conditions of extraction such as difficulty of terrain.
Because it is standing trees or logs which are of value to the forest industry, it is likely that levies based on stumpage volume will continue to be an important component of the forest revenue system.
Strengths and weaknesses of volume- based stumpage prices: Volume-based levies can closely reflect the value of the standing timber and roundwood sold because stumpage prices can be varied by species, quality and location, characteristics that determine the value of the timber.
Volume-based stumpage prices require log measurement, supervision, a billing system, and all the administrative costs that go with them. Varying stumpage prices to properly reflect stumpage values can add to the complexity of stumpage prices and the revenue collection system, to administrative costs, and generate evasion and avoidance problems.
For jurisdictions with a strong forest administration, volume-based stumpage prices will likely remain the major forest revenue mechanism. Stumpage prices that reflect timber values can help to support forest management. But unless stumpage fees are coupled with management restrictions they could result in “highgrading” or “creaming” of the forest if only the most valuable trees are extracted.
Per tree stumpage fees have been used in only a few countries, Ghana and Nigeria, for example. Valuable hardwoods in North America, Europe and elsewhere are sometimes sold as single trees on a per tree basis, often for thousands of dollars.
Per tree stumpage fees are a uniform price for each tree sold or felled. In this form, they are a simple revenue mechanism. No scaling of logs is required and the charges can be easily verified by counting stumps. Per tree stumpage fees are usually most appropriate for timber of uniform size and quality.
Strengths and weaknesses of per tree stumpage fees: Per tree stumpage fees have advantages of simplicity. They avoid the administrative costs, problems and complexities of log measurement. Payment may be easily verified by on-the-ground inspection and counting of stumps. But they cannot properly reflect the value of all the trees and so might not be able to generate as much revenue as a properly designed system based on stumpage volume and timber market prices. Per tree fees are most appropriate where simplicity of administration is important, and where log measurement scaling is expensive or difficult.
Per tree stumpage fees may be used to support selective cutting. Per tree stumpage prices may result in «high-grading», leaving the smaller or less valuable trees uncut.
Per tree stumpage fees may also be a useful pricing mechanism for plantation timber, both for thinning and the final cut. In plantation logging operations, trees may be counted at the roadside prior to transportation, stumps may be counted after logging, or trees may be marked and billed prior to logging.
With a lump sum timber sale all merchantable trees in an area, or only those trees marked for cutting, are sold for a single amount of money. Buyers then cut as many trees (or marked trees), and utilize as much of each tree, as they wish. No further payment is required. Thus, the buyer has an incentive to use as many trees, and as much of each tree, as financially merchantable. Lump sum timber sales have been used in Europe, some US states and by private forest owners for the sale of blocks of timber.
Lump sum timber sales require a detailed inventory or timber cruise of the area. The timber contained in the area is then sold as a block. If the stand is to be clear-cut, all the timber is sold. If it is to be cut under a selective silviculture system, trees to be cut are marked, and only marked trees sold.
The timber may be sold at an administratively established and appraised lump sum price. But commonly it is sold by oral auction, or sealed tender bid. In any case, a reliable timber cruise of the area is required, both to reassure the government of what it is selling and to reduce uncertainty among bidders.
Strengths and weaknesses of lump sum timber sales: Lump sum timber sales have advantages, of administrative simplicity, and they encourage greater utilization. However, if pursued under selective cutting management schemes, they may require considerable expertise and measurement. They may be more appropriate where clear-cut silviculture systems are used, where competitive bidding can be encouraged (assuming there is a competitive bidding situation), and where reliable pre-sale timber surveys are possible.
Lump sum timber sales can be ideal for the sale of even-aged, second growth, and especially for plantation timber. Plantation timber is of uniform size, stocking is uniform, the timber is easily surveyed and the surveys will be more reliable.
Forest fees may be levied on volumes of sawnwood, plywood or other processed forest products instead of stumpage fees on the volume of input wood raw materials. They may also be levied as an ad valorem (percentage of value) charge.
Thus, in some jurisdictions, levies set for sawmills are based on lumber output rather than on log input. This is a generally inefficient method because it discourages the adequate use of timber and recovery of lumber.
Indonesia shifted the base for forest royalties from log volumes to the output of processed wood products (plywood and lumber) in 1985 (Gray and Hadi, 1990). In the Malaysian states of Sabah and Sarawak, royalties could be paid on either roundwood production or the sawnwood output (Gray, 1983). Several Canadian provinces (Manitoba, Saskatchewan and Newfoundland) have levied forest fees on lumber output rather than roundwood log input.
Strengths and weaknesses of forest fees on processed products: Forest fees on processed forest products are easier to administer than charges on the timber cut. Measurement points are fewer and more central. Avoidance and evasion problems are lessened, and policing is easier.
However, as mentioned, fees on processed forest products will not encourage efficient utilization of wood. Because fees are levied on the processed products, no fees are paid on the logs, there is no cost in wasting wood, and therefore there is no incentive for improved recovery of processed products. As a result, fees based on processed forest products might penalize firms that achieve improved utilization and higher recovery.
Export taxes are based on the volumes of logs or wood products exported at a rate per unit specified for each species, class or grade, or as ad valorem (percentage of value) rates.
Export taxes on logs or processed wood products may be levied for revenue purposes as a substitute for other forest fees; or they may be levied for economic policy purposes, to encourage domestic processing. However, their impacts on forestry and the forest industry are often complex and unintentional results may occur.
Log export taxes
Log export taxes are used in a number of countries as a substitute for volume-based stumpage prices on timber. It is easier to measure volumes and collect revenues at export ports or borders than at remote locations in the forest. This works well if a large proportion of the harvest is exported.
Log export taxes may also be used to encourage domestic processing of wood. By reducing the export market through tax, domestic prices of logs will tend to fall, thus benefiting the forest industry (Repetto and Gillis, 1988). However, a supply of cheap logs will not encourage efficiency in raw material use, utilization or competitiveness. Instead, they may help to support and maintain inefficient, wasteful processing operations, and discourage improved utilization. Low log prices may also induce conversion of forest lands to other uses such as cattle ranching.
Export taxes on processed products
Using a similar reasoning, export taxes have been imposed on wood products with a low level of processing, such as lumber, to encourage development of industries with a higher level of processing, such as furniture. Indonesia, for example, introduced an export tax on sawnwood in 1989 to encourage further processing of lumber into more highly processed products and furniture (Gray and Hadi, 1990).
Strengths and weaknesses of export taxes: Export taxes on logs are easier for log exporting countries to administer than volume-based stumpage prices. If combined with charges on the log input of processing plants, they can substitute for volume-based stumpage prices. For some jurisdictions, lacking a well-developed administrative system, on balance they may be better than volume-based stumpage prices.
Export taxes on logs may also serve to encourage domestic processing. However, to encourage en efficient domestic processing they need to be combined with other forest fees on logs processed domestically. A pure export log tax will tend to reduce the price of logs in the domestic market and induce further waste and the conversion of forest lands to other more profitable uses.
Export taxes on processed products (lumber, plywood or other products) have a variety of hard-to-predict distorting impacts on the forest industry, on log prices, product prices, utilization, productivity and investment. If used, they should be introduced with caution, and only following careful analysis of their incentive effects and impacts.
Log export taxes are better than log export bans or export quotas. Log export taxes can discourage roundwood exports and encourage domestic processing, and they will generate revenue from those logs which are still exported.
Initial licence fees on forest contracts may be levied upon the award of the contract. They may be either a fixed, lump sum fee, or they may be area-based fees, based on the total area or the productive forest area of the contract. An area-based initial licence fee, based on the total area of the concession, is the simplest to administer. The total area applied for is quickly and easily calculated. An initial licence fee based on the productive forest area, or the operating area, would require completion of the forest inventory.
Initial licence fees have been used in a number of countries. In most jurisdictions, initial licence fees on long-term timber supply agreements are very modest. Côte d’Ivoire has levied an initial licence fee on new concessions, based on the total concession area. Cameroon has levied initial concession fees based on the total licence area. However, these initial concession fees generated less than 1 percent of forest revenue (Grut, Gray and Egli, 1991). Indonesia has levied an initial Forest Concession Licence Fee based on the total licence area payable on issuance of the concession (Gray and Hadi, 1990).
Strengths and weaknesses of initial licence fees on forest contracts: Initial licence fees on forest contracts are simple and easy to administer, especially if levied as a fixed charge or as a per hectare fee on the entire area. Such fees on forest contracts and other forest tenures serve three purposes: (a) to cover the administrative costs of processing the application, surveys, inventories, inspections, environmental review and administration of the approval process; (b) to reflect part of the value of the forest contract, the value of a secure timber supply; and (c) to prevent speculative applications.
There is scope for greater use of initial licence fees to reflect the value of these forest tenures, and to recover the administrative costs involved. Per hectare initial licence fees, combined with annual area-based ground rentals (discussed below) may encourage more intensive forestry, forest management and utilization.
Used in many countries, area fees, levied annually, are simple forest revenue mechanisms that are easy to administer and collect. However, in most countries they represent a very small proportion of total forest revenues (less than 5 percent) and play little or no role in forest management (Grut, Gray and Egli, 1991).
Area fees may be a more significant revenue source and can complement volume-based stumpage prices.
Annual area fees may also serve to reflect the security value of the timber supply provided by the forest contract and capture a share of that value as forest revenue. When exacted annually, area fees provide incentives for using the forest under contract more efficiently, more intensive forestry land use, and for improved utilization in logging (i.e. production of more timber on a smaller area). Minimum per hectare area fees may serve to reflect the value of forest lands in other uses and thus help to support land use policies.
Strengths and weaknesses of annual area fees on forest contracts: Annual area fees have advantages that make them a useful component of a forest revenue system. They are easy to administer with less bias against long-term investments. Monitoring compliance is easier. However, they must be attached to management plans, otherwise there is an incentive to cream the forest. When this is done, they also provide incentives for more efficient use of forest lands and economizing on forest areas. They can support and encourage more intensive forestry on forest utilization contracts. Annual per hectare area provides stronger incentives for relinquishing excess lands to other land uses. This is the next variant described below.
An annual fee based on the allowable annual cut is an alternative to an annual area-based fee. For example, Bolivia imposes a fee in timber concessions which is equal to $1 per hectare per year but at the same time imposes a minimum rotation period of 20 years and demands a sustainable forest management plan. Thus, in any particular year only 5 percent of the concession area can be harvested. This reduces the incentive to extract only the most valuable woods. An annual fee based on the annual allowable cut may better reflect the value of the forest contract and the security of timber supply, but is more complex.
Strengths and weaknesses of annual allowable cut fees on forest contracts: Annual allowable cut fees may better reflect the value of the concession and of the timber supply guaranteed by the forest concession tenure. However, they require a calculation of the annual allowable cut before they can be implemented. Management plans are needed and controls to ensure compliance must be in place.
Property taxes and variations are applied to forests on freehold private lands in Canada, the United States and Europe. They are not normally applied to forest contracts on public lands. However, property taxes have been applied to forests on public lands in a few developing countries. For example, in Indonesia a land and improvement tax is applied to public forest lands within forest concessions (Gray and Hadi, 1990).
Strengths and weaknesses of property taxes on forest contracts: As property taxes are based on assessed values, they may reflect differing values of the forest. However, the administrative complexity, manpower requirements and financial cost involved in assessing values make property taxation a less attractive alternative.
Minimum area-based fees on forest contracts and minimum volume-based fees on timber set a floor level for both area fees and stumpage fees, and may prevent timber and concessions being sold “too cheaply”. Minimum forest fees will ensure that timber and forest contracts are not given away with little return to the country. They may be set to reflect the value of the timber or forest areas in other uses (environmental protection, wildlife, forest foods, watershed protection, biodiversity, etc.). As suggested above, these non-timber benefits can be significant (Bishop, 1999; Kramer et al., 1992).
Normally, when used singularly, none of the levy types mentioned above allows capturing the full amount of revenue and compliance that government (society) expects from a particular forest utilization contract. For this reason, it is common for a number of levy types to be used in combination forming what is known as a forest revenue system. The appropriate revenue system for a specific contract depends on the country’s socio-economic conditions and on variables, such as type of forest, available information, administrative capacity, technologies of operations, etc.
A forest revenue system, fees and charges must contribute to the sustainable management of forests, efficient utilization of timber, be relatively simple to administer and achieve easy compliance for the forest industry. The forest industry has an interest in a forest revenue system that supports and encourages productive efficiency and easy compliance. A poorly designed forest revenue system can easily increase industry costs, discourage recovery and utilization, reduce competitiveness, and in the end diminish the timber values and potential revenues available.
Developing a forest revenue mechanism to meet the forestry policy objectives and fully capturing expected income involves, first, choosing individual levy types based on their individual merits, and second, combining its use in such a way that they mutually reinforce and complement each other. The structuring of the forest revenue system is the main determining factor in the success of a forest utilization contract from society’s point of view.
The forest revenue system selected will be based upon levy types chosen because:
Most forest revenues in developed or developing countries are heavily dependent on volume-based stumpage fees, accounting for 90-95 percent or more of forest revenue for most countries. Yet stumpage fees and other volume-based fees are notoriously difficult to collect and are subject to abuse and corruption (under-measurement, under-reporting, miss classification of species, illegal logging, etc.). Stumpage fees and other volume-based fees require forest departments to have the field capability to measure log volumes, or to independently check log volumes and records of logging companies. Thus, depending on the administrative capacity of government and the levels of transparency in implementing forest utilization contracts, stumpage fees and other volume-based forest fees may be supplemented with, or even replaced by, easier to collect area fees based on the area of the forest contract. While area fees may entail some loss of potential revenue for governments, it is quite possible that, according to the specific circumstances of the contract, such loss may be lower than that deriving from systems based on volume fees that in theory may be more efficient but in practice cannot be effectively implemented.
Pricing policies and revenue mechanisms for non-timber and non-wood forest outputs, products and values are more difficult to design and to implement, for three reasons. First, non-timber products and values represent a much more diverse range of forest uses than does timber. Second, many non-timber outputs involve non-market values. These non-market outputs include goods like wilderness values and biodiversity; externality or spillover benefits and costs like watershed protection; or common property resources and outputs like wildlife and fisheries. Non-market outputs and values by their very nature are difficult to value. Third, most of the non-timber and non-wood forest outputs and products are harvested by individuals and households, or very small firms, making it extremely difficult to supervise harvesting and collect forest fees. In addition, many are subsistence forest produce, for which it may be inappropriate to levy more than token fees.
For these reasons we cannot expect to be able to establish prices for all non-timber forest outputs. Nevertheless, it is often possible to develop imaginative pricing policies and revenue mechanisms for a number of situations, and to use pricing policies as a tool of resource management. A selection of potential revenue mechanisms for non-timber forest outputs is presented in Table 8.1. It is only a partial listing, presented to indicate the potential for equal and parallel treatment of timber and non-timber forest outputs.
Table 8.1: Potential revenue mechanisms for non-timber forest outputs
Fuelwood and charcoal Subsistence resource use Recreation revenue mechanisms Hunting and fishing Watershed management outputs Accounting prices for non-market resource outputs and values |
As shown earlier in this chapter, resource pricing systems have been developed to measure non-market resource values for a variety of resources and in a number of countries. Pricing systems have been applied in environmental management, water quality and quantity management, water pollution control, litter control and traffic congestion.
Pricing systems have been used to some extent to reflect the values of non-timber forest outputs and to manage the resource - in recreation management through park entrance and recreational use fees, campground fees, permits, and differential fees between residents and non-residents and between peak and off-peak use; in hunting and fishing through differential licence and tag fees by species and between residents and non-residents; and in water management by water pricing and licence fees. There is potential for refinement of pricing policies in these areas and for more extensive use of prices in resource management.
Further examples of, and experience with, revenue mechanisms for non-market outputs and values may also be found in other areas of public policy, in public finance theory and practice, in local government finance, in public utility pricing theory and practice, and in local government user charges.
However, not all non-market values can be reflected in prices and revenues. For these values to be properly taken into account in resource management, it may be helpful to develop some, admittedly crude, accounting values and prices for non-timber, non-market outputs and uses. These crude values could then be used for internal resource management and forest land use planning.
A full and comprehensive review of potential revenue mechanisms for non-timber forest outputs and values is beyond the scope of the present study. However, it is important that non-timber outputs and non-market values be recognized and accounted for.
Previous sections have discussed forest fees and forest revenue systems for forest utilization contracts. This section discusses payment terms for goods and services procurement contracts. The timing of payments - whether prices are fixed ahead of time or adjusted for inflation, cost increases or other factors - the basis and method of payment must all be clearly specified in the procurement contract. The payments, method and timing of payments, adjustment procedures, etc., will all have a significant effect on the bids or prices negotiated because they affect cash-flows for the successful contractor as well as the level of risk that must be borne by the contractor and the government.
Seven different payment systems are described below: (1) fixed price contract, (2) annual or periodic payments plus bonus bid contract, (3) per unit quantity contract, (4) per unit quantity plus bonus contract, (5) cost plus contract, (6) incentive contract, and (7) contingency contract.
Under a fixed price procurement contract, government pays a fixed sum of money independent of other factors (economic conditions, the contractor’s actual costs, etc.). The contract price is simply the amount of a firm’s bid or the negotiated contract price. It is the simplest method and a common form of government contract in procuring goods or services (Cassidy, 1994).
This method is most appropriate for short-duration projects, or contracts involving small amounts of money. Under these procurement contracts, payment is generally made once the contract has been completed. This provides an incentive for contract compliance (quality of product or service). The contract may also include “hold-back” provisions of a proportion of the final payment until contract performance has been verified, or the programme is operating satisfactorily. In other cases, payment may be broken down into a series of payments over the life of the contract at specified stages of completion. This will provide the contractors with a cash-flow to cover part of their costs, while spreading out payment for the government. However, to provide an incentive for the contractor to complete the project, it is important that a sufficient proportion of the payments be held until completion of the contract and that the “hold-back” be sufficient to encourage completion and performance.
There are advantages and disadvantages to this type of contract. It is a simple contract to design and award. Administration costs are generally low, and collecting payment is simple. However, as the contract price is fixed, after the contract is signed the contractor will bear all the risks associated with changes in costs, prices, interest rates and other factors that affect project finances. As a result, contractors will raise their bids and the price of goods and services to the government may be higher.
This method is applicable to longer-term and ongoing procurement contracts. Annual or periodic payments are specified in the contract and bidding or negotiation takes place on a bonus payment over and above these. The bonus may be an initial, annual or periodic one.
This type of contract is almost as simple to administer as the fixed price contract. Administration costs are generally low. However, as with the fixed price contract, once the contract is signed the contractor bears all the risks associated with changes in costs, prices, interest rates and other factors that affect project finances.
Payments may be specified on a per unit output basis. Payments are made periodically (monthly or quarterly, for example), based on the amount (volume, number, etc.) of the goods or services produced. This approach is appropriate for contracts of longer duration, or when the total contract is large. In contract administration this method requires regular and systematic measurement of the quantity and quality of the goods or services produced, and agreement between the parties on output quantity and quality. The measurement procedures and output quality of these contracts will need to be audited or checked. Measurement of project output and auditing will add to the cost of contract administration. It can also open up opportunities for bribery and corruption.
This type of contract is identical to the previous one, with the addition of an initial or annual lump sum bonus. The bonus is determined by competitive bidding or negotiation.
Under this contract method, the government pays a fee to the firm plus the firm’s costs in carrying out a project which could be based on lump sum or per unit production as described above. This method is used for capital projects, such as construction of roads and facilities, but it may also be used for contracts to provide services, such as forest inventory, inspections, log measurement (scaling), forest certification, etc. Governments may have to use this contract method when there is uncertainty over the time and costs associated with the contract and contractors are unwilling to bid for the contract under other contract methods. Under cost plus contracting, the government assumes the full cost of completing the project, and all risks are therefore borne by the government. A problem with this method is that the contractor has no incentive to keep down or control the costs of the project. In fact, if the contract is written in terms of costs plus a percentage of costs, the contractor will have an incentive to increase costs and therefore his profit. Cost plus contracts can easily result in large cost overruns from the initial estimates, which must all be absorbed by the government. For these reasons, cost plus contracts should be avoided wherever possible.
The incentive contract combines some of the features of the cost plus and the fixed price contracts. With this method, the government’s payment depends on both the firm’s bid and the actual costs for completing the contract. If the actual costs exceed the bid, then part of the cost overrun is paid by the firm and part by the government, according to a pre-arranged sharing ratio. If the costs are less than the bid, the government and the firm share the savings. Thus, both the government’s payment and the contractor’s profits vary with the costs actually incurred. Risk is shared proportionally between the two. The reasoning for this method is that, with the government accepting some of the project risk, contractors will be willing to accept a lower profit or rate of return and, as a result, they will submit lower bids for the contract.
The advantages to government of the incentive method are that it will attract more potential contractors because risks are shared with government and the contractor’s risks are lower. Therefore, there is potential for more bidders and for lower bids. A major disadvantage of incentive contracts is that the government must have a reliable means of assessing and auditing the contractor’s costs.
Where information on the project or activity is well known to both government and contractors, a contingency contract may be used. Under contingency contracts, the size or level of payments depends on the specified factors of the project or activity. For example, payments under a road construction contract might be based on soil conditions, the amount of gravel available, the amount of rock requiring drilling and blasting, etc. This payment system reduces the risk and uncertainty which contractors must contend with in preparing their bids and in carrying out the contract (McAfee and McMillan, 1988). The contractor’s payments vary directly with the underlying cause of unpredictable cost. In the contingency contracts, the contractors and the government must agree ahead of time on which aspects of the contract risks are to be shared.
There are two drawbacks to this method. The first is that, like the incentive contract, the two parties must agree on a method for assessing when conditions have changed in such a way that costs are higher than originally estimated. Agreement must also be reached on who is responsible for taking and interpreting the required measurements. Again, independent of who assumes this responsibility, the other party must somehow audit procedures, so the costs of contract administration are higher. The second shortcoming is that under contingency contracts the government will absorb almost all the risk associated with cost overruns resulting from higher cost conditions.
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