Economic efficiency is an underlying objective of government policy in most countries and should be reflected in forestry policies. Economic theory shows that economies tend to function most efficiently when the levels of output and prices of goods and services are established through competitive markets. Therefore, in situations where the government influences the production of a good or service, such as in the case of forest charges,3 it is important to ensure that these policies do not introduce unnecessary distortions into the economy.4
Forest charges can be structured in a variety of ways, such as: flat-rate charges per cubic metre of roundwood cut or taken from the forest; annual charges on the area of forest in a concession; percentage tariffs on the value of forest products produced or exported; or as a combination of such charges (see: Gray (1983), for a comprehensive discussion of the different types of forest charges commonly in use around the World). Such charges are often set with reference to the economic rent from roundwood production. However, there has been a long-running debate about whether forest charges in many countries have been set at sufficiently high levels to capture a significant share of the economic rent from roundwood production (see, for example: Repetto and Gillis (1988) for an early review of the level of forest charges in place around the world).
This section of the report describes what economic rent is and shows how it can be calculated and used as a guide for setting forest charges. It then describes some of the challenges to calculating economic rent, before finishing by re-emphasising why it is so important to establish the correct level of charges for the use of forest resources.
Economic rent can be defined as the surplus value created during the production of a good or service, due to the ownership of a factor of production that is in fixed or limited supply. In many economic activities, it is not possible to create economic rents. Thus, for example, if a sawmiller could sell sawnwood for far more than the cost of production (and thus, earn an economic rent from that activity), other producers would soon enter the market and drive product prices down, such that the surplus would disappear. However, if that activity was dependant upon a factor of production in fixed supply (e.g. a prime location in a city or an exclusive property right such as a patented production process or copyright on a product design), then other producers could not enter that particular part of the market and drive prices down and the economic rent would persist.
The classic example of an economic rent is a land rent. Land supply is generally fixed and land (usually) costs nothing to produce yet, with the addition of other inputs, land can be made to produce outputs that are higher in value than the total cost of these other inputs. On very productive land or land in favourable locations, the economic rent is high; while in more remote or less productive areas, economic rent is much lower. In a competitive market, potential users of the land would compete to use the land, resulting in a rental payment to the owner(s) of the land that would be equal to the economic rent from the best use of that land.
It should also be noted that other factors of production can earn economic rents if there are artificial barriers or other rigidities that restrict the supply of these factors to the market. An important point for governments to note is that they can have a major impact on the creation of rents in many parts of the economy if the policies they pursue affect the flow of capital or place other constraints on the way that markets function.
Economic rent in the forestry sector differs between plantation forests and natural forests. In plantation forests, inputs are required to plant and manage the trees, so it is the land that is in fixed supply and the economic rent is basically a land rent. In the case of natural forests, the situation is slightly different because the trees are produced for free (i.e. the resource occurs naturally). In this case, it is the forest that is in fixed supply (i.e. natural forest can not be created, except over a very long time-period) so the economic rent is the standing (or “stumpage”) value of the roundwood that can be produced from these free trees.
As already noted, in competitive markets, buyers and sellers would compete to establish land rents and prices for roundwood from the natural forest, such that all of the economic rent would accrue to the owners of the resource. Thus, for example, in the case of forest plantations, forest managers would compete for land with other potential land users, resulting in market-based rental payments for the land. Similarly, in the case of natural forests, purchasers of roundwood would compete with each other to determine market-based stumpage prices, such that forest owners would receive the full value of the economic rent from the trees that are produced by nature. In some countries, roundwood is sold standing by competitive means such as auctions or tenders but, for a number of reasons, this is not common in tropical forests managed under selective cutting systems.
In cases where competition is imperfect, it is possible for the forest industry to capture some of the economic rent from forest production, resulting in lower payments to the owners of the resource and a distortion of the benefits from forest production away from the owners of the resource and towards the industry. Such imperfect competition in the market for harvesting rights is quite common for a number of reasons. Firstly, there is often an information failure. The forest industry operates in competitive local and international markets and usually has a good understanding of the costs and value of production while resource owners often have much less information about what their resource might be worth. Secondly, the structure of the market may also limit competition. Small numbers of producers in the forest processing sector may reduce competition for the resource, particularly when the effect of location is taken into account. For example, because of the relatively high costs of transporting roundwood, competition to harvest roundwood from a forest at any particular location is often limited to only a handful of local companies. This is certainly the case in Fiji, where the number of forest processing companies is quite small. Thus, in the absence of perfect competition, the rationale for using economic rent analysis is that it provides a methodology for estimating what stumpage prices would be under more competitive conditions and it can be used to as a guide to setting forest charges that result in the full recovery of economic rent for the resource owners.
The rationale behind government involvement in the setting of forest charges depends on the type of forest ownership. In many countries, natural forests are owned by the state, so the forest charges set by the government are equivalent to the stumpage price of roundwood. In such cases, it is important for the government to set the correct level of charges so that government revenues from forest harvesting are optimised and so that the resource is priced correctly.
In the case of Fiji, the majority of the natural forest is owned by traditional landowners and the royalties collected by government are distributed amongst them. In addition, landowners also set their own charges for harvesting rights on top of the government royalties (“commissions” and payments for “goodwill”). Therefore, the role of government in setting forest charges is somewhat less important than in many other countries. However, at the national level, it is still in the interest of economic efficiency to ensure that the resource is priced correctly. Furthermore, it could be argued that the government should influence stumpage prices or forest charges to protect resource owners and ensure that they gain the maximum benefit from the use of their resource.
An additional point that should be considered is that there are also a few relatively small forest charges that are collected and retained by the Government (i.e. the Forestry Department) and other statutory bodies such as the Native Land Trust Board (NLTB). In such cases, these charges should be included in the economic rent analysis and the level of these charges should be set at a rate that allows these institutions to recover all reasonable costs incurred for the services rendered.
It can usually be assumed that the markets for most of the factors of production in the forestry sector are competitive markets. Therefore, the economic rent from forest harvesting can be simply estimated by subtracting the costs of production from the value of production, where the value of production is measured at a point where the product is sold in a competitive market. This “residual value” approach is the methodology used in many countries around the World to estimate economic rent and stumpage prices or forest charges.
However, this calculation is often more complicated than it seems. Firstly, it is usually necessary to build-up the total cost of production from the cost of individual activities (e.g. forest management and planning, felling, extraction and transport to the point of sale). Secondly, the cost of each activity also usually has to be constructed from its individual components (e.g. labour costs; the costs of consumable items used in the activity such as raw materials, fuel and minor tools and spare parts, and the cost of capital such as equipment, machinery and buildings). In addition to these cost components, the calculation of total production cost should also include an allowance for normal profit (see Box 2).
Box 2 Normal profit in the calculation of production costs and economic rent
Thirdly, the calculation can involve estimating the costs of numerous activities, depending upon the point at which the product is sold in a competitive market. For example, if there are many buyers and sellers of delivered roundwood (e.g. where there are independent loggers) it may be possible to obtain market prices for delivered roundwood and calculate the economic rent by subtracting harvesting, extraction and delivery costs from these prices. If, however, most roundwood is used in integrated forest operations (i.e. harvesting and processing by the same company), then it may be necessary to work back from forest product prices. This will involve taking into account the costs of forest processing (in addition to the costs mentioned above) in the calculation of economic rent. In the case of forest plantations, the economic rent calculation is complicated further by the need to include in the calculation the costs of planting and managing the resource (including an allowance for normal profit on the forest plantation investment).
The two cost components that are generally the most difficult to estimate are capital costs and the level of profit that a forest operator should be allowed to retain (i.e. the normal profit). The cost of capital is usually based on the economic depreciation of capital used in the production process (see Whiteman (1999a) for a discussion of depreciation). The level of normal profit is usually expressed as a required rate of return on the total amount of capital invested in the production process.
The pie chart shown in Figure 3 demonstrates how the market price of delivered roundwood might be distributed between labour and raw material costs, capital costs, normal profit and economic rent.5 The price paid for roundwood is represented by the size of the pie. The various components of the delivered roundwood production cost are represented by the shaded slices of the pie and the unshaded slice represents the economic rent.
It is worthwhile noting that, in most forest operations, a large proportion of the roundwood production cost is usually accounted for by the cost of capital and normal profit. Because this cost is largely fixed (i.e. it doesn’t vary with output levels), the efficiency of capital utilisation can have a dramatic impact on the total roundwood production cost and, consequently, the level of economic rent earned from roundwood production.
Where forest charges fail to capture all of the economic rent from production, the remaining surplus accrues to the producer and is referred to as “windfall profit” or “excess profit”.
Figure 3 The relationship between production costs, profits, economic rent and forest charges
There are three main challenges when attempting to calculate economic rent: the collection of accurate and reliable cost and price information; the variability in economic rent in different locations and types of forest; and the question of what is an appropriate level of normal profit in the sector.
There are two main problems with the collection of cost and price data for economic rent analysis. The first is that such information is often not readily available and, even if it is, it may not be very reliable. This is particularly the case with some of the components of the production cost (e.g. the cost of repairs and maintenance) where forest operators often do not keep accurate records. This can partly be overcome by referring to machine operator’s handbooks and collecting information about the cost of typical repair and maintenance activities in order to calculate an estimate of the cost. Another way in which the situation may be addressed is by asking forest operators about how often they perform various activities such as maintenance in order to get a general idea of the cost of such activities.
The second problem that occurs is that it is often in the interest of the respondents to any enquiry to understate prices and overstate costs in order to give the impression that profitability is low (and, consequently, that forest charges should be low). Some take this a step further and deliberately record low prices in their records in order to alter their tax position (this is particularly a problem in integrated forest operations where this practice, known as artificial transfer pricing, can be used to considerable advantage). This problem can only be overcome by judging how reliable the data collected is, by comparing the responses given by individuals with each other and with any competitive market information that may be available.
The second challenge is that, like any rent, the level of economic rent from roundwood production can vary greatly due to a number of factors such as the productivity of a site, the volume of commercial species present, transport distances and other site conditions.
Where the total roundwood production cost varies due to factors over which the forest operator has little control, this variability should be taken into account in the design of the forest charging policy. In other words if, for example, the total roundwood production cost from a particular area is high because it is a long way from the market, this should be accommodated in the forest charging system by setting a lower forest charge for outputs produced from this area. Examples of factors that should be accommodated in this way include: the level of stocking of commercial species in the forest; terrain and other working conditions; and the distance from the forest to the market. The most important of these factors is likely to be transport distance and this is the main variable that is examined in this analysis.
There is also a second group of factors that can affect the economic rent from production, over which forest operators do have some control. These mostly concern the efficiency of operations and include variables such as: the length of skid-trails used to extract timber; harvesting machine availability and utilisation rates; and the utilisation of appropriate technology. In these cases, the charging policy and the way in which forest licences are awarded and supervised should aim to encourage greater efficiency and the reduction of the total roundwood production cost, in order that the economic rent from production can be maximised. In other words, inefficiency and low productivity is not a reasonable excuse for setting low forest charges.
The last major challenge in the calculation of economic rent is determining what the normal level of profit should be. As noted above, the forest charging system should aim to set charges at a level that results in resource owners capturing most or all of the economic rent from forest production. However, if forest charges are set at a level that is too high, this will reduce the level of profits in the sector and will reduce investment in the sector. The consequences of this could be just as damaging for the sector as setting a level of forest charges that is too low. Therefore, a careful balance must be achieved between the rights of forest owners to receive the full value of production from their resource and the need of forest operators to earn a normal level of profit.
In discussions with a number of forest operators, it was claimed that they are currently not making any profit and that they are just recovering their operating costs (i.e. they were implying that they were not making enough income to cover capital costs, let alone an allowance for normal profit or a return on capital). However, some visits to sawmills and discussions with the Forestry Department showed that they are making new capital investments, so it seems unlikely that they are not making any profit.
In view of the fact that the charging policy should, in the long-run, allow forest operators to make new investments, normal profit has been included in the calculation of economic rent as an amount that allows the forest operator to earn a rate of return of 20 percent on their capital investment. The figure of 20 percent return on capital (ROC) has been based on discussions with various stakeholders in the sector and is comparable with the current rate of interest in Fiji, after allowing for the risk of investment in the forestry sector.6
The above discussion has explained the concept of economic rent and shown how it can be calculated and used to guide forest charging policies. This section briefly discusses the two main reasons why it is so important to try to achieve the correct level of forest charges.
The most obvious reason for setting the correct level of forest charges is that this will have a direct impact on the income that landowners will obtain from the utilisation of their forest resource. If charges are too low (which is often the case) landowners income will not be maximised and this will reduce the potential for forest revenues to lift landowners out of poverty. If, on the other hand, forest charges are set too high, this may also result in reduced production from the sector and could lead to landowners obtaining sub-optimal levels of revenues from the sector.
Related to this, if forest resources appear to be producing relatively low levels of income, there will be little incentive to preserve and manage them for wood production and more of an incentive to convert them to other land-uses. While this is probably not a major concern in Fiji at the moment, it could be important in the long-run if competing activities such as agriculture increase in importance.
A third more subtle reason for attempting to get the forest charging policy right is that governments tend to base the priority that they give to different parts of their administration on the relative importance of each sector to the national economy. If the revenues generated from forest charges are low, this will generally limit the attention that the government gives to the forestry sector and reduce the scope for the forestry administration to finance and implement other policies for the sector that they wish to pursue.
Although revenue collection is often an important consideration, a potentially far more important concern about forest charging policies is that, if the policies are not well designed, they can allow low levels of efficiency in roundwood production and forest processing to persist. This leads to waste and the misallocation of resources (not only in terms of forest resources, but also labour and capital) and can have negative social and environmental consequences as well.
Some examples of the detrimental effects of poorly designed forest charging policies include:
• low charges reduce the incentive for forest operators to reduce production costs to a minimum;
• incorrect charges for different locations and species can discourage producers from maximising production from each area of forest and can give an unfair advantage to certain locations and certain types of forest; and
• low charges reduce the incentive to improve the marketing of roundwood and forest products.
Not only are these effects wasteful, but they can encourage the development of a processing sector that is too large (i.e. if roundwood is cheap – more companies want to use it) and discourage efficiency in roundwood utilisation in the processing sector.7 They can also lead to vast amounts of capital being tied-up in a poorly performing forest processing sector, when some of this capital would be more profitably employed in other sectors of the economy.
There may be circumstances where the government deliberately decides to influence charging policies in order to give a subsidy to roundwood production or to the domestic forest processing industry. However, experience has shown that forest charging policies are often a crude tool for implementing broader forestry or economic development policies and can often result in unintended effects. For example, economic rent that is not captured by resource owners might be kept by forest operators, but it could be passed on to consumers, contractors or others involved in the production process.8
In summary, these issues are critical because they have the potential to distort the whole of the economy and trap economic development into a cycle of poorly performing industries dependent upon the wasteful use of the forest resource.
3 The term “forest charges” is used here as a generic term to include all fees, royalties and other payments made by users of the forest resource. The latter terms all have specific meanings in Fiji, which are described in Section 4 of this report. In many countries, forest charges are set by the government and equate to the standing or “stumpage” price of roundwood. However, in the case of Fiji, it should be noted that landowners also set their own charges for the use of the resource.
4 In some cases, distortions in the economy can be justified on social, environmental or economic grounds. It is beyond the scope of this study to examine if and when such distortions could be justified in Fiji, although Section 7 will offer some preliminary comments on this.
5 Note here that the economic rent is shown as the difference between the production cost and the market price of roundwood. In the case of Fiji, very little roundwood is traded on the open market, so the analysis has gone a stage further and calculated the economic rent as the difference between the value of finished products and their production costs. These figures have then been converted to give the economic rent per cubic metre of roundwood production.
6 The commercial bank lending rate in Fiji is currently about 8 percent to 12 percent in real (i.e. inflation adjusted) terms, but banks are reluctant to invest in forest operations. Finance companies that offer loans for purchasing mobile equipment (e.g. bulldozers, skidders and trucks, etc.) charge 15 percent to 18 percent and are making loans to the sector. Considering that these institutions have a more balanced portfolio of investment risks, the required rate of return for investors in the forestry sector should be somewhat high than this, so a rate of return of 20 percent (in real terms) seems reasonable.
7 For example, there is no incentive to invest thousands of dollars in machinery with high product recovery rates to save a few hundred dollars on wood raw material costs.
8 This can also include government officials involved in the awarding and monitoring of forest licences. In many countries, low rent capture finances corruption in the forestry sector.