R.A. Crossley, T. Lent, D. Propper de Callejon and C. Sethare
Rachel A. Crossley, Tony Lent, Diana Propper de Callejon and Camilla Sethare are with Environmental Advantage, an NGO based in New York, United States. Note: This article is based on a paper prepared for Financial Mechanisms and Sources of Finance for Sustainable Forestry, a workshop held in Pretoria, South Africa, from 4 to 7 June 1996.
The principal purpose of this article is to identify financing mechanisms (primarily in the private sector) that can realistically be created or adapted and implemented to promote the transition to, and growth of, sustainable forest management worldwide.
Innovative financing, for any given sector, may refer to the creation and development of entirely new financing mechanisms and instruments (e.g. debt-for-nature swaps). In addition, financial innovation may also encompass the adaptation and application of well-established financial vehicles (e.g. bonds, investment funds) to new and emerging investment areas such as sustainable forest management, renewable energy, biological diversity protection enterprises and conservation. The added benefit of adapting existing financial instruments is that the perceived risks of investing in these emerging markets are lowered, since private sector investors (as well as public and multilateral financiers) are already familiar and comfortable with these market-tested instruments.
Conversely, new financing mechanisms for sustainable forest management have the disadvantage of being experimental and unknown and may therefore arouse more concern and scepticism than support within financing circles. For example, entirely new financial vehicles, such as carbon offset trades, have their own inherent financial technology risk because the underlying financing mechanism is new and unproven. Thus, employing new financial vehicles to fund sustainable forest management could further limit the number of potential investors to a select few innovative and entrepreneurial financiers who are willing to take significant risks. As a result, sustainable forest management could remain a small, underfinanced niche within the overall forestry sector.
The authors argue that the real challenge is to apply and customize today's normative "best practice" public and private financial strategies and mechanisms to the business realities and opportunities of sustainable forestry enterprises and projects. The issue is not to focus on innovative finance, but rather on financing innovative forestry. It is widely recognized that public funds to promote sustainable forestry practices have been lacking and existing funds have not been very effective in reducing deforestation or in achieving sustainability objectives.
Public financing available for sustainable forest management (or any other area of natural resource management) is not likely to increase, given that public financing for development overall has been insufficient and even on the decline. By contrast, private capital flows to forestry, in the form of investment and lending, have increased each year since 1991.
The expansion of private investment in forestry and the extension of the global capital market into developing country economies offer potential opportunities and, possibly, threats (if the investment is poorly directed) to the long-term stewardship of the world's forests. The challenge is to redirect and channel existing private sector resources and capital market investment vehicles and services to sustainable forest management.
This article therefore focuses on investments from the private sector for two primary reasons: i) the private sector is increasingly involved in forest extraction and management worldwide; and ii) private sector finance will be the probable source of funds to make up for the current and possibly future shortfall of official assistance and public finance in the forestry sector.
To attract private capital to a new business opportunity area, be it sustainable forestry, renewable energy or any other emerging market, that area needs to be made accessible and attractive to professional, established investors. This can be accomplished by: educating capital markets about the investment opportunities in sustainable forestry; packaging and structuring these opportunities in ways which are easily understood and recognized by private sector investors; and by reducing risks and incremental costs specific to an emerging industry.
Engaging and educating capital markets
Before investors can be directed towards the forestry sector (and within this towards sustainable forest management), they need to be educated systematically about the opportunity in a credible way. Critical barriers to investment in sustainable forestry include a lack of key knowledge and reliable information. Furthermore, only in rare cases has sustainable forest management, or specific opportunities within the sector, been packaged from an investor's perspective; an analysis of business performance and financial returns of sustainable forestry enterprises is lacking.
Mitigating sector risks and emerging market risks
There are two general classes of business risk facing investors who may consider investing in sustainable forestry in developing countries: emerging sector risk and emerging market risk. Sustainable forest management as a sector is a new investment area, unfamiliar to most professional investors. Few businesses within the sector have a long track record of strong financial performance, which could be used as investment benchmarks for financial professionals. Addressing emerging sector risk requires new approaches. Several financial vehicles have been conceptualized or developed to direct capital to forest management enterprises and mitigate risks specific to a new business sector. These structures can serve as models for scaling up investment in sustainable forestry.
Many of the most promising investments in sustainable forestry are in developing countries, which often do not have well-established business and capital markets infrastructure. Investors' concerns are magnified by other conditions such as ill-defined property rights, currency risk, tax and tariff issues even though similar risks face any emerging market area. There are a suite of tools to manage these risks, which include political risk insurance, currency hedging and negotiated tax breaks.
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Defining sustainable forestry Considerable debate still surrounds the definition forestry. However, most of the controversy concerns the magnitude and depth of change required by the forest products industry to achieve sustainability. What most key players from the timber industry to environmental NGOs do agree on is that fundamental improvements are necessary to move conventional forest practices beyond the objective of a sustained yield (and even this is not yet the norm) towards sustainability. It is also generally agreed that, at present, the definition of sustainable forestry lacks scientific resolution. However, as changes to forest management are made, science will be able to study the results of the new practices and refine further our understanding of what constitutes sustainable forest management. New scientific knowledge can then be used to inform and improve forest management systems. This article considers financing mechanisms that currently fund, or could be adapted to fund, the capital needs of projects and enterprises along the sustainable forestry spectrum. Particular attention is paid to those forestry enterprises and initiatives which are practicing (or moving towards practicing) leading-edge ecosystem management. This involves forest management that consistently improves or maintains the productivity and health of the forests so that future generations can continue to benefit from the same array and quality of forest goods and services as the present generation. |
Funding the cost of internalizing environmental externalities
Any emerging sustainable industry encompasses the adoption of new practices and operations. In the case of sustainable forestry, these new business practices focus on increasing the efficient use and conservation of the forest ecosystem. Examples of these new practices include: baseline assessment of the biological diversity of the forest ecosystem to determine the economic value of all tree species and non-timber forest products; monitoring the impact of harvesting activities; using market-based instruments to structure economic incentives properly so that the environmental costs of commercial activity are minimized.
To incorporate sustainable practices, a business assumes additional incremental costs. Moreover, by adding costs, a business may experience lower returns initially, thereby reducing investors interest. Several approaches have been developed to address these challenges, most of which centre around subsidizing or offsetting the incremental costs of these new business practices. For example, forest certification is designed to define and differentiate forest products from sustainably managed forests so that consumers can select these products over non-certified offerings, even at a higher price. Another example is the use of public funds to subsidize the cost to private sustainable forest enterprises of biological diversity assessment, monitoring and economic valuation.
Funding the expense of moving capital to a new investment area
When beginning to invest in the sustainable forestry sector, private sector investors - whether investment fund managers or commercial banks - face several new costs of running their investment operations. The extra costs fall into three main categories: paying for deal flow identification; paying for project and investment preparation; paying for incremental management costs. These costs are difficult for investment managers to overcome and often this is the primary reason why investors shy away from new investment areas. In order to attract private capital to the sustainable forestry sector, these additional costs of placing and managing investments can be covered, at least in part, by public and concessional aid. Once sustainable forestry is scaled up to a commercial scale, these transaction costs will be lowered and can be integrated into the normal costs of managing investment funds.
The remainder of this article presents case-studies from around the world which illustrate best practices and lessons learned in moving capital towards sustainable forestry and similar sectors. The case-studies provide multidimensional examples of finance innovation that is, or could be, applied to sustainable forestry. The matrix shown in Table 1 provides the organizing structure for the case-studies considered in preparation of the full paper prepared for the Pretoria workshop: nine categories that correspond to three main types of financing public sector, private sector and mixed public/private; and three sources of financing - foreign, domestic and combined foreign/domestic, domestic. In this article, only selected case-studies related to private and mixed public and private funding are presented. For those related to public funding, the reader is referred to the full workshop paper.
Private financing from foreign sources
Market defining forestry funds: Xylem and The Forestland Group. (Source: Charles Collins, President, The Forestland Group, correspondence and personal communication.) The Forestland Group Xylem Investments Incorporated is an international timber investment management firm that makes private equity investments in international, publicly traded plantation-based forest companies. Xylem is the first company to be successful in attracting United States institutional forest land investors to forestry investment in emerging markets. Xylem manages approximately US$ 235 million in forest assets, comprising six timber equity investments across ten countries and 1.4 million ha of softwood and hardwood plantations that are managed on a sustained yield forestry plan.
TABLE 1. Matrix of financing mechanisms
|
Financing type (sector) |
Financing source or mechanism | ||
|
|
Foreign |
Domestic |
Combined foreign and domestic |
|
Public |
A |
B |
C |
|
|
· Bilateral ODA flows |
· Domestic public sources of finance and domestic public financial instruments used to promote sustainability |
· Sustainable enterprises funded through a mix of foreign and domestic public sources |
|
Private |
D |
E |
F |
|
|
· Foreign private institutional investment in sustainable enterprises and projects |
· Local debt/equity investments |
· Foreign and domestic private investment capital |
|
Mixed |
G |
H |
I |
|
|
· Mixed public and private investment funds |
· Domestic sources of public and private assistance used to finance sustainability |
· Foreign and domestic investment from public and private sources |
TABLE 2. Summary of case-studies
|
Financing type (sector) |
Financing source or mechanism |
||
|
Foreign |
Domestic |
Combined |
|
|
Public |
A |
B |
C |
|
|
· Sustainable Market Transformation Init. |
· Niger Household Energy Project |
· National environment funds |
|
Private |
D |
E |
F |
|
|
Xylem |
· O Boticario Foundation |
· Piqro |
|
Mixed |
G |
H |
I |
|
|
· GEFI/OPIC |
· Tax breaks for reforestation, Panama |
· IFC Biodiversity Enterprise Fund |
The fund is a good example of a sector-defining fund in that it is helping institutional investors, who do not generally invest in forestry in emerging markets, to become familiar with and invest in a new market opportunity. Furthermore, even though the fund is investing in a new area with new risk, many of the structures and features of the fund will be familiar to an institutional investor, so there is less perceived risk.
There is potential to extend many aspects of the Xylem model to sustainable forest management on a wider scale; however, when considering such an extension, one should be sure to recognize several important limitations. First, while Xylem does specify that investments are made in companies managing forests on the basis of a sustainable yield plan, it is unclear as to exactly what this means (i.e. how far towards overall sustainability the sustained yield is) and how rigorously such a plan is implemented. Second, this may not be a feasible approach in developing countries where there is no stock market.
The Forestland Group (TFG) is a second example of a dedicated sector-specific fund focused on forestry. Unlike Xylem, a central aspect of TFG is that it focuses on natural forest lands which are, or can be, managed in very long-rotation sustainable harvesting regimes. TFG's investment strategy focuses on natural and regenerated hardwood and pine forests, believed to be undervalued emphasizing properties where biological growth can result in dramatic increases in value as timber moves into higher product classes.
TFG represents a good model to copy to developing country markets. However, it is noteworthy that in order to market itself successfully, the fund had to downplay many of its environmental attributes and emphasize returns and profitability. For example, originally the management company was called Heartland Group, but this was perceived as too "green" and was renamed The Forestland Group.
Private financing from domestic sources
Internalizing environmental externalities: O. Boticario Foundation for the Protection of Nature, Brazil. (Source: O Boticario Foundation Staff.) O Boticario is a Brazilian perfume and beauty care company founded in 1977. It has 1100 franchise stores throughout Brazil and more than 30 shops outside Brazil (e.g. in England and Chile). In 1990, O Boticario's interests led to the creation of O Boticario Foundation for the Protection of Nature (FPN), a non-profit foundation whose objective is the conservation of Brazil's natural resources.
O Boticario contributes 5 percent of its net profits to FPN, with additional funding for the foundation coming from other private Brazilian donors. On average, FPN makes grants totalling US$ 200000 annually. Typical recipients of grants are universities and other academic institutions, research institutes and scientific organizations and environmental groups as well as other NGOs. Grant proposals are reviewed by a team of outside consultants, all of whom are experts in diverse scientific areas and ecosystem management.
The O Boticario Foundation is:
· the first corporate foundation of its kind in Brazil to support environmental conservation;· a new source of conservation funds and a corporation whose products and basic business operations and revenues are dependent on the protection of natural resources and the genetic base of biological diversity (in this sense, O Boticario is investing in its own long-term commercial survival).
The Government of Brazil created an incentive, albeit small, to get the private sector to invest in conservation, and O Boticario has proved that the private sector can collaborate with environmental groups and draw on the expertise of scientists to assist in identifying the most critical and important areas in which to intervene.
The potential for replication is good. In any (developing) country, a timber company's profits and operations are dependent on the extraction of natural resources and the continued existence of those resources. Governments can work with these operators both to support ongoing private sector conservation and to encourage additional activities. Incentives provided could range from tax breaks for to set up wildlife reserves or buffer zones adjacent to logging operations to creating tax breaks or export subsidies to timber operators that log according to sustainable practices.
The Environmental Protection Bank, SA: Poland. The Environmental Protection Bank SA (Bank Ochrony Srodowiska- BOS), whose founder and primary shareholder is the National Fund, is among the 20 largest commercial banks in Poland. The bank's innovation is in its provision of "soft" financing for projects, although it remains a "universal bank" with a full range of traditional banking services. During 1995, BOS provided approximately US$ 190.6 million worth of loans of which 55.6 percent were for ecological projects. This level of lending represents a 75 percent growth from the previous year.
BOS has been used as a model of innovative financing for the environment since its inception. A Chinese delegation has been referred to BOS by representatives of the United States EXIM Bank, and numerous other countries interested in improving the financing of their environmental sectors are examining the bank's structure and lending programmes. Although there have been recent allegations that the National Fund failed to apply the selection criteria laid out by its supervisory council in relation to the preferential interest rates on loans thereby facilitating the bank's financing of questionable projects - The lending model set by BOS should still be considered a positive and transferable innovation for environmental finance.
The bank's preferential lending model can also be considered as a means for channeling investment to sustainable forestry activities. Such a bank could set up a low-interest revolving credit fund for the up-front costs associated with the transition to sustainable management, including new business costs. National or regional forest policy objectives could be incorporated into lending criteria just as Poland's national objectives were used to help prioritize loan applications.
Private financing from combined foreign and domestic sources
Combining international domestic investment both to fund a sustainable operation and create vital market linkages: Piqro, Mexico. (Source: Juan Peon, Manage,; Piqro). Piqro, a laminated flooring manufacturer in Chetumal, Mexico, is an example of a company that showcases interesting foreign and domestic financing partnerships, and also of how sustainable forestry can lead to business advantages in the marketplace.
Piqro was created by the Mexican Government in 1989 as a state-owned company serving the regional flooring market. The company was sold to a local family business as part of privatization efforts in the early 1990s because it had failed to reach profitability under state management. Coincidentally, Piqro is located near the widely acclaimed Plan Forestal programme, a large sustainable forestry cooperative which was assisted by the German Agency for Technical Cooperation (GTZ) and which sells lumber and logs that have been certified by two international independent certifiers.
When Piqro was privatized, the new owners wanted to create export outlets for their products as a means of boosting revenues. To implement this plan they hired a general manager who had experience in natural products exports. As a result, Piqro started purchasing wood from Plan Forestal and marketing the first certified tropical hardwood flooring on the United States market. In the ensuing year, International Hardwood Flooring (IHF.), the largest tropical flooring importer for the United States market, negotiated to buy and distribute exclusively all of Piqro's export grade product and, in exchange for the exclusivity agreement, IHF agreed to make capital investments in bringing Piqro's manufacturing quality up to world class standards, essentially becoming a strategic partner ID Piqro's business.
In addition to bringing a foreign source of private capital into a domestic business concentrating on sustainably produced forest- raw materials, this example instructive in that it created a significant link to an export market. The general outlines of this example are widely replicable and, in fact, there are many other examples of a similar nature.
Mixed public and private financing
Mixed funding instruments provide public financing institutions with an opportunity to give leverage to and multiply capital moving into sustainable forestry. In the past, much of public sector funding in forestry in developing countries has been directed towards supporting forest conservation programmes and building the regulatory capacity of forestry ministries. The cases in this section illustrate an opportunity Which has received less attention: using public funds to attract private sector investments to sustainable forestry enterprises.
The Danish International Development Agency (DANIDA) helps to cover some costs of a Ghanian business making the transition to sustainable forestry. (Sources: DANIDA Project Document, Erik Albrechtsen, DLH, personal communication.) DANIDA, a bilateral aid agency, is involved in a project in Ghana the Gwira Banso Project - aimed at improving forest management in a threatened tropical forest area. While forest management practices are reasonably controlled within forest "reserves" (areas dedicated to production and subject to Forest Department standards and procedures), outside these areas practices ate very poor. The project's overall objective is to establish sustainable natural resource management in an off-reserve forest concession area as a basis for improved living conditions for local communities and long-term supplies to the timber industry. The project's strategy is to support a well-established large Danish timber trading company with progressive practices, Dalhoff-Larsen & Horneman A/S (DLH), in forging stronger trade links with one of its principal suppliers, Ghana Primewood Products Ltd (GAP), a wholly Ghanaian-owned company.
The following features of the project are worthy of note:
· it was initiated by a private company (DLH) wishing to ensure its long· term commercial interests and realizing that this requires forests to be managed sustainably;
· it establishes closer trade links between a buyer and seller of timber, allowing them to work more closely together and thereby probably decreasing their transaction costs and providing long-term security to GAP, which should in turn enable that company to make long-term investments in good forest management;
· public money from DANIDA is only being used in a two-year start-up phase;
· the project has potential for widescale replication in many countries.
Tax-exempt bond for public purpose forestry: Environmental Advantage, United States. (Source: Environmental Advantage.) In the last two decades, forestry management in the United States has become just as contentious as in many tropical forestry areas. A central problem is finding ways of managing forests which are in private hands and stocked with timber but which also have significant environmental or public values. Many environmental stewardship organizations and government agencies have expressed a strong desire to purchase these types of forest, but the resources for such a purchase simply do not exist in the public or environmental sector.
A solution being developed by Environmental Advantage, a tax-exempt bond for public purpose forestry, applies a conventional source of private sector funds to address the problem. In the United States there is a large market (worth more than US$ 200 billion per year) for long-term (10 to 50 years) tax-exempt bonds. The mechanisms of tax-exempt financing are as follows. The debt is purchased by the private sector institutional market because the rate of return is guaranteed by the United States Government and is also subsidized - the federal government lowers the interest rate on the bond to 2 to 4 percent below commercial sector rates.
Tax-exempt bonds have also been extended in the past into emerging environmental business areas, such as paying for the costs of building recycling centres and for the cost of adding deinking technology in the paper industry. With this precedent in mind, Environmental Advantage is extending the tax-exempt bond to be used for moving private forest land into more sustainable management. The rationale is threefold: i) the lower rate of interest is better matched to sustainable harvest rates than private debt or equity; ii) the length of the bonds (up to 50 years) is a better support of sustainable long-term management: and iii) the sustainable income-generating management of environmentally critical forests represents a public or common good, which qualifies it for tax-exempt status.
The mechanics are extremely simple. A stewardship-oriented non-profit entity issues a tax-exempt bond and buys the forest at a fair market value with the bond's proceeds. The debt is paid down over time by revenues generated from sustainable harvesting operations overseen by the nonprofit enterprise. At this time Environmental Advantage is evaluating initial transactions in three forestry regions of the country. A first deal using this new vehicle will probably be completed in the first half of 1997.
The innovations highlighted in this case are:
· A conventional financing instrument, i.e. tax-exempt financing will be applied to a new investment opportunity, i.e. sustainable forestry.· For the first time in the United States, sustainable forestry and non-profit stewardship organizations will be able to gain access to institutional capital for conservation objectives.
· The lower interest rates of tax-exempt financing allow harvesting to be conducted at or close to sustainable levels.
The potential for replication of this financing instrument (and its underlying concepts) in developing countries is very good. Of particular importance is that governments are able to structure their countries' financial systems in such a way that private capital can be attracted to invest In projects that have public value,
There is a significant funding gap for investment in sustainable forestry. The gap in funding for public and private investment in sustainable forest conservation and management is estimated to be US$ 67 billion per year. Closing this funding gap will require utilizing existing capital market vehicles which focus on the market opportunity in sustainable forestry. While government and private development entities have been dedicating resources to the development of new financial instruments to address sustainable forestry, the huge shifts in global capital markets in the last five years suggest that the main issue is not developing new financial instruments, but linking existing investment flows more directly to sustainability.
The private sector is the logical source of capital to meet the funding shortfall in moving towards sustainable forest management. By working together, the public sector and private capital markets could find new ways to close the funding gap. Particularly important is the identification of means by which public funds can give leverage to domestic and foreign private capital and then not just transfer capital to but also finance expertise for, developing countries.
Establishing links to capital markets and channeling capital into the new area of sustainable forestry investment requires the creation of capital markets infrastructure. Both financial and technical support needs to be directed towards building the financial sectors in developing countries to facilitate investment in this (and other) emerging opportunities. Potential investors need to be educated about the investment potential of this "newly emerging industrial sector" - in language with which they are familiar. Appropriate financing instruments need to be put in: place to channel investment. Applying or adapting existing financing instruments to this sector's opportunities is likely to be the most efficient way of financing it-rather than creating new untried and untested vehicles unfamiliar to investors. Examples of such vehicles are targeted early-stage venture capital funds or vector defining funds (offering equity, debt or both). The specific risks associated with this sector need to be identified and means found to mitigate them, perhaps through soft loan or grant elements (from public funds) attached to private sector loans or equity investments. Finally, investment needs to be made in all links in the "value chain", i.e. in forest management and harvesting operations, primary and secondary processing facilities and distribution and sales enterprises - to ensure that a viable and prosperous industry based on sustainable forest management is created and continues to grow.
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