June 29, 2009
Each successful forestry carbon project I have seen has the following two components. These components form the Rational Convergence business strategy model. They are:
Scientists will tell us that "land dictates the rules" of the project. This means that we must understand the land that encompasses our project and its surrounding locale by applying a complex systems approach. This means soil quality, biodiversity, watersheds, seasonality, hydrology, community needs, commercial needs, and regulatory needs all must be understood as integral components that change over time within the project's design concept. This implies that projects need to be flexible enough to be iterative and adaptively managed for unforeseen events. Frankly speaking, we only have the land we have, so we have to use the land we have for our carbon forestry project. The quality of the land will dictate the rules from which we design our project.
Local rural communities and their proxies will tell us that "we are the gatekeepers for this project". This means that we need to work within the local rural community when designing the carbon forestry project. In other words, if the local rural community hesitates to support the project, we may develop problems in the long-run as the project is implemented, monitored, and adjusted to meet future criteria. Local rural communities, instead of being seen as adversaries, should be seen as catalysts for project success. By appropriately engaging with the local rural communities through employment, knowledge dissemination, and synergistic feedback loops, the local rural community will eventually have a stake in ensuring project success, and hence mitigating project risk.
Government will tell us that we need to work within their existing legal frameworks to develop a carbon project. Yet sometimes these frameworks change over time and between administrations. Also there may exist different legal criteria at different levels of government, whether local, provincial, national and international. We need to seek coherence between all four legal levels seeking capacity development opportunities that engage government within their strengths. International "best-practices" are preferred since this may mitigate project legal risk long-term especially in the absence of sufficient local, provincial, and national laws. Finally, we find that the key to any successful project is clean and clear title registered with and acknowledged by the appropriate local, provincial, and national authorities. Sometimes, local, provincial, and national authorities will have different interpretations of land registration. By focusing on projects that initially have correctly registered land title that is approved of at jurisdiction levels, project risk is mitigated. Finally, any forestry carbon project is simply a legal transfer of timber rights or similar. Therefore, it is important to ensure that the landowner agrees in writing to the legal transfer of their timber (or forestry carbon) rights to third-parties. This is because any forestry carbon project is a legal transfer of carbon rights to the carbon credit buyer downstream, so we need to make sure that the buyer downstream has a "right" they can legally purchase and resell.
Businesses all worry about making money in this alternative asset class. Many individuals ask me "how many credits can I get from my land?" I always respond politely and suggest that maybe they may wish to ask "what quality of project can I develop?" Let me use an analogy to explain why I change the question. If I was starting an automobile manufacturing company today, would I ask how many cars can I sell or would I ask what quality of cars can I sell? The point is that the quality is a critical differentiator in this market. This is because a higher quality project will have less risk throughout its design, implementation, and monitoring timeframes. These timeframes can be long-term with some timeframes 100 years long. So let me now ask you a question. If you were going to build a widget that is supposed to last for 100 years, would you want to build a high quality widget that you would not have to fix time and time again or would you rather build a low quality widget that would always need to be fixed. In conclusion, by spending time strategically analyzing the quality of the credits that might be produced, the project owner will be mitigating their business risk.
Now we have described the four actors, so this is what we do next. We need to understand each actor's situational and psychological profile. This means we need to understand the following about each actor from a financial (which refers to the cash flow stream originating from carbon credit sales), community, and biodiversity perspective:
- Attitudes toward returns from the project
- Attitudes towards risks from the project
- Legal and regulatory concerns
- Tax implications
- Time horizons
- Liquidity concerns
- Unique project co-benefits
- Situational profile of each actor including whether they are cautious, methodical, individualistic, or spontaneous
If we apply the Rational Convergence model which includes clear and precise carbon accounting standards, compelling co-benefits, clean and clear legal title, and appropriate business strategy, we are able to design effective forestry projects by focusing on effective communication between the four actors. Let me first set the stage by showing you how forestry carbon credits are generated and then we can discuss effective communication.
The successful strategic approach to forest carbon project development has three stages. These stages include planning, screening, and implementation.
Planning: Each project is managed for aspects related to being real and measurable, permanent, demonstrate co-benefits, transparent and credible, clear and prior consent of owners, legal, minimize business risk, minimize sovereign risk, assurance of completion, marketable, and liquidity. (see slide 3)
Screening: Each project is screened for aspects related to legitimacy, legality, and rough mtCO2e estimate. Sometimes a project may be locally legitimate yet it may face illegitimacy claims from other sources. Various legal interpretations of laws at the four levels of jurisprudence – local, provincial, national, and international – can create confusion for the project owner. This is why we focus on the intersection between legality, legitimacy, and carbon credit estimate. This process needs to be managed appropriately during the screening stage. (see slide 4)
Generation of Forestry Carbon Credits
If we use the analogy of an assembly line, forestry carbon projects are generated in three stages with a different individual at each stage.
Raw Materials Sourcing: The first individual is the project owner who may be the landowner or may legally represent the landowner. The project owner needs to have clean and clear title to their land. This title needs to be registered with the appropriate authorities. The project owner also needs to have clear and prior consent to own and sell the carbon rights from the trees on their property. This land the project owner has title to needs to have had, has now, or will have trees on it to qualify for forestry carbon credits. Trees are perennial woody plants with one dominant sprout that increases in circumference due to secondary growth. They reach a minimum of 2 to 5 meters in height and need to have crown cover greater than 10% to 30% of the minimum land area to qualify as a forest. (see slide 6)
Generation: The second individual is the project developer. These are firms like MGM InternationalTM and all of our ‘coopetitors' in the forestry carbon industry. Coopetitors include scientists, verifiers, validators, and competitors who engage in forestry carbon project development, implementation, management, and monitoring. MGM InternationalTM and these firms assemble all the moving parts that are needed for high quality, long-lasting carbon credits. There are three styles of successful forestry carbon projects. First, we can grow trees more rapidly than before. This is called afforestation, reforestation and revegetation (ARR) and improved forest management (IFM). Second, we can choose to not cut trees. This is called avoided deforestation (AD) and reducing emissions from deforestation and degradation (REDD). Third, we can use timber as structural component in the built environment. This is called long-lived wood products (LLWP). (see slide 7)
Sales: The final individual is the carbon credit buyer or end user of the forestry carbon credits. These buyers have five reasons to purchase credits. They purchase credits for compliance, pre-compliance, investing, carbon neutral products offsetting, and public relations reasons. Buyers currently making purchases in the market include corporations, lending institutions, funds, private investors, governmental agencies, high net worth individuals, and LLCs. (see slide 8)
This is the forestry carbon credit assembly line. Applying this simple three-step business model clarifies the roles each individual has in the forestry carbon markets.
Trees Eat Carbon
Businesses, whether for-profit or not-for-profit, need revenue generated from their activities to be a going concern. This means they need income to pay their bills and employees. This income allows them to stay in business. In a forestry carbon project, this revenue comes from the sale of carbon credits. Carbon credits accrue when the land owner or project owner changes her behavior and no longer follows a business-as-usual scenario. To qualify this change in behavior, the project owner needs to pass an additionality test. Then forestry carbon credits can be generated from the difference in carbon sequestration between the new behavior and the old behavior. Behavior change can be one of the three following types:
- Growing trees where trees didn't grow previously
- Not cutting trees where trees were being cut previously
- Using timber in as a structural element for the built environment
Forestry Carbon: Alternative Asset Class for Financial Investors
Forestry carbon is an alternative asset class for financial investors. Individuals and institutions who have an appropriate risk appetite can invest in forestry carbon projects as first stage funders, second stage funders, and purchasers of credits. Modern Portfolio Theory (MPT) tells us how rational investors, with a proper understanding of asset integration, risk aversion, and rational expectations, can use diversification of their assets to optimize their portfolios if they understand how to price their assets. Since we argued earlier that forestry carbon assets are simply a version of timber rights, we can easily apply MPT to our forestry carbon projects. Of course, we need to intrinsically understand that climate change is an emotional debate, yet a rational solution focusing on improving forestry asset returns by developing a carbon cash flow stream may engage the general investing public and their institutions in developing forestry carbon projects. This is because simply – "I can sometimes make more money from forestry carbon cash flows than from cash flows were this carbon is emitted into the atmosphere". For this statement to be true, we must correctly understand the risk and return profiles of our forestry carbon assets.
Bringing it all Together: Effective Communication
Now let's bring it all together. We emit carbon dioxide when we drive, heat our homes, and fly to visit out-of-town family. This carbon dioxide is increasing in the atmosphere causing global climatic disruption. Yet trees can eat this excess carbon dioxide and in exchange they then emit water and oxygen and provide biodiversity and community ecosystem services. We can create carbon credits from the carbon dioxide consumed by these trees if there is a behavioral change called additionality. This means property owners and their proxies can make money from selling carbon credits generated from three behavior changes. These three behavior changes are growing trees, not cutting trees, and using timber in the built environment. Project developers and their coopetitors generate these credits for landowners and their proxies and then they sell these credits to a long list of institutional and individual buyers. These investments are a new alternative asset class called forestry carbon with its unique risk and return profiles depending on the quality of the forestry carbon project. Folks in the US need to understand that carbon forestry projects are simply another legal right that can be transferred and sold with the higher quality "rights" making more money when sold. Forestry carbon projects properly managed apply a strategy called Rational Convergence. When forestry projects are properly managed, they can develop into a significant cash flow for local rural landowners and communities.
Gabriel Thoumi is Sr. Business Development Manager for MGM International, a global carbon trading, advisory, and project development firm, and a graduate from the Erb Institute for Global Sustainable Enterprise at the University of Michigan. The views expressed in this article represent Gabriel's professional opinions.
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