Will Forest Carbon Markets Thrive, or Get Lost in the Woods?
For thousands of years, we have been planting and growing trees without difficulty. It’s simple, and forest carbon business strategy can be, too. In fact, it’s core to what I’m trying to teach the MBA/MS students in my course at the Erb Institute this semester: If the world’s best available technology for removing carbon dioxide from the atmosphere is employing the natural photosynthetic capacity of natural forest management, we can too.
But in many ways, we are all unable to see the forests for the trees.
Even though the global carbon market grew to $136 billion with 8.3 billion tons of carbon dioxide traded in 2009, less than 0.1 percent of that was based on removing existing carbon dioxide out of the atmosphere using photosynthesis. While it is very important to engage in developing a low-carbon economy, it is equally important to remove existing carbon dioxide out of the atmosphere, especially since this is, in fact, a key to mitigating climate change.
Rainforest in Borneo (April 2008). Photo by Rhett A. Butler
Forest carbon offset projects — whether planting trees, improving harvesting techniques, or not cutting trees — have some unique characteristics that may make these assets a unique investment asset class. Investors can make debt and equity investments in forest carbon offset companies while they can also invest in spot and forward transactions of the mtCO2e produced by these forest carbon offset projects.
According to the Department of Energy, U.S. demand alone for forest carbon offsets could grow at least 100 times by 2020 (PDF), depending on the scenario. And although forest carbon offsets are emerging as a new alternative investment asset class, the market has been stagnant for the past several years.
What can be done to avoid market failure while promoting rapid market growth?
Limit Risky Business
Overall the risks in the sector are long-date project finance risk, such as currency convertibility, expropriation, political risk, climate change risk, local community risk, and model risk.
These risks are framed by the various investment options available from which to garner forest carbon offset asset returns, including venture capital investment in LLCs, private placement and public equity, sovereign and municipal debt, commercial lending, long-dated options on tons from sequestration, and direct sales to institutional and retail sectors. The sector has specific legal and regulatory risks framed within fee simple property ownership within timberlands, private ownership, and community forests.
In this model, often a sale or investment in forest carbon offset assets becomes a first lien on the property as a risk mitigation tool against project non-performance or malfeasance.
It is, of course, recommended that all project proponents conduct independent title search on water, timber, oil and gas, mineral, and development rights coupled with a specific understanding of the conversation around sub-national and national project rights within the growing forest carbon partnership facility, United Nations Forum on Forests, UN REDD, and other international regulatory pre-compliance and compliance frameworks.
Taxes within a forest carbon project currently are uncertain and realized as professional services contracts as ordinary taxes. Yet it is expected that long-dated investments will eventually by realized as capital gains.
If the forest carbon offset assets become a first lien on a property or property is transferred within the time frame of a long-dated investment, wealth transfer and property transfer taxes may be applied. Forest carbon offset assets are generally considered illiquid with transactions usually taking two or three months of due diligence and negotiation.
Forest carbon project risk mitigation needs to employ applying credit ratings so that the credit markets can fund projects. In 2009, the global credit markets (global bond markets) were $83 trillion (PDF) while the global forest carbon markets were roughly $40 million.
If project developers decide to use a traditional project finance platform to develop their projects by mimicking the global credit markets, scalability and climate change risk mitigation is possible! Furthermore, project developers should also apply to use the project insurance tools that are available to manage currency convertibility, expropriation, political risk, and project risk.
The forest carbon offset asset sector needs our institutional financial services sector to provide us with the capacity to obtain credit ratings, financial insurance, along with transparent financial accounting guidelines from the Financial Accounting Standards Board so as to increase transparency and minimize financial risk. With less financial risk, more investments in this sector can occur — further mitigating climate change.
Be Financially Transparent
Currently, project developers can recognize their assets on- and off-balance sheet as intangible assets, on-balance sheet as inventory, and possibly as a deferred asset.
Given that transparency is a key aspect of mitigating climate change while engaging the business sector, I would gently suggest that it would be appropriate to engage in further analysis and research resulting in clear financial accounting guidelines for forest carbon offset assets if the market will indeed increase by 100 times within the next 10 years.
This lack of financial accounting transparency decreases the investability of this sector as an investment grade asset. Currently, it is not yet possible to receive a credit rating on a forest carbon offset asset investment or sale. Therefore, the market scale for investments and sales is stuck in the speculative space, with too many good projects fighting for too little money, resulting in an inability for projects to be sold to large institutional investors because of a lack of a credit rating or financial accounting transparency.
Organizations and individuals in this sector simply need to choose their skill set within a trans-disciplinary framework, not a multi-disciplinary framework. Masquerading occurs when NGOs act as bankers and bankers act as foresters.
Examples of this include:
- NGOs masquerading as financiers on Wall Street
- Financiers masquerading as biologists and foresters
- Standards masquerading as insurers
This masquerading issue begs the question, where on the continuum between conscience and commerce is an organization’s core competency?
Organizations need to focus on one core competency in this spectrum so that we can actively develop an alternative investment asset class that allows for sustainable economic development and biodiversity maintenance and improvement while providing for the development of the best available control technology for mitigating climate change — photosynthesis.
The forest carbon offset asset market will not grow without clear participation from the financial markets on:
- Insurance and reinsurance
- Credit ratings and contractual recourse
- Forest carbon offsets address both GHG emissions and ecosystem services
- Uniform financial accounting
Without these clear guidelines from the institutional finance sector, forest carbon offsets assets will not grow into their alternative investment asset class and the market will continue to stagnate and fail while the rest of the carbon markets continue to grow.
Next year, I would much rather write about how the forest carbon markets in 2010 grew to more than $500 million in value and was on track to making a significant contribution to mitigating climate change, providing sustainable local economic development opportunities and conserving biodiversity, rather than writing again about market failure and stagnation.
Gabriel Thoumi is a consultant with Forest Carbon Offsets, LLC and is a lecturer at the Ross School of Business at the University of Michigan on impact investing and forest carbon business strategy.
This post was published originally at GreenBiz.com. It has been posted with the permission of the author and GreenBiz.com.