Real options analysis of forestry management under carbon credit payments

Abstract

As a ratifying nation, New Zealand is certain to be affected significantly if the Kyoto Protocol enters into force. Under the Protocol, forest sinks would earn tradable emission units, carbon credits, in exchange for sequestering harmful carbon dioxide, thus providing an incentive to enhance sinks. However, the domestic institutional arrangements for the allocation of credits are yet to be finalized, despite the first commitment period being less than five years away. With the inclusion of forest sinks in the Protocol, many have suggested that New Zealand forest owners (who are predicted to be net sellers of credits, and enjoy a comparative advantage in quick-growing species such as P. Radiata) will be winners. Yet, little has been done to examine the effect carbon credit payments may have on the investment decisions of New Zealand growers. In this study we introduce three possible schemes for allocating carbon credits: one where credits are allocated according to the annual flow of carbon, another where annual credits are proportional to the stock of carbon, and a third where the credit endowment is a one-off lump-sum payment. Using a Real Options framework, we examine the effect of payments under these schemes on the timing of harvest, the likelihood of replanting and abandonment, and the present value of a generic New Zealand forest, under uncertainty in timber prices. We find that the flows and stock schemes yield very similar outcomes for growers, and under these regimes forests are unambiguously harvested later. The effect on the timing of harvest is ambiguous under the lump-sum scheme, however the Kyoto obligations imposed by this regime erode the option value of abandonment. Furthermore, carbon credit payments distort wood production by lowering the intrinsic value of timber. Forest owners will prefer the lump-sum scheme as it creates the least distortion in wood production, thus yielding the highest forest values, whereas the flow scheme is the least preferred as it creates the greatest distortions. In contrast, the government will prefer most the flows scheme, as it is the least costly to implement, and the lump-sum scheme is the least preferred. Hence, there is potential for a misalignment of preferences.