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Climate change: throwing the carbon sink at the problem

05 March 2007

While the Government’s climate change policy framework currently has few specific policies, one sector where concrete policy has emerged is forestry. With the Permanent Forest Sink Initiative (PFSI) scheduled to commence on 1 January 2008, the release of a MAF Discussion Document on further details of the PFSI imminent, and public debate over the Government’s forestry policy heating up, we offer a review of the current PFSI proposals and what they mean for landowners and business.

This issue of Counsel is the third in a series of articles on climate change policy.

What is the PFSI?

Growing forests are termed forest or carbon "sinks" because of their ability to convert CO2 absorbed from the atmosphere into carbon, which is then sequestered in the form of wood and soil organic matter.

Under the PFSI, the Government will reward those who establish new permanent forests with tradable Kyoto Protocol (Kyoto) compliant "emission units" (generally known as carbon credits). A key feature of the PFSI is that the Government itself will not claim the benefit of these credits to offset New Zealand’s liability under Kyoto. Emission units issued under the PFSI will be an internationally recognised commodity that the holder of the units will be free to trade to whomever they choose, both nationally and internationally.

How will the PFSI work?

Landowners will be awarded emission units based on the increase in the carbon stock during the commitment period, not the total carbon stock at the end of 2012.

While units will not be transferred to landowners until the amount of increased CO2 stored in the forest has been verified, landowners will be able to trade "forward" by selling their credits in advance. While the Kyoto rules have only been negotiated internationally for the first commitment period, under the PFSI, landowners will have rights to emission units beyond 2012 if allowed under future Kyoto rules.

Critically, much of the detail of how the PFSI will operate is currently being developed by the Government, and MAF is due to release shortly a discussion document on proposed regulations to govern the operation of the PFSI. Regulations are currently scheduled to be enacted around July this year.

Emission units are tradable rights to emit greenhouse gases and are the currency under the Kyoto Protocol. An emission unit is equivalent to one tonne of CO2 (or its equivalent in other greenhouse gases) which would otherwise have been emitted into the atmosphere.

The term ‘greenhouse gases’ primarily captures water vapour, carbon dioxide (CO2), methane (CH4) and nitrous oxide (N2O). Greenhouse gas emissions are generally converted into CO2 equivalent for ease of comparison. This Counsel uses ‘CO2’ as a shortened form CO2 equivalent for simplicity.

Which forests will qualify for the PFSI?

Debate has raged over the last few months over eligibility for emission units for forest sinks in New Zealand, with the Government accused of being "carbon thieves" and nationalising forest owners’ property rights (that is, their right to carbon credits).

Is this criticism justified?

There are two key points to understanding which forests qualify for credits under Kyoto, and which do not:

  1. Kyoto only recognises as forest sinks land that was not covered by forest on 31 December 1989. It is only the carbon sequestered post-1990 that can offset emissions post-1990, and therefore be eligible for credits under Kyoto.
  2. Kyoto further requires that the forest must be "directly human induced". While this means some form of active management in establishing the forest will be required, it is likely that actions such as the promotion of natural seed sources – for example, by allowing land to revert back to scrub, and eventually turn into PFSI-compliant forest – will be sufficiently "human induced".

In addition to these international rules, the PFSI imposes a further eligibility criteria. Only those exotic forests established on Kyoto-compliant land after 17 October 2002 (being the date the PFSI was announced by the Government), and indigenous Kyoto-compliant forests established after 1 January 1990, will be eligible to enter the PFSI and to receive emission units.

The Government has taken the view that to issue credits to owners of exotic forests planted before 17 October 2002 would mean a windfall to such forest owners, at the potential expense of an increase in New Zealand’s liability under Kyoto. As the Minister of Agriculture and Fisheries, Hon Jim Anderton, noted, devolving credits for trees already planted would, in the Government’s view, create a $1.24 billion windfall at the expense of ordinary taxpayers, with no increase in carbon storage.1

A forest is defined under the Kyoto Protocol as exceeding one hectare, greater than 30 metres wide, and containing species capable of reaching five metres or more in height at maturity and greater than 30 percent crown cover of the site. Eligibility will have to be determined on a case-by-case basis in some areas, such as mixed scrub and pasture.

What are forest owners’ liabilities under the PFSI?

  • Landowners will need to agree with the administrators of the PFSI a management plan, including the actions they propose to establish the forest.
  • The rights and obligations of landowners and the Crown under the initiative will also need to be formalised in a forest sink covenant between landowners and the Crown.
  • The covenant will be registered against the title to the land, and will run with the land, binding all future landowners.
  • Harvesting will be permitted on a "continuous canopy basis", allowing an estimated 20% of the trees to be removed.
  • The forest must be allowed to recover before a further 20% is harvested.
  • Clear-felling of the forest will be prohibited and will incur penalty payments.
  • Carbon lost by "natural" and/or "unnatural" causes, including harvesting, fire or wind throw must be replaced by landowners. Every emission unit generated will create an equal contingent liability, which will crystallise at the end of 2012 if the level of carbon sequestered in the forest has decreased for any reason.
  • Replacement of emission units is likely to involve the landowner paying the monetary value of the carbon deemed to be released from the trees.
  • All harvesting restrictions will be lifted after 99 years.
  • Landowners will need to meet all costs associated with generating the emission units – for example, the costs of ongoing forest monitoring and verification of sequestration rates.
  • PFSI participants will need to establish an account with the New Zealand Emission Unit Register (NZEUR) to hold and trade the Kyoto-compliant emission units.
  • Development of the electronic register, another of the country’s Kyoto obligations, is underway. More information about the NZEUR can be found at www.nzeur.govt.nz.

What are the implications for landowners and forest owners?

With the introduction of the PFSI, "carbon farming" is now a potentially viable commercial opportunity for landowners and forestry investors. It is important though to understand the implications, including potential risks, of the PFSI.

Forest sinks are a long-term commitment

Investing in the development of carbon sinks carries long-term risks. To some extent, this is inherent in any forestry investment – trees take time to grow, and unless cutting rights are sold in advance, substantial revenues do not accrue until the forest has matured.

Forest sinks are a little different. Revenue will be generated in the short to medium term as carbon credits are verified and registered – and this will commence as soon as forests are established. But under the PFSI, liability for replacement obligations (whether due to harvesting, fire, wind throw or other deliberate or accidental acts) rests with the landowner for 99 years. In most instances, this will be longer than the capacity for the trees to generate credits (and therefore revenue) from carbon sequestration.

Landowners will need to ensure that appropriate financial provision is made to cover this long-term risk. Insurance is likely to be important in offsetting this risk, but carrying insurance for 99 years comes with a cost. Off-loading this risk to purchasers of the carbon credits is likely to be of little value in the long term, as the likelihood of the purchaser of a carbon credit in, say, year five of a forest sink venture still being around to carry the financial burden of a replacement obligation in year 85 is remote.

Price discovery – who will buy the credits?

There is currently no global exchange for carbon credits generated from forest sinks. Forest sink credits are unable to be sold into the European Union Emission Trading Scheme, currently the most developed and liquid market for emissions and carbon financial instruments. Voluntary and other such "grey" markets are emerging, but in the absence of a globally integrated market for emissions and other carbon financial instruments, full price discovery and access to a liquid market for forest sink credits will be difficult.

It is likely that, in the short term at least, much trading will continue to occur by way of private treaty – the purchasers being countries (including New Zealand) that have an emissions liability under the Kyoto Protocol, or New Zealand and overseas companies that find themselves subject to a liability under an emissions cap or by companies that want to enhance their climate change credentials by acquiring forest sink credits to reduce their "carbon footprint".

The NZX is currently exploring the creation of a market platform on which emission units can be freely traded, much in the same way as markets for commodities such as oil, gold and currency operate. The New Zealand Government has already signalled a preference for price-based climate change initiatives, and the creation of such a commodity market would make a significant contribution to the efficient adoption of the Government’s policy initiatives on climate change.

Emissions trading exchanges

The creation of emission units begs the question, where can you trade them? Currently New Zealand has a nascent carbon market, although this is likely to change. NZX is exploring the feasibility of establishing a market and the Government has signalled support for private sector initiatives to establish a local carbon exchange. Crown Research Institute Landcare Research currently operates a voluntary exchange, EBEX21, where registered landowners with regenerating scrubland are paid with credits which can then be bought by companies wanting to be carbon neutral.

Already there have been several substantial sales of emission units by New Zealand entities to overseas purchasers. British Gas will pay Christchurch City Council $3 million between 2008 and 2012 for credits awarded by the Government in 2004 for the capture and transport of methane gas from the closed Burwood Landfill to heat and power the QEII Park sports facility.

Meridian Energy sold emission units gained from its wind farms activities to the Dutch Government in 2003 and HSBC in 2005.

By comparison Europe and the US have relatively well-developed carbon markets. In 2003, US corporations began voluntarily trading greenhouse gas emission allowances on the Chicago Climate Exchange. The EU ETS, set up in 2005, is now the largest multi-national, greenhouse gas emissions trading scheme in the world. All 25-member states of the European Union participate in the scheme, which covers nearly half of the EU’s total CO2 emissions.2

In the first nine months of 2006, the global carbon market grew to nearly $22 billion, more than doubling in value over the almost $11 billion recorded in 2005.3 The EU ETS dominated the global carbon market in terms of value, accounting for nearly US$19 billion of the total market worth.4

Risk of change in government policy

To some extent, changes in government policy are an inherent risk of doing business. However, as the future of the Kyoto Protocol post-2012 is unclear (as the international rules are yet to be negotiated), investing in the generation of forest sink credits that will largely accumulate post-2012 carries the risk that the credits will not be recognised, or cannot be widely traded either domestically or internationally, under whatever rules exist post 2012.

Given the momentum of government and public support around the world for climate change initiatives, it is likely that the future will be Kyoto-like. However, until the post-2012 rules are negotiated and agreed at an international level, investing in a forest sink is a leap of faith.

The profitability of a forest sink as a business venture will vary with site quality

The commercial viability of the establishment of a forest sink will vary depending on a number of factors, including site quality (e.g. soil quality and climate), location and accessibility, and the carbon sequestration potential of the tree species comprising the forest – certain tree species (generally hardwood species) will sequester more carbon than softer wood species. Crucial too will be the current and future value of carbon credits, and the long-term costs that landowners may face once the generation of further carbon credits from the forest has long since declined. This will be true for many industries in the future, with the "carbon cost" potentially a significant part of many commercial activities.

Landowners will need to consider all these factors, and weigh up the viability of a forest sink against alternative land use, such as farming.

Potential for incidental environmental benefits to be recognised

It is possible that in the future environmental benefits that have directly resulted from the establishment and/or management of forests and related activities, including the enhancement of biodiversity, soil improvement, the conservation of native vegetation and the conservation of water catchment areas, will be recognised as having an wider economic value for which the person creating the benefits is entitled to a financial reward. This could potentially provide further returns to developers of forest sinks.

This could be in the form of a tax credit, or potentially even a tradable credit, much the same as forest sink credits. However any such environmental "credits" are likely to be recognised only on a local or national basis, rather than at an international level.

PFSI timeline – key dates

Much of the detail of the PFSI discussed in this Counsel will be developed and enacted through regulations. MAF’s timeline for developing the PFSI is:

  • February 2007 – Guide to eligibility of land available on the PFSI website (www.maf.govt.nz/forestry/pfsi) and consultation document for the regulations and cost recovery provisions released
  • March 2007 – Submissions on the consultation document close
  • July 2007 – Regulations scheduled to be approved. MAF’s Indigenous Forestry Unit will then be able to approve PFSI applications
  • January 2008 – start of the first Kyoto commitment period.


Footnotes

1 Hon Jim Anderton, Press release, 14 February 2007.
2 EU emissions trading - an open scheme promoting global innovation, European Commission, September 2005, 7. The first trading period under the EU ETS (2005-2007) covers only CO2 emissions from large emitters in certain sectors. The addition to the scheme of other sectors and more greenhouse gases is currently being considered.
3 The World Bank and the International Emissions Trading Association, State of the Carbon Market Report Update (October 2006)
4 Ibid 5.

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