If you think forests are only about construction products, think again. Timberland investing has changed and in today’s market requires a differentiated approach to investing, one that includes the kind of climate-smart forestry that creates value for investors, stores carbon and helps mitigate the impact of climate change. Bettina von Hagen, co-founder and CEO of Ecotrust Forest Management explains.
You are an advocate of timberland investing for the 21st century. How has timberland investment changed during this new century?
Financial investing in forests really started about 35 years ago when ERISA rules were relaxed and pension funds were able to invest more broadly, and institutional investors began investing in forestland. Given the limited investors and knowledge of the asset class, returns from timberland investing were around 20 percent that first decade. As the number of investors increased and the market realized the benefits of the asset class, those investment returns have declined. During the past decade, NCREIF, which is the financial benchmark for forestland investing, has reflected about a 5 percent return.
Forestland is still a great investment — it’s a hedge against inflation and a portfolio diversifier, among other attributes. However, with declining returns from conventional management approaches that are exclusively focused on timber production, the new innovation is to invest in the full array of products and services forests offer. These include new products like biofuel and biochar to ecosystem services such as carbon storage, habitat, water protection to the growing demand for recreation and scenic values. There are emerging tools to monetize these new services and benefits for investors, such as carbon credits, conservation and recreational easements, and mitigation payments. In a carbon-constrained world with a growing population and shrinking resources, this new approach to forestland investing can meet investor needs while actively addressing climate change, biodiversity loss, and water scarcity.
What is climate-smart forestry?
Climate-smart forestry is an innovative investment approach to forestland investment and management that monetizes the full attributes of the forest, not just the timber aspect, while improving the forests, biodiversity, resilience and carbon storage capability. There is a growing public recognition that natural intact forest ecosystems across the globe need significant protection and investment in the face of climate change. By increasing the amount of carbon being sequestered by forests, climate-smart forestry can not only directly address climate-change mitigation goals, it can play a significant role as a carbon and financial hedge in an investor’s portfolio.
What are the broader attributes of the forest that serve investors’ priorities?
Forests produce a wide variety of important goods and services. The primary product that usually springs to mind is wood for building materials, which fulfills a basic human need. From an investor’s perspective, investing in a fundamental need lowers risk. While the level of demand — for example, expressed in housing starts — may fluctuate from year to year, building products are a basic need that will never go out of fashion.
The beauty of forestland investing, especially in natural forests, is that the primary source of value creation is the biological growth of forests, and this growth comes from free inputs — sunlight, water and soil nutrients. Depending on the productivity of the forest, biological growth can contribute a 3 percent to 8 percent annual increase in inventory. The other great advantage of forests from an investment perspective is the capacity of forests to store value “on the stump.” Unlike farming and ranching, where producers are dependent on annual commodity markets, trees do not have to be harvested annually and instead harvests can be timed to good markets. In addition, while the trees are waiting, they continue to add value through growth, expressed both as an increase in volume and an improvement in value as larger trees generally contain more valuable wood. Forests can wait patiently through market downturns, trade wars and elections, with low holding costs providing additional flexibility. In addition to providing building materials and pulp and paper, forests play very important roles in carbon storage, water provision, habitat for millions of species, and soil formation, as well as recreation, foraging, hunting and scenic values.
From an investment perspective, the question is: How can these values be monetized for forestland owners and investors?
Let’s take carbon storage as an example. There are a number of regulatory and voluntary carbon markets. California has one of the largest, a cap-and-trade regulatory system that places a cap on emissions and reduces that cap over time. To meet the cap, manufacturing plants, utilities and other emitting entities have a couple of options to reduce emissions. They can make investments in their own plant or facilities, they can buy allowances from other regulated entities, or they can — and this is where forests come in — buy offsets from forests that are storing carbon above and beyond usual practices. The forest owner then enters into a 100-year contract or obligation to store carbon to offset the emissions from the entity that is under the cap. The value of a ton of CO2 has been increasing over time, with a current price of around $18 per ton, which is expected to continue to rise. From an investor’s perspective, the forest owner now has two products to sell, timber or carbon under the cap-and-trade market.
What kind of timeline or hold period should investors expect?
Forestland investing typically requires a long hold period relative to most other asset classes and investors have several options to gain exposure to forestland investments. Investors may hold forestland properties directly and then the hold period is determined by their length of ownership. More commonly, if they are investing through a pooled vehicle, these are typically structured similar to private equity funds that have 10- to 12-year hold periods. This structure allows investors to benefit from the biological growth of trees that can translate to capital appreciation. Forests can grow anywhere between 3 percent to 8 percent per year, depending on the species and geography. These longer-term pooled vehicles also provide the opportunity for forestry investment managers to complete the sale of easements — for example, to retire development rights or to commit to certain forestry practices — to provide perpetual protection of forests while creating cash flow for investors, to develop carbon projects and/or harvest merchantable timber.
There is also an increasing recognition of the need to hold forestry investments in perpetuity and increasing investor appetite for evergreen fund structures or emerging corporate structures that allow for longer term ownership. Certain investors who can allocate to pooled funds for longer periods will benefit from, and can realize the value of, complete rotation cycles in forests from when a tree is planted to harvested. These structures also allow managers to invest in innovative, longer-term projects or entice processing facilities to locate near their forests, giving them the opportunity to monetize future opportunities such as biomass to create jet fuel or other bio-based plastics.
What about the massive forest fires around the world?
The catastrophic forest fires are a signal that something is seriously wrong with the health of our forests, and it is not just the changing climate. Forest degradation and fragmentation, with the resulting changes to species composition and forest structure, are a significant factor. If you then add houses, utility lines and other structures pushing ever deeper into the forest, you have additional sources of fire ignition. Finally, and paradoxically, fire suppression in fire-adapted forests, such as the forests of the western United States and Australia, builds up fuels and creates the conditions for catastrophic fires. After decades of fire suppression and changes in forest composition to tree species that are not adapted to fire, a lightning strike or abandoned campfire can turn into a catastrophic fire consuming hundreds of thousands of acres. If you then add a warming climate with the resulting lower moisture content and erratic weather patterns, you get the result we are seeing in the news repeatedly — more fires, bigger fires and an extended fire season.
We can and should address this challenge vigorously through a number of strategies: First, we should limit further fragmentation, development and sources of ignition — such as powerlines — in intact forests. Second, we should address forest health by thinning overcrowded stands, replanting and favoring fire-adapted species such as Ponderosa Pine, and addressing slash piles left behind by logging operations. Third, we should address fire risk at a landscape scale, recognizing that fire doesn’t respect landowner boundaries. We need regional-scale plans, which include adding wood processing capacity to appropriately thin forests and create fuel breaks where needed.
This kind of approach can create new investment opportunities to reinvigorate not only stagnating forests but also create a new forest industry focused on the whole array of forest products and services and with forest health at its core. Investing in fire risk reduction cannot only restore forest health but also bring new vitality to many rural communities through job and enterprise creation.
In tropical rainforest countries, carbon has been an important financing strategy to protect intact forests. In Colombia, for example, a tax on petroleum products has created a mechanism to invest tax revenues in forest protection and restoration. This program is generating hundreds of millions of dollars in carbon revenues, protecting hundreds of thousands of acres of forest, storing millions of tons of carbon, and attracting significant domestic and international investment. California is also using carbon financing to protect and restore forests; hundreds of millions of dollars secured through the sale of carbon auction revenues are being directed to communities to restore forests and reduce fire risk.
What role can forests play with respect to climate change?
Forests account for 92 percent of all terrestrial biomass globally, storing approximately 400 billion tons of carbon. As a point of reference, current annual global carbon emissions are 10 billion tons, primarily from burning fossil fuels. Forests are unique in that they can be both a source of emissions and a carbon sink. As trees grow, they absorb carbon dioxide through photosynthesis, releasing oxygen and storing carbon in their trunks, branches, leaves and roots. For example, in Oregon, net carbon sequestration from forests offsets about half of the fossil fuel emissions in the state.
Fortunately, there are significant actions we can take to reduce catastrophic fires and significantly increase the carbon that forests sequester. One widely cited study estimates that forests and other natural ecosystems could provide more than one-third of the total CO2 reductions required to keep global warming below 2 degrees centigrade through 2030. Forest carbon strategies include protecting existing natural forests — avoiding deforestation — improved management of forests, and reforesting degraded landscapes.
Improving forest management through the implementation of climate-smart forestry approaches is one of the most economical, low-risk methods of carbon sequestration. A recent analysis concluded climate-smart forestry could increase carbon stores by 30 percent in managed forests in the Pacific Northwest. Ecotrust Forest Management, the company I co-founded and run, has been practicing climate-smart forestry since its inception in 2005, including keeping trees for longer between harvests by increasing rotations, retaining trees in harvest units, protecting trees in sensitive ecological areas, and restoring degraded forests. With the new monetization tools described above, retained trees can be “monetized” through carbon sales, conservation easements and other mechanisms, creating a win for climate, forests and investors.
How does timber typically perform during recession?
Timberland investments represent an uncorrelated asset class and typically holds up well during recessions. Trees grow regardless of market cycles and political swings, making forestland a great portfolio diversifier. This is because timber assets are biological assets, and trees grow consistently year over year independent of the state of the economy or markets. Unlike agricultural crops that have a definite shelf-life, forestland owners can time harvests to strong log-markets and can store value on the stump in weak markets. Timberland also has low operating costs as growth is primarily driven by nature’s free inputs — sun, water and soil. And while markets may be volatile, as long as managers are not highly leveraged and don’t have a high burden of interest payments, timberland assets have the capacity to ride out most market cycles. Other advantages to timber investments is that they are considered one of the best hedges against inflation and tends to be very tax advantaged.
What else should investors know?
Forests are really extraordinary in that they have the opportunity to provide win/win solutions for investors, winning from a financial perspective and from an environmental perspective. The beauty of forests is that by managing for the whole host of products and services, which include not only timber production, but also carbon storage, water and habitat protection, and managing for recreation, managers increase the number of products and services they can monetize for investors. This creates optionality that can lower execution risk and provide investors with the potential for higher returns alongside creating tangible ecological and climate benefits.
Climate-smart forestry focuses on managing forests for longer rotations, resulting in more timber over the long term, which can come at a financial cost if you are delaying harvest, but that can be more than offset by monetizing non-timber opportunities. These forests are also more structurally complex and diverse, which results in increased biodiversity and carbon storage, so those forests that are managed with a climate-smart approach are better for the investor and for the world around us.
This Q&A with Bettina von Hagen was largely excerpted from a Real Assets Adviser podcast conducted with her on the subject in January. Listen to the podcast at this link: https://bit.ly/2TQ1ct8