The global financial crisis has temporarily depressed timber demand and prices, tightened credit markets, and dampened investor appetites for risk, leaving many timber managers struggling to manage, let alone invest in growth.
The global financial crisis has temporarily depressed timber demand and prices, tightened credit markets, and dampened investor appetites for risk, leaving many timber managers struggling to manage, let alone invest in growth. Yet current economic conditions should not cause investors to forget attractive long-term opportunities in sustainable commercial reforestation in the tropics. The factors driving long-term demand for forest products are strong, including a growing population and increasing incomes and consumption in the world, made stronger by pressures on forests from growing demand for agricultural products. If enacted, climate change legislation in major industrialized markets could also increase demand for forests’ greenhouse gas sequestration potential.
Carefully designed sustainable commercial reforestation projects have the potential to generate significant long-run economic returns in an environmentally and socially responsible manner. The FAO estimates that there are between 450 and 650 million ha of degraded lands in the tropics - many of which were once covered by dense primary forest. Reforesting even a fraction of these lands can generate attractive investment returns while providing productive employment opportunities for local communities. If they include native species and habitat restoration components, reforestation projects can improve biodiversity and ecosystem health. They also sequester significant quantities of carbon in the trees and beneath the earth’s surface, which is essential in the fight to control greenhouse gas emissions. While these investments are susceptible to a number of risks and uncertainties, many tropical timber plantations anticipate internal rates of return of 10-15% or higher.
Realizing these opportunities will require overcoming operational and financial hurdles that have constrained the sector’s ability to achieve its potential. To understand barriers to growth and identify strategies for scaling up investment in sustainable commercial plantations, we interviewed more than 50 investors at private equity funds, pension funds, timber investment management organizations (TIMOs), NGOs, commercial banks, and other finance companies. We worked with 14 project developers to create a fact base on the project and investment economics of forestation investments. We used what we learned to identify crucial barriers to growth of sustainable commercial plantations. In this article, we offer four core recommendations for scaling up the market.
The Challenges
Global growth in sustainable commercial plantations, in tropical countries in particular, has been limited despite widespread and growing interest in timber as an investment class. Three basic challenges face sustainable commercial plantations in the tropics: challenges that make projects difficult to originate and fund, and challenges that have restricted investor demand for tropical forestry as an investment class.
Challenges That Make Projects Difficult To Originate and Fund
Three challenges have limited the supply of sustainable commercial plantations in tropical countries: difficulty obtaining secure access to suitable land; difficult and unpredictable in-country business environments; and a shortage of experienced project development teams with the range of capabilities required for effective execution.
Secure control of land is essential given the long-term nature of sustainable commercial plantation investments. However, identifying suitable land, establishing clear use rights, and securing access on favourable terms (through concession, lease, or purchase) is very difficult in most tropical countries, where property rights, land tenure rules, and dispute settlement procedures may be poorly defined. Project developers told us that securing access to land is the most important obstacle to expanding their operations.
“...targeted action by project developers, host governments, and policymakers in the developed and developing world could make a significant difference.”
Complex and inefficient permitting procedures at multiple levels of government can make it difficult to develop plantations even after developers have secured access to land. Unclear procedures and unpredictable regulatory decisions tie up capital and management attention and obstruct the efficient deployment of investment. Some project developers described routine delays of over a year in obtaining basic permits required to proceed with forestation activities.
Finally, developing sustainable commercial plantations is difficult because doing so requires an unusually broad range of operational and planning capabilities that are generally in short supply. Operational capabilities, including local networks and relationships, tropical silvicultural expertise, and workforce management capabilities, are the more binding constraints. But even parties with strong operational capabilities will not attract commercial capital unless they also have strong planning capabilities, including business planning and financial management skills. Despite the importance of these capabilities, we identified only a handful of organizations - including both private organizations and NGOs - that have achieved distinctiveness in more than a few of these areas.
Factors Limiting Investor Interest in Tropical Forestry as an Asset Class
Many potential capital providers are concerned about the risks, marginal cash flow profile, and limited size of potential investments. Experienced forestry investors who have made successful forest investments have different concerns than new forestry investors, who are interested in the sector but have yet to invest.
Experienced forestry investors are most concerned about political risk, marginal cash flow profiles, and small project scale. They consider political risk - defined primarily as lack of clarity around who owns land, difficulty establishing title or concession rights, and lack of assurance over the strength or permanence of these rights - to be the most significant barrier to investment. They are also concerned about the very long holding periods required before significant positive cash flows, which can be 20-25 years for some hardwood species. Finally, small project scale produces small scale returns and does not allow injection of large amounts of capital. Comparatively high due diligence and transaction costs make small projects less attractive to project investors, especially in unfamiliar geographies. Many project developers sought up-front capital investment of around $10 million, whereas the median minimum investment that experienced forestry investors in our sample were interested in making was around $20 million.
New forestry investors shared the same concerns but had other concerns as well. These investors are more concerned about perceived lack of investment liquidity. The limited number of publicly-traded vehicles, combined with long duration of cash flows, restricts the ability of investors to monetize returns quickly, particularly for hardwood plantations. New investors also had real return expectations, which were several percentage points higher than experienced investors did, acting as an effective hedge against the additional risk that new investors perceive in this asset class. Our interviews were conducted before the current financial crisis dramatically reduced the supply of capital and altered investors’ risk appetites, suggesting that such concerns are even more relevant today.
Recommendations for Scaling Up Sustainable Commercial Reforestation
No silver bullet solution exists to solve these challenges, but targeted actions by project developers, host governments, and policymakers in the developed and developing world could make a significant difference. We offer four core recommendations for scaling up sustainable commercial plantations by addressing the factors that have limited investment in recent years, while ensuring the social and environmental sustainability of plantation investments are high. Each recommendation targets a specific set of stakeholders, but all market participants must collaborate and share responsibility for implementation.
1. Host countries should support reforestation readiness. Sustainable commercial reforestation should be only part of a country’s forestation strategy (smallholder and public forests arguably have greater roles to play). However, tropical countries can benefit substantially by attracting and channeling private investment into carefully designed projects. To do so, host governments should consider implementing forestation “readiness programs” that include four actions. First, transparent and robust sustainability guidelines are needed to channel investment into environmentally and socially beneficial projects while giving investors clear guidance on these requirements (e.g. avoidance of monocultures, structures and processes for community engagement). Second, clear communication of commercial terms and conditions for commercial investment, including requirements for permitting, licensing and renewal, are needed to create greater investor confidence. Third, clarifying land tenure rules and dispute resolution procedures are essential to resolve a major pain point for investors who find these processes confusing and unreliable. Finally, bolstering administrative capacity in the forestry sector will facilitate more rapid and consistent review and oversight over new investments. While most of these actions fall within the responsibility of host country governments, other stakeholders, such as donor agencies and NGOs, can play important supporting roles.
2. Project developers should take actions to make projects more attractive. First, they should innovate to optimize the value they extract from plantation projects, although in an environmentally and socially responsible manner. For example, generating carbon credits for sale in the voluntary carbon markets can add up to 2% to project returns. Use of wastes to fuel biomass power plants can improve returns, as can inter-cropping of food crops such as cocoa. Second, project developers should join investors to pursue best practices in political risk management, in part through open dialogue with local stakeholders to clarify expectations and tenure/titling issues. Third, focusing on particular stages in the project cycle, such as early-stage development, can create investment opportunities (e.g., in mature plantations) with different risk and liquidity profiles that may be easier to pitch to investors.
3. Global negotiators should create robust markets for ecosystem service payments. Dramatically expanding forest cover, particularly in commercial plantations, will require drawing in new sources of capital with higher return expectations, and one way to increase returns is to compensate forests for providing ecosystem services. However, sales of carbon credits at today’s voluntary price of $5 -10 per ton would add only 1- 2% to project returns. Boosting plantation IRRs to the “new forestry investor” hurdle rate of 20% might require carbon prices in the range of $40-50 per ton, though more modest hurdle rates can be achieved at lower prices. Markets for other ecosystem services, such as watershed management and biodiversity conservation, offer additional potential, but are unlikely in the near term to provide sufficient financing for sustainable commercial plantations without the creation of binding regulatory regimes.
4. Civil society should develop comprehensive, common, and credible standards for sustainable forest management. The prospect of substantially increased plantation area worries some stakeholders who have seen large-scale plantations generate social and ecological problems. Plantations - and any large-scale land use change - can have negative social and environmental consequences. There are legitimate concerns that plantations can be a driver of land-clearing and deforestation, that poor matching of species to sites can deplete watersheds, that monocultures of non-native species can damage biodiversity, that large tracts of privately owned forest can displace the poor, and that rapid rotations and aggressive harvesting practices can deplete soils. Host countries can mitigate these risks through national forestation readiness programs, but civil society actors should articulate a set of comprehensive, common, and credible standards to create clear expectations and strong incentives for truly sustainable commercial plantations.
While most markets - particularly those for illiquid assets - are in a period of unprecedented turmoil, the global importance of the forest products sector to the imperatives of economic development and environmental sustainability suggest real long-term potential for investors. Host governments, project developers, global policymakers, and NGOs can take advantage of the lull in deal flow to lay the groundwork for sustained growth and triple bottom line returns.
Carter Bales is an Emeritus Director and Senior Advisor at McKinsey & Company. Albert Cho is an Engagement Manager and Climate Change Strategy Fellow at McKinsey & Company.
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