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In this FYI we focus on Government's proposals as to the application of the Emissions Trading Scheme (ETS) to forestry. Based on our own analysis and discussions with others in the forestry sector we provide some comment and identify legal issues that will need to be worked through.
In late September Government finally unveiled its proposals for an ETS with the release of the Framework for a New Zealand Emissions Trading Scheme.1 Contemporaneously it released a more detailed document entitled Forestry in a New Zealand Emissions Trading Scheme.2 Since the release of those documents Government has initiated various engagement sessions, which we have attended.
Background
Under the ETS a core obligation is imposed on certain parties to hold and surrender to Government a tradable emission instrument called a New Zealand Unit (NZU) for each tonne of carbon dioxide equivalent emissions for which that party is responsible. Under the ETS the ability of forest to remove CO2 from the atmosphere is recognised by allocating NZUs to owners of eligible forest land for each tonne of CO2 so removed. Conversely participating forest owners will have to account for any deemed emissions when the forest is harvested.
Of the six major sectors that will be progressively brought into the ETS, forestry is the first sector with a start date of 1 January 2008. The ETS effectively divides land currently in forest into three categories: land planted in forest pre-1990, land first planted in forest from the beginning of 1990 (post-1989 forest) and indigenous forest.
Pre-1990 Forest
Pre-1990 exotic forest will automatically be included within the ETS. Owners of such forest will incur emission obligations if following harvest they convert their forest to a non-forest use instead of replanting. In recognition of the constraint this obligation places upon owners of pre-1990 forest land, Government will allocate free NZUs to those landowners on a pro-rata area basis. However, the allocation is not automatic; owners of pre-1990 forest will need to apply to the (yet to be confirmed) administrating agency within 18 months of the enactment of the ETS legislation. Initial indications are that the allocation will be equivalent to 5% of the sequestration potential of the pre-1990 forest area (39 NZUs per hectare). The timing of the initial allocation of approximately 21 million NZU's is 2008/2009 but the owners of land carrying young and medium aged trees will receive post-dated NZU's. A further allocation of approximately 34 million units is envisaged in 2012/2013.
Whilst any recipient of NZU's will be able to sell their NZU's, pre-1990 forest landowners who do not intend to deforest will be less concerned about future liability as to deemed emissions and the need to hold NZU's allocated to them. Those owners of pre-1990 forest land who do not wish to replant all or part of their land following harvesting, but who do not have enough NZUs to cover the amount of deemed emissions arising from such deforestation, will have to buy additional NZUs or equivalent units from the international market.
There will be some exemptions. Owners of 50 hectares or less of pre-1990 forest land will not be included in the ETS. Owners deforesting less than 2 hectares will not have to account for their deemed emissions. Such exemptions are not automatic; they must be applied for.
A significant proportion of pre-1990 forest is on land subject to Crown Forestry Licences and unresolved Treaty Claims. Such claimants will need to be aware of the impost the ETS places on pre-1990 forest land and factor this into their negotiations.
Post-1989 Forest
Owners of forest planted onto pasture land since 1 January 1990 will be able to elect to enter the ETS as of 1 January 2008. Based on normal forest measurement procedures carried out at regular intervals, the amount of carbon sequestered by the forest crop from 1 January 2008 will be estimated by a certified professional and NZUs then issued to the participant.
When the forest is harvested there is an immediate deemed emission of CO2 of approximately 70 to 75% of the carbon previously sequestered. This is on the basis that carbon "stored" in the trunk of the tree is deemed to be immediately emitted as CO2. That carbon in the roots is deemed to be released over a longer period. Following harvest the participating ETS forest owner will have to account for the deemed emissions by surrendering NZUs held by them or by purchasing NZUs from the market. If the forest owner immediately replants, the obligation to surrender NZUs will be reduced, due largely to the root factor, compared to a forest owner who decides not to replant. Forest age and area distribution on the rest of the ETS participating forest area will also be factors when calculating the cost/benefits of joining the ETS.
A participating forest owner who sells NZU's as they are received will face the risk that at harvest time the price that they received for their NZU's is now less than the current market price that they now have to pay (taking into account the time value of money). There is also the risk of loss of forest (and thus deemed emissions) through fire or other catastrophic event. In this context forest owners should review their insurance arrangements.
Government has assured the sector that an owner who elects to participate in the ETS will only be liable to account for deemed emissions up to the amount of NZUs granted to the forest owner in recognition of the carbon sequestration process. In other words Government will take on the liability of having to account for the release of carbon accumulated in a forest prior to 1 January 2008 and for which the forest owner does not receive any NZUs.
Owners of post-1989 forest will have 18 months from the passage of the enabling legislation to decide to join the ETS. Forest owners wishing to join the ETS after this date will have to wait until after the end of the first commitment period (post-2012). If a forest owner chooses not to participate in the ETS, then Government assumes the benefits and liabilities associated with the carbon sequestration/emission process.
Indigenous Forest
Under the Kyoto Protocol, Government will have to account for any deforestation of land in indigenous forests pre-1990. Government has indicated that, if after discussion with such owners they decide to include deforestation emissions from indigenous forests in the ETS, then there would be provision for the free allocation of units, though at a much lower rate than that for planted forests. As Maori hold significant areas of non Crown indigenous forest land, this is an area of particular significance for Maori.
Observations/Comments
Our general impression from attending engagement sessions and discussing the ETS with various forestry participants is that until the costs and risks of the ETS are better understood, it is difficult to say whether the ETS represents a real opportunity with potentially significant upside or a risky venture with potentially significant downsides. At this stage many would-be participants are awaiting further detail from Government before making their decision. In the interim they are assessing the application of the scheme to them in so far as they are able.
Price: A key driver of the ETS is the opportunity for forest owners to trade NZUs and generate mid rotation income and/or create ongoing trading / profit opportunities. For this opportunity to be realised, much depends on the pricing by the market of NZUs.
The sector is rapidly coming to grips with the plethora of carbon units that exist in a global context and that not all carbon units are created equal. Assurances by Officials at the engagement sessions that NZUs will be able to be converted into top level Kyoto Protocol Assigned Amount Units (AAU's) and traded internationally, subject to some restrictions, is seen as very positive in terms of facilitating liquidity in the market for NZUs and achieving the higher end of the envisaged price range.
A further positive factor that should assist in underpinning NZU pricing is a reputational/integrity one. In other words, systems developed and ultimately monitored and supervised by our Government might well be rated higher (and thus command a price premium) over other carbon trading schemes. The suggestion that the NZ Stock Exchange may provide a trading forum is also encouraging. However, the sector is also aware of the price volatility experienced in the EU carbon credit market. Whilst acknowledging price volatility may be a factor in any market from time to time, Government has suggested that the power to impose a price cap may be necessary in the ETS legislation. The recent press release concerning the copying of a letter to the Prime Minister (originally sent to the Minister of Energy in early June from representatives of various sectors of the economy) also raised the question that "a cap on prices (safety valve)" may be a necessary part of the ETS.
Pre-1990 Forest: It is clear that owners of pre-1990 forest are not happy. Their gripe is that imposing a retrospective land use restriction via the liability arising on deforestation imposes an unreasonable and potentially significant restriction on their rights as land owners. The allocation of free NZUs is seen as less than generous and uneven.
Back in 2003 Government had lifted the deforestation cap (under which it then proposed to meet all liabilities for deforestation) to 10% and there was some expectation in industry circles that it would go higher. Thus a reversion to what is effectively a 5% cap is seen as inequitable.
Government is up front about the fact that the pro rata allocation of NZUs based on land area will result in some landowners being overcompensated and some being undercompensated, but for reasons of expediency and simplicity it believes the pro rata allocation to be preferable. This unevenness can be demonstrated by the following simple example.
Landowner A owns 100 hectares of pre-1990 forest on land which is best suited for forestry. Government gives Landowner A its pro rata allocation of NZUs and assuming a price of $15/ NZU, this equates to approximately $585 per hectare. Landowner A could at that price sell these NZUs for a windfall gain of $58,500 gross. Landowner B also owns 100 hectares of pre-1990 forest, but Landowner B's land has potential as a new residential subdivision following harvest. Landowner B's NZUs would also be worth approximately $58,500. However, the liability for deforesting those 100 hectares (estimated at around $12,000 per hectare at $15 a tonne of CO2) could equate to $1.2 million.
Grey Market: Assuming a post-1989 forest owner elects to participate in the ETS, that participant will then receive NZUs equal to all carbon sequestered in the relevant forest from 1 January 2008 onwards. Thus for a forest planted in 1994 the forest owner is not given the benefit, under the ETS, of carbon sequestered prior to 1 January 2008. Leading players in the industry have suggested the possibility of creating a grey market where forest owners can trade credits which represent sequestered carbon prior to the start of the ETS.
On a global basis there are many existing and emerging markets for carbon credits across many levels, including markets for the trade of Kyoto compliant units, markets created at the state level and voluntary markets. Any grey market in New Zealand units other than NZUs will require a process whereby the carbon sequestered is verified by an appropriately qualified and respected organisation, a market exists or is created which recognises some value in the carbon sequestered and such a grey market is permitted by the ETS legislation. Clearly, establishing such a grey market will raise a number of complex and technical issues and ultimately may depend on the detail of the ETS yet to come.
Post-1989 Forest – Come in or Stay Out?: An ETS forest owner could choose to hold or "bank" the NZUs it receives. The participant could then surrender those NZUs to the Government when it harvests and potentially sell any excess NZUs in the future. Alternatively the participant could promptly sell some or all of the NZUs earned on the domestic or international markets. That participant will then need to meet its future liabilities on harvest by buying further NZUs (or equivalent) to surrender to the Government. If the participant sells high and buys low, then they will profit. However the opposite could occur and, notwithstanding the trade offs around the Net Present Value of mid rotation income, they may lose. No doubt a range of financial instruments will emerge to assist a participant manage these risks.
Another key factor is the harvest profile of the particular forest in question. For example if you had a single age woodlot planted on 1 January 1990 you only start accruing NZUs from 1 January 2008. When harvest occurs it is possible the deemed carbon loss would be greater than the NZUs accrued. Even though Government has agreed to cap the forest owner’s liability to the amount of NZU's in such a scenario, on harvest such a participant would need to find/surrender all of the NZUs issued to it.
Compare the above to a forest planted on 1 January 2008. At the time of harvest (taking into account the general proposition that on harvest only approximately 75% of the carbon is deemed released) the participant would need to surrender 75% of the NZUs that they were issued (assuming they replant). This should mean that such a participant will have approximately 25% of its NZUs free to trade.
Costs of the ETS: The development, installation and commissioning of the all-important central registry will not come cheap. Will Government absorb these capital costs or will they attempt to recover them from ETS participants? Certainly Government has indicated that the direct costs of administering the ETS will be passed onto participants. Then there is the quantum of ongoing costs. From a forest owner’s perspective ongoing costs could include matters such as the cost of; entering the ETS, having their forests certified, applying for and receiving NZUs, costs associated with reporting increases/decreases in carbon stored and the cost of searching/accessing the central register. Clearly there is potential for ongoing administration and reporting costs to eat into any benefit or profit from trading NZUs. Officials have indicated that the intent is that fees will only be on a cost recovery basis, but this is another area of uncertainty.
Some Legal Considerations
Split ownership of land/forest: Since the 1990s, the use of forestry rights has enabled a split between the ownership of the land and the forest crop planted on it. Prior to the enactment of the associated legislation, this legal split was often achieved by way of a lease.
In relation to any pre-1990 forests, by default, landowners and not forestry right holders, will be liable for any deforestation liabilities. The landowner will receive the free NZU allocation. There is no indication from Government that holders of forestry rights or lessees would have any entitlement to such NZU's and presumably the ETS legislation is intended to cut across any pre-existing contractual terms. However, in circumstances where the holder or lessee may have the contractual right to deforest, then in such circumstances it is envisaged that the landowner can apply to have the liability transferred to the holder or lessee. This concession may be targeted at the likes of a lessee exercising a contractual right to put in harvest roads or clear forest for a quarry to obtain roading material.
In relation to any post-1989 forests, where a lease or forestry right exists, the forestry right holder or lessee will be the participant in the ETS entitled to the NZUs and responsible for liabilities. Government has said that here they will require both the landowner and the forestry right holder/lessee to agree to enter into the ETS. This is designed to provide an opportunity for the landowner and holder/lessee to agree how to share NZUs and liabilities. Negotiating the sharing of NZUs and liabilities may not be a straight-forward process. It will invariably involve a careful review of the current terms of the forestry right or lease to determine whether the parties are contractually bound in this regard already and therefore whether there is any potential to require the landowner or holder/licensee to enter into the ETS.
When entering into any new forestry right, the landowner and the holder/lessee will need to clearly set out who is entitled to any NZUs in relation to the property and who is responsible for any liabilities. In our work in the context of the existing Permanent Forest Sinks Initiative we have dealt with similar issues. This is an area where Simpson Grierson has significant expertise to assist.
Buying and Selling Forests: Over the years Simpson Grierson has advised on many transactions involving forestry assets and businesses. The ETS gives rise to a number of new issues which buyers and sellers of forests will need to be alive to now and in the future.
The first issue any seller or buyer will have to determine is what part of the target property constitutes pre-1990 forests and what part of the property constitutes post-1989 forests.
Once it is determined that there are pre-1990 forests on the target property, the following issues may need to be reviewed. A buyer purchasing before the free NZU allocation occurs, may as new owner of the land be able to apply for and receive the free allocation of NZUs. Following the free NZU allocation, a buyer purchasing must recognise that it is acquiring a deforestation liability without any NZUs to offset that liability (unless it also acquires the NZUs held by the seller). This will affect land value, particularly if the buyer has any plans to change the land use of the pre-1990 forest or if the property in question has the potential to be put to a higher and better use.
In relation to any post-1989 forest identified, the buyer would need to determine whether the seller has opted in to the ETS. If the seller has not opted into the ETS, then, assuming the time window was still open to enter into the ETS (currently suggested as 18 months from the enactment of the legislation), the buyer could elect whether or not to enter into the ETS in respect of the target forest.
If the seller has entered into the ETS, the seller would retain all NZUs and liabilities for the period up to settlement and the buyer would want to be entitled to receive NZUs for future carbon sequestrated and accept future liabilities. A stock taking exercise would need to occur pending settlement. The central registry will need to be reviewed to determine the level of carbon stored and a carbon assessment as at settlement may need to occur. These and other considerations will need to be negotiated in the context of the provisions of the sale agreement.
Tax Issues: In our recent FYI entitled Emissions Trading – Tax Issues, we comment on the Government discussion paper on the tax issues arising in the ETS - see http://www.simpsongrierson.com/fyi_energy_works.html and in particular on timing issues for recognition of income and expenditure and the manner in which the treatment of GST could impact unfavourably on the those who are allocated or earn NZUs.
Uncertainty: We emphasise that our comments are based only on the details available to date and there is a lot more to come. In summary, there are a number of potential pitfalls which may or may not eventuate in the final ETS as introduced and a number of potential opportunities. In this regard some in the industry are concerned at the possibility that future governments may decide to change the rules to the detriment of forestry participants. As is the case with business in general, those who are well informed will be best placed to take advantage of the opportunities and to mitigate or avoid the pitfalls. We will be monitoring progress carefully and considering what other impacts the ETS may have upon the forestry sector and each owner of forest land should be doing the same.
Complementary Government measures to the ETS
Government's Kyoto policy drivers mean it is keen to encourage long term afforestation and is proceeding with several other afforestation initiatives. They are: the entirely new Afforestation Grant Scheme (AGS) and some changes/modifications to the more recent Permanent Forest Sinks Initiative (PFSI) and the long running East Coast Forestry Project (ECFP). We briefly discuss the AGS below.
Afforestation Grant Scheme (AGS)
This is a brand new Government policy initiative. Afforestation grants will only be available to those landowners wishing to plant new forests where the target land is not part of the ETS, the ECFP or the PFSI. Government has indicated that it will set aside $50 million in the AGS to be allocated over a yet as undefined period. A policy objective of the AGS is the targeting of other environmental benefits such as reduction of soil erosion and flooding. Participants will be able to harvest and sell the tree crop but Government will retain the carbon credits and take responsibility for meeting all harvesting and deforestation emission liabilities.
Government has indicated its preference is that rather than a straight per hectare grant participants will bid for a share of the grant dollars available in any one year. The lowest bids will be allocated grant dollars ahead of those that make a higher dollar per hectare bid. Exactly how the Government will weight competing bids in terms of bidders claiming environmental benefits (eg reduced erosion) has yet to finalised. In this regard we note that the ECFP was initially a bidding system but due to the difficulties of fairly weighting bids it has now moved to a cash grant approach. Once the forest is successfully established (being a minimum stocking of 750 spha) the grant is paid out with the applicable silviculture regime being up to the landowner.
Government sees a role for district and regional local authorities to not only participate but also encourage use of the AGS in their region. Exactly what is envisaged here is unclear as yet.
1. For a more detailed treatment of the "why's" and "how's" behind the Government's proposal as to the adoption of an ETS as its core measure for mitigating climate change go to http://www.simpsongrierson.com/fyi_energy_works.html
2. http://www.maf.govt.nz/climatechange/background-reportsand-analysis/forestry-in-nz-emissions-trading-scheme/
This newsletter is produced by Simpson Grierson. It is intended to provide general information in summary form. The contents do not constitute legal advice and should not be relied on as such. Specialist legal advice should be sought in particular matters.
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