How Might We Establish Carbon Discount Rates for New Zealand Investments

1st May 2024

Forestry carbon investments have developed to become an important facet of the forestry landscape in New Zealand as investors have sought to jump on the bandwagon to decarbonise. For many investors it is an economic play where they are seeking to make economic profits as well as potentially offsetting carbon liabilities elsewhere.

New Zealand has one of the few existing formal emissions trading schemes (ETS) with a significant history beginning in 2008. The ETS has three pathways for earning New Zealand emission units (NZUs), the permanent forest category, and two commercial forest schemes – the original stock change approach (legacy approach) and the recently introduced averaging approach. This latter approach implemented from 1 January 2023 will apply to all new entrants to the ETS from this date. The averaging approach was seemingly introduced to reduce liability risk for investors and encourage growth in carbon investments, growth which at the time of original development of the approach, had stalled. Investment in ETS compliant carbon projects carries risks for investors which differ from pure commercial forestry risks:

  • Carbon price risk – emission units are earned early and potentially sold early in the investments life whereas liabilities to repay credits under the stock change approach are generally at the end of the rotation,
  • Liability risk – under the stock change approach, investors are liable to repay any earned credits where the forest is damaged or destroyed by biotic and abiotic agencies,
  • Regulatory and legal risk – these risks include changes in government policy, and introduction/changes to cost recoveries,
  • Carbon release – no benefit is recognised for the long-lived nature of wood products post-harvest,
  • Once only earning of credits – under the averaging approach, the risk of repayment being required is mitigated but benefits only accrue up to the averaging age of the first rotation. No credits are earned in future rotations,
  • Risk reduction strategies – the inherent risks of carbon investment under stock change (particularly price risk) are somewhat reduced by trading only safe carbon at the cost of overall economic return.

Given these risks, how do investors think about the discount rate for carbon investments? This has been particularly unclear causing significant difficulties when it comes time to value the carbon for financial reporting, transaction analysis and investment strategizing. Margules Groome has noted a wide range of discount rates being employed by forest appraisers usually without adequate corroborating evidence. These can range from low rates similar to market discount rates for timberland investments to relatively high rates reflecting a perception by some investors of higher regulatory and price risks.

Given this situation, Margules Groome has looked to market evidence. As transaction evidence for existing carbon forests is particularly scant and incomplete, we have therefore turned to market evidence for ETS compliant land acquired for carbon forestry. There is significant transaction evidence for post-1989 land which is ETS compliant and pre-1990 land with no carbon potential. This does cause a dilemma however as there are two unknowns, discount rate and future carbon price. By developing carbon forestry models for the different approaches available under the ETS and considering independent market forecasts for NZUs, Margules Groome has developed relationships for each of the approaches comparing imputed discount rates with future carbon price assumptions. The results of this exercise have been enlightening, showing distinct differences between carbon discount rates for commercial forestry with carbon (stock change and averaging) and for permanent carbon forestry. Commercial forestry with carbon appears to be perceived as a higher risk investment.

Parties that are interested in understanding carbon discount rates and how the work we have undertaken can benefit their situation, should contact Margules Groome.