Carbon is the New Black Gold

This week I’ve been working on a valuation for a project that aims to reduce emissions from deforestation and degradation (otherwise known by its acronym REDD). In modeling and analyzing cash flows in terms of their sensitivity to numerous variables (price of carbon, rate of deforestation, etc) , and working with local investors, I’ve gained an appreciation of the position of the project developer in the highly glamorous voluntary carbon market.

Two quick links on carbon finance – both are chock full of info and materials if you want to find out more about these new markets: http://www.newcarbonfinance.com/, http://www.cdmgoldstandard.org/

Back to Indonesia 1997

Indonesia is central to the deforestation story-- because of all of its natural treasures and because of their misuse. In that story, one of the saddest chapters has to be what happened here in 1997-1998. Ten million hectares (25 million acres – an area eleven times the size of Yellowstone National Park) of forest were lost to fires that ravaged the earth. In 1997, the world was experiencing El Nino, a climactic phenomenon caused by the interaction between the atmosphere and warm water in the East Pacific ocean off the coast of South America. El Nino hit particularly hard in Indonesia, causing drought.

The sad part is that looking back on the event, researchers theorized that many of the fires were not due to the drought-like conditions, but were set intentionally by timber and agribusiness companies intent on clearing land for cheap, and ignorant of controlled burning techniques (some of which, ironically, had been practiced by locals for years). El Nino was a convenient excuse.

According to “Trial By Fire: Forest Fires and Forestry Policy in Indonesia's Era of Crisis and Reform” by the World Resources Institute/Forest Frontiers Initiative, there were numerous disincentives for logging companies to operate more efficiently. The government charged tax on the timber exported not on the volume cut down, thereby offering no regulatory incentive for the timber companies to be any less wasteful. In addition, companies didn’t just cut the trees, but many also operated as processing companies and used the logs to subsidize their inefficient processing facilities. This encouraged companies to try and source logs (the processing facilities raw material) at the lowest possible price, even it meant logging illegally.

The story goes beyond 1997-- Indonesia lost 1.5 million hectares each year from 1986-1997 as a result of land use policies under former President Suharto, a total of 40 million hectares (Germany and Holland combined) since the 1960s, 30% of Indonesia's forest cover.

But, 1997 was particularly bad. If I remember right, 1997 was the year Indonesia became the third large source of carbon emissions in the world behind the US and China. The effects of the fires were physically felt by people in countries as far as Malaysia and Singapore; the smog causes asthma, bronchitis, respiratory infections, etc. I can begin, from experience, to imagine how it felt. I was in Moscow in the summer of 2002 when, because of high temperatures, the peat bogs under Moscow began to burn. There was a cloud of smog over Moscow and you couldn’t venture outside without coming home smelling a little like burnt hair. Firefighters had to dig moats around the fires and it took an inhuman effort to put them out.

The earth was literally boiling. I don’t know how much peat there is under Moscow, but there are roughly 27 million hectares of peatland in SE Asia (think British Isles-size). Peatlands are bogs, but they are also huge carbon sinks, created over thousands of years and storing thousands of metric tons of today’s black gold. In 1997 peatland destruction alone may have caused 15-40% of global CO2 emissions (3000-9000 Mt).

Markets for Conservation
The carbon markets have created an opportunity for people to earn money for protecting forests and peatland. It’s not easy – project developers have to be able to get concessions from the government, understand the true value in carbon $$$ of the land to which they have the rights, document that through their efforts additional deforestation is not taking place, protect and maintain the land, work with local communities, and offer investors liquidity at some point in the future. They have to do all this with an uncertain future price of carbon, with risk of expropriation, in an environment in which middle men are slowly but surely lining up to take their cut.

So, the business model is full of uncertainty (great for Crystal Ball), but as an alternative to palm oil and paper and pulp plantations, it’s the coolest thing ever!