Elsevier

Forest Policy and Economics

Volume 34, September 2013, Pages 56-64
Forest Policy and Economics

Investing in energy forestry under uncertainty

https://doi.org/10.1016/j.forpol.2013.06.001Get rights and content

Highlights

  • We provide a real option model framing the decision to invest in energy forestry.

  • We analyze the establishment of SRC willow stands in Central East Sweden.

  • We discuss how government subsidies to energy forestry may accelerate investment.

  • Compensation for sewage sludge management stimulates investment in new willow stands.

Abstract

Farmer's decisions to invest in renewable energy sources can contribute to lower greenhouse gas and mitigate climate change. However, it remains unclear how associated high sunk establishment costs, long-term commitment, highly uncertain net returns, and policy induced incentives could drive farmer's decision to afforest agricultural land. A real option model is used to theoretically frame the decision to switch from agriculture to energy forestry. Optimal investment timing is modeled and the functioning of government subsidies offered to speed up the switch to energy forestry is analyzed. The empirical analysis examines the establishment of new short-rotation coppice willow stands in Central East Sweden. It is shown that in the presence of volatile agricultural profits and high establishment costs, subsidies are needed to accelerate investment. We then examine the case of the municipality of Enköping and show that the combination of governmental subsidies for energy forestry with compensation for sewage sludge treatment provides an effective stimulus to investment in new willow stands which also has environmental benefits.

Introduction

In a few decades climate change may pose serious threats to society and urgent measures are required to face this challenge (World Wildlife Fund, 2011). In this respect, within the European Union, particular support has been given to renewable energy sources which, with respect to fossil fuels, may significantly contribute to lower greenhouse gas (hereafter, GHG) emissions.1 Among renewables, biomass, mainly represented by forest wood, plays a prominent role in Scandinavian countries like Sweden and Finland (Ericsson et al., 2004).

In Sweden, bioenergy covers 18% of the energy supply (Aronsson et al., 2008). After the oil crisis of the 1970s, research was conducted in order to adopt short rotation coppice (hereafter, SRC) forests for the production of energy (Mola-Yudego and Gonzalez-Olabarria, 2010). As a result of this research effort, new varieties of SRC forests with higher yields and improved resistance against frost and fungal attacks were introduced. Of the various tree varieties, willow (Salix), due also to its ability to resprout after multiple harvests, has proved to be particularly rewarding in terms of yield (Buonocore et al., 2011).2 Between 1991 and 1996 willow plantations increased significantly by 2000 new hectares per year, reaching a total surface of about 16,000 ha. Three main factors contributed to this expansion. Firstly, the generous subsidies paid by the government,3 secondly, the presence in Sweden of a well developed system of district heat and power plants (hereafter, DHP) needing biomass as input4 and thirdly, environmental taxes on sulfur and CO2 emissions and energy taxes on fossil fuels which favored tax exempt fuels such as biomass5 (Rosenqvist et al., 2000, Johnsson et al., 2002). However, in 1996, after joining the European Union, the Swedish government decreased the subsidies granted to farmers investing in willow.6 Lower subsidies, together with more volatile grain prices, had a negative impact on the establishment of new stands which reduced to only 500 new hectares per year. As a result, in the last 15 years the surface covered by willow has decreased reaching 12,500 ha in 2009 (Dimitrou et al., 2011, Rosenqvist et al., 2013).

Considering the importance that energy forestry may have in order to meet GHG reduction targets, it becomes crucial for the design of appropriate policies to understand what factors are driving the farmer's decision to afforest agricultural land. In this paper we view the farmer as holding an option to switch from traditional farming to energy forestry and frame the decision problem using option theory.7 Our approach allows us to properly account for specific features characterizing willow forestry, namely high sunk establishment costs, long-term commitment and highly uncertain net returns. We assume known and constant net revenues from forestry while we let agricultural net revenues follow a geometric Brownian motion. We determine the optimal timing for establishing new willow stands and then study the impact that government subsidies may have as a stimulus for this initiative.

Our paper belongs to the stream of contributions applying option theory in agricultural and forest economics.8 These applications include land set-aside (Isik and Yang, 2004), land-use change (Song et al., 2011, Musshoff, 2012), optimal harvesting problems (Clarke and Reed, 1989, Saphores, 2003), old-growth forest conservation (Reed, 1993, Conrad, 1997, Bulte et al., 2002, Di Corato et al., 2011), and investment in afforestation (Thorsen, 1999).

The closest paper to ours is Musshoff (2012) where the author investigates conversion of set-aside land to short rotation coppice and suggests government measures to stimulate it. We depart from this contribution by developing a conceptual model where we also consider the impact of traditional agricultural return as investment opportunity cost. The model is then applied to assess the profitability of investing in SRC willow plantations in central-east Sweden. In this respect, we contribute by providing a real option analysis of specific investment decisions which have, to the best of our knowledge, been investigated only under a standard net present value (hereafter, NPV) approach (see e.g. Rosenqvist and Ness, 2004, Ericsson et al., 2009).

Our results show that considering current subsidy level and net revenues from energy forestry and agriculture, the establishment of new willow stands is not attractive for farmers. However, the picture drastically changes if we account for the possibility of compensating farmers for the provision of services such as the treatment of the municipal sewage sludge. This is due to the fact that the above possibility entails two benefits for the farmer. First, the monetary compensation for the service provided and second the savings on the purchase of fertilizers which are excellently substituted by the sewage sludge obtained at no cost (Börjesson, 1999, Buonocore et al., 2011). These results suggest that there is room for improving the design of energy programs targeting the establishment of perennial energy crops. In fact, since plantations in the proximity of municipalities may be privately profitable even in the absence of subsidies, then potential savings could be used in order to provide additional support to farmers contemplating investment in energy forestry on lands where, due to their location, returns are limited to the biomass price paid by DHP plants and transport costs may further reduce the investment profitability.

The remainder of the paper is organized as follows. In Section 2 we develop a conceptual model for the farmer's decision problem and discuss the impact of two possible types of subsidies. In Section 3 we introduce our case study and apply the model to farms in Central East Sweden and then to farms belonging to the municipality of Enköping. We present our findings and discuss their implications for the policy design. Section 4 concludes.

Section snippets

The conceptual model

Consider a farmer having the option to switch from traditional agriculture to SRC energy forestry. Assume that the decision to switch is irreversible and that once taken, a flow of known and certain9 instantaneous per-hectare net returns, πw, accrues for the entire forestry project lifespan, T.10

Empirical application

In the following our analysis focuses firstly on SRC willow plantations to be potentially established in Central East Sweden.17 This is done in

Conclusions

In this paper a real option model was developed to investigate the factors affecting the decision to switch from agricultural production to SRC energy forestry.

Our findings show that for willow plantations treated with commercial fertilizers energy forestry returns are too low to stimulate the establishment of new plantations. We show that the current subsidy, covering 40% of the initial investment costs, can only, by raising the critical profit investment threshold, make the investment more

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