Afforestation as a real option with joint production of environmental services

Highlights

• Many land use decisions are irreversible and involve uncertainty.

• Often ecosystem services are jointly produced.

• We extend real option decision models to handle two additive ecosystem services.

• Values of ecosystem services from afforestation are uncertain and may be correlated.

• Joint production increases the value of conversion and incentives to afforest.

Abstract

Real option applications in conservation have showed that with irreversibility and uncertainty about the value of preservation decisions may change. More specifically, returns must be high enough to also pay out the value of waiting if conversion into more intensive land uses is to become optimal. However, many environmental policies today focus on nature restoration, where conversion has previously taken place. In this study, we therefore reverse the problem and ask when to afforest productive agricultural land, when we face uncertainty about the value of ecosystem services delivered by afforestation. Furthermore, projects such as afforestation are often associated with joint production of forest products and environmental goods, like biodiversity, hunting, groundwater production, carbon storage, recreation etc. Thus, we extend state-of-the-art models to handle two additive ecosystem services, which both are uncertain and may be correlated. The joint production aspect increases the value of conversion, the stopping value, and hence the incentives to afforest. Increasing uncertainty decreases this incentive, as expected. However, contrary to the existing literature evaluating exclusive options, less than perfect correlation between the values of future ecosystem services decreases the value of the real option and increases the set of states, where afforestation is the preferred decision. This causes afforestation to be attractive for a wider set of states of the world than otherwise and has implications where joint production is feasible. We discuss these findings and the potential application of this analysis for handling real options with joint production in other research domains.

Introduction

Around the world, many governments and non-governmental organisations have been engaged in afforesting agricultural and wasteland or reforesting harvested forest stands. There are many reasons for implementing policies, which promote this land use conversion. A range of socioeconomic benefits are expected from afforestation, for example afforestation may result in higher recreational benefits, reduce erosion and desertification problems, protect groundwater, create a supply of fuel wood and timber and contribute to carbon storing and climate change mitigation. The global investments are significant. More than 14 million hectares are annually afforested and reforested (FAO, 2015). To initiate such investment, decision makers at any level from governments to landowners, need to evaluate whether the afforestation is a financially more attractive investment than other land use alternatives. In particular when the investment is subject to great uncertainty about future costs and benefits, irreversibility in the sense of not being able to fully recover investments, and the benefits may be multiple and jointly produced (Nelson et al., 2009). This study discusses and analyses this problem of deciding for what states of nature to invest in afforestation when the values of ecosystem services from forests are stochastic and jointly produced. We analysed this in the context of real option theory and add to the research field by applying a new framework of additive real options. Our focus is in a sense the reverse of earlier studies, focused on when to intensify land use and halt conservation (e.g. Conrad, 1997; Kassar and Lasserre, 2004), as we here focus on reducing land use intensity, switching land use from agriculture to forest.

Even newly established afforestation areas quickly provide a wide range of ecosystem services such as recreation or increased quality of drinking water production (Vesterdal et al., 2002; Zandersen et al., 2007), and increasing the forest area on a property may increase hunting values (Meilby et al., 2006; Lundhede et al., 2015). Other services from afforestation may only happen in the long term, e.g. reaching a suitable habitat for important biodiversity (Hermy and Verheyen, 2007) or significant returns from timber harvest. In valuing such outputs/services of multifunctional forestry, it is important to account for the joint production of services. The joint production properties may fall into categories of fixed, complementarity, independency, and competitive relationships between the services (Randall, 2002). Ignoring these properties, any attempt to value the services provided by forest reserves may fail and inappropriate information may flow into relevant decision processes. The Sustainable Development Goals and the 2030 agenda highlight sustainable use of terrestrial ecosystems and management of forests. The EU Commission has acceded to major international declarations, recommendations, treaties or conventions of immediate relevance to sustainable forest and nature management, e.g. the EU Forest Action Plan and the Strategy of Lisbon‘s environmental pillar, the Convention on Biological Diversity, and has strongly supported the promotion of forest management through its programmes. The EU and EU member countries annually spend billions of euros on contributing to development of sustainable forest and nature management to halt the decline of biodiversity and promote the provision of ecosystem services (e.g. see the EU Natura 2000). The Millennium Ecosystem Assessment of nature's contributions to human well-being (Braat and de Groot, 2012; Carpenter et al., 2006; Pascual et al., 2017; TEEB, 2010) as well as the climate change debate and discussion on the potential roles of forests have increased the research community interest in several issues. Topics include the role of spatial correlation, spatial connection/dis-connection, and potential joint production of provisional services (e.g. forest and agricultural production, drinking water), regulatory services (e.g. carbon, nutrient cycling, biodiversity) or cultural services (e.g. hunting, recreation) and potential for win-win solutions and spin-offs of conservation and restoration projects (Bateman et al., 2013; Carpenter et al., 2006; Nelson et al., 2009; Venter et al., 2009).

From society's point of view as well as the private land owner's perspective, it is therefore an issue that the value of these possible effects and correlations are not well known. Nor are the quantitative measures of their provision. Consequently, the values associated with afforestation areas are uncertain. The expected value of e.g. future biodiversity may increase as society grows richer (Jacobsen and Hanley, 2009), as may marketed recreational services like hunting (Lundhede et al., 2015; Meilby et al., 2006). The supply of resources may become increasingly scarce (Schroter et al., 2005). On the other hand, the perceived and expected future value of a specific afforestation areas' value may also decline. An example is if e.g. biophysical limits to growth cause demand from non-consumptive benefits to decrease relative to consumptive goods. Or if changes in surrounding land use decrease the quality and value of ecosystem services provided from the afforestation area. At the same time, the afforestation investment may be seen as irreversible. Converting back to agriculture likely implies a larger cost of removing tree stumps and re-establishing the agricultural field, the more time has passed. As time passes the trees grow valuable which reduce net cost of conversion back to agriculture. However, in many instances legislation may prohibit such conversion. Thus, setting aside agricultural land for afforestation may be seen as a decision problem of when to exercise the option of not only one, but the sum of several jointly produced ecosystem services. The value of which is governed by possibly correlated stochastic processes. Here we address this problem applying two additive real options as an example, recreational hunting and forest products.

The use of real option value models and the timing of (dis-)investment decisions have been investigated in resource economics, building on e.g. McDonald and Siegel (1986) and picking up speed with Dixit and Pindyck (1994). Specifically concerning the issues of different option values and preservation, Arrow and Fisher (1974) and Henry (1974) pointed out the (quasi-) option value related to continued preservation (as opposed to development) of a resource when benefits from development are uncertain. As already mentioned, the problem we analysed here is the reverse one of earlier studies focused on when to intensify land use and halt conservation (e.g. Conrad, 1997; Kassar and Lasserre, 2004). Furthermore, the explicit attention to the joint and additive values being produced following afforestation is a novel contribution to the real option analysis in resource economics. The extension to multiple services is highly relevant, but it comes at the expense of the mathematical tractability of analysing the decision problem. We had to resort, as is often the case in such problems, to numerical solution procedures to solve explicitly defined examples.