Q16: Market size & segmentation: How do you define this market, and what segments is it broken down to? Is it constrained by land, regulations, or something else? Can the market be grown over time?
In the short-term, we are in the business of selling carbon offsets. In particular, we are focused on the California compliance market, which is our initial target market for reasons discussed in prior questions. The offset market in California is currently supply-constrained, with a shortfall of 65 million offsets between 2020-2030. This is because historically, most offsets in California have been generated from “improved forest management” (IFM) projects, which I think are becoming increasingly harder to find. IFM projects involve taking existing timber plantations and managing them more sustainably. Most IFM projects generate a “flush” of offsets at the start of the project, followed by a small trickle of offsets every year thereafter. This is because if a forest has historically been managed more sustainably than “normal” (by comparison to its peers), the ARB IFM protocol will grant offsets representing the difference. The number of forests for which this is true is finite, and I suspect many of the best “IFM flush” opportunities have been taken already.
Unlike IFM projects, reforestation projects are not constrained by the existence of sustainably managed timberlands that can be monetized via the flush. Instead, reforestation projects are constrained by the availability and price of land that can be reforested in the United States. Assuming 50 CCOs per ha per year of reforested land, to completely fill the offset supply shortage in California, we would need to reforest 100,000-150,000 ha, which is roughly the size of Los Angeles. This is not an unreasonable amount of forest. For comparison, Weyerhaeuser, the largest timber REIT, owns 5.2M ha of forestland in the United States, and private corporate landowners own nearly 50M ha. I’m currently doing some research to figure out where the available land is, and how much of it is actually viable for reforestation. My early research suggests there is more land available for reforestation than there is carbon offset demand in California (i.e., you’d run out of demand for offsets before you ran out of land).
We are thus constrained more by regulation than land. At the moment, there aren’t that many good compliance markets outside of California that accept forestry credits. The EU ETS is the largest, but because of how loose the offset protocols are there, offsets (called CERs) trade at 30 Euro cents/mtCO2e, which is ~1/50th the California price. I expect this to change in the future. Over 90 countries have indicated they plan to introduce or are considering introducing carbon pricing and trading schemes as part of their Paris Accord compliance, so I think the market for compliance-based offsets will get much larger in the future. Also, if we were able to sell our offsets into the voluntary markets (e.g., by pooling long-term buyers at a pre-set price), this constraint would become less important.
In any case, we are using offset sales as a means of financing reforestation, which means that in the long-run, we are a timber company. While it’s hard to forecast how any market will perform 25-50 years from now (which is the time it will take for our newly planted trees to mature), if the market for timber right now is any indication, timber is a great business to be in. From 1995-2015, the NCREIF Timberlands Index returned a cumulative 340% gain, vs the S&P at 240%:
This performance also came with less correlation and volatility. As a result, capital inflows into timber investment organizations doubled from $50B in 2005 to $100B in 2015. There are a few reasons why timber is such a good investment. First, timberlands benefit from capital appreciation on both land *and* the timber itself every year, as the trees are literally growing. Mature, high-quality timberlands trade at up to $4,000 per acre (roughly $10,000 per ha) in the West, and around half that in the South. Second, timberlands generate highly predictable revenue, because every year the owner harvests trees and sells them on the market. Third, timberlands can be managed sustainably, such that they never fully deplete. This excerpt from a 2015 Goldman Sachs analyst report (on which much of the above analysis is based) sums it up well:
We like Timberlands long-term for its potential capital appreciation as its use as an alternative investment grows, and also its favorable supply/demand profile. […] A key point of differentiation for Timberlands compared to other agricultural land (such as corn or soybean acres) is its optionality. If commodity prices are low, Timberland managers can choose to leave the tree on the stump for it to continue growing in value and defer harvest until prices recover without losing value. Trees in favorable growing climates of the US typically grow at a rate of 4-8% annually, so even in adverse economic times, the “inventory” on timberlands grows (unlike oilfields, mines, chemical plants, or containerboard mills). Additionally, unlike oilfields or mines, timberlands never fully deplete (if managed sustainably) giving them virtually infinite years of reserves, and over time they can be converted into “higher and better uses” (e.g. housing developments) often at a substantial capital gain. Because of their 4-8% growth profile, a mid-single-digit percentage of standing timber can be harvested each year without drawing down inventory. For example, we estimate that each year WY [Weyerhaeuser] harvests roughly 6.5% of its standing timber inventory (from roughly 2%-3% of its acreage), which is sort of like a dividend, without compromising the total amount of timber inventory, which is sort of like the principal in investment parlance.Goldman Sachs, 2015 Analyst Report on Forestry
Not all timberlands are created equal. Generally, timberlands located in the Western United States are more valuable than those in the South, because of their proximity to coastal ports for shipping to Asian markets. In addition, some high-value species like Douglas Fir are worth much more than others because of their use in high-end applications like flooring and furniture (vs pulp and paper). These species tend also to be relatively slow-growing but more effective at sequestering carbon over their lifetime, making them a good fit for Evergrow.
Q17: Defensibility & returns to scale: What is the defensibility of the business at scale? Does the business exhibit increasing or decreasing returns on scale? Are there potential network effects?
Evergrow benefits from a positive feedback loop. For each new plot of land, we generate positive cash flow by planting trees and selling the resulting offsets. We recycle this cash into acquiring even more land and repeat the cycle. As a result, the more land we acquire and develop, the more capital we have to acquire and develop yet more land, resulting in a flywheel that gets stronger as it goes and is constrained only by the size of the market and the pace of development.
In the short-term, this model is not defensible and can be copied by others. In particular, experienced timberland developers could take this playbook and run with it. I believe our initial competitive advantage here will come from (i) securing investor capital to provide initial financing for both development and offtake (Devco and Offco), and (ii) identifying the best plots of land to develop. Ultimately, this is a race to acquire and develop the best lands available for reforestation, so speed will matter a lot. Once we have sizable timber holdings and a track record of successful projects, we can use this scale to position Offco and Holdco as the offtaker and exit option of choice for reforestation developers. When this happens, developers become our partners, not our competitors.
In the long-run, I think being a timberlands owner is extremely defensible from competitors because when you own the trees, they’re yours to keep. In addition, there are advantages to scale that large incumbents have, like being able to self-insure against disease and fire risk due to the geographic diversity of your timberland assets, which lowers costs. If there comes a time where we can no longer acquire and plant new land – e.g., because the carbon offset markets are no longer favorable – then we can become a timber management company that pays out a dividend to its shareholders, just like Weyerhaeuser. Therefore, I believe the only meaningful threat to the business here is a secular and permanent decline in global demand for wood products, even those from sustainably managed forests. This is difficult to predict, but seems unlikely at the time of writing; in fact, multiple reports (links below) predict a shortage of sustainably managed wood over the coming decades.
Q18: Competitors and substitutes: Who would you consider competitors and what would you consider substitutes for demand in this model?
We expect to compete with carbon project developers and timber developers for land acquisition. In the early days, I am hoping that we can use technology to uncover opportunities to acquire land that nobody else is looking at. Also, my sense is very few competitors are looking at combining reforestation and carbon offsets, so I think we have a short window of opportunity to acquire the best plots of land available for reforestation.
We compete with carbon project developers for the dollars and mindshare in the California compliance offset market. I fear this competition the most. While in theory CCOs are a commodity, relying on this fact alone seems risky. Instead, I think we need to accumulate relationships with multiple compliance buyers in California to cover our pipeline of offsets, and/or outsource this problem to the financial counterparties in Offco. Also, reductions in emissions and/or abatement projects are substitutes for offsets – e.g., a company can simply reduce its emissions and forego the need to buy offsets completely. This is happening right now: one effect of the COVID-19 pandemic has been a decrease in the price of CCAs and CCOs, because companies are expecting to emit less this year than in the past due to the various lockdowns and overall decline in economic activity.
We will compete with every other timberland owner when selling our timber in 25-50 years. Like with offsets, while this is a commodity, I hope we can aggregate forward-looking buyers and get long-term contracts in place for our timber. In addition, we would want to certify our forests with the Forest Stewardship Council. I’ve read that less than 15% of the world’s timberland is currently FSC certified, so I’m hopeful that in 25-50 years, timber that has been grown in an FSC-certified manner from the day they were planted commands a higher price in the market. In addition, we would plant high-value, high-sequestration species that take longer to grow than normal plantation owners might be able to wait.
Sources & notes:
- I can’t publicly repost the Goldman Sachs report I cited above, but for those with access, it’s called “Americas: Paper and Forest Products”, and was published by GS Equity Research on September 22, 2016.
- IETA report on carbon pricing schemes under consideration
- Forestry ownership in the US
- WWF Living Carbon report on forestry demand in the future
- US Forestry Service analysis of future demand for wood
- Australian report on projected demand for timber
- I need to better understand CA compliance offset buyer behavior to figure out (a) what “real” demand is in the market, and (b) if there’s potential to aggregate them into a pool on long-term commitments.