Insuring Carbon Farms  forests grown for the purpose of sequestering carbon

With the NZU price lifting to over $80, we have seen a dramatic rise in enquiries seeking insurance for carbon farms.  These enquiries come from both new plantings and the conversion from existing rotation plantations into carbon farms.

The depth of understanding about the ETS varies, so getting the right information from which to base important decisions on can, at times, be a struggle for all involved.

A regular question raised by carbon farmers is around how to structure insurance cover on a carbon farm.  The ETS is a complicated subject, so for this general commentary, we will stay at 20,000 feet in covering the following subjects.

How carbon forestry works

If you have two identical trees on either side of a road, one grown for timber and one for carbon, then fundamentally they present the same risk proposition to insure [we deal with this in more detail below].  However, one of the first and most important questions will be how to value the trees, given their different activity, i.e. grown to sequester carbon vs produce timber.

There are presently three schemes under which forests can be registered:

    a)  Stock Change

    b)  Averaging

    c)  Permanent

Stock Change

Usually the members of this scheme require two aspects to be insured:

    1)  Surrender liability – the total number of NZUs issued against a forest [and sold]. These units have a liability against them to be repaid to the Govt in the event of deforestation.

    2)  Loss Of Future Earnings ‘LOFE’ – lost future earnings following a deforestation event from an insured loss, i.e. fire

From 1 January 2023, it is proposed the surrender liability to the Government can be avoided providing certain criteria is met, i.e. replant within a timeframe.  This is great to reduce the insurable value of the forest, which, given the premium is calculated on the insured value, will aid in keeping the premium costs down.  The flip side to this is that the forest will forsake any future NZUs until the trees attain the pre-loss age.  So, if the trees are at 15 years when damaged by fire, no NZUs will be earned until they reach that age after being replaced.  Often this isn’t an ideal situation for those relying on the carbon yields each year, so owners under Stock Change tend to keep the surrender value as part of the insured value and pay a higher premium based on this.

The LOFE can be calculated using a discounted cashflow model, or more simply, by looking at the annual NZU yield x the NZU value x the number of years future income, e.g.

annual yield 5,000 NZUs x $85 x 3 years = $1.275M

The combination of these two values, surrender and LOFE, will generally determine the insured value for the forest.  Re-establishment costs are an additional limit and set out in the policy based on the limit offered by the insurer.

Averaging

This scheme provides an option for rotation timber foresters to benefit from the ETS for a period [presently] up to the first 16 years.  If there is a temporary deforestation event, i.e. fire, the scheme allows for foresters to avoid the surrender liability, but again there will be no NZU income until the forest attains its pre-loss age.  Under Averaging, usually the carbon farmer will often insure their LOFE for 3-5 years, up to a maximum age of 16 years of age – beyond this the Averaging scheme ends, and no carbon income is claimable. Re-establishment etc. offered in addition to this value.  An important twist is that as the trees get closer to the 16-year threshold, their value for carbon diminishes [because the LOFE diminishes] and the timber value becomes the greater insurable loss. There is no simple formula for assessing how to calculate this transition between the insurable values and it is for the owner to weigh up the best strategy.

Under Stock Change and Averaging, you cannot insure both the timber and carbon values on the same forest.  If you are intending to harvest your trees, but claim and sell NZUs, your asset is the NPV of the timber. You have financially benefited from the income from the NZUs, so receiving an insurance payment on both the NPV value of the timber lost, plus the surrender and LOFE of carbon, would be double indemnity, making you considerably better off financially by receiving an insurance settlement than you otherwise would be.  There is a qualification to this where an owner is growing trees for harvest and has an off-take agreement with a third party who is ‘harvesting’ the carbon from the same forest.  Each party has differing insurable interests, so in this case, it would be possible for there to be two policies on the same forest for different entities.

Permanent

The permanent scheme similarly can also avoid the surrender liability if replanted, but again, the owner forsakes any NZU income until the trees attain their pre-loss age.  Here the owner may elect to insure the surrender liability [as with Stock Change] plus the LOFE.  They may also view their profile as a long-term play and only insure the LOFE [as with Averaging].

Risks covered

Fire is the primary risk and poses the most catastrophic exposure.  Windstorm can also be insured but it is expensive due to the higher frequency of Wind events that occur. If windstorm is offered, it will be subject to a sub-limit of the Fire insured value.  Other perils such as earthquake, landslip and volcanic activity can also be insured, again offered as sub-limits.

Assessing risks

When determining the premium and policy deductible, there are numerous factors taken into account that have an impact on terms that may be offered.  Considerable weight is applied to the regional profile of a forest’s location – some of the elements factored in are: propensity for rainfall, drought/dry periods, wind and soil type as examples.

Other key factors taken into account may include:

•         Whether powerlines cross/border the property.  The statistics show downed lines are the cause of a significant number of fires, so this is a higher risk indicator.
•         Proximity to urban areas.  Over 90% of fires are started by apeople.
•         Whether there is a building/house on the property.  Sparks from outdoor fires or indoor fireplaces travel considerable distances and start fires, especially in dry periods. Spark arrestors should be fitted if the fire is not emissions approved, i.e. double burning.  Having someone living on-site can be a positive as they keep an eye on the property and can raise an alarm should a fire be detected.
•         The forests being used for other activities, i.e. camping, commercial operations organised trail rides etc.
•         Access to water.
•         The tending regime undertaken on your plantation? Those with good husbandry practices, fire management plans, H&S safeguards and active management of plantations pose better risks
•         Previous losses suffered on your property, plus the general region’s own history

Changing landscape

Forestry insurance has always struggled to deliver a return to insurance companies.  While insurers may go three years with acceptable losses, as we have seen in 2015 and 2020, large fires in New Zealand forestry can obliterate several years’ worth of premium income in one season.  As a result of this, in recent years we have seen the number of insurers providing forestry cover in New Zealand reduce from five to three.  Of the remaining three, only one is providing insurance for carbon forests [Sage Partners & Lloyd’s].

All the weather modelling we have anaylised points towards changing weather patterns, making regions that were considered low risk, now dryer for longer or windier than previously thought. Similarly, some regions are expected to have higher than usual rainfall. The short answer is no-one can comfortably predict what a region will experience in any given year i.e., we had a large fire in 2020 which burnt for several days and it was unseasonal snow that helped extinguish the fire. Anyone who has a better than 70% accuracy rate in weather predictions should apply within!

For many other countries – e.g., USA, Canada, South America, and most of Australia, capacity has been withdrawn after consistent losses and a growing perception those territories are ‘always on fire’.  Internationally, New Zealand is still considered amongst the better territories for insurers to make capital available for forestry risks.  This is largely due to a local presence who understands the market and deals directly with brokers and their forest owners, working with them to take steps to mitigate threats where possible.

Hoping this has been on some value to you. With summer here, we trust you have a safe and uneventful fire season.

Geoff Manks

Managing Director

Sage Partners Ltd are a Lloyd’s Coverholder.  This article is intended to provide some insight as to how we, as insurers, view carbon forestry risks and is not to be taken as advice.  When looking to insure your forest, you must seek your own advice from a licensed and qualified insurance broker or forestry consultant.