I thank the Chairman and the members of the committee for the opportunity to address it this afternoon. I have followed the work of the committee for some time and I congratulate it on the quality of its output and the contribution it makes to the climate change debate, an area many of you know I am passionate about. I have been involved in the carbon area since 2004, when I launched Bank of Ireland's presence in the market. We remain the only domestic bank with a dedicated capability in the carbon markets and we have a reputation as an innovative niche player, having been the first bank to transact an emissions-related derivative with a corporate customer and the first bank to offer a carbon-linked deposit to Irish investors. We do not engage in proprietary activities in the carbon market.
In addition to the carbon activities of the bank, I am the chair of the expert carbon group of the Clearing House Group, which is tasked with the development of carbon-related initiatives in the context of the green IFSC. The range and reach of the carbon markets covers several diverse sectors that are at varying stages of development. I have ensured I am well versed in the areas that offer the greatest potential business opportunity and, for that reason, in an Irish context I have paid close attention to the emerging carbon removal capacity of forestry. I hope to offer an insight into how the application of carbon offsets to forestry transforms the investment potential of the sector, which could be of significant benefit to Ireland. My contribution to this committee is based on my experience of carbon markets in a broad industry context. I propose delivering a short presentation outlining the scope of forestry offset investment potential and I will be happy to answer any questions committee members may have on the subject matter.
I wish to set the scene in terms of the current situation and the structure of the existing forestry investments before reviewing the key components of investment criteria and considering the value of carbon in this respect. I will offer an insight into how forestry investment can use the value of carbon sequestration to transform the nature of capital raising, providing cost-efficient ways of implementing afforestation.
Ireland has a low percentage of forest cover relative to the European average. Conversely, we have an extremely high agricultural emissions rate. As part of a commitment to EU targets, we must reduce non-traded emissions by 20% by 2020. Our current sequestration rate is a net 2.4 million tonnes per year. Given the efficiency of forestry to act as a carbon sink, it is clear that increased afforestation in Ireland would make a contribution to meeting our non-traded sector target. It is important to find a way to encourage afforestation in a viable way, which will entail strengthening the investor proposition. The benefits of increased afforestation are well documented. In addition to the increased sequestration potential, biomass capacity will be enhanced, the tourism proposition will be developed and direct and indirect employment prospects will be improved. The opportunities in the forest tech sector, for data analysis products in particular, are very strong and are often overlooked. I have in mind TreeMetrics in Cork, which represents a prime example of a young exciting company with a business model based on technical forestry analysis.
I will move on to an examination of traditional forestry investment. Forestry investment is a distinct asset class with unique features. The land element, on which the timber is grown, represents a larger percentage of the value during the early phase of the investment. The timber crop will generate a large percentage of overall investment value towards maturity. The value of incentives and allowances at the commencement of the investment and tax relief or exemption on disposal of the asset, will shape returns. Forestry investment is by definition a long-term, principally illiquid investment with an average life of between ten and 12 years. The associated cash flow is back-ended, with balloon repayment on maturity at the disposal of the timber harvest and, in many cases, land transfer. Minor cash flow may be generated from the proceeds of thinnings throughout the life of the investment but, for the purposes of calculating overall yield, this is marginal. The long-term nature of the investment, with uncertainty over timber yield and the final saleable value of the crop and land values over the period, means that the returns are difficult to calculate. This is a factor that discourages investors. Further risks to the investment return centre on natural risks such as damage from wind, frost, disease and fire although in the overall context, this can be neutralised by insurance cover.
All investment decisions are dependent on the required rate of return comprising five main elements. The first is the risk-free interest rate, the rate of return an investment can earn without any risk. This is illustrated in the slide, showing the 20-year euro interest rate curve. The second element is the inflation premium, the rate added to an investment to adjust it for the market's expectation of future inflation. The liquidity premium compensates the investor for being unable to realise the value of an asset before maturity. Forestry investment is typically illiquid and the premium for the inability to exit the investment is high. This aspect remains the single biggest deterrent to potential investors. The default risk premium is the risk that the investment will not deliver on its obligations. In the forestry context, this refers to the risk inherent in the variability of the timber crop price and the risk that wind, fire and disease will reduce the projected harvest yields. There is an element of risk associated with adverse future land valuation. The final aspect is the maturity premium. The longer the maturity, the greater the risk of capital loss. With forestry investments of between 12 and 20 years, the maturity premium will be substantial. Unsurprisingly, traditional offerings in forestry investment carry a significantly greater weighting of the last three elements. Applying these elements to the risk-free return, the investor return curve is deepened dramatically. This is reflected in the columns across the maturity curve in the slide. This calculator curve reflects the current required return of more than 7% for 20-year forestry investment, which is consistent with current market offerings. The key issue for those seeking to raise money in the sector is that the maturity profile of forestry investments, with all the returns back-ended into balloon repayment, means investors will continue to demand a high risk premium adjustment, making capital raising expensive relative to other sectors. The ability of the forestry business to vary or modify cash flow to deliver coupon-type returns unlock the potential for cheaper funding. This point makes the application of carbon sequestration rights so interesting. The graph on the slide being shown illustrates the current projected forward prices of carbon beyond phase 3 of the EU emissions trading scheme. It assumes an increasingly lower cap in Europe and the emergence of a linked market in the US, Japan and Australia. Current pricing is available up to and including 2020 and the price curve beyond that point is based on the aforementioned assumptions, adjusted volatility and the future interest rate curve.
The graph now being shown illustrates the current value of projected carbon sequestration under various scenarios using data from the committee's report on the EU Green Paper on protecting forests against climate change. If the current long-term carbon prices are applied to the various scenarios one can see the annual euro value after ten years is a minimum of €80 million and as much as €120 million.
The availability of a stream of forestry credits issued annually presents an opportunity for the transformation of the forestry investment offering. This transformation of the cashflow architecture opens up the possibility for forest owners to be able to diversify their investment offerings and cheapen the overall cost of capital. The additional flow of funds from the periodic disposal of carbon offsets could most effectively be used to address the key issue that has been identified as a barrier to investments, namely, liquidity. The prospect of a cashflow that facilitates coupon payments to investors over the life of an investment would have a positive effect on the composition of the investor return premium referred to previously.
The most efficient way of utilising prospective cashflow is for the forestry company to issue a range of investment opportunities through a special purpose vehicle, SPV. Such an SPV would be likely to hold a portfolio of various forests. Investments could vary in structure to appeal to the widest range of investors and include bond equities and deposit products. The advantage of using such a structure would mean the company could utilise various maturities to reduce its risk profile and thereby cheapen the capital cost. The inflow of credits when monetised could cover debt servicing. A contingency or buffer pool of credits must be maintained to ensure the cashflow is maintained in the event of non-performance of any of the plantations in the SPV. This could happen if the plantation were hit by fire, disease or other yield constraints. Any assumption regarding the future price of carbon should be reinforced with long-term hedging of the market risk. This could be achieved either through forward sale agreements or through the purchase of floors.
It is undeniable that the forestry credits concept is in its infancy but like many features of the carbon market there is a rapid rate of development globally as these points illustrate. lnterestingly last week the Chinese state forestry administration announced plans to launch an afforestation monitoring centre with a view to including forestry in its domestic voluntary market. I believe the demand for forestry credits is set to increase, in common with other carbon-linked assets, and my experience of the investor asset class suggests that demand for carbon-related investment opportunities is growing. If one considers a domestic offset scheme, the availability of forestry offsets may make a very strong contribution. This is my vision for the Irish non-traded sector which clearly shows the input that forestry carbon could have in a commercial application in such a system. Demand to purchase forestry offsets may well emerge from non-traded sector businesses in Ireland.
I hope I have shown how carbon sequestration rights can be used to transform forestry investments in such a way as to make afforestation an attractive proposition. This would benefit the country on many levels, support the farming community and encourage the financial sector to develop structures facilitating this aspect of the carbon market and attract investment funds into Irish forestry.