How does real option value compare with Faustmann value in the context of the New Zealand Emissions Trading Scheme?

Stochastic Dynamic Programming is used to determine the expected bare land value under the New Zealand ETS (Emissions Trading Scheme) with both log prices and carbon prices following a random walk. This value is substantially higher than the Faustmann NPV. This is in contrast to the situation without carbon where the difference is small and reduces as log price increases. When carbon is included, the difference in value is also large for existing stands and increases with stand age until at least the minimum harvest age is reached. Additional value comes from the flexibility of when to harvest and hence when carbon units have to be surrendered.The real options approach also provides additional insight on the probability of a stand being harvested. Harvesting does not occur at low log prices and only occurs at higher log prices when carbon prices are relatively low.

► New Zealand has enacted an Emissions Trading Scheme that includes forestry.
► For traditional forestry real option value is not much higher than Faustmann value.
► With the inclusion of carbon, real option value is higher than Faustmann value.
► The difference in value increases with stand age.
► The option value differential increases with price volatility.