ANNEX 2: ECONOMIC RENT AND FOREST CHARGES

Economic efficiency is an underlying objective of government policy in most countries and should be reflected in the way that forestry administrations organise their forest revenue systems. Economic theory shows that economies tend to function most efficiently when the levels of output and prices of goods and services are established through competitive markets. Therefore, in situations where the government licences the production of a good or service, such as they do with forest concessions, a useful starting point for developing a charging policy is that the government should aim to charge for the use of forest resources in a way that resembles what might be achieved in a competitive market.

It is sometimes possible for the government to implement efficient forest charging policies by managing their forest resources in a way that replicates the competitive market. For example, the state could divide production amongst a number of competing state enterprises or use a competitive mechanism (such as auctions or sealed tenders) to sell the rights to harvest forest products. However, where forest concessions are awarded for relatively long periods of time (as opposed to short-term cutting licences), it is often technically difficult to introduce competition into the process of awarding and supervising the concessions. Therefore, governments usually have to set charges for the use of the forest in a way that reflects what the competitive market value of the outputs from the resource would probably be.

There is a further complication in the case of forests (and some other types of natural resources), in that these resources are essentially produced for free (i.e. the resources occur naturally, although the production of outputs from these resources involves a production cost). Therefore, it is not possible to look at the cost of creating the resource as a guide to what the charge for using it might be. Furthermore, unless there is a private forest owning sector, it is not even possible to get a reference price for the value of these outputs from the private-sector. Therefore, in the case of forests and other natural resources, the amount that the government charges for the use of the resource has to be calculated from theory and the "economic rent" from production is often chosen as an appropriate measure on which to base forest charges.

This annex describes what economic rent is and shows how it can be calculated and used as a guide to setting forest charges. It then describes some of the challenges to calculating economic rent.

Economic rent can be defined as the surplus value created during the production of a good or service, due to the ownership of a factor of production that is in fixed or limited supply. In many economic activities, it is not possible to create economic rents. Thus, for example, if a sawmiller could sell sawnwood for far more than the cost of production (and thus, earn an economic rent from that activity), other producers would soon enter the market and drive product prices down, such that the surplus would disappear. However, if that activity was dependant upon a fixed factor of production (e.g. a prime location in a city or an exclusive property right such as a patented production process or copyright on a product design), then other producers could not enter that particular part of the market and drive prices down and the economic rent would persist.

The classic example of an economic rent is a land rent. Land supply is generally fixed and land costs nothing to produce yet, with the addition of other inputs, land can be made to produce outputs that are far higher in value than the total cost of the inputs. On very productive land or land in favourable locations, the economic rent is high; while in more remote or less productive areas, economic rent is much lower. In a competitive market, potential users of the land would be prepared to pay a rent to the owners of the land that is equal to the economic rent from its use.

It should be noted however, that other factors of production can also earn economic rents if there are artificial barriers or other rigidities that restrict the supply of these factors to the market. An important point for governments to note is that they can have a major impact on the creation of rents in an economy if the policies they pursue affect the flow of capital or place other constraints on the way that markets function.

Economic rent in the context of forest concessions

The economic rent from a forest concession is a type of land rent. In the case of the natural forest, the resource occurs without any investment (i.e. it occurs naturally and is not planted or created in any way) and the value of outputs from the forest will be higher than the costs of production up until the point at which low stocking, poor accessibility or distance from markets makes production uneconomic.

The economic rent from roundwood production is generally referred to as the stumpage value of roundwood, or the price that would be obtained if the timber were sold standing in a competitive market. In some countries, timber is sold standing by competitive means such as auctions or tenders but, for a number of reasons, this is not common in tropical forests managed under selective cutting systems. Therefore, the government has to estimate what an appropriate level of forest charges should be and the estimated economic rent from roundwood production is often chosen as the basis for setting forest charges.

In the context of forests managed for timber production, economic rent is simply estimated by subtracting the costs of roundwood production from the value of roundwood produced from the resource. However, this calculation is often more complicated than it seems. Firstly, it is often necessary to build-up the total cost of roundwood production from the cost of each individual forestry activity (e.g. forest management and planning, felling, extraction and transport to the point of sale). Furthermore, the cost of each activity also usually has to be constructed from its individual components (e.g. labour costs; the costs of consumable items used in the activity such as raw materials, fuel and minor tools and spare parts, and the cost of capital such as equipment, machinery and buildings). In addition to these cost components, the calculation of total production cost should also include an allowance for normal profit (see Box 2).

The two cost components that are generally the most difficult to estimate are the capital cost and the level of profit that a forest concessionaire should be allowed to retain (i.e. the normal profit). The cost of capital is usually based on the depreciation of capital used in the production process. The level of normal profit is usually expressed as a required rate of return on the total amount of capital invested in the production process.

The pie chart shown in Figure 3 demonstrates how the total value of roundwood production might be distributed between labour and raw material costs, capital cost, normal profit and economic rent. The value of roundwood is represented by the total size of the pie. The various components of the total roundwood production cost are represented by the dark shaded slices of the pie and the unshaded slice represents the economic rent. It is worthwhile noting that a large proportion of the roundwood production cost is usually accounted for by the cost of capital and normal profit in most forest operations. Because this cost is largely fixed (i.e. it doesn’t vary with output levels), the efficiency of capital utilisation can have a dramatic impact on the total roundwood production cost and, consequently, the level of economic rent earned from roundwood production.

As Figure 3 above shows, the economic rent from roundwood production is the surplus remaining from the sale of the roundwood after all the production costs have been covered. In other words, if the rights to cut a particular area of forest were auctioned in a competitive market, it could be expected that the highest bid would be close to this level of economic rent. Therefore, if roundwood is harvested from state-owned forest, the charge that the forestry administration sets for the use of the resource should usually be set at a level that captures a significant proportion of this economic rent.

Any economic rent, which is not captured by government levies, is earned by the forest concessionaire, the concessionaire's customers (i.e. the sawmill owner, which may be the same person) or, occasionally, contractors or others involved in the production process. This proportion of the economic rent that does not accrue to the government (as the owner of the resource) is usually referred to as "excess profits" or "windfall profits".

There may be circumstances where the government deliberately decides to collect less than the total amount of economic rent in order to give a subsidy to roundwood production or to the domestic forest processing industry. However, it is often the case that government charges fail to capture the total amount of economic rent from roundwood production, because the government is uncertain about the level of economic rent being generated in the sector.

There are three main challenges when attempting to calculate economic rent: the collection of accurate and reliable cost and price information; the variability in economic rent across different regions and types of forest; and the question of what is an appropriate level of normal profit in the sector.

Data quality

There are two main problems with the collection of cost and price data for economic rent analysis. The first is that such information is often not readily available and, even if it is, it may not be very reliable. This is particularly the case with some of the components of the production cost (e.g. the cost of repairs and maintenance) where forest operators often do not keep accurate records. This can partly be overcome by referring to machine operator’s handbooks and collecting information about the cost of typical repair and maintenance activities in order to calculate an estimate of the cost. Another way in which the situation may be addressed is by asking forest managers about how often they perform various activities such as maintenance in order to get a general idea of the cost of such activities.

The second problem that occurs, is that it is often in the interests of the respondents to any enquiry to understate prices and overstate costs in order to give the impression that profitability is low (and consequently that forest charges should be low). Some take this a step further and deliberately record low prices in their records in order to alter their tax position (this is particularly a problem where the forest concessionaire supplies a sawmill owned by the same person or company where this practice, known as artificial transfer pricing, can be used to considerable advantage). This problem can only be overcome by judging how reliable the data collected is by comparing the responses given by individuals with each other and with any competitive market information that may be available (for example, by working back to a roundwood price from the sale price of finished wood products).

Variability

The second challenge is that, like any land rent, the level of economic rent from roundwood production can vary greatly due to a number of factors such as the productivity of a site, the volume of commercial species present, transport distances and other site conditions.

Where the total roundwood production cost varies due to factors over which the forest concessionaire has little control, this variability should be taken into account in the design of the forest charging policy. In other words if, for example, the total roundwood production cost from a particular concession is high because it is a long way from the market, this should be accommodated in the forest charging system by setting a lower forest charge for outputs produced from this area. Examples of factors that should be accommodated in this way include: the level of stocking of commercial species in the forest; terrain and other working conditions; and the distance from the forest concession to the market. The most important of these factors is likely to be transport distance.

There is also a second group of factors that can affect the economic rent from production, over which forest managers do have some control. These mostly concern the efficiency of operations and include variables such as: the length of skid-trails used to extract timber; harvesting machine availability and utilisation rates; and the utilisation of appropriate technology. In these cases, the charging policy and the way in which forest concessions are awarded and supervised should aim to encourage greater efficiency and the reduction of the total roundwood production cost, in order that the economic rent from production can be maximised. In other words, inefficiency and low productivity is not a reasonable excuse for setting low forest charges.

Normal profit

The last major challenge in the calculation of economic rent is determining what the normal level of profit should be. As noted above, the forest charging system should aim to set charges such that the government captures any economic rent that is currently being captured by the private-sector in the form of excess profits. If, however, the government sets charges too high, they may reduce the level of profits that the forest concessionaire can retain so much that there will be no new investment in the sector and forest concessionaires will eventually leave the sector.

In view of the fact that the charging policy should, in the long-run, allow forest concessionaires to make new investments, it is appropriate that they should be allowed to retain a certain proportion of their profits. Normal profit can be estimated by discussing profit expectations with concessionaires or by deriving an estimate from the returns from other investments in the economy. For example, current nominal interest rates in Zambian Government Bonds are in the range of 30% to 40%. Thus, after adjusting these for inflation and risk, the rate of return or profit that might reasonably be allowed in the forestry sector may be in the range of 20% to 30%.