Tops of trees - pine forest

The inherent heterogeneity and riskiness of forestry projects pose severe challenges to investors targeting narrowly defined risk-return profiles and lacking the expertise and resources to engage in effective project selection, thus hampering the ability of originators to deliver investable forestry assets to market.

Forestry projects aimed at carbon sequestration share common features related to the lifecycle of trees and their carbon capture potential. However, each project also differs by a variety of attributes including location, tree type and forest age, to name a few. Such attributes modulate a project’s exposure to various sources of risk, such as weather hazards and wildfire risk, as well as its ability to sequester carbon over time and meet biodiversity targets.

In this report, we consider in detail security design mechanisms in relation to forestry projects bundled into forestry-backed securities. We focus on foundational concepts of forest aggregation, which should be of interest to any originator of forestry-linked securities. Once the mechanics of risk aggregation are well understood, it becomes relatively straightforward to tranche the forestry pool to deliver forestry-backed instruments with different yields depending on investors’ risk appetite. We therefore devote our attention to understanding the aggregation of forestry assets along different dimensions, separately and jointly. The main risk drivers we consider in our analysis are geography, forestry vintage, wildfire risk exposure and carbon sequestration potential. We also provide examples of multidimensional project screening, taking into account also the biodiversity dimension.

The report is co-authored by Enrico Biffis, an Associate Professor of Actuarial Finance at Imperial College Business School, alongside Giuseppe Brandi, also from Imperial, as well as authors from Terraformation, a forest tech startup. It is the first in a forthcoming series on novel insights into forest carbon investments.