Supplementing forest sustainability certificates with fiscal instruments by Fiscal Forestry
A legally and economically viable mechanism to drastically increase the effectiveness of sustainability certificates for traded timber.
STRUCTURE OF OUR ANSWERS
Below we present an overview of the different aspects of the mechanism. For details, we furthermore provide you with an accompanying booklet at http://ssrn.com/abstract=2617815
Many developed countries have the declared objective of supporting forest sustainability around the globe, but the world’s most important forests are, in fact, outside their jurisdictions. Actions to protect these forests are therefore constrained by the legal problem of extraterritoriality. To legally act outside their borders, developed countries have supported sustainability certificates on production practices and price-based instruments. However, neither instrument reached beyond niche market shares, administration and compliance costs were high, and the two types of instruments worked alongside each other without much synergies.
Here we provide an economically and legally feasible way to integrate forestry certificates with price-based instruments, in a way that exploits synergies, and gives dynamic incentives for sustainable use of forests while keeping down the costs. It is a scheme that satisfies legal extraterritoriality constraints while allowing countries to act outside their borders.
The mechanism consists of a tax imposed by a timber-importing country on a default assumption regarding the sustainability of the timber, combined with a tax discount that is provided on proof that the sustainability was higher than assumed. The proof is established by showing a sustainability certificate to the customs authority when the timber is imported.
This basic “Feebate” mechanism overcomes a range of standard problems in the literature on certification and fiscal instruments for strengthening the sustainability of overseas forestry, such as the great data needs for efficient pricing of externalities in the forestry sector, without either violating legal restrictions of extraterritoriality or causing high administration and compliance cost.
What actions do you propose?
Here we first explain the mechanism and then the problems that it solves.
When timber is imported, custom authorities apply a “tax for unsustainable production” which departs from the assumption that the timber is not sustainable. The burden of proof is on the taxpayer to prove the sustainability. This proof works through showing a sustainability certificates and the customs authorities respond to it by issuing a tax discount.
The customs authority accepts that the sustainability is proven through certificates which are issued by registered certification agencies.
These agencies can, in principle, be foreign states. For example, if the customs authority trusts that a foreign state will adequately monitor all its timber exports for legality, it can accept certificates of legality that are issued by the foreign state and grant tax discounts for these. These tax discounts provide the foreign states with incentives to maintain and expand their control of legality standards and progressively also raise the ambition and enforcement of domestic sustainability standards.
There will be many cases, however, where the customs authority cannot fully trust assurances from foreign states that timber exports are legal, given the abundant evidence that much timber trade is not from legal sources despite treaties banning such trade. This well-documented problem is even greater for sustainability standards that go beyond just assuring legality. In each of these cases where certification by foreign states is not enough, the customs authority would require certifications to come from registered, private certification agencies. Our paper sets out the conditions under which those companies should be registered and liable in the customs authority’s home market. The private certification agencies would be hired by foreign forest owners to control and certify their sustainability. The forest owner has the incentive to hire these agencies in order for its produce to qualify for the tax discounts and hence attract better prices.
This mechanism would overcome the following problems that occur in the many situations where international forestry treaties are not sufficient to guarantee the legality and sustainability of traded forest products.
Due to the diversity of forests, the literature generally finds that much data would be needed to efficiently vary the pricing of forestry products in destination markets according to the sustainability of production in the origin countries. Legally, however, there are great restrictions for raising this data, since overseas forests fall outside of the jurisdiction of the destination market’s state, such that the release of the needed data cannot be mandated. By setting a tax rate based on default values, the tax can be set without such legal problems and with minimum administrative cost, and by providing a tax discount for proof of being better than the default value, the required data is raised even without jurisdictional power.
Whereas international public law prevents the taxing state from itself ascertaining the sustainability of overseas timber, private certification agencies such as the Forest Stewardship Council (FSC) receive these rights through contract law. Certification agencies therefore provide a channel for raising the needed data to make the net tax faced by foreign forest owners reflect their sustainability standards.
Improving the incentives of forest owners to produce sustainably
Two fundamental problems with certification agencies today is that many forest owners in developing countries cannot afford them, and that those forest owners who do participate face insufficiently dynamic incentives to keep improving. Our mechanism tackles these problems on three fronts.
1. Compliance costs
Today, forest owners face high costs for having the sustainability of their production checked through certification agencies. These high compliance costs can partly be explained by a lack of competition between such agencies. Addressing this problem is difficult, because competition between certification agencies would require consumers to handle the information of various competing sustainability labels. The empirical literature suggests that a greater number of competing sustainability labels leads to consumer confusion, thus putting a natural barrier on the competitive pressure that can be introduced into the current market for sustainability certification.
Our mechanism reduces this problem by creating a role for certificates beyond consumer information: The certificates are used to provide information to the customs authority, and for this role there is no problem with multiple competing certificates, given that the authority does not suffer from the same limitations as consumers in handling the complexity of multiple certificates. More certification agencies can hence be allowed, competition becomes possible, and compliance costs can be driven down to provide more forest owners with an ability to prove their sustainability.
2. Cost for threshold investments
To obtain a sustainability certificate, many forest owners need to make large one-off adjustments to their production. This is because even the least ambitious certificate is often already a long shot away from current production standards. The threshold to be attained for getting into certification schemes could be lowered by offering a greater diversity of certificates. Providing more low-level sustainability certificates would enable some forest owners who do not have the capital for large changes to their production to at least do small improvements and get rewarded. But since consumers commonly fail at differentiating low-quality from high-quality certificates, these greater incentives for low-quality forest producers to start improving their production would simultaneously reduce the incentives for higher-quality forest producers as confused consumers shift away from the high-quality labels to buy the new, supposedly substitutable products, considering all timber with labels the same. The problem of threshold investments can therefore not be efficiently addressed with the current market structure for certificates.
3. Dynamic incentives
Certification agencies face the trade-off that any increase in their sustainability standards increase the problem of threshold investments, while without such increases the forest owners who have already attained the certificate face no dynamic incentives to improve further.
Each of these problems improves with our mechanism as the tax authority can allow any quantity of certification instruments as it is comparatively inexpensive for the state to grade the relative worth of these certificates compared to consumers. The customs authority would just award different amounts of the tax discount for timber with the different sustainability certificates, given its ranking of the certificates' relative worth. As this diversity of certificates becomes possible, each forest owner faces a dynamic incentive to improve its sustainability because there is a certificate that is sufficiently close in reach to make even a small improvement already bear some fruit.
Complementing, not substituting, the previous role of certificates
While the new fiscal role of sustainability certificates would remedy these problems, the existing role of sustainability certificates as guides to consumers could still be continued. One option for making this possible is to allow any number of certificates for claiming the tax discount but restrict which certificates are allowed to be displayed to consumers on products. In this case the certificates would be treated just as other information that already today is communicated to custom agencies without being visible to end-consumers. In the paper we show that with the new role of certificates, there are no great efficiency losses to letting consumers only see the certificate for high-sustainability products. This is because the fiscal system already internalizes external costs for timber products and the main purpose of then still displaying certificates to consumers is to allow the consumer to disagree with the state’s calculation of the external costs and demand an even greater degree of cost internalization. And as the most caring consumers who want sustainability beyond the degree that the fiscal system already enforces will tend to also demand high-sustainability products, only the certificates documenting the highest sustainability standards need to be shown on consumer products.
Assignment of the tax liability
In the accompanying paper we analyze the effects that allowing this special treatment for the top certificates has on competition between certification agencies. We then also consider an alternative, where consumers do not see the label of the certification agency on their product but instead the grading of the product’s sustainability that the customs authority inferred from the sustainability certificate. This type of labeling would be similar to the energy efficiency labeling in the EU, where consumers see a rating of products according to their sustainability on a simple scale from A to G. When a timber product arrives in the destination market with a sustainability certificate, the tax authority already needs to rank the sustainability standard expressed by that certificate in comparison with other certificates on a scale in order to set the tax discount. The only change now would be that the consumer would be provided with the information how the sustainability of the product was ranked by the tax authority. Different products would always need to display this information in the same standardized way. Consumer confusion would not anymore arise from a proliferation of many similarly-looking labels with symbols or statements that the consumer does not understand.
Above, we described how the problem of data unavailability could be solved despite the state’s legal restriction for extraterritorial action. Equally to contain the extraterritorial action, the tax liability itself would need to be imposed on domestic actors and not on the overseas forest owner. This is because the taxing state does not have jurisdiction over overseas entities. Instead, the legal tax liability would need to be imposed on the importer of the timber cargo. This is a domestic entity (as mandated, for example, in the EU Customs Code) and hence legitimately subject to the taxing state’s fiscal policy. Economically, this attribution of the tax liability changes none of the incentives for the forest owner, however, because the economic incidence of the tax is the same whether the forest owner bears the legal tax liability or the forest owner’s transaction partner in the taxing country. Since the forest owner or any intermediate body purchasing the timber from the forest owner negotiates the price for the timber with the entity importing the timber, the price signal is conveyed. In a further paper substantiating our proposal, we furthermore show that the proportion of the price signal that is conveyed to each actor on the supply chain coincides with the proportion of external damages that forest owner, middlemen and consumer each cause. The tax incidence received is hence not just unaffected by the attribution of the legal tax liability but it also reflects the proportionate causation of the problem of unsustainably sourced timber that the producers and consumers of forestry products are jointly causing.
WTO compatibility and protection against fraud
In the paper substantiating this proposal we also show how the mechanism would be guarded against fraud, and how WTO law would require that the establishment of the mentioned system for imported timber requires a similar system for domestic timber as well. There are no major problems with this extension, in fact it just improves the efficiency of the use of certificates in existing forestry policy.
Who will take these actions?
Given that the certification of the sustainability of a forest product is worth a reduction in the tax, this certification is of economic interest to all persons who trade the product. The actors along the supply chain in this contractual and financial relations include the forest owner, a middle-man who exports the product (consignor), the person in the destination market who imports the product (consignee), the shipping company, certification agencies, and the custom authority that levies the tax and grants the tax deduction if the product comes with a sustainability certificate.
The key actor will first be the taxing state, who creates the demand and market for certified timber products and establish certification agencies. Then there are forest owners who react according to the incentives.
The mechanism allows a large role for private actors and private enforcement without at the same time risking chaos. Private governance through certification agencies is allowed and private contract law receives a prominent role in shaping forestry solutions, but at the same time there is coordination through a clearly-defined role for the public sector, and therefore a protection against erosion of sustainability standards.
Actions that we as a project team undertake is to present our proposal to stakeholders (including World Bank, IMF, IUCN Jakarta), to introduce the idea into policy circles, and also to gather feedback for further improving the mechanism. We consider the MIT Solve Conference to be a key platform in getting decision makers on board, and would be delighted to be given the opportunity to present there.
Where will these actions be taken?
Any timber-importing country could enact the proposed mechanism. The mechanism is particularly useful to countries that import timber from origins where sustainability standards are lower than at home (since the mechanism then also reduces carbon leakage for domestic forestry policy).
Furthermore, the advantage of using private certification agencies depends on the foreign government’s own control of timber legality and sustainability standards. For example, if the foreign government is perfectly reliable at checking the legality of its timber exports, private certification agencies are not needed for legality checks. This situation applies for some developing countries that import timber from developed countries; but the opposite is more usual. The mechanism is therefore most useful to developed countries importing from developing countries where forestry standards are too low and under-enforced.
Another reason why this mechanism would particularly help forestry policy of developed countries is because those countries are more affected by the problem of extraterritoriality. There are much less remaining forests in developed countries, so if those do want to attain their objectives of making a significant contribution to forest protection, they need to act also outside their borders. Here we have shown a way how this action can work without the usual limits of legal extraterritoritality and data unavailability.
Since the mechanism has low compliance and administration costs, it is, however, sufficiently inexpensive to introduce for a great variety of countries. Customs charges are inexpensive to operate relative to other environmental taxes, and the customs bureaucracy to oversee a scheme such as this one would be available even in countries with low administrative capacity. This is hence a rather cheap forestry policy. So while developed countries might benefit the most, others could act too.
How much will emissions be reduced or sequestered vs. business as usual levels?
Approximately 850 million hectares of degraded forests around the world could potentially be restored, and approximately four tons of carbon to be sequestrated per hectare per year. Globally, the current FSC-certified forest areas are, however, just around 190 million hectares, with just 18 percent of the area located outside North America and Europe. Our proposal aims at increasing the certified forest percentage in developing countries by setting up dynamic incentives through the two stages mechanism (legality and sustainability) and thereby mitigating emissions from land-use changes there. As we show in the paper, these improvements in the origin countries of the timber also reduce carbon leakage from forestry policy in developed countries (by reducing carbon leakage). Furthermore, there would be a possible reduction of emissions from the use of the revenue. This is because UNFCCC Art. 3 would require that some of the revenue from the tax be used for climate finance.
What are other key benefits?
Current global climate change negotiation on Reducing Emissions from Deforestation and Forest Degradation is faced with many challenges. Not only because of the multiple stakeholders and their various interests involved, but also because of its immense scope and uncertainties regarding its precise contents and funding. Our proposal seeks to include the primary actors in the supply chain with a more focused scope and more concrete actions. Beyond the benefits of carbon mitigation and carbon sequestration through better forest management in our proposal, this mechanism can achieve a number of the co-benefits, such as adaptation, conserving biodiversity, protecting watersheds, taking into account the right of indigenous people, the need for economic growth in the developing countries. Moreover, in our proposed system, unlike REDD+ facing major threats on lack of financing, this scheme has the potential to generate revenues and provide funding for further forestry management.
What are the proposal’s costs?
Any forestry policy will involve significant costs because the determination of the sustainability standards of a forest is such a complex exercise. Applying environmental fiscal policy is generally complex, but for forestry the problem is worse, given that forests vary so much, while --for example-- the definition of a ton of pollution from a power station is rather clear. We address this cost of finding the information needed for fiscal policy on forests through a certification system. This is not just kicking a can down a street, as the overall costs for the information fall through the involvement of the certification system. Still, the certification system itself has costs that are significant.
However, the costs of the certification system in the form that we described needs to be compared to the costs of the existing certification system. The existing system reaches only a niche market, partly because of the identified structural problems and partly because compliance costs are high. Those compliance costs would fall with competition, which our mechanism enables.
Administration costs would be low, partly because we are reusing existing customs transactions for the scheme, partly because our paper sets out an information exchange mechanism that saves cost, and partly because the mechanism creates an efficient role for private governance.
The proposed mechanism can be applied within five years since the fundamental needed infrastructures for our mechanism are already in place.
This infrastructure particularly involves the custom databases needed, which are available.
The custom authority of the implementing state would, however, need time for estimating the relative value of alternative sustainability certificates. The cost and time for establishing this classification system could be reduced by turning the burden of proof on certification companies, who would need to prove that they are better than their competitors if they want their certificates to receive higher tax discounts.
Time would also be needed if the customs authority wants to set the default value for the tax rate equal to the Pigouvian level. In the empirical literature, the estimates of external cost for unsustainable forestry vary widely. But even if the default value was set at a wrong rate, that problem can be remedied over time, as the submissions of sustainability certificates would provide the customs authority with increasingly more data to refine its original estimate. Furthermore, a default value based on a too pessimistic assumption for sustainability levels prevailent in timber imports would just cause a larger number of taxpayers to submit certificates demonstrating their true sustainability. The consequences of initially making an error in the setting of the default value would therefore by limited. Knowing that these repercussions would not be dangerous, the custom authority could take this decision more quickly and not require more than a few years of preparation.
Our mechanism is the sibling of the transport proposal “Economically, legally and politically viable mechanism for taxing shipping fuel emissions”. With the two proposals, we are aiming to sketch solutions for fiscal climate policy in two of the most difficult sectors. This is because climate policy for overseas forests and in the maritime sector have both been plagued by the legal corset of extraterritoriality, great information availability problems and carbon leakage. In the forestry sector this situation led to a proliferation of small, largely ineffective showcase policies, while in the maritime sector only a few regulatory minimum standards have been agreed. For both sectors, we describe how such a fiscal policy could be realized, without a requirement for unanimity, while avoiding data problems and extraterritoriality. Both mechanisms save on administration costs and compliance costs. And both mechanisms are accompanied by a paper with more detailed legal and economic analysis.
Please see our accompanying paper with the details on the mechanism and its relation to the scientific literature at http://ssrn.com/abstract=2617815