Risk and uncertainty in Forest Investment: Risk management, decision making with uncertainty Concept Terminology Difference between risk and uncertainty Sources Rational decisions and criterion Mean expected value

Future is always uncertain: Farmers – few months to harvest crop Industrial investors – a return within few years But forester’s effort materialize (may not) after decades – even centuries The uncontrollable and unpredictable factors operating over a forest rotation presents so horrifying a prospect that many foresters ignore them altogether. But this is inexcusable and irresponsible. There are techniques that help to predict the trend of relevant economic and political variables.

Terminology State of nature: condition of factor in natural, economic or political environment over which the decision makers have no control e.g., rainfall, world timber price, drought Strategy: course of action controlled by decision makers and adopted in response to risk and uncertainty e.g., planting a species tolerant to prolonged drought, fire insurance, doing nothing Outcome: predicted result of a strategy in a given state of nature: if we plant pinus caribaea (strategy) and there is a prolonged drought (state of nature), the crop will fail (outcome).

Ignorance: we know nothing Uncertainty: range of relevant states of nature, and therefore what outcomes are possible, but not the relative probabilities of each state of nature Risk: distinguished from uncertainty by knowledge of the probability of each state of nature (tossing a coin)

Risk and uncertainty Treating future circumstances as risky rather than uncertain needs either: Actuarial data (historical evidence) – fire incidence, earthquake insurance Mathematical modeling – forecasts Certainty: which state of nature will eventuate, and precisely what outcome of strategy followed.

Sources of risks and uncertainties faced by forestry Natural environment – climate hazards, biotic – insects, pathogens, browsing animals Technological – new inventions (samill in Chaubas) Human factors – accidental fires, illicit felling, encroachment Market – unexpected surges and collapses (e.g., taxus) Political milieu – changes of government, wars, policy and taxation

Rational decisions under uncertainty A decision to establish plantations with associated sawmill in one of the three islands lying along a hurricane track. Data for decision making under uncertainty (NPV $ million) State Strategy of nature St Fitts St Starts Ambigua With hurricane 5 -2 2 Without hurricane 8 16 10

Decision making criterion Wald’s (1950): adopt strategy giving best outcome in worst circumstances – pessimistic Maximax: select strategy of best outcome in the best state of nature - optimistic Savage’s (1951): minimax regret is complex – devise the strategy for which maximum regret that could be felt is smaller than for any other strategy.

Savage contd Should there be a hurricane, and st Fitts had been chosen, there will be no regret about the choice of strategy, but without hurricane, the NPV would be $ 8 million rather than $16 million which could have been obtained, had st starts been selected. The margin between what was actually obtained and what have been obtained in that state of nature is a measure of regret: in this case $8million.

The Minimax regret criterion strategy St Fitts St Starts Ambigua 3 With hurricane 7 6 Without hurricane 8

Which criterion? Wald’s – St Fitts Minimax – St Starts Savage’s – Ambigua The criteria gives 3 answers but none of the criteria takes account of the existing evidence on real frequency of hurricanes

RISK AND MEAN EXPECTED VALUE Steps: 1) Classify strategies and state of nature 2) Determine the probability of each sate of nature from records, system simulation, expert’s and local people’s view, informed guesswork 3) Determine the outcome of each strategy under each state of nature 4) For each strategy, sum all the state of nature 5) This sum is the mean expected value of the strategy, the strategy with highest sum is selected.

Mean Expected Value

Effect of adding 5% risk premium to discount rate

Often revenues do become less certain the further into future that revenues accrue but: 1) not all risks increase over time (fire risk at early stage of plantation) 2) where risk do increase through time, it is not always in the exponential way of compound interest 3) Market and political uncertainty is not sufficient reason for discounting 4) a higher discount rate need not penalize investment at all, a risk premium of 5% actually makes the project acceptable.

Climate and market risk