Forestry Tasmania and the RFA

The following was a background paper prepared as part of a series of articles on Regional Forest Agreements  by Gregg Borschmann published by The Guardian. An overview can be found  HERE.
The Guardian asked the Tasmanian minister responsible for forestry a series of questions about the RFA. The questions and the Minister's responses are included at the end of this blog.

The Tasmanian Regional Forest Agreement (RFA) signed in 1997, was supposed to provide a framework for the sustainable management of Tasmania’s forests.

If financial sustainability was the aim, the outcome has been a complete failure. Since 1997 the state-owned Forestry Tasmania (FT) has suffered cash operating losses of $94 million. In simple terms it was selling timber far too cheaply.

But the overall picture is even worse. Capital spending of $368 million on plant and equipment, roads and plantations, most sourced from government funds, failed to add anything to FT’s asset base.  FT’s total operating cash loss over 20 years was therefore $454 million.

That’s just the cash losses.

Not only did new capital spending fail to increase FT’s asset base, there were huge non-cash losses as forests under its trusteeship lost $750 million or 90 per cent of their value.

Impact on native forests

In 1997 almost all FT‘s income was from native forests. from 1998 to 2000 it received a total of $72 million from the RFA as compensation at market value for native forests transferred into reserves.

 Native forest production mainly woodchips kept growing grow from around 1.8 million m3 in 1997 to 3.3 million m3 in 2004 before steadily falling below one million m3 in 2012 where it has since remained. The pattern closely followed the fortunes of FT’s major customer Gunns which went into administration in October 2012.The following chart paints the picture.

Operating surpluses

The increased haul from native forests didn’t flow through to FT’s bottom line. Gross profit from forest operations persistently declined after 1998 as evidenced by the following chart.

Gross profit is forest revenue less direct costs of harvesting, cartage, freight and in the later years chipping and wharf costs when FT assumed some of those tasks after Gunns’ demise. In 2013 and 2014 gross profit was negative. This simply means revenue failed to cover the cost of taking the product to market. There was nothing left to cover FT wage costs and other overheads, nor the capital costs of roads needed for harvest operations. The pickup in the past three years was due to FT cutting out the middleman after Gunns’ departure, for both native forest and increasingly, plantation woodchips. This won’t last as most of the chippable plantations have just been sold and FT’s Board proposes to get out of value adding activities, instead selling its timber on a stumpage basis.

By deducting overheads and borrowing costs from gross profits, cash operating surpluses are derived.

Cash operating surpluses persistently declined over the period with the last 10 years showing deficits. Quite simply FT failed to generate enough from operations to cover all its operating costs. Since 2007 cash deficits totalling $217 million have been recorded. These are just the operating deficits. Excluded are specific deficit funding from the State government and the funds from the RFA, from 1998 to 2000, the Tasmanian Community Forest Agreement (TCFA) from 2005 to 2010, and the Intergovernmental Agreement (IGA)from 2012 to 2017. Included are government grants for firefighting and other community service obligations.

Capital spending

Capital spending is also excluded from the calculation of operating deficits. In FT’s case these amounts included spending on property plant and equipment (PPE), plantation establishment and roads. The basic accounting rule is that capital amounts have enduring benefits and are depreciated over their useful lives rather than immediately expensed. However, as the State’s Auditor General commented in a draft report on FT’s performance issued April 2009: “.......without stronger financial performance, investment in roads and plantations over the past 15 years will not yield future benefits to Forestry and arguably should be expensed rather than capitalised. On that basis, it can be argued that ordinary operations from 1994 to 2008 have yielded little profit.”

The Auditor General put forward a simple common-sense proposition that amounts normally considered as capital should be immediately expensed if they‘re not expected to produce future benefits.

When one looks at FT’s financials over the 20-year period from 1998 the value of PPE on the balance sheet has declined from $31 million in 1998 to $14 million in 2017. Property here is land/office buildings or other industrial land and does not include any part of the forest estate. Given the decline in the balance sheet value of PPE it is therefore reasonable, pursuant to the Auditor General’s dictum, to include PPE cash outlays to operating deficits.

Similarly, the value of roads as per the balance sheet is considerably less in 2017 than in 1998. Hence any spending on roads can be expensed and also included in an adjusted operating cash deficit calculation.

In the case of hardwood plantations FT owned approximately 18,000 hectares in 1999. In 2017 FT only had 18,000 hectares of plantations that it had established. This followed the 2017 sale of 29,000 hectares of plantations needed to discharge the line of credit that had allowed FT to operate for the past two years, Hence no change in 20 years. FT however now owns a further 3,200 hectares of plantations established by Gunns’ managed investment scheme (MIS) growers on FT’s land that it inherited after the windup of those schemes. FT, or Sustainable Timbers Tasmania (STT) as it is now called, therefore has about 21,000 hectares of hardwood plantations on its books as at today.

Spending on plantations over 20 years has increased neither the size nor the value of the forest estate (see further comments below on the value of the forest estate) and therefore should be expensed.

Adjusted losses

Therefore since 1998, $368 million spent on PPE, roads and plantations will yield zero future benefits for FT and should be included in any measure of operating surpluses/(deficits).

The adjusted operating surpluses for FT over the past 20 years looks like this:

Three years experienced very small surpluses, $4 million in 1998 and 2002, and $2 million in 2004. The rest of the years produced deficits. Over 20 years the net cash deficits totalled $454 million.

In the early years despite the underlying deficits, the financial statements showed accounting profits on the bottom line which meant income tax equivalents as well as dividend payments to the government as owner. These amounted to $68 million. In addition, the government took an equity withdrawal of $40 million in 1999 when a 50% share of most of the State’s softwoods were sold.

The payments to government when added to operating cash losses resulted in overall cash losses of $562 million.

Cash funding

How were the cash deficits funded?

The RFA, TCFA and IGA were programs designed for the whole forest industry. FT received less than half, $72 million from TFA, $146 million from TCFA and $87 million from IGA. The State government contributed a further $80 million and plantation sales totalled $193 million. The latter comprised $133 million of softwood plantations and $60 million for the recent hardwood plantation sale.

That’s it in a nutshell. Twenty years of cash deficits totalling $562 million were funded by both the Australian and the State government plus proceeds from the sale of 75,000 hectares of plantation assets. The hardwood plantation assets which were fulsomely promoted and funded by governments and which were supposed to lay the foundations for a sustainable FT have now mostly been sold, to cover the cash deficits which they were eventually supposed to fix. Ninety per cent of the softwood assets have also been sold. The continuous losses were principally due to native forest operations. FT was grossly negligent in not addressing these losses much, much earlier. It’s been a monumental failure.

The forest estate and how its valued

Maybe however, despite the cash deficits and the sale of plantation assets the total value of the forest estate may have been increasing? Alas the reverse is the case as this chart shows.

The forest estate is valued as one, then subjectively split between the three components, land, roads and forests. For a while, land was allocated a value based on the Valuer-General’s assessment, roads given their depreciated value, with forests ending up with the balance.

FT is always keen to attribute its problems, or some of them at least, to the loss of productive forests. However, the value of the estate in 1998 of $852 million already excluded the value of forests for which the RFA provided compensation equal to market value. 

When a forest estate is valued, future yields are estimated, as are future prices and holding costs over the period until harvest, plus harvesting and other costs to get the product to market. The resultant future net proceeds are then converted into a lump sum present value using a discount factor, essentially an expected rate of return weighted for risk. In 1999 the discount factor rose leading to a sudden fall in value. In 2010 the discount factor actually fell slightly. The precipitous fall in the value of the forest estate in that year was due to a change of valuer who reviewed the inputs into the valuation model, costs, yields etc and came up with a sharply reduced figure.

With the overall forest estate value plummeting after 2009, it was decided to allocate land a zero value. Had that not occurred the value of native forests, being the residual amount after land and roads, would have been zero.

However, the overall value of the forest estate kept falling to a point where the forest roads were worth more than the trees in the forest. Both were located on land deemed worthless. How can sensible public policy decisions be made based on models with such ridiculous assumptions? Another change was made. Roads were allocated a value based on the road tolls earned, which is negligible, rather than their written down value. This left more for forests. But it’s such an arbitrary approach, lacking any scientific rigour which foresters are always keen to stress underpins their profession.

The above chart, in respect of 2017, reflects the sale of the plantation estate completed after June 2017. While the plantation sale was the sale of a forestry right which gives the holder the right to the existing crop plus the right, indeed obligation, to use the land for forestry purposes for 99 years, it is likely the value of this forestry right will differ from the balance sheet value of a forest which only values the current crop.

If we reduce the balance sheet value by the full value of the hardwood plantation disposal after June 2017, the forest estate falls to $101 million.  From $852 million in 1998 to $101 million today.  That’s a balance sheet loss of $751 million.  

FT experienced further balance sheet losses with a blowout in its unfunded superannuation liability. The government took over the liability relating to past employees in 2017, leaving FT with a liability relating only to current employees of $20 million at the end of 2017. The balance sheet loss, in this case the increase in liability, for the 20-year period was $89 million. Adding this to the fall in forest value of $751 million gives FT’s total balance sheet or non-cash losses of $840 million.

The current public production forest estate of almost 800,000 hectares, about 40% of which is set aside in informal reserves or other non-productions, includes the remaining 21,000 odd hectares of hardwood plantations most of which have been pruned and thinned. Let’s say the remaining hardwood plantations are worth $50 million which incidentally is far less than the establishment costs. If the whole forest estate is worth $101 million, subtracting the plantation value of $50 million and roads value of $7 million only leaves $44 million as the value of native production forests.

Even if the figure is not quite that low, say it is unreasonable to reduce forest value by the full amount of the $60 million obtained for the forestry right after June 2017, the current value of native forest will certainly be much less than $100 million. FT hasn’t publicly advised the split up of forest values between plantations and native forest since 2008.

Native forests financial sustainability

Two conclusions are now possible.

First, it is completely reasonable to do as the Auditor General suggested and expense outlays on PPE, plantations and roads to arrive at a true operating cash deficit figure. The assets acquired have either been sold or won’t yield future benefits.

Second expensing the cost of roads to harvest native timber means future net harvest proceeds will be less resulting in most native forest harvesting being unprofitable. Even if there are positive net harvest proceeds they are unlikely to cover overheads. A corollary is the value of forests will also fall.

Any valuation methodology suffers from the necessary assumptions that need to be made. A forest is valued as an income producing forest and hence non-timber values that may attach to forested land are ignored. There is little doubt that there are environmental values that even most hardnosed bean counters would acknowledge. 

Furthermore, as outlined above holding costs are included to calculate net harvest proceeds. In the case of leased land this would include any rent payable. In the case of FT’s land an imputed rent is not included in holding costs because, FT argues, land is assigned a value once the overall forest estate value is calculated. But since 2010 land has been assigned a zero value. The valuation methodology effectively ignores land. It is not given a value, nor is an imputed rent figure included in holding costs used to calculated net harvest proceeds. Any loss of non-timber values at harvest time are forgotten. If rents were imputed to FT’s land, native forests would likely have zero value. Or if the non-timber value of land is considered, which conservationists essentially argue is severely impaired at harvest time then balance sheet losses would be even greater.

Even so, had FT’s financial accounts expensed PPE, plantation and road expenses over the last 20 years as we have done above, the unprofitability of native forest logging would have been obvious much earlier.

Things are unlikely to turn around in a hurry. Coupes for harvest are increasingly remote. Harvest cartage and road costs are rising much faster than prices. Price rises are restrained by the existence of long term supply contracts negligently agreed to by FT in the past and by the culture of the industry that FT is there to clear the market providing industry with an inherent subsidy if necessary even if that means FT making losses.

Reporting FT’s performance

Every year from 2008 onwards the Auditor General in his reports to Parliament warned that something needed to be done about FT’s operating cash deficits which were barely disguised by, at the time, TCFA grants from government.

Nothing happened.

The Auditor General commenced a more detailed look at FT’s financial performance in 2009. When he finally released his report in 2011, he also released earlier drafts which had been submitted to FT for comment. The 2009 draft contained the damning assessment that money spent on roads and plantations ought to be immediately expensed because it was unlikely to produce future benefits as capital expenditure should.

FT had quarantined itself from reality. In 2011, then CEO Bob Gordon made the extraordinary statement to a parliamentary hearing that “...........we are still in a position where we can return a profit, a dividend, pay taxes and maintain a cash balance necessary to have some capacity for investment in new activities and to pay our way.” Six months later the government included $100 million worth of bail out funds in the 2013 Budget to be spent over the ensuing four years.

It wasn’t until 2014 when the Treasury Secretary elbowed his way onto FT’s Board that we have seen any semblance of realism. The Board’s report to the Government in 2016, effectively the report of a voluntary administrator to shareholders, outlined how FT was not viable if it had to supply its mandated level of high quality sawlogs of 137,000 m3. This level agreed to by all parties to the IGA process as a sustainable level for production from native forest each year may have been ecologically sustainable, but it was far from being financially sustainable for FT. The five-year IGA process which led to FT receiving $87 million and over $300 million to other industry participants, didn’t address FT’s financial sustainability. What was the point of the grant? Other than just another handout?

The effects on State finances

In the early years the State government removed $108 million in cash from FT but since then $80 million has been recontributed. Of that $40 million was extracted from TasNetworks, the government’s electricity business involved in transmission and distribution. The overall impact on State government finances has therefore been relatively small.

The government also assumed $113 million of FT’s unfunded superannuation liability, which will be paid over the next forty years or so, which spreads the burden over a long period.

Grants received from the Australian government pursuant to the TFA, TCFA and IGA have been quarantined when calculating Tasmania’s GST share. As part of the Commonwealth Grants Commission methodology for calculating states’ GST entitlements, most specific purpose grants, say national partnership payments, are taken into account. But some one-off grants are excluded. Rather than Tasmania’s GST share being reduced, the forestry grants have been additional. If forestry grants had impacted on Tasmania’s GST share, behaviour of politicians and other participants might have been different. Senator Harradine also made Tasmanians acutely aware of the put option that can be used to get money from the Australian government. Nowhere has moral hazard flourished as well as within the Tasmanian forest industry.

In conclusion…

Since 1998 FT’s operations have produced cash and non-cash losses of $1,306 million or an average of $65 million per year. The Auditor General sounded the alert in 2008. FT insiders must have known about the inherent flaws in its model when woodchipping starting declining after 2004. FT’s financial reporting may have adhered to prevailing accounting standards but so often those standards are used to obfuscate rather than explain. This has allowed the Tasmanian native forest industry to perpetrate a giant fraud on taxpayers. The relentless pattern of losses since 1998 can’t simply be attributed to the Global Financial Crisis, locking up a few forests or the actions of a few greenies as conventional wisdom would have us believe.

One thing missing from the sorry saga of an insolvent FT was because it’s publicly owned we missed out on the golden opportunity that comes when private companies go belly up. Schumpeter’s creative destruction quickly moves to find a more sustainable model. Instead we’ve limped along to who knows where, bound by non-viable contracts and coerced by the sovereign risk argument.

QUESTIONS FOR RESOURCES MINISTER, Guy Barnett

The Guardian, 26 March, 2018

• What evidence is there that the Tasmanian RFA 1997-2017 delivered an 'internationally competitive forest products industries which are economically sustainable'?
• Over the course of the Tasmanian RFA 1997-2017, Forestry Tasmania/STT operations produced cash and non-cash loses of more than $1.3 billion, according to Tasmanian economist and accountant John Lawrence.  Does the Minister agree with that figure?

… [$454m of total adjusted operating deficits + $751m write down in asset base + 89m blow-out in the unfunded superannuation liability]

• Is native forest logging profitable if all costs of harvesting are included, as well as roading and regeneration costs?
• Does the Minister acknowledge that increasingly remote coupes cause native forest logging costs to rise faster than revenue?
• If land were valued based on its best possible use - the benchmark that valuers use when given a block of land to value - is the Minister confident the value of STTs’ land will be zero in all cases as it currently is? Does valuing land at zero raise the risks that incorrect resource allocation decisions are more likely?
• FT have not advised the split of forest values between plantations and native forests since 2008.  What are those respective valuations as at 30 June 2017?

• Has the govt taken a dividend from the proceeds of the $60m hardwood plantation sale earlier by STT this financial year?
• How long does the Minister anticipate the proceeds will be able to fund on-going operations for STT?
• Is there a Plan B when the proceeds are spent? What is it? When is that likely?
• Has the Minister seen STT’s latest business plan? Does it reveal any more cash deficits in the near future?
• Can the Minister guarantee that if all costs of harvesting are accounted for (including road and regeneration costs) that native forest logging – including the current contracts for sawlogs and peeler billets – will be profitable?

  

Response from Minister Barnett

27 March, 2018

 “The Tasmanian RFA provides a balanced framework for sustainable management of production forests.

“Over 20 years of operation so far, the RFA has the runs on the board - enabling forest industries to operate responsibly and competitively in global markets and supporting thousands of jobs in regional communities.

“Over the same period there have been significant environmental outcomes.  The State of the Forests Report 2017 shows that in 1996 just 55 percent of Tasmania’s old growth forests were protected in reserves.  Today that figure has grown by more 300,000 hectares to 87 percent, or more than one million hectares in total.

“The Government has been working with Sustainable Timber Tasmania to improve the bottom line and looks forward to significantly better results for the year to June.”