Carbon Subsidies and Optimal Forest Management

We consider the effect of carbon subsidies and taxes in the form of carbon credit allocations on forest owners' land use and harvest decisions. We introduce three possible credit allocation regimes: one where credits are allocated according to the annual flow of carbon another where annual credits are proportional to the stock of carbon and a third involving lump sum payments. Using a real options model with uncertain future timber prices we examine the effect on the timing of harvest the replanting-abandonment decision and the value of a forest. We show that forests are less likely to be converted to alternative land uses under all three regimes relative to the situation without any carbon credit allocation. We also show that the flows and stocks schemes lengthen optimal rotations while lump sum allocations shorten them. Thus the objectives of reduced deforestation and longer rotations are best met by the flows and stocks schemes. Our numerical experiments suggest that these two regimes yield very similar outcomes.