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2 de julio de 2012

Economic methods for estimating cost opportunity of agroforestry: A literature survey (review) of the methodologies

                  
                I.            INTRODUCTION AND BACKGROUND[1] (Draft version. Please do not quote)
Paraguay is located in central South America, surrounded by Bolivia, Argentina and Brazil, within the latitude and longitude of 23°00´ S, 58°00´ W with a population is 6,000,000 people. The total land area of the country is 406,750 sq km, with 31.1% of forest land area. The economy of the country is based on agricultural production including cattle rising. The primary sector represents almost 20% do the GNP (14 billion US$. In 2010), out of with forest production covers 6% (2010), with a decreasing trend[2]. (See Table 1, 11 and 12 and Figure 1 in Annexe)
The Forestry Law of Paraguay states in its Article 42 that all farms with more than 20 hectares of land must have at least 5% of the total area covered with forest or tree plantation. For farms with forest cover, one fourth must be kept[3]. The application of the law was highly limited by implementation and enforcement problems and up to certain point due to lack of political interest. Consequently, between 1973 and 2000, Paraguay lost almost two-third of its Atlantic Forest (Per. comm.. Monges, L. 2011).
In 2008, after 61 years in power the Colorado Party lost the presidential election to a coalition lead by the Liberal party along with many small left-wing oriented parties. The new authorities, many of them coming from the NGOs sectors (very critical of the intensive farming system applied by agribusiness-operated commercial farm) started to enforce the Forestry Law given a high priority to the Article 42.
The Federation of Production Coops from Paraguay (FECOPROD)[4] gathers most of the agriculture cooperatives in the country[5]. The majority of its members are coops with agribusiness-operated commercial farm, specialized in annual crops production (soybean, maize and wheat), beef for the local and external markets, and milk for the local market. Due to the size of their farm they are also know as medium and large size farmers[6].
FECOPROD reacted to the enforcement of the law by preparing an appraisal of the Forestry situation of its cooperatives members and by developing a strategic plan (2011-2005) for the sector[7]. The title of the document “Forestry Development: An option integrated to the agriculture production”[8] shows the compromise or the aim of the Federation to support or encourage its cooperatives members to include tree plantation into the farming system in compliance with the Article 42 of the Forestry Law.
Farmers in Paraguay in general have increased interest in tree plantation due to scarcity of fuel wood and the constant price increase of commercial wood[9]. Farmers want to profit from this market opportunity, taking into consideration the climate conditions in the country is excellent for growing trees. Currently, two coops associated to FECOPROOD, Cooperativa Colonias Unidas y Cooperativs Volendam[10], have already developed some schemes to support tree plantation. The former one provides loans fuel-wood production to be used in the drying of grain. Salas (2010) provides an excellent description on the use of fuelwood by Cooperativa Colonias Unidas.
The specialized literature, as so far reviewed, main focus in on agroforestry systems for small peasant farmers or at a more aggregate level. Besides, some studies done from Australian Government Authorities, there are few studies for an agribusiness-operated commercial farm. For a successful timber production within those farms, to which this paper focuses, a scientific designed system is needed. The system must include the complementary effects of tree planting into the net returns of the farm. However, relatively little information exists on designing an optimal tree plantation system combining both biophysical information and economic or financial information for any type of farm in Paraguay.
The limitation of data on the on the one hand causes that feasibility decisions must often be made on incomplete or preliminary data. On the other hand imposes the need to develop practical methods to address the complexity of financial and economic evaluation of agroforestry systems. The methodology must take into account the bio-physical implications of agroforestry. The identification of the opportunity cost of different alternatives with methodologies that includes bio-physical information will allow the correct or proper allocation of the resources in the farm. The reality of Paraguay is that for agroforestry projects, there is often little experimental quantification of possible complementary or supplementary biological responses to intercropping.
In order to assess the profitability of tree planting, the most common action is to use economic analyses. The use of economic will help answer questions such as: (1) what is the optimal combination of two options of agroforestry, known as joint production possibility, (2) what is the best or optimal mix of options to apply to a given area? (Thomas, 1991). In short, what it has to be assessed is the cost of the forgone benefits of the farmer due to the plantation of trees in his farm. This is known as the opportunity cost.
The opportunity cost of different agroforestry possibilities can be measured from a very wide set of options, starting at a very elemental and basic static cost–benefit passing through dynamic modeling and econometric analyses which requires the use of powerful software and statistical packages (Brown, 2000; Graves, 2007; Borner, J. et al. 2009).  As progress is made towards the last ones, the quality of the data also increases and the level of details is more demanding. In developing countries, the availability of data (economic as well as bio-physical) limits the implementation of most modeling as well as econometric analyses[11], (Brown, 2000; Graves, 2007) not to mention limitations in the qualification of human resources.
The political decision by the Federation been taken; now the efforts are concentrated on developing the assessment methodology of introducing trees plantation into agricultural farms.
At this point some questions arise:
 
a)      It is a fact that farmers want to make profit from their farming activities, so how will tree plantation impact on the profitability of the farm in a scenario characterized by high commodity prices and the forecast that they will keep increasing? What is the opportunity cost?
b)      Another fact is that there is almost no forest area left on most farms. Then, is 5% area profitable or it will mean a reduction in the farm profits? What about larger areas, let us say 7%, 15%, 20% or more? What is the break even area in relation to the size of the farm?
c)      If timber production is an option for diversification of farm income activities, as frequently cited in the specialized literature, how should it combine with annual crops in order to maximize benefits taking into account the production factors endowment of the farm?
d)     The usual feasibility studies of the cooperative to decide on loans are financial in essence. Then what about the economic and environmental gains including positive externalities?
e)      Assuming that re-planting the obligated 5% trees does not have a positive return to the farmer, should society, through taxes, provide subsidies to a re-planting/re-forestation scheme or program?
f)       What is the “model” to be implemented? In the specific case of interest of this paper the idea of agroforestry is a little different of what is more commonly understood[12]. The interest of farmers is towards intercropping of pure tree plantation in one plot and pure crop plot plantation, not a mixing of both in the same plot. An explanation could be the fact that their labour is dependent on machines (mechanized farms) rather than hand-working as peasant-farmers do. Then, what is the combination of trees an crops, plant density, rotation period, management system, etc.?
g)      What technical coefficients for tree growing shall be used, knowing the shortage of systematic research on the subject in the country?
                 II.            OBJECTIVE
The overall objective is to develop a methodology to assess the feasibility (financial, economic and environmental) of introducing tree plantation into the agribusiness-operated commercial farms.  It will answer the question of whether silvoarable[13] forestry could provide a profitable alternative land use in areas dominated by annual commodities crops.
Due to the broad scope of the overall objective, intermediate ones are set. The first specific objective concentrates on financial aspects: to determine the opportunity costs of the introduction of tree planting in the farm production system. Agribusiness-operated commercial farms main objective is capital accumulation and income generation. Any other benefits accrued from their farming activities are considered as by-products. Then, the financial profitability of reforestation investment will be a key issue for the development of private plantation forestry.
              III.            METHODOLOGY
 Therefore, the first step is to know the financial methodologies by which investments in agro-forestry and tree plantation are evaluated. To avoid reinventing the wheel, a literature review of the methods use in financial appraisal will be implemented as well as the identification of the inputs needed to apply the reviewed methods. Additionally, some examples found in the specialized literature will be presented.
              IV.            MAIN RESULTS
The review summarizes the key elements of the existing approaches to evaluate the impact of tree planting in a farm. The following tools are reviewed: (a) Classical project evaluation technique also known as cost-benefit analysis: (b) Linear programming; (c) Bio-economic models. The review of each methodology is organized as follows: (a) description of the tools, (b) The information needed; (c) Examples of the application of the tool.

a)      Cost-benefit analysis

Three are the most common cost-benefit analysis indicators use to measure the financial and economic performance of an agroforestry project: Net Present Value (NPV), Internal Rate of Return (IRR) and Ratio Benefit/cost (B/C). The combined used of three indicators for each option allows the identification of the best alternative. Decision based only on of the indicators ignoring the analysis of the ohters may lead to improper selection.
The steps for an assessment using these tools include (Betters, 1988; Thomas, 1991)
·         Identify relevant inputs.
·         Quantify the levels of inputs to be used according to technical coefficients related to the local conditions.
·         Simulate the production of the timber and the agricultural output.
·         Calculate cost, revenues and cash flow of the alternatives being analyzed for the years of the rotation
·         Calculate the indicators: NPV, B/C and IRR.
·         Make sensitivity analysis of price and discounted rates
·         Analyze the information and select the alternative
 Net Present Value: Net present value is the different between the present projected revenues and the present value of the project costs. In order for the values to be “present” a discount rate that represents the minimum rate of return that the farmer is willing to accept for his capital invested has to be used. The decision follows: if the NPV is negative the alternative or project being analyzed does not meet the minimum return expected for the capital at the stated rate Jones, Grado and  Demarais, (2010).
The rate used for discounting has to represent the opportunity cost of the farmer, meaning the best alternative to de current activity. When the estimation of this rate may create some difficult, the interest rate paid on loans to which the farmer have access to it is commonly used as a proxy (Betters, 1988). When such information is not available, different methodologies are applied. The formula of the net present value is (Betters, 1988):
 where R is revenue, C is cost, i is  the discount rate expressed in decimals, and n is the year in which the transaction takes place.
Internal rate of return: It is the rate which the NPV equal zero, meaning that higher rates will represent negatives NPV. Putting it in a different context, the IRR represents the maximum return rate possible to the investor or the maximum time preference rate for the farmer. The decision follows this rule: if IRR is greater than the cost of the capital or the minimum acceptable rate of return stated by the investor the project is accepted. IRR, though commonly use in project appraisal, has a severe limitation. It ignores the timing and relative magnitude of costs and returns. The IRR formula is as follows (Betters, 1988).

 
Benefit-cost ratios:  It is the ratio of discounted benefits/discounted costs, representing the benefit for each unit of money invested. The B–C ratio of greater than 1 indicates that the project is profitable. It can be calculated with the following formula (Betters, 1988).
 

In Table 2 in Annexes, uses of the indicators are illustrated. Using a case extracted from Betters, (1988), where the farmer has to decide introduce Eucalyptus in his farm and has to choose between two options of agroforestry: Eucalyptus and beans and Eucalyptus and maize. The table shows the production, the cost and the return for the investment for each of the options. Since the time frame of the investment, all values are brought to the first year using a discount rate of 6%. The rotation period is three years.
Let us analyze the results: (Table 2, in Annexes)
The Eucalyptus-beans option might be the elected one based on a greater NPV and an IRR superior to the expected rate of return. However, in a situation where access to loans is limited, the other option, Eucalyptus-maize would be chosen for it has a greater return on every monetary unit invested. This is to say that every 100 $ invested returns with a profit of 240 $, while in the other option is 210 $. Beside, the return from Eucalyptus-maize is almost 13 points above that of Eucalyptus-beans.
Prices can decrease over the period of the agroforestry scheme, affecting farmers benefit and specifically NPV, IRR and B/C. The same impact can cause an increase in the interest rate. The possible impact is measured by means of a sensitivity analysis, consisting in changing the price (reduction and increase) and their impact on the assessment indicators. The usual analysis is conducted by reducing selling prices and increasing discount rate. In Table 3 in Annexes an increase in the discount rate reduces shows the effects on the NPV. In situations of uncertainty caused by lack of adequate data on prices for instance, or difficulties to select a proper discount rate, sensitivity analysis is a must in the assessment of projects. Some examples on the use of benefit-cost analysis in farming decision are presented in the Table 4.
b)     Linear programming
Linear programming (LP) is a mathematical model able to calculate the optimal allocation of resources (land, capital and labour) between alternatives (agroforestry or monocropping) that will maximizes the net present value of the farm. At the same time, LP satisfies the specified constrains and requirements stated by farmers. The optimum may include either maximization (incomes for instance) or minimization (costs for instance) (Verinumbe, Knispscheer and Enabor, 1985; Thomas, 1991; Bertomeu, Bertomeu and Gimenez 2006)
Basically, LP finds the solution by solving a series of linear equations. Some basic problems can even be solved by hands, but the common practice is to use softwares; LINDO Systems[14], GAMS[15], XPRESS-MP[16]. Microsoft Excel has a complement called Solver which is a powerful optimization and resource allocation too (Aieta, 1997).
To clarify the functioning of linear programing, let us resource to an example developed by Bertomeu, Bertomeu and Gimenez (2006)
 A farmer having a farm of 5 ha, an availability of 900 labour hours, a 1200 $ of budget, a demand of 60 m3 of fuelwood and 900 kg of protein, needs to know the best combination between two options of agroforestry (eucalyptus-beans and eucalyptus-maize) in order to get the maximum possible benefits subject to the constrains of the resources and the need of fuelwood and protein as stated before.
In order to “run” a LP exercise some information and data has to be collected. The first group of data includes the resource availability (or constraints from another point of view). In the example they are land, capital and labour. In this specific case, the farmer adds two other constrains, as they are the requirements of protein income and fuelwood demand are needed.  The term “constrains” is used in the sense that the selected solution must fulfill the required constraints. For instance, the solution cannot demand more than 900 hours of labour or produce less than 60 m3 of fuelwood. A second group of information is related to technical coefficients and budget requirements. They are gross margin and labour demanded per hectare. Finally, all the information is fed into the program. See Table 5 in Annexes
The mains results are organized in three groups. The first is the maximum possible gross margin. The second group contains the area of cultivation of each one of the alternative. Finally, there is information on the use of the resources o the accomplishment of minimum requirements (fuelwood and protein). In the specific case of Solver, it provides other information such as the opportunity cost of each one of the restriction (constraints) and of how changes in the value of the parameters affect the optimum solution (sensitivity analysis).
LP has some limitation that must be taking into consideration. It is applicable only in situations where the objective or constrains can be expressed as a straight line equation. Furthermore, parameters used are assumed to constant. Reality is not linear nor constant, at least not always. Linear programming models assigns portions of the farm to the different options (monocropping, intercropping, fallow, etc.). They do not provide information on the exact location and arrangement of the options. To do so a spatially explicit programming model need to be used (Mendoza, et al. 1986; Wojtkowski, Brister and Cubbage, 1988). .
Qualitative or variable factors as weather conditions are not taken into consideration. It does not consider (or does not quantifies) others benefits-ecological, social, economical and cultural. In short, it ignores the multidimensionality of agroforestry. One alternative is to use multi-objective programming for it can optimize several objective functions simultaneously (Mendoza, et al. 1986; Wojtkowski, Brister and Cubbage, 1988; Bertomeu, Bertomeu and Gimenez 2006). However, as Bertomeu, Bertomeu and Gimenez (2006)) state, when it is assumed that the main objective of the farmers is financial benefits (as it is most of the time), LP is well suited.
Research using LP was common in the 1980s. Some examples of the use of LP in farming decision are presented in the Table 6 of Annexes.
c)      Bio-economic models
The development of computer science and the easy access to computers, favored the investigation to more complex and elaborated tools for optimization and modeling the reality. The identification of the opportunity cost of different alternatives with methodologies that includes bio-physical information will allow the correct or proper allocation of the resources in the farm (Brown, 2000; Kruseman, 2000; Stewart, H. et al. 2011).
Nowadays it is common to use simulation models to measure recreate the effects of changes in some of the variable of a system (Brown, 2000). These models can be applied at the farm-house level or at the aggregate level (village, watershed, community of users) or even for global simulations. Pure economic models run short of describing the effect on production, farm profitability and environmental impacts of the decision-making. Most suitable for these purposes are the bio-economic models. They deal with the modeling of decision-making and the modeling of biological processes (Ruben et al, 2000, cited by Brown, 2000). Bio-economics models are in the middle of the spectrum economic-biophysical models. As stated by Graves et al (2007) they can go from a “detailed biophysical model with limited economic analysis to economic models that use biophysical data from an external source”
An economic model aims to model the decision making process of humans, while the biological attempts to model the biological processes. For instance, a simple economic model as LP optimizes farm incomes. However, it becomes a bio-economic model when it includes biophysical features that attempts to measure biological or ecological processes as well. To do so, it can use as proxy level of erosion, (Brown, 2000; Namaalwa, Sankhayan and Hofstad 2007).
More sophisticated models includes multiple objective programming for a variety of objective such as the maximization of financial returns, maximization of timber volume or number of cows grazed, or maintenance of the site for ecological purposes (Mendoza et al, 1986). They aim to simulate the dynamic relationships of biological and economic processes (Brown, 2000).
Biological models are designed to simulate agro-ecological processes. They model plant and animal growth, soil physical characteristics and nutrient flows and balances, as well as interspecies interaction, competition and feedback from one subsystem components to the other (Brown, 2000). The biological models cover a great deal of agro-ecological processes: forestry, crop production, grassland, savannah, soil nutrients, and water dynamics and animal/livestock systems. Basic biological models uses empirical measures of biological processes (Pulina et al, 1999; Kruseman, 2000) while others more sophisticated attempt to model the underlying processes or mechanisms at a more basic level.
Ruben et al, 2000 (cited by Brown, 2000) describes ideal bio-economic models as those that
“… capture the dynamic nature of the biological processes involved and allow for dynamic feedback effects between human decisions, biological processes, and the range of possibilities available for future decisions. An ideal bio-economic model has to be dynamic capturing the biological processes and allow the feedback in a dynamical way of the interaction between human decision, biological processes and the infinite decision that may result in the future.” Not much else to be said.

To illustrate the process of applying a bio-economic analysis we use (Graves, et al, 2007) paper (Table 7-10 in Annexes). They describe the integrated used of biophysical and economic models in order to determine the biophysical and economic performance of arable, forestry, and silvoarable systems three European countries: Spain, France, and The Netherlands. The authors also simulated with no grants, with the pre-2005 grants and two scenarios for the post-2005 grants.
They developed a biophysical model called “Yield-SAFE” to predict long term yields and an economic model named “Farm-SAFE” to predict profitability.  Their methodology five steps: (1) identifying and characterizing potential sites for the uptake of silvoarable agroforestry, (2) defining potential arable, forestry and silvoarable systems for those sites, (3) using a bio-physical model to determine yields for those systems, (4) defining the revenue, costs and grant regimes associated with each site, and (5) using an economic model to determine the financial effects at a plot- and farmscale.
The inputs needed to run the model are cited:
Biophysical data: It included daily mean values of air temperature, total short-wave radiation, rainfall, soil depth and texture, soil water content. The sources were diverse data bases, results of investigation done by scholars, opinion of experts. At the end, field visits were made to confirm and improve existing interpretation, as well as to provide missing data.
Management system: It was defined according to local or experts opinion. The data included tree species and crop rotation, management of the arable systems and the forestry systems (planting densities, thinning, and pruning), rotation period, local dry wood densities, reference yields for each crop and tree.
Economic inputs: The financial data collected include definition of revenue, costs, (values for arable crops, variable costs, fixed costs) and grants for each system species resourcing to secondary data and expert opinion.
The results are shown in the tables presented in Annexes
Table presents the data fed into “Yield-SAFE” the biophysical model for portion of two regions in Spain. Table gives information of the agricultural area for each hypothetical farm and on the biophysical characteristics and the crop rotation pattern. The data are inputs for “Yield-SAFE”. In Table is a summary and description of predicted yields for crops and trees coming out of “Yield-SAFE”. The last table is the outcome of the economic model, representing the equivalent annual value of the three management systems: arable, forestry and silvoarable system for different scenario.
The main conclusions were
  • Without grants, silvoarable systems were frequently the most profitable system at the landscape test sites.
  • However, the pre-2005 grant regime altered the profitability of silvoarable systems, relative to arable and forestry systems. This was especially the case in Spain, where silvoarable systems became the least profitable system on all 19 land units.
  • Under scenarios 1 and 2 of the post-2005 grant regime, support for silvoarable systems was generally predicted to be more equitable in comparison with the pre-2005 grant regime.
d)     Computers-based models
Though the aim of this review is does not include revision of sofwtares, some issues needs to be expressed .The complexity of the bio-economic models requires the use of software packages (also known as computer-based models). This is also applied to economics and biophysical models. The first forestry simulation models were developed en the 1960s (Brown, D., 2000) (Fries 1974 cited by Graves et al, 2011)).  Biophysical simulations of agroforestry systems commenced in the 1980s (Arthur-Workshop 1984, cited by Graves et al, 2001) and first computer models of agroforestry economics in the 1980s Arthur- Workshop 1984; Cox et al. 1988 cited by Graves et al, 2011.
Computer-based models have a wide range, running from the use of a spreadsheet (Ms Excel) as developed by Thomas (1991), to a dynamic model such as the developed by Justine Namaalwa, et al (2007).  In 2004, within the Silvoarable Agroforestry for Europe (SAFE), Graves et al (2007) reviewed the existing computer models of silvoarable economics. They describe in details five of them POPMOD, ARBUSTRA, the Agroforestry Estate Model, WaNuLCAS, and the Agroforestry Calculator. This is a good consulting document to have a general idea of the state-of-the-arte in modeling in bio-economics.
                V.            PRELIMINARY CONCLUSIONS
1.- The reviewed methodologies provides a wide range of information for decision-making as well as on the impact of the decision.  The range of analysis is quite wide.  At the simplest extreme, it is possible to calculate the financial rate of return of an investment in tree planting for a household, village, region, or watershed. In the other extreme, the tools reviewed can calculate not only financial aspects, but also economic and bio-physical aspects, leading with the use of software to spatially location of the best alternative.
2.- The complexity and power of the methodologies reviewed are directly correlated with the quality of the information required. As stated in the document, data availability is a serious limitation. The classical cost benefits analysis required less information than the other methods. On the other extreme, bio-economics models and software demand for high quality data and information.
3.- The population aimed with this reviewed give high priority to income generation and capital accumulation. Their decision is quite simple: financial profitability. On the other side, it is known that farming decision-making impacts on the quality of the quality of the environment and natural resources. Therefore, the methodology for evaluation has to simple, practical and realistic. It has to provide the demanded information but taking into account the biophysical impact of the decision.
4.- With the information coming out from this review the following methodology is suggested for the practitioner level:
a)      Divide the farm in sections according to soil characteristics.
b)      Select the combinations of crops and trees for the farm.
c)      Decide on the management of the crops and trees.
d)     Calculate their cost and revenues.
e)       Select a proxy for the environmental benefits of tree planting.
f)       Compute the assessment using cost/benefit analysis including the environmental benefit.
g)      Select the two best alternatives (if possible select three)
h)      Run linear programming with the selected alternatives.
i)        Analyzed the results and select the best alternatives taking into consideration the maximized net benefit value; the use of resources and the cost of opportunity.
5.- At the academic level two line of research are proposed. The first one is to work in the adjustment of the methodology proposed in number four. The second lines is to development and organize a data base with the needed information to run more detailed evaluation models which include biophysical data.
 

[1] Document prepared within the Biodiversity management Project: Potentials and limits for the local implementation.Technische Universität Dresden –Facultad de Ciencias Agrarias-UNA (July, 2011). Victor Enciso
 
[2] World Bank Paraguay Country data profile. Available at http://data.worldbank.org/country/paraguay
[3] Ley 422/73: Artículo 42. - Todas las propiedades rurales de más de veinte hectáreas en zonas forestales deberán mantener el veinticinco por ciento de su área de bosques naturales. En caso de no tener este porcentaje mínimo, el propietario deberá reforzar una superficie equivalente al cinco por ciento de la superficie del predio.
[5] The inclusion of “production” in its name is with the sole purpose to differentiate them from the more financial orientated coops specialized in loan and saving schemes.
[6] Small farmers, now days known as Family Farming include farms up to 50 hectares.
[7] The document can be downloaded from the web page: www.fecoprod.com.py
[8] In the original “Desarrollo  Forestal: Opción Integrada a la Producción Agropecuaria”
[9] For a description of the timber business in Paraguay refer to “Timber Investment Returns in Paraguay  in
[11] However, there has been a spectacular increase in the availability and quality of data from developing countries in recent years. See http://ipl.econ.duke.edu/dthomas/dev_data/index.html for information of data in developing countries
[12] The simultaneous mixing in both time and space of some combination of perennial and annual plants and/or animal production
[13] Silvoarable agroforestry is defined as the practice of growing an arable crop between spatially zoned trees (Dupraz and Newman, 1997; Burgess et al., 2004b, cited by Graves et al., 2007), seems the most suitable practice for commodities farm in Paraguay.
[15]General Algebraic Modeling System http://www.gams.com/


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