Afforestation as a real option: Some policy implications

The theory of real options is applied to the decision of establishing a new forest stand. Assuming that afforestation costs are known and constant and that future net prices of roundwood follow a Geometric Brownian Motion, a simple model of the decision problem is formulated. Using this model, a real option analysis of the afforestation opportunity is performed. Next, the implications of the real option approach for afforestation subsidy schemes are analyzed. It is found that the subsidies needed to induce a desired investment behavior will in general increase, and that the actual increment will depend on the way subsidies are offered to the landowners and affect their expectations. An empirical example is used to illustrate the potential significance of the findings.