Seeing the Forest as well as the Trees

The
Economic Freedom
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Seeing the Forest
as well as the Trees

The troubled state of the forest industry in British Columbia has been making headlines on a daily basis for the past several months. Mills are shutting down across the province and employees are being laid off, with temporary shutdowns often turning into permanent closures. Industry observers are divided between those who view this as part of a severe but normal cyclical downturn, and those who see it in more serious terms. Many commentators have suggested that external events are largely responsible for the severity of the industry’s problems: the “Asian Flu” has led to the collapse of the Japanese market and driven global commodity prices down while the Softwood Lumber Agreement has restricted access to the US, BC’s largest market.

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In looking for a solution, most commentators have addressed the issue of delivered wood costs in BC. Many industry analysts and economists in BC have pointed out that the fees paid for harvesting public timber, or stumpage, in BC are two to three times higher than they are elsewhere in Canada. They argue that this, coupled with increased harvesting costs stemming from the Forest Practices Code, have combined to make BC wood uneconomic. The solution, therefore, is to lower that cost by decreasing stumpage levels and reducing regulation.

While this analysis is superficially correct, it is incomplete. The issues facing the forest industry stem from structural changes in the marketplace and in the changing nature of the supply of wood fibre. While the Asian Flu and the Softwood Lumber Agreement are aggravating the problem for BC, they are not responsible for the difficulty the industry is facing in adapting to these changes.

Figure 1 shows the prices for the three most important forest products produced in BC: lumber, pulp, and newsprint, all corrected for inflation. This figure shows that while each price series fluctuates dramatically, there is no significant change in the overall trend, and current prices (averaged through the first part of the year) are at approximately the long-term average.

In other words, lumber and pulp prices are no lower today than they have been on a long-term basis. Low commodity prices, then, cannot explain why the industry is in so much difficulty. Instead, we have to examine what has happened to costs in the industry.

Figure 2 shows the relative change in variable costs in the sawmilling industry in BC (these costs include labour, energy, and material, but exclude all capital-related costs such as interest and overhead). Unit costs bottomed out in 1984 and have been steadily increasing since. (Even after stumpage costs are excluded, the pattern remains. A graph for the pulp and paper industry would show a similar pattern but would understate the problem as capital expenses have increased significantly in recent years.)

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There are many reasons why costs have increased. Some are easily quantifiable, such as stumpage rates, which the government raised in the past decade, and access costs, which have increased as the industry has progressively moved into more difficult terrain and lower quality wood. What is not so easily quantifiable is how much of BC’s costs can be attributed to the administrative system that governs the allocation and pricing of wood. Some indication of how large the system has grown can be seen in figure 3, which shows the trend in annual expenditures by the Ministry of Forests, corrected for inflation and harvest levels by dividing expenditures by the harvest on Crown lands. Over the past 15 years, these costs increased nearly four-fold.¹

The BC government’s administrative approach, while modified over the years, has essentially remained unchanged since the early part of the century. Each provincial government since the turn of the century has chosen to directly allocate wood through a series of various leasing arrangements (otherwise known as tenure) in exchange for various commitments to build processing facilities and maintain harvest levels (and thereby employment).

Successive BC governments were able to make these arrangements because the economics favoured this province. An enormous endowment of large stands of valuable timber with low access costs attracted industry in the early part of the century. Following World War II, technological developments enabled sawmills to manufacture lumber from the smaller logs found in the province’s interior. This substantially increased the volume of merchantable wood in the province that the government then leased to sawmills. In turn, the sawmills found that by increasing the size of their mills and the speed at which they could run, they could lower their costs through economies of scale. At the same time, the increased production could easily be sold into the growing US market. Similarly, the expansion of the Interior sawmill industry increased the supply of wood chips to an expanding pulp and paper industry in the Interior. BC mills faced no particular transportation disadvantage as much of the domestic US lumber production took place in the Western US.

The difference between what the wood could be sold for and the relatively low cost of production over this time created resource rents (the revenue left over after all economic costs have been deducted) that permitted BC to have its cake and eat it, too. These resource rents allowed the provincial government to create an elaborate regulatory structure while still attracting capital. Investment could be secured by granting rights to harvest timber, while the pricing system for timber helped sustain high wages within the industry by making labour costs deductible when calculating stumpage (this provision was dropped in 1987). The system, in effect, focused on exploiting and redistributing the existing economic rent from BC’s endowment of natural capital.

Today, however, these conditions no longer hold. BC no longer has a comparative advantage in the production of wood products relative to the rest of the world (or more specifically, North America). This reflects both a change in its competitors and in its own timber supply. Today, mills in Ontario and Quebec are using the same technology originally employed in BC’s Interior to saw logs that until 10 years ago were used for pulp. As a result, sawmills in Eastern Canada can now supply their own lumber needs as well as ship into the US, while pulp mills in the region enjoy an increased supply of residual chips. Eastern Canadian mills enjoy a freight advantage as well as lower labour costs. (Figure 4 shows relative labour costs in 1995 for BC, Quebec, and Ontario.) The same pattern is also true for sawmills in the Southern US, which have become the largest regional suppliers of lumber in the US (and where labour costs are even lower). At the same time, we in BC have exploited most of the easily accessible timber and have restricted access to the remaining timber through environmental set-asides as well as policy constraints that require timber harvesting to be dispersed (both geographically and across forest types). Furthermore, we will be increasingly processing smaller wood and more second-growth wood in the future. Under such conditions, it appears inevitable that the economic margins will be increasingly squeezed. What, then, will distinguish the forest industry in BC? Where will the BC advantage lie?

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Some commentators have suggested that by increasing the amount of timber going into value-added production we can simultaneously increase unit values while adding more labour to escape these tightening margins. (This type of production involves further remanufacturing of solid wood products into material such as mouldings, window frames, and fencing.) They have argued that lack of access to fibre has precluded the development of this sector and the government has responded by making additional fibre available to remanufacturers. However, the industry is not irrational—if it made economic sense to invest in further processing, it would have done so sooner. The main problem is that these markets tend to be small and localized.

BC still has a tremendous timber resource: over half of the mature timber volume in Canada is in BC. This timber can provide the raw material necessary to sustain and even expand the industry in the future. We should also understand that the future of the forest industry in BC will depend upon those goods that we can produce and sell in large volumes. There are ways to increase the value of BC’s forestry products, such as through the increased development of Machine Stress Rated (MSR) lumber, appearance-grade lumber, and specialty groundwood paper (MSR lumber is lumber that meets pre-specified strength tests and groundwood papers include newspaper and directory papers). Equally important is the need to reduce our costs through continuing to increase our productivity so that we can compete with our newer competitors. There are also opportunities for developing new products such as engineered lumber and composite wood panels. Critical to all of these approaches is the need to attract investment on an on-going basis.

What BC needs to understand is that our current system of timber allocation and pricing has now become an impediment to achieving those objectives. The introduction of new products and new competitors has meant that product prices change more rapidly than they have in the past (for example, prices for lumber changed 10 percent on average and, at times, up to 30 percent over a three-month period in the last two-and-a-half years). Firms need to be able to respond quickly to changes in demand; however, the administrative approach followed in BC requires them to follow long-term harvesting plans laid out two to five years in advance with little flexibility to adapt to changing markets.

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The problem goes beyond the rules that govern harvesting. For example, firms are required to harvest the forest profile (this means taking all the trees rather than the most valuable ones in a stand) which requires mills to handle a variety of log sizes and species. In turn, this prevents firms from specializing and can also limit their ability to respond to market opportunities. Firms cannot close facilities that are no longer economically viable since this will violate conditions tied to their cutting rights which further locks them into particular product mixes.

Furthermore, investment in any kind of processing facility requires firms to plan 15 to 20 years out into the future. There is a fundamental lack of knowledge about forest inventories since firms have little incentive to identify what already exists, since there is no certainty that they may be able to cut it. The administered pricing system has become increasingly complex as it attempts to deal with a rapidly changing environment. This only adds to the uncertainties for any firm willing to risk its capital. How can firms that invest in new technologies be assured that they will earn an adequate return on their investments? There is also a commitment problem: to what extent can firms rely on government promises made today in making long-term investment decisions?

In the past, the government could encourage investment in new markets and new product development or in new facilities by providing access to additional fibre. Today, however, the government cannot allocate this fibre to one investor without taking it away from another party, and the current system of allocating fibre becomes a disincentive for investment since it effectively fixes the prices and quantities of harvested timber.

Recent discussion has returned to the idea of using markets in some form in BC as a means of making fibre available to the industry, either through government log markets or the privatization of forest land. While the size and scope of these markets differ depending on the proposal, the virtue of any market lies in the signals sent by changing prices and the ability of participants to respond to such signals. Markets also reward those firms that invest in more productive technologies and in products that yield higher returns. Perhaps most importantly, firms know that markets offer the impetus to remain competitive: as long as a firm can either sell its products for more, or produce them for less, under a market system it will be able to obtain the fibre it needs rather than having to rely on government discretion.

The idea of using markets is met with varying degrees of scepticism from forest industry participants—labour, government, and industry—reflecting their various viewpoints. Each sector can see how a change from the status quo might affect their own economic interests, and it is far easier for them to focus on the perceived benefits each derives from the current system rather than agree to some hypothetical benefit that will accrue to the province as a whole by changing the system.

To the extent that we remain focused on how each individual group benefits from it, though, we will find ourselves continuing to be locked into a system that leaves us as the highest cost producer in all of our traditional markets. This will leave us increasingly at the mercy of outside economic forces unless we choose to make the fundamental changes that will ensure the forest industry in BC becomes competitive again. Ultimately, the focus on stumpage in the current debate is correct after all, but for the wrong reason. In economic theory, stumpage should reflect the economic rent, or residual left over after all economic costs are deducted. Our focus should be on how we can ultimately increase that residual to the benefit of all British Columbians, rather than focusing on how to redistribute it.

Note

¹These expenditures include those spent on silviculture and fire-fighting. However, silvicultural expenditures in nominal terms have dropped considerably over this time. In addition, Forest Renewal BC (FRBC), a new Crown Corporation, commenced operations between 1994 and 1995, and 1995 includes $185 million in expenditures made by FRBC.

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Last Modified: Wednesday, October 20, 1999.