The option value of non-contaminated forest watersheds

Abstract

Non-contaminated drinking water may become a scarce resource in the future. In that case, forest watersheds will play a significant role in ensuring the supply of clean drinking water. However, forest management affects this supply considerably. Christmas tree production is an important income generator in Danish forestry but is also a significant contributor to non-point contamination of groundwater resources because of its application of fertiliser and pesticides. This paper analyses the decision to convert a natural or semi-natural forest into Christmas tree production, when groundwater contamination is irreversible and future returns on non-contaminated groundwater resources and Christmas tree production are uncertain. It is concluded that conventional expected net present value analysis which treats conversion as a ‘now or never’ decision, may not lead to an optimal decision rule. It is shown how the option to postpone conversion and acquire new information should be included. Application of an option value approach shows that the optimal decision strategy is more conservative when the option to postpone is recognised, i.e. option value analysis prescribes that the return on Christmas tree production should be higher to justify conversion. An empirical example shows that when using option value analysis the return on Christmas tree production should increase by more than 100% to justify conversion. Moreover, it is shown that the economic value of a natural forest may increase by more than 12% when the option value is included.