Ministry of Agriculture & Land ReclamationUS Agency For IntI. DevelopmentAgriculture Policy Reform ProgramReform Design and Implementation

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Ministry ofAgriculture and Land Reclamation

AGRICULTURE POLICY REFORMPROGRAM

Reform Design and Implementation Unit (RDl)

USAID CONTRACT NO. 263-C-OO-97-OOOO5-OO

4PRPReform Design and Implementation Unit

, Development Alternatives Inc. Group: Officefor Studies & Finance. National ConsultingFirm Development Associates, Cargill Technical Services, The Services Group. Training

Resources Group, Purdue Universities, University ofMaryland

Report No. 88

Estimating the Productivity of~ahogany(khayaseneglensil~in

association with otherundergrowth crops grown with

Waste Water in Egypt

Prepared byDr. Kenneth G. Swanberg

Prof. Aida Allam

December 1999

ACKNOWLEDGMENTS

This study would not have been possible had it not been for the inspiration of Dr.Mamdouh Riad, the Undersecretary for Afforestation in the Ministry of Agriculture and LandReform. Dr. Riad has single-handidly spread the idea of using trees to solve the problem of howto dispose of the effluents from Stage II waste water treatment facilities in Egypt. By deliveringthis water to tree plantations, it is possible to use desert lands as a Stage III facility for cleansingthe water before returning it to the Nile River water system. However, Dr. Riad's insight was notonly to use trees for this filtering process but to plant exotic tropical hardwoods or fast growingsoftwoods, so that the wood produced in these plantations would be of the highest quality andvalue. This has been accomplished by planting mahogany, cypress, casuarina, teak, etc., andachieving phenomenal growth rates in the process.

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However, financing tree plantations is not easy because of the delay in the harvestingperiod. A new financial instrument is required in order to bridge the gap between the time whenthe tree plantation is established and when it is harvested. V.J. Page designed a program to copewith this situation when he introduced "tree bonds" for teak production. This paper attempts toapply this concept to the mahogany and other trees planted in Egypt using waste water forirrigation. Data used in making the calculations and projections oftree growth in Egypt havebeen obtained from Dr. Riad's offices and the experimental plantation at the Luxor waste watertreatment facility. The author has used the measurements of these trees and others mature treesin Luxor and Aswan to estimate the growth rates of mahogany over 20 years in order to predictthe volume and value of these trees if they are harvested in 15 years. The author hopes that thisanalysis will create a supportive environment for developing extensive expanses of treecultivation using waste water irrigation, with the possibility that "tree bonds" might be used asthe financing instrument facilitating this expansion.

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CONTENTS

Acknowledgments

I. Introduction

II. Mahogany and Waste Water in Egypt

2.12.22.32.42.52.6

Waste water Treatment and Environmental ConcernsDeveloping "Tree Bonds"Productivity Analysis of Mahogany Trees in LuxorTable I ReviewApplying the Size Projections to the Tree Bond CalculationsTable II Review

III. An Environmental Capital Development Fund as "Bond Broker"

IV. Forestry Research & ExtensionlBusiness Development & Advisory Services

Attachment I

Policy RecommendationStage III Waste Water Treatment FacilitiesBasic Characteristics of Timber TreesThe Rationale for "Tree Bonds"Why Create an Environmental Capital Development Fund?How Will the Fund Operate?Why form a centrally managed Environmental Capital Development Fund - why not letthe BOT operators design and manage their own "tree bonds"?Implementation ScheduleFund Income

I.

Estimating the Productivity of Mahogany (khaya seneglensiis)in association with other undergrowth crops

grown with Waste Water in Egypt

Introduction

There are few ifany man-made plantations ofAfrican mahogany (khaya seneglensiis)anywhere in the world. We know of only one plantation of South American mahogany(swietenia macrophyla) in Bolivia. This means that this valuable resource will soon beexhausted throughout the world. Since these two kinds of mahogany are preferred woods forfurniture, doors and other cabinetry (mahogany and teak are the most well-known exotichardwoods), anyone who can regenerate these woods will find a relatively high and elasticdemand for their supply.

Egypt has a need for a non-food crop to absorb "waste water" to purifY it before it isrecycled for human use. The Ministry of Agriculture and Land Reclamation (MALR), throughits Afforestation Undersecretariat, initiated tests with khaya from Burkina Faso four years agoirrigated with waste water in the Luxor Governorate. Nearby that site, there had been a plantingof mahogany over thirty years ago as ornamental trees in front of the regional agriculturaloffices. Nine trees majestically stand there in a row ranging in age from 35 years old to 15 years

.. old. The largest is now over a meter in diameter and 15 meters high. We have also found fifty­year old khaya, swietenia. tectona grandis (teak) and dalbergia latifolia (rosewood) in thebotanical garden in Aswan (Kitchner's Island). Based on these examples, the Ministry of

IIIIi Agriculture personnel chose the khaya for testing in Luxor.

The mahogany trees in Luxor have fared well, and the technicians of the program haveenthusiastically expanded their testing program to seven sites scattered around Egypt wheretreated waste water is available. The Luxor site provides seedlings for distribution, growingalmost 200,000 per year. The plan is to establish mahogany plantations wherever there is a wastewater treatment plant (or the need for one). The trees can also be grown in any area where \vateris available and the potential for extensive acreages in the Toshka area is evident.

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However, exotic hardwoods traditionally take thirty years or more to mature. Because ofthis time span, traditional investors (who generally seek quick returns) are reluctant plant suchcrop species. That is why there are so few exotic tree plantations around the world. But in Indiaand Costa Rica, a new program has been introduced that sells the future value of the trees atplanting time. In this way the investor i3 reimbursed for the entire investment and maintenancecosts by the sale of these "futures". In this situation, the investor is simply a manager ofaplantation that has cost little capital and, in fact, may even collect "futures" contributions inexcess of establishment and maintenance costs. These "futures" are known as "tree bonds", atype of stock that is tradable in the private market for business-type stocks and bonds. The rateof return on these bonds is generally at the level of30% compared to common corporate bondrates of II %.

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In order to develop a viable "tree bond" program, the grov.th rates of the various speciesof trees that will be included in the plan must be estimated fairly accurately. For this reason.measurements have been made on the trees in the pilot programs for waste water in Luzor, on thetrees in front of the Agricultural Offices in Luzor and on the trees in Aswan's Botanical Gardens.This paper then uses these measurements of khaya mahogany as well as MALR measurements ofother potential associated crops to develop a "tree bond" program for Egypt.

II. Mahogany and Waste Water in Egypt

2.1. Waste Water Treatment and Environmental Concerns

The Stage I waste water treatment process is to remove sludge and other solids throughchemical and physical treatment in an enclosed facility. Stage II places the waste water in openponds with chemicals for aeration treatment to further remove toxic material. Stage III isdesigned to place the water in open agricultural fields in which a crop is cultivated. Afterpassing through these three treatments the water will be safe to return to the Nile river system orthe underground water table.

Water exiting Stage II treatment facilities is not safe for consumption, and hence, itcannot be used to cultivate food crops. Although cotton is not a food crop, cotton seeds can beused for vegetable oil and cattle feed, and so cotton may not be permissible or may be grownonly for fiber production. (This may require special control and treatment because of the fearthat cotton seeds could be used for vegetable oil or animal feed.) Virtually the only crops thathave been tested and meet all the criteria for Stage III treatment in Egypt are timber trees,mulberry (for silk worms) andjatropha curcas (a castor oil that is a diesel and kerosene oilsubstitute with no black carbon smoke.). The question then becomes whether these crops arefeasible from a production perspective and economically viable from an investment perspective.

The MALR Timber Trees Research Unit of the Central Administration for Afforestationhas been testing mahogany (khaya seneglensiis) using waste water for the last three years inseveral sites. The reason for using trees in the fields designated for dumping waste water hasbeen referred to above, namely that the crops must be non-food crops. Because of the richnutrients in the waste water, growth rates of the trees appear to be faster than the norm foundelsewhere in tropical climates for these hardwoods. Usually, foresters will maintain thatmahogany requires over thirty years to mature to the point where it can be harvested for timberwood. But the waste water seems to enhance the growth rate for the mahogany to a rate where itapparently grows faster than one inch in diameter per year. At this rate it is projected that it willbe over 40 centimeters in diameter by year fifteen and approximately 10 meters high. The samemahogany harvested at years ten and twenty in Luxor have been tested for their usability forcabinetry and they appear to be quite suitable. As a result the value ofsuch trees is significant.One tree at 15 years, priced conservatively at just LelO per board foot yields approximatelyLe3,500. However, because establishment and maintenance costs mount up during thisgestation period, few investors would be willing to wait fifteen years without any returns.

2.2. Developing "Tree Bonds"

Investing in slow-growth tropical hardwood trees is a long term process. Investors mustcommit significant amounts ofland and funds for several years to establish and maintain theplantations before returns are realized. "Tree Bonds", which have been developed in Costa Ricaand India, provide a way in which the operators and owners of the waste water production fieldscan finance their operations without incurring any costs to themselves, while at the same timethey can configure the combination of trees that are produced on these lands so that initial returns

iii to both bondholders and plantation operators (the investors) begin within five years. This is doneby planting high-density fast growing softwoods under the mahogany that are scheduled to beharvested in five years, reseeded and harvested again in ten years, and so on for each five-yearperiod. In some instances, the mahogany itself must be thinned in eight years, and this alsobrings in additional revenue earlier than the fifteenth year.

In Costa Rica, the firm Puerto Carillo planted teak and sold equity shares for the futurevalue of their profits. Returns to stockholders began to materialize in just six years after plantingas the first cuttings of the six inch diameter teak was begun. The young teak was marketed toSwitzerland for parquet flooring. Testing of this teak by the quality assurance testing firmBauerwerks in Switzerland, confirmed that the quality was of FEQ (Fine European Quality)standard. Similar tree bond programs exist in Costa Rica for fruit trees, especially for orangetrees where the bondholder receives a portion of the annual output of oranges for each treepurchased.

In the early nineties, several firms in India established "tree bonds" for Teak, inter­planted with Sevan (Indian Cedar). Costs of the bonds were Rupees 5,000 (approximately SIOO)and returns were Rupees 10,000 in year six, 20,000 in year eight, 40,000 in year 10 and 80,000 inyear 12 (totaling 150,000 rupees, IRR of 41 %). Other programs, with Rs. 6,000 invested,featured annual returns ofRs 900, with balloon payments ofRs. 8,000 iI: ye:rr 6, Rs. 25,000 inyear 8, Rs. 60,000 in year 12 and Rs. 102,000 in year 15, for a total ofRs. 210,000. It is obviousthat these returns are substantial (IRR of 38%). Also in India, bonds are sold for mango trees,similar to orange tree bonds in Costa Rica.

2.3. Productivity Analysis of Mahogany Trees in Luxor

The Afforestation Division of the MALR initiated plantings of khaya mahogany fromBurkina Fasso in 1995. Subsequent plantings were made in 1996 and now 200,000 seedlings areproduced each year. Distribution of the seedlings have been made around the country stretchingfrom Ismailia to the East to El Kharga in the West and from Toshka in the South to New Borg ElArab in the North. However, the only four and three year old trees are in Lu.xor. The others areless than three years old.

A sample of23 trees planted in 1995 and ten trees planted in 1996 were measured inSeptember of 1999. Measurements of the base diameter and diameter at five feet were taken, as

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was the height of the trunk up to the first branches. Measurements were also taken on nine treeslocated at the Luxor Regional Agricultural Offices, which varied in age from 15 years to 35years. Lastly, size estimates were made on the two khaya mahogany trees found in the botanicalgardens at Kitchner's Island in Aswan, which are estimated to be 50 to 60 years old. Data fromthese trees allows us to estimate the growth rate of the mahogany under Egyptian conditions.Although the older trees were not grown with waste water, their growth rates are still substantialand can act as a lower limit to our productivity projections. However, the initial gro""th rates ofthe four and three year old trees indicate that the rate ofgrowth of the diameter is more than oneinch per year, which is faster than the teak that was used in the "tree bond" programs in India.(Note that the Indian and Costa Rican six year old trees grew at one inch per year and wereharvested in year six for parquet and tongue and groove flooring, moldings for doors andwindows and component furniture pieces.)

The following table gives the results of regression analyses of these tree samples.Equations were developed for linear relationships between age and diameter, age and height (tofirst branch) and age and volume. Exponential growth functions were also fit to the data and thisimproved the estimates slightly. However, the productivity curve is said to be that of an S­shaped production or biological growth function, whereby the start is delayed I to 2 years, then itspurts upward for 10 to IS years and then levels out as the tree fully matures. The data that wehave is limited in the sense that we have information for 10 trees three years old and 23 trees fouryears old, a set of nine trees ranging from IS to 35 years old, and two trees 50 years old. As aresult, the growth estimates projected by these functions may severely underestimate the actualgrowth rates that will be experienced in the fields because it does not measure the growth periodbetween 5 and IS years where growth may be the fastest. Nevertheless, we feel it would be bestto use the conservative figures given by these equations rather than guess at what the highergrowth rate might be.

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Table I. Empirical Relations betweenDiameter, Volume, Height and Wood Value According to Age of Trees

for Mahogany (khaya senagalensis) Grown in Egypt

estimate for year...10 15 ~o

value!board footestimate

dependentvariable equation -Diameter Y-bX Y-.96X Y- 24.27 36.40 48.54

R2-.96 tree value @S3!bf S 353 S 794 SI.411tree value @S2!bf S 235 S 529 S 941

Y-a+bX Y-2.23+.87X Y- 27.79 38.85 49.92R2-.98 tree value @S3!bf S 416 S904 SI,791

tree value @S2!bf S278 5 603 SI,194Volume I Z-bX Z-.37X Z- 3.68 553 7.37

R2-.71 tree value @S3!bf S2,812 $4.218 I S5,624tree value @52!bf SI,875 52,812 53,749

Z-a+bX Z-2.22+.45X Z- 2.30 4.56 6.63R2-.77 tree value @53!bf 51,758 53,484 55.211

tree value @52!bf 51,172 S2.323 53,474Diameter Y-e X Y-e X Y- 30.10 41.84 52.86

R2-.97 tree value @53!bf 5 489 51,049 52,009tree value @52!bf S 326 S 699 51.339

Volume Z-e X Z=e X Z- 1.\4 3.10 6.30R2-.97 tree value @53!bf S 343 S 9'~ 51,894,-

tree value @S2!bf 5 229 5 621 51263Height W-e X W-e X W- 6.32 8.88 11.31

R2-.95 tree value @53!bf S 343 S 931 51,893

Notes: X denotes the age of trees m years.e denotes the base of natural logarithms, and equals 2.713

2.4. Table! Review

The first equation estimates a linear relationship between diameter and age. At agefifteen the diameter is projected to be 36.40 centimeters and this generates a tree value of$794(at $3 a board foot sales price). Increasing the age to 20 years leads to a diameter of 48.54centimeters and a corresponding tree value increase to $1,411. Cutting at 10 years yields lessthan half the value ofcutting at 15 years. The first equation forces the curve through the zerovertical intercept at the start (year 0). The second equation is similar to the first but in thisinstance a vertical intercept is computed. This regression generates a line which is closest to alldata points excluding the zero starting point. In this case the line starts above the first line andcontinues as such past year 20 but at a lesser slope so that the two lines will cross past year 25.

The next two equations estimate the volume of the trees, passing the line through the zerointercept in the first case and computing the intercept in the second case. These equations, whichare not based on direct measurements but on multiples of the radius and height, and thus giveexaggerated values for trees projected at high ages. The R-squares are also significantly less than

for the first two equations, .71 and.77 respectively, compared to .96 and .98 for the diameterequations. I

However, in the next equation, the exponential function of the diameter-age relationshipgives better fit, which is more in line with what the foresters estimate that the tree sizes \\-;11 be infifteen years. In this case the diameter is estimated to be 41.84 centimeters at year fifteen. whichgives a tree value of $1 ,049 at $3 a board foot for the wood at 60% utilization. Notice that in thiscase the value estimate for 20 years is almost double the value at 15 years, so that it may beprofitable keep the trees growing for more than fifteen years if the value of the increased growthis greater than the compounded interest rate on the investment during this time period.

The exponential volume equation, once again, gives unrealistic results. Here theregression bends upwards, which once again shows the problem of regressing age against asquare of the radius and three times the height (pi times height). The volume is extremely low inthe early years and then rises rapidly as the radius is squared. Since there are only a couple datapoints in the high age years there are not enough points to influence the shape of the curvecompared to those data points in the early years, and as a result the curve does not level out butcontinues to rise indefinitely. This equation is rejected because it curves continuously in thewrong direction, even though the values of the trees are close to those predicted in the lastexponential diameter equation.

The last equation is an estimate of the height by age relationship. This equation gives aheight of almost 9 meters and a corresponding value of$931 for a fifteen year old tree. Thisequation is used to estimate the height of the trees for the diameter-based regression projectionswhich are used for the tree bond estimates of potential earnings. Since it is expected that thetrees will grow taller in the earlier years and then fill out as they mature, the calculated values forthe height at years 10, 15 and 20 have been increased slightly above those projected in theexponential height equation.

2.5. Applying the Size Projections to the Tree Bond Calculations

From the tree size estimates generated by the equations above, it is possible to projectwhat the size of the mahogany trees would be at different ages in a production program usingwaste water in Egypt. The waste water tree bond program is designed for 200 feddans. TheBOT operator (build, operate and transfer contractor) would contract with the Ministry ofAgriculture to lease the land and manage the plantation for 15 to 20 years and then return it to theGovernment (or exercise a release option). The MALR has issued a decree and agreed to make

... lOne minus r-squared (I - r-squared) is the percentage of the variali~n of the data not explained by the regressionline. The closer the r-squared is to I, the bener the fit of the regression line. The regression minimizes the sum ofthe squares of the distances from each data point to the line and directs the line through the maze of data points sothat the line is as close as possible to all points. The lower the percentage of unexplained error (I - r-squared) thehigher the percentage "closeness" of fit is the regression line, and the more reliable are the estimates obtained whenusing the modeL)

land available for these purposes near each of the existing waste water treatment plants. (Seerelated Benchmark in Tranche III of the APRP.) The contracts that would be signed by the BOToperator would stipulate the varieties of trees to be planted their spacing densities andappropriate mixes, their maintenance schedules, and their cutting and harvesting plans. TheNOPWASD (National Organization for Potable Water and Sanitary Drainage) will arrange to

.. have the waste water from Stage II treatment facilities delivered to the 200 feddan plots that theBOT operators will establish and manage. The plantations approved for this program will bebased on the principal stand of mahogany associated with a selection of undergro\Vth cropswhich could be fast growing softwoods for paper pulp or medium density fiber board, such aspoplar, willow, causarina, or cypress, mulberry for silk worms, jojoba for engine lubricating oils.jatropha curcas for carbon-less diesel fuel or kerosene oil, flowers and ornamental plants, orpossibly cotton. Tests to determine the appropriate mix for the undergro\Vth crops are ongoingaround the country supervised by the Afforestation Undersecretariat and other private sectorentrepreneurs.

For our preliminary "tree bond" program we have opted to consider grov"ing poplar underthe mahogany. The mahogany is projected to be planted at a density of250 tree per feddan or 4meters by 4 meters between trees. This would allow for the planting of over three thousandpoplars at a 1.2 meters by 1.2 meters density in between the mahogany. The poplar trees wouldbe harvested in 5 years and 10 years, and the mahogany in 15 years. (No poplar would beplanted during the third period of gro\Vth after the 10" year cutting.) The costs and returns of thisprogram are laid out in the table which follows.

Table II. Tree Bond Financial Analysis using regression correlation projectionsfor diameter and height by year of growth, assuming harvest in year 15.

Bond Bond Investment 4 yr Accum 5 yr Accum Bondholdr BOTopert'rPrice Income Cost Cash Flow Cash Flow Rerum Rerum520 5500K -5294K -5 74K +51,887K 44% 83%526 5650K -5294K +576K +S2,037K 39% 111%S30 S750K -S294K +5176K +S2,137K 37% 136%$35 5875K -S294K +5301K +S2,262K 34% 173%$40 SI,OOOK -5294K +$426K +S2,387K 32% ?19%

2.6. Table II Review

The 200 feddan will be planted to mahogany and an undergrowth crop. The cost forestablishing the plantation is estimated 'tt $294,000 (Investment Cost, column 3). The wastewater treatment program in collaboration with the MALR, will make the land available for leaseto the BOT operators and deliver the Stage II treated water to the plots. The BOT operator willhave to develop the within field irrigation distribution system and obtain and plant the trees.Yearly maintenance costs are estimated at $70,000 per year (for irrigation pumping, labor andsecurity).

The idea is to sell "tree bonds" for the mahogany trees to public individuals on a tree bytree basis. Each tree is to be sold at the Bond Price (column I). For each bond priceaccumulated cash flows and returns to bondholders and BOT operators have been calculated.The income from the bond sales (Bond Income, column 2) will cover the costs of theestablishment (Investment Cost) and maintenance costs up until the first harvest of theundergrowth crop. In this example, the undergrowth crop of poplar will be harvested in year fiveand its proceeds are included in the accumulated cash flow column above. The 4-yearaccumulated cash flow (4-yr Accum Cash Flow, Column 4) and the 5-year accumulated cashflow (5-yr Accum Cash Flow, Column 5) show that the BOT operator will run into negative cashflows only if the choice of the bond price is below $26. The last two columns present theinternal rates of return to the bondholders and the BOT operators. Returns to the bondholders arehighest when the bond price is lower. The bondholder will receive the value of the 15 year oldmahogany tree and a proportion of the undergrowth trees associated with that tree. In otherwords, if there are 250 bondholders for each feddan, they would share equally the proceeds of thesales of the 3,400 poplar trees in that feddan each fifth year and tenth year, in addition to theirmahogany proceeds. This total value amounts to $1,178 per mahogany tree bond. The internalrate ofreturn of this investment is presented in column 6.'

The program will work this way. If the BOT operator were to sell tree bonds for all ofthe mahogany, then the operator would not eam more than the value of the tree bonds. However,if the BOT operator sells tree bonds for some proportion of the mahogany trees planted, forexample 50% of them, then the operator would receive the bond income plus the value of theundergrowth trees and the mahogany trees from 50% of the plantation. If the BOT operator wereto actually invest the cost of the establishment (in this case $294 thousand) then the returns to theoperator would be as presented in column 7 for each bond price. But in fact, the BOT operatoruses the proceeds of the bonds to cover the costs of the establishment, so in reality the returns tothe BOT operator are incalculable because no initial investment is required. The only investmentthat will be required is bridge financing from the time of initial investment for establishmentuntil the bonds have been sold. Total proceeds to the BOT operators over the fifteen year periodreach $29 million dollars if the bond prices are $30. (These proceeds only vary by $1 million asthe bond prices varie up or down between $26 to $40.) The net present value of these proceedsat a 12% discount rate would be $5.7 million dollars and such a project could conceivably betraded (bought and sold) for some value under this limit. If this program is managed by aprofessional bond trading company it is conceivable that bond sales could proceed prior toestablishment of the field plantation, based solely on the feasibility plans and bond offerings, andhence the operator would have no out ofpocket costs.

Since normal corporate bonds in Egypt are offered at 10% to I I% this bond offeringappears to be supremely attractive. Although the offerings may be semi-private in the sense thateach investor will have to trust the honesty of each BOT operator to manage the tree production

2 Growth estimates for poplar in five years are 5" diameter and 12 meters height. The utilization rate for plywoodcore fillers, flooring or moldings is 60% and the board foot price is 15 cents U.S. If the poplar trees were to be usedfor paper pulp and/or medium density fiber board (MDF), then the entire tree would be utilized at a specified priceper cubic meter.

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efficiently (the moral hazard), the investor will have the certificate of ov;nership for an actualphysical asset, a "real tree", that is located at a specified place where one could go and inspect it,touch it and watch it grow. Also, the bond trading company may develop different forms ofguarantees, such as the purchase of a zero-coupon bond for the initial bond price that matures insix years, or a type of insurance or guarantee through an endowment of some kind. Also,because it is recommended that the BOT operator only sell 50% of the plantation as "tree bond",reserve trees should be available to substitute for the bonded trees in the event that they die orbecome diseased (an eventuality that is extremely uncommon for well-established hardwoodmahogany trees). All of these details have yet to be developed for each BOT stand and thisprocess is ongoing.

III. An Environmental Capital Development Fund as "Bond Broker"

Preliminary calculations for the Egyptian tree bonds, as indicated above, suggest that theinternal rate ofreturn for the bondholder would be over 30%. Although this is an attractivereturn compared to normal expected returns on the Egyptian stock market for corporate bonds, itis unlikely that any individual BOT operator will be capable of designing, setting up andmanaging a tree bond program of this kind. The uncertainties and risks are great (the trees couldbecome infected, grow slowly, succumb to fire or be stolen), and the delayed payments areproblematic for private investors. But most importantly, the private sector in Egypt has littleknowledge, experience or understanding of the workings ofthe bond markets for privatelyoffered corporate bonds. Not only must a BOT operator know how to grow tropical hardwoods'but they must also know how to establish a bond financing project and manage it. Those whoknow the agriculture of tree production usually are not professionals in the art ofcapital marketoperations. Moreover, the guarantees needed to establish this type ofprogram in Egypt aremissing if each BOT operator must manage their own tree bond program independently. A"Bond Broker" operating through a Fund could take over this risk and manage it collectively.The Fund could set up recommended tree planting designs (types of trees, spacing, combinationsof profitable undergrowth crops together with mahogany or mahogany substitutes such as teak orrosewood, water delivery designs, fertilization and pest management recommendations, etc.), andoffer technical assistance to all BOT operators during the growth period. The technicalassistance would insure that each BOT operator follows their own plan and design, harvests theundergrowth crops as indicated, and cuts and sells the mahogany on schedule. The Fund wouldthen collect the proceeds of the harvestings and make the payouts to the bondholders.

The GOE could and should sponsor this Fund and vouch for the validity of itsrecommendations. This would provide a significant guarantee and sense of seriousness andreliability that the bondholders would require in order to make these kinds oflong-terminvestments. In addition, the Fund would use professional fund managers and bond or stockbrokers to assist in the design and promote the bond issues, to issue the bonds and collect theproceeds and pass these proceeds on to the BOT operators, and ultimately to receive the returns

3 This has not been done commercially in Egypt before, nor do we have evidence that this has been done with khayamahogany anywhere in the worid [0 date.

from the sales of the bonded crops and trees and deliver these returns to the bondholders. TheFund would act as a "bond (or stock) broker".

IV. Forestry Research & ExtensionlBusiness Development & AdvisoryServices

To insure that the Fund will be successful, it would be worthwhile for the GOE to investin forest timber tree research and adaptation, to test different tree species and undergrowth treeand crop combinations for the new programs in environmental and waste water "tree bond"developments. Several new tree species are being sought and tested, such as the swieteniamacrophyla, the mahogany from Latin America which is expected to do well in the Cairo toAlexandria latitudes. Also, testing is being done on poplar, cottonwood and willow trees whichcan be grown at much higher densities than the mahogany and used as pulp for paper production,chips for MDFB (medium-density fiber board), core pieces for plywood, moldings and flooring.and timbers and poles for building construction. Teak trees, tectonis grandes, have also beenplanted in the nurseries using fresh water in the Cairo latitude and appears to be grov,ing fasterthan that observed in India in the tree bond programs there. Further tests are also required forrosewood, dalbergia lati/olia and dalbergia sissoo. Significant testing is well underway formulberry but needs further assistance. Jatropha Curcas (castor oil) has been tested in Luxor \viththe mahogany and Jojoba has been tested in Ismailyia. Inter-cropping recommendations ofail ofthe above must also be tested and developed. And this testing must be done at all of the latitudesusing fresh and waste water to develop the appropriate recommendations for each area

In addition, the Fund should offer extension services to the BOT operators on all aspectsof tree and crop production and harvesting. The BOT operators cannot possibly know ail there isto know about the production of these tree species because the experimentation is just beginningin Egypt. Tree plantations for some of these species are not well-known anywhere in the world,and certainly not under these desert latitudes. The BOT operators will need special assistance tomake this program work.

Lastly, the idea of combining bonds with slow-growing tree production is novel at best.It apparently has only been successful in Costa Rica and India. Business development andadvisory services will be needed to ensure that the BOT operators understand how to develop

ill these projects, and on-going service will be required to make sure that they continue to managethe projects properly. The Fund should provide these services to assure that the bondholderswill reap their due returns in 15 years. Advice on how to harvest and process the timber, once itis grown, would also be necessary.

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.... Attachment IPolicy Recommendation

That an environmental Capital Development Fund be created in a partnership withthe private sector and the GOE to manage long-term investments through "treebonds" that have been designed for Stage III Waste Water Treatment Facilities

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Waste water sewage effluents in Egypt must pass through Stage III treatment facilities,Ilil which are conceived of as being designated land areas covered with non-food crops. The

afforestation section of the Ministry of Agriculture and Land Reclamation (i\lfALR) has testedseveral species of exotic tropical hardwoods, namely African mahogany, and has witnessedsignificant growth rates such that harvesting could be commercially viable in 15 years.

However, most investors are unwilling to wait this long to generate returns on theirmoney. In India and Costa Rica, tree development has been financed through "tree bonds", aunique system designed to elicit small investors to put up relatively small amounts ofcash \viththe expectation of receiving high returns periodically over this time period, reaching internalrates ofretum in excess of30%.

This Policy Recommendation is for the creation ofa Fund that would manage theissuance ofthe "tree bonds" for the BOT (Build, Operate and Transfer) Stage III waste watertreatment facility operators. The Fund would be managed privately but receive joint financingfrom the GOE and donors for different components of the operation, including the possibility ofan endowment. The MALR's Afforestation Undersecretary would be responsible forresearching, developing and adapting the appropriate tree species for the field applications. TheNOPWASD (National Organization for Potable Water and Sanitary Drainage) will organize thedelivery of the waste water to 200 feddan plots that the BOT operators will develop and manage.The 200 feddan plots will be made available from the MALR on a leasehold basis for up totwenty years with renewable options.

Stage III Waste Water Treatment Facilities

Stage I and Stage II waste water treatment is a combination of chemically treated slews,tanks and ponds which take out the sludge and other toxic elements in the water. But Stage IIItreatment is required to make the water safe for human and animal consumption.

Stage III treatment requires that the water drain through open fields with cropcultivation.

Only non-food crops can be cultivated in these fields, and any crops whose by-productscan be used for animal feed (if the animal is consumed by humans) are also banned.

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This limits the selection of crops to timber trees. (Under certain conditions mulberry forsilk worms,jatropha curcas (a castor oil grown as a substitute for diesel fuel), or other non-foodcrops, such as cotton, may be grown under the timber trees while they mature to harvestdimensions).

Basic Characteristics of Timber Trees

An impressive selection of Timber Trees have been tested for production using wastewater in Egypt, which include Mahogany, Terminalia, Eucalyptus, Causarina, and Pine.Mahogany appears to be the most promising specie. Observed gro"'th rates in seven sitesthroughout Upper Egypt, ranging from one to three-onelhalf years old, in addition to the ten treesfound at the Agricultural Offices in Luxor that are 10 to 25 years old, suggest that mahoganygrows faster under these conditions than ever expected. Mahogany is usually harvested after 30years but under these growing conditions it appears that 15 year gro",ths or less may be suitablefor cutting and for use in cabinetry and furniture.

Wholesale prices for Mahogany in the U.S. are over $15 a board foot. Using only $3 aboard foot and a 60% utilization rate, a mahogany tree grown under Egyptian conditions usingwaste water can be expected to yield over LE 5,000 in 15 years.

However, few investors can afford the long gestation period before returns are realized,even if these returns may be significantly higher than normal returns on corporate bonds andstocks in the current capital markets.

The Rationale for "Tree Bonds"

One technique for resolving the problem of the long gestation period before returns arerealized is to sell the future value of the trees by issuing corporate bonds or stocks at the time ofplanting. Bondholders will realize internal rates ofreturn over 30% (compared to corporate bondrates in the local capital market of 11%) and total returns 50 times the initial cost or value of thebond.

The owner/operators of the area used for the Stage III waste water treatment plots caneam return rates over 75% with virtually little or no up-front investment required, and totalreturns 100 times the initial "Stage III waste water treatment plant" (or in this case, the treeplantation) establishment costs.

Private investors have been invited to submit bids for the development ofStage m wastewater treatment facilities and the Government has promised access to and long-term use of200feddan of land and the delivery of ample waste water to this area. These are being offered underBOT (build, operate and transfer) programs by the Ministry of Public Works and Sanitation.

Why Create an Environmental Capital Development Fund?

An Environmental Capital Development Fund should be created to lend credibility tothe "tree bond" program so that the individuals purchasing the "bonds" will feel that they are

.IIi guaranteed their returns. Guarantees on the principal may be offered and built into the program.(See details below in Attachment I.)

iii The Fund will manage the issuance of the "bonds" for each BOT contractor (but ,,,ill nottake ownership).

The Ministry of Public Works and Sanitation is currently planning to let contracts toprivate operators who will submit bids for BOT's (Build, Operate and Transfer) for 200 feddanof land that would use waste water to grow trees for twenty years. The BOT operators willprepare the land for irrigation with the waste water that the MPWS will deliver to the fields.(Land use rental rates from the MPWS have not been determined but will presumably benegligible - the MPWS has no other choice but to treat the water this way or else pump it far outinto the desert.)

For each of the Stage III treatment facilities incorporated into the Fund, the BOTmanagers will be able to select their own mixture of trees from a set ofrecommended productionpatterns developed by the Fund in collaboration with the MALR's Central Administration forForestry, Timber Trees Research Unit. The BOT managers will be required to follow an agreedupon development and production plan (business plan) for the time period stipulated in the BOTcontract.

How will the Fund operate?

Any Stage III waste water treatment facility BOT operator may join the Fund, byallowing the Fund to design a "tree bond" project for their facility, and to assign the sales of the"bonds" to the Fund managers. The BOT operators will receive the proceeds of the tree bondsales (as and when they are sold) less a fee for research and brokerage management. The BOToperators will then be required to deliver to the Fund the earnings of the trees (and underlyingcrops) harvested according to the cutting schedules laid out in the BOT contract for each treefinanced with a "tree bond". The Fund, acting for the MPWS, will award the BOT contractsbased on a competitive bidding process.

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The Fund will be created by the Private Sector with the support and endorsement of theMALR and the MPWS. It will be managed by an experienced funds manager. The Fund willoperate like a private corporation and thus, will be able to issue corporate bonds, i.e. the so-called"tree bonds". The BOT operators will be assigned an identification number to their set of bondsso that the bondholders will be able to identify which area, what kind of trees and which type ofplan will be linked to their specific bond issue. Earnings will accrue according to the returnsgenerated by the BOT operators for their respective trees and crops: Proceeds of the sales of thedesignated trees in each BOT program will revert to the Fund for distribution to thebondholders. Returns will be tied to actual production and sales stemming from the sales of thetrees produced in each designated area for this purpose. (Not all of the trees produced in a 200

feddan project will be specified as bonded trees. Roughly half of the trees planted will be sofinanced and designated to produce returns for the bondholders.)

The Fund will use a portion of the proceeds generated through the "bond" sales toindemnify the bondholders for their principal, by purchasing zero-coupon bonds that will matureprior to the date of sales of the harvested wood, and whose value at maturity will just equal theinitial bond price. This will mean that the bonds ",ill be guaranteed for their face value.

The Fund will also deduct a minimal amount from the bond sales to cover the costs ofconducting research on different tree species, such as mahogany (khaya anthoteca andswietennia), teak (tectonis grandes), rosewood (dalbergia latifolia and dalbergia sissoo),terminalia and other hardwoods, as well as various fast-growing hard and soft woods such aswillow, pine, poplar, cottonwood, causarina, eucalyptus and others.

The Fund will seek to develop an $8,000,000 endowment from donor agencies, theproceeds of which will be used to cover the start up costs of the tree bonding program for wastewater treatment facilities. (Costs will be incurred for setting up the bond issues, continuing treeresearch using waste water, and providing technical agronomic assistance and business advice topotential BOT operators.)

Why form a centrally managed Environmental Capital Development Fund ­why not let the BOT operators design and manage their own "tree bonds"?

The BOT operators will generally not be familiar with both tree production and irrigationmanagement as well as how to operate in the capital bond market. Most of them ",ill not havethe capacity to issue corporate bonds individually. However, a Fund could be created to managethis program and to operate as bond brokers for each Bot operator wishing to join the Fund. Noone will be obligated to join the Fund; BOT operators may establish their own individualprojects.

The capital markets in Egypt are inexperienced with this kind of bond issue. (Only Indiaand Costa Rica have successfully developed "tree bonds".) Moreover, the capital markers lackexperience in corporate bonds in general and only well-known and well-established firms havebeen able to attract buyers for private corporate issues. Individual BOT operators would beunlikely to be able to attract significant numbers of buyers.

There are inherent risks in tree production in Egypt. Experience in timber tree productionfor commercial purposes is limited in the Egyptian environm;:nt and some laws (or remnants ofsome laws even though the laws have been changed or eliminated) still prohibit tree productionin some areas.

The agronomics of tree production are not well-known in Egypt. The species beingintroduced are new to the country in many instances, or have only been grown under ratherunique circumstances (such as on Kitchener's Botanical island in Aswan). Although field trials

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are currently underway. the long-term nature of tree production will require several years for thetrial results to be verified. Growth rates are preliminary estimates based on early results (up tothree years) from seven sites scattered around Upper Egypt. Potential for disease or other naturalcalamities is unknown (such as fire or civil unrest that could destroy the plantations.)

There are no known commercial, man-made plantations of mahogany currently underproduction anywhere in the world, to our knowledge.

Given these risks and uncertainties, it would appear that the a centrally managed Fundwould be imperative in order to entice BOT operators to consider "tree bond" productionprojects. Start up costs would be required to design the bonds, develop the issuance mechanismand to advertise for them. At the same time the individual BOT operators will have to plant theirplantations and the MPWS will have to deliver the waste water to the fields. The MALR forestrydepartment will also have to continue their research and extension for these types ofprograms,designing the plantation layouts and determining the mix of trees with regard to long-termhardwoods and short-term undergrowths.

Implementation Schedule

A Steering Committee will be formed from amongst the key participants who attendedthe three Waste Water Treatment/Afforestation workshops organized by the AfforestationUndersecretary of the MALR.

Capital portfolio managers have already been identified who may be wil1ing tounderwrite and/or manage the Fund and they will be invited to join the Steering Committee.

The Steering Committee will meet in early May to layout the plan for creating the Fund.The plan will determine how the Fund will be formulated, who will manage the Fund and howthe start-up costs will be covered.

Fund Income

The Fund (or bond broker, in this case) will manage the issuance of20 sets of BOT "treebonds". Each BOT will cover approximately 100 feddan of mahogany trees and under gro\Vthcrops that will be sold as "tree bonds". If a mahogany tree sells for $30 each, then 100 feddanwill generate $750,000. Bond issuance and management fees of4% would yield $600,000 forthe broker if all 20 BOT sets are sold in their entirety. $4 per bond would be used to purchase azero-coupon bond for 15 years at 14.5%, which would guarantee the principal of the bond to thebondholder, i.e. equaling the original unit share price. Hence, the yield to the investor for each$30 bond would be $25.85, ($30 less $4 zero-coupon bond cost and SUS management fee). or$646,250 for 100 feddan, which will just cover the establishment and maintenance costs for theBOT investor until the first harvest of the under growth trees comes in at the fifth year.

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