Building bio-based supply chains: theoretical perspectives on innovative contract design.

• Author: Endres, Jody M.
• Position: I. Introduction through II. Theoretical Approaches to Biomass Contract Design, p. 72-117

1. INTRODUCTION II. THEORETICAL APPROACHES TO BIOMASS CONTRACT DESIGN A. The Socio-Compatibility Perspective B. The Risk-Minimizing Perspective 1. The Unavailability and Limits of Traditional Agricultural Risk Management Tools 2. Learning, Experience, and Risk Management 3. Economic Contract Theory and Risk-Sharing C. The Cost-Minimizing Perspective 1. Information Asymmetry Costs- Searching, Measuring, Monitoring a. Information Asymmetry b. Moral Hazard 2. Incompleteness Costs- Asset Specificity, Property Rights, and Holdup III. CONSTRUCTING A FRAMEWORK FOR BIOMASS CONTRACTS A. Trans-Disciplinary Approaches to Biomass Contracts B. Biomass Contracting Framework Considerations 1. Production Diversity- Crop and Location Selection 2. Education and Information Sharing 3. Biomass Production- Pricing, Yield Risk, Incentives, and Specifications a. Price b. Yield Risk c. Incentives d. End-Product Specifications, Storage, and Delivery i. Product Specification ii. Storage and Transportation 4. Property and Production Issues- Land Acquisition and Ancillary Property Rights a. Acquiring Farmland b. Ancillary Property Rights: Germplasm and Ecosystem Service Payments 5. Duration/Assignment/Renewability IV. CONCLUDING THOUGHTS- "SUSTAINABLE" BIOMASS CONTRACTING I. INTRODUCTION

   A robust mix of domestic and international policies increasingly recognize the importance of renewable energy in combating climate change, achieving energy independence, and stimulating rural redevelopment. In addition to wind and solar power, biomass-based energy from crops and forests holds significant untapped potential. Projections indicate that by 2030 the U.S. will consume 329 million dry tons of forest and agricultural feedstocks for energy production, primarily for co-firing electricity generation facilities. (1) State renewable portfolio standards (2) and limits on stationary source emissions of greenhouse gasses (GHGs) (3) are incentivizing electricity generators and other large emission sources to seek out a long-term, reliable supply of combustible agricultural and forest biomass. (4) Likewise, mandates embedded within the federal Renewable Fuel Standard (RFS2) (5) will require significant biomass supplies to produce up to sixteen billion gallons of advanced biofuels each year. On the supply-side, the Biomass Crop Assistance Program (BCAP) attempts to link agricultural producers of crops, such as Miscanthus, switchgrass, hybrid poplar, and camelina with qualified biomass conversion facilities.

   Mandates and subsidies aside, scholars who have empirically evaluated producers' willingness to participate in the biomass industry have unearthed a plethora of critical issues that farmers face in the adoption of energy crops. (6) Producers unfamiliar with novel cropping and harvesting practices must adopt new techniques and invest in production infrastructure that is costly and involves substantial risk. Adding to the novelty of a perennial cropping system is the likelihood that producers will be obligated to meet environmental and social sustainability requirements incorporated within bioenergy policies. For example, the European Union's Renewable Energy Directive requires sustainability certification to protect against conversion of high conservation and carbon value lands, and agricultural pollution. (7) U.S. producers seeking to access Europe's emerging renewable energy market must obtain third-party certification under an approved sustainability standard. Domestically, the RFS2 excludes biofuels derived from newly converted agricultural or forest land (8) and, depending on the outcome of U.S. Environmental Protection Agency (EPA) studies, (9) may require in the future some form of sustainability accounting.

   Although organic certification has been available in the U.S. for two decades, and some environmental requirements already apply on certain agricultural lands, the vast majority of potential biomass producers in the U.S. are not familiar with sustainability requirements or production certification schemes of any type. (10) Compounding uncertainty are the diverse set of end-users obligated to achieve GHG reductions under bioenergy statutes--ranging from petroleum refiners to biofuels power generators--most of whom are unfamiliar with rural culture and agricultural practices. All these barriers to adoption stand in the way of more rapidly developing the nation's bio-economy. Moreover, potential biomass producers consistently voice concerns related to risk, cost, and the negative impacts on social networks when discussing abandonment of traditional commodity crop production in favor of bioenergy feedstocks. (11)

   Contractual agreements are one way to address these concerns and bring together growers and end-users to reduce uncertainty on both sides of the equation. Scholars from the disciplines of economics, finance, rural sociology, and the law have developed generalized theoretical approaches to contracting from risk-minimizing, cost-minimizing, or sociological-compatibility perspectives. In the rapidly evolving world of renewable energy, it is clear that existing theoretical approaches may not address adequately the new challenges of a bio-based economy. Rather, a comparative analysis of the focused, goal-specific orientation of each disciplinary perspective has enabled us to identify potential areas of conflict that, within the defined space of biomass production contracts, may engender significant barriers to innovation adoption--obstacles that a developing industry must overcome in the near term in order to secure sufficient biomass supply to meet demand.

   Categorizing and approaching potential issues from the perspective of the biomass producer has allowed us to develop a novel, interdisciplinary Biomass Contract Framework and methodology to address farmer concerns in a systematic manner. The framework facilitates contracting parties' ability to identify tradeoffs and strike balances between conflicting contractual goals when applied to biomass-specific issues. Accordingly, the development of the Biomass Contract Framework provides greater theoretical understanding to the development of biomass supply chains and the importance of contract design to facilitate reliable sources of renewable energy. And, although the specific context of this article remains the biomass supply chain for renewable energy production, this framework could apply in other supply chain contexts involving similarly innovative end-products and disruptive technologies.

   Part II describes foundational, theoretical considerations taken into account in the Biomass Contract Framework. Part III outlines the framework within the context of two leading biomass feedstocks--perennial energy grasses and corn stover. (12) The article concludes in Part IV with our observations of the biomass supply chain and recommendations for future research, including governance considerations and the ability of sustainability standards to lower transaction costs.

2. THEORETICAL APPROACHES TO BIOMASS CONTRACT DESIGN

   Contract theorists have devoted considerable literature to determining which organizational structure is most likely or appropriate for the developing biomass industry. Scholars have placed particular emphasis on complete vertical integration, commodity market models, cooperative structures, and vertical coordination. (13) For reasons detailed below, we assume a vertically coordinated industry structure.

   No commodity markets currently exist for bioenergy crops. Experience tells us that spot markets traditionally fail to develop due to inadequate competition and price information, producer unwillingness to invest in land and production assets, and inadequate reflection of consumer preferences for product attributes in prices. (14) All these factors characterize the current state of the biomass industry. Although proposals to develop energy crop commodity markets do exist, (15) the current chicken-versus-egg problem hinders any significant progress. More specifically, biomass conversion facilities are unwilling to engage in substantial capital investment absent a stable source of raw material (i.e., biomass), while farmers remain skeptical about converting otherwise profitable and productive land resources to dedicated bioenergy crop production in the absence of a reliable (and at least equally profitable) market for their products. As spot markets for biomass commodities are unlikely to emerge until the industry is much more well-established, we concur with Altman and Johnson that current structural constraints make it likely that the bioenergy industry must be vertically coordinated in its early stages. (16)

   Although a few large-scale, purely vertically integrated models have arisen, (17) these models may have limited feasibility, particularly in areas such as the Midwest. By "vertical integration," we refer to industry structures where a party (either a producer cooperative or end-user) owns and operates all levels of the value chain. While initial pilot-scale projects may utilize successfully this type of wholly integrated structure, other financial, management, and environmental constraints may limit end-users' ability to vertically integrate sufficient land and production resources to supply large-scale bio-refineries over the medium- and long-term. Complete vertical integration seems more feasible when end-users are able to secure large contiguous tracts of land from a few large landowners. Particularly in the productive Midwest Corn Belt region, high agricultural land values may constrain energy crop production to "marginal" lands, creating the need for thousands of smaller tracts of farm land owned and operated by a diffuse set of landowners and producers. Moreover, vertical integration of sufficient land and production resources requires enormous start-up capital, which may also prove prohibitive for all but the most capital-rich end-users (e.g., petroleum...