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

• Author: Endres, Jody M.
• Position: III. Constructing a Framework for Biomass Contracts through IV. Concluding Thoughts, with footnotes, p. 117-147

3. CONSTRUCTING A FRAMEWORK FOR BIOMASS CONTRACTS

   The preceding deconstruction of the sociological, risk-minimizing, and cost-minimizing perspectives yields several theoretical insights for an optimal biomass contracting framework, including key elements of contract design and opportunities for trade-offs in the negotiation process.

   From the sociological perspective, sensitivity to non-economic factors tends to dominate decision making in the innovation context. The ability to maintain existing agricultural practices and social networks throughout the education, field trial, and commercial production stages minimizes farmer disincentives to enter into production contracts for novel biomass crops. Trialibility, information sharing, and education also have strong influences on the sociological-compatibility perspective of contracts. The risk-minimizing framework shares with the sociological perspective elements of information sharing, educational experience, and use of existing agricultural risk management tools, but also incorporates the concept of risk-incentive tradeoffs and minimization of common risk. Likewise, the cost-minimizing perspective incorporates aspects of the risk-incentive framework. But, cost-minimizing also includes unique attributes of controlling for moral hazards and adverse selection, as well as intentional design of incomplete contracts to incorporate renegotiation opportunities. Table 1, below, summarizes these results.

   TABLE 1. AGGREGATE FRAMEWORK PERSPECTIVES OF THE AGRICULTURAL CONTRACT Contract Attribute Sociological Risk- Cost- Minimizing Minimizing Compatibility Sensitive to Non-Economic X Factors Existing Agricultural X X Practices and Risk Management Tools Educational Experience X X Information Sharing X X Trialibility X Risk Incentive Tradeoff X X Minimization of common X Risks Control for Moral hazard X Control for Adverse X Selection Design for contract X Incompleteness Accordingly, a trans-disciplinary approach to optimal biomass contract design would incorporate, to the extent possible, each of the contract attributes identified in Table 1. As discussed below, where perspectives overlap, contract design should be able to accommodate the differing frameworks, or at the least identify specific issues for negotiated bargaining. The more difficult proposition is when these principles are in conflict. For example, information sharing is a fundamental aspect of the sociological-compatibility perspective (and to a lesser extent in the risk-minimization framework), but is absent, or even discouraged from the cost-minimization perspective. The following section, therefore, analyzes the tools and implications of a Biomass Contracting Framework from a trans-disciplinary perspective.

   1. Trans-Disciplinary Approaches to Biomass Contracts

      Economic contract theory posits that parties to a contract must optimize the tradeoff between costs and risk, such that both parties' aversion to risk is equal to the additional cost of minimizing that risk. (195) As producers have different levels of risk tolerance, the appropriate amount of risk minimization will differ; risk adverse producers will be more costly to incentivize to participate than their risk neutral colleagues. Moreover, identifying and addressing the risk tolerance of producers can be a key factor in adverse selection problems.

      On the other hand, perhaps the most exacting lesson from the sociological literature is that producers have multiple and varied non-economic goals and barriers that must be addressed in order to facilitate adoption of energy crops. (196) What the sociology perspective implies, however, is that many of these non-economic goals cannot be adequately compensated by greater monetary incentives (the economic theory's risk vs. cost dichotomy); in order to overcome these constraints, contracting parties must incorporate other strategies to align the goals and incentives of the contract with non-economic considerations, (197) such as the impact on producer autonomy, lifestyle, current farming operation, and core values. (198)

      At first glance, the absence of monetary incentives complements the cost-minimization perspective, but upon careful consideration it creates unique problems due to information asymmetry. Determining the underlying non-economic goals and barriers can be costly, especially for entities without extensive experience in the agricultural sector. For example, where a multinational oil company seeks entry to the biofuels market as the result of the RFS2 blending mandate, or where an electric utility previously reliant on coal and natural gas seeks a biomass supply for co-firing a power plant to comply with a state renewable portfolio standard, both actors may lack the institutional capacity to identify fundamental, non-economic barriers to farmer adoption.

      The adverse selection problem discussed in the context of cost-minimization is made more complex as the end-user cannot confine information seeking activities to the differentiation of true high- and low-cost producers, as the end-user must also consider producers with divergent and variable non-economic goals not satisfied merely through financial means. As a result, theoretical methods of eliminating information asymmetry through rationing, screening, and auctions may not produce the desired results. On the other hand, the process of signaling (199) can enable end-users to identify particular non-economic barriers, along with the traditional high or low production cost structure. Moreover, cooperation and information sharing requirements embedded within a contract can enhance education and training elements, while also reducing information asymmetry. (200)

      Cost-minimization and the sociological-compatibility perspectives thus are not inherently in conflict. The problem of information asymmetry and moral hazard is illustrative. As discussed above, one method for the Principal to manage moral hazard is via monitoring, and one potential model is the creation of a network of fieldmen to periodically visit producers. (201) Fieldmen can identify opportunistic or suboptimal behavior, while also providing a source of information among networked producers regarding not only technical production practices, but also financial information to lower future transaction costs.

      The use of monitoring strategies (e.g., fieldmen) also implicates the risk-minimization perspective. Although incentives provide one method to allocate endogenous risk of opportunistic behavior, (202) incentive payments alone cannot differentiate between the endogenous risk of lack of producer effort from exogenous factors, such as poor weather. Moreover, incentive payments may not provide adequate compensation for the non-economic considerations described in the sociological-compatibility perspective. Alternative policing mechanisms, such as monitoring and collaboration through fieldmen, however, could address the endogenous moral hazard problems and minimize risk premiums. (203) Similarly, relative performance contracts, such as tournament contracts, incorporate producer performance incentives relative to similar producers, rather than absolute measures that depend on common risks (e.g., weather). (204)

      In addition to relative performance incentives and the use of fieldmen as means to address moral hazard problems without shifting additional, exogenous risk to producers, (205) pricing mechanisms can reallocate risk/minimize cost, while also facilitating access to traditional risk management strategies. The choice of pricing models offered in a biomass production contract can therefore have important implications for each of the three theoretical frameworks.

      The simplest price provision offers a set price per unit of biomass throughout the duration of the contract. While this eliminates all down-side price risk from producers, it also forgoes the potential for higher gains should the value of biomass increase. An acreage contract that compensates the producer only by acres of production eliminates producer yield risk, but has analogous price risk consequences. Cost-plus pricing similarly eliminates all down-side price risk to producers by setting a fixed profit margin above the seasonably fluctuating cost of required inputs and shifts the long-range risk of rising input costs to the end-user. On the other hand, indexed pricing provisions, where the price of the biomass is tied to commodity prices or other benchmarks that fluctuate over time, account for the opportunity cost (206) of biomass production and enable use of traditional agricultural risk management tools, such as the commodity market strategies discussed previously. The theory behind index pricing is to identify a correlation in pricing between biomass and established commodities. For example, the price of biomass may fluctuate proportionately to the price of corn, crude oil, or natural gas. Parties may develop creative indices to try to better match the price fluctuations of biomass, such as basing price on a theoretical "biomass index," which could consist of various percentages of commodity contracts. (207) The actual index price need not match the biomass price, but merely have proportionate price fluctuations. If this can be achieved, producers could employ market strategies (e.g., hedging, futures, options) in the respective commodities that compose the "biomass index" to protect their primary investments in biomass production.

      Of course, producers will have heterogeneous preferences for pricing provisions based on their individual risk tolerances and marketing skills. Because of these differences, no single compensation provision will be optimal for every producer. Producers with low risk tolerance will likely prefer fixed pricing or profit margins, or guaranteed minimum revenue provisions. Producers with high risk tolerances may prefer indexed pricing arrangements to allow them the opportunity to gain from...