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, 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. 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 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, hydroponic trays 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.
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 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 higher prices while employing market strategies to minimize downside risks. As illustrated in the above discussion of pricing mechanisms, the potential contractual provisions embedded in a biomass contract are varied and fraught with complex tradeoffs unique to the agricultural context and further heightened due to the novelty of the bio-energy industry. Accordingly, the following section outlines many of the particular considerations of a biomass contract.In Table 2, below, we propose a list of specialized contract provisions in relation to the identified contract attributes . The result is a matrix framework for biomass contracting that incorporates the essential elements of the social compatibility, risk minimization, and cost-minimization contract models. Traditionally, biomass contracts have originated from end users, and this model is likely to continue. The extent to which individual producers have the ability to negotiate provisions identified in Table 2 is questionable at this stage in the industry’s development, and will likely vary by end-user.
Notwithstanding the current state of the market and its “take-it or-leave-it” biomass supply contracts, consideration of the issues and solutions discussed below can enhance participation and promote a more sustainable, stable biomass supply. And a stable, long-term biomass supply, at a low cost, is the single most important end-user objective. The more secure the biomass production agreements, the more assured the end-users and their financiers are that the processing plant will be able to operate at a profitable rate and duration. From an external information perspective, a transparent, vertically coordinated system allows for the end-user to offer contracts to a large number of producers. Overly restrictive confidentiality clauses, however, may foreclose the ability of producers to make this decision in consultation with community based peers and role models. Although end-users may have legitimate business reasons to prohibit disclosure of some contract terms, care should be taken to balance those needs with the underlying consideration that the beliefs and values of producers and their rural communities are important factors in the decision making process.221 Toward this end, conversion facilities targeting “community leaders” and more innovative farmers can take advantage of the reputation of traditional first movers in the community to encourage other participation. It is important to note that the current trialibility of most energy crops is often inherently poor, adding to the information uncertainty dynamics of contract negotiation. Offering apreliminary, short term contract with smaller quantity requirements, while providing equal access to quality information regarding research trials and production practices, will increase trialibility and reduce information uncertainty. As further incentive to engage producers in a step toward large scale bio-energy crop production, these initial trial contracts could include, subject to performance measures, guaranteed renewability and quantity expansion terms In sum, many of the risk-minimizing approaches to information asymmetry can complement non-economic goals and social interaction factors to make producers more comfortable in the decision to enter into a biomass supply contract.
The principles from sociology are simple, but powerful. The stronger the relationship between the two parties, and the more value a party perceives in a favorable reputation, the less a party will be willing to hold up a contracting partner or otherwise act opportunistically. Acting opportunistically, especially in relatively tight-knit rural communities, damages a Principal’s reputation and may hinder the ability to contract with other potential Agents. In general, biomass supply contracts should attempt to be cooperative rather than secretive, and account for the interaction and input of community engagement in the both negotiation and contract performance.As discussed above, contracts can minimize both exogenous and endogenous risks for both parties. Transferring risk to the other party, however, usually results in a risk-transfer premium, while attempting to minimize total risk through complete contract design is difficult to achieve and incurs its own set of costs. Accordingly, assigning price risk between the parties is one of the most important provisions in biomass production contracts. Several common pricing provisions have been considered in the literature, the simplest of which offers a set price per unit of biomass throughout the duration of the contract. While this assigning of price risk eliminates the producer’s exposure to all down-side price risk, it also eliminates the potential for higher gains, should the value of biomass or crop substitutes increase. An acreage contract that compensates the producer only by acres of production has similar price risk consequences, while also introducing yield risk. Cost-plus pricing eliminates all producer down-side price risk by setting a fixed profit margin, and also addresses input price risk. Similarly, escalators based on input costs is another technique to minimize producer price risk and may be especially important in perennial cropping systems in which producers are locked into a crop choice for extended periods. On the other hand, indexed pricing provisions may grow in popularity, where the price of the biomass is tied to commodity prices or other benchmarks that fluctuate over time. Different producers, however, may prefer different pricing provisions, seedling starter trays based on their individual risk tolerances and marketing skills. Producers with low risk tolerance will likely prefer fixed pricing schemes, or guaranteed minimum revenue provisions. Producers with high risk tolerances and marketing ability may prefer indexed pricing arrangements to allow opportunities for windfall profits. Opportunity cost pricing, in which the contract ties the price of biomass to the substitute ventures of the producer provides yet another option. Information asymmetry in the producer’s favor regarding pricing, however, allows an extraction of information rents from the end-user in the form of higher compensation levels. It is in this context that all the adverse selection tools become relevant: rationing, signaling, screening, signaling, and auctions. A rationing strategy of a fixed price per ton excludes producers that cannot turn a profit at the pre-determined level, and allows more efficient producers to gain information rents. This strategy, however, limits supply by excluding potential higher cost producers—a potentially costly strategy when a stable, low-cost supply is the most important end-user objective. Screening strategies to decrease information rents may increase supplies slightly, but developing optimal contracts to satisfy the incentive compatibility and participation constraints of all producer types is difficult and requires extensive information. What seems more feasible is for end-users to offer multiple compensation provisions to enable choice based on their risk tolerances. While this method does not address producers’ opportunity cost information, it is a simple way to address risk tolerance information, and avoids premiums for risk-averse producer acceptance of high-risk compensation provisions. A more complete analysis and discussion of screening to determine appropriate pricing provisions and contracts is beyond the scope of this paper, but merits further research. Signaling strategies may benefit both end-users and producers. End-users can establish eligibility requirements and collect observable information on local producers, thereby facilitating discriminatory pricing based on producer characteristics. For example, producers who are closer to the end-user; have a large amount of marginal land; or already possess biomass compatible equipment, are presumed to have lower opportunity costs, and may accept lower prices. Producers without these characteristics are presumed to have higher opportunity costs, and thus warrant higher compensation. In negotiating for compensation, these high opportunity cost producers can signal characteristics that are difficult to fake to gain higher compensation relative to others. Finally, creative end-users may choose to set prices by reverse auctioning.
This method may only be feasible after end-users have secured sufficient interest from producers to ensure competitive pricing, which may only be possible once the industry is more developed. In this method, the end-user would auction off standard allotments of “biomass production rights.” To illustrate: the end-user would determine the amount of biomass needed to keep the plant at full capacity for a year, say 1 million tons. The end-user would then break this total capacity into standard contracts—perhaps 5,000 contracts of 200 tons. The end-user would then begin reverse auctioning the production rights, starting with a high bid and quoting lower prices until a single producer is left willing to produce at that price. That producer can then state how many set contracts of production he is willing to produce at that price. The auction continues until all 5,000 contracts are purchased by producers. Within the contracts, producers would prefer the ability to transfer or assign production rights. This allows for producers to transfer the production rights to subsequent lower-cost producers over time, thus making the production rights a fungible asset, similar in form to a commodity. Generally, producers might prefer to transfer all yield risk to the end-user through provisions, such as the acreage contract. This is consistent with the Risk-Minimizing perspective implication to loosen incentives to decrease producer risk. The moral hazard that this creates can be addressed through management strategies, such as monitoring. When end-users are unwilling to accept all yield risk, or are unable to adequately deal with moral hazard through monitoring and increased control, yield incentive contracts may be necessary. In fact, where the specific risks that affect yield are adequately addressed, incentive contracts may be equally acceptable to producers. In these contracts producer incentives are based on performance relative to other similar producers, rather than absolute measures of performance that are subject to common risks that affect all producers equally . By creating relative performance incentives, end-users can address moral hazard problems without shifting the incidence of common risk to producers. Contracts can further reduce common risk by grouping producers according to characteristics, such as by geography for weather risk and planting dates for other production risk. This reduction of common risk, however, may not eliminate idiosyncratic risks of producers, such as disease outbreaks, equipment failures, etc., and end-users retain some yield risk as they are not guaranteed a fixed amount of biomass for the conversion facility. Contracts should also address the consequences of a production surplus. Under an incentive contract, producers would prefer no maximum delivery amount. End-users, however, may desire a delivery ceiling to limit end-user waste when biomass production outstrips conversion facility capacity. Due to the extreme asset specificity of the surplus biomass in a nascent market, the end-user may retain all bargaining power for spot market purchases of surplus production.