Asymmetric information and contract design for payments for environmental services

TL;DR: In this paper, the authors propose three approaches to reduce informational rents to landowners: (1) acquire information on observable landowner attributes that are correlated with compliance costs; (2) offer landowners a menu of screening contracts; and (3) allocate contracts through procurement auctions.

About: This article is published in Ecological Economics.The article was published on 2008-05-01 and is currently open access. It has received 588 citations till now. The article focuses on the topics: Additionality & Opportunity cost.

Summary

1. Introduction

• Payment schemes for environmental services (PES) generally have two common features.
• The word “landowner” denotes any entity that is in the position (de jure or de facto) to supply environmental services through its influence on an ecosystem.
• There are two important information asymmetries in the design of contracts: hidden information and hidden action.
• PES programs may also serve as an instrument for income redistribution and thus reducing informational rents to landowners may have implications for other goals associated with PES programs (see Section 6).

2. Hidden Information

• Participation is voluntary and thus contract payments must at least cover the landowner’s opportunity costs (in the theoretical jargon, the “participation (H) and those with low-opportunity costs (L).
• The conservation agent would like to contract with type L landowners first, and only contract with type H landowners if the agent’s demand for habitat quality was not satisfied by type L landowners.
• Indirect evidence of informational rents going to landowners in conservation payment initiatives has been observed in the United States, Europe and Central America.
• Commenting on the same program, Ortíz et al. (2003, p. 64) report average returns to land classes for a variety of activities and find that forest protection contracts compete favorably on only one type of land—marginal lands with zero opportunity cost of conservation (for another example, see The Economist’s (1999) report on the California Headwater Forest purchase).
• Policy mechanisms that reduce informational rents can be broadly classified into three categories: (1) gathering more information on landowners in the form of costly-to-fake signals; (2) relying on screening contracts (self-selection mechanisms); or (3) harnessing competitive forces through procurement auctions.

3. Gathering Information from Costly-to-Fake Signals

• The simplest, and coarsest, approach to addressing the hidden information of landowners is to gather information on observable landowner attributes that are correlated with opportunity costs and use these attributes to establish contract prices.
• With this information one can create eligibility requirements for receiving a given contract type and price.
• Facilitate the designation and collection of information on these attributes.
• If the gains to contracting are substantial, high-cost landowners may find ways to express costly-to-fake signals on their own (e.g., hiring a forester to certify the value of their timber).
• Note, however, that collecting information about landowner characteristics can still be costly and the ability of this information to reduce information rents without distorting the conservation outcome will only be as good as the strength of the correlations between the characteristics and landowner types.

4. Screening Contracts

• An alternative approach to gathering information on landowner characteristics is to induce landowners to reveal their type by offering a contract for each of the different “types” of off choosing the contract intended for another type.
• The following menu of contracts satisfies the landowners’ participation constraints and incentive-compatibility constraints: (1) $382 for h = 100; and (2) $201 for h = 10.2 A type L landowner prefers contract (1) and a type H landowner prefers contract (2).
• Thus their contract choices reveal their types.
• The low-cost landowner still supplies the same amount of habitat quality as in the perfect information context (in jargon, the “no-distortion-at-the-top rule” holds), but in order to reduce the attractiveness of low-cost landowners claiming to be high-cost, the contracts aimed at high-cost landowners require a lower level of habitat quality.
• Their design is not straightforward in the field.

5. Procurement Auctions for PES Contracts

• Procurement of goods and services for which there are no well-established markets is commonly performed using auctions.
• Moreover, whereas the theory of screening contracts offers some clear predictions about landowner responses to menus of PES contracts (albeit often under stylized assumptions), auction theory does not offer clear predictions for PES contract auctions because they tend to have unusual attributes, such as multiple units, risk-averse bidders, budget-constrained buyers, and repeated auctions over time.
• Using agent-based modeling of multi-unit auctions, Hailu and Thoyer (2005) find that over-bidding made the discriminativeprice auction more expensive than a uniform-price auction.
• Theory often assumes that bidders have independent private values, which implies each landowner knows the opportunity costs of accepting a conservation contract and these costs do not depend on the costs of the other landowners (i.e., learning the costs of other landowners may change one’s bid, but not one’s costs).
• A more sophisticated approach would assign an environmental benefit value to each contract.

6. PES Contracting in Low and Middle-Income Nations

• Within the context of low and middle-income nations (and rural areas of high-income nations), PES programs may have two competing objectives: supplying environmental amenities at least cost and providing income redistribution to the rural poor.
• Given that budgets for ecosystem protection in low and middle-income nations are quite limited, one would need to make a careful case for paying information rents as a means of helping the rural poor.
• These maps can be used, in combination with biophysical data, to more cost-efficiently target conservation activities.
• Given the absence of conservation screening contracts in high-income nations, one might infer that the ability of administrators in low and middle-income nations to design them is questionable.
• Note, however, that PES procurement auctions are a relatively recent phenomenon in highincome nations and thus, like many institutional innovations, lessons may be learned and eventually borrowed and adapted for use in low and middle-income nations.

7. Conclusion

• The two dominant forms of price setting for PES contracts are bilateral bargaining and posted prices (i.e., fixed take-it-or-leave-it prices).
• American Journal of Agricultural Economics, 74(3):646-654. Moral Hazard in Agri-Environmental Schemes.
• A review of the theoretical and empirical literature, also known as Auctions for conservation contracts.

Figures

Table 1 - Approaches to Addressing Hidden Information in PES Contracting

Frequently asked questions

Q1. What are the contributions in this paper?

In this paper, the authors focus on contract issues related to hidden information in the context of PES contracts.