Contracting for Energy Crops: Effect of Risk Preferences and Land Quality

This paper analyzes the effect of landowner risk preferences and land quality on the optimal mix of vertically integrated production and contracted production of an energy crop in a region characterized by heterogeneity in landowners’ risk preferences and land quality and with riskiness of returns from both energy crop and conventional crop production. We examine the determinants of the decision of landowners to grow an energy crop for biofuel production under one of three types of contracts, a land leasing contract, a fixed price contract and a revenue sharing contract and the impact of risk and time preferences, land quality and riskiness of energy crop production and prices on the optimal contract terms and effective cost of biomass. We find that as the degree of risk aversion and rate of time preference increases and as the riskiness of producing both the conventional crop and the energy crop increases, the share of vertically integrated production of energy crops increases. While low quality land is more likely to be converted to energy crop production, an increase in the degree of risk aversion results in an increase in the threshold level of land quality converted to energy crops under a land leasing contract but a decrease in the threshold level of land quality converted under a fixed price contract and a revenue sharing contract. We also find that the refinery can potentially earn a higher profit by offering a menu of different types of contracts rather than a single type of contract only; by allowing self-selection of contract type based on their risk preferences, the risk premium needed to induce production of energy crops is reduced.