Contractual possibilities

In the last section we showed that, when the contracting process cannot take place in a world of competition or promises, governance is needed to address the problem of asset specificity.

The contract design necessary to address this problem depends on the attributes present in the scenario in which the scheme is implemented. Contracts should ensure the provision of environmental services without endangering the quasi rents of the transaction partners. In the following, we review the contractual possibilities of the agency.

Contract length

Short-term contracting implies the risk of one party having advantages that can be exploited in bilateral negotiations over renewal terms, and thus discourage specific investments (Pollak 1985, p.582).

According to Klein (1978), the primary alternative to vertical integration, as a solution to the risk of quasi rent appropriation, is offering economically enforceable long-term contracts.

This would imply integrating reforestation and conservation payments under the same contract.

Long-term contracts act as an enforced contractual guarantee and allow the specification of possible contingencies. However, the longer and more detailed contracts are, the more negotia-tion time and potential legal fees may be required (Greiber 2009, p.47). This often implies high costs of policing and litigation, detection of violations and contract enforcement (Klein et al.

1978, p.303).

Long-term contracts can also employ market instead of legal enforcement mechanisms, such as the imposition of a capital loss through the withdrawal of expected future transactions (Klein et al. 1978, p.303).

4.3. Contract Design

Payment design

The payment structure can be adapted according to the specific situation. For example, higher initial payments can be made in the presence of liquidity constraints, in order to ensure that investments can be made (Pagiola et al. 2005, 245).

In order to give land users an incentive to meet the environmental goal, the contract can include result-oriented payments. These payments are directly linked to the desired environ-mental goal, for example, land users may receive payments per surviving tree. By increasing land users’ intrinsic motivation, result-oriented payments can create incentives for land users to be innovative, and to choose the best practices according to their own know-how. Making at least part of the compensation dependent on the performance, can prevent non compliance (Matzdorf & Lorenz 2010, p.536), and thus reduce the risk of quasi rent appropriation. Result-oriented payments can only be implemented when the environmental goal is quantifiable and observable, such that the development of appropriate indicators is possible (Matzdorf & Lorenz 2010, p.537).

Payments can be thought of as an insurance for the agency to prevent non-compliance (Klein et al. 1978, p.305). Land users can be offered future payments whose present discounted value exceeds the gain from opportunism, creating quasi rents that would make opportunism unprofitable. Payments increase with the monitoring and enforcement costs (Klein et al. 1978, p.304).

Result-oriented payments might negatively influence the willingness to participate of land users if meeting the environmental goal does not only depend on their efforts, but also on exogenous factors, such as the weather condition (Wätzold & Schwerdtner 2005).

Flexible terms

Long-term contracts increase the rigidity of land conversion (Parks 1995, p.35). If land users expect crop prices to rise over time, they would require very high payments in order to commit to a long-term contract for reforestation and conservation, or might not even be willing to enter into a contractual relationship with the agency. Although both parties have an incentive to sustain the contractual relationship ex post, they cannot be expected to accede to proposals for contract adaptation. Adjustments of conservation payments have a zero sum quality, meaning that the benefit of one party would be the loss of the other one. There is therefore a need for flexibility under terms which both trust (Williamson 1985, p.76). Long-term contracts can

adapt to changing external conditions, as long as an exogenous, relevant and easily verifiable indicator exists (Williamson 1985, p.77).

If the trees have a commercial value, their opportunity costs of conservation will increase over time with the growth of the trees. In order to ensure participation, conservation payments have to increase with the opportunity costs of conservation. The same is true for increasing crop prices. The agency has an incentive to increase conservation payments over time, provided that this is more cost-effective than reforesting other land units.

Sanctions

An alternative to the costly specification of every possible contingency, is imposing costs on the opportunistic party (Klein et al. 1978, p.303). The reduction of the likelihood of non-compliance requires an adequate deterrent. A sanction to avoid contract termination or non compliance should be high enough to make the expected value of this options unprofitable.

One possibility is to terminate future payments. If the payments have been made ex ante, then an alternative form of sanctioning would be necessary (Greiber 2009, p.54). Sanctions could take the form of monetary penalties, however, this could be counterproductive to develop trust among the parties, and to promote participation. Within particular social contexts, seemingly weaker penalties can prove effective, such as the the exclusion of the payment scheme for a certain period (Greiber 2009, pp.54-56).

The transaction costs incurred through the specification of contracts have to be taken into account. The costs implied should not exceed the potential benefits of sanctioning or of the procedures for non-compliance (Greiber 2009, p.56).

Bonding

Another alternative to detailed long-term contracts is bonding (Klein et al. 1978, p.303).

A fully bonded contract implies that each party is fully insured against opportunism. Both transaction partners would pay for the investment. Part of these payments would be used to finance it, and the other part would serve as a bond to enforce the contract. An impartial umpire, assigns responsibility for any action deceiving the initial agreement between the transaction partners. This prevents both sides from being harmed by opportunism, and allows enforcing the agreement without difficulty (Kennan 1979, p.62).

4.3. Contract Design

Bonding contracts are however only feasible as long as land users do not face liquidity constraints. In the presence of liquidity constraints, the agency would have to offer ex ante payments to the land users for them to be able to undertake the investment. Premiums as an incentive to meet the agency’s environmental goal would therefore be necessary to ensure the provision.