Optimal Mix of Vertical Integration and Contracting for Energy Crops: Effect of Risk Preferences and Land Quality

Abstract

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.

Where can switchgrass production be more profitable than corn and soybean? An integrated subfield assessment in Iowa, USA

“…Given the combination of uncertainties and costly reversibility associated with perennials, farmers are unlikely to switch unless they sign long‐term contracts specifying trading conditions (payments, production, and delivery conditions, etc.). Several studies have illustrated how contract design can strongly influence farmer participation, renegotiation incentives, efficiency, and risk distribution (Alexander et al ., ; Yoder et al ., ; Yang et al ., ). The lack of consideration for contract design in the present analysis limits the interpretation of the results to an upper bound estimate of switchgrass conversion under a set of necessary conditions for adoption (instead of a lower bound estimate based on sufficient conditions for adoption).…”

The Future of Biofuels in an Electrifying Global Transportation Sector: Imperative, Prospects and Challenges

“…Farmer surveys show that high fixed costs of establishing these energy crops, lags of two to three years between planting these crops and obtaining a harvestable yield, absence of crop insurance, and constraints on credit to cover upfront costs are likely to lead risk-averse, loss averse, and present-biased farmers to be less willing to produce perennial energy crops (Khanna, Louviere, and Yang 2017;Miao and Khanna 2017;Anand, Miao, and Khanna 2019). Risk-sharing contracts, establishment cost-share subsidies, and energy crop insurance are likely to be required to induce risk-averse farmers to convert cropland from annual row crops to perennial energy crops (Yang, Paulson, and Khanna 2016). Farmers also report low willingness to convert marginal land to grow energy crops unless biomass prices are high because of the other environmental amenities they obtain from that land such as landscape diversification and wildlife habitat (Skevas et al 2016;Jiang, Zipp, and Jacobson 2018).…”

Adopting bioenergy crops: Does farmers’ attitude toward loss matter?

“…The price of the conventional crop is a stochastic variable, whose distribution is known to the farmer. For bioenergy crops, production is assumed to occur under a long‐term fixed price contract between the farmer and a biorefinery to ensure certainty of supply of biomass for the biorefinery (Yang, Paulson, & Khanna, ) . Under such a contract, biomass price is fixed at over its lifespan and we assume that this price is the same for miscanthus, switchgrass, and corn stover.…”