Moreover, field men visits can provide a source of information and a familiar contact through which producers could “negotiate contract terms, share technical information, estimate expected yields, and maintain a presence to ensure that the contract will be renewed” The use of field men to monitor also allows for more flexibility over time, and creates “shared understanding of what constitutes standards of good professional practice” Thus, working in a cooperative spirit allows for expectation adjustments without costly negotiations or conflicts. It must be mentioned, however, that although the field men monitoring model has many benefits, several costs are involved, including the cost of hiring, training, and employing a staff of specialists to serve in this role. The previous discussion of adverse selection problems stemming from information asymmetry and the moral hazard problems associated with unobserved action offers several potential contract based solutions, including rationing, screening, signaling, and auctioning, as well as measurement and monitoring strategies. But, much of the economic contract theory discussed above assumes that parties are able and willing to write “complete” contracts— contracts that specify each party’s obligations for possible contingencies. In practice, however, parties often are unable or unwilling to write and enforce complete contracts. Accordingly, in the following section, we introduce a second important transaction cost—contract incompleteness, and remedial strategies in the biomass supply chain context.Consider the situation where the end-user and producer negotiate and execute ex ante a biomass production agreement that specifies a time and amount for delivery , but fails to specify a delivery location in the contract.
Assume the end-user has two facilities,one ten miles from the producer and another, larger facility, vertical grow system one hundred miles from the producer. The lack of a specified delivery location is a source of incompleteness in the contract. Contracts literature contains several theories for explaining why parties sign incomplete contracts. In extreme cases, complete contracts may not be necessary, such as in a transaction in an environment where all contingencies and variables are observable and verifiable, allowing perfect information to eliminate the risk of adverse selection or moral hazard. But this is a rare situation. Parties may end up signing incomplete contracts because of the bounded rationality of the parties, the presence of uncertainty in the transaction, or the inability of the parties to objectively measure and evaluate relevant variables. A third explanation, closely related to the bounded rationality of the parties, is based on Williamson’s transaction cost theory. Williamson argues that complete contracts are unattainable because the transaction costs of writing and enforcing outweighs the benefits of obtaining perfection. The marginal cost of additional completeness increases, while the marginal benefit of completeness decreases; thus, parties choose to write contracts with an optimal level of incompleteness where the marginal cost is equal to the marginal benefit of additional completeness. As a bottom line, the general consensus is that contracts are necessarily incomplete; it is impossible to cover every possible contingency sufficiently well such that neither party will be able to take advantage of a loophole or ambiguity and act opportunistically. Thus, incompleteness gives rise to the risk of ex post opportunistic behavior, which in turn creates transaction costs.
In the complete contract literature, renegotiation serves as an ex ante constraint, incentivizing the parties to remain with the original contract, but incompleteness creates the need for ex post renegotiation. Renegotiation can be a beneficial tool where a contingency occurs that leaves both parties worse off under the terms of the original contract; this flexibility allows the parties to adjust to changes in their environment. This flexibility may even make incomplete contracts preferable to complete contracts in some scenarios. However, when certain transacting environments are present , renegotiation may be detrimental to one party, as it reduces commitment and may lead to strategic behavior. Accordingly, a party may take advantage of any ambiguity or contingency not explicitly addressed in the contract to improve ex post payoff through renegotiation. When incompleteness exists, the future returns on a party’s ex ante investment will depend on the bargaining position of the party ex post . Within incomplete contracts, economic contract literature has identified at least two factors in a transaction that influence a party’s exposure to ex post opportunistic behavior: asset specificity and allocation of property rights. Both of these factors may create holdup, a form of opportunism. Williamson defines the condition of asset specificity as “investments in which the full productive values are realized only in the context of an ongoing relation between the original parties to a transaction such assets cannot be transferred to alternative uses or users without loss of productive value.” Legal scholars refer to specific assets as reliance investments. Asset specificity creates a bilateral dependence between the parties and a quasi-rent or “surplus over opportunity cost that increases the potential for opportunistic behavior.”
Several types of asset specificity have been defined other than physical asset specificity, including “value-added specificity” , time specificity , and site specificity . When a party makes ex ante investments with high asset specificity, the seller is especially vulnerable in renegotiation, as the buyer knows that the next best value for the seller is substantially lower. In renegotiation contexts, the buyer will offer to pay only just above the next best offer, leaving the seller with no rents. This opportunistic behavior on behalf of the buyer is called the “hold-up problem.” The party who considers ex ante whether or not to make an investment with high asset specificity can perceive the threat of holdup. He realizes he has no incentive to invest as he will receive no rents, and therefore, will under invest. This inefficient level of investment creates transaction costs and barriers to entry. Again, consider our example of the biomass production contract. The biomass producer may choose ex ante to produce a crop of Miscanthus, and make a corresponding investment. Upon harvest the parties must determine the delivery location. The harvested crop of Miscanthus has a high level of asset specificity; because the farmer has no alternative market for the energy crop, the next highest value is near zero. The biomass conversion facility understands this and, consequently, has significant bargaining power. The end-user may assert that delivery was meant to be at the larger, more efficient plant 100 miles away. The level of asset specificity puts the farmer in a weak ex post bargaining position, as he is dependent on the contract with the end-user and must satisfy the end-user to obtain revenue. Thus the farmer, even though he will incur higher transportation costs, would rather accept the added costs of transportation to a distant market than forego contract payments. In addition to this holdup, other producers who observe this scenario may refuse to invest, perceiving uncertainty and weaker incentives. Thus, one can see that asset specificity may create risk of opportunism and holdup. Several fields of literature have identified different strategies of addressing holdup, which we discuss below. However, the theoretical strategies—when placed within the context of biomass production for renewable energy products—may conflict, indoor weed growing accessories requiring a balancing approach as well as careful analysis of specific issues to determine optimal strategies.The preceding deconstruction of the sociological, risk minimizing, and cost-minimizing perspectives yields several theoretical insights for an optimal biomass contracting framework, including key elements of contract design and opportunities for trade-offs in the negotiation process. From the sociological perspective, sensitivity to non-economic factors tends to dominate decision making in the innovation context. The ability to maintain existing agricultural practices and social networks throughout the education, field trial, and commercial production stages minimizes farmer disincentives to enter into production contracts for novel biomass crops. Trialibility, information sharing, and education also have strong influences on the sociological-compatibility perspective of contracts. The risk minimizing framework shares with the sociological perspective elements of information sharing, educational experience, and use of existing agricultural risk management tools, but also incorporates the concept of risk-incentive tradeoffs and minimization of common risk.
Likewise, the cost-minimizing perspective incorporates aspects of the risk-incentive framework. But, cost-minimizing also includes unique attributes of controlling for moral hazards and adverse selection, as well as intentional design of incomplete contracts to incorporate renegotiation opportunities. Table 1, below, summarizes these results.Accordingly, a trans-disciplinary approach to optimal biomass contract design would incorporate, to the extent possible, each of the contract attributes identified in Table 1. As discussed below, where perspectives overlap, contract design should be able to accommodate the differing frameworks, or at the least identify specific issues for negotiated bargaining. The more difficult proposition is when these principles are in conflict. For example, information sharing is a fundamental aspect of the sociological compatibility perspective , but is absent, or even discouraged from the cost-minimization perspective. The following section, therefore, analyzes the tools and implications of a Biomass Contracting Framework from a trans-disciplinary perspective.Economic contract theory posits that parties to a contract must optimize the tradeoff between costs and risk, such that both parties’ aversion to risk is equal to the additional cost of minimizing that risk. As producers have different levels of risk tolerance, the appropriate amount of risk minimization will differ; risk adverse producers will be more costly to incentivize to participate than their risk neutral colleagues. Moreover,identifying and addressing the risk tolerance of producers can be a key factor in adverse selection problems. On the other hand, perhaps the most exacting lesson from the sociological literature is that producers have multiple and varied non-economic goals and barriers that must be addressed in order to facilitate adoption of energy crops. What the sociology perspective implies, however, is that many of these non-economic goals cannot be adequately compensated by greater monetary incentives ; in order to overcome these constraints, contracting parties must incorporate other strategies to align the goals and incentives of the contract with non-economic considerations, such as the impact on producer autonomy, lifestyle, current farming operation, and core values. At first glance, the absence of monetary incentives complements the cost-minimization perspective, but upon careful consideration it creates unique problems due to information asymmetry. Determining the underlying non-economic goals and barriers can be costly, especially for entities without extensive experience in the agricultural sector. For example, where a multinational oil company seeks entry to the bio-fuels market as the result of the RFS2 blending mandate, or where an electric utility previously reliant on coal and natural gas seeks a biomass supply for co-firing a power plant to comply with a state renewable portfolio standard, both actors may lack the institutional capacity to identify fundamental, non-economic barriers to farmer adoption. The adverse selection problem discussed in the context of cost minimization is made more complex as the end-user cannot confine information seeking activities to the differentiation of true high- and low-cost producers, as the end-user must also consider producers with divergent and variable non-economicgoals not satisfied merely through financial means. As a result, theoretical methods of eliminating information asymmetry through rationing, screening, and auctions may not produce the desired results. On the other hand, the process of signaling can enable end-users to identify particular non-economic barriers, along with the traditional high or low production cost structure. Moreover, cooperation and information sharing requirements embedded within a contract can enhance education and training elements, while also reducing information asymmetry. The problem of information asymmetry and moral hazard is illustrative. As discussed above, one method for the Principal to manage moral hazard is via monitoring, and one potential model is the creation of a network of fieldmen to periodically visit producers. Fieldmen can identify opportunistic or suboptimal behavior, while also providing a source of information among networked producers regarding not only technical production practices, but also financial information to lower future transaction costs. The use of monitoring strategies also implicates the risk-minimization perspective. Although incentives provide one method to allocate endogenous risk of opportunistic behavior,202 incentive payments alone cannot differentiate between the endogenous risk of lack of producer effort from exogenous factors, such as poor weather. Moreover, incentive payments may not provide adequate compensation for the non-economic considerations described in the sociological compatibility perspective. Alternative policing mechanisms, such as monitoring and collaboration through fieldmen, however, could address the endogenous moral hazard problems and minimize risk premiums. Similarly, relative performance contracts, such as tournament contracts, incorporate producer performance incentives relative to similar producers, rather than absolute measures that depend on common risks .