Contracting for Perennial Energy Crops Under Uncertainty and Costly Reversibility

This paper addresses the impact that different contracts can have on a farmer’s willingness to grow perennial crops, and both the risk the cost effectiveness of each type. Growing perennial energy crops such as poplar, requires large up front capital costs that are largely irreversible. It is also associated with highly volatile returns that can discourage cultivation. Traditional approaches to predict the entry threshold for a given project, such as NPV or Marshallian entry neglect to account for the uncertain, sunk, and intertemporal nature of these types of problems and thus under-estimate the profitability required for entry (Dixit and Pindyck, 1994). This study addresses this problem by using real options analysis. Higher degrees of uncertainty and irreversibility translate into higher premiums on entry due to the value of waiting for more information. Our results suggest that different contracts can erode some of this premium. This study finds the specific type of contract that would trigger cultivation at the lowest possible cost to the biofuel plant. This study considers three different types of payment (performance, acreage, and cost index) to induce investment into poplar tree cultivation. It solves for the entry and exit net revenue thresholds under multiple levels and payment types, using real options. It then uses this threshold to calculate performance, acreage, and the total payment required for entry on a per ton of biomass basis.