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Enforcement-proof contracts with moral hazard in precaution: ensuring �permanence� in carbon sequestration

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  • Ian A. MacKenzie
  • Markus Ohndorf
  • Charles Palmer

Abstract

Opportunistic behaviour due to incomplete contract enforcement is a risk in many economic transactions such as forest carbon sequestration contracts. In this paper, an enforcement-proof incentive contract is developed in which a buyer demands a guaranteed delivery of a good or service given a productive upfront payment, moral hazard in precaution, and the potential for opportunistic contract breach. The optimal design of forest carbon contracts to ensure permanence is derived. Buyer liability for loss of a carbon sink is shown to yield an ineficiently low level of sequestration. Yet it remains higher than the case where liability is neither allocated to the buyer nor the seller. Indexing contract prices to the seller�s opportunity costs potentially boosts the upfront investment as does shifting liability to the seller but not beyond first-best levels. Assigning liability is shown to have implications for forest carbon contracts in an international climate policy regime.

Suggested Citation

  • Ian A. MacKenzie & Markus Ohndorf & Charles Palmer, 2010. "Enforcement-proof contracts with moral hazard in precaution: ensuring �permanence� in carbon sequestration," GRI Working Papers 27, Grantham Research Institute on Climate Change and the Environment.
    • Handle: RePEc:lsg:lsgwps:wp27
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    Cited by:

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    4. Stefanie Engel & Charles Palmer & Luca Taschini & Simon Urech, 2012. "Cost-effective payments for reducing emissions from deforestation under uncertainty," GRI Working Papers 72, Grantham Research Institute on Climate Change and the Environment.

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