Designing Contracts for Reducing Emissions from Deforestation and Forest Degradation

Reduction of carbon emissions from deforestation and forest degradation (REDD) has been identified as a cost effective element of the post-Kyoto strategy to achieve long-term climate objectives. The success of REDD depends primarily on the design and implementation of a financial mechanism that provides land-holders sufficient incentives to participate in a REDD scheme. This paper proposes relational contracting as a more appropriate framework for analyzing proposed REDD incentive regimes rather than that of complete contracting enforcement because relational contracting relies upon mutual self-enforcement in a repeated transaction framework, which better suits the stylized facts of REDD. We characterize the optimal REDD relational contract and provide the parameters under which self-enforcement is sustainable. The optimal payment scheme suggests that all payments should be made contingent on the carbon offsets delivered. Thus, the optimal contract does not observe any fixed ex ante payment. Self-enforcement is more difficult to sustain the higher the cost of forest conservation is relative to the value of the carbon offsets from the contract. Necessary extensions to the relational contracting model are also discussed.