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Contracting for Perennial Energy Crops Under Uncertainty and Costly Reversibility


  • McCarty, Tanner
  • Sesmero, Juan
  • Gramig, Ben


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.

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  • McCarty, Tanner & Sesmero, Juan & Gramig, Ben, 2016. "Contracting for Perennial Energy Crops Under Uncertainty and Costly Reversibility," 2016 Annual Meeting, July 31-August 2, Boston, Massachusetts 236092, Agricultural and Applied Economics Association.
  • Handle: RePEc:ags:aaea16:236092

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    References listed on IDEAS

    1. Schatzki, Todd, 2003. "Options, uncertainty and sunk costs:: an empirical analysis of land use change," Journal of Environmental Economics and Management, Elsevier, vol. 46(1), pages 86-105, July.
    2. Alexander, Corinne & Ivanic, Rasto & Rosch, Stephanie & Tyner, Wallace & Wu, Steven Y. & Yoder, Joshua R., 2012. "Contract theory and implications for perennial energy crop contracting," Energy Economics, Elsevier, vol. 34(4), pages 970-979.
    3. Price, T. Jeffrey & Wetzstein, Michael E., 1999. "Irreversible Investment Decisions In Perennial Crops With Yield And Price Uncertainty," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 24(1), pages 1-13, July.
    4. Feng Song & Jinhua Zhao & Scott M. Swinton, 2011. "Switching to Perennial Energy Crops Under Uncertainty and Costly Reversibility," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 93(3), pages 764-779.
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    Crop Production/Industries; Resource /Energy Economics and Policy; Risk and Uncertainty;

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