Should We Pay for Ecosystem Service Outputs, Actions or Both?

Payments for ecosystem service outputs have become a popular policy prescription for a range of agri-environmental schemes. The focus of this paper is on the choice of sets of instruments in an ecosystem service principal-agent model that addresses adverse selection and moral-hazard. Results show that input-based and output-based contracts are equivalent where there is full information. With missing information, input-based contracts are more efficient at reducing the informational rent related to adverse selection than output-based contracts. There is an efficiency gain related to using mixed contracts especially where one input is not observable. These contracts allow the regulator to target variables that are costly-to-fake as opposed to those prone to moral hazard such as labour inputs. We then consider the implications of moral hazard and dynamic contracting. An overall finding is that in designing agri-environmental schemes, it is critical that the regulator has an understanding of the link between actions and ecosystem service outputs and, ideally, an estimate of their economic value. Without these in place, payment for ecosystem service schemes will be inefficient and poorly targeted.