Contracting for Energy Crops: Effect of Risk Preferences and Land Quality

1. Contracting for Energy Crops: Effect of Risk Preferences and Land Quality Madhu Khanna with Xi Yang and Nick Paulson University of Illinois, Urbana-Champaign International Consortium on Applied Bioeconomy Research June 18-21, 2013 Ravello

2. Introduction • Energy crops (perennial grasses, short rotation trees) potentially important feedstocks to meet advanced biofuel mandates in the US • High yield, potential on low quality land • Minimal competition with food crops • Significant potential to reduce GHG emissions • Policy incentives include. • EISA 2007 Renewable Fuel Standard Mandate • Biomass Crop Assistance Program

3. Energy Crop Production • Long lived investment (10-15 years) • Lag between initial investment and returns • Establishment phase of 1-2 years • High costs of transportation of biomass • Limited radius of supply • No uses other than for bioenergy • Poses a number of risks for farmers and refineries that may differ from conventional crops • Adoption decisions will depend on risk preferences, time preferences, liquidity constraints

4. Risks associated with energy crops • Sources of riskfor farmers • Weather related yield risk • Output price risk arising from energy markets • Cost of land risk from agricultural markets • Demand for biomass • Considerations for a refinery: • Large capital costs associated with refinery investment • Need for reliable supply of biomass to operate at or near capacity • Reliance on spot markets – exposure to price and availability risks • Should the biorefinery contract for biomass or be vertically integrated? • Marketing contracts used widely to manage risks with prices and quantities. • 40% of agricultural production in 2008 covered by contracts

5. Contract Types 1. Leasing contract The biorefinery pays a fixed dollar amount (ω1) per acre to the farmer and biorefinery uses the land to plant bioenergy crops. Refinery bears yield risk, biomass and biofuel price risk; farmer bears an opportunity cost of land risk (foregone profits from corn production). 2. Fixed price contract The biorefinery pays a fixed rate (P1) per ton of biomass and farmers commit to deliver (YB) tons of biomass to the biorefinery. Farmer bears yield risk and cost of land risk while refinery bears the biofuel price risk 3. Profit sharing contract The biorefinery pays (α) percent of its revenue to farmers and farmers commit to deliver (YB) tons of biomass to the biorefinery Farmer bears yield risk and cost of land risk; shares the biomass price and biofuel price risk with refinery 4. Spot market sales: Farmer bears price and demand risks

6. Purpose of this Research • Develop an integrated model of landowners and refinery’s choice about energy crop production under alternative contracts • Analyze the implicationsof heterogeneous risk preferences, land quality and riskiness of production for • Choice of contract and incentive compatible share of biomass production under various contracts • Endogenously determined contract terms • Net benefits to farmers and the refinery • Net benefits of offering a menu of contracts vs. a single type of contract

7. Existing Literature • Literature on technology adoption shows the effects of risk aversion and threshold land quality in inducing adoption of land augmenting technologies • Effect of land quality on choice of energy crop vs row crops under certainty • Shows risk aversion can lead to a preference for contracts instead of spot market sales in livestock (hogs, cattle, chicken) and crop (like tomatoes) production • Energy crops: Studies have analyzed first-order and second-order stochastic dominance ordering of alternative types of contracts • Effects of liquidity constraints and risk preferences on adoption decision of a representative landowner • This research incorporates the interaction of heterogeneous farmers and the biorefinery in determining the optimal contract structure and terms.

8. Energy Crop Production Problem • Biorefinery with a fixed capacity located in a region with N parcels of 1 acre each associated with heterogeneous land quality and risk preference • Seeks to induce landowners to switch from conventional crop to energy crop production • Lease land and undertake vertically integrated production by refinery • Contract for biomass at fixed price or fixed revenue share(zero transportation costs) • Purchase biomass from spot market; incur transportation cost per ton of biomass • Selects types of contract and contract terms to offer to induce biomass production

9. Decision Problem • Refinery maximizes expected profits by offering a menu of biomass production contracts to farmers subject to • Capacity constraint • Production and price uncertainty • Heterogeneous land quality • Asymmetric information about farmers’ risk preferences and offers a menu of take it or leave it contracts • Allows self-selection of farmers based on risk preferences and land quality • Each farmer/land parcel maximizes expected utility by choosing among production options subject to • Risk preference (mean-variance utility function) • Land quality

10. Conceptual Results: Terms of the land rental contract • Rental payment to induce a risk averse farmer to lease land to the refinery • is lower than that needed to induce a risk neutral farmer • decreases with • an increase in variability of energy crop yield and price • increase in the variability of biofuel price and conventional crop profits • increase in the degree of risk aversion, • increase in the rate of time preference • with a decrease in land quality of the parcel.

11. Terms of a Fixed Price or Revenue Sharing Contract • Fixed biomass price and revenue sharing contract needed to induce a risk averse landowner to choose a fixed price contract increases with • an increase in the variability of biomass yield and spot price • increase in the degree of risk aversion and land quality • decrease in the volatility of conventional crop profits • Revenue sharing rate increases with an increase in biofuel price volatility • Lower for a risk loving farmer than for a risk averse farmer

12. Contract Type Choices Low quality High quality qi Row Crops Profit Sharing Contract Leasing Contract Fixed Price Contract λi Risk loving Risk averse

13. Stylized Assumptions • Capacity of the refinery 35 MGY • Discount rate 2% • Yield of energy crop 8 tons/acre • Life of energy crop 10 years • Average biomass price $60/ton • Average biofuel price $2.4 per gallon • Biomass conversion cost 80 gallons/ton • Establishment cost of bioenergy $1000/acre • Production cost of energy crop per acre $300/acre • Capital Cost of Refinery $303M • Operating cost of refinery $0.35/gallon • Biomass transportation cost $10 per ton

14. Distributions of Land Quality, Risk Aversion and Prices

15. Contract Choice and Terms under Benchmark Assumptions

16. Concentrated Risk Preferences Benchmark Diversified Risk Preferences Lower average risk aversion

17. Other Determinants of Contract Choice: % of Production

19. Menu of Contracts vs a Single ContractProfits of the Refinery ($M)

20. Net Benefits of Farmers ($M)

21. Summary of Findings • Farmers with a lower land quality and a higher degree of risk aversion are more likely to lease their land for energy crop production • those with low land quality but low degree of risk aversion are more willing to grow the energy crop themselves under a revenue-sharing contract. • A biorefinery will prefer to be more vertically integrated • when biomass yield and price risks are high • variability in returns to crop production is high • Loss of profits to a biorefinery of being fully vertically integrated is 1-2% • But loss of net benefits to farmers could be 20-25% particularly when energy crop production is very risky