Optimal Mix of Vertical Integration and Contracting for Energy Crops: Effect of Risk Preferences and Land Quality

Abstract

Long‐term contracts are likely to be critical to induce the production of perennial energy crops as a feedstock for the emerging cellulosic biofuel industry. This paper develops a framework to analyze the determinants of landowner choice among a land‐leasing contract, a fixed‐price contract, and a revenue‐sharing contract for energy crop production. We examine the effect of heterogeneous landowners' risk and time preferences and land quality on the optimal mix and equilibrium terms of these contracts, which jointly maximize the net benefits of the refinery and landowners in a region; this has implications for the extent to which energy crop production is likely to be vertically integrated or independently contracted by a biorefinery. We find that the refinery can potentially earn a higher profit by offering a choice of these three types of contracts rather than a single type of contract only; by allowing self‐selection of contract type based on landowner risk and time preferences, the contractual terms needed to induce production of energy crops are reduced. Although it is optimal for vertically‐integrated and contracted production to co‐exist, we find that the share of the former is predominant across a range of assumptions about the distribution of risk preferences, time preferences, and relative riskiness of conventional and energy crop production. We also find that the impact of having multiple contract types to choose from on landowners' welfare is ambiguous.