Overexploitation Risk in “Green Mountains and Clear Water”

Abstract

This study is motivated by a real project in China in the context of “Green Mountains and Clear Water”. As pointed out by Xi (2016), “to improve the environment is to boost productivity”. The purpose of this paper is to devise optimal capital allocation and compensation mechanisms when there exist social and environmental responsibility risks. A firm with access to a single investment project in an ecoregion may engage in environmental violations, and the ecoregion's proprietor (say municipal government) with preferences for ecological protection privately observes the process audit effort level. I extend the contract theory to a more general setting and find that given linear compensation schemes, the optimal solution is to set the non-negative share of project cash flows larger than 100% while the fixed component negative. The incentive-compatible mechanism gives rise to the overinvestment and overexploitation problems relative to the first-best level, and both problems become smaller as process audit effort level increases. Finally, I investigate how the model may vary with relevant characteristics such as multi-resource requirement, risk-averse government, and verifiable process audit information. Given unverifiable process audit information, municipal government faces a dilemma of gaining a higher compensation but losing a larger ecological area. In such a case, municipal government has to seek a compromise and may pin hopes on higher audit effort levels from superior administration units. The analysis also highlights the power of stricter process audit to reduce market surplus loss caused by information asymmetry.