Contracting for perennial energy crops and the cost-effectiveness of the Biomass Crop Assistance Program

Highlights: • We derive sub game perfect Nash equilibrium contract for Perennial crops. • Performance, establishment, and acreage payments are used in equilibrium. • Establishment subsidy payments dominate acreage subsidy payments from a risk-adjusted cost-effectiveness perspective. • The Biomass Crop Assistance Program should allocate more resources to establishment payments. Using a framework that meshes mechanism design theory and real options analysis, we recover the contract terms that a biomass processing plant would offer a farmer to induce conversion of land to perennial energy crops. We consider three contract terms: performance payment (price per dry ton of biomass), establishment payment (one-time payment per acre planted), and acreage payment (annual payment per acre planted). We find that, in equilibrium, the contract signed by farmers and buyers of Miscanthus (the perennial energy crop of choice in our analysis) uses a combination of all three payments. Conditional on the equilibrium contract, we show how changes in the structure of the Biomass Crop Assistance Program affect cost and risk along the vertical supply chain. Our analysis reveals that subsidies to both establishment and acreage payments are equally cost-effective in reducing production cost of cellulosic biofuels. However, establishment subsidies are more effective at reducing risk for the buyer and, therefore, dominate acreage subsidies from a risk-adjusted cost-effectiveness criterion. This suggests that a larger share of the Biomass Crop Assistance Program budget should be allocated to establishment subsidies to the detriment of matching payments (subsidies to performance payments) and maintenance payments (subsidies to acreage payments).