Long-term contracts for commodity biofuel crops
This thesis examines theoretical contract designs applicable to a commercial biofuel crop market. Perennial crops are not presently grown at commercial scale, however, and the investment cost of a plant to process these feedstocks is greater than for a conventional corn-fueled plant. This leads to an investment hold-up problem: firms are unwilling to commit resources to build a refinery to process perennial crops without first ensuring an adequate supply of feedstocks. We propose using long-term contracts as a solution to this investment hold-up problem and compare theoretically optimal contract designs using experimental subjects. Our model predicts that indexed contracts have the best potential to be renegotiation-proof during times of high commodity prices, even if the index does not capture all changes in the opportunity cost of the competing crop. Truncated or attenuating indexes change the probability distribution of contract prices relative to the distribution of a base price index. These designs limit ex post contract price movements, protecting refiners against high input costs and farmers against low commodity prices, but weaken incentives to avoid renegotiation. Laboratory evidence suggests that an attenuating index induces higher levels of participation and fewer contract defaults than either a perfectly indexed or a fixed price contract. A fixed price contract where the price is determined by a continous-time button auction yielded the lowest average unit cost for the refiner, but had the highest level of contract defaults. The results for default rates are consistent with our theoretical model for the fixed price contract, but inconsistent for the perfectly indexed contract design. Possible explanations for this discrepancy include discounting payoffs over the course of the experiment, lack of saliency for losses due to defaulting, and differences in subjects' perceived “intellectual challenge" across treatments. Additional theoretical models and experiments are needed to investigate these hypotheses and explore the sensitivity of attenuation to contract duration and choice of base price distribution.
Wu, Purdue University.
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