Developing a Bioenergy Crop Supply Chain: Contracts and Policy ` Madhu Khanna University of Illinois, Urbana-Champaign

Cellulosic Biofuels  Biofuel mandate in the US for 16 billion gallons of biofuels from non-food crops, cellulosic biomass  Commercial production emerging using crop residues  Large scale and environmentally sustainable biofuel production will require dedicated energy crops ( Miscanthus, switchgrass,energy cane)  Perennials  High yielding  Can be grown on low quality land  Provide environmental benefits to soil and water quality  Energy crops yet to be grown commercially on a large scale  in the US Miscanthus Energy Cane Switchgrass

Stylized Features of Energy Crop Production  1-3 year lag between planting and harvestable yields  Opportunity cost of land: foregone income from annual conventional crop production  Long term commitment: year lifespan  Riskiness of profits: price, yield and cost of land risks  Not covered by crop insurance  High fixed costs of establishment  Thin markets for biomass: Costly to transport long distance

Farmer Preferences That Affect Energy Crop Production Discount rate Risk Preferences

Risks associated with energy crops  Sources of risk for 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

Effect of Time and Risk Preference  A farmer with a lower discount rate will have greater incentives to invest in an energy crop.  Effect of risk aversion on share of land converted to an energy crop is ambiguous  Could increase if the energy crop reduces variance of profits  Could decrease if establishment costs are very high leading to a large temporal variability in returns  Could increase if diversification benefits of energy crop are high  Risk aversion and high discount rates could raise the price at which farmers are willing to supply energy crops  Farmers are heterogenous in their risk and time preferences  Risk premium and rate of return premium will vary across farmers  Asymmetric information about preferences

Risk Sharing  Instruments for sharing risks between refinery and farmer  Contracts or vertically integrated production?  Which type of contract (s) to use?  Incentive compatible terms of the contract?  Leverage heterogeneity in preferences to minimize feedstock cost  Cost-sharing investment in feedstock production  Sharing risks between government and farmer  Crop insurance: Should it be subsidized?  Establishment cost share payments- can reduce temporal variability in income  Particularly for credit constrained farmers

Some Contract Types 1. Leasing contract The biorefinery leases land at a fixed payment per acre and bears the 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 price per ton of biomass for delivering a fixed quantity of biomass 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 Farmer bears yield risk and cost of land risk; shares the biomass price and biofuel price risk with refinery 4. Spot market sales: Farmer and refinery each bear price and demand risks

Choice of Contracts  Consider a refinery that is deciding  the proportion of its feedstock to produce itself on leased land and the proportion to contract from farmers  The type of contract (fixed price or revenue sharing contract) and the terms of the contracts  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  Farmers are heterogeneous in their risk preferences and the opportunity cost of their land

Contract Choice and Terms  Mix of contracts is optimal  To leverage heterogeneous preferences  By allowing farmers to choose the contract that best fits their risk preferences and land quality, the incentive payments needed to induce production are minimized  Refinery likely to be less risk averse and have lower discount rate  More efficient to bear risk and upfront costs of investment  Vertical integration a dominant form of feedstock production Leasing Contract Fixed Price Contract Revenue Sharing Contract Row Crops Contract Terms Risk Premium-45%10% Profit ($/Acre) Signup Rate41.5%8.3%4.5%45.7%

Concentrated Risk Preferences Benchmark Diversified Risk Preferences Lower average risk aversion

Policies to Induce Supply of Energy Crops  Eliminating subsidized crop insurance for conventional crops  Energy crop insurance and premium subsidy: Positive effect  if profits of the two crops are uncorrelated or positively correlated  if energy crop adoption reduces the variance of total profits  Establishment cost share will increase land allocated to an energy crop  If there is a credit constraint  Analyze effects on farmer with various combinations of risk and time preferences with and without conventional crop insurance and with and without a credit constraint

Simulation Results

Effects of Crop Insurance and Establishment Cost Share Subsidy  We find crop insurance even with subsidy has a small marginal effect on the biomass price farmers need to supply an energy crop because  Low yield risk and fixed price contract  Yield risks occur after establishment of the crop and value gets discounted  But it can increase acreage under miscanthus by encouraging production in low yield high risk areas  Establishment cost share subsidy can lower biomass price by 40-50% especially wnen farmers are credit constrained, risk averse and have a high discount rate

Spatial Effects of Risk Aversion and Credit Constraint on Land Allocated to Miscanthus (a)Low risk aversion, low discount rate, no credit constraint (b)High risk aversion, low discount rate, no credit constraint (c)High risk aversion, low discount rate and credit constraint

Spatial Effect of Policies on Acreage Allocated to Miscanthus with High Risk Aversion, High Discount Rate and Credit Constraint (a) No Policy (b) 5% Energy Crop Insurance Subsidy (c) 100% Establishment Cost Share Subsidy

Conclusions  Perennial energy crop production involve risky production with high establishment costs and requires long term commitment of land  Supply chain development will require innovative marketing contracts and policies to mitigate and share risk  A mix of vertically integrated production and contractual production offers a mutually appealing arrangement for sharing risk between a refinery and farmers that are heterogeneous in their risk aversion  Contracts accompanied by establishment costs sharing can significantly lower overall costs of energy crop production, particularly if farmers are credit constrained.  Removing existing conventional crop insurance more effective at lowering the price of energy crop production compared to offering energy crop insurance