ES and Risk: Implications for Designing Payment Contracts for Small Farmers Nancy McCarthy International Food Policy Research Institute, And Visiting Researcher, Food and Agricultural Organization

Motivation Many ES are expected to reduce production risks faced by poor farmers –Stone bunds, ridges, terracing for better rainwater regulation, may soil/wind erosion –Trees, shrubs to stabilize soils, soil/wind erosion control and/or better rainwater regulation Climate Change expected to increase production risks, particularly extreme events

Can PES programs improve provision of Activities that generate Risk- Reducing ES by small farmers? First, need to determine if such activities are currently underprovided in a “local social optimum” sense, and if so, understand why Then ask: Can contracts be structured to increase ES provided by poor that improve their welfare?

Outline of Presentation The Risk Simulation Model and Data for Baseline Results: ES activities provided without payments, depending on wealth levels and heterogeneity Affect of Different ES schemes on provision of ES, given fixed agricultural production Results when: optimally choose both ES to provide and agricultural production

Simulation Model Quasi Mean-Variance…

Simulation Model Assumptions: –2 farmers –ES only affects yield variance –Decreasing Absolute Risk Aversion, Constant Relative Risk Aversion –Yield Risk =

Data to Baseline Model Household and Community-Level Data collected in northeast Burkina Faso 2000 and 2002 Information of production, prices, yields, investments in stone bunds and reforestation; latter at both household and community level. For stone bunds, appears that biggest impact is on variance, not on mean yields (do worse in good years, better in bad, same on average… don’t take too seriously, only two time periods) Had to increase “safe income” to at least $2000

1st Round Simulations

2 nd Round Simulations: X AG fixed SO=175, NC=127. What do the incentives look like? (Based on EU)

2 nd Round Simulations: Pay for All Environmental Services Provided, Perfect Monitoring. Cost per household: $17.5 Payoff Matrix, Imperfect Monitoring (cheater gets away with it) – PES increases incentives to cheat… For THIS scenario, not possible to eliminate Incentives to not be Suckered without generating positive incentives to cheat…

2 nd Round Simulations:

Group Punishment, Perfect Monitoring… Makes much more costly to reduce incentives not to be suckered. Now costs $107 per farm… [At higher payment incentives to cheat are reduced further still, but they’re negative in base scenario anyway] WHY? The scheme exacerbates incentives not to be suckered

Some Conclusions Relatively cheap, in this example, to construct a “privileged”, self-enforcing contract IF monitoring is costless Without “credible” monitoring and enforcement, a straight PES contract increases incentives to cheat BUT group punishment only makes matters worse (from a self-enforcing point of view; may, of course induce within-group monitoring). With costly monitoring, Group Subsidies may do better – offsets increases in incentives to cheat when monitoring imperfect, but: As long as “penalty” for smaller group compliance is not too high, can handle incentives not to be suckered. But… (tantalizing) preliminary result

Additionally,… DOES not capture possibility of “insuring” within group (micro-credit literature) –May be more difficult anyway – have to Provide ES; not as easy to cover as $ –Location specificity may reduce possibilities to recruit new members, credible threats of expulsion Specific to the underlying Assurance Game structure; contract effects differ if underlying incentives have different structure (e.g. Prisoner’s Dilemma)

What if Choose Both Production and Provision of ES simultaneously? Simulation Results for: introducing and increasing the PES, poor vs. rich households (in terms of safe income) Simulation Results for decreasing costs of providing the ES, poor vs. rich households

Some preliminary conclusions Poor are more likely to “income substitute” away from ES, especially with payments for ES, muted response when decrease costs of provision Rich are more likely to increase at least over some range, but start from a much lower base Incentive structure always resembles a Prisoner’s Dilemma for poor; switches between Assurance and PD for wealthier

Concluding Comments Difficult to get model to solve for paying only on incremental increases in ES; seems to require very high payments. Preliminary results suggest that ag. production decreases with increases in ES Some intuitively appealing results, but model still sensitive, especially when allow both choice variables…