Interfaces with Other DisciplinesMultidimensional auctions for long-term procurement contracts with early-exit options: The case of conservation contracts
Introduction
Procurement contracts can be broadly divided into two categories. On the one hand, there are contracts governing a single transaction, such as those related to the construction of public infrastructure facilities without operational duties. On the other hand, there are contracts where sellers commit themselves to supply a flow of goods or services over an extended period of time.
Conservation contracts (or “Payments for ecosystem services”, PES)1 fit the latter category, as they typically require long-term commitments to preserve natural habitats or to set-aside croplands, in order to provide environmental services (ES), such as maintenance of biodiversity, carbon sequestration, soil erosion control or visual amenities. Meanwhile, landowners2 will be entitled to receive a flow of payments for the forgone market earnings and the direct additional costs related to conservation management activities.3
Traditionally, governments have offered flat-rate payments for compliance with a predetermined combination of management prescriptions. However, following a general trend in the public procurement sector, interest in bidding mechanisms has gradually grown, in order to increase the cost-effectiveness, transparency and political acceptance of environmental payments (Latacz-Lohmann & Schilizzi, 2005). Competitive bidding, when used, often comes in the form of multi-dimensional auctions where bidders are asked to submit proposals on both price and conservation activities, and offers are ranked according to pre-specified scoring rules. Examples of competitive tendering can be found in the US, where bidding mechanisms have been pioneered under the Conservation Reserve Program (CRP), in Australia (Bush Tender and Auction for Landscape Recovery), Germany (Grassland Conservation Pilot Tender) and Scotland (Challenge Funds) (Zandersen, Braten, & Lindhjem, 2009).
Starting with the seminal paper by Che (1993), there is by now a large body of theoretical literature on scoring procurement auctions and several studies have specifically focused on the design and evaluation of conservation tenders. An issue, however, which has not received much attention in either the general literature on multi-dimensional auctions or conservation literature is the impact of premature termination of supply on bidding behavior and on auction performance. This is largely explained by the fact that the standard auction theory has mainly focused on single transactions, in so doing directing attention to contract breaches stemming from failure to comply with quality and/or quantity specifications.4 Conservation auction models, in turn, though recognizing the long-term nature of PES schemes, are generally built on the implicit assumption that time commitments, set forth in the agreement, will be honored by contract winners (see, e.g., Claassen, Cattaneo, Johansson, 2008, Espinosa-Arredondo, 2008, Kirwan, Lubowski, Roberts, 2005, Vukina, Zheng, Marra, Levy, 2008, Wu, Lin, 2010).
Yet, premature termination of procurement contracts and public-private partnerships is not uncommon.5 For instance, breaches of contract can be tied, on the one hand, to unanticipated reductions in private profits, and on the other to the lack of adequate incentives against opportunistic behavior by suppliers, notably the absence of reputational mechanisms (Kelman, 1990, Spagnolo, 2012), the weakness of penalties for contract infringements, or the weak enforcement of contractual claims (Dosi & Moretto, 2015).
In the case of conservation agreements, early termination can be traced to changes in the private opportunity cost of keeping land idle for environmental purposes (e.g., sharp rises in crop prices, increases in land price to urban expansion). In turn, governments can face political pressure, or other outside influences, to soft early termination fees. For example, in the USA, agricultural associations have frequently lobbied for reducing payments for early release of CRP acres and in 2011 some Members of the Congress asked President Obama to release CRP land without penalty for the purpose of grain production (Stubbs, 2012). Moreover, legal remedies for breach of contracts can be threatened by institutional failures leading to costly litigation or inefficient settlement processes (Guash, Laffont, & Straub, 2006). For instance, institutional failures weakening the effectiveness of contractual claims have been pointed out by several studies analyzing PES programs aimed at reducing degradation of tropical forests in developing countries (see, e.g., Cordero Salas, Cordero Salas, Roe, 2012, Palmer, 2011).
This study contributes to the literature on procurement and conservation auctions by investigating the effects of “exit options” on bidding behavior in multi-dimensional tenders for long-term supply contracts. Given the focus of the paper, we will restrict the analysis to the effects of the lack of sufficiently strong and credible exit “penalties”,6 by leaving aside topics addressed by other authors in the conservation literature such as (i) the imperfect monitoring of conservation activities (or final environmental outputs)7 and (ii) bidding behavior in budget-constrained conservation tenders (Latacz-Lohmann & van der Hamsvoort, 1997).
Up to our knowledge, ours is the first paper examining in a dynamic framework the impact of the moral hazard associated with the exercise of the option to breach a supply contract. The main findings can be summarized as follows. First, we show that bidders’ payoff is lower when competing for contracts which do not provide for enforceable time commitments. Secondly, that neglecting the risk of ex post opportunistic behavior by sellers can lead to contract awards that do not maximize the buyer’s potential payoff. Finally, we make suggestions about how to mitigate potential misallocations, by pointing out the role of eligibility rules and competition.
The remainder is organized as follows. The next section provides a brief overview of the related literatures. In Section 3, we set up the model. Section 4 illustrates the benchmark case in which the contractual duration is enforceable. In Section 5, we derive the equilibrium of the auction game when bidders do not face sufficiently strong incentives against early-exit and in Section 6, we discuss the impacts of ignoring the risk of a premature termination of contracts and possible remedies. We conclude in Section 7. The Appendix contains the proofs omitted from the text.
Section snippets
Related literature
This article is related to several lines of literature which have been developed in a largely independent fashion.
The first is the literature on multidimensional auctions in which bidders compete on both price and quality dimensions (see, for instance, Asker, Cantillon, 2008, Asker, Cantillon, 2010, Bushnell, Oren, 1994, Che, 1993, Lorentziadis, 2010, Wang, 2013), where the term “quality” conveys different meanings depending on the nature of the exchange being made. The guarantee of supply over
Model set up
Consider n ≥ 2 risk-neutral agents, each one holding one unit of a natural asset L that is currently kept “idle”, meaning that it does not provide the owners with any (relevant) private benefit.
For the sake of simplicity and without loss of generality we assume that all parcels are suitable for producing one unit of a homogeneous marketable product (good 1). However, this requires developing the asset (e.g., draining a wetland for agricultural use), by affording a sunk investment cost K(θi), 10
Benchmark: perfect enforcement
We begin by analyzing the outcome of the award process when bidders bid knowing that they cannot prematurely terminate the contract. Implicitly, we assume that the buyer does not face any constraints to stipulate and to costlessly enforce arbitrarily large exit penalties.
Non-enforceable contract duration
Now suppose that sellers do not face sufficiently strong and credible exit penalties. As already argued, this can be due to several reasons, e.g., the weakness of contractual penalties or to the weak enforcement of contractual claims. Further, let us suppose that the buyer turns a blind eye on the risk of premature termination of supply and, as above, ranks bids on the basis of the annual payoff si. In the following, we will show how opportunistic behavior gives rise to moral hazard and, thus,
The buyer’s payoff
When the contract duration is not enforceable, the buyer’s total expected payoff is given by: where Ti is the seller’s optimal time for breaching the contract.
Proposition 3 implies that allocating the contract on the basis of the highest annual score si may turn out not be the best decision for the buyer because the winner (least-cost) agent can be more prone than others to early-exit.
This becomes clear if we take a closer look at the derivative of Eq. (15.1)
Final remarks
Contracts providing payments for preserving and enhancing natural assets generally require long-term commitments. Agents, however, can find it profitable to breach the contract when the opportunity cost of conservation requirements increase and contracts do not provide for sufficiently strong and credible exit penalties.
The question addressed in the paper is how this can affect bidding behavior and the parties’ individual payoffs in procurement auctions where contractors are selected on the
Acknowledgements
We thank the associate editor and three anonymous referees for their useful comments and suggestions. All remaining errors are ours. Luca Di Corato and Michele Moretto gratefully acknowledge financial support from the University of Padova, grant BIRD 173594.
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