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Executive Summary

Background and objectives

Since the launch of the Agri-Environmental Regulation in 1992, environmental contracting has become a key instrument of rural environmental policy across the EU. In Scotland, more than 1.2 million hectares of land are enrolled in agri-environmental schemes. The area of land under conservation management is set to increase further: Scotland is introducing a system of whole-farm support, called Land Management Contracts, designed to reward the full mix of economic, social and environmental benefits provided by farmers and crofters. The increased importance of agri-environmental policy in Scotland and elsewhere has, to date, not been reflected in innovative policy design. It remains the norm in European agri-environmental policy to offer a single, fixed payment for compliance with a pre-determined set of management prescriptions. Innovative policies based on contract and auction theory have been proposed to improve policy performance.

This report aims to provide SEERAD with a comprehensive review of the literature on conservation contract design and the use of auctions in agri-environmental policy and natural resource management. The theory and practice of auction and contract design is a burgeoning field of economic research which, because of technicalities, is not easily accessible to the layman. This report is intended to bridge the knowledge gap between researchers in the field and officials who consider using auction and contract theory to inform practical policy design. In particular, it aims to address key questions of auction and contract design and to provide SEERAD with conclusions as to whether or not, under current knowledge, an auction system could now be used in Scotland.

An economic critique of agri-environmental contracting

While environmental contracting represents a significant innovation in policy terms, there are a variety of fundamental limits to this approach. The source of most of these problems lies in the fact that landholders know more about on-site costs and local impacts than the conservation agency, a situation referred to as 'information asymmetry'. This can give rise to incentive problems limiting the effectiveness of environmental contracts as follows:

Adverse selection means that farmers who have already managed their land in an environmentally friendly way have a greater incentive to join a conservation scheme than farmers with less environmentally friendly farming practices: the former will have to make fewer and less severe changes to current farming practices, resulting in lower compliance costs. This will result in comparatively small additional environmental benefits and an overcompensation of compliance costs. The basis of adverse selection is information asymmetry: farmers differ in their compliance costs, and if these differences could be observed by the agency then farmers could be paid a rate equal to their individual compliance costs. In the absence of such information, the agency can only offer a flat rate, which cannot be cost-effective.

Moral hazard occurs if the conservation authority does not perfectly monitor compliance with the terms of the contract. Imperfect compliance monitoring can provide farmers with an incentive to renege on their contracts: if they are successful in avoiding detection by the conservation agency, they receive the compensation payment without incurring the costs implied by their contractual obligations. Evidence reported in the literature suggests that adverse selection and moral hazard are widespread phenomena of agri-environmental management.

The typical agri-environmental contract does not provide producers with adequate incentives for entrepreneurship: to seek out new methods of reducing costs, to introduce new ideas, or to be willing to take risks for the provision of countryside goods. This is because environmental goods and services are normally not directly contractable, implying that rewards cannot be based upon environmental outcomes and must instead be linked to activities, i.e. changes to the management of the land.

There are uncertainties over the property rights in the environmental capital generated through contracting. When contracts expire, there can be no guarantee that the conservation assets will continue to be maintained because farmers are free to revert to intensive farming practices. Government may respond by introducing restrictive designations or covenants to protect long-term environmental gains. The prospect of this happening may deter farmers from considering participation in the first place.

The need to deal with information asymmetry and producer heterogeneity can give rise to high administrative costs. An empirical study reports average annual administration costs between â'¬9 and â'¬75 per hectare and between â'¬140 and â'¬2,446 per participant.

Agri-environmental contract design with limited information

Policy mechanisms designed to address adverse selection can be broadly classified into two categories: self-selection mechanisms (through contract menus) and auction mechanisms. Self-selection mechanisms are set up as principal-agent models whereby the principal (the conservation agency) devises different contracts for different resource settings of agents (the farmers), depending, for instance, on whether they are high-cost or low-cost compliers. The principal tailors farmers' choices in such a way as to induce farmers with a particular resource setting to choose the contract meant for them. This tailoring is done through contractual provisions which require that farmers with a particular resource setting, say highly productive land, prefer the contract intended for highly productive land to all other options offered in the menu. By choosing the appropriate contract, landholders reveal their resource setting to the conservation agency, thereby reducing the information asymmetry. Despite this advantage, no use seems to have been made of incentive-compatible contracts in the practice of agri-environmental management. This is not surprising given the theoretical nature of contract mechanism design and the restrictive assumptions underlying the models.

Rather than relying on self-selection, auctions harness market forces to induce farmers to reveal, through the bidding process, their compliance costs to the conservation agency. Competition is the driving force behind this cost revelation: farmers are asked to bid competitively for a limited number of conservation contracts. In formulating their bids, they thus face a trade-off between a higher net gain from a higher bid and a reduced chance of winning. Producers facing competition are less likely to 'overbid' relative to their true compliance costs. Competitive bidding thus reduces over-compensation and increases cost-effectiveness. Auctions have the added advantage of acting as a price discovery mechanism for environmental goods and services for which there are no well-established markets and thus no prices. In an auction, prices are determined through a decentralised process which takes account of private information held by the bidders. However, an auction is a complex incentive mechanism, involving a higher risk of failure than a simple fixed-rate payment. The diffusion of auctions into the practice of agri-environmental management has been slow, but interest in auctions for purchasing conservation services from private landholders has recently grown.

Progress on designing efficient solutions to the moral hazard problem has been slower and confined to theoretical models with little relevance to the practice of agri-environmental management. The important policy conclusions from the literature are these: Incentives for non-compliance are shaped by the farmer's compliance costs, the payment level, the non-compliance detection probability and the level of fines for detected violations. The propensity to compromise conservation agreements is highest when compliance costs are high in relation to the payment level. This in turn suggests that (a) overcompensation can reduce the risk of non-compliance and thus the need for compliance monitoring and (b) that monitoring efforts should be concentrated on high-cost farmers, e.g. farmers with high pre-contractual land use intensities. Payments in excess of compliance costs are most likely to be cost-effective in situations where compliance monitoring is technically difficult (and thus costly).

We considered the proposition to pay farmers based on environmental outcomes rather than, as is common practice, on the landholder's activities or conservation effort. There is a dilemma here between two aspects. Payments made on the sole basis of effort without reference to output create little incentive for achieving the desired output, effectively exacerbating moral hazard and adverse selection. Payments made on the sole basis of output without reference to effort can create a very risky situation for the landholder, insofar as many factors beyond his or her control (such as droughts, floods or pest invasions) can intervene to perturb the relationship between effort and outcome. Agents who are willing to bear that risk will demand a high risk premium in return which, in turn, may make the transaction unattractive to the conservation agency. The problem is exacerbated by uncertainties with the observational and measurement techniques available. It is often difficult, if not impossible, to come up with precise and reliable estimates of environmental change. This is likely to lead to complaints and appeals from landholders, resulting in high transaction costs. In theory, and abstracting from the measurement problem, contracts could be devised whereby the total payment is split into two: an effort-based and an outcome-based instalment. The effort-based payment could be made once a farmer has signed a conservation contract and has implemented the stipulated conservation activities. The outcome-based payment would depend upon some quantitative measure of the environmental benefits after a stipulated time period. Mainly because of the problem of unobservability of environmental outcomes and the risks of litigation linked to unclear landholder responsibility, it appears preferable, for the time being, and until some general guidelines have been worked out, to stick to effort based-payments. However, improvements in knowledge (for example, new technology that allows lower-cost monitoring of specific environmental outcomes) may enable conservation agencies to base at least part of their payments on output.

Conservation auction design

Auctions can be regarded as a trading mechanism and analysed from a design perspective - that is, how these markets can be designed in such a way that they achieve specific outcomes. Outcomes commonly sought in conservation auctions are allocative efficiency, i.e. selection of participants with the highest benefit-cost ratio, and budgetary cost-effectiveness - that is, buying the most conservation benefit with a given budget of public money. Auction theory is not well developed for conservation auctions and thus offers little guidance for the design of tendering mechanisms in such contexts. Most analyses testing alternative auction designs therefore have relied on economic experiments, numerical simulations or, simply, intuition and economic reasoning.

There is the choice between different payment formats. In the discriminatory format (the most commonly used), each bidder is paid an amount equal to his or her actual winning bid. In a uniform-price auction, by contrast, all successful bidders earn the cut-off price - either the highest accepted or the lowest rejected bid. The main difference between discriminatory and uniform pricing is its impact on bidding behaviour. Under the discriminatory format, bid formation depends not only on a bidder's own cost of conservation activities but also on his or her best guess of what the highest acceptable unit bid might be. This creates room for bidders to shade their bids above their true opportunity costs and thereby to secure themselves a profit or rent. Overbidding implies that the auction does not reveal bidders' true opportunity costs. Theoretical modelling suggests that overbidding is highest for the lowest-cost bidders, whereas the highest-cost bidders bid closest to their true costs (though still marginally above). However, these highest-cost bidders are not those that are usually selected; rather, the lowest-cost bidders are, but they get paid well above their true costs. Note however that this overpayment is usually smaller than under a flat-rate scheme.

Under uniform pricing, by contrast, a bidder's bid only determines the chance of winning but not the payment received. Bidders' dominant strategy thus is to bid their true opportunity costs. Any other strategy would reduce a bidder's potential gain from the auction. Bids under uniform pricing rules can thus reveal bidders' true opportunity costs.

Theory provides little guidance to tell which of the alternative pricing rules can generally yield greater budgetary cost-effectiveness. On balance, the discriminatory payment format appears to be the more appropriate payment rule for conservation auctions, except when there are reasons to believe that bidders will considerably shade their bids. However, if cost revelation (rather than value for money) is the overarching priority, and perceptions of fairness are not a political issue, then the implication is to use uniform-price auctions.

A reserve price strategy is a key element of auction design. A reserve price is an upper limit on the amount the agency is willing to pay for a unit of the conservation good being traded. This can be pre-announced or not. There are two potential reasons why conservation agencies should consider setting a reserve price. The first is bidding competition: a reserve price adds to the risk that bidders might lose an auction by bidding too high. Second, it may act as a signal of the agency's (or society's) maximum willingness to pay for conservation services, thus representing the demand side of the 'market' in countryside benefits. A reserve price should be considered if bidding competition is expected to be weak and if there is risk of bidder collusion. This is the case when the number of potential bidders is small or when bidders learn to 'game' the auction in multiple bidding rounds. Reserve prices are less important where there is a strict budget constraint.

Conservation auctions can be conducted either with a fixed budget (which is the norm) or, alternatively, with a fixed target. In the first case, the agency accepts bidders based on their benefits to bid ratios until a predetermined fixed budget is exhausted. The size of the conservation scheme in terms of hectares of land enrolled is determined as a residual from the budget and the bids offered. In the target-constrained auction, by contrast, the agency predetermines the size of the conservation scheme and accepts bids until the target is achieved. In this case, the necessary budget is not known before the auction is completed. There are no a priori reasons to believe that one auction format is better than the other except, perhaps, that the existence of a budget constraint may have the psychological effect of 'disciplining' bidders, encouraging them to enter more competitive bids. Experimental studies found no significant differences in the performance of the two auction formats. We thus conclude that there are no strong reasons to suggest the preferred use of one of the two auction formats. Practical considerations, however, call for the preferred use of the budget-constrained auction: it is the more 'natural' format in the environmental area where schemes usually have a limited budget and EU regulations limit the degree of overcompensation of farmers' opportunity costs. A target-constrained auction may be called for in situations where the agency cannot fall short of its environmental objectives.

Auctions for conservation contracts are normally designed as repeated auctions where bids for the same contracts are invited over a sequence of years. Such a system provides scope for bidders to analyse the results of preceding bidding rounds and use this information to update their bids. Experience with the Conservation Reserve Program in the US has shown that after a few bidding rounds the average bid was almost exactly equal to the maximum acceptable payment level from preceding rounds, implying that farmers had learned the cut-off points. Under no circumstances should the conservation agency therefore publish information about the average or the maximum accepted bid or the distribution of bids received in preceding bidding rounds. Another potential remedy to the problem of learning is to amend the rules of the auction in each bidding round. This would make the system less predictable, thus maintaining a certain degree of uncertainty among bidders. A reserve price may also be effective in countering bidder learning.

A parcel's conservation value may increase if adjacent parcels are also put under conservation management. The presence of such site synergies requires auction design refinements. The agency may wish to encourage all pertinent landholders to participate in an auction so that bids with synergetic values are accepted together. One solution is to allow neighbouring landholders to submit joint bids that cover sites belonging to different holdings. Landholders who submit a joint bid have the local knowledge to decide among themselves how best to share effort and payments among their members, thereby helping the agency with the funding decision. The efficiency and payment properties of joint bidding are barely explored in the literature and detailed auction rules are yet to be developed. These properties would need to be explored through appropriately designed economic experiments, before such schemes can be recommended for practical use. Another unresolved issue is how best to provide incentives for landholders to act together. One way is for the conservation agency to score bids contingently: landholder A's score would be greater if he or she were successful in conjunction with landholder B. This would have to be communicated to potential bidders before bidding commences. Since landholders cannot be expected to be aware of conservation synergies, it is important to inform those landholders that they were providing synergy benefits. In the Scottish context, this may be relevant to the Rural Stewardship Scheme, particularly its Common Grazing measures.

The choice of an appropriate bid evaluation system is a key design issue. The main purpose of bid evaluation is to incorporate information on conservation benefits in an auction. Conservation benefits are often site specific and depend upon the resource setting. Benefit indicators can be used to quantify site-specific effects of conservation activities. If bids contain more than one conservation benefit, a multi-criteria bid scoring system can be used to aggregate the various benefit variables into one figure representing an estimate of the overall conservation benefit of each bid. These aggregate measures of conservation value draw on environmental assessments conducted by ecologists and are limited by whatever data a conservation agency is able to collect. Aggregation methods differ mainly in the choice of relative weights for individual benefit variables. Examples include the biodiversity quality ( BQ) index used in the BushTender pilots in Australia and the environmental benefit index ( EBI) used to select bids under the Conservation Reserve Program in the US.

We advocate the use of Data Envelope Analysis ( DEA) to construct a so-called value-for-money frontier. DEA is a benchmarking technique based on linear programming. Bids that lie on the frontier are assigned a value of one, indicating that they offer the best value for money. For all bids not on the frontier, DEA indicates by how much the bid would have to be lowered so that the proposal represents the best value for money. In order to take account of the agency's preferences for different quality attributes, one can input preference weights to come up with appropriate scores for bid selection. Bids are then ranked by these efficiency scores, and the offers with the highest scores would be selected until the budget is exhausted. The information needed to construct the value-for-money frontier comprises, for each bid, estimates of the different quality attributes and the bid amount. All quality attributes must be readily observable and not subject to manipulation or misrepresentation by the bidders. From a practical perspective, DEA offers the advantage of generating virtually incontestable bid rankings: if a bid turns out to be bad value for money, then there is a strong argument for rejecting the bid. This minimizes the scope for complaints and appeals by unsuccessful bidders. However, DEA is less transparent and more difficult to explain to bidders and stakeholders than alternative, more intuitive bid ranking systems.

Prior to landholders forming their bids, the government agency needs to decide how much information about what it values in the auction it is going to reveal to them. Theoretical considerations suggest that if bidders know their own quality estimates and the agency's preferences, they will strategically avoid price competition and offer the mix of service attributes that best matches the agency's preferences. They thus compete directly only with those offering the same quality mix, thereby reducing price competition. By contrast, lack of information on the agency's preferences compounds the guesswork that bidders face in formulating their bids: not knowing the agency's preferences, bidders are unable to supply favourable but costly service attributes and price competition becomes the driving force of the auction, preventing bidders from capturing large rents. These theoretical predictions have been confirmed by laboratory experiments. A reasonable compromise between full information revelation and no information revelation might be to publicise the quality criteria but not the weights attached to individual attributes. Knowledge of the package of attributes that the conservation agency intends to purchase is necessary to attract the 'right' landholders and give them some guidance to formulate proposals that match the agency's preferences. On the other hand, too detailed knowledge of the criteria and the weights for each attribute may encourage bidders who offer high-quality packages to shade their bids too much above opportunity costs.

Case studies of conservation auctions

We reviewed case studies of conservation auctions covering the USA, Australia, continental Europe and the UK. For each auction, we reviewed the problem addressed, objectives, auction design, auction outcomes, and lessons learned. The schemes reviewed differ in their policy goals, their ways of setting reserve prices and their methods of assessing environmental benefits and ranking bids. These case studies are summarised in the table below and further explained thereafter.

Summary table of case studies reported

(1) Note the importance of (perceived) fairness as a criterion of political acceptability.
(2) EBI = Environmental Benefit Index
(3) TC = Transaction Costs

The Conservation Reserve Program ( USA) has multiple objectives ranging from erosion control through habitat improvement to income support for farmers. Under this program, landholders bid for government funds for retiring their lands from farm production for a period of 10 to 15 years. Current CRP auctions employ an environmental benefit index to compare bids. This index accounts for land quality heterogeneity and weights various environmental objectives according to their relative importance. Currently (2005), approximately 33.5 million acres of farmland are enrolled in the CRP. Each contract covers an average of 74 acres with an average rental rate of $45.95 per acre. From its beginning in 1986, the CRP was conceived as a multiple sign-up scheme. This has allowed landholders to learn where the (implicit) bid cap lies and to gradually adjust their bids to this cap, eroding the cost-effectiveness of the auction.

The BushTender pilots, carried out in 2001-2003 in Victoria, Australia, were designed to test the idea according to which auctions could efficiently purchase public environmental goods from private landholders. The good in question was biodiversity as captured through improved 'bush' ( i.e. native vegetation) management. Expressions of interest were first called for, then government officers visited the farms and the land areas up for tender. Ecological data were collected on these areas and analysed by scientists to devise a Biodiversity Benefits Index ( BBI). Bids were ranked according to the BBI/bid ratio, from highest value per dollar bid down, until the budget constraint was hit. Subsequent analysis of first round results claimed a benefit of 700% of that which would have been obtained through a fixed-price scheme. We question the validity of this figure because of the 'non-standard' way in which it has been computed. Transaction costs for the first round of BushTender, which included on-site research, ecological scoring and auction administration costs, amounted to roughly 50% to 60% of the amount spent in the auction. The involvement of government officers and their dedication to explain to farmers the ins and outs of this new payment system were found to be important for securing sufficient participation and thereby the level of competition necessary for the auction to play its efficiency role.

The Auction for Landscape Recovery ( ALR) aimed at securing multiple benefits from land management improvements in Western Australia, namely biodiversity enhancement, salinity control, and groundwater recharge abatement. Landholders who had expressed interest were encouraged to submit a tender describing their proposed management activities, anticipated environmental outcomes and a bid. The tender process was communicated as rewarding those who deliver the greatest environmental benefit per dollar. Tenders were evaluated using a regional metric of 'biodiversity complementarity' within a systematic conservation planning framework. This metric, unlike the BBI, accounts for synergistic aspects due to number, size and distance of several areas; the BBI focuses on the individual value of each land area. Some interesting outcomes emerge from this experience:

• Cost-effectiveness of the ALR compared to that of a uniform price scheme varies between 315% and 207% in round 1 and 165% and 186% in round 2, depending on whether the fixed price scheme is input-based or output-based.
• There was no evidence to show that the auction imposed higher administrative costs than equivalent schemes using the same amount of information to underpin the selection process. This was because most of these costs were not linked to the specifics of running an auction.
• The building by natural scientists of a comprehensive scoring index for ranking multidimensional auctions is an exercise fraught with pitfalls. Subjectivity cannot be avoided, even if it is buried in the appearance of an objective measure (the scoring index).

EcoTender, carried out in the state of Victoria, Australia, is an offshoot of BushTender and similar in intent to the Western Australian Auction for Landscape Recovery ( ALR), in that it aims to secure multiple environmental benefits, including improvements in salinity control, biodiversity enhancement and water quality. A specific feature of EcoTender is that it uses information from catchment-based modelling to estimate both local and catchment-wide impacts on environmental outcomes as a result of changed land use and management. Bids can be lumped or separate; that is, a landholder can submit a bid for a number of areas or separate bids for each. Pooled bids across several farmers are also allowed. Payments are not only input-based (management actions), but also include an output-based element. This is an ongoing programme for which no results are yet available (2005).

Challenge Funding was introduced into Scottish forestry policy in 1997 - with the launch of the Grampian Challenge Fund and the Central Scotland Challenge Fund. These funds operated under the umbrella of the Woodland Grant Scheme ( WGS) and offered additional grants to the standard WGS grants for extending the woodland area in specific geographical areas. They were competitive in that applicants were required to submit bids to the Forestry Commission ( FC) for this additional money. Both funds were closed for applicants in 2002. Currently only one challenge fund is in operation. This is the Woodlands In and Around Towns ( WIAT) Challenge. A judging panel awarded grants to those applicants whose plans best met the aims of the Challenge and offered the best value for money. The panel selected high-scoring, low-cost bids first. Beyond that they traded off score against cost in a subjective way. The funds were very successful in rapidly expanding the land area under forestry. Subsequent analysis of the data showed that, to secure all the bids with a fixed-rate premium would have required a budget 33% to 36% above that spent under Challenge Funding. Forestry Commission staff reckon that operating the challenge funds took 20 per cent more staff time per application than fixed-rate incentives. A subsequent survey revealed some dissatisfaction with a grant scheme based on tendering. The main comment was that it was 'unfair' in some way. There was a consensus from stakeholders that challenge funds were too uncertain for the applicant and that they should be replaced by locational premia ( i.e. fixed rates per ha).

The focus of the Grassland Conservation Pilot Tender (Germany) was on maintaining low-intensity grazing systems. The conservation agency had initially offered fixed-rate payments. After only very few farmers had signed up, an auction was run to determine the excess payment required to induce broader participation. A bid cap of 53 per cent of the fixed-rate payment was imposed for the first round. All bids below that reserve price were accepted. The reserve price was not known to the bidders before auction. Fewer farmers than expected (15 in each of the three bidding rounds) submitted a bid, implying that the scheme was not effective in encouraging broader participation in agri-environmental management. Subsequent analysis revealed that uncertainty over yield losses and the impacts of the latest CAP reform were key deterrents to participation.

Conservation auction performance

Conservation auctions are still in their infancy and data from the field are scarce. Anecdotal evidence on auction performance is often spurious and intuition unreliable. There are claims that the amount of biodiversity benefits acquired through the first round of BushTender auctions would have cost about seven times as much if a fixed-price scheme had been used instead. A study is in the process of evaluating the Scottish 2001 fishing vessel decommissioning exercise, and preliminary results suggest that the gains from the auction relative to a budget-equivalent fixed price scheme are not nearly as high. These results are more in line with findings reported in Latacz-Lohmann and van der Hamsvoort (1997) who simulated farmers' bidding behaviour in a hypothetical conservation programme. They found efficiency gains ranging from 16 to 29%, depending on how the auction was implemented and how winners were selected. These figures compare to Challenge Fund's 33 to 36%. However, White and Burton (2005) find efficiency gains between 200 and 315% for the Auction of Landscape Recovery ( ALR) pilot in Western Australia. Some care has to be taken in interpreting all these figures: because they are based on different counterfactual fixed-payment rates, they cannot be compared to each other. These variations suggest that it is probably too early to make a robust assessment of the cost-effectiveness of auctions in agri-environmental management. However, there is unanimity in the empirical literature that bidder learning poses a substantial threat to the efficiency of multiple-round conservation auctions. Both experimental studies and agent-based simulation studies have confirmed the experience with the US Conservation Reserve Program: when bidders have the opportunity to learn from preceding bidding rounds, they will use that information to update their bids and reap higher rents - at the detriment of auction performance.

Conclusions for agri-environmental management in Scotland

Given the lack of theoretical backdrop and practical experience, we advise a cautious approach to the use of auctions in conservation contracting. We do not consider competitive bidding to be ideal for allocating Land Management Contracts as a routine policy mechanism - for a number of reasons:

First, there is unlikely to be much variation among landholders in the costs of carrying out the management options. For bidding to be effective, farms must be heterogeneous in their compliance costs. Second, most of the measures are reasonably straightforward to cost. There is thus no need to use an auction as a price discovery mechanism. Third, Land Management Contracts are heterogeneous. Different landholders will include different combinations of management options in their bids. SEERAD would face the challenge of devising a multi-criteria bid scoring system to aggregate the various dimensions of a bid into one figure representing an estimate of the overall (economic, social and environmental) benefit of each bid. While this is not an infeasible task, in practice it is likely to involve high transaction costs and the risk of complaints and appeals from unsuccessful applicants.

Whether competitive bidding is the appropriate mechanism for allocating contracts for the extended Land Management Contracts Scheme (to be launched in 2007) is a matter of debate. This scheme is designed to deliver tailored (rather than widespread) economic, social and environmental benefits. Tailored benefits usually require very specific measures targeted to specific resource settings. To the extent that tailoring involves spatial targeting or the use of strict eligibility criteria, the number of potential applicants may fall below the level required to secure sufficient bidding competition. In such circumstances, an auction is not the appropriate incentive mechanism and fixed-rate payments or individually negotiated grants should be considered instead.

Auctions work best when the number of bidders is high, contracts are homogenous and landholders are heterogeneous in their compliance costs. Of all agri-environmental schemes offered in Scotland, the Organic Farming Scheme is probably the one which best meets these requirements.

To the extent that theory provides insufficient guidance for most conservation applications and empirical evidence on auction performance is inconclusive, we conclude with a recommendation not to implement any full scale auction schemes without first carrying out some experimental investigations, first in the controlled conditions of the laboratory, then as reduced-scale field pilots. This 'test-bedding' of policies allows policy makers and administrators to make at low cost all the serious and potentially expensive mistakes both in the financial and in the political sense. Controlled laboratory experiments thus represent a central stage in the learning process towards successful auction design and implementation.

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