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1. Introduction
1.1 Background to the study
Agri-environmental policy originated in response to the perceived limitations of conventional agricultural policy and has initially served the dual purpose of supply control and environmental protection. However, as the policy has matured it is increasingly justified in terms of multifunctionality: agri-environment policies promote non-commodity outputs jointly produced with agricultural commodity outputs. Because the non-commodity outputs have public-good characteristics there is market failure and hence the state has a role in promoting agri-environmental outputs. Agri-environmental policy may thus be seen to create 'quasi-markets' in these goods in that government undertakes to purchase these goods from private landholders on behalf of society. The EU Rural Development Regulation grants Member States a large measure of subsidiarity for designing their own schemes, matching them to local conditions and advancing regional priorities. This discretion has resulted in a wide variety of measures with a range of objectives and management prescriptions, implemented at different geographical scales - from local to national.
The Forward Strategy for Scottish Agriculture stresses the multifunctional role of Scottish agriculture. The Strategy states that "future support to farming must be designed in a way which rewards the mix of benefits required by the Scottish public and does not mask market signals" ( http://www.scotland.gov.uk/library3/agri/fssa-02.asp). The Custodian of Change Report reinforces this view, stating that "Agriculture and the environment are inextricably linked: the agricultural industry has the potential, responsibility and opportunity to bring increased environmental and agricultural benefits to the countryside" ( http://www.scotland.gov.uk/library5/agri/aewg-00.asp).
The importance of agriculture to the environment is recognised by the introduction of agri-environmental schemes. Spatially targeted schemes in Scotland include the SSSIs and ESAs. Other environmental schemes such as the Rural Stewardship Scheme, the Farm Woodland Premium Scheme and the Organic Aid Scheme operate throughout Scotland. Overall more than 1.2 million hectares of land in Scotland are enrolled in agri-environmental schemes. Expenditure on agri-environmental programmes was about _33 million in 2003 whilst the expenditure of Scottish Natural Heritage on land management agreements promoting biodiversity and access to private land amounted to _14 million. The budget for agri-environmental and rural development measures is set to increase through 'modulation': 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. The main obstacle to designing and implementing more targeted policies is limited information on the side of policy makers and regulators. Information asymmetries between landholders and environmental agencies can give rise to a range of incentive problems limiting the effectiveness of the schemes and making them expensive to run. This information asymmetry implies that first-best programmes are often not possible. For example, farmers cannot be offered an incentive payment equal to their individual compliance costs because the conservation agency lacks the relevant information. Second-best programmes can be obtained by applying mechanism design theory under asymmetric information. Competitive bidding has been proposed as one such mechanism. In a conservation auction, 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. The expectation thus is that competitive bidding will increase the cost-effectiveness of agri-environmental spending.
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. Governments in Australia and elsewhere increasingly recognise the potential of auctions as a policy tool for allocating public resources. Designing auctions that work well in the field, however, can pose significant challenges. The literature on auction design is littered with examples of failure and highlights the need for auctions to be tailored to the specific characteristics of different situations. 1 Noteworthy examples include the New Zealand and the Dutch auctions for broadband spectrums (McMillan, 1994). Klemperer (2002; 2004) and Rothkopf and Harstad (1994) review the practical implementation problems of auctions and highlight the gap between theory and practice. Success of conservation auctions depends on having a thorough understanding of bidding behaviour and paying close attention to design details. Auction theory provides a framework for developing practical design guidelines.
While auctions can address the problem of overcompensation, they do not overcome the problem of moral hazard. The basis of the moral hazard problem is imperfect information about farmers' actual compliance. Imperfect compliance monitoring provides farmers with an incentive to renege on their contracts. The problem is exacerbated by lack of information about environmental outcomes and the relationship between farmers' actions and such outcomes. A number of approaches to combating moral hazard have been proposed in the contract design literature, but hardly any of these are well enough adapted to the complex regulatory process of agri-environmental contracting as to be of practical use for policy administrators.
1.2 Objectives
The overarching objective of this study is 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. However, it is not easily accessible. Much of the literature is presented in a technical way. As a result, many results remain obscure to outsiders. This report is intended as a primer on auction and contract design in the field of environmental policy, aiming to fill the knowledge gap between researchers in the field and officials who consider using auction and contract theory to enhance the performance of agri-environmental policy.
The specific objectives of this research are to:
- consider the rationale and relevance of auctions to agri-environmental and nature conservation policy, including a discussion of the pros and cons of conservation auctions in different contexts and circumstances;
- review the main types of auction that could be used to allocate conservation contracts and discuss the key features to be considered in the design of conservation auctions and of agri-environmental contracts in general;
- assess the information requirements relating to the specification and measurement of nature conservation/biodiversity outputs, including a review of different bid ranking mechanisms;
- examine monitoring and measurement problems, including a discussion of contract enforcement issues and whether contracts should be based on actions (inputs) or results (outputs);
- review case studies of auctions in the practice of conservation contracting covering UK, EU and Australian examples.
The report aims to provide SEERAD with conclusions as to whether or not, under current knowledge, an auction system could be used in Scotland and, if not, what further research would be useful.
1.3. Methodology
The methodology for the study comprises the following elements:
(a) A comprehensive review of the literature on conservation contract design in the presence of information asymmetry and of the use of auctions in agri-environmental policy and natural resource management. This review covers both theoretical and empirical/practical aspects of contract and auction design. At a more general level, we demonstrate how asymmetric information can give rise to different types of incentive problems in agri-environmental contracting. We then review approaches designed to alleviate these problems. We finally home in on conservation auctions and provide an in-depth discussion of the design and running of auctions, including ways of ranking bids. We also review results from empirical and experimental studies into the performance of conservation auctions to provide SEERAD with some indication of the potential cost savings from using auctions.
(b) A combined postal/telephone survey of conservation agencies that use auctions to allocate conservation contracts. The purpose of the survey is to gauge experiences gained and lessons learned, to identify solutions to limitations and practical difficulties experienced in the running of conservation auctions, and to gauge opinions on ways of increasing the performance of auctions.
1.4. Outline of the report
The report is organised into six further sections.
Section 2 provides an economic critique of conservation contracting. We demonstrate how different types of information asymmetry can give rise to different types of incentive problems, and how this incentive incompatibility can undermine the effectiveness of agri-environmental contracts.
Section 3 is a review of the literature on agri-environmental contract design under asymmetric information. We review policy approaches designed to alleviate both moral hazard ( i.e. the problem of farmers compromising their contractual obligations) and adverse selection ( i.e. the problem of overcompensation and targeting the 'wrong' farmers). We assess the rationale for using auctions to allocate conservation contracts and demonstrate that auctions are but one approach to dealing with adverse selection. Section 4 looks at conservation auction design - that is, how this trading mechanism can be designed in such a way that it achieves specific outcomes. Section 5 reviews case studies of conservation auctions covering the USA, Australia, continental Europe and the UK. For each auction, we review the problem addressed, auction design, auction outcomes and lessons learned. Section 6 summarises the results of empirical studies into the performance of conservation auctions vis-à-vis alternative contract allocation mechanisms. Section 7 summarises the main findings of the report with a view of providing an overall assessment of auctions as a contract allocation mechanism. The report concludes with a critical discussion as to whether or not, under current knowledge, conservation auctions should be used to select landholders for conservation schemes in Scotland.
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