September 29, 2008
Series Editor: Ian Parry
Managing Editor: Felicia Day
Assistant Editors: John Anderson and Adrienne Foerster
Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.
This week’s commentary, by new RFF Fellow Carolyn Kousky, with her colleagues Sam Walsh and Richard Zeckhauser, addresses an innovative proposal to limit the potential damages caused by natural disasters. This involves upfront contingent contracting that would allow the government to seize private property in the event of a disaster (for example, to clear private land of trees to contain a forest fire) in exchange for some agreed amount of compensation. The authors discuss the potential applicability of this type of contracting to a diverse range of disaster situations and how various obstacles to the writing of such contracts might be overcome.
Options Contracts for Contingent Takings: A Tool for Improving Disaster Management
Carolyn Kousky, Sam Walsh, and Richard J. Zeckhauser
|A major flood crest is moving down the Mississippi. Tearing down some agricultural levees and flooding the fields might well save downstream levees protecting billions of dollars of development. Cutting down trees on privately owned land might stop a forest fire from spreading. Killing a rancher’s infected cattle might prevent much wider losses or a public health crisis. First responders to a hurricane could be more effective with access to private buildings to treat injured victims or store supplies, or to private vehicles to reach those in need.|
In crises, the government’s ability to use, impinge upon, or take over private property can dramatically reduce costs. While the government at times forcibly commandeers property even if the owner is unwilling to oblige—when a foot patrolman takes a car to catch a criminal, for example—there are many times when the government leaves private property undisturbed, even when using it would offer substantial social benefits. The reasons why include questions about proper authority or whether the follow-on economic or political costs would be too high.
We propose a new policy tool for situations like this: options contracts for contingent takings. These are contracts between the government and private parties in which the government pays for the right to use and possibly damage property if a low-probability event occurs that would make temporary use of it by the government highly valuable. The individual or firm would be compensated for such use through an upfront payment and an additional payment should the uncertain circumstances arise.
Without such contracts, the government might simply take the property or negotiate with private entities when the disaster occurs. Some might say that having one’s property taken during an emergency is simply a risk one takes when living in an interdependent society. Given the likely political and legal costs, however, many efficient takings will not happen absent contracts. In addition, arguments of risk spreading and equity suggest that compensation is desirable. Contracts for compensation must be negotiated in advance; in emergencies, there is rarely time to bargain and negotiate a contract. And a bargain un-struck is a great loss taken. In addition, in the height of the crisis, there will be those that try to take advantage of the urgency of the situation, whereas lower prices could be arranged if determined in advance.
RFF Fellow Carolyn Kousky’s research interests include natural resource management, land use, decisionmaking under uncertainty, and individual and societal responses to natural disaster risk. She is also interested in ecosystem services policy, and has examined the design of incentive-based mechanisms to supply ecosystem services and local government investments in natural capital.
During a disaster, the spirit of voluntarism is high. Might contracts be superfluous? There will be some Good Samaritans, surely, but there will be others, perhaps ordinary businessmen and women, who pursue their own interests. Some good souls will find that they cannot recover payments for the use of their supplies during the disaster. For example, Wal-Mart generously provided many supplies after Katrina, but compensation became a worry, because establishing purchasing agreements proved almost impossible in the aftermath of the storm.
The contingent contracts we envision are essentially call options. A call option is a contract that gives one party the right, but not the obligation, to purchase a particular asset from another at a particular price, what is labeled the “exercise” price. To obtain this right, the holder pays some amount up front for the option. If the private entity is risk averse, our research shows the optimal payment structure sets the exercise price equal to the loss imposed by the taking. Any surplus (the difference between the cost to the private entity and the benefits to the government) received is paid up front. When the government needs the participation of many entities, a reverse auction can be used to award the contracts to those who would suffer least from a taking. Georgia has put such contracts into practice to compensate farmers for suspending irrigation during a drought.
Moral hazard could be a problem in these contracts if the exercise price is set equal to the loss (determined after the fact) and there are unobservable actions that could be taken to reduce losses. For example, perhaps the farmer could harvest his crop early or relocate equipment. If he knew he would be compensated for any magnitude of loss, however, he might not undertake these actions. Some risk has to be placed on the farmer to induce him to undertake these actions. Another option is to base payments on a measure over which the farmer has no control but that is correlated with his losses. Payments could be based on losses to neighboring farms, thus giving the farmer the incentive to reduce his own losses as much as possible. A final possibility would set an exercise price up front, though that would do less well in reducing the farmer’s risk.
Particularly for contracts related to land use, holdouts are also a potential problem. To flood an area, a cluster of farms may be needed. Individual farmers may hold out to try to extract the largest percentage of the surplus possible. One solution may be mutually contingent contracts, where the government offers a payment above opportunity costs, contingent on all the needed landowners participating. More likely, legislation will be needed to coerce holdouts. Participation might be mandatory once a certain percentage of the needed landowners is reached. This could be a form of a compulsory purchase law, only instead of the government forcing sale of the land, it would force participation in the contract at a fair price. There is U.S. precedent in some states for forcing holdouts to agree in the compulsory unitization rules that force oil companies into the most efficient extraction of a common pool of oil.
Options contracts for contingent takings can be used beyond our focus area of disaster response. For example, sea level rise could threaten public beaches as homeowners armor the shore to protect their personal buildings. James Titus has suggested rolling easements to overcome this problem; options contracts for public purchase of the property when inundated are similar in spirit. In another case, Defenders of Wildlife compensates farmers if a wolf eats their livestock to reduce opposition to reintroduction of the species.
While there are a few salient examples of these arrangements, there are likely many more cases where such contracts could improve social welfare. To test their performance, a pilot project in the area of flood damage reduction could be undertaken, as this is an area where there is already recognition of the merits of such an approach and where the experience of the USDA contracting with farmers might ease implementation. Options contracts for contingent takings may prove as valuable as emergency personnel in reducing the losses from some disasters. The agricultural levee ripped down by prior agreement may save as many lives and dollars as the downstream levee sustained through recent reinforcement.
Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.
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Manale, A. 2000. “Flood and Water Quality Management through Targeted, Temporary Restoration of Landscape Functions: Paying Upland Farmers to Control Runoff.” Journal of Soil and Water Conservation. 55: 285–95.
Titus, J. G. 1998. “Rising Seas, Coastal Erosion, and the Takings Clause: How to Save Wetlands and Beaches Without Hurting Property Owners.” Maryland Law Review. 57:1279-1399.