Contracting in the Biofuel Sector

To accommodate rapid technological change in agriculture, contract farming has emerged as a market response to manage and share risks along the supply chain. Contract farming strengthens vertical coordination for producers and processors motivated by desire to decrease randomness, overcome credit and risk constraints, assure production targets, and address environmental considerations. Using contract theory perspective, this paper shows why multiple contract forms exist to address different types of risk, market size and maturity, and other constraints. Our findings suggest that, in the case of biofuels, contract design depends on land quality, output prices and markets, farmers’ risk preference, and other constraints. In establishing a refinery, the decision-maker must determine the size of refinery, quantity of in-house feedstock production, and strategy for purchasing additional feedstock. When facility capacity exceeds in-house production, the processor needs to rely on external feedstock. Processors and producers with higher land quality are shown to benefit from vertical integration, while lower land quality should result in conversion to biofuel production due to lower opportunity cost. As second generation feedstock production grows and matures, policies must consider contract design, technology adoption, and vertical integration.