Enforcement-proof contracts with moral hazard in precaution: ensuring ‘permanence’ in carbon sequestration

Abstract

Opportunistic behaviour due to imperfect contract enforcement is a risk in many economic transactions. In this paper, an enforcement-proof incentive contract is developed in which a buyer demands a guaranteed delivery of a good or service given a productive upfront payment, moral hazard in precaution, and the potential for opportunistic contract breach. Investing in a contract upfront is found to be restricted by moral hazard and opportunistic contract breach. This limits the size of investment up to a specific level even if an infinite scale-up of production were beneficial. A more severe moral hazard problem results in a smaller distortion. The framework is applied and extended to international carbon sequestration contracts. In comparison to alternative liability attributions, the current regime of buyer liability yields inefficiently low levels of investment in carbon sequestration.

Reference

MacKenzie, I. A., Ohndorf, M., and Palmer, C. December 2011 (published online). Enforcement-proof contracts with moral hazard in precaution: ensuring ‘permanence’ in carbon sequestration. Oxford Economic Papers.