Esuola, Adeyemi (University of Guelph, 38-252 Stone Road West, Guelph, ON, N1G 2V7, Canada; Phone: 519- 824 4120 ext 53625; Fax: 519-767-1510; Email: aesuola@uoguelph.ca)

Economic Analysis of Efficient Risk Allocation in Contracts to Sequester Carbon in Agriculture and Forestry

A. Esuola *

Carbon that has been sequestered either in the soil or forest is reversible. The reversibility could be due to a course of action taken by the seller of the carbon or could be due to a natural hazard like a fire or pest outbreak. When the sequestered carbon is released the question that needs to be asked is, who is responsible for the loss of the carbon? Maybe if the loss of the carbon is deliberate, one could argue that the seller of the carbon should be liable for the loss. What about when the loss is due to natural causes. Who should be held responsible?

Contracts are now being negotiated between farmers or foresters and large GHG emitters that establish the conditions under which carbon is to be sequestered by the farmer or forester. The conditions include the price of carbon, the contract length, and liability period for temporary or permanent credits. Unresolved issues in the implementation of the Canadian offset system include the length of a permanent credit and what happens when a permanent credit is reversed. With a temporary credit, there are questions surrounding how long maintenance can generate credits and what happens if a large emitter defaults on replacing a temporary credit with a permanent credit. One of the more difficult conditions to be negotiated is the means by which risk associated with the release of stored carbon from a random act of nature or a deliberate act by the seller of carbon should be allocated. The different options that have been advocated in allocating this risk of carbon release include seller liability, buyer liability or shared seller-buyer liability. The applicability of any of these will depend on the compliance and enforcement environment. A seller (buyer) liability may be applicable in a strong (weak) compliance and enforcement environment. Other options of risk allocation include a rental approach or carbon banking.

The purpose of this paper is to examine the optimal allocation of risk in a contract designed to sequester carbon. The focus is on the risk of both intentional and unintentional release of stored carbon. The paper begins by reviewing how an efficient contract allocates risk theoretically. Alternative means of allocating risk between the buyer and seller of a carbon contract are then outlined followed by a discussion of the advantages and disadvantages of the approaches. The paper concludes with policy implications.