© ADAS 2014 i

Review of Mechanisms for Agri-Environment

Schemes

Reference No: LM0105

Issued by: ADAS

Date: 31 August 2015

Annex 1

ii

1 Contents

1 Mechanisms for Agri-Environment Schemes ......................................................................... 1

1.1 Learning from Environmental Stewardship ............................................................................ 1

2 Mechanism Design Options .................................................................................................. 4

2.1 Award Mechanism Options ..................................................................................................... 4

2.2 Payment Mechanism Options ................................................................................................. 6

3 Auction Mechanism Options .............................................................................................. 12

3.1 Landscape Coordination Options .......................................................................................... 17

3.2 Private Finance Options ........................................................................................................ 17

References ................................................................................................................................. 20

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1 Mechanisms for Agri-Environment Schemes

The central purpose of this project is to research mechanisms to improve the value for money from

the new environmental land management scheme (Countryside Stewardship) in England. These

mechanisms include the use of reverse auctions to improve efficiency and opportunities to leverage

additional funding under a Payments for Ecosystem Services (PES) framework. Efficiency in this

context is defined as realising greater environmental improvements per pound of expenditure.

Our focus is not on the sorts of management activities that farmers might be asked to adopt under

agri-environment schemes, but rather on the economic mechanism by which farmers are

incentivised to participate in the scheme. In essence, that mechanism helps determine how farmers

are selected into the scheme and how much each gets paid for the activities that they commit to

undertake. There are very many possible mechanism designs, each presenting farmers with different

incentives and each resulting in potentially very different outcomes. This research seeks to scope,

review and test the most promising options and make recommendations for piloting auctions in

Countryside Stewardship.

1.1 Learning from Environmental Stewardship

We first review the mechanisms used in Environmental Stewardship (ES) (the precursor agri-

environment scheme in England) through which agri-environment agreements in England are

currently delivered. It aims to protect and improve the environment, the landscape and its features,

natural resources, the soil and genetic diversity. There are important differences between the

mechanisms employed in the Entry Level Stewardship (ELS) and Higher Level Stewardship (HLS)

elements of the ES scheme.

ELS is a “broad and shallow” scheme open to all farmers. It is designed to be available to all

and straightforward to apply for. Farmers are presented a menu of options detailing

different management activities. Each option carries a different fixed point score and to

qualify for ELS funding a farmer must choose options that total up to a quantity at least

equal to 30 points per hectare of their farm (or more precisely, their eligible land). Any

farmer entering an application that meets that requirement is entitled to an agreement that

offers them a flat-rate payment of £30 per hectare per year over 5 years.

HLS is a targeted and competitive scheme. Only farmers in particular areas of the country or

with high priority features on their land are invited to enter applications. Like ELS, farmers

entering applications in HLS are presented with a menu of options. Unlike ELS, however, a

successful applicant’s payment depends on the number and type of options a farmer agrees

to adopt. Applications to HLS are not accepted automatically but are assessed competitively

with respect to the potential for delivering environmental benefits, particularly with regards

to the priority targets for their area. The process for assessment of competing bids is not

well described or transparent to applicant.

While somewhat similar, there are some significant differences in how these two elements of ES

operate. Consider first ELS in which any farmer willing to commit to a bundle of options that equate

to at least 30 points per hectare across the eligible area (individual options attract different points

scores) is entitled to a flat rate payment of £30 per hectare. Given this threshold, it is unlikely that a

farmer would choose to undertake substantially more options than those required to meet the

qualifying target; since the payment is a flat-rate, they would not receive any extra reward for taking

on those options. Likewise, farmers who are only prepared to take on options equating to less than

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the qualifying points total will not enter the scheme at all. In contrast, under HLS farmers are not

paid a flat rate per hectare, rather payments are determined by the options agreed with Natural

England. Under this mechanism farmers are incentivised to select at least those options for which

payment exceeds the costs of implementation. The limiting factor in this case is the balance of

options which deliver policy priorities in that locality and that fit within the wider scheme budget

(delivering on other priorities through agreements elsewhere).

A second key difference between the ELS and HLS schemes concerns the use of competitive

allocation in the latter. Unlike ELS where farmers will aim to select options that take them to the

qualifying level of points, in HLS competitive pressures might lead a farmer to select an option that

pays less than the costs of implementation within an overall agreement that is deemed economically

attractive. In particular, if payments for other chosen options are sufficiently generous, then a

farmer might choose to take on a loss-making option if inclusion of that option improved the

chances of their application being accepted in the competition.

Finally, the eligibility criteria for HLS limits applications to those in priority locations. Unlike ELS, the

HLS scheme applies a screening mechanism, that is to say it makes use of information concerning

applicants in order to discriminate between farmers. In this case, screening is used to target HLS

funding at farmers in priority locations.

In addition to these differences, the mechanisms applied in HLS and ELS also suffer from a number of

common mechanism ‘ailments’.

First, in the ELS scheme a farmer pondering which options to choose in order to reach the 30 points

per hectare qualifying bar, will tend to select those that they can implement at least cost. In many

cases, that entails choosing options that are either already observed or require little change in

management to achieve. As a result, the ELS mechanism risks directing funding to agreements that

focus on maintaining what is already there and offer relatively little environmental improvement.

This is the problem of adverse selection. While in HLS, faced with a flat-rate payment for options,

farmers will preferentially want to choose those options that are less costly to implement, the more

hands-on role of Natural England means that there is a negotiation in achieving better

environmental outcomes.

Second, in both schemes, farmers receive payments for adopting management practices which aim

to deliver environmental improvements. Anything a farmer can do to reduce the cost of

implementing those management practices will improve their net earnings from the scheme.

Third, from the point of view of using RDPE funds efficiently, both mechanisms exhibit some flaws.

Over-Payment: The payment mechanism used in both ELS and HLS do not differentiate

between low-cost and high-cost providers for individual options: all farmers receive identical

payments independent of their costs. A mechanism that tailored payments to better reflect

farmers’ individual costs would, of course, likely result in efficiency gains. The key problem in

designing such a mechanism is that information on costs is asymmetric; farmers know their

individual costs, but that information is not readily available to the public agency.

Environmental Targeting: The level of environmental benefits derived from any particular

agreement will also differ across farmers. Compared to a flat-rate payment open to all

farmers, therefore, a mechanism that directed funding to farmers able to deliver relatively

higher levels of environmental benefits could also result in efficiency gains. The eligibility

requirements for HLS funding are a simple example of such a mechanism. Of course,

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asymmetries may also exist with regards to information about the potential for delivering

environmental benefits.

Landscape-Level Synergies: Environmental benefits may be contingent in complex ways on

the set of options (perhaps undertaken by different farmers) chosen for funding across a

landscape. For example, actions may complement each other making the environmental

benefits of the two actions greater than when each is undertaken alone (e.g. the biodiversity

benefits of habitat creation may increase the more projects creating habitats are funded in a

particular area). Alternatively, actions may substitute for each other in such a way that

funding a second action offers little gain over funding the first alone (e.g. actions to reduce

nutrient application may offer little additional water quality benefits if actions to create

buffer strips along rivers are also funded). The HLS mechanism makes some attempt to deal

with these landscape issues by favouring applications with priority options for a region.

Dynamic Incentives: Payments that are made simply for undertaking management activities

fail to incentivise land owners to deliver on environmental outcomes. Mechanisms that

reward delivery of environmental outcomes will likely deliver efficiencies through

encouraging farmers to undertake prescribed actions in an environmentally optimal way

while encouraging additional effort and innovation in delivering environmental outcomes

(Ferraro, 2008). However, any efficiency gains could be offset by increased monitoring and

evaluation costs.

Leveraging Private Finance: As well as benefiting the general public, agri-environment

schemes may fund actions that deliver benefits that are of direct or potential benefit to

specific groups or organisations. For example, improvements in water quality may directly

benefit water companies by reducing their treatment costs. Likewise, changes in land

management may result in carbon sequestration that could potentially benefit an

organisation looking to offset its own emissions. For the purposes of this report we shall

describe this diverse set of groups and organisations as private agencies. Efficiencies could

be realised for government, if those private agencies were prepared to contribute to

payments made through the scheme. ELS and HLS do not offer a mechanism through which

private agents can make such contributions. A crucial issue in designing mechanisms that

encourage such contributions is over-coming incentives to free ride. Why would private

agencies choose to contribute if they believe that the government will pay for the actions

they desire without their intervention?

Many of these shortcomings of the existing mechanism are well recognised1 and research has

recently been undertaken to consider potential improvements. For example, Defra (2012)

considered restricting the option choice of farmers in order to direct them towards those with

higher environmental value. Indeed the move to Countryside Stewardship is an explicit recognition

of the need to get more from a limited budget in the context of increasing environmental pressures.

1 The Mid Term Evaluation of the RDPE (ec.europa.eu/agriculture/rurdev/countries/uk/mte-rep-uk-

england_en.pdf) highlighted the successful mainstreaming of agri-environment schemes but also the need to

selectively reduce deadweight where it is most evident, most notably in ELS.

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2 Mechanism Design Options

Within context of Countryside Stewardship, it is necessary to consider the range of options available

for mechanisms design. The mechanism will determine who is awarded agreements through the

scheme (the award mechanism) and how much they are paid for implementing offered activities

(the payment mechanism). In this section we consider the award mechanism and the payment

mechanism in the context of Countryside Stewardship. We then look at more detail at specific

issues regarding auction design and how the mechanism might be adapted to take advantage of

synergies at the landscape level and to leverage finance from the public sector.

Box 1 sets out some outline characteristics of Countryside Stewardship insofar as they are available

Box 1: New Environmental Land Management Scheme (Countryside Stewardship)

The new scheme will have three elements:

Priority site agreements): These will be similar to the current HLS. Most applications are expected to

come from expiring HLS beneficiaries. A national menu of revenue and capital options would be

available.

Priority area agreements: Simpler, less demanding changes than those in the Upper Tier, targeted to

areas of the country having the greatest potential to address priority environmental outcomes. The

application process will be self-service online and those received in each round will be scored against

each other to get best value for money. Capital items may or may not be included

Universal small-scale capital grants: Available countrywide with simple on-line guidance. Might

include hedgerow restoration/gapping up, hedgerow trees, bat boxes and woodland management

plans.

There will be specific woodland options within Countryside Stewardship. These may include:

Woodland Planning Grant to help prepare Woodland Management Plans; Woodland Creation to

increase woodland cover; Woodland Improvement could fund, for example, fencing to protect

regeneration of native woodlands; Woodland Regeneration to restock woodlands following plant

health issues; Woodland Infrastructure to improve access. Payment rates for many of the options

are expected to change, reflecting changes in typical costs of implementation. Payments are based

on ‘Income foregone’, which is discussed in more detail in 2.2.

2.1 Award Mechanism Options

Perhaps the most basic decision that must be made in designing the mechanism for an agri-

environment scheme concerns how farmers are selected for funding. In essence, there exist three

different approaches to the selection process; those based on posted prices, those based on

competitive bidding and those based on individual negotiation.

Posted Prices

An allocation process based on posted prices awards agreements to all farmers that are willing to

sign-up for an option at the stipulated payment. That payment may be a flat rate or might be

calculated in some more complex manner. Importantly, however, the payment is set by the public

agency and a farmer’s choice reduces to accepting or rejecting the option at that price.

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In circumstances where the costs and benefits that farmers experience in implementing an option

are similar across farmers, then allocation through a posted price may be the best approach. The

method is straightforward and, provided sufficient information is available to the government, the

posted price can be set at a level that attracts applications but also delivers on efficiency.

Of course when the costs and benefits of an option differ greatly between farmers, a posted price

allocation mechanism may result in adverse selection and is therefore unlikely to maximise net

benefits. Our previous discussion suggested that this was likely to be a problem with ELS. However, it

may be possible to create more sophisticated pricing structures that mitigate such problems.

Competitive Bidding

One obvious way in which the inefficiencies that may accompany the use of posted prices might be

overcome is by awarding agreements through a process of competitive bidding. Mechanisms that

exploit competitive bidding are usually described as auctions. Auctions have been extensively

studied in the economics literature (Klemperer, 1999), research that provides both theoretical and

empirical insights as to how they perform under different circumstances.

In general, the purpose of using an auction mechanism to allocate agri-environment agreements

would be to create competitive pressures that encourage farmers to bid down their requests for

payments under the scheme to reflect actual cost of delivery (to allow more or higher value

agreements to be accommodated within a given budget). Accordingly, the key determinant of

whether an auction will be successful will be the degree to which it manages to generate

competitive pressures. In order to ensure the elicitation of competitive bids in an auction, at least

four major issues must be addressed;

Constraint: An auction must place bidders in a situation in which asking for too high a

payment in the scheme reduces the chances of being awarded an agreement. Accordingly,

an auction must place a meaningful constraint on the quantity of agreements that will be

approved through the mechanism. Those constraints might come in the form, for example,

of a meaningfully constrained budget cap or a meaningfully limited number of awards.

Participation: In a similar vein, in order to establish competitive pressures, an auction must

ensure that there are sufficient bidders applying for funding through the scheme. More

applications mean more bids chasing a constrained quantity of possible awards.

Collusion: Auctions must guard against the possibility of participants explicitly or tacitly

colluding when formulating their bids. In the context of an auction for agri-environment

agreements that collusion would take the form of farmers agreeing (again explicitly or

tacitly) not to bid down their requested payments.

Renegotiation: Auctions will only generate meaningfully competitive bids if those bids

cannot be renegotiated after the auction. If bidders can make ex post alterations in the

agreement perhaps by increasing their payment or reducing their commitments, then little is

gained by allocating agreements through a competitive process.

Provided auctions can generate competitive pressures, then they are likely to increase the efficiency

of allocation compared to posted prices particularly in circumstances where there are large variation

in the costs of delivering options across farmers.

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Negotiation

A final mechanism through which agreements could be allocated is through negotiation. In this case,

the terms of an agri-environment agreement would be decided through a process of negotiation

between the government and an individual farmer. The agreement reached through that process of

negotiation would outline the specific commitments of the farmer and the payment that would

receive. Again competition may be important in the negotiating process. In particular, the

government will be in a stronger negotiating position if there are other farmers with whom they

could strike alternative agreements. If that is so then the government has the credible threat of

pulling out of a particular negotiation unless a farmer is prepared to compromise on their level of

commitments and/or payment.

In general, negotiating agreements may be a preferred allocation strategy when the government has

good information as to which farmers it wishes to engage in the agri-environment scheme. In

contrast, when that information is not available an auction mechanism may work better insofar as it

opens up participation to all farmers to bid for funding and allows the government to simultaneously

compare those bids across all applicants. Of course, it may be possible to combine elements of

competitive bidding and negotiation through a two round process. In the first round, a competitive

process is used to screen farmers’ applications while in the second round the details of the

agreement are decided upon through individual negotiation (not dissimilar from HLS).

Likewise, if the activities that the government wants the farmer to implement are precisely defined

and do not differ substantially across different contexts, then an auction mechanism is likely to have

advantages (Bajari et al., 2002). In contrast, negotiation may be the only way to progress for

complex activities that need consideration of each individual farmer’s situation.

2.2 Payment Mechanism Options

The second major consideration in mechanism design concerns the basic structure of the contract

made between a farmer and government. Not only will that contract detail the activities that the

farmer has agreed to implement but it will also stipulate the way in which the farmer will receive

payments for those efforts. As already discussed, the level of those payments may be established

through a posted price or through a process of bidding or negotiation. Payment for management

options must adhere to the requirements of European funding protocols, notably on how payment

rates are set and administered. Box 2 describes the requirements that the estimated payments must

meet.

Box 2: Requirements for income foregone calculations

The criteria for the calculations, methodology and costings used in determining standard rates of

payment for management prescriptions in the Environmental Stewardship Scheme are set out in

Article 53 of the Commission Regulation for implementing Council Regulation EC (1974/2006) of 15th

December 20062. The criteria are:

The budgets contain ‘only elements that are verifiable’ to the extent that this is possible and in

the context of conditions at the time that projections were drawn up.

They are ‘based on figures established by appropriate expertise’.

They should ‘indicate clearly the source of the figures’.

2 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2006:368:0015:0073:EN:PDF

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They are ‘differentiated to take into account regional or local conditions and actual land use as

appropriate’. The MESME prescriptions are intended for use throughout the English region.

They must ‘not contain elements linked to fixed investment costs’

These criteria were recently confirmed to have been met for the updated base data to be used in

determining “costs of participation” and in verifying the calculation methodology and costings used

for determining payments for Making Environmental Stewardship More Effective additions (Defra

2011a and Defra 2011b).

Rather than the overall level of payment, the issue we address in this section concerns the

conditions in the contract that define how payment is calculated and when payments are made.

Fundamentally, contracts determine the incentive properties of the agreement: that is to say, in

stipulating how the farmer gets paid, a contract determines what a farmer is, and is not, motivated

to do. For example, the government’s objective is to achieve environmental improvements. If the

contract stipulates that payments are paid simply for undertaking defined management activities

then farmers are incentivised simply to undertake those activities in a way that imposes the least

cost on their business. They will have little incentive to perform those activities (or potentially

additional activities) in such a way as to ensure they deliver the greatest environmental

improvement.

In addition, in situations characterised by uncertain futures, contracts play a crucial role in allocating

risk across the contracting parties. In agri-environment schemes a number of such uncertainties may

be important;

Implementation costs: Farmers may have some uncertainty over how much it will cost them

to implement some particular set of management activities until they attempt to put those

into place.

Economic conditions: Economic conditions may change over the course of an agreement. For

example, the prices of agricultural output could go up or down. In that case, farmers face

uncertain costs in making decisions regarding activities that take land out of production.

Conversely, fixed price term contracts can protect against uncertain economic conditions.

Environmental conditions: The government’s objective is to achieve environmental

improvements, but delivering such improvements is not entirely within the gift of a farmer.

Environmental quality might be subject to natural fluctuation or change as a result of the

actions of other economic agents. If a farmer’s payment is related to levels of environmental

improvement, then in deciding whether to participate in an agri-environment scheme they

face uncertainty as to what they will be paid.

Again there is a vast literature on contract design (Laffont and Mortimart, 2002; Bolton and

Dewatripont, 2005). For our purposes, the key insights provided by that literature are that the

contract should be written so as to best align farmers’ incentives with those of the government

though that task is made complicated by information asymmetries (e.g. for example, the

government may find it hard to monitor the actual activities of a farmer while also having difficulties

measuring how those activities contribute to environmental improvements). In addition, the

contract should seek to share risks (e.g. future commodity price fluctuations) across the parties in a

manner that reflects differences in their preferences for risk. In the context of agri-environment

schemes, individual farmers are likely to be considerably more risk averse than the public agency.

Accordingly, it tends to make sense for the public agency to shoulder the lion’s share of the risk.

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Putting too much risk on farmers may simply dissuade them from participating in agri-environment

schemes. That does not mean that farmers should be completely sheltered from risk. For example, a

contract could completely shelter farmers from larger than expected costs in implementing activities

by promising to directly pay those implementation costs as the project unfolds (presumably upon

receipt of proof of purchase documentation from the farmer). However, this may reduce a farmer’s

incentive to find the cheapest way to implement activities.

Here we review some of the key elements of contract design reflecting particularly on how choices

might contribute to agreements that encourage dynamic efficiency and deal with issues arising from

the potential for moral hazard.

Payment by Activities

A fundamental decision in designing an agri-environment mechanism is to define the item or items

that the government is seeking to purchase from farmers. In current schemes farmers are paid for

implementing combinations of activities chosen from a menu of ES options. An alternative would be

to more closely align farmers’ incentives with those of the government by making their payments

depend on environmental outcomes. We refer to these as payment-by-activities and payment-by-

results designs respectively. Exploring this is agreed to be outside the scope of this work.

Fixed Price Contracts

The simplest payment-by-activities design is one in which the government offers a fixed price

contract. In a fixed price contract farmers agree to perform a specified set of activities over a

particular period of time in return for a fixed payment. In most respects, this is the form of contract

offered by current environmental stewardship schemes.

Fixed price contracts have the benefit of imposing the smallest administrative burden on both

parties. They also give farmers the greatest incentive to control their costs of implementation.

Unfortunately, as we have already established, fixed price contracts are liable to result in adverse

selection and may be an inefficient use of public funds if those that choose to take up such contracts

are very low cost providers being paid well in excess of their costs. In addition, there is no guarantee

that farmers selecting to take up such contracts will be those that can deliver the greatest

environmental improvements.

Non-Linear Pricing

One approach to reducing levels of overpayment when the costs of implementing activities differ

across farmers is to adopt a system of non-linear prices. In the context of agri-environment schemes,

those prices are quoted on a unit of activity; for example, the payment per hectare of buffer strips or

the payment per metre of hedgerow. With non-linear pricing, that payment per unit is decreased as

a farmer commits to larger and larger quantities of the activity.

The logic behind non-linear pricing is as follows. At a fixed price, farmers with relatively low costs will

tend to choose larger quantities of an activity. In essence, farmers reveal information on their costs

through their choice of quantity of activity. By dropping the price paid per unit for higher levels of

activity, the government is attempting to discriminate between farmers. In effect, those with low

costs are offered a relatively lower per unit payment such that the government secures more of the

surplus from the exchange.

Price Discrimination

Another form of payments by activities is price discrimination. This could help improve the efficiency

of agri-environment schemes where the prices offered to farmers differed across locations and

across observable features of farms. Clearly the purpose of offering different prices across locations

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would be to encourage uptake in locations in which activities are likely to deliver substantial

environmental benefits. Likewise, offering different prices across different farm types would seek to

tailor payments more closely to the expected costs of different farmers. As such this approach

requires good information of the distribution of costs among farmers. This is challenging in view of

the heterogeneity of returns among farmers across and within agro-climatic regions, reflecting both

farming systems and management capability as well as constraints such as soil type, topography etc.

Payment by Results

In an ideal world, the government would be able to reward farmers according to the degree to

which their activities deliver environmental improvements. Payments based on measures of those

environmental improvements would provide the ideal incentive for farmers to deliver on the

government’s objective. There are, however, several substantial difficulties with implementing

payment-by-outcome designs in agri-environment schemes;

First, measuring changes in environmental outcomes may be technically difficult and a

potentially costly undertaking. As a result, it may be difficult to identify a suitable metric of

environmental outcomes upon which payments can be based. Moreover, adopting easier to

monitor yet inaccurate measures of environmental outcomes might incentivise farmers to

undertake inappropriate activities that nonetheless increase their payments.

Second, isolating the independent impact of one farmer’s activities on environmental

outcomes may be an impossible task. For example, levels of biodiversity or water quality will

depend on activities across a much wider landscape. Accordingly, it may be impossible to

tailor an individual farmer’s payment to the contribution they have made to improving

environmental quality.

Third, environmental outcomes are determined by numerous factors outside the control of

farmers; for example, patterns of weather or outbreaks of disease in plants and animals. It

follows, that payments based on outcomes may exhibit variation completely independent of

a farmer’s efforts to deliver environmental quality. Farmers may be unwilling to accept such

risks and would likely demand high payments from the government in order to take on such

contracts (a so-called risk premium). One possible compromise would be to share that risk

across the farmer and government. In such a design farmers would receive a payment for

their actions as well as an additional element that would be determined by environmental

outcomes.

The review carried out by Schwarz et al. (2008) concluded that for these reasons, a full scale

implementation of payment-by-results designs in agri-environment schemes was unlikely to be an

immediate reality.

A payments-for-results mechanism based on individual farmer performance is currently not a

consideration under Countryside Stewardship. Subsequently, we discuss how performance related

payments may play a role at the landscape level and possibly also in encouraging private finance into

agri-environment schemes.

Sharing Cost Risks

Even contracts with activity-based payments expose farmers to some risk, particularly with regard to

uncertainties in the costs of performing those activities. Those cost uncertainties may arise as a

result of unforeseen difficulties or expenditures in performing those activities. Alternatively they

might arise from changes in economic conditions, perhaps most importantly resulting from changes

in the price of agricultural output.

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Such issues are prominent in various other areas of government procurement, for example, in

contracting large construction projects. In that arena, it is relatively common to adopt what are

termed cost-plus contracts and/or economic adjustment contracts that seek to share the risks of

those uncertainties between the government and the contractor. Since contractors are assumed to

be averse to risk, the benefit of such risk-sharing contracts is that contractors will not demand as

great a risk premium in their payments. Indeed, that saving should, on average, be greater than the

expenditure that the government might incur in covering some or all of cost risks. However, costs

associated with implementing agri-environment options are much more modest and likely to be

known to some degree to the farmer.

Cost-Plus Contracts

The simplest form of cost-plus contract would promise to pay farmers a fixed fee while fully

reimbursing costs incurred in performing activities under an agri-environment agreement. Variants

on that theme would seek only to share costs with farmers, thereby incentivising financial prudence

in undertaking contracted activities. Given the large number of farmers participating in agri-

environment schemes, however, the monitoring and verification of costs associated with

administering cost-plus contracts are likely to dwarf any potential benefits from the sharing of risk.

Economic Adjustment Contract

Simpler to implement would be an economic adjustment contract in which payments to farmers for

activities that took land out of production could be made conditional on prices of agricultural

output, rising when those prices go up and falling when those prices go down. Again price

discrimination may be necessary to ensure that adjustments in prices reflect changes in the prices of

agricultural output pertinent to particular farms.

Cost-plus contracts are unlikely to be a viable payment mechanism for agri-environment schemes,

due to the need for public payments to be maintained within budgetary limits. Similarly, fixed prices

offer protection for farmers against falling markets and/or increasing costs of production.

Payments Linked to Verification and Contract Renewal

In the absence of a payments-by-results contract, moral hazard is a potential issue in agri-

environment schemes whereby contracted farmers fail to fully comply with their commitments

under the scheme. In current schemes representatives of the Rural Payments Agency (RPA) inspect

a percentage of farmers each year to assess compliance. The scheme allows farmers payments to be

suspended or discontinued if they are found to be in breach.

As well as withholding payments, two other incentive mechanisms could address the problem of

moral hazard. First, an alternative to threatening to withhold payments in the event of partial

compliance is to offer a bonus payment on completion of the agreement for full compliance with the

scheme’s requirements. Second, farmers found to be in breach of their agreements could lose their

right to apply for agri-environment funding for some specified period. The ELS Handbook describes

the penalties applied that are based upon the difference between target points claimed and target

points found. It shows that when the points difference between target and actual is more than 3%,

the corresponding penalty is more than the original payment.

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3 Auction Mechanism Options

Over recent years, there has been increasing interest in the use of auctions for allocating agri-

environment and conservation contracts to farmers. Several reviews of that material are available

(e.g. EA, 2012; Duke et al., 2012; Latacz-Lohmann and Schilizzi, 2005) and that literature provides

numerous insights as to how auctions might be designed in the agri-environment context.

Item(s) for which bids are elicited

Given the difficulties in implementing payment-by-results designs in an agri-environment scheme,

we focus our discussion on using auctions to allocate payment-by-activities contracts. While those

contracts may allow for adjustments in payments in response to changing prices of agricultural

output and might also stipulate bonuses or penalties associated with compliance, those contract

design features have little bearing on our discussion. As such, for the time being, those complexities

are ignored.

In a payment-by-activities scheme, farmers are presented with a menu of activities that might be

funded under the scheme. The purpose of the auction is to elicit bids from farmers that state the

amount they wish to be paid in order to undertake one or more of those activities. The fact that

farmers may be prepared to take on multiple activities introduces an immediate complication.

Should farmers be asked to enter separate bids for each activity? Or should they be asked to present

just one bid indicating the payment they would require to undertake their chosen set of activities?

The pilot auction in the Fowey River Improvement Scheme (Day et al., 2013) suggests that allowing

separate bids for each activity may have certain advantages. In that auction, farmers were asked to

enter a single take-it-or-leave-it bid for a bundle of activities. Farmers responded to the competitive

pressures in that auction by only bidding for activities that they anticipated would provide positive

benefits for their farm business. Since those benefits would off-set the costs of implementing those

activities, that strategy allowed farmers to enter relatively low bids. Unfortunately, that also meant

that bids tended to exclude activities from which farm businesses gained little benefit, even if those

excluded activities delivered the greatest environmental improvements.

Allowing farmers to enter a bid list that stipulates the payment they are seeking for each individual

activity circumvents that problem. With such an auction design, farmers could enter bids for as many

activities as they see fit, safe in the knowledge that the competitiveness (or lack thereof) of the bid

for one activity will not impact on the likelihood of the bid for a separate activity being accepted. In

addition, an auction that elicits bid lists allows the government to pick and choose which activities to

fund ensuring funds are directed towards the particular activities in each farmer’s application that

offer the greatest value for money.

A further complication arises if a farmer’s bid for one activity is contingent on the government also

funding a second activity. One response to that possibility would be to allow farmers to enter

multiple lists of bids: for example, one bid list might detail the payments required if a certain activity

is funded and another the payments required if that activity is not funded. A less flexible but easier

to administer design would elicit only one bid list but allows farmers to indicate those groups of

activities that must be funded in concert.

Bid Evaluation

In simple auctions for a homogenous item, bids can be compared simply on the level of requested

payments. Things are not so straightforward in a payment-by-activities agri-environment scheme

where farmers enter bid lists for multiple activities. In particular, different activities are

13

denominated in different units and will deliver very different levels of environmental improvements.

Accordingly, comparing bids across different activities makes little sense.

One way forward would be to allow a more meaningful comparison of bids by breaking the auction

up into a series of sub-auctions, one for each activity. Even with that approach, however, the

evaluation of bids would not account for the differences in the environmental benefits of activities

across farmers engaged in different farming practices across different parts of the country (nor the

issue of contingent activities mentioned above).

Alternatively, a suitably constructed scoring system would allow for the simultaneous comparison of

bids for all activities across all farmers. That scoring system would allot points to a farmer’s bid for

an activity according to the level of environmental benefits anticipated from that farmer undertaking

that activity. The scores should be commensurate across activities and across farmers.

Such metrics have been used in previous auctions including those based on measures of habitat

hectares, the calculation of a biodiversity benefits index or a water quality improvement metric (see,

for example, Parkes et al., 2003; Oliver et al., 2005; Day et al., 2013).

Armed with such a scoring system, the government can weight the payment asked for in any bid by

its environmental score in order to calculate a measure of value-for-money. Funds would then be

dispersed to those bids that offer the highest value-for-money.

Reserve Prices

Most auctions institute a reserve price to guard against the risk of having to honour bids demanding

unreasonably high levels of payment. In the context of an agri-environment auction, there are at

least two possibilities for introducing reserve prices;

First, farmers could be guided in their bids by a reserve price set on activities. That price

would indicate the maximum possible bid per unit of an activity that is acceptable to the

government. One risk is that providing such information would lead farmers to anchor on

those prices thereby diluting pressures to bid low. On the other hand, those reserve prices

could closely follow the prices currently listed in environmental stewardship schemes such

that the government could ensure that, in terms of payment rates for activities, an auction

could fare no worse than those posted-price schemes.

Second, the government might set a reserve on value-for-money scores. Such a reserve

would ensure that bids were only accepted if they delivered environmental improvements at

reasonable cost.

There seems little reason to contend with the proposal that both forms of reserve could be

integrated into an agri-environment auction.

Auction Budget

To ensure competitive pressures in an auction, farmers must be aware that funding is somehow

constrained. In the context of agri-environment schemes, that amounts to fixing a budget that will

be allocated to farmers through the auction. The government commits to funding bids that rank

highest according to the value-for-money index (provided they exceed the value-for-money reserve

price) up to the limit imposed by the fixed budget.

Payment format

Auctions may use a uniform price (for which read value-for-money) or discriminatory price format

and these two formats have quite different incentive properties.

14

Uniform price auctions pay a fixed price to all successful participants, where that price is

usually determined by the bid of the marginal bidder (i.e. a Vickery auction). This format

encourages bidders to truthfully reveal the minimum amount they would need to be paid to

perform a particular activity.

Discriminatory price auctions pay successful participants exactly what they bid. This format

encourages bidders to shade up their offers, particularly those that believe they have a

competitive advantage since they can deliver the activity at relatively lower costs.

It cannot be predicted with certainty, however, whether a uniform price or a discriminatory price

auction will deliver more environmental improvement for a fixed budget (Schilizzi and Latacz-

Lohmann, 2012). Given that uncertainty, the prudent option may be to favour the discriminatory

price format. In particular, offering to pay farmers the amount requested in their bid is a simple and

transparent mechanism. A discriminatory price format also offers the possibility of delivering cost

efficiencies if competition can encourage low cost bidders to ask for relatively low payments.

Geographical Scale

There are clear efficiency arguments for running auctions at the maximum possible geographic scale.

First, running one auction for the whole of England rather than a series of regional auctions will likely

reduce the costs of administration. Second, a single auction will allow the simultaneous comparison

of farmer’s bids from across England, allowing funds to be directed to those bids offering the very

best value-for-money. Finally, an auction run at the national scale will increase participation and

potentially reduce the possibilities for tacit or explicit collusion between farmers.

The implementation of an auction for agri-environment funding at the England scale will only be

possible if a suitable environmental scoring system has been developed that accurately reflects

differences in priorities across the whole territory. One potential risk is that such a scoring system,

especially in the early stages of its development and application, may result in an unanticipated

allocation of agreements. For example, farmers in a certain geographic location may enter

unexpectedly low bids for certain activities and, therefore, claim an unacceptably large portion of

agri-environment funds.

To protect against such outcomes, in initial applications of the auction approach it may be wise to

allocate separate budgets to different groups uniquely defined either by farm type or location (or

both). Defining separate budgets would limit the funding available to each group while gathering

information as to how the scoring system ranked bids from those different groups. Over subsequent

rounds of agri-environment funding, the scoring system could be refined until such point as the

government was confident it appropriately ranked bids across all farm types and regions.

Single or Multiple Rounds

In a multiple round auction only bids entered in the final round are binding. The preliminary rounds

can be used either to whittle down applicants or as a device by which bidders can learn about the

bidding behaviour of others. Over successive rounds, bidders can capitalise on that information

revising their bid to their advantage in anticipation of the final round.

There is no clear consensus as to whether allowing for such learning in iterative auction formats

leads to demand for lower or higher payments. There is evidence to suggest that those who find

their bids to be uncompetitive revise them downwards in a multiple round auction while, at the

same time, those who find they have bid relatively low may choose to revise their bids up as the

rounds of the auction progress (Cummings, 2003; Rolfe et al., 2009).

15

Accordingly, the prudent design which also results in lower administrative costs, is to run a one-off

auction. Indeed, since agri-environment funding competitions will likely be repeated at regular

intervals (perhaps annually?) farmers that fail in their bid in one auction are afforded the

opportunity to learn from that experience in formulating their bid for a subsequent competition.

There would appear to be little additional advantage to running each separate auction over multiple

rounds.

Information Provision

As may be evident from the previous discussion, one of the key issues to be considered in auction

design concerns the question of information provision. The information available to farmers will

guide their decision as to whether to enter a bid in the auction and determine the degree to which

farmers’ bids are shaped by competitive pressures. In the following, we bring consideration of the

information issue together in one place in attempting to answer the question of what information

should be made available to whom and when in an auction.

Budget Information

An agri-environment auction will only exert downward pressure on bids if farmers suspect that there

is a real possibility that bids will be rejected. At the highest level, that competitive pressure is

determined by the government establishing an overall budget for distribution through the auction.

Where uncertainty exists over the number and size of bids that might be submitted to an auction,

one strategy may be to withhold information on the size of the budget in the hope that that

uncertainty will encourage competitive bidding.

Withholding budget information would not be possible in the context of an agri-environment

scheme funded through public finance. At the same time, to encourage competition, information

might be provided to farmers with respect to levels of demand for funding. For example, in the

context of an annual auction for agri-environment funds, information might be provided on the

extent to which the total of bids received in previous rounds of funding exceeded the budget.

At the same time, care must be taken in how such information is communicated to farmers. For

example, in the Fowey River Improvement Auction, information was provided on the size of the

budget for allocation and on the number of farmers invited to participate in the auction. Feedback

from some farmers suggested that they used that information to calculate the funds available per

farmer and entered a bid that requested a payment reflecting their ‘fair share’ of the budget. In

other words, the information provided to farmers must carefully avoid cueing farmers into ways of

thinking about their bids other than with respect to their private costs of undertaking activities and

the surplus they might hope to gain through securing agri-environmental funding.

In-Auction Bid Information

While it is possible to reveal the contents of participant’s bids during an auction, it is generally

argued that sealed bid auctions promote participation, are less prone to collusion and make it

significantly more difficult to bid strategically (Athey et al., 2011). On the other hand, lack of

information regarding the level of bids being posted in the auction may reduce competitive

pressures.

Without disclosing full details of all participants’ bids, it is still possible to feedback information on

the relative competitiveness of a participant’s own bid. For example, in the context of a multiple

round auction farmers can be informed after each round whether their bid is sufficiently competitive

that it is currently being considered for funding. As we have already discussed, such feedback may

have the effect of clustering bids around the value of the marginal bid.

16

An alternative would be to give feedback on farmers’ bids that is completely exogenous to the bids

received in the auction. For example, an auction might be organised to allow bids to be entered and

revised over some predetermined period of time. On receiving a bid the government could grade

that bid, perhaps using a traffic light system where green would represent a low cost bid, amber a

mid-cost bid and red a high-cost bid. That grading would be fed back to farmers who might

subsequently revise their bid. Importantly, the grading is an independent and objective assessment

of whether the farmer’s bid is high-, mid- or low-cost, it does not indicate how competitive the bid is

relative to other bids in the auction. For example, a low-cost bid might still be unsuccessful in the

auction if all other bids received are also in the low-cost category.

Post-Auction Bid Information

Consideration also has to be given as to what information is made publicly available after the

auction. Since agri-environment funding competitions will likely be repeated at regular intervals, it is

possible that information from previous auctions may guide farmers in preparing bids for

subsequent competitions. Similar issues arise as in multiple-round auctions. Indeed, the prudent

position to take would be to provide general information on the level of (hopefully) oversubscription

of the auction, and perhaps the number and distribution of agreements. Information on the level of

payment made to the marginal bid should probably be withheld to avoid farmers anchoring on that

level of payment in preparing bids for subsequent competitions.

Environmental Scoring Information

As we have already discussed, in order to institute an efficient auction for agri-environment funds it

is necessary to grade the benefits delivered by each bid using an environmental scoring system. A

question that arises is whether farmers should be told the environmental score they would be

awarded for committing to certain activities under the scheme. In an experimental setting, Cason et

al. (2003) report evidence suggesting that revealing score information will reduce the cost-

effectiveness of the auction by encouraging those with high scores to shade up their bids aware that

they have a competitive advantage over other participants.

In a recent article, however, Glebe (2013) shows that consideration needs to be given to a

counteracting effect. In particular, revealing environmental score information can improve efficiency

by encouraging those with high scores to enter bids in the auction. Glebe goes on to argue that a

compromise mechanism in which farmers are informed of their environmental score but not how

that score is used to calculate the value-for-money index used to ranks bids, may provide the best of

both worlds.

There are precedents for such mechanisms. Miller (2004) records how the BushTender scheme in

Australia provided farmers with only partial information regarding the environmental value of their

bids in an auction seeking to purchase improved land management of native vegetation. In that case,

the full environmental score combined a measure of the baseline environmental quality and the

environmental improvements resulting from the farmers proposed activities. Only the latter

measure was disclosed to farmers.

Reserve Prices

While listing maximum per unit bids for activities may provide the government with some protection

against over-bidding, it is less clear whether the value-for-money reserve price should be revealed to

farmers. Given the fact that there are good reasons why we may wish to withhold information on

the value-for-money scores of individual farmer’s bids, there appears little advantage to revealing a

reserve price denominated in that metric. As a result, it should be sufficient to simply inform farmers

17

that such a reserve price exists and that uncompetitive bids which exceed that threshold value-for-

money score will not be funded.

3.1 Landscape Coordination Options

In an agri-environment scheme, some environmental improvements depend not only on the

quantity of agreements made with farmers to change farm activities but also on the location of

those changes both in the landscape and relative to one another. For example, biodiversity

conservation may only be achieved if farms that are connected in the landscape agree to undertake

coordinated changes in their farm activities. Adapting agri-environment schemes to deliver such

coordinated landscape outcomes introduces a new layer of complexity.

Spatially Discriminating Scoring

One relatively simple approach to delivering landscape scale coordination would be for the public

agency to decide explicitly where they wish to encourage that coordination. Those decisions could

then be reflected in location-specific “bonuses” in the scoring metric used to compare bids in an

agri-environment auction (e.g. Wünscher et al., 2008). Landscape outcomes are achieved because

that preferential treatment ensures that bids in particular locations are more likely to be funded.

If environmental outcomes depend not on specific locations but rather upon more nebulous

conditions such as the density of activities in a landscape or on connectivity between farms

undertaking conservation activities, then things become more difficult. In that case, the

environmental benefits of any particular bid, depend on the set of other bids approved for funding.

Indeed, the scoring metric used to evaluate bids must be developed so as to reflect that

dependency. Choosing which particular set of bids to fund necessitates working out which particular

combination of bids delivers the best environmental outcomes within the budget constraint. To

solve such problems requires adopting methods developed for combinatorial optimisation

(Hajkowicz et al., 2007).

Coordination Auctions

An alternative to approaches that achieve landscape coordination through the careful choice of

successful bids after the auction, are mechanisms that encourage coordination amongst bidders

through information feedback over successive rounds of a multiple round auction. In essence,

farmers are informed as to how their choice of activities may deliver synergies when coupled with

similar choices by other farmers in their location. Progressing from round to round of the auction,

farmers are provided with information on the location and bids of other farmers in their region and

have the potential to coordinate with those neighbours in order to promote environmental

improvements at the landscape level. Such mechanisms have been explored in experimental settings

(e.g. Parkhurst and Shogren, 2009; Reeson et al., 2011 ) with some success, but the practical and

cost implications of implementing such a complicated multi-round auction design at the scale of a

national agri-environment scheme mitigate against such an approach being adopted for the

purposes of Countryside Stewardship.

3.2 Private Finance Options

As part of preliminary research we plan to meet with a variety of private agents in order to explore

possible mechanisms through which they might fund or part fund changes in farmer activities.

Independent or Combined Schemes

Some private agents have already experimented with their own schemes for financing changes in

farming activities (e.g. South West Water’s Upstream Thinking project). A key question is whether

18

those independent agri-environment schemes should be encouraged or whether Countryside

Stewardship should be designed so as to allow private and public finance to flow through the same

mechanism.

There would appear to be many advantages for designing Countryside Stewardship to allow for

private financing. First, the combination of schemes under a single administration could result in

cost savings for all parties. Private agents would avoid the costs of running their own schemes and

might be asked to contribute to the administrative costs of Countryside Stewardship. Second,

providing farmers with a single interface to agri-environment funding minimises the costs to farmers

of making applications. Finally, allowing private and public funding to be brought together in

Countryside Stewardship opens up the possibility of coordinating the two streams of investment to

bring benefits of all parties.

There is a risk of competition between schemes/lack of coordination, the need to cross-check dual-

funding, opportunities for synergy between different environmental objectives may be missed (or

worse pursuit of one objective through private funding may be at the detriment of another for which

there is only public funding), separate schemes can be confusing for applicants and the opportunity

for economies of scale in delivery is missed cost savings. Finally private interests typically have

limited experience of operating schemes of this type.

While a combined scheme would seem to have many advantages, a number of issues will have to be

explored with private agents regarding the practicalities of implementation. For example, private

agents may wish for additional options to be offered to farmers. Likewise private agents may have

different priorities as to the locations that should be targeted through Countryside Stewardship.

Finally, private agents would have to synchronise their funding cycles with that envisaged for

Countryside Stewardship.

Independent or Brokered Purchasing

Within a combined scheme private agents could either act as entirely independent buyers or the

public agency and private agencies could agree to coordinate their buying activities.

If acting independently, then Countryside Stewardship would present private and public agencies

with the opportunity to review farmers’ applications and select which applications they wish to

finance. Naturally, the scheme would have to play some coordinating role particularly in situations

where more than one agent wishes to fund a particular application. Where the benefits of changing

farming activities provide a public good, for example by reducing pollution in rivers, free-riding

problems may arise between the different purchasing agents. In that case the level of financing will

be less than optimal.

One way of overcoming those problems would be for private and governments to coordinate their

purchasing. In order to achieve that coordination, the private and governments would have to agree

in advance to a set of purchasing rules. Those rules would define how each agent wanted to see

their money used and how decisions should be made as to which applications to select under

different circumstances. With such a set of rules in place, a (possibly independent) broker would

make the decisions on behalf of all agents, taking advantage of possible synergies to choose

applications that mean that all agents benefit from the cooperation.

Purchasing Rules

It seems inevitable that private agents will only be interested in financing some subset of

Countryside Stewardship options and often only in some specified region. Accordingly, a very simple

19

set of purchasing rules would be for a private agent to put forward a budget and ask the broker to

finance as many agreements as possible that deliver that option in their target region.

An alternative purchasing rule might see the private agent making some fixed (percentage)

contribution to the costs of all applications that the government decides to finance delivering the

private agent’s focus options in their target region (perhaps up to some predetermined private agent

budget cap).

Private agents may also have concerns about financing management activities when their immediate

concern is levels of environmental improvement. Accordingly, another possible purchasing rule

would see the private agent making payments to farmers based on their performance in delivering

environmental improvements. Given our earlier discussion, perhaps a more realistic mechanism

would be one that allows private agents to partially insure themselves against the risk of activities

not delivering environmental improvements. For example, a private agent might agree to make

some upfront contribution to the financing of applications delivering its focus options with, in the

first instance, the government covering the rest of the costs. Subsequently, environmental quality

would be monitored and the private agent would pay money back to the government where the

levels of payment are determined by the levels of improvement in environmental quality.

20

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