Options Contracts for Contingent Takings

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.

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.

Richard Zeckhauser is the Frank Plumpton Ramsey Professor of Political Economy at Harvard University's John F. Kennedy School of Government. Zeckhauser's current major research addresses the performance of institutions confronted with inadequate commitment capabilities, incomplete information flow, and human participants who fail to behave in accordance with models of rationality.