Payments and Penalties in Ecosystem Services Programs

Payment for ecosystem services (PES) program contracts include penalties for nonperformance to ensure that they receive the environmental benefits they have been paying for. The standard penalty structure in PES programs requires participants to pay back all program payments received if the contract is terminated before the end of the contract lifetime. We derive the optimal non-completion penalty structure, which decouples the penalty from payments received. The standard penalty is backward-looking and equal to the sum of total payments received up to the date of contract termination. In contrast, the optimal penalty is forward-looking and equals the government’s net future environmental benefits lost due to contract non-completion. A numerical policy simulation based on features in federal agricultural conservation programs in the United States suggests that the optimal penalty structure can increase realized net environmental benefits significantly. Our results suggest that performance of most kinds of PES programs can be enhanced by decoupling non-completion penalties from payments and by adjusting how penalties vary over contract lifetimes