The Design of Payments for Avoided Deforestation Under Uncertainty: Insight from Real Option Theory

The objective of this paper is to analyse the implications of landowners’ option values in land allocation and derive policy recommendations for payments for Reducing Emissions from Deforestation and Forest Degradation (REDD). We examine the determinants of landowner participation in REDD implementation and consider particularly the effect of alternative designs of REDD payment schemes on permanence of emission reductions. It is shown that the common practice of making either fixed payments per hectare or linking payments to carbon markets is not a cost-effective approach. A given level of permanence can be achieved at considerably lower cost to the REDD service buyer if REDD payments are linked to an agricultural commodity index that correlates with landowners’ opportunity costs.