Utilizing Contingent Claims to Improve the Management of CAFOs

By Gramig, Ben M.; Skees, Jerry R. et al. | Journal of Agricultural and Applied Economics, August 2004 | Go to article overview

Utilizing Contingent Claims to Improve the Management of CAFOs


Gramig, Ben M., Skees, Jerry R., Black, J. Roy, Journal of Agricultural and Applied Economics


We propose a market-based approach to reducing the environmental risk posed by concentrated animal feeding operations (CAFOs). The dual problems of hidden information and hidden action faced by policymakers are considered alongside the competing incentives faced by the CAFO manager in a multiple principal-agent setting. A new approach that uses insurance-like contracts is introduced by use of the specific example of a swine operation with a lagoon-based manure management system. Index-based contingent claims contracts in tandem with third-party auditing and waste hauling options are introduced as a complement to regulatory frameworks designed to reduce negative externalities from production.

Key Words: animal feeding operations, asymmetric information, environmental risk, insurance, public policy, regulation

JEL Classifications: D82, G22, L51, Q18, Q25, Q28

We introduce the idea of using marketbased solutions along with regulations to reduce the environmental risk associated with animal feeding operations (AFOs). There is an emerging literature regarding how insurance underwriters, who are risk-sharing partners, might be more effective in changing behavior than government regulators (Freeman and Kunreuther 1996, 1997; Kunreuther, McNulty, and Kang 2002). This literature is motivated by the incentives to change the hidden information and hidden action that are at the core of success or failure in regulating industrial processes to control externalities.1 This has been a major reason for recent changes in concentrated AFO (CAFO) regulations that require more information via Comprehensive Nutrient Management Plans (CNMPs). The challenge in designing market-based solutions involves considering how to build on the existing regulatory frameworks. More fundamentally, the ideas presented here would use information from the regulatory requirements, science-based models, and third-party auditing to both mitigate and shift risk in the operation of CAFOs. The case of a hog operation with an anaerobic waste treatment lagoon will be used throughout this article for the illustration of key concepts. The broader application of these ideas to facilities with different waste management systems and species is addressed in the conclusion.

Background

Much attention has been devoted to AFOs in recent years as a result of industry concentration, accompanied by a change in production methods, higher observed levels of water pollution attributed to such operations (U.S. Environmental Protection Agency [EPA]), and several high-profile environmental accidents that have been widely reported in the media. An April 1993 Cryptosporidium outbreak in the Milwaukee drinking water system that was attributed to runoff from livestock waste on nearby dairy operations caused over 40 deaths and 370,000 illnesses (Terry). In 1995, the collapse of a wall at a 10,000-head swine operation in North Carolina resulted in the release of a volume of hog waste two times that of the Exxon Valdez oil spill-25 million gallons (Smothers). Hurricanes in North Carolina in 1996 and 1999 generated a great amount of publicity around large-scale hog confinement operations in that state (Kilborn) and intensified the national dialog about the risks of environmental release posed by such large scale livestock operations.

With greater public attention to this contentious issue, there has been increased regulation which has:

* defined different size classes with the largest such operations designated as CAFOs;

* required permitting under the National Pollutant Discharge Elimination System (NPDES) for operations on the basis of size or individual system characteristics;

* put in place design standards for waste management systems; and

* prescribed the adoption of best management practices (BMPs) for waste handling and utilization.

The most recently issued federal regulations are contained in the EPA's Final CAFO Rule (Final Rule)2 and have increased the number of operations nationwide that fall under the requirements for a permit. …

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