Options Contracts for Contingent Takings

Abstract

Disasters are low-probability situations with high potential losses. Shortly before and during some disasters, government use of private property may reduce losses to others that strongly outweigh the costs imposed on the property owner, implying significant net benefits. Coercive takings or attempts to contract at the time of the emergency will frequently be defeated by transactions costs. We propose a policy tool to realize the available net benefits: options contracts for contingent takings. Such contracts between the government and private parties allow the government to take property in the event of a low-probability event that would make the property much more valuable in government hands. In exchange for such use, the property owner is compensated, in part up front and in part when the option is exercised. Setting the exercise payment equal to the cost of losses promotes efficiency in both risk spreading and the incentives for exercise. Options contracts of this form will be valuable in a range of settings, from improving disaster response by guaranteeing a flow of needed supplies, to reducing potential damages by diverting floodwaters to low-value lands, or even to helping ensure the survival of some endangered species. The moral hazard and hold-out problems that may afflict such contracts can be controlled.