| Summary: | Payment for ecosystem services (PES) program contracts include penalties for non-performance to ensure that these programs 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. In contrast to the backward-looking standard penalty, the optimal penalty is forward-looking and equals the principal's net future environmental benefits lost due to contract non-completion. The optimal penalty thus falls over the life of the contract, in contrast to the standard penalty, which rises over the life of the contract. A numerical policy simulation with heterogeneous agents 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.
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