Contracts in the payments for ecosystem services: the case of bio-prospecting

We examine the economics of royalties in bioprospecting contracts between a pharmaceutical and genetic resource supplier (local), with an eye to understanding the relative advantages of indexing royalty payments to gross revenue or net revenue. We show a risk-averse f irm facing only production or only cost risks will index royalties to net revenue. When facing both types of risk, the choice of royalty type depends on the relative magnitudes of the pro-duction and cost risk. In each case, the risk-averse f irm chooses the royalty-type that shifts as much risk as possible to the local. When the local is risk neutral, the pharmaceutical’s and local’s preferences are compatible. If the local is risk averse and there is only one type of risk, it will prefer a gross revenue royalty, and shift as much risk as pos-sible to the fi rm: here the local and fi rm preferences are compatible only if the fi rm is risk-neutral. Lastly, we show if the f irm sets the terms of the contract, and both agents are risk averse, the f irm will not likely volunteer to imple-ment the socially optimal royalty arrangement as it prefers to shift as much risk to the local, who now also prefers a more certain return. This last outcome is at the heart of the benef it sharing discussion and suggests if risk sharing and equity are a concern in benef it sharing, then the choice of royalty type can be an important part of negotiations between pharmaceuticals and locals for the phytochemical from nature for new drug discovery.