Licensing resource exploitation with endogenous and privately known reserves

We design optimal mechanism to collect revenues from nonrenewable resource exploitation, when the resource must be explored and discovered and when there is asymmetric information. The exploration effort may result in a discovery that is revealed only to the firm, and the effort is not observed by the owner. After discovery, the firm may pay development costs including set-up costs to build extraction capacity. To overcome the discontinuity caused by the set-up costs in this adverse selection problem, we use a two-step procedure to solve the model and show that the optimal license contract involves a discontinuity at the reserve cut-off level. We show that compared to the case without any pricing of the resource exploitation, the optimal mechanism requires richer discoveries to yield a reserve, induces less exploration, and results in lower capacity and extraction. We also argue that often applied royalties and resource rent taxes distort exploration and extraction even when deductions for exploration expenses are allowed.