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Reservoirs for the transient storage of water in order to lower river flood peaks would usually be built on farmland and used in case of a serious flood event. Farmers’ willingness to have their lands included in a reservoir critically depends on the compensation they will obtain. Our paper proposes a new compensation scheme that consists of an unconditional annual payment and a reparation payment conditional on flooding. We determine the properties of an optimal contract offered by the river authorities to farmers that specifies the compensation scheme and the rules for the use of the reservoir. The two-tier payment scheme induces crop choices of farmers that lower the damage profile of land use and it covers the long-term costs of land use change to ensure voluntary participation. We illustrate the working of the payment scheme using data from a case study from the river Tisza in Hungary.

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