News + Media

Peter Dizikes, MIT News Office

The structure of the auditing business appears problematic: Typically, major companies pay auditors to examine their books under the so-called “third-party” audit system. But when an auditing firm’s revenues come directly from its clients, the auditors have an incentive not to deliver bad news to them.

So: Does this arrangement affect the actual performance of auditors?

In an eye-opening experiment involving roughly 500 industrial plants in the state of Gujarat, in western India, changing the auditing system has indeed produced dramatically different outcomes — reducing pollution, and more generally calling into question the whole practice of letting firms pay the auditors who scrutinize them.

“There is a fundamental conflict of interest in the way auditing markets are set up around the world,” says MIT economist Michael Greenstone, one of the co-authors of the study, whose findings are published today in the Quarterly Journal of Economics. “We suggested some reforms to remove the conflict of interest, officials in Gujarat implemented them, and it produced notable results.”

The two-year experiment was conducted by MIT and Harvard University researchers along with the Gujarat Pollution Control Board (GPCB). It found that randomly assigning auditors to plants, paying auditors from central funds, double-checking their work, and rewarding the auditors for accuracy had large effects. Among other things, the project revealed that 59 percent of the plants were actually violating India’s laws on particulate emissions, but only 7 percent of the plants were cited for this offense when standard audits were used.

Across all types of pollutants, 29 percent of audits, using the standard practice, wrongly reported that emissions were below legal levels. 

The study also produced real-world effects: The state used the information to enforce its pollution laws, and within six months, air and water pollution from the plants receiving the new form of audit were significantly lower than at plants assessed using the traditional method.

The co-authors of the paper are Greenstone, the 3M Professor of Environmental Economics at MIT; Esther Duflo, the Abdul Latif Jameel Professor of Poverty Alleviation and Development Economics at MIT; Rohini Pande, a professor of public policy at the Harvard Kennedy School; and Nicholas Ryan PhD ’12, now a visiting postdoc at Harvard.

The power of random assignment

The experiment involved 473 industrial plants in two parts of Gujarat, which has a large manufacturing industry. Since 1996 the GPCB has used the third-party audit system, in which auditors check air and water pollution levels three times annually, then submit a yearly report to the GPCB.

To conduct the study, 233 of the plants tried a new arrangement: Instead of auditors being hired by the companies running the power plants, the GPCB randomly assigned them to plants in this group. The auditors were paid fixed fees from a pool of money; 20 percent of their audits were randomly chosen for re-examination. Finally, the auditors received incentive payments for accurate reports.

In comparing the 233 plants using the new method with the 240 using the standard practice, the researchers uncovered that almost 75 percent of traditional audits reported particulate-matter emissions just below the legal limit; using the randomized method, only 19 percent of plants fell in that narrow band.

All told, across several different air- and water-pollution measures, inaccurate reports of plants complying with the law dropped by about 80 percent when the randomized method was employed.

The researchers emphasize that the experiment enabled the real-world follow-up to occur.

“The ultimate hope with the experiment was definitely to see pollution at the firm level drop,” Duflo says. The state’s enforcement was effective, as Pande explains, partly because “it becomes cheaper for some of the more egregious pollution violators to reduce pollution levels than to attempt to persuade auditors to falsify reports.”

According to Ryan, the Gujarat case also dispels myths about the difficulty of enforcing laws, since the experiment “shows the government has credibility and will.” 

But how general is the finding?

In the paper, the authors broaden their critique of the audit system, referring to standard corporate financial reports and the global debt-rating system as other areas where auditors have skewed auditing incentives. Still, it is an open question how broadly the current study’s findings can be generalized.

“It would be a mistake to assume that quarterly financial reports for public companies in the U.S. are exactly the same as pollution reports in Gujarat, India,” Greenstone acknowledges. “But one thing I do know is that these markets were all set up with an obvious fundamental flaw — they all have the feature that the auditors are paid by the firms who have a stake in the outcome of the audit.”

Some scholars of finance say the study deserves wide dissemination.

“This is a wonderful paper,” says Andrew Metrick, a professor and deputy dean at the Yale School of Management. “It is a very strong piece of evidence that, in the context they studied, random assignment produces unbiased results. And I think it’s broadly applicable.”

Indeed, Metrick says he may make the paper required reading in a new program Yale established this year that provides research and training for financial regulators from around the world.

To be sure, many large corporations have complicated operations that cannot be audited in the manner of emissions; in those cases, a counterargument goes, retaining the same auditor who knows the firm well may be a better practice. But Metrick suggests that in such cases, auditors could be randomly assigned to firms for, say, five-year periods. At a minimum, he notes, the Dodd-Frank law on financial regulation mandates further study of these issues.

Greenstone also says he hopes the current finding will spur related experiments, and gain notice among regulators and policymakers.

“No one has really had the political will to do something about this,” Greenstone says. “Now we have some evidence.”

The study was funded by the Center for Energy and Environmental Policy Research, the Harvard Environmental Economics Program, the International Growth Centre, the International Initiative for Impact Evaluation, the National Science Foundation and the Sustainability Science Program at Harvard.

International leaders have gathered this week in Kumamoto, Japan to sign a landmark treaty to curb the use of mercury. The treaty, named the Minamata Convention after a Japanese city where serious health damage occurred from mercury pollution in the mid-20th Century, is both wide-ranging and legally binding. MIT researcher Noelle Selin is attending the conference and presenting research on the impacts of mercury pollution and the importance of policies to control it.

Selin was part of an expert panel discussing the science of and policies regarding mercury pollution this weekend, hosted by the National Institute of Minamata Disease and the Society of Environmental Toxicology and Chemistry.

Learn more about the UNEP event: United Nations Convention Tackling Hazardous Mercury To Open for Signature

Learn more about Dr. Selin’s mercury research:

Will the New Global Mercury Treaty be Effective?

MIT researcher Noelle Selin assesses the challenges of implementing the first global mercury treaty.
 

Science Policy in Action

MIT students participate in the final mercury talks resulting in an international treaty.

Strategies to Reduce Mercury Revealed Ahead of International Talks

Harvard, MIT researchers map future trends of mercury and ways to reduce it on eve of international negotiations.

The Sverdrup Gold Medal is "granted to researchers who make outstanding contributions to the scientific knowledge of interactions between the oceans and the atmosphere." The award, in the form of a medallion, will be presented at the AMS Annual Meeting to be held on 2–6 February 2014 in Atlanta, GA.

John Marshall is an oceanographer with broad interests in climate and the general circulation of the atmosphere and oceans, which he studies through the development of mathematical and numerical models of physical and biogeochemical processes. His research has focused on problems of ocean circulation involving interactions between motions on different scales, using theory, laboratory experiments, and observations as well as innovative approaches to global ocean modeling pioneered by his group at MIT.

Current research foci include: ocean convection and subduction, stirring and mixing in the ocean, eddy dynamics and the Antarctic Circumpolar Current, the role of the ocean in climate, climate dynamics, aquaplanets.

Professor Marshall received his PhD in atmospheric sciences from Imperial College, London in 1980. He joined EAPS in 1991 as an associate professor and has been a professor in the department since 1993. He was elected a Fellow of the Royal Society in 2008. He is coordinator of Oceans at MIT, a new umbrella organization dedicated to all things related to the ocean across the Institute, and director of MIT’s Climate Modeling Initiative (CMI)

Jennifer Chu, MIT News Office

Nitrous oxide is commonly associated with laughing gas — the pleasantly benign vapor that puts patients at ease in the dentist’s chair. But outside the dentist’s office, the gas plays a serious role in the planet’s warming climate.

After carbon dioxide and methane, nitrous oxide is the third-largest contributor of greenhouse-gas emissions to the atmosphere. The colorless gas is also the top culprit in the depletion of ozone — the layer of the atmosphere that protects Earth from the sun’s ultraviolet radiation.

The majority of nitrous oxide emissions arise naturally from soil, where microbes break down nitrogen, releasing nitrous oxide as a byproduct. However, human activities such as farming, and the use of fertilizer, in particular, have increased nitrous oxide emissions over the last 35 years — a rise that has contributed to the overall warming of the planet.

Now scientists in MIT’s Center for Global Change Science have developed a highly detailed model that simulates levels of nitrous oxide emissions in different regions and ecosystems of the world. Based on local soil temperature and moisture content, some of the simulations were able to reproduce actual nitrous oxide measurements.

From their simulations, the researchers discovered a surprising pattern: Regions around the world typically experience a decrease in nitrous oxide emissions during El Niño events, which periodically create unusually warm waters in the Pacific Ocean, affecting temperature and rainfall patterns around the world. Conversely, they found that emissions rise during periods of La Niña, the opposing weather pattern, in which colder waters take over the Pacific. The findings suggest a feedback mechanism in which nitrous oxide not only contributes to global warming, but may also be affected by climate patterns. 

“If more emissions are released into the atmosphere, there will be more global warming … and with higher temperatures, we would have more nitrous oxide coming out,” says Eri Saikawa, who led the research as a postdoc at MIT. “Many people may not consider the nitrogen cycle, but we do have to realize it is pretty important.”

Saikawa, who is now an assistant professor of environmental studies at Emory University, collaborated with Ron Prinn, the TEPCO Professor of Atmospheric Science at MIT and director of the Center for Global Change Science, as well as principal research scientist Adam Schlosser. The group has published its results in the journal Global Biogeochemical Cycles.

A seesaw of emissions

To simulate nitrous oxide emissions around the world, Saikawa adapted a model of soil temperature and moisture content that is often used by hydrologists to track the movement of water through soil.

Saikawa added to this model a component that calculates how much nitrous oxide is likely emitted from a region, given variables such as soil temperature and moisture. She simulated monthly global nitrous oxide emissions from 1975 to 2008; to check that the model generated accurate calculations, Saikawa simulated nitrous oxide emissions in regions where actual nitrous oxide measurements were available, including 25 locations in the Amazon, North and Central America, Asia, Africa and Europe.

For many of the sites, the model’s calculations agreed with observations, verifying its ability to accurately simulate nitrous oxide emissions. Looking at the variability of emissions from year to year, Saikawa noticed a dramatic correlation with the El Niño/La Niña climate pattern, particularly in tropical regions near the equator: Nitrous oxide emissions dipped during periods of El Niño, and spiked during La Niña events.

Saikawa says this periodic seesaw in emissions makes sense: As El Niño warms the Pacific, rainfall increases to the east, causing flooding in parts of South America, and droughts in parts of South Asia. Saikawa points out that the largest sources of nitrous oxide emissions arise from South Asia; Saikawa observed that decreased soil moisture from El Niño led to a large dip in emissions from those regions, with the opposite effect from La Niña.

“We thought we would see some variability, but we didn’t think it would be this significant,” Saikawa says. “There is a need for more research to really determine what are the possible impacts from future climate change.”

William Horwath, a professor of soil biogeochemistry at the University of California at Davis, says the group’s model, while relatively simple, generally does a good job of predicting nitrous oxide events. However, to truly dig down to the root cause of emissions, he says the model will have to incorporate many more factors, including the presence of iron, which Horwath says is a big player in regulating microbes and nitrous oxide emissions.

“Future modeling studies stand to gain valuable information by considering iron among the regional drivers of N₂O emission,” Horwath says.

Modeling better fertilizer 

Going forward, the team will incorporate agricultural components into the model, to simulate the effect of certain fertilizers on nitrous oxide emissions. Many types of fertilizer introduce nitrogen to the soil — an ingredient that nitrogen bacteria thrive upon. The more fertilizer nitrogen there is in soil, the more bacteria break it down, releasing nitrous oxide as a byproduct.

Prinn says that deforestation has also stirred up nitrous oxide emissions, particularly in regions such as Brazil. The Brazilian government, he says, is exploring the increased production of biofuels, fertilizing croplands in place of forests.

“Brazil and other countries are very concerned about the sustainable production of biofuels in the future,” Prinn says. “What damage will it do to soil health? … Will they be making biofuels that are causing nitrous oxide and carbon dioxide emissions?”

A model like Saikawa’s, he says, may help simulate the effect of biofuel production on nitrous oxide emissions, and present more sustainable methods for growing biofuel crops.

“We should think about the impact that we have from our agricultural activities,” Saikawa says. “Over-fertilizing our soil could be potentially quite damaging for the climate and also for the ozone.”

China’s deployment of renewable electricity generation – starting with hydropower, then wind, and now biomass and solar – is massive. China leads the world in installed renewable energy capacity (both including and excluding hydro) and has sustained annual wind additions in excess of 10 gigawatts (10 GW) for four straight years. Half of the hydropower installed worldwide last year was in China. And solar and biomass-fired electricity are expected to grow ten-fold over the period 2010-2020. Most striking amidst all these impressive accomplishments has been the Chinese government’s seemingly unwavering financial support for renewable energy generators even as other countries scale back or restructure similar support programs.

The balance sheets of the central renewable energy fund are changing, however. Supplied primarily through a fixed surcharge on all electricity purchases, it has faced increasing shortfalls in recent years as renewable growth picked up, which may have contributed to late or non-payment to generators. Especially as more costly solar comes online, both the revenue streams and subsidy outlays to generators will require difficult modifications to keep the fund solvent. More broadly, investment decisions are largely influenced by the historically high penetration of state-owned energy companies in the renewables sector, which have responsibilities to the state besides turning a profit.

Recognizing these challenges of solvency and efficiency, the central government is facing a crossroads in its policy support for renewable sector, of which one possible approach would be migrating to a hybrid system of generation subsidies coupled with mandatory renewable portfolio standards (RPS). This fourth and final post in the Transforming China’s Grid series looks out to 2020 at how China’s renewable energy policies may evolve and how they must evolve to ensure strong growth in the share of renewable energy in the power mix.

Policy Support to Date

Investment in renewable energy has risen steadily in China over the last decade, with the wind and solar sectors hitting a record $68 billion in 2012, according to Bloomberg New Energy Finance (BNEF). These sums – together with massive state-led investments in hydropower – have translated into a surge of renewable energy capacity, which since 2006 included annual wind capacity additions of 10-15 GW and a near doubling of hydropower (see graph). Renewables now provide more than a quarter of China’s electricity generating capacity.

Early on in both the wind and solar sectors, the tariffs paid to generators were determined by auction in designated resource development areas (called concessions). These auctions underwent a number of iterations to get at rates the market will bear before policy support was transitioned to the fixed regional feed-in-tariffs currently in place: 0.51-0.61 yuan / kWh (8.3-10.0 US¢ / kWh) for wind, and 0.90-1.00 yuan / kWh (15-16 US¢ / kWh) for solar. The result of this methodical policy evolution was the steady growth of wind and solar power capacity year-after-year. Contrast these with the uneven capacity additions of wind in the U.S., attributable to the haphazard boom-bust cycles in U.S. wind policy (see graph). Hydropower project planning is directed by the government and rates are set project-by-project (typically lower than the wind or solar FITs).

Also important to developers – thought not captured in BNEF’s investment totals – are reduced value-added-taxes on renewable energy projects, preferential land and loan terms, as well as significant transmission projects serving renewable power bases socialized across all ratepayers. On the manufacturing side, the government has also stepped in to prop up and consolidate key solar companies.

Guiding these policies has been continued ratcheting up of capacity targets beginning with the Medium to Long-Term Renewable Energy Plan in 2007. These national goals – while not legally binding – shape sectoral policies and encourage local officials to go the extra mile in support of these types of projects. The most recent iterations call for 104 GW of wind, 260 GW of hydro, and 35 GW of solar installed and grid-connected by 2015 (see table). In addition to these “soft” pushes, generators with over 5 GW of capacity were required under the 2007 plan to reach specified capacity targets for non-hydro renewables: 3% by 2010 and 8% by 2020. However, there appeared to be no penalty for non-compliance: half of the companies missed their 2010 mandatory market share targets.

China’ renewable energy targets as of September 2013
(GW, grid-connected)

Sources
 

Rubber Missing the Road in Generation

Amidst the backdrop of impressive capacity additions, a separate story has unfolded with respect to generation. Wind in China faces twin challenges of connection and curtailment, as I outlined previously, which result in much lower capacity factors than wind turbines abroad. These have persisted for several years, so one might think that wise developers would demand higher tariffs before investing and a new, lower equilibrium would be established.

But the incentives to invest in China’s power sector are rarely based on economics alone. The vast majority of wind projects are developed by larger, state-owned enterprises (SOEs). In recent years, SOEs have been responsible for as much as 90% of wind capacity installed (for comparison, SOE’s are responsible for an average of 70% for the overall power mix). In 2011, the top 10 wind developers were all SOEs which faced some scrutiny under the 2010 mandatory share requirements because of their size. In addition, because generators only faced a capacity requirement, it was more important to get the turbines in the ground than get them spinning right away (though as we saw, many still missed their capacity targets). Grid companies, on the other hand, had generation targets (1% by 2010 and 3% by 2020), which were also unmet in some locations. The next round of policies have sought to address both generation and connection issues.

Other Cracks in the Support Structure

Though generation lagged capacity, it was still growing much faster than predicted, leading to shortfalls in funds to pay the feed-in-tariff. A single surcharge on all electricity purchases supplies the centrally-administered renewable energy fund, which fell short by 1.4 billion yuan ($200 million) in 2010 and 22 billion yuan ($3.4 billion) in 2011. Prior to the recent surcharge rise, some estimated the shortfall will rise to 80 billion yuan ($14 billion) by 2015. The difference would either not make it to developers or have to be appropriated from elsewhere.

In addition, from 2010-2012, there were long delays in reimbursing generators their premium under the FIT. The situation was so serious that the central planning ministry, the National Development and Reform Commission (NDRC), put out a notice in 2012 demanding grid companies pay the two-year old backlog. These receivables issues are particularly damaging to wind developers who operate on slim margins and need equity to invest in new projects.

To address the solvency of the renewable energy fund, in August, the NDRC doubled the electricity surcharge on industrial customers to 0.015 yuan / kWh (0.25 US¢ / kWh), keeping the residential and agriculture surcharge at 0.008 yuan / kWh (0.13 US¢ / kWh) (Chinese announcement). With a little over three-quarters of electricity going to industry, this will increase substantially the contributions to the fund. At the same time, solar FITs were scaled back slightly by instituting a regional three-tier system akin to that developed for wind: sunny but remote areas in the north and northwest offer 0.90-0.95 yuan / kWh (15-15.5 US¢ / kWh) while eastern and southern provinces close to load centers but with lower quality resources offer 1 yuan / kWh (16 US¢ / kWh) (Chinese announcement).

Additionally, distributed solar electricity consumed on-site (which could be anything from rooftops to factories with panels) will receive a 0.42 yuan / kWh (6.9 US¢ / kWh) subsidy. Excess electricity sold back on the grid, where grid connections and policy are in place, will be at the prevailing coal tariff, ranging from 0.3-0.5 yuan / kWh (5-8 US¢ / kWh). It is unclear if these adjustments will mitigate the expected large financial demands to support solar (whose FIT outlays per kWh are still more than double wind).

Wind, whose FIT has been in place since 2009, may not be immune to this restructuring either. Some cite the falling cost of wind equipment and the fund gap as cause for scaling back wind subsidies.

Where to Go From Here

Despite this budget squeeze, the Chinese government seems intent on sustaining the clean energy push. Even as it weakens financial incentives for renewable energy, the central government is getting smarter about how to achieve its long-term clean energy targets. Last year the National Energy Administration (NEA) released draft renewable portfolio standards (RPS), which would replace the mandatory share program with a tighter target focused on generation: an average of 6.5% from non-hydro renewables by 2015. Grid companies will have purchase requirements ranging from 3% to 15%, and provincial consumption targets range from 1% to 15% (more details here, subscription req’d). This approach appropriately recognizes the myriad regulatory barriers to increasing wind uptake by putting responsibility for meeting targets on all stakeholders.

China is paving new ground as it shifts further toward low-carbon sources of electricity. What has worked in the past, when wind and solar’s contributions to China’s energy mix were minor, will likely not be sufficient to meet cost constraints and integration challenges out to 2020. As with all policies in China, designing the policy is less than half the battle; implementation and enforcement are central to changing to the status quo.