Truth-telling by Third-party Auditors and the Response of Polluting Firms

Interesting paper by Esther Duflo, Michael Greenstone, Rohini Pande and Nicholas Ryan

In many regulated markets, private, third-party auditors are chosen and paid by the firms that they audit, potentially creating a conflict of interest. This article reports on a two-year field experiment in the Indian state of Gujarat that sought to curb such a conflict by altering the market structure for environmental audits of industrial plants to incentivize accurate reporting. There are three main results. First, the status quo system was largely corrupted, with auditors systematically reporting plant emissions just below the standard, although true emissions were typically higher. Second, the treatment caused auditors to report more truthfully and very significantly lowered the fraction of plants that were falsely reported as compliant with pollution standards. Third, treatment plants, in turn, reduced their pollution emissions. The results suggest reformed incentives for third-party auditors can improve their reporting and make regulation more effective.

The authors explain

Our experiment altered the market structure in several complementary ways to incentivize accurate reporting. All 473 audit-eligible plants in two populous and heavily polluted industrial regions of Gujarat entered the experimental sample. In each region, half the plants were randomized into a treatment with four parts. First, treatment plants were randomly assigned an auditor they were required to use. Second, auditors were paid from a central pool, rather than by the plant, and their fee was set in advance at a flat rate, high enough to cover pollution measurement and leave the auditor a modest profit margin.

In practice the critical issue is to get the central pool to work effectively (honestly).