Powering households and industrial growth: Emerging insights from evolving evidence

Rapid industrial growth in countries like China and India has greatly reduced poverty, but it has also led to severe air and water pollution, which cause people to lead shorter and sicker lives. The World Health Organization estimates that urban air pollution causes 1.3 million deaths worldwide per year, most of which are in middle-income countries. According to the World Bank, the annual cost of environmental degradation in India amounts to nearly 6 percent of the country’s 2009 gross domestic product.

One way to curb such pollution is through third-party audits. Around the world, governments use third-party audits to monitor compliance with regulations in health, safety, finance, and the environment. Yet in virtually all cases, auditors are paid by and report to the company they are auditing, creating a conflict of interest for the auditor. Auditors may have incentives to distort or falsify their reporting to maintain business in such a system. Moreover, if auditors do not report the truth, there is no reason for the parties being regulated to try to comply, since regulators do not have the information necessary to punish violators.

In 1996, the Indian state of Gujarat sought to strengthen its environmental regulatory framework by introducing the first third-party environmental audit system in India. The initial system, however, was found to produce unreliable information about pollution. Recognizing this problem, the Gujarat Pollution Control Board (GPCB) sought out researchers to help reform the audit market in 2009. The goal of reform was to improve the accuracy of audit reports and, ultimately, compliance with environmental regulation.

Gujarat is one of India’s fastest growing industrial states. Since 1992, net state domestic product has grown at 8 percent per year on average. It produces about one-fifth of the country’s manufacturing output. Industrial growth has been accompanied by air and water quality degradation, which persist in some industrial areas despite strict statutory regulations.

Over the past decade, Gujarat has made strong commitments to sustainable development, making large investments in environmental infrastructure and building a robust regulatory framework to limit pollution. The Gujarat Pollution Control Board is responsible for enforcing national pollution laws and regulations within the state. In 1996, the High Court of Gujarat instituted a third-party audit system to help the GPCB better enforce pollution limits. All plants with high pollution potential are required to submit a yearly environmental audit conducted by an external auditing firm hired and paid for by the plant. Auditors measure plants’ air and water pollution three times a year and submit an annual report of their findings to the GPCB.

The GPCB can issue a variety of penalties if companies violate pollution standards, from warnings and fines to plant closure and disconnection of water and electricity for the worst violators. The GPCB has indeed often used these penalties when there is clear evidence of violations; for example, almost 10 percent of plants had had their utilities disconnected for at least some period of time in the year before the evaluation. Yet, before this evaluation was conducted in 2009, auditors, industrial plants, and the GPCB agreed that the audit system was providing unreliable information about pollution emissions.

When auditors were hired and paid by the firms they were auditing, as in the status quo audit system, false reporting and pollution were high.

Auditors in status quo plants were paid about 24,000 rupees per audit on average, which is well below the average cost of conducting a full audit at 40,000 rupees. This suggests that many auditors did not conduct all the tests needed to complete an audit properly.

Twenty-nine percent of audit reports in comparison plants falsely reported pollution as below the relevant regulatory standard. For particulate matter pollution, auditors reported that 7 percent of plants violated the standard, while in fact 59 percent were in violation. They also reported that nearly three-quarters of plants polluted just below the standard, but the independent backchecks reveal that only 19 percent of plants polluted in this narrow range. This shows that auditors systematically reported firms as being narrowly compliant with national pollution standards.

The new audit system led auditors to report pollution more truthfully and substantially lowered the number of plants that were falsely reported as compliant with pollution standards.

Relative to auditors in comparison plants, auditors working under the new system reported much higher pollution. They were also 23 percentage points (or 80 percent) less likely to falsely report a pollution reading as compliant with the relevant regulatory standard. Auditors working under the new system also reported that far fewer plants were polluting right below the standard. However, their reports still bunched a little beneath the standard, relative to the true pollution readings.

Since some auditors worked in both treatment and comparison plants, researchers were able to compare their behavior under both audit systems. They found that the same auditors reported pollution more accurately under the new system than they did in comparison plants that they were auditing at the same time. This shows that the increased accuracy was due to the new audit system and not to treatment plants having better auditors or auditing firms with more financial resources.

Industrial plants reduced pollution in response to more accurate audits.

Plants facing the new auditing system reduced pollution by 0.21 standard deviations on average. This reduction is driven by an even larger reduction in water pollution, which is a top regulatory priority for the GPCB. The pollution reductions came from the highest-polluting plants. In practice, the GPCB reserves the harshest penalties, like plant closure, for plants with readings that significantly exceed the standard. This is reflected in the fact that the dirtiest plants responded by reducing emissions the most.

When auditors are chosen and paid by the firms they are auditing, third-party audit systems may yield very inaccurate reports.

In Gujarat, when auditors were hired and paid by the plants they were auditing, they did not provide regulators with reliable information about pollution. There is evidence that many auditors did not even conduct all the tests necessary to complete a full audit. If they are to be an effective policy tool for enforcing regulation, third-party audit systems must be designed to incentivize accurate reporting.

Resolving this conflict of interest can lead to more accurate reporting.

Randomly assigning auditors to industrial plants, paying them a fixed fee from a central pool, and double checking their accuracy led auditors to report industrial pollution much more accurately.

When the environmental regulator received better information about pollution levels, industrial plants responded. In response to more accurate pollution audits, the dirtiest industrial plants reduced their emissions substantially.

This suggests that plants may also change their behavior if the regulator obtained more accurate information through other means, such as its own inspections or better emissions monitoring technologies.

Eliminating conflicts of interest for auditors could improve third-party audit systems in other sectors beyond environmental regulation.

The core problem in Gujarat’s environmental audit system—that auditors had poor incentives to report pollution levels accurately when they were chosen and paid by the firms they audited—exists in virtually all other third-party audit systems. This evaluation provides the first-ever findings on removing the fundamental conflict of interest that characterizes third-party audit markets. It seems reasonable to assume that a version of these reforms adapted to the particular institutional features of other third-party audit markets would produce similar results.

Global electricity consumption will increase dramatically in the next few decades, and much of this increase is expected to come from developing countries. However, expanding access to electrification may introduce new challenges for service providers and for households. In a standard model, electricity is purchased on a credit basis: households consume electricity throughout the month and receive a bill for what they have already consumed. This model, however, may not be well suited to the income and expenditure patterns of poorer households, who may struggle to find the resources to pay the bill. Subsequently, high rates of nonpayment may prevent electricity companies from serving these households.

One potential solution is to sell electricity on a prepaid basis. With prepaid electricity meters, consumers purchase electricity in any amount and at any time in advance of use. When the balance on a meter runs out, the household’s electricity shuts off. Consumers may benefit from prepaid electricity by gaining the ability to control their own consumption, and utility companies may benefit from prepaid meters by recovering a larger share of the money that customers owe to them. While prepaid meters are increasingly common in developing countries, including Africa, there is little rigorous evidence on the effects of prepaid meters on electricity use, revenue, and cost recovery for utility companies.

South Africa was an early adopter of prepaid electricity meters. In 2011, electrification rates formal settlements in Cape Town exceeded 99 percent. At the onset of the study, about 75 percent of Cape Town residents who received their power through the city used prepaid meters.

In late 2014, the City of Cape Town initiated a program to convert households that remained on a credit payment system to prepaid meters in low-income neighborhoods. In these neighborhoods, prior to installation of prepaid meters, over half of electricity bills were paid late, and 26 percent of customers had multiple outstanding unpaid bills. Twenty percent had been disconnected at some point as a result of delinquent bills.

Researchers partnered with the City of Cape Town to test the impact of switching from monthly billing to prepaid meters on household electricity use, payment behavior, and utility company returns.

The City implemented mandatory meter replacement in fifteen low- to middle-income neighborhoods throughout Cape Town. Meter replacement was randomly assigned across thirteen groups of around 150 neighboring households in the first stage, and across fourteen groups in the second stage, covering 4,175 customers in total.

To measure the impact of the prepaid meters, researchers analyzed data from the City of Cape Town’s billing and prepaid vending system.

The results presented below are based on random variation in when a household switched to a prepaid meter, rather than comparison with a pure control group that never received prepaid meters. The random variation in the timing acted as a statistical instrument to identify causal effects.

Overall, although household electricity use declined under prepaid meters, the utility was able to recover more of its costs. The utility company saw the greatest improvements in profitability when poorer customers, and those with a history of delinquent payment behavior, switched to prepaid meters. These findings suggest that metering technologies may play an important role in expanding energy access for the poor.

Electricity Usage: As a result of switching to prepaid meters, households reduced their electricity consumption; this decrease persisted for at least 12 months. Specifically, switching to prepaid meters led customers to reduce their electricity usage on average by 1.9 kWh per day, from an average of around 16.21 kWh prior to the intervention, or around 0.14 log points (a decrease of 14 percent) for all customers. The decrease in energy usage also resulted in a corresponding decrease in the amount owed to the utility company by US$6.87 per month, from an average of US$52 prior to the intervention.

Returns to the Utility Company: Despite the fact that customers’ electricity use decreased, switching to prepaid meters led to better payment recovery, lower recovery costs, and earlier payments for the utility company. The utility company also avoided the costs associated with meter reading, bill preparation, and enforcement through disconnecting delinquent customers.

In this context, the cost reductions to the utility company outweighed the reductions in customer payment levels on average, making the switch to prepaid meters profitable overall. The utility company experienced higher returns from the prepaid meters among lower-income customers and those who had previously failed to pay their bills. However, they experienced negative returns from the prepaid meters relative to postpaid meters among customers who had paid all of their previous bills. This implies that the profitability of a prepaid meter system depends on the context in which it is introduced.

Based on the results of this study, the City of Cape Town has continued its efforts to switch customers to prepaid electricity meters, while also exploring complementary policies that help poor consumers meet their energy needs and stay current on their utility bills. Researchers are collaborating with City officials on multiple follow up evaluations.