Marking a milestone in the tumultuous journey towards a unified energy policy, the European Union (EU) member states have initiated joint procurement of a portion of their gas consumption. This coordinated effort has been facilitated through a gas purchasing mechanism, the AggregateEU, as of May 2023. In this policy brief we discuss the challenges this mechanism faces, given its design characteristics and the altered dynamics of the gas market following the energy crisis.
The necessity for a coordinated approach to energy security within the EU has been recognized at least since 2009, when its legal base was explicitly introduced in Article 194 of the Treaty of Lisbon. However, the de facto implementation of the solidarity principle has been lagging for many years. In response to the 2022 surge in gas prices, the EU has at last taken the solidarity approach to common energy security seriously. One of the most prominent steps is the creation of the AggregateEU mechanism, launched at the end of 2022. This mechanism aggregates the demand of registered buyers from different member states and matches it with competitive bids from external gas suppliers. It aims at improving and diversifying the EU gas supply, avoiding unnecessary buyer competition within the EU and building up the buyer power of EU member states. Furthermore, the mechanism is meant to reduce uncertainty and mitigate price volatility by providing information about accessible energy supplies. The mechanism covers both pipeline natural gas and Liquified Natural Gas (LNG) and organizes tenders every two months. While EU member states are required to submit demand bids for 15 percent of their 90 percent storage targets for the upcoming 2023-24 season through the mechanism, there is no obligation to sign any contracts based on the resulting match (more details can be found here and here).
The first three rounds of tendering via the mechanism, which took place May-October 2023, matched approximately 34 billion cubic meters of natural gas, exceeding the anticipated initial volumes. This outcome is currently perceived as a great achievement, enabling more vulnerable countries to benefit from coordinated purchases and resulting in increased bargaining power. Driven by this success, the European Commission (EC) has considered making demand aggregation via the mechanism a permanent feature of the EU’s gas market – and even extending it to hydrogen. However, while these agreed trades are a positive development, they may not reflect the mechanism’s overall success. Demand submission obligations may increase the number of demand calls which could project into more matches, but as they are not binding the subsequent agreements may not necessarily result in finalized contracts or lower prices.
In this brief, we argue that the mechanism’s benefits remain uncertain, primarily due to the current state of the EU’s gas market and the design flaws arising from efforts to address disparities in energy security among member states. These considerations call for a direct impact assessment, which however remains impossible due to the EC’s inability (or even reluctancy?) to collect and disclose the contracted outcomes resulting from the mechanism matches. This is especially problematic in light of the EC’s intentions to extend the mechanism’s coverage.
Limited Mechanism Benefits Under New Market Trends
Over the past two years, the EU has undertaken drastic efforts to address the energy security concerns within its gas market caused by the radical reduction in Russia’s natural gas exports to Europe. The EU has managed to sizably improve the diversification of its gas imports (see Figure 1), fill its storage facilities, and lower its gas demand (see McWilliams, Sgaravatti, and Zachmann (2021) and McWilliams and Zachmann (2023)).
Figure 1. Composition of EU natural gas imports.
As a result, a certain balance of supply and demand has been achieved, and the gas prices in the EU market have fallen to pre-war price levels (though they are still somewhat higher than their earlier long-term trend), as depicted in Figure 2. The ease of market tensions in 2023 has led many to argue that market forces are sufficient to resolve potential problems in the EU gas market and that mechanism costs would not be justified (see, e.g., Eurogas or International Association of Oil and Gas Producers opinions).
However, in the coming years the EU gas market is expected to be relatively tight due to capacity constraints both in the LNG market and for pipeline gas producers (as noted by, e.g., Bloomberg and IEA). This tightness makes the market highly sensitive to shocks, and a twofold increase in exposure to LNG – with its global liquidity – only adds to the problem. A good illustration of this concern is the recent market reaction to the Israel-Palestine war: the fear of supply disruptions lead to a whopping 55 percent increase in the European gas tariff TTF in the second week of October and to an EC initiative to prolong the emergency gas price cap, initially introduced in February 2023. This despite the EU’s gas storage nearing 98 percent of capacity and relatively low current prices.
Such a “seller market” situation implies that buyers’ ability to exercise buyer power and negotiate down prices may be highly limited when needed the most. Specifically, buyer power would be most effective when buyers have a credible outside option, e.g., the ability to claim that their gas demand needs can be facilitated elsewhere. The tighter the market, the more difficult it would be to find such volumes elsewhere, further limiting buyers’ ability to negotiate down prices. To put it differently: current market conditions may undermine the original purpose of the mechanism.
The current “shock-sensitivity” of the gas market may also give rise to additional concerns regarding the mechanism’s mere purpose – demand aggregation for vulnerable buyers. One of the by-products of demand aggregation is that (pooled) buyers are more likely to face correlated risks, e.g., by purchasing gas from the same producer. If markets are highly shock-sensitive – as they currently seem to be – such aggregation may further increase market volatility, implying that vulnerable buyers would be affected the most.
Figure 2. Natural gas prices in the EU, January 2021-October 2023 (prices in EUR).
Mechanism Design: Constraints vs. Efficiency
Some design elements of the purchasing mechanism may also challenge the mechanism’s ability to deliver an efficient outcome. First, quantity and price under the matching process are not binding, and buyers and sellers are expected to continue negotiations individually after the matching. This feature was introduced due to the concern that it would be challenging to offer a “one size fits all” binding contract to incorporate all participants of the pooled demand. This, as argued by Le Coq and Paltseva (2012; 2022), was one of the reasons for the previous failure to implement a mutual insurance and solidarity mechanism across the EU. However, the non-binding matching outcome will likely give rise to re-negotiations, price increases, and failure to exercise consolidated “buyer power”.
Moreover, a company can act on behalf of small or financially constrained buyers, purchase gas for them, and become an “Agent-on-behalf” and “Central Buyer”. In the process, companies will inevitably exchange sensitive information. This may limit competition and increase the market power of the “Central Buyer” company. In addition, firms may choose not to participate in the mechanism for at least two reasons. First, they may fear the threat of revealing valuable private information. Second, demand aggregation may discourage market participants with stronger buyer positions from participating, as being pooled with weaker participants would undermine their bargaining power. Both these cases would create a so-called adverse selection effect, where the more performant market participants would choose to avoid the joint purchasing mechanism. As a result, the joint buyer power may be strongly undermined, and the price-suppressing effect seems uncertain. This may explain why some firms, like several large German firms, have opted to sign long-term contracts with gas suppliers directly rather than via the mechanism
Several of these concerns arise not from the mechanism design per se but rather in combination with the inherent asymmetries between EU buyers, including variations in gas demand, risk exposure, etc. To put it differently: it is well justified that a “one size fits all” approach would fail in ensuring broad (and voluntary) mechanism participation; however, the choice of a more flexible solution, as implemented by the AggregateEU mechanism, creates commitment issues and adverse selection, and may undermine an effective use of buyer power.
Impact Assessment: Necessary but Currently Impossible
The new EU gas purchasing system is a significant step towards creating a unified energy policy. However, the design of such a procurement auction raises concerns about its contribution, especially under the new gas market dynamics. The current low gas prices make the immediate cost-benefit tradeoff of the mechanism nonobvious. More importantly, the tightness of the EU gas market in the next few years makes the “seller” power unlikely to be counteracted by the EU’s buyer power. Further, the absence of legal commitment between matched participants, and increased market volatility can lead to repeated ex-post renegotiations. These elements undermine the mechanism’s role and raise doubts about its benefits. Some of the mechanism’s inherent features, such as incentives for abuse of market power, also contribute to potential efficiency loss.
Hence, while the motivation behind this tool is clear, the implementation and potential design flaws may undermine the gains. It is therefore particularly important to understand whether the mechanism is effectively meeting its objectives, especially given the recent initiative to make it a permanent feature of the EU gas market and a key solution for the European Hydrogen Bank in the future. These considerations make a strong call for an impact assessment. An unbiased measure of AggregateEU’s impact would be necessary to assess the benefits of the mechanism (and to weigh them against the bureaucratic implementation costs). Currently, however, the EC has chosen not to collect, let alone disclose, the contractual outcomes resulting from matches. In a recent interview, Matthew Baldwin, deputy director-general at the EC’s energy directorate, said, “The reality is we’ve had relatively little feedback so far because companies are not required to give that to us in terms of the deals”. One may argue that many of the potential deficiencies of the mechanism design – e.g., non-binding matching and adverse selection – are justified by asymmetries across participants and other inherent market features. However, the absence of (appropriately desensitized) data about actual outcomes resulting from mechanism matches is more difficult to justify. The lack of data prevents us from evaluating the AggregateEU’s performance and raises additional concerns about its efficiency. Thus, gathering relevant information and conducting a comprehensive impact assessment based on sensible criteria are essential prerequisites for the future use, and expansion of the AggregateEU mechanism.
- Le Coq, C. and E. Paltseva. (2012). Assessing Gas Transit Risks: Russia vs. the EU, Energy Policy (4), 642-650. https://doi.org/10.1016/j.enpol.2011.12.037
- Le Coq, C. and E. Paltseva. (2022). What does the Gas Crisis Reveal About European Energy Security? FREE Policy Brief, https://freepolicybriefs.org/2022/01/24/gas-crisis-european-energy/
- McWilliams, B., Sgaravatti, G. and G. Zachmann. (2021). ‘European natural gas imports’, Bruegel Datasets. https://www.bruegel.org/publications/datasets/european-natural-gas-imports/
- McWilliams, B. and G. Zachmann. (2023). ‘European natural gas demand tracker’, Bruegel Datasets. https://www.bruegel.org/dataset/european-natural-gas-demand-tracker
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
In March 2023, the European Parliament’s legal affairs committee voted unanimously in favor of a proposed update to the EU Directive on environmental crimes (Directive 2008/99/EC). The update seeks to step up enforcement of environmental legislation across Members States through criminal law aimed at severely punishing very serious environmental offenses. We argue that, while laudable in its goal of strengthening enforcement of environmental regulation at the EU level, the current effort might be insufficient since moderately serious offenses might remain largely unpunished. To address this shortcoming, we propose harmonizing administrative law as well. We consider additional benefits from relying on administrative law in terms of flexibility of punishment design, based on the US experience of using environmentally beneficial projects performed in affected areas as a form of punishment in administrative environmental settlements. We discuss evidence on the merits and potential limitations of the US approach based on Campa and Muehlenbachs (2022) and conclude that such an approach is worth considering in the EU context.
While the EU has set aggressive pollution reduction targets across its Member States (European Commission, 2021a), for example pledging to reduce deaths due to particulate matters to 55 percent of 2005 levels by 2030 (European Commission, 2023a), much work remains to be done. As documented in Lehne (2021), in 2020 all countries in Europe reported PM2.5 concentrations above the World Health Organization (WHO) guideline of 5mg/m3. Six countries, including three EU Member States (Italy, Croatia, and Poland) reported levels above the EU’s annual limit value of 25mg/m3. Further, Bulgaria, Poland, Portugal, Croatia, and Romania did not meet national targets for PM2.5 reduction (European Environment Agency, 2023). Main contributors to PM2.5 pollution are transportation and industrial activity, including energy production. High concentrations of these particles are known to increase physical and mental health risks (Persico, 2022; Persico et al., 2016), and risk of premature deaths (Fuller et al., 2022).
Environmental concerns across EU Member States are also not limited to air pollution. Across the EU, 28 percent of groundwater sources are affected by pollution from agriculture, 14 percent from industrial contamination, and 7.5 percent from mining waste (Kampa et al., 2021). The persistent pollution problems in the EU and their unequal distribution across regions despite growing EU-level environmental legislation underscores the importance of law enforcement. While all EU Member States are theoretically subject to the same overarching environmental standards and regulations, the enforcement of environmental laws differs widely across countries. To address this issue, the EU Commission (henceforth EC) has recently taken steps to further harmonize environmental enforcement across EU Member States.
In this brief we consider the EC’s proposal and argue that, while commendable in the goal of strengthening enforcement of environmental regulation at the EU level, it is also quite limited in terms of enforcement tools that it considers. Specifically, we discuss potential advantages of leveraging administrative law tools to enforce environmental regulation, whereas the EC approach is currently focused on criminal law. We consider the higher probability of prosecution and the enhanced flexibility in the type of penalties allowed by administrative enforcement actions. Finally, we discuss results from Campa and Muehlenbachs (2022), which studies the use of administrative penalties for environmental violations in the US and draws some lessons for environmental enforcement in other jurisdictions.
Strengthening Environmental Enforcement at the EU Level
While environmental regulation is a shared competence of the EU, enforcement has historically been left to national environmental authorities (European Parliament, 2016). In the face of a lack of institutional capacity at the national level, a result of this arrangement are generally low levels of environmental enforcement, widely heterogeneous across Member States (Mazur, 2011). EU institutions have tried unsuccessfully over time to address this challenge and harmonize enforcement across EU Member States. An early attempt was made in 2001, when the EU put in place minimum standards for environmental inspections that Member States carry out, though these were only non-binding guidelines, and Member States could not be sanctioned for flouting them (European Parliament, 2001). Mandatory standards were then introduced in 2008, with the EU Directive on environmental crimes (Directive 2008/99/EC), which forced national governments to apply criminal sanctions to those causing “substantial damage” to the environment. However, it has typically been difficult for the EC to sanction non-abiding Member States. Moreover, the obligation is limited to areas where the EU has competence and does not include minimum penalties.
In another attempt to step up their enforcement efforts, in 2016 the EC began publishing the annual Environmental Implementation Review, where each country is evaluated on its environmental affairs and enforcement (European Commission, 2023b). Although this does not improve the EC’s ability to efficiently sanction Member States, it does increase scrutiny and visibility. In 2021, the EC tabled a proposal to update the 2008 Directive on environmental crimes (European Commission, 2021b). The proposal acknowledged the insufficient number of environmental criminal cases successfully investigated and prosecuted as well as the large discrepancies in the transposition of the 2008 Directive across Member States. Against this background, the EC proposed to enlarge the scope of the 2008 Directive, establish minimum penalties, foster cross-border investigation and prosecution, and promote data collection and dissemination on criminal enforcement actions. In March 2023, the European Parliament’s legal affairs committee voted in support of the EC proposal, extending the list of offenses that would be criminally charged and increasing the size of the minimum penalties.
Environmental Enforcement, Administrative Law and “In-kind” Punishment
The efforts of EU institutions to improve and harmonize enforcement are exclusively focused on criminal law instruments. The EC’s 2021 proposal specifically links poor enforcement in Member States to their reliance on administrative law, which limits fines and thus allegedly reduces the deterrence value of enforcement actions. Indeed, sufficiently high fines are considered crucial to deter future violations (see, e.g., Aguzzoni et al., 2013). However, we argue that reliance on administrative law also has some advantages. In particular, we consider two potential benefits of administrative law based on existing studies, namely higher probability of case initiation and more flexibility in terms of penalty design.
Probability of Case Initiation
One of the shortcomings of the current enforcement framework highlighted by the EC is the very low number of environmental criminal cases that are ultimately prosecuted. Research on enforcement tends to link the low frequency of observed criminal cases to the high cost of criminal proceedings, especially relative to more informal administrative procedures (Faure and Svatikova, 2012). The cost dimension is especially relevant for cases that are moderately serious, but that nevertheless in aggregate contribute significantly to environmental degradation. The probability of catching violations is also relevant, together with the size of the penalty. A very large penalty for a criminal case that is highly unlikely to be prosecuted might be less deterring than a moderate penalty associated with very high probability of prosecution.
Federal environmental regulations in the US are enforced through a combination of administrative and criminal law. The Environmental Protection Agency (EPA) initiates administrative cases or refers them to the Department of Justice when the gravity of the violation is large. Administrative cases result in settlements where the defendant can be ordered to pay a fine, which can vary from a few thousand to a few million dollars and which is determined according to various factors, such as the magnitude of environmental harm, the firm’s economic gain from violation, its violation history, and its ability to pay. Additionally, when a fine is established, defendants are given the opportunity to volunteer to pay for an environmentally beneficial project in the affected area. The EPA encourages these projects especially in areas subject to environmental justice concerns, namely those characterized by a large share of minority and low-income households.
Campa and Muehlenbachs (2022) study the implications of using these projects in environmental enforcement cases in the US. The study reveals a large preference among the public for this “in-kind” form of penalty versus traditional fines, based on a survey of US residents. Moreover, a randomized survey experiment reveals that these environmental projects elevate the profile of the firm among the public as compared to a firm that only pays a fine, even when the penalties stem from the same violation. Similarly, the stock-market response to the announcement of these projects is positive, whereas announcing a settlement with a large penalty causes a drop in the stock-market price of the defendant. In terms of implications for environmental justice, the data analysis shows that the whitest and richest communities are the most likely to receive these projects, but the second largest share goes to communities where there are highest concentrations of minorities and low-income households.
Overall, the study finds that punishing firms through environmental projects can be beneficial for political economy reasons, given the large preference for this enforcement tool among the public and likely among firms, since firms seem to benefit from undertaking the projects. Moreover, while the targeting of environmental justice communities in the US is not perfect, tweaking the US arrangement could guarantee that the projects predominantly benefit those communities most harmed by environmental violations.
For EU adoption of environmental projects enforcement, a caveat is that the perception of these projects might be different among the public in the EU. Nonetheless, large-scale surveys modelled on those presented in Campa and Muehlenbachs (2022) can help in understanding public views in different regions. Moreover, the paper emphasizes that on the one hand, by benefiting defendants, the environmental projects might ultimately be a more lenient punishment than fines, with implications for deterrence and future environmental quality. On the other hand, environmental quality might also improve as a direct effect of the projects being implemented and due to improved monitoring in affected communities (Dimitri et al., 2006). Overall, the study finds that future environmental quality might be more likely to improve following fines rather than environmental projects. However, it cautions the reader on data limitations that causes the result to not be conclusive enough and calls for further research.
The persistence of environmental problems in the EU, as well as the striking differences in pollution levels across EU Member States, underscores the need for more and better environmental regulation. However, even in the presence of comprehensive and strict environmental rules, the protection of the environment is still inadequate if a proper enforcement mechanism is not in place. As observed in OECD (2009), proper enforcement ensures deterrence. Successful deterrence provides the best protection for the environment, while reducing the resources necessary to administer laws by addressing non-compliance before it occurs. EU institutions have recently taken important steps to improve and further harmonize enforcement of environmental regulation across Member States, with proposed updates to the existing Directive on the matter scheduled for Member-State discussion in upcoming months.
Specifically, the EU is seeking to step up the use of criminal law to prosecute environmental offenses across Member States, with mandatory penalties and increased cross-border coordination. We argue that the focus on criminal law has some drawbacks, which could be addressed by also harmonizing administrative enforcement across EU Member States. Researchers have previously argued that reliance on administrative law might increase the likelihood that offenses are investigated and prosecuted. We also present evidence from the use of administrative law in the US, where defendants in environmental cases can settle to pay part of their penalty “in-kind”, i.e. by performing environmental projects in areas affected by the alleged violations. The evidence suggests that the use of these projects is worth considering in other jurisdictions, including the EU, because they might be preferred by the public and could help addressing environmental justice concerns. An important caveat is that their implications for environmental protection are not clear, and more research should address this important aspect. On the subject, the existing evidence on environmental enforcement in the US, such as that presented in Campa and Muehlenbachs (2022), is established thanks to the availability of rich data sources kept by the US’ EPA. The EC’s recent proposal to systematically collect and disseminate data on environmental crimes is thus particularly welcome and should not be overlooked in the upcoming negotiations with Member States on the final content of the proposed Directive.
- Aguzzoni, L., Langus, G., & Motta, M. (2013). The Effect of EU Antitrust Investigations and Fines on a Firm’s Valuation. The Journal of Industrial Economics. 61, 290–338.
- Campa, P. & Muehlenbachs, L. (2022) Addressing Environmental Justice through In-Kind Court Settlements. CEPR DP16293 https://drive.google.com/file/d/1xlN7sYepHnkqGWjtOMxSAj36e9yk-d6X/view
- Dimitri, N., G. Piga, & Spagnolo, G. (2006). Handbook of procurement. Cambridge University Press.
- European Commission. (2021a). COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE AND THE COMMITTEE OF THE REGIONS Pathway to a Healthy Planet for All EU Action Plan: ’Towards Zero Pollution for Air, Water and Soil’.
- European Commission. (2021b). Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the protection of the environment through criminal law and replacing Directive 2008/99/EC. European Commission. https://www.europarl.europa.eu/RegData/docs_autres_institutions/commission_europeenne/
- European Commission. (2023a). Energy, Climate change, Environment – Air pollution. https://environment.ec.europa.eu/topics/air_en
- European Commission. (2023b). Environmental Implementation Review. https://environment.ec.europa.eu/law-and-governance/environmental-implementation-review_en
- European Environment Agency. (2017). Changes in urban waste water treatment in eastern Europe. https://www.eea.europa.eu/data-and-maps/daviz/changes-in-wastewater-treatment-in-11#tab-dashboard-01
- European Environment Agency. (2020). Urban waste water collection and treatment in Europe, 2017. https://www.eea.europa.eu/data-and-maps/daviz/urban-waste-water-treatment-in-europe#tab-chart_1_filters=%7B%22rowFilters%22%3A%7B%7D%3B%22column
- European Environment Agency. (2023). Europe’s air quality status 2022. European Environment Agency. https://www.eea.europa.eu/publications/status-of-air-quality-in-Europe-2022/europes-air-quality-status-2022#:~:text=Despite%20reductions%20in%20emissions%2C%20in,of%205%20%C2%B5g%2Fm3
- European Parliament. (2001). Recommendation of the European Parliament and of the Council of 4 April 2001 providing for minimum criteria for environmental inspections in the Member States.
- European Parliament. (2016). Consolidated version of the Treaty on the Functioning of the European Union PART ONE – PRINCIPLES TITLE I – CATEGORIES AND AREAS
OF UNION COMPETENCE Article 4.
- Faure, M. G., & Svatikova, K. (2012). Criminal or administrative law to protect the environment? Evidence from Western Europe. Journal of Environmental Law. 24 (2),
- Fuller, R., Landrigan, P. J., Balakrishnan, K., Bathan, G., Bose-O’Reilly, S., Brauer, M., Caravanos, J., Chiles, T., Cohen, A., Corra, L., Cropper, M., Ferraro, G., Hanna, J.,
Hanrahan, D., Hu, H., Hunter, D., Janata, G., Kupka, R., Lanphear, B. & Yan, C. (2022). Pollution and health: a progress update. The Lancet Planetary Health. 6,
- Kampa, E., Völker, J., Stein, U., Mohaupt, V., & Kristensen, P. (2021). Drivers of and
pressures arising from selected key water management challenges A European
overview. European Environment Agency. Report No 9/2021.
- Lehne, J. (2021). Pollution and the COVID-19 Pandemic: Air Quality in Eastern Europe.
Stockholm Institute of Transition Economics.
- Mazur, E. (2011). Environmental Enforcement in Decentralised Governance Systems: Toward a Nationwide Level Playing Field. OECD.
- OECD. (2009). Ensuring Environmental Compliance: Trends and Good Practices.
- Persico, C. (2022). Can Pollution Cause Poverty? The Effects of Pollution on
Educational, Health and Economic Outcomes. National Bureau of Economic Research.
- Persico, C., Figlio, D., & Roth, J. (2016). Inequality Before Birth: The Developmental
Consequences of Environmental Toxicants. National Bureau of Economic Research.
- Romano, V. (2023). EU lawmakers back heavy fines, jail sentences against green crimes.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
On the 17th of April 2018 the European Commission adopted a package of measures to increase protections for whistleblowers (European Commission Newsroom, 2018). This is good news, as whistleblower protection in Europe has been uneven and in some member states non-existent. Transparency International (2013) rated a disappointing four European countries as having adequate or extensive protection. In a report by Wolfe et al (2014), several European countries, including Germany, France and Italy, were judged to have inadequate laws with respect to several aspects of whistleblower protection, although France and Italy recently improved them considerably. Corruption, fraud of various types, and related forms of economic crime are widespread almost everywhere in the world (See e.g. Dyck et al 2014, and Global Crime Survey 2016). Criminal organizations such as drug cartels, have become increasingly sophisticated and their ability to use the international financial markets has made it ever more difficult for law enforcement agencies to discover them with more traditional law enforcement tools (see e.g. Radu 2016 for an overview). Incentivizing whistleblowers through protection and rewards can prove effective at getting information on these hard-to-detect crimes. Whistleblower protection is central for ensuring democratic values such as freedom of speech and fair elections, and recent cases also suggest that it may be central for protecting investigative journalists and their sources.
The Need for Protection and Possibly Rewards
On February 26th 2018 Ján Kuciak, a Slovakian journalist, was murdered in his home for investigating political connections to organized crime in the heart of Europe (Washington Post, 2018); Daphne Caruana Galizia was killed on 16th of October 2017 by a car bomb while she had been writing about corruption in Malta in connection with the Panama papers (Financial Times, 2018a); Maria Efimova, an employee at a private bank that claimed that her employer had illegally moved funds for Maltese politicians, is under an arrest warrant from Malta and Cyprus on seemingly unrelated charges (The Guardian, 2018); and Hervé Falciani, who blew the whistle on the bank he was working for in Switzerland that helped clients evade billions of dollars in taxes, was arrested in April in Spain after an arrest warrant issued by Switzerland on March 19th, though he has now been released on bail (Financial Times, 2018b).
While some EU countries recently improved whistleblower protection, some seem to be heading in the opposite direction. An extreme example is Germany. A provision packed into the German Data Retention Framework of 2015 allows for prison sentences of up to 3 years for the handling of “stolen data”, and journalists are no longer protected against search and seizure (European Digital Rights, 2017). This provision was included despite Germany’s problems with underreporting of corporate crime. On the need of whistleblowing in the country, consider Volkswagen’s emissions scandal in 2015 when the public learned that the company had installed defeat devices in millions of diesel cars to ‘cheat’ on environmental emissions standards and increase pollution all over the world. The response of management was to blame a set of “rouge engineers” (Congressional Hearing, 2015), while we now know that power points on how to circumvent U.S. emissions tests by a top technology executive circulated within the company as early as 2006 (New York Times, 2016). Excess diesel emissions were associated 38 000 premature deaths in 2015 (Anenberg et al, 2017), implying that whistleblowing could have saved thousands of lives, yet the wrongdoing went on for close to a decade without anyone blowing the whistle. Cheating on emissions tests also turned out to be an industry wide phenomenon.
Germany also has a history of treating whistleblowers poorly. Consider for example the case where a German nurse brought a complaint to her employer in December of 2004 over poor treatment of patients, and she was fired in January 2005. Her employer cited repeated illness as the reason for being fired, the nurse claimed that it was retaliation for speaking out about poor conditions. The nurse then filed a complaint in German Labor Court which was dismissed in August 2005. She then brought the claim to the European Convention of Human Rights, alleging that her right to expression under article 10 of the European Convention of Human Rights had been violated by her employer. She won that case in 2011, and Germany was ordered to pay the nurse 10 000 Euro in non-pecuniary damages, and 5000 for costs and expenses (Heinish V Germany 2011).
Large firms do not appear to be doing better. Even after the Siemens scandal in 2008, when the company was discovered pursuing a long-term, extensive and systematic strategy of bribing foreign governments and purchasing agencies, and promises about a drastic change in corporate governance. Recent cases suggest that the corporate culture at Siemens has not improved. Meng-Lin Liu, a compliance officer at Siemens China, brought attention to alleged kickbacks paid in connection with equipment sales to army hospitals in China to the chief financial officer for healthcare in China. He was fired after reporting internally and filed a claim alleging violations of the Foreign Corrupt Practices Act. Siemens lawyers argued that since he was no longer an employee, he was not entitled to protection under Dodd-Franks definition of “whistleblower” (Forbes, 2014).
The situation in such an important European country like Germany suggests that protection applying across all member states is needed, and the experience of other countries further suggest that protection may not be enough. In the UK, the country recognized to have some of the best protections in the EU (Wolfe 2014, Transparency International 2013), whistleblowers are still experiencing pushback. The recent case of Jes Staley, Barclays Bank’s CEO is enlightening. He ordered his security team to unveil the identity of an uncomfortable whistleblower, going so far as to request video footage of the person who bought the postage for the letter. Yet, the Financial Conduct Authority and the Prudential Regulation Authority (FiCA & PRA) decided to just fine him £642 000 – a small fraction of his pay package that year (Reuters, 2018). Cases like this suggest that the US Congress was right in pushing for rewards. The mild sanctions established by the UK regulators sent a loud and clear message to prospective whistleblowers: even in the UK, where protection was judged as high in the above-mentioned reports, a CEO that violates the law trying to uncover someone reporting his potential mismanagement (probably not to give him a premium), will just have to pay a mild fine, if he is caught of course!
In the following we review the new proposal for whistleblower protections and argue that evidence from the US suggests that financial incentives for whistleblowers may still be needed to ensure an adequate level of reporting. We then consider objections to monetary rewards which are praised by regulators in the US, while EU agencies remains hesitant. Finally, we conclude with suggestions on how to improve the European legislation.
The EU Proposed Directive Versus US Developments
The new Directive includes mandatory establishment of internal reporting channels for firms with more than 50 employees that should allow for anonymous claims (Article 5). It includes prohibition against a wide range of retaliation (Article 14); and the burden of proof is reversed in case of alleged retaliation (Article 15). Who counts as a whistleblower under the Directive is defined widely to encompass subcontractors, trainees, and people associated with a wrongdoing firm in a “work-related context” (Article 2).
The Directive is bound to improve the situation for whistleblowers given the current uneven protection. It bears similarities with the US Sarbanes-Oxley act of 2002 (SOX), but it goes beyond SOX in that it applies more broadly. Since SOX, the legal debate in the US has increasingly focused on rewards to whistleblowers as protections alone are often insufficient to ensure an adequate level of reporting.
After the financial crisis, the US concluded in the Dodd-Frank Act of 2008 that protections were insufficient, and that above and beyond protections, Dodd-Frank allows for rewards to whistleblowers who report wrongdoings in securities trading where the sanction against the wrongdoing party exceeds 1$ million.
The use of rewards was not unfamiliar to the US before Dodd-Frank. They had formerly concluded that in the tax area, whistleblowers who report tax evasion should be eligible for rewards through the Tax Relief and Health Care Act of 2006 which established the Internal Revenue Service “Office of the Whistleblower”. Although previously to 2006 whistleblowers could receive rewards at the IRS, this was entirely up to the agency’s discretion.
In the procurement area, whistleblowers are also eligible for rewards in the US under the False Claims Act (FCA) enacted in 1863. The commitment to rewards was reaffirmed in 1986 when revisions to the act reinvigorated the whistleblower or “qui tam” provisions of act (for an overview of reward programs, see Nyreröd & Spagnolo 2017).
Despite being regarded as having some of the best whistleblower protections in the world (see e.g. Wolfe et al 2014), the US did not settle for protections alone in key regulatory areas. The new EU directive does not address rewards at all which is unfortunate given their law enforcement potential if they are coupled with independent and competent judicial institutions.
Although the US experiment with whistleblower rewards is working, the only EU institution to evaluate reward policies to our knowledge is the UK’s PRA & FiCA on the request of the UK parliament. Their assessment concludes strongly against rewards, yet they do not provide any evidence to back up their negative assessment and make claims that later evidence has refuted. In the following, we review the concerns raised by critics of reward programs, primarily the PRA & FiCA.
Evidence on the Effectiveness of Rewards
Under reward programs in the U.S whistleblowers can receive a percentage of the fine imposed on the wrongdoing firm or person. The range is usually between 15-30% of the sanctions against the firm, and of the money recovered. The exact reward percentage within the range is determined by how central the whistleblowers information was to unearth and sanction the wrongdoing.
One fundamental concern with rewards is their cost effectiveness. Some argue that they can come with a costly government structure and that they attract a lot of meritless claims by opportunist employees, which increase the administrative costs (PRA & FiCA 2014, Ebersole 2011).
On the other hand, many argue that they can be a cost-effective tool in an age when governments are looking for austere economic policies (Engstrom 2014). Some argue that they are at least as efficient as classical “command and control” methods of enforcement, such as selecting random persons or firms for audit. We evaluate cost-effectiveness with respect to three important effects: deterrence, increased quality of claims, and increase quantity of claims.
A significant part of determining cost-effectiveness is the extent to which whistleblowing has any significant deterrence effects on future misbehavior. Johannesen & Stolper (2017) found that whistleblowing had deterrence effects in the off-shore banking sector. They studied the stock market reaction before and after the whistleblower Heinrich Kieber leaked important tax document from the Liechtenstein based LGT Bank. They found abnormal stock returns in the period after the leak, and the market value of banks known to derive some of their revenues from offshore activities decreased.
Wilde (2017) also provide evidence that whistleblowing deters financial misreporting and tax aggressiveness. Using a dataset of retaliation complaints filed with OSHA between 2003 through 2010 on violations of paragraph 806 which outlaw’s retaliation against employees who provide evidence of fraud, he found that firms subject to whistleblower allegations exhibited decreases in financial misreporting and tax aggressiveness.
As for experimental evidence, Abbink and Wu (2017) conducted laboratory experiments studying collusive bribery, corruption, and the effects of whistleblower rewards on deterrence. They find that amnesty for whistleblowers and rewards strongly deter illegal transactions in a one-shot setting, but in repeated interaction the deterrence effect is limited. Their results support a reward mechanism, especially for petty forms of bribery (which are more like one-shot games).
Bigoni et al (2012) conducted laboratory experiments on leniency policies and rewards as tools to fight cartel formation. They find that rewards financed by the fines imposed on the other cartel participants had a strong effect on average price (returning it to a competitive level). In the model setting, this implies that rewards have a deterring and desisting effect on cartel formation.
Another central question is whether rewards increase the quality and quantity of claims. PRA & FiCA (2014) writes that “There is as yet no empirical evidence of incentives leading to an increase in the number or quality of disclosures received by regulators” (PRA & FiCA 2014, p.2).
As for increased quality, there is evidence suggesting that this claim is untrue. Dyck et al (2010) compared whistleblowing in the health care sector where rewards are available through the FCA with non-healthcare sectors where they are not. They found that 41% of fraud cases are detected by employees in the healthcare sector. That number was only 14% for other sectors, a difference highly statistically significant (at the 1% level) despite a small sample size (Dyck et al 2010, p. 2247).
More recently, Call et al (2017) examined empirically the link between whistleblowing and (i) penalties, (ii) prison sentences, and (iii) duration of regulatory enforcement actions for financial misrepresentation. They found that whistleblowers’ involvement in financial misrepresentation enforcement actions was correlated with higher monetary sanctions for the wrongdoing firm and increased jail time for culpable executives. They also found that enforcement proceedings began quicker, and further that whistleblower involvement increased the likelihood that criminal sanctions were imposed by 8.58%, and that criminal sanctions were imposed against the targeted wrongdoer increased by 6.64%.
Another highly contested point is the relation between the quantity and quality of claims and regulatory effectiveness. Some argue that rewards may attract a lot of meritless claims by employees who are either malicious or hope to reap some reward (PRA & FiCA 2014, Ebersole 2011). This does seem to have been the case with some reward programs, but not to the extent many opponents of rewards argue, and this effect does not render rewards a futile or ineffective policy approach, see Nyreröd & Spagnolo (2017) for a thorough discussion.
There are, however, valuable lessons to be learned from the quantity of claims received and the percentage of claims determined to have merit from, for example, the IRS Whistleblower Office. At the IRS there has been a significant backlog of claims, and an exceedingly small number of claimants receive rewards. The IRS program, under 7623(a), does not have a threshold for claims to be considered, and the vast majority of claims fall under 7623(a). These are lessons for optimal design, but not an insurmountable obstacle for effective reward programs. One way around this problem is to have a threshold for claims to be considered. Another is the FCA model, where persons pursue litigation on their own if the Department of Justice declines to join, thereby taking on the risks and costs of losing in court.
Concerns over administrative burden and costly government structures are not salient enough to warrant a rejection of reward policies, as benefit in deterrence and quality outweigh the administrative costs of reviewing even large quantities of incorrect claims.
Entrapment and Malicious Claims
Another central concern has been that “Some market participants might seek to ‘entrap’ others into, for example, an insider dealing conspiracy, to blow the whistle and benefit financially”, FiCA & PRA (2014).
There are presently good ways of preventing this issue, which does not seem to have been salient in the U.S. experience with these policies. Regarding the FCA, for example, when the relator (whistleblower) initiated or planned the wrongdoing, courts can reduce the reward below 15% as they see fit (False Claims Act, 31 U.S.C. §3730 (d) (3)). The IRS has similar restrictions that in cases where the whistleblower planned and initiated the tax evasion, they may considerably reduce or deny any reward. If the whistleblower is convicted of criminal conduct related to the suit, then they should deny her any reward (Internal Revenue Code, 26 U.S.C §7623 (b) (3)).
These restrictions on reward payouts is probably the reason why, judging from the reports by the U.S agencies, entrapment has not emerged as a salient issue in the US experience with the various programs. As for evidence, the National Whistleblower Center (2014) claims they did not find a single case of entrapment in over 10 000 cases in which the planner and initiator of the wrongdoing received an award. Of course this does not exclude the possibility that a poorly run European agency/regulator might mismanage the whistleblower program to the point where this indeed becomes an issue; a sufficiently incompetent administration can generate problems even with the most robust and effective tools.
A related concern is that financial incentives could encourage employees to submit fraudulent claims, e.g. to “fabricate claims of wrongdoing for personal profit” (Howse & Daniels 1995, p.540, see also Rose 2014, p.1283). A similar concern is that: “Financial incentives might lead to more approaches from opportunists and uninformed parties passing on speculative rumors or public information. The reputation of innocent parties could be unfairly damaged as a result” (PRA & FiCA 2014, see also Vega 2012, p.510). There is also the fear that opportunistic whistleblowers will force “corporations into financial settlements in order to avoid the adverse reputational and related effects caused by highly public, albeit ill-founded, accusations” (Howse & Daniels 1995, p.526/27).
Although evidence on this is hard to find, judging from the reports of agencies, fraudulent and malicious has not been a significant issue. This is probably because fraudulent reporting is a crime, and a whistleblower who report fraudulent information exposes him or herself to a legal fight with the falsely accused employer and to sanctions against perjury and defamation. Indeed, in the case of the IRS, the information is submitted under penalty of perjury (Internal Revenue Code, 26 U.S.C §7623 (b)(6)(C)), which is also the case of the SEC if the whistleblower is represented by an attorney (Exchange Act, U.S.C 78u-6(h)). In the case of the FCA, should the whistleblower lie to the court, he risks felony charges punishable by up to five years in jail for perjury, and the possibly of being convicted of other crimes related to lying under oath. Further, the FCA has a reverse fee-shift for obviously frivolous claims (Engstrom 2016, p.10).
Whether fraudulent claims are a concern for the efficacy of a whistleblower reward program depends to a large extent on the precision of the court system. Buccirossi et al. (2017) analyze this concern within a formal economic model. They show that fraudulent reports are entirely irrelevant for countries with sufficiently precise/competent court systems, provided strong sanctions against perjury, defamation and lying under oath are there to balance the incentives generated by large bounties. Where the judicial system makes a lot of mistakes, instead, this may not be sufficient for the scheme to have crime deterrence effects, which may make it preferable not to introduce large rewards for whistleblowers.
Some suggest that the European hesitation over improving whistleblower protection and considering rewards may have partially historical roots, as both Nazi Germany and Soviet Russia relied heavily on citizens reporting on one another (Givati 2016, p.26.). But the lack of voices speaking out against what the Nazi’s were doing should suggest the opposite, and it is not clear how these parallels should be drawn when we are talking about rewarding whistleblowers in the financial offices of private corporations.
It is also the case that most valuable information to law enforcement is often in the hands of higher-ups in the organization, those who have more to lose in the case of whistleblowing (Engstrom 2016), and for whom protections would be an insufficient compensation relative to their current position and salary. The blunt tool that is horizontal protection for whistleblowers who report violations of EU law could be coupled with precise tools such as rewards for violations of specific EU laws whose undermining can be particularly detrimental to financial stability or the environment.
If European countries and their regulatory and law enforcement institutions are not capable of having an open and honest debate, competently based on the available evidence from rigorous research and from previous experiences in other countries, then they would hardly be able to competently design and properly administer a system of rewards for whistleblowers. As argued in Buccirossi et al. (2017), in countries with weak institutions high powered tools like whistleblower rewards should better be avoided, as in the hand of incompetent law makers and corrupt regulators they would likely produce more damage than good.
- Abbink, Klaus & K. Wu. 2013. “Reward Self-Reporting to Deter Corruption: An Experiment on Mitigating Collusive Bribery”, Monash University Discussion Paper 42/13, 2013.
- Anenberg, S. 2017. “Impacts and mitigation of excess diesel-related NOx emissions in 11 major vehicle markets”, Nature 545, 467-471.
- Bank of England: Prudential Regulations Authority & Financial Conduct Authority. 2014.” Financial Incentives for Whistleblowers”, available at: https://www.fca.org.uk/news/financial-incentives-for-whistleblowers
- Berghoff, H. 2017. “´Organized irresponsibility´”? The Siemens corruption scandal of the 1990s and 2000s”, Business History, DOI: 10.1080/00076791.2017.1330332
- Bigoni, M., C. Le Coq, S. Fridolfsson and G. Spagnolo. 2012. “Fines, Leniency and Rewards in Antitrust”, RAND Journal of Economics, 43(2), 368-390.
- Buccirossi P, Immordno G, and Spagnolo G. 2017. “Whistleblower Rewards, False Reports, and Corporate Fraud”, Stockholm Institute of Transition Economics Working Paper No.42.
- Congressional Hearing (2015) of Volkswagens head of American Operations Michael Horn, October.
- Dyck, A. Morse, A. Zingales, L. 2010. ”Who Blows the Whistle on Corporate Fraud?”, The Journal of Finance, Vol.65, No.6, pp.2213-2253.
- Dyck, A. Morse, A. Zingales, L. 2013. ”How Pervasive is Corporate Fraud?”, Rotman School of Management Working Paper no.2222608.
- Ebersole, D. 2011. “Blowing the Whistle on the Dodd-Frank Whistleblower Provisions”, 6 Ohio St. Entrepen. Bus. L. J. 123.
- Engstrom, D. 2016. “Bounty Regimes”, in RESEARCH HANDBOOK ON CORPORATE CRIMINAL ENFORCEMENT AND FINANCIAL MISDEALING (Jennifer Arlen ed., Edward Elgar Press, forthcoming 2016)
- Engstrom, D. 2014. “Private Enforcement’s Pathways: Lessons from Qui Tam Litigation”, Columbia Law Review, Vol.114, December, No.8.
- European Commission. 2018. “Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the protection of persons reporting on breaches of Union law”, available at: https://ec.europa.eu/info/publications/annexes-proposal-directive-protection-persons-reporting-breaches-union-law_en
- European Commission Newsroom. 2018. “Robust protections for whistleblowers across EU: commission proposes new rules” available at: http://ec.europa.eu/newsroom/just/item-detail.cfm?item_id=620400
- European Digital Rights. 2017.“Germany: fighting anti-whistleblower provision” available at: https://edri.org/germany-fighting-anti-whistleblower-provision/
- Givati, Y. 2016. “A Theory of Whistleblower Rewards.” Journal of Legal Studies, 45, 2016.
- Heinish V Germany. 2011. European Court of Human Rights.
- Howse, R., Daniels, R. J. 1995. “Rewarding Whistleblowers: The Costs and Benefits of an Incentive-Based Compliance Strategy.” 525-549. Retrieved from: http://repository.upenn.edu/law_series/4
- Jahmani, Y. Dowling, W. 2008. “The Impact of Sarbanes-Oxley Act”, Journal of Business & Economic Research, Vol 6, Number 10.
- Johannesen, Niels and Stolper, Tim B.M. 2017. “The Deterrence Effect of Whistleblowing – An Event Study of Leaked Customer Information from Banks in Tax Havens”, Working Paper of the Max Planck Institute for Tax Law and Public Finance No. 2017-4. Available at SSRN: https://ssrn.com/abstract=2976321 or http://dx.doi.org/10.2139/ssrn.2976321
- National Whistleblower Center. 2014. “The Importance Of Whistleblower Rewards in
- Combating International Corruption.” Available at: https://www.whistleblowers.org/storage/docs2/anti-corruption-report.pdf
- Nyreröd, T. Spagnolo, G. 2017. “Myths and Numbers on Whistleblower Rewards”, SITE Working Paper Series no.44, available at: SSRN: https://ssrn.com/abstract=3100754
- Vega, M. 2012. “Beyond Incentives: Making Corporate Whistleblowing Moral in the New Era of Dodd-Frank Act ‘Bounty Hunting’”, Connecticut Law Review, Vol. 45.
- Jaron H. Wilde. 2017. “The Deterrent Effect of Employee Whistleblowing on Firms’ Financial Misreporting and Tax Aggressiveness”, The Accounting Review, In-Press.
- Call, Andrew C. and Martin, Gerald S. and Sharp, Nathan Y. and Wilde, Jaron H. 2017. “Whistleblowers and Outcomes of Financial Misrepresentation Enforcement Actions”, available at SSRN: https://ssrn.com/abstract=2506418 or http://dx.doi.org/10.2139/ssrn.2506418
- Wolfe, S. et al. 2014. “Whistleblower Protection Laws in G20 Countries, priorities for Action”, Available at <http://schd.ws/hosted_files/16iacc/0b/IACC%20whistleblower%20improvements%209.3.15.pdf>
- Radu, P. 2016. “Follow the Money: A Digital Guide for Tracking Corruption”, International Center for Journalists, Romanian Centre for Investigative Journalism. Avaliable at: https://www.icfj.org/sites/default/files/Follow_Money.pdf
- Financial Times. 2018a. “Maltese journalist Caruana Galizia was assassinated, says her son”, available at: https://www.ft.com/content/d410b136-b34b-11e7-a398-73d59db9e399
- Financial Times .2018b. “HSBC whistleblower Hervé Falciani arrested in Spain”, available at: https://www.ft.com/content/f662b04e-3830-11e8-8b98-2f31af407cc8
- Forbes .2014. “SEC ready to rumble in Siemens whistleblower case” available at: https://www.forbes.com/sites/erikakelton/2014/03/04/sec-ready-to-rumble-in-siemens-whistleblower-case/#17a3cda856c4
- The Washington Post. 2018. “Police believe a journalist was killed for reporting on fraud in the heart of Europe”, available at: https://www.washingtonpost.com/news/worldviews/wp/2018/02/26/police-believe-a-journalist-was-killed-for-reporting-on-fraud-in-the-heart-of-europe/?noredirect=on&utm_term=.cac1bdef7f00
- The Guardian. 2018. “Malta corruption whistleblower hands herself in to police”, available at: https://www.theguardian.com/world/2018/mar/20/malta-corruption-whistleblower-maria-efimova-hands-herself-in-police
- New York Times. 2016. “VW Presentation in ’06 Showed How to Foil Emissions Tests” available at: http://www.nytimes.com/2016/04/27/business/international/vw-presentation-in-06-showed-how-to-foil-emissions-tests.html?smid=tw-share&_r=1
Disclaimer: Opinions expressed in policy papers and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.