Can carbon emission trading scheme reshape audit reporting aggressiveness? Evidence from an incremental information perspective

Using a sample of listed Chinese companies between 2010 and 2019, this study examines the impact of the carbon emissions trading scheme (ETS) on audit reporting aggressiveness. We find that the ETS implementation reduces audit reporting aggressiveness. The mechanism tests indicate that the incremental carbon and environmental-related information provided by emission-regulated companies enhances auditors ’ prudence, leading to informed judgments. Further analysis reveals that auditors with comparatively lower competency benefit more from the incremental information, and the ETS impact is more pronounced for firms with strong external monitoring and higher carbon risk, which indicates varied incremental information value for auditors ’ judgment.


Introduction
Climate change is a global challenge.Carbon markets offer market-based solutions.Research on the European Union carbon market shows that the carbon emissions trading scheme (ETS) is associated with decreased CO 2 emissions, improved economic performance, enhanced corporate competitiveness, and innovation (Martin et al., 2016).In late 2013, China initiated its pilot ETS in response to its carbon reduction endeavors and progressively implemented it in eight regions: Beijing, Tianjin, Shanghai, Shenzhen, Hubei, Guangdong, Fujian, and Chongqing.Similar to the impact of ETS in the European region, the implementation of ETS in China has proven effective in reducing energy consumption and carbon emissions (Hu et al., 2020) while fostering economic growth (Zhang et al., 2020).Firm-level analyses further demonstrate the influence of the ETS on corporate innovation, financial performance, and investment decisions (Chen et al., 2022;Liu and Li, 2022;Dong et al., 2022).
While ETS research primarily focuses on the environmental and economic effects, little attention has been paid to the role of auditors.Efficient capital markets rely on a continuous supply of reliable, timely, and audited information (Knechel, 2021).Auditors function as the "gatekeepers" of accounting information quality for listed companies and are crucial intermediaries in the capital market.How auditors perceive the operational fluctuations and risks in emission-regulated companies under the pilot ETS and whether auditors can effectively incorporate these aspects into audit reports can directly impact the efficiency of the capital market.This study aims to address this critical research gap by examining the impact of ETS on audit reporting aggressiveness and the mechanisms underlying this phenomenon.
The presence of aggressive audits suggests that auditors have high thresholds for issuing modified audit opinions (Gul et al., 2013), usually stemming from the auditors' inability to detect misstatements.Distinguishing our study from audit quality literature, our paper adopts an auditor-centric approach and investigates how auditors respond to the incremental information following ETS regulations.In other words, we focused on audit opinions, which are more direct indicators of audit quality (DeFond and Zhang, 2014), rather than measures of financial reporting quality, such as discretionary accruals and meeting/exceeding earnings benchmarks.We predict that ETS implementation influences auditor reporting aggressiveness in two ways.On the one hand, the incremental information perspective suggests that emission-regulated firms are encouraged to disclose carbon and environmental-related information.These disclosures support audit judgments by providing incremental information in addition to financial data and a clearer grasp of carbon risks, resulting in less aggressive audit reporting.On the other hand, the selective information perspective highlights that the increased compliance costs and risks facing emission-regulated firms can drive them to manipulate earnings upwards (Long et al., 2023).Managers might also use carbon disclosure to hide poor profitability or unfavorable news (Fan et al., 2021).This biased approach can confuse auditors, and it may also compromise the prudence level of auditors, consequently diminishing the likelihood of them issuing modified opinions.Given the competing views, whether and how the ETS influences an auditor's judgment remains an empirical question.
Using a sample of Chinese A-share listed firms from 2010 to 2019, this study employed the ETS pilots as a "quasi-natural experiment" to address the research question.The results reveal a negative link between ETS implementation and audit reporting aggressiveness.The mechanism test results suggest the reported relationship is attributed to improved carbon and environmental-related information disclosure, supporting our incremental information perspective.In addition, while emission-regulated firms may manipulate earnings upwards, auditors can still identify invalid evidence and lean toward less aggressive judgments, rejecting the selective information perspective.Furthermore, auditors with comparatively lower competency, namely those affiliated with smaller audit firms, occupying non-audit partner roles, lacking accounting education backgrounds, and possessing education levels below postgraduate, benefit more from incremental information.Cross-sectional examinations indicate that the influence of implementing the ETS is more notable for companies subject to intense external oversight (i.e., companies with a larger number of institutional investors and high analyst coverage) and for industries with high carbon risk (i.e., manufacturing and energy sectors).The results suggest that the information provided by these companies is more valuable for auditors' judgments, thus further validating the incremental information perspective.
This paper contributes to the existing literature in three ways.First, it addresses the limited attention given to the impact of carbon emission trading policies on external stakeholders of firms, particularly the auditors, who play a pivotal role as crucial information intermediaries.Second, our findings regarding the effects of environmental policy, expanding beyond the attributes of audit firms (DeAngelo, 1981;Minutti-Meza, 2013;Francis et al., 2014) and audit partners (Gul et al., 2013;Cameran et al., 2022), can contribute to research on audit quality.Third, we delve into the underlying mechanisms.Our findings can offer valuable insights into the channels through which carbon trading policy affects auditors' performance, thereby contributing to a deeper understanding of the dynamics between environmental policies and the role of auditors.
The rest of this paper is organized as follows.Section 2 develops the hypotheses.Section 3 presents the research design, and Section 4 reports the empirical results.Section 5 concludes.

Hypotheses development
China's National Development and Reform Commission released the "Guidelines for Accounting and Reporting Greenhouse Gas Emissions (Trial)", which provides instructions for companies to disclose emission data, quantification methods, monitoring plans, and other relevant information.Due to regulatory constraints (Hu et al., 2020) and market preferences (Patrick and Marcin, 2021), emission-regulated firms are incentivized to disclose greenhouse gas emissions and other environmental-related information.We posit that relevant information on carbon emissions and environmental practices can impact auditors' judgments from two perspectives: incremental information perspective and selective information perspective.

Incremental information perspective
Prior research has contended that voluntary non-financial reporting is disseminated to offer stakeholders additional information about corporate performance (Guthrie and Parker, 1989).This viewpoint aligns with the incremental information perspective, which posits that increased disclosures contribute to well-informed decision-making processes.
First, carbon and environmental-related information disclosure encompasses additional carbon-related details pertinent to the economic and financial state of a given enterprise.For instance, carbon emission is a vital indicator of a company's unaccounted carbon liabilities and costs, signaling potential fines, penalties, and litigation expenses (Andrew and Cortese, 2019).This incremental information provides additional support for audit judgments.
Second, carbon and environmental-related information may also encourage auditors to pay more attention to areas such as risks, opportunities, and governance, enabling them to appropriately assess the impact of carbon emissions on a company's economic performance (Choi et al., 2021;Jiang et al., 2021).These elements lead to an informed understanding of carbon risks, resulting in reduced aggressiveness in audit reporting (i.e., increased likelihood of issuing modified audit opinions than what would be predicted).Accordingly, we hypothesize the following: W. Long et al.H1a: The implementation of the ETS reduces audit reporting aggressiveness.

Selective information perspective
However, increased compliance costs and risks for emission-regulated firms incentivize them to manipulate earnings upwards (Long et al., 2023).Managers might employ carbon information disclosure to mask insufficient profitability or other adverse news.These disclosures selectively present positive information regarding a company's carbon performance while concealing the negative aspects (Fan et al., 2021).Biased information disclosures diminish auditors' comprehension of a company and its environmental activities, thus leading them astray in assessing the risks of misreporting.As a result, auditors can be misled, and this increases the likelihood that auditors overlook aggressive accounting practices, thus reducing the probability of the issuance of a modified audit opinion.Therefore, our competing hypothesis is stated as follows: H1b: The implementation of ETS increases audit reporting aggressiveness.

Data and sample
Our sample includes all Chinese A-share listed companies from 2010 to 2019.Our sample starts in 2010 to avoid the impact of the Global Financial Crisis (GFC), and it ends in 2019 to eliminate the impact of the COVID-19 pandemic.China's pilot ETS started in late 2013, gradually incorporating emission-regulated firms into the pilot lists during the sample period.We manually identify regulated firms using the ETS pilot list for each year.Companies from the finance and insurance sectors, those with special designations (ST, PT, or *ST), and those with missing financial data are excluded.Therefore, a final sample consists of 17,945 firm-year observations.Financial data is sourced from the China Stock Market & Accounting Research (CSMAR) database.To mitigate the impact of outliers, we winsorize all continuous variables at the top and bottom 1 % of their distributions.

Methodology
We use China's pilot ETS as a natural quasi-experiment.To explore the relationship between the carbon trading policy and audit reporting aggressiveness, we employ the staggered difference-in-differences (DID) method, as described by Model (1): In Model (1), where i, j, and p denote the firm, industry, and province, respectively, and t represents the year.ARAgg is the dependent variable representing audit reporting aggressiveness.Following Gul et al. (2013) and Chen et al. (2017), this study employs a logistic model (Model 2) to predict the likelihood of auditors issuing a modified audit opinion (Predicted_MAO): where MAO is a dummy variable that equals 1 if the auditor issues a modified audit opinion, and 0 otherwise, and quality measure (ARAgg) is the predicted probability minus the actual value of MAO.A higher ARAgg value indicates a lower propensity of the issuance of MAOs by auditors than what would be predicted.
The independent variable of Model ( 1) is Pilot, which equals 1 when the firm is included in the carbon trading pilots and thereafter, and 0 otherwise.The coefficient β 0 measures the impact of ETS on audit reporting aggressiveness.Following Gul et al. (2013), we include several determinants of audit reporting aggressiveness as controls.We also include firm fixed effects (θ), year fixed effects (γ), province-year interaction fixed effects (μ), and industry-year interaction fixed effects (δ).ε represents the random error term.
Furthermore, to address the issue of heteroscedasticity, we cluster standard error at both the firm and industry levels.The variable definitions are provided in Appendix A, and Table 1 presents the summary statistics of key variables.

Main results
In Table 2, columns (1) and ( 2) present the baseline regression results.The estimated coefficient for Pilot is negative and statistically significant in both columns.This result suggests that audit reporting aggressiveness significantly reduces after the implementation of the ETS.Therefore, Hypothesis 1a is supported.

Mechanism analysis
We examine whether implementing carbon trading enhances corporate information disclosure and provides incremental information for auditors in making informed audit opinions.Following Yu and Van Luu (2021), we use the Bloomberg Environmental Disclosure Score (EPscore) 1 to measure the extent of carbon and environmental information that a company shares with the public.In Table 2, column (3) shows that ETS improves the carbon and environmental-related information disclosure of emission-regulated firms.Moreover, high disclosure reduces aggressive auditor reporting only for firms that have disclosed more carbon and environmental-related information (Table 2, columns 4 and 5), supporting the view that ETS implementation reduces audit reporting aggressiveness due to incremental information disclosures.
We further investigate why the assumption based on the selective information perspective does not hold.In Appendix B, the results show that, post-ETS, emission-regulated firms increase upward earnings manipulation while aggressive audit reporting reduces significantly regardless of the degree of earning manipulation.These outcomes indicate that auditors, as gatekeepers of accounting information quality, can identify invalid evidence and curb the impact of biased information disclosures on their audit opinions.

Robustness tests
We perform a battery of robustness tests.First, when we use alternative measures of audit reporting aggressiveness, such as audit opinion types (denoted as AO, Wu and Ye, 2020) or auditor reporting conservatism (denoted as MAO, Chen et al., 2016), our main results remain (Table 3 columns 1 and 2).Second, we examine the characteristics of Key Audit Matters (KAM S ) obtained from textual analysis.The number (KNnumber) and length (KN Description) of KAMs reflect auditor prudence and judgments.The results remain quantitatively similar (Table 3 columns 3 and 4).Third, by employing the company, governance, and auditor characteristic variables included in the baseline regression as matching variables, we perform propensity score matching (PSM) using 1:1 nearest neighbor matching and radius matching with a caliper of 0.01, respectively.The results (Table 3 columns 5 and 6) obtained from regression using the matched samples support the baseline regression results.
Fourth, we conduct a parallel trends test.Fig. 1 confirms that the parallel trend assumption is maintained in our DID estimation.Finally, we run placebo tests to rule out the possibility that our results are driven by randomness.We randomly select treatment groups and repeat the regression 1000 times to generate a distribution of the estimated coefficient.Fig. 2 illustrates that the coefficient obtained from the baseline regression lies in the lower tail of the distribution of t-values from the pseudo-treatment group.These robustness test results collectively support Hypothesis 1a.Gul et al. (2013) highlight that audit aggressiveness varies across individual auditors.Therefore, this study further investigates 1 A higher Bloomberg score indicates a greater dissemination of non-financial information but does not indicate a higher environmental performance (Yu and Van Luu, 2021).

Auditor characteristics
W. Long et al. whether auditors with certain characteristics benefit more from incremental information.The empirical findings in Table 4 reveal that auditors with relatively low competence, namely those associated with smaller audit firms, holding positions as non-audit partners, lacking educational backgrounds in accounting, and possessing education levels below postgraduate, achieve greater benefits from incremental information.Consequently, this leads to a greater impact in reducing their reporting aggressiveness.

External monitoring
Given the growing concerns of institutional investors and analysts about climate change, studies suggest they can leverage their advantageous information position and pressure management to enhance the quality of carbon-related disclosures (Ilhan et al., 2023).Thus, incremental information provided by companies becomes especially relevant and valuable to auditors when external monitoring T-values are in parentheses under the coefficients.***, **, and * denote significance at 1 %, 5 %, and 10 % levels, respectively.All variables are defined in Appendix A.
W. Long et al. is strong.Results reported in Table 5 (columns 1-4) indicate that high external monitoring quality, proxied by high institutional ownership and high analyst following, enhances the quality of carbon information disclosure and assists auditors in making informed judgments, thus reducing auditor reporting aggressiveness.

Industry heterogeneity
Lastly, considering the broad coverage of carbon emission regulations in critical industries such as steel, power, chemicals, construction, and non-ferrous metals, this section examines incremental information from which industries, in particular, can assist auditors in making prudent judgments.The regression results in Table 5 (columns 5-7) highlight significant industry-specific effects, particularly in the manufacturing and energy sectors.As major carbon emitters and monitoring targets, these industries could face T-values are in parentheses under coefficients.***, **, and * denote significance at 1 %, 5 %, and 10 % levels, respectively.Fixed effects include firm, year, province-year interaction, and industry-year interaction fixed effects.All variables are defined in Appendix A.   T-values are in parentheses under coefficients.***, **, and * denote significance at 1 %, 5 %, and 10 % levels, respectively.Fixed effects include firm, year, province-year interaction, and industry-year interaction fixed effects.
W. Long et al. increased carbon risks, thereby making their carbon-related information disclosures valuable and supportive for auditors' judgments.This results in less aggressive audit reporting.

Conclusion
Using data from listed Chinese companies between 2010 and 2019, we find a negative relationship between ETS implementation and audit reporting aggressiveness.Our findings highlight the effect of incremental carbon and environmental-related information disclosures via the implementation of ETS in the audit process, which contributes to improved audit quality by enhancing the prudence of auditors.Our research also has important implications for both regulators and corporations.First, the incremental information serving as a crucial intermediary provides auditors with a basis for more precise judgments, which contributes to the efficiency of capital markets.Second, emission-regulated companies should implement effective measures to reduce costs and enhance efficiency rather than manipulate financial reporting information because such actions have a limited impact on auditors' judgment.T-values are in parentheses under coefficients.***, **, and * denote significance at 1 %, 5 %, and 10 % levels, respectively.Fixed effects include firm, year, province-year interaction, and industry-year interaction fixed effects.

Table 2
Main regression results and mechanism analyses results.

Table 3
Robustness tests results.

Table 4
Emissions trading scheme, auditor characteristics, and audit reporting aggressiveness.

Table 5
Emissions trading scheme, external monitoring, industry heterogeneity, and audit reporting aggressiveness.
W.Long et al.Appendix A.

Definitions of variables
that equals 1 if the same person holds both the CEO and board chairperson positions, and 0 otherwise Top10 Ownership concentration Proportion of the shareholding of top 10 shareholders to the total outstanding shares Big4 Big4 auditor A dummy variable that equals 1 if the auditor is from Big4 audit firms, and 0 otherwise Change Change in auditors A dummy variable that equals 1 if the auditor changes, and 0 otherwise Ln Tenure Auditor tenure Natural logarithm of years the audit firm provide audit services to the clients Degree Auditor educational background A dummy variable that equals 1 if the auditor has a qualification of undergraduate or above, and 0 otherwise Major Auditor major A dummy variable that equals 1 if the auditor majors in accounting, and 0 otherwise Male Auditor gender A dummy variable that equals 1 if the auditor is male, and 0 otherwise Partner Audit partner A dummy variable that equals 1 if the auditor is a partner and 0 otherwise Mod Previous year modified audit opinions A dummy variable that equals 1 if the auditor issues a modified audit opinion in year t-1, and 0 otherwise Robustness test variable AO Audit opinion types An ordered variable takes a value from 0 to 4 for clean opinions, unqualified opinions with explanatory notes, qualified opinions, disclaimed opinions, and adverse opinions, respectively MAO Auditor reporting conservatism A dummy variable that equals 1 if the auditor issues a modified audit opinion, and 0 otherwise KNnumber Number of KAMs The logarithm of the number of disclosed KAMs in the annual audit report for the respective year KN DescriptionLength of KAMsThe logarithm of the character count in the descriptions of KAMs disclosed in the annual audit report for the respective year.This count includes Arabic numerals, Chinese characters, and punctuation marks