China Espionage Knocks Wind Out of US Firms

March 17, 2012 by  
Filed under Green Energy News

Last June, three men squeezed
inside a wind turbine in China’s Gobi Desert. They were
employees of American Superconductor Corp., a maker of computer
systems that serve as the electronic brains of the device. From
time to time, AMSC workers are required to head out to a wind
farm in some desolate location — that’s where the wind usually
is — to check on the equipment, do maintenance, make repairs,
and keep the customers happy.

On this occasion, the AMSC technicians were investigating a
malfunction. They entered the cylindrical main shaft of the
turbine, harnessed themselves to a ladder, and climbed 230 feet
in darkness up to the nacelle, an overpacked compartment that
holds the machinery used to convert the rotation of the blades
into electricity. Devens, Massachusetts-based AMSC had been
using the turbine, manufactured by the company’s largest
customer, China’s Sinovel Wind Group Co. (601558), to test a new version
of its control system software.

The software was designed to disable the turbine several
weeks earlier, at the end of the testing period. But for some
reason, this turbine ignored the system’s shutdown command and
the blades kept right on spinning. The AMSC technicians tapped
into the turbine’s computer to get to the bottom of the glitch.

The problem wasn’t immediately clear, so the technicians
made a copy of the control system’s software and sent it to the
company’s research center in Klagenfurt, Austria, which produced
some startling findings, Bloomberg Businessweek reports in its
March 19 issue. The Sinovel turbine appeared to be running a
stolen version of AMSC’s software. Worse, the software revealed
Beijing-based Sinovel had complete access to AMSC’s proprietary
source code. In short, Sinovel didn’t really need AMSC anymore.

Bad News

Three days after that expedition in the Gobi, Daniel McGahn,
AMSC’s chief executive officer, got the news on his mobile phone
while he was traveling in Russia. Hired in 2006, McGahn helped
revamp the then-floundering company by focusing it on two things:
China and wind power. Those bets paid off for a while, as
Sinovel bought more and more turbine controllers from AMSC. Then
in March 2011, Sinovel abruptly and inexplicably began turning
away AMSC’s shipments at its enormous turbine assembly factory
in Liaoning province.

On April 5, AMSC had no choice but to announce that Sinovel
– now its biggest customer, accounting for more than two-thirds
of the company’s $315 million in revenue in 2010 — had stopped
making purchases. Investors fled, erasing 40 percent of AMSC’s
value in a single day and 84 percent of it by September. The
company’s stock chart looks like the electrocardiogram of a
person rushing toward white light.

Sinovel Relationship

On June 15, standing in a St. Petersburg office tower,
McGahn listened to the report from the Austrian team for
30 minutes and felt the blood drain from his face. He had been
trying for months to save the relationship with Sinovel and was
making almost no progress. By the time he ended the call from
his Austrian team, he knew why.

What McGahn says happened to AMSC may be incredibly brazen,
but it’s hardly exceptional. There have been a large number of
corporate spying cases involving China recently, and they are
coming to light as President Barack Obama and the U.S., along
with Japan and the European Union, have filed a formal complaint
to the World Trade Organization over China’s unfair trading
practices. The complaint includes the hoarding of rare earths,
the metals required for the manufacture of other green energy
technologies such as batteries for hybrid vehicles.

Far-Reaching Campaign

In November, 14 U.S. intelligence agencies issued a report
describing a far-reaching industrial espionage campaign by
Chinese spy agencies. This campaign has been in the works for
years and targets a swath of industries: biotechnology,
telecommunications, and nanotechnology, as well as clean energy.
One U.S. metallurgical company lost technology to China’s
hackers that cost $1 billion and 20 years to develop, U.S.
officials said last year. An Apple Inc. (AAPL) global supply manager
pled guilty in 2011 to funneling designs and pricing information
to China and other countries; a Ford Motor Co. (F) engineer was
sentenced to six years in prison in 2010 for trying to smuggle
4,000 documents, including design specs, to China. Earlier this
month, the National Aeronautics and Space Administration told
Congress that China-based hackers had gained access to sensitive
files stored on computers at the Jet Propulsion Laboratory.

As the toll adds up, political leaders and intelligence
officials in the U.S. and Europe are coming to a disturbing
conclusion.

“It’s the greatest transfer of wealth in history,” General
Keith Alexander, director of the National Security Agency, said
at a security conference at New York’s Fordham University in
January.

Covering Digital Tracks

In other espionage cases, such as those involving Google
Inc. (GOOG)
, Lockheed Martin Corp. (LMT) and DuPont Co., thieves did a far
better job of covering their digital tracks. Sinovel, however,
was caught red-handed. AMSC has presented to law enforcement
officials in Austria and China computer logs and messages that
show Sinovel courting one of the U.S. company’s employees and
paying him to aid in the code heist.

“It’s a red-hot smoking gun example,” said John Kerry,
chairman of the Senate Foreign Relations Committee and the
Democratic U.S. senator from AMSC’s home state. “If this is the
way the Chinese choose to do business, it’s going to be very
contentious and tough sledding ahead for this relationship.”

Intellectual Property Abuses

U.S. politicians and corporate executives have groused
about China’s intellectual property abuses for years, to little
effect. China often promises to take a harder stance against
such thefts but rarely backs up the words with actions. For
example, Chinese officials have promised to crack down on the
theft of Microsoft Corp.’s (MSFT) Windows operating system; the company
said it’s still seeing mass downloads of its software that were
never paid for. McGahn, though, has taken a highly unusual step.
He decided to fight back — in China.

AMSC has filed four complaints against Sinovel in Chinese
courts — where Sinovel has a steep home-field advantage –
seeking $1.2 billion in damages. Sinovel has filed its own
countersuits claiming AMSC owes it $207 million for problems
including defective equipment. Sinovel declined to make its
chairman available for an interview or to comment for this story.
And because Chinese courts don’t make legal documents available
to the public, it wasn’t possible to read Sinovel’s
counterclaims.

“How China responds to this is going to be central to how
they respond to other issues of concern between us,” Kerry said.

Superconductive Material

AMSC was founded in 1987 by four professors at the
Massachusetts Institute of Technology. The idea was to develop
power transmission lines made from cooled superconductive
material, which dramatically reduces energy loss. At the time,
superconductivity looked like science’s latest gift to big
business. But the technology has never quite lived up to those
early hopes, and AMSC’s business wallowed in the red for decades.
In 2006 the company hired McGahn, a gregarious executive with a
master’s degree in marine engineering from MIT, as a vice
president charged with exploring new businesses.

As McGahn surveyed AMSC’s technology, he focused on the
company’s research into wind-turbine control systems. A modern
1.5-megawatt turbine is the equivalent of a 160-ton, high-
performance pinwheel. Each gets stuffed with as much as $200,000
worth of electronics, including a power converter and what’s
called a programmable logic controller, an industrial computer
the size of a couple of cigarette cartons. These devices are
used to do everything from filling up the bottles in a Budweiser
brewery to controlling valves in oil pipelines. In the case of
turbines, they can rapidly adjust the yaw and pitch of blades,
among other functions. McGahn sensed an opportunity to take this
technology and capitalize on China’s efforts to harvest energy
from the wind.

Clean Energy Law

The same year AMSC hired McGahn, China passed a clean
energy law calling for the creation of seven 10,000-megawatt
wind farms in strategic zones throughout the country, including
Gansu, Zhejiang, Inner Mongolia, and Jiangsu provinces. The law
made China the hottest wind market in the world. In 2009,
according to a U.S. wind industry report, a new turbine was
going up in China every hour. By 2020 just one of those wind
farms may produce as much power as 10 nuclear power reactors.

AMSC began packaging the electronic components and selling
them to China’s small but growing domestic manufacturers, which
had plenty of capital and cheap labor to make the turbines’
steel skeletons but lacked the sophisticated gadgetry to run
them. The arrangement was working the way it was supposed to:
China would turn out the commodity hardware — the turbines –
and a U.S. company would retain control of the high-margin
intellectual capital-end of the business.

‘Symbiotic Relationship’

“We always saw it as a symbiotic relationship of having
China’s low-manufacturing cost coupled with Western
technology,” McGahn said. “We would grow as they grew.”

McGahn was well aware of the dangers of working with
Chinese companies, which have become notorious for cutting out
their partners after squeezing them for technology through
transfer agreements and other means. Now 40, McGahn built a
career out of taking technology startups and building them into
revenue generators, often by finding customers among Asian
manufacturers. He used this approach with nanotube plastics for
auto parts at a Cambridge, Massachusetts-based company called
Hyperion Catalysis International and with photovoltaic film at
Lowell-based Konarka Technologies.

Before arriving at AMSC, he had worked in Japan and South
Korea and said he succeeded by carefully sizing up both partners
and rivals. McGahn likes to tell people that almost all of
history’s wars started because political leaders misunderstood
their adversaries.

“I spend an inordinate amount of time studying my
counterparts,” he said.

Secure Barriers

If McGahn was going to bet AMSC’s future on partnerships
with Chinese companies, he wanted secure barriers around its
intellectual property. He designed AMSC’s China operations — in
fact, reorganized much of the company — with that in mind. To
hire AMSC’s first 30 employees in China, McGahn interviewed 400
people, handpicking the ones he thought he could trust. When
AMSC opened a factory in China’s Jiangsu province to assemble
power converters, McGahn made sure firmware and other
technology-rich components were built in factories in the U.S.
and then shipped to Asia.

Software was sequestered at the company’s research facility
in Austria, which has a booming clean energy sector much like
Germany’s. The source code to AMSC’s control system software
sits on a secure server in Klagenfurt. To protect the code from
hackers, the server isn’t accessible from the Internet.

Strategy From Beginning

“The idea of dividing up the intellectual property part of
the content and not having them in China was part of the
strategy from the beginning,” he said.

McGahn thought he’d planned for every contingency to keep
AMSC safe. He also believed the company could find a way to have
both partners benefit. He was wrong on both counts.

Chinese businesses have proven very good at copying Western
goods and methods. This even appears to be true of espionage
itself. China didn’t invent intellectual property theft; it’s
just doing it on an unprecedented scale.

Willy Shih, a professor at Harvard Business School who has
testified before Congress about business dealings between the
U.S. and China, takes a historical view of intellectual property
theft. In the 1870s, American textile companies would send
employees to work in British factories. They would take notes on
textile equipment and bring back the information. The Russians
and East Germans stole U.S. computer and chip designs during the
Cold War.

“And similar things have been true of Korean companies and
Japanese companies,” said Shih. “I would argue that it’s a
normal development pattern.”

Good Timing

China’s been helped by good timing. It’s emerging as a
global economic power at a time when nearly every secret worth
stealing sits on a computer server. U.S. intelligence agencies
fear that Chinese spies have already siphoned terabytes of data
from thousands of Western companies.

Stealing information, however, isn’t the same as being able
to use it. The Soviets ended up generations behind their U.S.
rivals in computing technology because they couldn’t advance the
cloned equipment fast enough. Shih said that for the Chinese to
succeed at the current game, they will need to build a research
and development culture that can supersede their skills at
mimicry.

“Many countries go through an imitation phase, but the
real challenge is moving to an innovation phase,” he said.

Found a Shortcut

Sinovel, arguably, found a shortcut to get there. Han Junliang, Sinovel’s president, is 47 and wears thin-rimmed
glasses below thick hair parted in the middle. His rather drab
profile doesn’t match his status as one of China’s most famous
entrepreneurs. He rose over 17 years through the ranks of a
state-owned manufacturer, Dalian Heavy Industry Group Co., which
builds steel-rolling equipment and other massive machinery. He
eventually became chairman of an electrical equipment division.
When Han left in 2006 to start Sinovel, Dalian Heavy was among
the company’s major shareholders and its biggest benefactor. Han
himself has a 13.3 percent stake in Sinovel through an
investment that included personal loans and other means,
according to company documents and wind energy experts.

Unlike some of its Chinese rivals, there are no tennis
courts or Ping-Pong tables at Sinovel. The company isn’t focused
on amenities, just rapid and relentless growth. Workers
assembling the massive turbine bodies in the hangar-size factory
in the northern province of Liaoning wear coats and hats on the
plant floor because the facility isn’t heated. In less than four
years, Han has made the company into the second-largest turbine
maker in the world, after the Danish manufacturer Vestas Wind
Systems A/S. (VWS)

Not Alone

He didn’t do it alone. Sinovel is one of the best-connected
clean energy companies in China. Among its major investors is
the private equity group New Horizon Capital (NEHICZ), co-founded by Wen
Yunsong, also known as Winston Wen, son of China’s premier, Wen Jiabao. Han was also close to Zhang Guobao, until recently head
of China’s powerful National Energy Administration. According to
a former U.S. diplomat, who didn’t want to be named because he
still works in China, Han’s relation to Zhang may have given him
an early look at yet-to-be-published government regulations and
provided Sinovel preference in the kinds of turbines chosen to
power the state-planned wind farms.

When China finalized bids for a mega-wind project in 2008,
Sinovel won 47 percent of the deal, by far the biggest share of
any manufacturer.

“Han seems to have ridden the wave just perfectly,” said
Louis Schwartz, president of China Strategies, a firm that
advises Western companies on China’s wind sector.

Visible Flaws

By late 2010 there were visible flaws in China’s wind power
industry. The first was the production quality of the turbines.
Since the government planners demanded quantity, and not
performance, wind farm developers tended to cut corners.
Thousands of China’s turbines lack the more expensive technology
that keeps them operating when there is a disturbance on the
power grid. In April 2011, wind farms totaling 1,346 turbines
shut down suddenly, a major technical failure that caused
disruptions on the electricity grid of two provinces.

The second problem was oversupply, which persists to this
day. China has ended up with more than 80 wind turbine
manufacturers in a market that analysts believe can support
about 10. The price of a 1.5-megawatt turbine in the country has
dropped about 40 percent and continues to fall, placing enormous
pressure on Han and his company. Sinovel had signed multiyear
contracts with AMSC, keeping what his company paid for a
turbine’s electronics suite steady even as Sinovel’s prices
plummeted. AMSC’s products accounted for about 12 percent of a
Sinovel turbine’s cost in 2008, according to public filings. By
2011 they made up 18 percent, said Schwartz, the U.S. consultant.

‘See The Motivation’

“You can see the motivation to acquire that technology,”
he said. “Everybody was getting squeezed except AMSC.”

The semi-trailer load of ASMC electronic components that
Sinovel turned away March 31 was worth $70 million, and the U.S.
company claims it’s owed another $70 million for components
already shipped. Sinovel and AMSC had several supply contracts
extending to 2013 that together were worth more than
$700 million. That all adds up to a very large chunk of AMSC’s
current and future revenue stream.

The one piece of leverage that AMSC thought it had until
last June was proposed regulations in China that will require
existing wind turbines to be retrofitted with an updated
technology called “low voltage ride through,” or LVRT.

LVRT capability keeps turbines from shutting down when
there is a large voltage dip on the grid, which can occur from
little more than a tree falling on a transmission line. The
technology would have prevented the April wind farm shutdowns.
Even if Sinovel wanted to renege on its contracts, all its
existing 1.5-megawatt turbines were powered by AMSC electronics.
If the company wanted the upgraded LVRT software, Sinovel would
have to come to the table.

Different Plan

Han apparently had a different plan in mind. According to
court documents, in 2010, Sinovel began recruiting Dejan
Karabasevic, a Serbian software engineer who worked at AMSC’s
research facility in Klagenfurt. In December, Karabasevic sent
his existing contract with AMSC to Sinovel employees for review;
by January 2011, Sinovel was hunting for an apartment for him in
Beijing.

Once in China, the engineer was pressed to create software
that could go on existing turbines as quickly as possible, using
source code taken from AMSC’s server in Austria. For five days
beginning May 10, Karabasevic said in a confession to Austrian
police, he worked steadily in his Beijing apartment and then
traveled to a wind farm with three Sinovel employees to test the
code in working turbines. By June it was done.

Pleaded Guilty

Karabasevic, who pleaded guilty, was sentenced in September
to 1 year in jail and two years probation for distribution of
trade secrets. His attorney, Gunter Huainigg, declined further
comment.

In court filings in a Beijing copyright infringement case,
one of the four theft-related cases filed by AMSC in China, the
company said it has evidence that the stolen code was already in
more than 1,000 Sinovel turbines by July. McGahn said he assumes
it’s been installed in many more since. Beginning in October,
Sinovel filed two countersuits totaling $207 million, claiming
it stopped accepting the company’s electronics because of
quality problems.

In hindsight, it now appears that Han never planned to
fulfill the kind of long-term partnership McGahn had envisioned.
In 2010, Han helped create a company called Dalian Guotong
Electric, making himself chairman and giving Sinovel a
20 percent stake.

Swapped Out

When AMSC investigators opened up a Sinovel turbine in a
second location in July, they found that an AMSC power converter
had been swapped out and replaced with a nearly identical one
made by Guotong. It was running on a version of AMSC’s control
system software obtained the year before by Sinovel and
decrypted by its engineers. It looks like Han wanted to make
Guotong Electric the Chinese version of AMSC.

Last June, after AMSC promoted McGahn from vice president
to CEO, the executive began to learn the full extent of how
wrong he was about Sinovel. As investigators scrambled to
determine who had stolen the control system source code, they
narrowed the possibilities down to three people, all of whom
worked at the Klagenfurt research facility. According to
interviews with people involved in the investigation and a
review of court documents, log files showed that the altered
code had been uploaded onto the Sinovel turbine on two different
days, June 2 and June 10. Two of the employees weren’t in China
at that time.

Vacation Days

The third, Karabasevic, had given notice at the end of
March and started using vacation days the company still owed him.
One of AMSC’s most valuable software engineers, Karabasevic and
his bosses had agreed he would stay in touch as they looked for
a replacement, so he retained a company e-mail account. The
investigators discovered he was accessing the e-mail from
computers in China. Next, they overlaid the computer addresses
with offices, production facilities, and wind sites linked to
Sinovel. The data sets matched.

In addition to its internal checks, AMSC brought in a
consulting firm that specializes in white-collar crime. The
company hired a private investigator to tail Karabasevic in
Beijing. Forensics experts examined his company laptop and
recovered data he had attempted to wipe from the machine. This
led to the discovery of hundreds of messages about the code
exchanged between Karabasevic and three Sinovel employees,
including one e-mail in which the engineer sent AMSC’s source
code to his Sinovel counterpart.

Austrian Authorities

AMSC eventually turned this evidence over to Austrian
authorities who took Karabasevic into custody. He admitted to
being courted over several months by Sinovel, and to
reprogramming the turbine-control system code from a Beijing
apartment Sinovel provided him. In a locked closet inside the
apartment, investigators found a six-year, $1.7 million
consulting contract with Sinovel and a related company. The
signature on the contract belonged to Han Junliang.

In terms of outright theft of intellectual property, there
is growing evidence that China’s intelligence agencies are
involved, as attacks spread from hits on large technology
companies to the hacking of startups and even law firms.

“The government can basically put their hands in and take
whatever they want,” said Michael Wessel, who sits on the U.S.-
China Economic and Security Review Commission that reports to
Congress. “We need to take more actions and protect our
intellectual property.”

Deflated Bubble

Those actions may create unexpected difficulties for
Sinovel in using AMSC’s stolen code. At the end of 2010, as
China’s wind-power bubble deflated, Sinovel had $1.7 billion in
unsold inventory and was owed $2 billion by its customers. The
obvious solution is to increase sales by looking overseas, part
of Sinovel’s long-term strategy in any case. The Chinese
company’s first major international deal, a contract in Ireland
with Dublin-based Mainstream Renewable Power Ltd., was shelved
last year after AMSC made its software theft public. If Sinovel
does export turbines with the stolen code, AMSC said it can file
lawsuits in those markets as well.

So far neither Sinovel nor China’s government is giving any
ground. Police in Beijing, after reviewing a case file provided
by AMSC, declined to open a criminal investigation against three
Sinovel employees named by Karabasevic. In the weeks leading up
to the Feb. 24 arbitration hearing in Beijing, the pressure on
McGahn and his company has grown. A fire in a turbine belonging
to another AMSC customer in China killed two people, and a
Chinese media report, citing an anonymous source, blamed AMSC’s
components. Jason Fredette, an AMSC spokesman, said that based
on information the company has obtained, its electronics weren’t
at fault.

Cyberattack

The day after the press report, AMSC computer networks in
Devens were hit by a cyberattack. Forged e-mails were sent to a
handful of company executives; they contained spyware designed
to copy confidential data, including documents and internal
communications. Fredette said e-mails were expertly crafted and
had a fake link to a story about Sinovel’s troubles, a bit of
irony inserted by the attackers. The U.S. Federal Bureau of
Investigation is investigating the incident.

McGahn said he still wants to do business in China. But
even if the company never sells another component there, he
contends AMSC will survive. He has since moved to secure deals
in Russia and is eyeing India as the next big wind market. In
the meantime, McGahn has been schooled about doing business in
China in a way he never imagined.

“I used to be a Sinophile,” McGahn said, then pauses for
a long exhale. “I don’t know what I am now.”

To contact the reporters on this story:
Michael A. Riley in Washington
at michaelriley@bloomberg.net;
Ashlee Vance in Palo Alto, California,
at avance3@bloomberg.net.

To contact the editor responsible for this story:
Michael Hytha at mhytha@bloomberg.net;
Josh Tyrangiel at jtyrangiel@bloomberg.net.

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