Accounting for carbon credits – cap and trade schemes

Carbon markets can broadly be split into compliance markets and voluntary markets. The specific features of carbon credits, including whether they are traded on compliance or voluntary markets, are key to determining the appropriate accounting treatment.

This publication focuses on the accounting considerations for entities in the role of an emitter in a compliance market with a cap-and-trade model. The accounting for carbon credits assets in such a market needs to be considered together with the related liability for retiring the credits to offset greenhouse gas emissions (GHG emissions).

Emissions trading schemes - Background

Following the ambiguous goals set by the 2015 Paris Agreement to reduce GHG emissions, many local jurisdictions introduced mandatory carbon emission schemes (compliance markets). Participation is mandatory for certain entities and is defined via the scheme’s rules. These markets are typically run by governments or their agencies. In such markets, entities use the carbon credits obtained from the local government, their agencies and/or purchased in the market to offset their greenhouse gas emission obligations.

The amount an entity needs to pay represents the amount of emission allowances an entity needs to obtain to settle an emissions liability with the government. The pricing of carbon credits will often depend on supply and demand, as well as the total amount of credits being traded under the scheme. The most common type of a mandatory scheme involves a cap-and-trade model whereby a permit, also known as an allowance, is made for each unit of emissions that is permitted within a cap that is set by the government. For every unit of emissions, emitting companies are required to surrender a permit. Permits can be obtained from the government (via auctions or free allocation) or through trading with other companies.

General accounting considerations

Existing IFRS standards do not contain specific guidance for accounting for cap-and-trade schemes¹ which means, a participant in such schemes is required to adopt an accounting policy for the recognition and measurement of the applicable scheme, in line with IAS 8.10².

Although there is no current guidance on how to account for such schemes, current practice involves applying IAS 38 Intangible Assets to the allowances granted or purchased, IAS 37 Provisions, Contingent Liabilities and Contingent Assets to the obligation to surrender the allowances and IAS 20 Accounting for Government Grants to account for allowances allocated by governments or their agencies for free or below market price.

Intangible assets

For accounting purposes, emissions rights held by an emitter in a compliance market are generally classified as intangible assets. Emissions allowances are identifiable non-monetary assets that do not have a physical substance. In circumstances where an entity is acting as a broker or trader, such that it acquires emissions rights with the intention of selling them to another market participant in the ordinary course of business, these rights fall under IAS 2 Inventories and accounted as such. The focus of the discussion below is where emission rights are accounted as intangible assets by an emitter in a compliance market.

Intangible assets are initially measured at cost, in circumstances where a non-monetary asset is received through a government grant, an entity can account for the non-monetary asset at fair value or at a nominal amount. The policy choice selected for the government grant would drive the initial recognition (fair value or nil) of the emission allowances granted by the government or its agency. When fair value is elected, the intangible asset is initially recorded at fair value.

It is unlikely that emission rights accounted for as intangible assets are amortised, as their depreciable amount is usually nil. The expected residual value at inception will be equal to their fair value. Thereafter, there is no consumption of economic benefit while the emission right is held. The economic benefits are realised instead by surrendering the rights to settle obligations under the scheme for emissions made.

Accounting for government grants

Government grant accounting is applicable in scenarios where emissions allowances are allocated for free (by a government or relevant government body) to an entity or allowances are purchased from a government or relevant government body for a price which is below the market value (the difference between purchased price and fair value is accounted under IAS 20 Accounting for Government grants).

A Government grant in the form of non-monetary assets can be accounted for at fair value or at a nominal value. Government grants allocated for free are recorded at the same time as the emission allowances asset (Dr intangible asset, Cr government grant). The grant is recorded as deferred income and amortised on a systematic and rational basis over the compliance period.

Provisions, Contingent liabilities and Contingent assets

For financial statement purposes, emissions obligations are generally classified as provisions in the scope of IAS 37 Provisions, Contingent liabilities and Contingent assets. Emissions obligations are liabilities of uncertain timing or amount.

Under cap-and-trade schemes, entities generally settle their obligation by surrendering emissions certificates to the local regulator.

Generally accepted approaches

Based on the discussion above, there are three generally accepted approaches that are applied in practice when accounting for each recognised element (asset, liability and government grant income for those allowances granted at a nil value³) in the financial statements. The approaches are discussed in detail below:
 

Approach 1: IFRIC 3⁴

	Asset	Government grants	Liability
When to recognise	When an entity is able to exercise control	At the same time when allowances are recognised.	When the liability is incurred.
Initial recognition	Granted allowances are recognised and measured at fair value at the date of issue. Acquired allowances are recognised at the purchase price which in general will be at fair value.	Recognised and measured at fair value at date of issue.	Measured at the fair value of allowances required to settle the incurred obligation.
Subsequent measurements	Emission allowances are subsequently measured at cost (initial recognition amount), subject to review for impairment, or under the revaluation model at fair value with the movement going through OCI. The revaluation approach is only allowed if an active market exists.	Government grant is amortised on a systematic and rational basis over compliance period, regardless of whether the allowance received continues to be held by the entity.	Liability is remeasured at the reporting period end based on the fair value of allowances that would be required to cover actual emissions, regardless of whether the allowances are on hand or would be purchased from the market.

 

 

Approach 2 – Initial fair value

	Asset	Government grants	Liability
When to recognise	When an entity is able to exercise control.	At the same time when allowances are recognised.	When the liability is incurred.
Initial recognition	Recognised and measured at fair value at date of issue for granted allowance. Acquired allowances are recognised at the purchase price which in general will be at fair value.	Recognised and measured at fair value at date of issue.	Measured based on the carrying amount of allowances on hand, plus the market value of allowances that would need to be acquired to cover any excess emissions (ie actual emissions in excess of allowances on hand).
Subsequent measurements	Emission allowances are subsequently measured at cost (initial recognition amount), subject to review for impairment, or under the revaluation model at fair value with the movement going through OCI. The revaluation approach is only allowed if an active market exists.	Government grant is amortised on a systematic and rational basis over compliance period, regardless of whether the allowance received continues to be held by the entity.	Liability is remeasured based on the carrying amount of allowances on hand at each period end to be used to cover actual emissions; plus the market value of allowances at each period end that would be required to cover any excess emissions (ie actual emissions in excess of allowances on hand).

 

 

Approach 3 – Nominal value

	Asset	Government grants	Liability
When to recognise	When an entity is able to exercise control.	At the same time when allowances are recognised.	When the liability is incurred.
Initial recognition	Recognised and measured at cost, which for granted allowances is nil.	Recognise and measure at cost (nominal value), which for granted allowances is nil as allowances are granted for free.	Nil, provided that the company has sufficient allowances, granted for nil cost, to satisfy the emission liability.
Subsequent measure	Measured at cost, which for granted allowances is usually nil and for acquired allowances is the purchase price, subject for impairment review for purchased allowances.	Not applicable as initial recognition was nil.	Liability is remeasured based on: the carrying amount of allowances on hand at each period end (nil or cost) to be used to cover actual emissions, plus the market value of allowances at each period end that would be required to cover any excess emissions (ie actual emissions in excess of allowances on hand.) Therefore, no liability for emissions would be recognised provided that the entity has sufficient allowances granted by the government at nil costs to satisfy the emission liability.

Other considerations

The discussion above provides a basic consideration to accounting for trade-and cap schemes, in practice these schemes can be complex and may require more detailed analysis and other general accounting considerations might need to be applied.

For more information, please contact Bernd Kremp.

 

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1. The IASB has a project in its pipeline for pollutant pricing mechanisms in which it notes the diversity in how such mechanisms (which include trade and cap schemes) are accounted for and that some of the issues identified relate to possible gaps and inconsistencies in IFRS accounting standards.

2. In the absence of an IFRS that specifically applies to a transaction, management shall use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable.

3. Purchased allowances do not result in the recognition of government grants. Guidance on government grants becomes relevant to those allowances granted at a nil value or value that is below market value of the granted allowances, the difference between purchase value and the market value of the allowance will be considered under the scope of IAS 20 Government grants.

4. While IFRIC 3 was withdrawn in 2005 it is still considered appropriate to use the guidance until the IASB’s pollutant and pricing mechanisms project is completed.