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Accounting for carbon The impact of carbon trading on financial statements KPMG LLP (UK) Providing insight and strategies to help organisations understand and manage the business implications of climate change © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Chairman’s foreword Welcome to the fifth in a series of white papers from KPMG’s Carbon Advisory Group. This paper outlines the accounting and reporting questions that businesses involved in the rapidly expanding market for carbon emissions allowances and credits will need to address to implement their carbon strategy effectively. The various trading and emissions schemes around the world can offer significant benefits of capital allocation for this scarce resource. For the first time carbon will become a real input cost for many businesses and managing the risks and opportunities of that input will become an important business priority. Accounting for carbon emissions will take many companies into entirely new territory for which no specific accounting standard currently exists. Communicating your objectives, policies and results to investors and analysts and explaining how they are reflected in the financial statements could be a significant challenge. This paper offers a guide to some of the key accounting issues to consider when transacting in the carbon market. It is essential that the accounting for these items is considered early to avoid any surprises in the financial statements. John Griffith-Jones, Chairman and Senior Partner KPMG LLP (UK) © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Accounting for Carbon 1 What is the issue? The recognition of climate change as a significant issue continues to grow and commercial activity is well underway, but, in the absence of authoritative accounting guidance, a diverse range of accounting treatments has evolved. This in turn has led to a lack of consistency in financial reporting that could undermine investors’ confidence in a company’s strategy and approach to carbon transactions including trading. The possible accounting approaches could lead to volatility and material and/or counter-intuitive effects on your financial statements in matters such as: • Timing of recognition of assets, liabilities, profits and losses • Measurement of balance sheet items at nominal value, cost or fair value • Current and deferred tax and VAT implications • Presentation and disclosure With many more UK organisations about to be included in the Carbon Reduction Commitment Scheme, the question is: Do you know how your company’s activities in the carbon arena and the accounting policies you have chosen will affect your financial results? “Carbon will be the world’s biggest commodity market and it could become the world’s largest market overall” Louis Redshaw, Head of Environmental Markets, Barclays Capital © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. 2 Accounting for Carbon Who needs to consider the impact of carbon accounting? Broadly speaking, the following business categories are already active within the carbon markets: • Emitters (under the EU Emissions Trading Scheme) – Certain companies are allocated emission allowances – they must either reduce emissions to remain within their allowance or buy additional allowances to cover total measured emissions. • Emitters (under the Carbon Reduction Commitment (CRC)) – Organisations spending £0.5m or more on electricity in the UK annually are likely to be included in the scheme and will need to buy emission allowances. • Creators (under the Clean Development Mechanism) – Companies can invest in or develop emissions-reducing projects overseas within production processes or produce ‘green energy’ products. Reductions must be certified to receive Certified Emission Reductions (CERs) which can then be sold or used to fulfil the organisation’s own emission obligations. • Traders/brokers/aggregators Dealers may buy and sell CERs and allowances or derivatives based on the underlying asset. • Investors/Consultants Consultants who assist others to reduce emissions and/or claim CERs may receive their fee in CERs or options to buy CERs. Investors may invest specifically in carbon related activities in return for CERs. These categories are not mutually exclusive. Some emitters also have in-house traders buying and selling for the company’s own use or for profit. Some also act as creators of emission reductions and/or consultants. There are also examples of companies running their own exchanges. We consider some of the accounting implications for each category in the following pages. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Accounting for Carbon 3 Which accounting standards currently apply? At the moment, there is no authoritative accounting guidance within International Financial Reporting Standards (IFRS) explicitly for transactions involving carbon allowances. Previously issued (but withdrawn) guidance provides some insight into the initial views of the International Accounting Standards Board (IASB): • The IASB issued IFRIC 3 on ‘Emission Rights’ but it was withdrawn in June 2005. Based on other IFRSs in issue at the time, IFRIC 3 concluded that: – Rights (allowances) are intangible assets (IAS 38 Intangible assets) – Where allowances are issued by governments for less than fair value, the difference between fair value and the amount paid, if any, is a government grant – Provisions for emissions-related liabilities should be recorded (IAS 37 Provisions, contingent liabilities and contingent assets) • The main reason for withdrawal was the potential volatility arising from recognising changes in the value of revalued allowances (intangible assets) in equity but movements on the provision for emissions in the income statement. • Despite the withdrawal of IFRIC 3 there remain a number of existing standards that provide authoritative guidance on relevant accounting on which companies must draw in forming their policies for carbonrelated transactions (including IAS 2, 20, 37, 38 and 39). • The IASB and the Financial Accounting Standards Board (FASB) have launched a joint project on carbon emission accounting models but have not yet published a conclusion. In the meantime companies must interpret the existing standards based on the fact pattern of their particular business model, strategy and transactions. This will include providing relevant disclosures of policies, transactions and balances included in their financial statements. In the UK in most cases we expect the corporate tax treatment to follow the accounting rather than to generate significant timing differences. • In May 2008 the IASB scope discussion confirmed that the project will cover all tradeable emission rights and obligations under emissions trading schemes. It will also address how activities undertaken in anticipation of receiving tradeable rights in future periods (e.g. CERs) will be accounted for. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. 4 Accounting for Carbon Principal Mechanisms Kyoto Protocol Cap and Trade EU Emissions Trading Scheme The Kyoto Protocol (1997) is an international treaty binding those developed nations that ratified it to reduce their emissions of the six most harmful greenhouse gases (GHGs). Each country is committed to a target, designed to lower overall global emissions by 5.2 percent compared with 1990 levels by the end of 2012. Under the treaty there are two main ways of trading and pricing carbon emissions – cap and trade schemes and rate-based schemes. These are both part of the regulated trading environment and should not be confused with the voluntary/unregulated sector which is part of the corporate and social ‘greening’ phenomenon of the past ten years. An example of a cap and trade scheme is the EU Emissions Trading Scheme (ETS), under which the EU has set emissions targets that reduce over time. Member states develop a National Allocation Plan (NAP) determining how allowances will be allocated to emitters in their territory. Each year, member states distribute these allowances to organisations in certain industries under their National Allocation Plan. In some cases companies pay the government for the allowances, through an auction system or at a nominal rate, while in others the government may issue them free of charge. At the end of each year each emitter surrenders to the government sufficient allowances to cover their actual emissions for the period. A company that has a surplus of allowances can sell the excess, while a company that exceeds its allocation must purchase more allowances from the market. Under most schemes, including the EU ETS, allowances can be rolled over from year to year but not from phase to phase (the current phase ends in 2012). Carbon Emissions Trading Market Regulated Markets Cap and Trade Schemes e.g. UK Carbon Reduction Commitment (CRC) Allowances Voluntary Markets Rate Based Schemes e.g. ETS European Union Allowances (EUAs) e.g. Clean Development Mechanism (CDM) CERs Carbon offsetting Voluntary Emission Reductions (VERs) Source: KPMG LLP (UK) 2008 © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. Accounting for Carbon 5 Rate-Based schemes Organisations included in the scheme can trade allowances with others not in the scheme, allowing third parties to join the market. The EU ETS provides a market for trading and valuation purposes – the market price of December 2012 EUA settlement was around €19 per tonne of CO2 at 19 November 2008, CER around €15 per tonne (source: europeanclimateexchange.com or www.pointcarbon.com) Under a rate-based scheme, emission credits (certificates or allowances) are issued to companies that reduce their emissions from an agreed level per unit of output. Emissions above the agreed level may result in an obligation to buy allowances. UK Carbon Reduction Commitment In addition to the EU scheme the UK government has introduced the Carbon Reduction Commitment (CRC), a mandatory cap and trade scheme targeted at large companies. Phase I is April 2010 to March 2013, with companies qualifying in 2008, depending on their usage. The CRC is similar to the EU Emissions Trading Scheme but it will apply to large, non-energy intensive organisations. Allowances will be sold to participants in a sealed bid uniform price auction. Those included in the scheme will need to buy allowances to cover expected total CO2 emissions for each year. The minimum cost of allowances, before any potential penalty, for companies just falling within the emission levels of the scheme, is estimated at £38,000. Additional or excess allowances can be bought and sold through a secondary market but the market price will be uncertain. At the end of the year allowances for all emissions must be submitted. Each year league tables ranking participants by their energy efficiency and success in reducing energy consumption will be prepared. This determines how much of the original cost of allowances is returned to the participants with a higher payments allocated to those at the top of the table. These credits are valuable as they can be used by emitters to settle an obligation to remit allowances under some cap and trade schemes. For example, eight percent of any shortfall of participants in the ETS Cap and Trade scheme can be met with allowances issued under a rate based scheme. An example of a rate based scheme is the Clean Development Mechanism (CDM). Within the CDM emission reductions can be earned through activities such as the generation of renewable energy or other projects that reduce overall carbon emissions from an existing production process per unit of output. Companies register their schemes or projects with the UN for accreditation. In some cases the emission reductions are subject to confirmation before the credits are issued. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. 6 Accounting for Carbon 1. Emitters Certain industries are included in the EU Emissions Trading Scheme, which is currently in Phase II (2008-2012), many other UK organisations are already included in the CRC. The governments of EU member states each draw up a National Allocation Plan representing the total emission allowances that will be made available for each year to emitters in their territory. Each entity, to which the scheme applies, is allocated its share of the total emission allowances. At the end of each period each emitter surrenders sufficient allowances to cover their emissions. A company that has a surplus of allowances can sell the excess allowances while a company that exceeds its allocation must purchase more allowances from the market. • Some allowances are now being auctioned, so the cost is not zero which may result in a balance sheet and income statement impact • Many companies during Phase II will need to acquire additional allowances resulting in a cost to the company that needs to be recorded in the financial statements • Stakeholders are more informed and aware of climate change, and want companies to provide information on this area of their operations Government administration As the EU ETS and other schemes mature and are refined we expect the following developments to increase the potential impact on performance reported in the financial statements. CRC Accounting for the CRC scheme will give rise to many of the same questions as for other cap and trade schemes, such as timing of recognition of the allowances purchased and the liability arising from emissions, the value initially attributed to them, subsequent re-measurement (if any) as well as the recognition of the repayment to be received. However an important difference will be that the organisations will have to pay cash out upfront and await subsequent measurement before any is returned. In the meantime, management decisions, based on the company’s objectives and strategies concerning whether (and when) to buy, hold or sell allowances based on projected emissions, will affect reported financial performance. In addition, the accounting policy choices that currently exist for carbon-related transactions can also impact financial performance and investor’s perception of management's strategy. A number of these choices are highlighted below. Government allocates EUAs to company The life of an EUA Company surrenders EUAs Company measures emissions Source: KPMG LLP (UK) 2008 © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.