«by Peter Warwick Chew Ng* Department of Accounting, Finance & Economics Griffith Business School Griffith University Abstract Following the ...»
The ‘Cost’ of Climate Change: How Carbon Emissions Allowances
are Accounted for Amongst European Union Companies
Department of Accounting, Finance & Economics
Griffith Business School
Following the withdrawal of IFRIC 3: Emissions Rights in 2005, European Union (EU)
companies participating in an Emissions Trading Scheme (ETS) do not have definitive
guidelines as to how to account for carbon emissions allowances. Using a content analysis methodology, this study examines disclosed accounting policies of companies participating in the EU ETS, and reveals how, in the absence of clear guidance, they account for their carbon emissions allowances. As the accounting method adopted will impact upon a company’s financial statements, these findings would be of interest to accounting standards setters, investors, financial reporting preparers, auditors, and academic audiences.
Key words: IFRIC 3, Emissions Trading Scheme, emissions allowances, and accounting policy choices JEL classification: M41 _____________________
* Corresponding author: Chew Ng, Department of Accounting, Finance and Economics, Griffith Business School, Griffith University, Nathan Campus, Queensland 4111, Australia, telephone: +61 7 3735 6492, facsimile: +61 7 3735 3719, e-mail: firstname.lastname@example.org The ‘Cost’ of Climate Change: How Carbon Emissions Allowances are Accounted for Amongst European Union Companies Abstract Following the withdrawal of IFRIC 3: Emissions Rights in 2005, European Union (EU) companies participating in an emissions trading scheme (ETS) do not have definitive guidelines as to how to account for carbon emissions allowances. Using a content analysis methodology, this study examines disclosed accounting policies of companies participating in the EU ETS, and reveals how, in the absence of clear guidance, they account for their carbon emissions allowances. As the accounting method adopted will impact upon a company’s financial statements, these findings will be of interest to accounting standards setters, investors, financial reporting preparers, auditors, and academic audiences.
The ‘Cost’ of Climate Change: How Carbon Emissions Allowances are Accounted for Amongst European Union Companies The Intergenerational Report 2010 (Australian Government 2010) identifies climate change as the largest threat to Australia’s environment and one of the most significant challenges to its economic sustainability. To tackle this challenge/threat, the former Rudd government committed to implementing a cap-and-trade scheme, called the Carbon Pollution Reduction Scheme (CPRS) in 20131, targeting a 5% reduction in emissions below 2000 levels by 2020 on a unilateral basis. Although the demise of the Rudd government in June 2010 and a subsequent hung parliament have created uncertainties over this initiative, the Gillard government announced In February 2011 that a carbon tax regime will be introduced as from July 1 2012, with the implementation of a CPRS in 2015.
Globally, thirty-two countries are currently operating, or are participating within, an emissions trading scheme (ETS), with other major economies moving towards the adoption of such a scheme (Australian Government 2010). To date, the European Union Emissions Trading System (EU ETS) is the largest multi-country and multi-sector scheme in the world. In 2008, of the total of 8.2 billion metric tonnes of carbon allowances (worth €92 billion or US$125 billion) traded globally, the EU ETS accounted for two-thirds of the global volume and three-quarters of global value (Point Carbon 2010: 5). With such material amounts involved, the way in which EU companies account for their carbon emissions allowances in their financial statements has also taken on greater significance.
However, since the withdrawal of the international accounting guidance, commonly referred to as IFRIC 3: Emission Rights, there has been no formal accounting recommendation as to how emissions are to be financially accounted for within a cap-and-trade emissions trading scheme. As noted in Deloitte (2009), EU companies therefore have a degree of accounting policy choice in defining what kind of asset an ‘emissions allowance’ is – intangible asset or inventory, and how it is valued – at cost or fair value.
The purpose of this study is to gain an empirical understanding of how carbon emissions allowances are accounted for by EU companies operating under the EU ETS. Examining approaches to accounting for emissions allowances is important since the financial implications arising from the EU ETS may be material in nature and amount. As mentioned previously, the EU ETS is the largest carbon market segment in the world. Since the EU ETS is an important mechanism for carbon reductions, an investigation of the way in which these companies account for their impact would provide useful information to governments, regulators, and other stakeholders. With the globalisation of ETS on the horizon, the accounting treatments of emissions allowances adopted by EU companies will also have increasing international relevance.
Currently academic research studies in this area are scant, though various organisations (including the Association of Chartered Certified Accountants, ACCA, and the International Emissions Trading Association, IETA) and Big 4 accounting firms
PricewaterhouseCoopers in conjunction with IETA in 2007 surveyed 26 European companies and identified six main accounting approaches to emissions allowances.
Ernst and Young (2008) found that of 32 companies investigated, 20 reported using some form of the net liability approach and 22 companies recognised emissions allowances as intangible assets. In a study conducted for ACCA and in conjunction with IETA, Lovell et al. (2010) found that most of the companies they surveyed were not following IFRIC 3. To the best of our knowledge, the present study is probably the first academic research in the area undertaken in 2009. Our findings would be of interest to accounting standards setters, investors, financial statement preparers, auditors and the academic community, not only in Europe, but in any country presently participating, or about to participate, in their version of an emissions trading scheme.
The remainder of this paper proceeds as follows. The next section introduces the EU ETS. This is followed by a discussion of the accounting treatments for emissions allowances. Our research questions are then raised. An outline of the type of analysis to be undertaken and the sample selection are followed. We then analyse and interpret our results. The paper concludes with a discussion on the implications of the findings, limitations of the study, and possible future research avenues.
EU Emissions Trading Scheme The Kyoto Protocol provides legally binding commitments for signatory countries to reduce greenhouse gases (GHG). To achieve the EU target of 20% emissions reduction from 1990 levels by 2020, a cap-and-trade emissions trading scheme was established and became operational as from 1 January 2005. Under the scheme, an overall emissions limit (i.e. cap) was initially set by each EU member state. The cap is converted into allowances (called European Union Allowances, or EUAs) which companies are required to obtain to cover the annual carbon emissions from their ‘installations’.2 A fixed amount of allowances are allocated free of charge, by the ‘scheme administrators’ (i.e. the governmental bodies of the EU member states), to account holders of operator companies responsible for the installation’s activities.
The account holders must report the quantity of independently verified emissions to the scheme administrators for each calendar year by 31 March of the following year.
For each tonne of carbon emissions produced, the account holder must surrender one EUA to the scheme administrator by 30 April of that year. This obligation may be satisfied through the surrender of appropriate numbers of EUAs matching the verified actual emissions. Financial penalties apply for non-compliance. Taking into account the number of EUAs held and their obligations to surrender EUAs for their emissions obligations, companies are free to buy and sell their EUAs in the actively traded ETS market. This process represents a market-based response by the EU to provide financial incentives for companies to curtail emissions (Bebbington and Larrinaga-Gonzalez 2008).
The EU ETS consists of three compliance periods (Robinson 2010). The first phase, operating from 2005 to 2007, was designed to serve as a learning phase.
During this period, the infrastructure of a carbon market was built and member states were required to allocate at least 95% of the allowances free of charge.
The second phase started at the beginning of 2008 and will run until the end of 2012, coinciding with the first commitment phase of the Kyoto Protocol. During this period, at least 90% of the allowances must be allocated free of charge. A penalty of €100 for every tonne of emissions that does not have matching allowances is also imposed.
Phase 3 of the scheme will commence in 2013 and run until 2020. During this period, the emissions cap will be set at a European level rather than by each member state individually (Robinson 2010). Under Directive 2009/29/EC of the European Parliament, more auctioning of allowances (carried out individually by EU member states) is planned, with a target of 70% being auctioned by 2020.
In addition to meeting emissions obligations, account holders may hold emissions allowances for speculative trading purposes. Prices of emissions allowances have been volatile over the past three years (Capoor and Ambrosi 2009), with a high of €28 on the spot market in July 2008 to a low of €8 in February 2009. In May 2010, emissions allowances were trading between €10 and €15. The existence of tradable emissions allowances creates further challenges for accountants as in principle these allowances should be treated as a financial commodity and be recognised in the accounts and reported in the financial statements (Bebbington and Larrinaga-Gonzalez 2008).
Accounting for Emissions Allowances Before we examine the issue of how EU companies are to account for EUAs, it is useful to review the accounting treatments for pollution allowances in the United States in the 1990s. This is because some of the accounting guidance as stated in IFRIC 3 appears to have been based on existing literature relating to accounting treatments for pollution allowances in the US.
In March 1993, the Federal Energy Regulatory Commission (FERC) issued financial reporting requirements for pollution allowances created under the Clear Air Act amendments of 1990. The FERC recommended that pollution allowances should be recorded according to their intended use and at historical cost. Allowances used to cover pollution emissions are reported as inventory in the ‘Allowance Inventory’ account, while allowances intended for use as investments are recorded in the ‘Other Investments’ account. Since allowances issued by the Environmental Protection Agency (EPA) were free of charge, under a historical cost accounting system, no assets or expenses were recognised. Only purchased allowances would be recorded as assets (according to the intended use) and an expense would be recognised when they were used to compensate for pollution emissions (Wambsganss and Sanford 1996: 645).
However, Wambsganss and Sanford (1996) argued that the above accounting treatments were inconsistent. They recommended that issued pollution allowances should be treated as donated assets and be valued at market price. Doing so would provide a uniform accounting treatment for all allowances, regardless of whether they are granted or purchased. Wambsganss and Sanford (1996) also argued that pollution allowances are intangible assets and should be valued at market price or fair value.
As the discussion in the following section reveals, the subsequent accounting guidance on emissions allowances recommended by the International Accounting Standards Board (IASB) appeared to adopt Wambsganss and Sanford’s view (Bebbington and Larrinaga-Gonzalez 2008: 705).
IFRIC Interpretation 3: Emission Rights An ETS raises the issue of whether and how to recognise emissions allowances and the obligation to deliver allowances. In the run-up to the launch of the EU ETS, the International Accounting Standards Board (IASB) instructed the International Financial Reporting Interpretations Committee (IFRIC) to develop accounting guidance for emissions allowances. In December 2004, IFRIC issued IFRIC Interpretation 3: Emission Rights (known as IFRIC 3) which was to be applicable for financial reporting periods beginning on or after 1 March 2005, with earlier adoption encouraged so that it could be implemented for the beginning of Phase 1 of the EU ETS. IFRIC 3 recommended that emissions allowances (an asset) be treated separately from the obligation to deliver allowances (a liability) arising under the EU ETS. This approach is referred to as a ‘gross’ basis (ACCA 2009: 7).
Emissions Allowances IFRIC 3 first considered whether emissions allowances (granted and purchased) were assets and concluded that they met the definition of assets. They then examined the nature of these allowances and decided that they were intangible assets and not financial instruments. Since they are intangible assets, IFRIC 3 recommended that, regardless of whether emissions allowances have been allocated free of charge or purchased, they should be treated in accordance with IAS 38 Intangible Assets (equivalent to AASB 138). Under this standard, financial statement preparers may adopt one of the two alternatives for subsequent measurement of intangibles: the cost method or the revaluation method. With a cost method, intangibles are subsequently measured at cost less amortisation and impairment. Since a revaluation model can only be adopted where intangibles are traded in an active market, EUAs will meet this requirement. Under this approach, emissions allowances are carried at fair value, with gains recognised under ‘Equity’ in the balance sheet as a revaluation surplus and the increase in the revaluation surplus included in the statement of comprehensive income as an item of ‘other comprehensive income’.
IAS 38 is also explicit that intangible assets held for sale in the ordinary course of business (such as trading) are to be accounted for as inventory in accordance with IAS 2 Inventories (equivalent to AASB 102).