Cap and Trade Accounting Issues

The Climate of Accounting:  Accounting and Climate Change

                Pollution is a principal unintended consequence of industrial production.  Pollution has many harmful environmental impacts.  Chief among the long term concerns is the greenhouse effect.  The greenhouse effect arises because the heat capacity of energy producing outputs is greater than the atmospheric heat capacity, leading to global warming.  Carbon dioxide is the main greenhouse gas, but other gases with greater greenhouse potential are also serious warming risks.  Inventories of human greenhouse gas production include power generation, industrial activity like manufacturing, and commercial and residential activity like operating facilities and driving.

                Cap and trade schemes are an attempt to limit the production of carbon dioxide by providing a fixed amount of carbon credits to power generators and industrial companies in covered sectors of activity.  The cap is a limit on the amount of production; the production cap is the total amount specified by the available credits.  The credit consists of a mass of greenhouse gas emitted per calendar year.  The mass of greenhouse gases is measured in carbon dioxide equivalents.  Other greenhouse gases are adjusted to a carbon dioxide basis by comparing heat capacity and atmospheric retention.  The calendar year is called the vintage year.  A certain number of credits are issued to an emitter based on historical emissions.  Additional credits are available at auction.  The total number of credits in future vintage years is less than the total number of credits in the current year to encourage the policy goal of decreasing emissions.

There are several classes of credit transactions.  Credits can be offset by other activities that lower emissions in a reliable way.  Past credits can be accumulated to be used in future years at full value.  Future credits must be discounted if used for present purposes.  Thus, credits have interest like properties.  Credits can also be swapped, either through over the counter broker markets or on organized exchanges.

Cap and trade schemes create a variety of accounting issues:

·         What is the nature of the reporting entity?

·         Should credits be recognized on the balance sheet?

·         Should credits accrete to comprehensive income?

·         How should an entity account for vintage year swaps?

Determining which entities should report in a cap and trade scheme requires an application of the cost benefit principle.  The facility is the accepted level of reporting.  For example, a power generation plant or a cement factory would qualify as a facility.  Facilities are contiguous properties with common productive purposes.  Facilities have to meet a certain threshold to report their emissions.  Facilities are also assessed based on their downstream carbon producing activity.  For example, a car manufacturer would be assessed for the greenhouse gases of the cars it produces in addition to the greenhouse gases emitted in manufacturing the cars.

Allowances meet the definition of an asset. Emitting greenhouse gases brings future benefit to the firm.  However, excessive emissions cause an involuntary surrender of the credits, raising issues of asset control.  Both the International Accounting Standards Board and Financial Accounting Standards Board have tentatively decided to recognize the allocation or purchase of allowances as the event that produces an asset.   The boards felt that the company’s ability to control the disposition of the credits was more relevant than the requirement to comply with emissions standards in determining whether an asset existed. The Boards decided to classify allocated allowances as assets even though they lack monetary consideration because they are fungible with purchased allowances.  This decision requires the existence of a liquid market to determine fair value. 

 Future discussions will focus on classification.  One proposed scheme classifies allowances used in production as an intangible asset, allowances held for trading purposes either by the financing arm of a corporation or by independent brokers and traders as inventory, and allowances held for speculation as investments.  Allowances may either be recorded at historical cost or fair value.  This decision has a material impact on the balance sheet.  Permits granted by the government have a historical cost of zero.  Only those purchased through auction or on the open market have a historical cost equal to fair value.

The existence and nature of the liability is open to interpretation.  The lack of monetary consideration to the scheme administrator raises an issue if a liability exists or whether the emissions are a component of equity.  Both the IASB and FASB have decided that the credits are a liability.  The open issue is the timing of the liability. The receipt of the credits could constitute a current obligation to limit emissions.  The accounting treatment would be similar to accounting for grants to farmers not to plant a certain crop.  Under IAS 41 Agriculture, the amount of the grant is treated as a “refundable advance” until the terms of the grant expires.  Thus, receipt of the emission allowance would credit a liability account “Refundable Emission Allowance Advance.”  Alternatively, receipt of the allowance could create an obligation based on future consumption of the credits.  Under this view, comprehensive income is credited.  The FASB has recently decided to recognize receipt of credits as a liability.