The most difficult question in accounting for emission trading schemes is deciding what to do with emission trading certificates received free of charge. Does the recipient have a liability on day 1? If not, should it recognise an immediate gain?
Previous answers to this question have been unconvincing because they did not reflect the nature of cap-and-trade schemes. These schemes combine 3 elements:
- a loan of emission trading certificates
- a grant of any surplus certificates that the recipient can sell
- an emission liability for excess emissions
This post suggests that:
- The loan element should be accounted for like any other loan. Not identifying the liability to repay the loan element has been at the heart of previous failures on this topic.
- Emission trading certificates are like a foreign currency. The closing rate should be used in translating all assets and liabilities denominated in that currency: (a) certificates held; (b) liabilities to repay loans of certificates received free of charge; and (c) liabilities for excess emissions.
The post does not discuss when and how to account for: (a) grants of any surplus certificates; and (b) liabilities for excess emissions. Those topics are important, but beyond the scope of this post.
The rest of this post discusses:
- Where previous discussions went wrong
- A fresh look
This section discusses emission trading schemes (sub-section 1.1) and IFRIC 3 Emission Rights (1.2). It then provides an example of applying IFRIC 3 (1.3) and summarises IASB work after IFRIC 3 (1.4).
1.1 Emission trading schemes
Emission trading schemes use tradeable emission certificates to limit and reduce emissions of greenhouse gases (for example, CO2) or other pollutants into the air or water. For a pollutant within the scope of a scheme, a government (or government agency) sets an aggregate ceiling on the total amount of the pollutant that emitters within that jurisdiction can emit in a specified period.
I will start by considering a common form of emission trading scheme, known as a cap-and-trade scheme. Towards the end of this post, I also look briefly another type known as a baseline-and-credit scheme.
In a cap-and-trade scheme, the government (or agency) issues emission trading certificates (ETCs) that permit the holder to emit a portion of the aggregate ceiling for the pollutant. For example, if a scheme has set a ceiling of 1 million tonnes of CO2,the scheme will issue ETCs that, in aggregate, permit emissions of 1 million tonnes. If a company holds ETCs covering 10,000 tonnes, the company has the right to emit 10,000 tonnes of CO2.
Governments or agencies issue ETCs either free or by auction (or other selling process). The most difficult accounting issues arise from ETCs issued free.
Objectives of emission trading schemes
Emission trading schemes are intended to meet two objectives:
- To keep the emissions produced in the jurisdiction at or below the aggregate ceiling.
- To use a market mechanism to distribute the ceiling among emitters in the most effective and efficient way.
How does that market mechanism work?
- If a company does not hold enough ETCs to permit its desired level of emissions, it must either: (a) buy ETCs; or (b) emit less than it wants to emit. If some companies want to buy ETCs, that demand will give the ETCs value. If no companies want to buy ETCs, they will have no value.
- An emitter is likely to be willing to pay more than other emitters if the emitter is more efficient than other emitters, or if its emission-causing activities create higher value than the emission-causing activities of other emitters. Thus, ETCs are likely to end up in the hands of the emitters that are the most efficient or that create the highest value.
- Setting the ceiling below the levels of emissions that would be expected if the ceiling were not in place helps achieve both of a scheme’s objectives:
- the ceiling reduces aggregate emissions
- the ceiling restricts the supply of ETCs. This restriction makes it more likely that the ETC’s price will rise to a level that induces some holders of free ETCs to sell them to other emitters that are more efficient or that can use them in creating higher value.
Some background information on emission trading schemes is available in an unpublished research paper presented to the IASB and the US Financial Accounting Standards Board (FASB) in 2010.
The research paper can be found at https://www.ifrs.org/content/dam/ifrs/meetings/2010/may/joint-iasb-fasb-2/ets0510b10aobs.pdf
1.2 IFRIC 3 Emissions Rights
In December 2004, the International Accounting Standards Board (IASB) issued IFRIC Interpretation IFRIC 3 Emission Rights. IFRIC 3 would have prescribed how to account for cap-and-trade schemes. However, in June 2005 the IASB withdrew IFRIC 3 before it came into effect, giving the following reasons in a public statement:
- the need for an Interpretation was less urgent than originally thought, because markets for ETCs were still thin and because some European governments had not yet issued ETCs needed to operate the EU scheme that was due to start in 2005.
- although IFRIC 3 was an appropriate interpretation of existing IFRS Standards, IFRIC 3 would have created unsatisfactory measurement and reporting mismatches.
- to avoid causing disruption by two separate rounds of change, the IASB would not try to solve those mismatches before working on its separate project on government grants, which might identify how best to account for ETCs received free of charge.
Main features of IFRIC 3
The main features of IFRIC 3 were:
- Both free and purchased ETCs held would be recognised as assets. Applying IAS 38 Intangible Assets, ETCs held would be measured initially at fair value. Later, they would be measured: (a) at that initial fair value (if the company uses the cost model in IAS 38); or (b) at current fair value, with increases in fair value presented in other comprehensive income (if the company uses the revaluation model in IAS 38).
- The acquisition of free ETCs would be treated as a government grant. Applying IAS 20 Accounting for Government Grants and Disclosure of Government Assistance, that grant would be recognised as income on a systematic basis over the ‘compliance period’, regardless of whether the ETCs are still held or have been sold.
- Applying IAS 37 Provisions, Contingent Liabilities and Contingent Assets, the emitter would recognise as a provision its liability to pay ETCs for emissions when (and only when) the emissions have already occurred. The liability would be measured at the best estimate of expenditure required to fulfil the liability—usually equal to the current fair value of the ETCs required to pay for emissions already made.
1.3 Example of applying IFRIC 3
On 1 January 20X1, Company A received, free of charge, ETCs giving it the right to emit 1,200 tonnes of CO2 in 20X1. The ETCs’ fair value was £1.00 per tonne at 1 January 20X1 and £1.20 per tonne at 31 March 20X1 and 31 December 20X1.
Company A emitted 300 tonnes of CO2 by 31 March 20X1, and a further 900 tonnes by 31 December 20X1.
Company A did not buy or sell any ETCs during 20X1. On 1 January 20X2, Company A remits (repays) all of the ETCs to the scheme.
Applying IFRIC 3
Applying IFRIC 3 on 1 January 20X1, Company A would recognise 1,200 tonnes of ETCs as an asset, with a carrying amount of £1,200. It would also recognise an emission liability with the same carrying amount of £1,200, depicting a government grant not yet recognised as income. Company A would recognise no income or expense on 1 January 20X1.
For the 3 months to 31 March 20X1, Company A would:
- recognise an emission liability of £300 (300 x £1.00) and emission scheme expense of the same amount.
- derecognise 3/12 of the government grant, recognising government grant income of £300, leaving a government grant liability with a remaining carrying amount of £900.
- if it uses the revaluation model in IAS 38, remeasure the ETCs held to £1,440 (1,200 x £1.20), recognising in other comprehensive income a remeasurement gain of £240 (£1,440 – £1,200). If Company A uses the cost model in IAS 38, it would not remeasure the ETCs.
- remeasure the emission liability to £360 (300 x £1.20), recognising in profit or loss a remeasurement loss of £60 (£360 – £300).
- recognise a profit of £60.
For the remaining 9 months up to 31 December 20X1, Company A would:
- recognise emission scheme expense of £1,080 (900 x £1.20) and increase the carrying amount of the emission liability by the same amount, bringing it up to £1,440 (1,200 x £1.20).
- derecognise the remaining 9/12 of the government grant liability, recognising government grant income of £900.
- (using the revaluation model in IAS 38) remeasure the ETCs held. On this fact pattern, the remeasurement is zero because the fair value of the ETCs did not change. If Company A uses the cost model in IAS 38, it would not remeasure the ETCs.
- remeasure the emission liability (no change on this fact pattern).
- recognise a loss of £180 (CU1,080 – CU900).
On 1 January 20X2, Company A fulfils its emission liability (carrying amount £1,440) by repaying all its ETCs, which have a carrying amount of £1,200 (cost model, giving a gain of CU240) or £1,440 (revaluation model, giving no gain or loss).
Table 1 summarises what Company A recognises in profit or loss for the 3 months to 31 March 20X1, the 9 months to 31 December 20X1 and 1 day of 1 January 20X2. All amounts are in £’000.
Table 1 shows one difference between the cost and revaluation models:
- In the cost model, the ETCs held are not remeasured while they are held. Company A then recognises a gain of £240 when it repays the ETCs to fulfil its emission liability.
- In contrast, in the revaluation model, Company A remeasures the ETCs held on 31 March 20X1, recognising a gain of CU240 in other comprehensive income. That gain is not subsequently recycled to profit or loss and so never appears in profit or loss.
This example shows some of the measurement mismatches that IFRC 3 would have caused:
- In the cost model, Company A starts remeasuring its emission liability as soon as emissions occur, but does not remeasure the free ETCs it holds. Company A then ultimately recognises a gain or loss when it pays the ETCs to fulfil its emission liability.
- In the revaluation model, Company A starts remeasuring the free ETCs held as soon as it receives them, but does not start remeasuring its emission liability until emissions occur. And until all emissions have occurred, the gain or loss on remeasuring the free ETCs will always be more than loss or gain on remeasuring the (smaller) emission liability.
- In the revaluation model, remeasurements of the ETCs held are recognised in other comprehensive income (and are never recycled to profit or loss) but remeasurements of the emission liability are recognised in profit or loss.
- If emissions produced over the whole period are exactly covered by free ETCs, with no shortfall and no surplus, Company A is not exposed to changes in the price of the ETCs, but the accounting suggests that it is exposed to those changes. That is because the accounting generates gains or losses in some periods that inevitably reverse in future periods.1
1 In the cost model, those gains or losses in early periods are recognised in profit or loss and also reverse subsequently in profit or loss. In the revaluation model, those gains or losses in early periods are recognised in other comprehensive income but they reverse only by subsequent losses or gains in profit or loss.
1.4 IASB work after IFRC 3
After withdrawing IFRIC 3, the IASB made some tentative decisions between 2007-2010 on government grants and also on emission trading schemes, but those initial decisions never led to proposals for changes to IFRS Standards. Those tentative decisions were:
- The receipt of free ETCs with no conditions attached is an unconditional government grant. The recipient would recognise the ETCs received as an asset. It would typically recognise no emission liability yet (because it has not yet produced emissions). Applying the IASB’s initial new thinking on government grants, the recipient would recognise the grant as income immediately (a ‘day-1 gain’).
- A conditional receipt of free ETCs is a conditional government grant. Applying the IASB’s initial new thinking on government grants, the recipient would recognise the grant as income as it satisfies the conditions.
- ETCs and emission liabilities would both be measured at the fair value of the ETCs.
These conclusions would have removed one of the mismatches that led the IASB to withdraw IFRIC 3: remeasurements of both the ETCs held and the emission liability would have been recognised only in profit or loss, without recognising anything in other comprehensive income.
But the conclusions would have added one even larger mismatch: the unconditional receipt of free ETCs would have led to a day-1 gain at the time of receipt. Further measurement mismatches would arise later when the recipient remeasures ETCs held before producing all of the emissions that those ETCs will pay for.
2 Where previous discussions went wrong
Previous discussions have assumed tacitly that:
- The receipt of all free ETCs is always the receipt of a government grant.
- The imposition of emission liabilities is always the imposition of a tax—even if the emitter can fulfil those liabilities fully with ETCs received free of charge.
Those tacit assumptions lead inevitably to measurement mismatches if it is not possible to conclude that receiving a free ETC creates a liability.
To avoid that outcome, many people tried hard to construct arguments that a liability to emit the pollutant already exists at the date of the receipt. The most common arguments were:
- if a company is a going concern, it cannot simply stop all emissions.
- a company has an obligation that it must fulfil either by emitting or by paying ETCs.
Neither of those arguments is convincing:
- A company will have to pay for many other things in the future if it continues in business. That fact alone is not enough to show that the company already has an obligation today to pay for those things.
- If a company can choose to take some action that will enable it to avoid paying ETCs, the company has no obligation at all (so long as the company has the practical ability to take that action—Conceptual Framework, paragraph 4.32).
In my view, there is no plausible argument that a company has any kind of obligation to make future emissions. Nevertheless, many believe that a company does incur an obligation when it receives free ETCs. I believe there is some logic underlying that widely held belief. I sketch out below what I think that obligation is.
3 A fresh look
This section takes a fresh look at the nature of emission trading schemes that issue free ETCs. The section reviews the nature of these schemes (subsection 3.1) and suggests how to measure the assets and liabilities these schemes create (3.2). It then provides an example using the suggested approach (3.3) and reviews some implications of baseline-and-credit schemes (3.4).
3.1 Nature of emission trading schemes that issue free ETCs
Emission trading schemes are not trying to eliminate emissions entirely. Indeed, if emissions were eliminated entirely, there would be no market for ETCs because no-one would buy them at any price. Rather, emission trading schemes are trying:
- to limit aggregate emissions in the jurisdiction as a whole.
- to establish a mechanism than induces emitters to trade emission rights to other emitters that are more efficient or that create higher value.
Thus, I disagree with both of the tacit assumptions underlying previous attempts to develop an accounting model for ETCs. In my view:
- Governments are not subsidising all emitters for all of the emissions they produce up to the quantity specified in the free ETCs issued to that emitter. They are providing some benefit to an emitter choosing to limit its emissions below that quantity—but only if that emitter can find another emitter to buy its surplus ETCs.
- Governments are not taxing emitters for all of the emissions they produce. They are taxing only the excess of that emitter’s emissions over the quantity specified in the free ETCs issued to that emitter.
In my view, free allocations of ETCs have 3 components:
- a loan of ETCs until the time when the borrower must return the ETCs
- a government grant for those emitters choosing to limit their emissions below the quantity specified in their free ETCs—but the grant will have value only if other emitters are willing to buy the surplus free ETCs. The amount of the grant is the quantity of surplus free ETCs that the emitter will not need to pay for its emissions.
- a tax on the excess emissions produced by emitters above the quantity specified in their free ETCs. The tax will typically be paid to other emitters that have sold their surplus free ETCs. (If an emitter has emitted more than the quantity specified in its ETCs and cannot obtain ETCs in the market, the government will typically levy a penalty.)
Analysing free ETCs in this way makes the question much more tractable:
- For most emitters, by far the largest component is the loan. The recipient has received a loan of the ETCs it will repay in fulfilling its emission liability for the emissions it produces. When the recipient receives the loan, it clearly incurs a liability. We all know how to account for loans received, subject to one measurement issue I discuss below.
- Some emitters will emit less pollutant than the quantity specified in the free ETCs they hold. These emitters have received both a loan (of the ETCs they will repay to fulfil their emission liability for the emissions they produce) and a grant (the surplus ETCs that they can sell).
- Some other emitters will emit more pollutant than the quantity specified in the free ETCs they hold. These emitters both have received a loan (of the ETCs they will repay to fulfil their emission liability for the emissions they produce) and also will have to pay a tax on their excess emissions. Emitters in this position have two separate liabilities: (a) a liability to repay the free ETCs; and (b) an emission liability for excess emissions.
Previous attempts have failed because they did not depict the fact that most recipients of free ETCs must ultimately return all or most of those ETCs. The analysis I am suggesting simplifies the problems greatly by applying a simple model to the loan of ETCs.
Difficult questions will still arise for the grant component and the tax component. I do not discuss those questions in this post. Those questions would include determining what event must occur before those components are recognised. For example, when would a grant component be recognised: when some specified probability threshold is crossed, or not until a surplus has already come into existence?
I regard ETCs as a form of currency, though admittedly a very unusual form of currency because it can be used for only one purpose: to fulfil emission liabilities. The following assets and liabilities are denominated in that currency: all ETCs held (whether free or purchased), all ETC loans received and all emission liabilities. At the end of the reporting period, I would translate all those assets and liabilities at the closing rate, which equals the fair value of the ETCs at that date.
I have not considered whether IAS 21 The Effects of Changes in Foreign Exchange Rates would need any amendment to make this approach possible.
3.3 Example using the suggested approach
Applying the approach I suggest in this post to the example given above, on 1 January 20X1 Company A would recognise 1,200 tonnes of ETCs as an asset. It would also recognise a loan liability to return 1,200 tonnes of ETCs. Translating the ETCs and the loan at the closing rate of £1.00 per tonne of ETC, the ETCs and the loan liability both have a carrying amount of £1,200. Company A would recognise no income or expense on 1 January 20X1.
For the 3 months to 31 March 20X1, Company A would recognise no emission expense, and there is no government grant to recognise. It would retranslate both the ETCs held and the loan liability at the new closing rate of £1.20, with no net gain or loss on translation.
For the remaining 9 months up to 31 December 20X1, Company A would retranslate both the ETCs held and the loan liability at the new closing rate (still £1.20), with no net gain or loss on translation. It has no other income or expense to recognise.
On 1 January 20X2, Company A fulfils its loan liability (translated carrying amount £1,440) by repaying all its ETCs, which also have a translated carrying amount of £1,440. Company A has no income or expense to recognise.
An important reminder: this example and this post do not deal with how to account for grants of surplus ETCs that an emitter can sell and with an emitter’s emission liability for excess emissions.
3.4 Baseline-and-credit schemes
The discussion above focuses on cap-and-trade schemes. A baseline-and-credit scheme has similar objectives but uses a slightly different mechanism. In these schemes, an emitter does not receive ETCs at the start of a period. Instead, at the end of a period, the scheme allocates to the emitter a ‘baseline’ level of emissions. The emitter pays nothing for the baseline. If the emitter emits less than the baseline, it receives ETCs for the difference. If the emitter emits more than its baseline, it must buy ETCs from other emitters. There are similarities and differences between cap-and-trade schemes and baseline-and-credit schemes:
- similarities: in both types of scheme, emitters end up (a) paying only for their excess emissions and (b) receiving ETCs for keeping emissions below the quantity of free ETCs / baseline.
- differences: in a cap-and-trade scheme, emitters receive a loan of ETCs at the start of the period. In a baseline-and-credit scheme, emitters do not receive ETCs until the end of the period, and receive them only for the unused portion of the baseline. Thus, cap-and-trade schemes are expected to lead to more liquid markets because a greater volume of ETCs is circulating, and for a longer period.
My suggestion would treat cap-and-trade schemes and baseline-and credit schemes similarly:
- in a cap-and-trade scheme, an emitter would recognise (a) its ETCs held as assets; and (b) its obligation to repay the loan as a liability. If the emitter still holds the ETCs, the carrying amount of the free ETCs held will equal the carrying amount of the ETC loan.
- in a baseline-and credit scheme, the emitter has not received a loan of any ETCs and so has no ETCs or loan liability. (Of course, if it buys and holds ETCs, it does have an asset.)
- in both types of scheme, an emitter would need at some point to account for grants of surplus ETCs that it can sell and its emission liability for excess emissions. I do not discuss that topic in this post.
Cap-and-trade schemes combine 3 elements:
- a loan of emission trading certificates received free of charge
- a grant of any surplus certificates that the recipient can sell
- an emission liability for excess emissions
The recipient of free emission trading certificates should account for its liability to repay the loan element like any other loan received. Not identifying this liability has been at the heart of previous failures on this topic.
Emission trading certificates are like a foreign currency. The closing rate should be used in translating all assets and liabilities denominated in that currency: ETCs held; liabilities to repay loans of ETCs received free of charge; and liabilities for excess emissions.