Accounting implications of the EU Emissions Trading Scheme

On 1 January, 2005 the European Union Greenhouse Gas (GHG) Emission Trading Scheme (EU ETS) will come into force, creating a new commodities market that some market observers predict could be worth up to £21bn a year. Robert Casamento reports on what the accounting profession is doing to provide guidance on how companies should account for these potentially new assets and liabilities

The EU ETS requires operators of certain installations (from sectors covered by the scheme) to surrender, by 30 April each year, allowances equal to the annual verified GHG emissions from the installation in the preceding year. Operators who fail to comply with this condition face a penalty for non-compliance, which for the first phase of the EU ETS (January 2005 to December 2007 inclusive) is set at of 40 euros per tonne rising to 100 euros per tonne for the second phase (2008-2012).

The scheme is based on the concept of �cap and trade�, whereby the total volume of GHG emissions are effectively �capped� by limiting the number of allowances made available. Participants are also allowed to manage their position by trading allowances. For example, if emissions exceed the number of allowances, an operator can obtain the required volume of allowances by purchasing them on the market. Alternatively, if an operator has excess allowances, they are able to potentially profit off these by selling them.

The scheme is expected to cover some 12,000 installations across a number of sectors, including energy, production and processing of ferrous metals (e.g. ore, steel), minerals (e.g. cement, ceramics) and pulp and paper. In terms of gases, while the directive (1) that establishes the scheme covers a basket of six GHGs (2), the first phase of the scheme only covers carbon dioxide. Despite this, the size of the market is expected to be significant. In the UK alone, the allocation of allowances to one individual entity for a three-year period (based on the UK�s draft National Allocation Plan, January 2004) is 65m allowances. Assuming a market price of 5 euros to 13 euros, this could represent a new asset or liability of 325m euros to 845m euros on the balance sheet.

Accounting developments

The International Accounting Standards Board (the Board), through the International Financial Reporting Interpretations Committee (IFRIC) (3), observed that many companies are, or will be, subject to such schemes. It also noted that no consensus was emerging among market participants on what the accounting treatment should be. As there was a risk of divergent practices developing, IFRIC concluded that it should develop an interpretation (4), which set out to explain how IFRS should be applied in the context of �cap and trade� emission trading schemes.

The decision for IFRIC to look into the matter was also supported by the fact that, commencing from 2005, many companies in the EU will be required to report their financial performance according to International Financial Reporting Standards (IFRS).

In May 2003, IFRIC issued a draft interpretation (D1, Emission Rights) for public comment (5). D1 focused on the following key issues: (6)

• does an emissions allowance scheme give rise to (i) a net asset or liability or (ii) an asset (for allowances held) and a liability, deferred income and/or income?
• if a separate asset is recognised, what is the nature of that asset?
• if a separate liability, deferred income and/or income is recognised, what is the nature of that item and how is it measured?
• when should a potential penalty, which will be incurred if a participant fails to deliver sufficient allowances to cover its actual emissions, be recognised, and how should it be measured?

After considering a number of alternative treatments IFRIC proposed that, depending on the circumstances, emissions trading schemes give rise to:

• 1. An asset for allowances held. Emission allowances, whether allocated by government or purchased in the market, are intangible assets and should be accounted for in accordance with IAS 38, Intangible Assets. Allowances that are allocated for less than fair value shall be measured initially at their fair value. Allowances shall not be amortised (7), but are to be tested for impairment under IAS 36, Impairment of Assets.
• 2. A government grant. When allowances are allocated by government for less than fair value (8), the difference between the amount paid and fair value is a government grant that shall be accounted for in accordance with IAS 20, Government Grants and Disclosure of Government Assistance. Accordingly, the grant is initially recognised as deferred income in the balance sheet and subsequently recognised as income on a systematic basis over the compliance period for which the allowances were allocated (9).
• 3. A liability for the obligation to deliver allowances equal to emissions that have been made. As emissions are made, a liability is recognised for the obligation to deliver allowances to cover those emissions (or to pay a penalty). This liability is a provision that falls under IAS 37, Provisions, Contingent Liabilities and Contingent Assets. The liability shall be measured at the best estimate of the expenditure required to settle the present obligation at the balance sheet date. This will normally be the present market price of the number of allowances required to cover emissions made up to the balance sheet date. However, if the participant�s best estimate is that some or the entire obligation will be settled by incurring a cash penalty, it (i.e. the participant) shall measure that part of its obligations at the cost of the penalty rather than at the market price of the relevant number of allowances (10).

This approach treats assets (i.e. allowances) independently to the liabilities (i.e. obligations). Accordingly, netting off (i.e. offsetting) of the asset and liability is not permitted.

Over 40 comment letters were received from various sources. Respondents welcomed IFRIC�s attempts to provide guidance on this issue; however, only two respondents fully supported the proposed approach. The key concerns were:

• 1. Artificial volatility in the income statement
  Many respondents commented on the lack of symmetry in measuring and reporting the changes in the three elements in the scheme (the allowances, the liability for emissions to date, and the government grant). These respondents were concerned that the lack of symmetry resulted in an entity reporting artificial volatility in its income statement (i.e. profit or loss). This arises because the current IFRS contain both a mixed measurement model (whereby some items are measured at cost and others at fair value) and a mixed presentation model (whereby some gains and losses are reported in the income statement and others in equity). In short, the proposed accounting treatment would: record a gain in the value of emission rights to equity, but the loss related to revaluing the liability would be recorded in profit or loss; and record a loss in the value of emission rights against previous gains recognised in equity, but the gain related to revaluing the liability would be recorded in profit or loss.
  Some respondents suggested a solution could be to amend IAS 38 so that gains and losses on allowances are recognised in income rather than equity.
• 2. Whether IFRIC should proceed with the interpretation at this time
  Some respondents questioned whether it was appropriate for IFRIC to issue an interpretation at this time given that projects on the Board�s active agenda, including the potential withdrawal of IAS 20 and a review of performance reporting, could affect the proposals outlined in D1.
  Other concerns centred on the fact that many respondents felt the proposals failed to reflect the economic substance of an emission trading scheme. Some respondents therefore proposed alternative accounting solutions or amendments to IFRIC�s proposals. These included: a net model, under which an entity does not recognise allocated allowances, and accounts for actual emissions only when it holds insufficient allowances to cover those emissions; an amortising model, under which an entity recognises allocated allowances as an asset, but then amortises the allowances as it pollutes. The entity therefore recognises a liability for actual emissions only when it holds insufficient allowances to cover those emissions; accounting for the allowances as an item of inventory; accounting for the allowances as financial assets and measuring them at fair value with gains and losses recognised in income; classifying the allowances as a derivative and accounting for them as a cash flow hedge; measuring the liability that the entity incurs as it emits at the cost of the allowances held by the entity; measuring the government grant by reference to the market value of the number of allowances it represents; specifying disclosure requirements; and providing guidance on how to account for allowances and obligations if there is no active market.

After considering the responses (including suggested alternative treatments), IFRIC confirmed its belief that the proposals set out in the draft interpretation are the most appropriate interpretation of existing IFRS. In doing so it confirmed its beliefs that: the gross approach is correct, rejecting the netting of the asset and liability; the suggested amortisation approach is not appropriate as this approach is considered incompatible with the inherent nature of the asset; an allowance is not an item of inventory or a financial asset; additional disclosure requirements should not be specified or recommended; and additional guidance for cases where allowances are not traded in an active market is not required.

They did note, however, the key concern regarding the lack of symmetry in the accounting and proposed creating a new category of intangible asset, one that considered the unique characteristics of an allowance. They concluded that the most faithful way to report an allowance is akin to monetary currency and, as such, should be accounted for in the same way. As such, IFRIC decided to ask the Board to amend IAS 38 so that any intangible asset:

• that is like a currency, because it has value only because it is used to settle an obligation, and
• whose fair value is determinable by reference to an active market (as defined in IAS 38), should be measured at fair value with changes in value recognised in profit or loss.

The Board agreed with this recommendation. The Board also noted that an important reference for the draft interpretation is IAS 20 and, in light of the tentative decision to withdraw IAS 20, the Board decided to accelerate work on replacing IAS 20 (11) and to consider the implications this may have when accounting for emission allowances.

Based on these discussions, the Board suggested that IFRIC re-expose its draft interpretation at the same time as the IASB exposes its intention to withdraw IAS 20 and to amend IAS 38. Documents outlining these changes are expected by June 2004 (it is to be hoped having an interpretation ready by November 2004). Given this timing, it remains unclear whether the interpretation will be part of the �stable platform� of IFRS to be adopted in 2005. However, many companies may choose to adopt the final interpretation because they may believe it provides a more �true and fair� presentation of their results.

Taxation

As with any new business activity, companies looking to participate in transactions associated with emission allowances will need to assess the possible tax consequences. Given the infancy of emission trading markets and the fact that much of the tax analysis depends upon specific facts and circumstances particular to each jurisdiction and individual transaction, no authoritative literature on the topic has been developed. Indeed many jurisdictions are adopting a �wait and see� approach to answering these questions. As a result, there is a significant amount of uncertainty as to the suitable tax treatment. Interested parties in the UK however have undertaken preliminary discussions. These are summarised in the following.

Income tax, corporation tax and capital gains tax

Discussions with the UK Inland Revenue have confirmed some general principles, but no UK legislation is expected to deal specifically with the EU ETS or emission allowances. This is because there may be many different tax treatments depending on who the potential taxpayer is (e.g. individuals, companies, charities) and the purpose for which they hold the allowance (e.g. trading stock, investments, or fixed assets of a business). Some taxpayers may also hold a variety of derivative instruments relating to the allowances. As such, no one ruling will apply - instead it is probable that normal tax law will be applicable.

Value added tax (VAT)

VAT discussions with the UK�s HM Customs & Excise have resulted in preliminary guidance (12) that concludes that an allowance will be classed as a supply of services (13) and, therefore, will be subject to VAT when traded in an open market (14). When issued, however, an allowance will not attract VAT because the activity of issuing an allowance is free of charge - it is not undertaken in return for any consideration.

Assessing what level of VAT is payable depends on the type of transaction taking place. Each of the following situations may result in slightly different VAT results: the simple trading of allowances; a trade which relates to the delivery of the underlying asset (i.e. the allowance) such as an option (15) or a deliverable forward/future; the trading of allowances that never result in the delivery of the underlying asset (e.g. contracts for difference); and trading by an intermediary, such as a broker. Discussions are ongoing with HM Customs & Excise to clarify the potential VAT results for these situations and guidance is expected to be published soon. In the interim, those interested in this issue should contact their relevant VAT specialist for advice.

Conclusion

If, as some experts predict, the market for GHG emissions allowances develops into a multi-million or even billion euro market, the necessity to develop appropriate accounting guidance is fundamental to providing useful information that helps readers of financial statements make better-informed economic decisions. While the accounting and taxation matters involved are challenging, IFRIC is taking proactive steps to ensure that sufficient guidance is available to enable companies to measure, assess and report the impact of emissions trading schemes in their financial statements.