Accounting for Carbon Emission

Credits By Govind Sekhar ( SRO

0211191)

Introduction

History

One of the greatest challenges facing human society is Global warming. In

order to address this issue, an international environmental treaty known as
United Nations Framework Conventions on Climate Change (UNFCCC or
FCCC) was adopted at the United Nations Conference on Environment and
Development (UNCED) informally known as the Earth Summit on June 1992.
The Objective of the treaty is to limit the concentration of Green House
Gases (GHG’s) in the atmosphere. The treaty provides for updates (called
"protocols") that would set mandatory emission limits. The principal update
is the Kyoto Protocol, which was adopted by the parties to the UNFCCC
(which at present is more than 190) in 1997 and which entered into force
from 16th February 2005. As of July 2010, 191 countries have signed and
ratified the protocol.

Under the protocol, 41 “developed “countries (Known as Annex 1 countries)

have to commit themselves to reduce their GHG emission by at least 5%
below their 1990 baseline emission levels by the commitment period of
2008-2012. To meet the emission reduction targets, binding countries in
turn set limits on the GHG emissions on their local businesses and entities.

What is carbon credit and how it works

Under the Kyoto protocol , a company has two ways to reduce

emissions :-

a. It can reduce the GHG (green house gases ) by adopting new

technology or improve upon its existing technology to attain the new
norms for emission of gases.

b. It can purchase “ absorption ability” from another nation , thereby

helping developing country or its companies “earn” credits.

Therefore, if an entity in Annex 1 country ( Mostly European since USA has

not ratified the protocol) wants to emit more than the ‘cap’ fixed for it , it
should ensure that equivalent to such excess , it has achieved a reduction in
carbon dioxide emission . This is made possible by the purchase of ‘carbon
credit ’ from entities in the developed economies or developing economies
( non annex 1 countries ) . A carbon credit is measured in terms of CER’s
( Certified emission reductions ) .One CER is a certificate of
acknowledgement of one tonne of carbon dioxide reduction achieved . They
are issued by UNFCCC to any company or a factory which has been able to
achieve this reduction.

Flexibility Mechanisms

Carbon credits are earned and traded under three mechanisms specified by
the protocol - Joint Implementation (JI), Clean Development Mechanism
(CDM) and International Emission Trading.

Under JI, a developed country with a relatively high cost of domestic GHG
reduction project can setup a project in another developed country that has
a relatively low cost and earn carbon credits that may be applied to their
emission targets.

In case of CDM, entities in developing/least developed countries can set up a

GHG reduction project(E.g.:- undertake a reforestation program , develop
windmill power plants etc ) , get it approved by UNFCCC and earn carbon
credits equivalent to the quantum of emission reduction achieved . Such
carbon credits generated can be bought by entities of developed countries
with emission reduction targets. To qualify for CER’s, CDM project must
meet a number of ‘additionality criteria’ , the minimum being

a. Reducing emissions below the level that would have occurred in the
absence of the project
b. Demonstrating that a project would not have occurred without the
additional incentive provided by the emission reduction credit
c. Obtaining certification of actual emission reduction from an
independent authority

Under IET, developed countries with emission reduction targets can simply
trade in the international carbon credit market. This implies that entities of
developed countries exceeding their emission limits can buy carbon credits
from those whose actual emissions are below their set limits

Carbon Trading and India

CDM , JI and IET have paved way for a huge global market in ‘ Carbon Trading’
which is currently estimated to be worth over USD 125 Billion and is traded in 5
exchanges - the Chicago Climate Exchange, European Climate Exchange, Nord
Pool, PowerNext and the European Energy Exchange. The market is very volatile
with prices of a unit of CER’s ranging between 20 to 30 USD. One of the biggest
beneficiary of the CDM have been China , India and Brazil which are the biggest
developing economies who are not bound by the Kyoto Protocol and consequently
are always suppliers of carbon credits . In India, the major corporate which have
tapped into this new stream of revenue includes Gujarath Fluro carbons Ltd, SRF
Ltd, Navin Fluorine International Ltd etc.

Accounting for Carbon Credits – Indian Scenario

Introduction

The accounting issues and the consequent account treatment involved in the
three different mechanisms mentioned above may be different. However,
since India is a non Annex 1 country, the carbon credits or CER’s generated
from CDM is only relevant . The ICAI, had issued a draft guidance note on”
Accounting for Self Generated Certified Emission Reductions (CER’s) “ in
2009 to provide guidance on matters of applying accounting principles
relating to recognition , measurement and disclosure of CER’s generated by
the entity under CDM . The final approved guidance note is yet to be issued
and hence, the accounting procedures discussed below is based on the
exposure draft.

Nature of CER’s - Asset

As per the exposure draft , a CER is treated as an asset , since it is a

resource controlled by the enterprise as a result of past events (issue of
CER by UNFCCC) from which future economic benefits are expected to flow (
proceeds from sale of CER ) .

Recognition of CER’s

According to the ‘Framework for the Preparation and Presentation of

Financial Statements’, once an item meets the definition of the term ‘asset’,
it has to meet the criteria for recognition of an asset as laid down in the
Framework so that it may be recognized in the financial statements. As per
paragraph 88 of the Framework, the criteria for recognition of an asset are as
follows:

“. An asset is recognized in the balance sheet when it is probable that the

future economic benefits associated with it will flow to the enterprise and the
asset has a cost or value that can be measured reliably.”

In accordance with the framework , the exposure draft requires three

conditions to be satisfied before a CER can be recognized as an asset :-
 a. Existence :- CERs come into existence when these are credited by
UNFCCC in a manner to be unconditionally available to the generating
entity

b. Probable Future economic benefits must flow from CER :- The

probability criterion is said to be met when there is a reasonable
assurance that future economic benefits will flow from the CERs to the
entity. As the market for CERs is relatively new, the future economic
benefits may not always be assured. Thus, an entity needs to make an
assessment for the probability of future economic benefits.

c. Measurement of Cost or Value :- As regards the criterion for

measurement of cost or value, there are certain costs which are
incurred to generate CERs, and therefore the cost of CERs can be
measured reliably. The value at which CERs are to be measured is
dependent upon the type of the asset which is discussed later .

What type of asset is CER

Though CERs are non-monetary assets without a physical form, they do not
strictly fall within the definition of ‘intangible asset’ as per AS 26. The reason
is that CERs are not held for use in the production or supply of goods or
services, and neither are CERs used for administrative purposes nor are they
used for the purpose of renting to others. Instead, CERs generated by the
generating entity are held for the purpose of sale.

It may be mentioned that though the definition of ‘intangible asset’ does not
mention assets held for sale, the other requirements of AS 26(Refer Para 44
of AS 26 ) , indicate that intangible assets include assets which are
developed by an entity for sale . However , AS 26 specifically scopes out
those intangible assets from its purview if they are specifically dealt with by
another accounting standards .

Since Intangible assets held for sale in the ordinary course of business comes
under the purview of the definition of inventories under AS -2 , the exposure
draft requires CER’s to be recognized as inventories in the financial
statement in accordance with the requirements of AS 2 . Consequently , they
are measured at the lower of cost or net realizable value .

Cost

As per AS 2 , cost of inventories include “all costs of purchase, costs of

conversion and other costs incurred in bringing the inventories to their
present location and condition.”. Various costs are incurred by an entity to
set up , operate and monitor - the CDM project . As per the exposure draft ,
these costs do not result in bringing the CER’s into existence and
accordingly cannot be inventorised instead these have to be treated
separately . For ex :- research cost for exploring alternative ways to reduce
emission should be treated in accordance with AS 26 , cost of construction
of plant and machineries for CDM is treated as per AS 10 etc and their
carrying values are tested for impairment as per AS 28.

However , it is important to note that , since these plant and equipments are
erected for the purpose of generating CER’s , the depreciation of such
devices should not be included in the cost of the inventory of the principal
products of the generating entity as they do not contribute to bringing the
inventory of the principal products to their present location and condition.

Only the costs incurred for the certification of CERs by UNFCCC is considered
to bring the CERs into existence and accordingly is treated as the cost of
inventory. The cost of certification includes

a. Levy by UNFCCC :- Two types of levies are imposed . The first type of
levy is in kind whereby a specified percentage of the CERs earned are
deducted at the point of issuance by the UNFCCC. This increases the
per unit cost of CER . The second type of levy imposed is in the form of
a cash payment which is charged by the UNFCCC towards meeting its
administration costs.

b. Consultants Fees: - The generating entity normally pays a fee to the

consultant for the services rendered to obtain the certification of CERs
by UNFCCC.

Net Realisable Value

NRV = Estimated selling price of CER’s in the ordinary course of business -

Estimated cost of completion and estimated cost necessary to make the sale

In Determination of the net realizable value of CER’s , paragraph 22 of AS 2

reproduced below should be used as guidance:-

“Estimates of net realisable value are based on the most reliable evidence
available at the time the estimates are made as to the amount the
inventories are expected to realise. These estimates take into consideration
fluctuations of price or cost directly relating to events occurring after the
balance sheet date to the extent that such events confirm the conditions
existing at the balance sheet date”

Revenue Recognition

Revenue from sale of CER’s is disclosed as income in the profit and loss
account , provided the revenue recognition criteria as per AS 9 is satisfied
Emission caps on units abroad

The Exposure draft does not cover Accounting for emission caps when Indian
entities have a factory / unit in Annex 1 countries. In such situations the
branch / factory may have to ‘cap’ their emission levels depending upon the
regulatory requirements in such countries . Currently under IFRS different
approaches are followed to account for emission caps such as the IFRIC 3
approach , the net liability approach and the Government Grant approach.
The Accounting treatmeant under each of the three approaches can be
summarised as under:-

a. IFRIC 3 Approach:-An Intangibe asset is recognised for the emission

permits received , they can be purchased or be allocated from the
government . They are recognised at the fair value prevailing at the
time of purchase / allocation . And a Liability is recognised when the
entity emits gases against such permits for the reporting period . Such
liability is usually measure at the fair value prevailing at the end of the
reporting period. In the income statement , income is recognised
corresponding to the intangible asset and likewise expense is
accounted for corresponding to the liability .

b. Net Liability Approach :- Under the net liability approach, emission

permits granted are recorded at their nominal amount (i.e., nil if
granted for nil consideration) and the entity only recognises a liability
once actual emissions exceed the permits granted and still held. Such
Liability is recorded at the fair value at the end of the reporting period .

c. Goverment Grant Approach :- Another approach which has gained

acceptance is to recognise the emission permits granted by the
government initially at their fair value and a corresponding
government grant (deferred income) in the balance sheet. The
government grant is subsequently recognised in income on a
systematic basis over the compliance period for which the permits are
issued. To that extent, the approach follows that required by IFRIC 3.
However, rather than measuring the liability at the present market
price of the permits, the liability is measured by reference to the
amounts recorded for the emission permits held as assets that will be
used to settle the liability

Accounting for Carbon Credits under IFRS

Introduction

At present there is no accounting standard or interpretation within

International Financial Reporting Standards (IFRS) that deals specifically with
the accounting for Certified emission reduction . In December 2004, the IASB
issued IFRIC 3 Emission Rights, to address the accounting for emission
permits arising from such schemes. However, the Interpretation met with
significant resistance on the basis that it resulted in accounting mismatches
between the measurement of assets and liabilities. Consequently, the IASB
decided to withdraw the Interpretation in June 2005 – despite the fact that it
considered it to be an appropriate interpretation of existing IFRS.

Until definitive guidance on accounting for CER’s is issued , an entity

applying IFRS has the option of either :-

a. Applying the principles of IFRIC 3 ( despite its withdrawal) or

b. Develop its own accounting policy based on the hierarchy of
authoritative guidance in IAS 8 Accounting Policies, Changes in
Accounting estimates and Errors

‘Commonly’ Followed Accounting Practices

Presently, entities following IFRS define their accounting policy considering

the nature of CER’s . They can be treated as a government grant since CER’s
meet the definition of government grants under IAS 20 Accounting for
Goverment Grants and Disclosure of Goverment Assistance . Such grants
are recognised when there is a reasonable assurance that the entity will
comply with the conditions attached to it . They are measured on initial
recognition either at nominal value or fair value .The debit is given in most
cases to the Intangible assets account with revenue recognised in the
income statement during the same period as the related costs are
recognised . However, some entites also recognise CERs as inventory in
accordance with IAS 2 Inventory if they are held for sale in the ordinary
course of business.

Conclusion

Accounting for carbon credits is a highly debated topic in the field of

business and finance. This is reflected in the fact that as on date there is not
a single ‘final ‘ standard on this issue either by the FASB , IASB or our very
own ICAI . The primary concerns revolve around in deciding which is the
best of the current ‘ commonly ‘ followed practices viz recognition of CER’s
as inventories or intangible assets and whether they are ‘marked to market ‘
or held at cost . Each of these methods have a entirely different impact on
the financials .For example, as per the exposure draft, CER’s will be
recognised only when they are issued by UNFCCC whereas if an entity
choose to consider CER’s as grant , it can , in effect pre-pone the recognition
of revenue since grant can be recognise when there is a reasonable
assurance that entity will comply with the conditions attached to it .
Therefore , regardless of the accounting approach adopted, the need to
communicate clearly with stakeholders and other users of the financial
report about how the entity’s performance and overall company value has
been, and will be, affected by the method of accounting followed is
paramount and if left unchecked it can lead to chaos and manipulations .