Accounting debates on carbon credits

While there can be no two opinions on whether carbon emissions should be reduced, there appears however to be a continuing debate among companies on how to appropriately account for carbon credits. "At present there is no authoritative literature under the generally accepted accounting principles (GAAP) in India or the US, or the International Financial Reporting Standards (IFRS) on CER (certified emission reduction) accounting," says Mr Rahul Chattopadhyay, Associate Director, PricewaterhouseCoopers, IFRS practice. "Most Indian companies show earnings out of carbon credit trading as other income as they are not recognised by tax laws."

For starters, CERs represent a unit of greenhouse gas that has been avoided and certified by the United Nations Framework for Climate Change (UNFCCC) under the CDM (Clean Development Mechanism) provisions of the Kyoto Protocol.

The CDM is a trading arrangement between industrialised countries that are committed to reducing their greenhouse gas emissions under the Kyoto protocol (so-called `Annex 1 countries') and fast-growing economies such as China, India and Brazil (so-called `host countries'). Annex 1 countries can invest in those entities based in the host countries that are eligible to receive CER certificates.

The number of entities in the fast-growing Kyoto-ratified economies that own and sell CERs issued according to the Kyoto Protocol's CDM has been increasing.

According to industry reports, the average size of Indian CDM project has grown to 80,000 CERs a year between January and August, as against about 55,000 CERs last year. (The global project average is 1,20,000 CER.) It may help to know that currently the price of one CER is 19 euros or Rs 1,200.

"The lack of accounting guidance in this area has created diverse financial reporting practices, posing clear challenges for the users of financial statements," frets Mr Chattopadhyay, in the course of a recent email interaction with Business Line. He is hopeful though that the robust IFRS framework may provide some solution in the interim period until the standard setters release the accounting pronouncement on emission rights.

Mr Chattopadhyay, a member of the Institute of Chartered Accountants of India, specialises in issues relating to business combinations under the IFRS and has advised clients on issues on acquisitions.

He has been primarily involved in advising clients on various listing issues in the international capital markets. Also, he has been actively involved in the firm's global responses to various IFRS exposure drafts and pronouncements.

Excerpts from the interview:

What are the issues that arise in the accounting of CERs?

The analysis under the IFRS requires us to answer the key question that drives the accounting for self-generated CERs by `green' entities: What is the nature of the CERs? The answer to this question lies in the specific circumstances of the green entity's core business and processes.

If the CERs generated are held for sale in the entity's ordinary course of business, CERs are within the scope of IAS 2, Inventories. If they are not, they should be considered as identifiable non-monetary assets without physical substance. They are therefore intangible assets.

The accounting for CERs is also driven by the applicability of IAS 20, Government Grants and Disclosure of Government Assistance. Management needs to assess if CERs are granted by government. If they are, and depending on the classification above, there are two alternative accounting approaches available to an entity.

While there is continuing debate as to whether the United Nations can be construed to be a government body, the accounting for CERs can be appropriately explained by treating the CERs as government grants in the absence of accounting guidance.

How is the revenue to be recognised?

CERs should only be recognised once there is reasonable assurance that the conditions attaching to the attribution of the CERs are met - these conditions may be met as the entity produces the `green product' (i.e., upon `generation') or may require fulfilment of other conditions attached to receiving the CERs. Since CERs are produced over the course of the project, they are not received by the producing entity until the project and the associated emissions reductions meet the conditions of grant and are issued by the CDM executive board.

If, however, the CERs are classified as intangibles they should meet the definition of an intangible asset under IAS 38, Intangible Assets. This may mean the CERs are recognised upon `generation' or at a later point in time.

Does measurement pose a problem?

Irrespective of whether CERs are treated as inventory or intangible, the initial measurement principles remain the same. Following the IAS 20 principles, on initial recognition, the CERs should be measured at either:

Nominal amount - production costs should be allocated on a rational and consistent basis between production cost of the `green product' if relevant and costs of production of the CERs; or

Fair value - CERs should be recognised at fair value and a government grant recognised for the difference between nominal amount and fair value.

While CERs treated as inventory are measured at lower of cost and net realisable value at each subsequent reporting date, those treated as intangibles are carried at cost less any amortisation and impairment. Alternatively, these intangibles may be measured at fair value, if an active market exists.

When the grant is measured at nominal amount, revenue is recognised only on actual sale of the CERs. When the CERs are initially recognised at fair value, the grant is recognised as other income. Consequently, there is a timing difference of recognition of income if CERs are recognised at nominal amount or at fair value under IAS 20.

Can you tell us about the ongoing work in creating the appropriate standards?

In December 2007 the International Accounting Standards Board (IASB) activated work on its emissions trading schemes project. At this meeting, the Board discussed the scope of the project. It tentatively decided to address the accounting for all tradable emissions rights and obligations arising under emissions trading schemes.

In addition, it will address the accounting for activities that an entity undertakes in contemplation of receiving tradable rights in future periods, example CERs.

The Board confirmed that in addressing the accounting issues the staff should not be constrained by existing IFRS, but the Framework would still be relevant.

Meanwhile, the debate continues and companies agree to disagree on the appropriate accounting treatment.

Your views on the current price of CERs.

The EU carbon market has also felt the rippling effects of the global financial crisis. Although it hasn't suffered the steep falls seen on the share markets, however the carbon prices shown significant volatility over the past month reacting sharply to the energy crisis, global financial meltdown and fear of recession.

The benchmark EUA contract for December 2008 closed significantly below the ?25 mark reached twice since the beginning of September. While there is euphoria on the growing size of the Indian carbon credit projects and indeed in the long run it does seem more lucrative for European companies to invest in India on such projects, one however needs to be marginally cautious of the current volatility as a result of the market meltdown.

A close watch on the market would be important in gauging the impact on the pricing and the related effect in the Indian carbon credit generating industries.

Source : Interview appeared in the hindu business line with Mr.Rahul Chattopadhyay, Associate Director, PricewaterhouseCoopers, IFRS practice