Accounting and reporting difficulties associated with environmental credits

Businesses all across the world are developing strategies to reduce their carbon footprint. Environmental credits have increased in popularity as a means for businesses to satisfy their emission reduction commitments.

“Many companies are already using or plan to use environmental credits as part of their overall strategy to achieve sustainability goals,” said Eric Knachel, senior consultation partner at Deloitte & Touche. “A lot of companies that set voluntary targets for carbon emission reduction may be realizing that relying on more efficient equipment or new technologies may not be sufficient to achieve their goals.”

The fundamentals

Carbon allowances and offsets, renewable energy certificates (RECs), and other climate and emissions credits are examples of environmental credits. These arrangements, as well as the definitions of the relevant credits, are complex, but they are critical for businesses creating strategies and wanting to comprehend the accounting and disclosure implications.

The following definitions were offered by Deloitte in an October 2022 accounting spotlight:

• A carbon credit is defined as a "market-based or legal instrument that signifies ownership of one metric tonne of carbon dioxide equivalent (MTCO2e) that can be kept, sold, or retired in order to achieve a required emissions cap or a voluntary emissions reduction objective."

• When one megawatt hour (MWh) of electricity is generated and delivered in the electricity system from a renewable energy resource, a REC is issued. Owners of renewable energy sources may be eligible for RECs. Buyers of RECs... are permitted to use the RECs to record lower Scope 2 emissions from purchased electricity."

• "Initially issued by regulatory bodies in carbon compliance programmes... (and) provides the holder with the legal authority to emit one MTCO2e. … [A] carbon compliance programme determines the overall volume of emissions permitted by all of its regulated entities in a given year, as well as the corresponding volume of allowances. Allowances are allocated or auctioned off by regulatory agencies to regulated enterprises. If an entity wants to emit more or less MTCO2e, it can buy or sell allowances to other entities... until it achieves the volume required to match its annual emissions... [E]ach permit is a tradable MTCO2e."

• An offset is "produced from projects with the goal of producing and selling verified carbon credits." Carbon credits generated by these initiatives are ultimately used to 'balance' the emissions of the organisation that acquires and retires the credits."

Accounting and financial reporting difficulties

Environmental credits are not particularly addressed in today's generally accepted accounting principles (GAAP) in the United States.

“For example, are environmental credits assets and, if so, how should they be classified?” Knachel asked. “Should environmental credits be subject to impairment testing, and when should entities record expenses related to their use of credits to offset their carbon emissions?”

Knachel stated that in the absence of particular accounting advice, organisations must fully grasp their business plan in relation to environmental credits and then analyse the most appropriate current accounting model.

“There isn’t necessarily a ‘one-size-fits-all’ model,” he said.

Environmental credits may be accounted for as assets in practise if they meet the GAAP definition of an asset providing an economic benefit that eventually results in prospective net cash inflows. There are concerns about whether the credits provide an economic benefit and the ability to generate cash flows from new environmental credit markets. There are also factors for when to de-recognize a credit based on its use or retirement.

Alternative techniques for accounting for environmental credits include using an inventory model if the company intends to trade the credits, or an intangible asset model, with concerns for whether to amortise and how to determine impairment. The asset model selected will determine how related expenses are reported on the income and cash flow statements. Another option is to deduct environmental credits when they are purchased.

In practise, producers of environmental credits may use either an inventory or an intangible model, which influences how they account for the production expenses paid in obtaining the credits. Environmental credits can be included in revenue arrangements if the vendor has independent performance responsibilities linked to transferring credits or delivering associated services, such as retiring carbon credits, as defined by Accounting Standards Codification Topic 606.

There may also be obligations associated with emissions that must be recorded. In practise, some businesses record a responsibility if their actual emissions exceed the value of their environmental credits, whilst others record a gross liability based on total emissions and the cost of acquiring required allowances. Based on the nature of the agreement, it may also be considered if financial instruments, including derivatives, must be accounted for.

The accounting models used will have an immediate impact on the financial statement disclosure obligations. Furthermore, significant disclosures about accounting estimates and assumptions, risks, obligations, and contingencies are required under existing GAAP in general, which must be applied to the domain of environmental credits.

Beyond financial statements, organisations must consider how they will disclose their overall strategy and success in lowering emissions, as well as how they will use these credits, in Securities and Exchange Commission (SEC) filings, other public announcements, and corporate communications.

Agendas for Regulation

The topic is on regulators' radar because of the diversity of accounting practise and the rising usage of environmental credits. Adjustments are expected to occur soon.

“It’s important for companies to think through the accounting and financial reporting implications, including potential disclosure requirements,” Knachel said.

In May, the Financial Accounting Standards Board (FASB) added a project to its technical agenda on the requirements for participation in compliance and voluntary programmes that result in the development of environmental credits. The project's preliminary scope includes legally enforceable and tradeable environmental credits.

The project's goal is to address the inconsistency in accounting practise. Credits fall into two categories: regulatory (e.g., RECs) that track compliance and voluntary (e.g., carbon offsets). The FASB is still deliberating; no date for an exposure draught has been set.

The use of environmental credits and how these credits have contributed to the company's progress in attaining climate targets is included in the SEC's proposed rule requiring climate-related disclosures. There are also recommended disclosures about the risks associated with using the credits and their availability.

The SEC is analysing feedback from approximately 15,000 public comments before enacting the rule, but the timeline of this regulation is unknown. In response to strong pushback, the agency is apparently considering modifying several components of the proposal.

By fLEXI tEAM