Sorry folks for the long delay in posting! Hereafter I will ensure that I am at least posting short articles frequently. Accounting for Carbon Credits or perhaps, carbon credit itself is one of the most debatable topics. After the implementation of Kyoto Protocol, Carbon Credits emerged as a distinct commodity by itself capable of being bought, sold or offset (used). Since Carbon Credits do not have a physical existence, the accounting and financial reporting of the same has aroused many interesting issues and challenges. Before going into the detailed accounting treatment of carbon credits it would be apt to go into a small introduction about what carbon credit is and its nature.
What is Carbon Credit?
As everyone is aware, Carbon – di –oxide (CO2) is the major contributor to global warming. Everyday more and more CO2 and other Green House Gases (GHGs) are pumped into our atmosphere. This is causing rapid climatic changes, much against human welfare. To address this issue of global warming, the United Nations Framework Convention on Climate Change (UNFCCC) was adopted in 1992. To supplement the UNFCCC, the Kyoto Protocol was enforced to limit the maximum amount of GHGs a country can emit into the atmosphere. This limit is at present is applicable only to 41 developed countries which are party to the Kyoto Protocol. These countries are also called Annex I countries. India being a developing country the emission commitment is not applicable.
In order to enforce this emission limit, the concept of Carbon Credit was proposed. According to this concept, each carbon credit is equal to 1 Metric Tonne of CO2 or an equivalent amount of other GHGs. Each Annex I country should hold one carbon credit in order to emit 1 Metric Tonne of Carbon into the atmosphere. In simple terms a carbon credit is a license / permit to emit 1 Tonne of Carbon into the atmosphere. Carbon emission credits are issued by the UNFCCC in demat form. Therefore they can be traded just like shares in stock / commodity exchanges. As per the Kyoto Protocol there are three types of carbon credits to serve three different purposes:
- Assigned Amount Units or AAU
- Emission Reduction Unit or ERU
- Certified Emission Reduction or CER
According to the Kyoto Protocol each Annex I country is allotted a fixed amount of AAUs by the UNFCCC in Demat Form. This represents the maximum GHGs the Annex I Country can emit into the atmosphere. The Annex I Country in turn will distribute AAUs to industrial organisations in its jurisdiction who want to emit carbon into the atmosphere.
Apart from the AAUs allotted by the UNFCCC, a developed country can set up projects that reduce carbon emission in another developed country, to earn carbon credits from UNFCCC. The carbon credits so earned are called Emission Reduction Unit or ERU. These ERUs represent the amount of carbon emissions saved by the project. ERUs can be used by the developed country to set off against its own emissions. This process of set off is called Carbon Offset.
The third type of carbon emission credit is the most interesting of all. It is called Certified Emission Reduction or CER. This type of carbon credit involves the developing and least developed countries which are not parties to the carbon reduction commitment. This ensures carbon emission reduction and enables sustainable development. The projects undertaken by the developing countries which reduce carbon emission are allotted CERs by the UNFCCC. The process of obtaining these CERs is known as Clean Development Mechanism or CDM.
For example let us consider that an Indian Company installs a windmill. The windmill generates energy using wind power instead of burning coal and in the process saves say some 25 tonnes of carbon dioxide per year. This project, subject to the approval of the National CDM Authority will be eligible to get 25 CERs from UNFCCC. The project at constant intervals, which is usually a year, is subject to verification by an External Auditor called Designated Operational Entity or DOE. After the verification process by the DOE, the UNFCCC allots CERs to the Indian Company in Demat form. These CERs can be sold to Developed countries for the purpose of carbon offset.
Trading of Carbon Emission Credits
The most important character of carbon credit is its tradability. Carbon credits can be bought and sold like any other commodity. Carbon credit trading is channelized through stock / commodities exchanges. In India the Multi commodity Exchange or MCX currently allows trading in Carbon credits. An organisation can buy and sell all types of carbon credits just like stocks and shares. Even futures, options and derivatives transactions are allowed in carbon credits. This trading not only allows developed countries to meet their emission reduction targets but also motivates developing countries to invest more in Clean Development Projects. This in turn directly or indirectly provides a gateway for sustainable development.
Issues in Accounting for Carbon Credits
Now, I hope everyone would have got a brief idea about what carbon credit is all about. So let’s now move into the crux of today’s discussion, i.e. the accounting aspect. Since only CERs are relevant in the Indian context, I am restricting my discussion to accounting for CERs alone. Carbon Credit being a nascent concept, at present there no uniform accepted accounting treatment for carbon credit. Internationally neither IASB, the issuer of IFRS nor IFRIC (International Financial Reporting Interpretation Committee) have instilled clarity in this issue. IFRIC 3 Emission Rights which dealt with this issue was withdrawn due to variety of reasons. Hence effectively there is no internationally accepted guidance on this issue. This has resulted in divergent schools of thought for accounting carbon emission credits.
Different entities have started treating carbon credits in different ways. Some entities recognise revenue from carbon credits only when the carbon credit is finally sold, that too as other income in the Profit and Loss statement. While some other entities recognise them as intangible assets, still others treat them as government grants and account them according to AS –12 Accounting for Government Grants. These divergent treatments have aroused as much principle debate as possible.
So what really is the correct accounting treatment for CERs? To solve this issue, ICAI has come out with a Guidance Note on Accounting for Self-generated Certified Emission Reductions. This to an extent has clarified all the issues relating to accounting for CERs.
Whether Carbon Credit is an Asset?
The first question that arises when we say that we have to account for CERs is whether CER is really an asset. The answer to this question is simple but it is not that easy to answer. The ‘Framework for the Preparation and Presentation of Financial Statements, issued by the ICAI, defines an ‘asset’ as
“a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.”
So a CER in order to be considered should be a resource controlled by the enterprise which resulted from past events and should be capable of bringing future economic benefits. A CER can be generated only if the enterprise engages in a CDM project. This is a past event. But a CER will not become a resource to the enterprise immediately after it engages in a CDM project. A long procedure has to be followed before any CER can be generated. First of all the project has to be approved by the National CDM Authority and latter be verified by a Designated Operational Entity (DOE). Only after these procedures, UNFCCC will be able to grant CERs to the enterprise. If anything goes wrong at any point of time, the project may not generate any CERs. This shows that there is a high degree of uncertainty involved in the generation of CERs. Accordingly, at this stage when emission reductions are taking place, CERs can, at best, be said to be contingent assets as per Accounting Standard (AS) 29, Provisions, Contingent Liabilities and Contingent Assets, which defines a contingent asset as
“a possible asset that arises from past events the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise”.
A contingent asset finds no place in the Financial Statement except at the best in the Notes to accounts. Hence a CER can be considered to be a resource controlled by the enterprise only when it finally receives a communication from the UNFCCC that CERs have been issued to the enterprise. After this certification a CER now has all the characters of an Asset as set out by the Framework.
What kind of asset is a CER?
Having concluded that a CER is an asset, the next question now arises as to what kind of an asset is CER. As everyone is aware, CER does not have any physical form. It is allotted by the UNFCCC in Demat form. Considering this fact, a CER should be classified as an Intangible Asset. By concluding that a CER is an Intangible asset, we have to apply the accounting principles prescribed by AS – 26 Intangible Assets. But when we carefully go through the text of AS – 26, it specifically excludes an intangible asset held for sale in the ordinary course of business. A CER is held for sale and not intended to be used in production.
Hence accounting for CER cannot be done according to AS – 26. So what other standard should we go to? The answer is quiet simple. It is AS – 2 Valuation of Inventories. Yes my friends all this hot discussion boils down to our very own familiar standard AS – 2.
According to AS – 2,
“Inventories are assets:
held for sale in the ordinary course of business;
in the process of production for such sale;
in the form of materials or supplies to be consumed in the production process or in the rendering of services.”
Since CER is held for sale in the normal course of business, it easily falls well within the boundaries of the above definition. Therefore, CERs have to be accounted just like any other item of inventory.
Valuation of CERs:
Having concluded that CERs are inventories now let us more into the valuation part of it. I am very sure every one of my friends here, knows how to value inventories. Any item of inventory has to been valued at Cost or Net Realisable Value (NRV) whichever is lower. Accordingly, CERs also have to be valued at cost or NRV whichever is lower. Now let me discuss each aspect of Cost of CERs and NRV of CERs elaborately.
Cost of CERs:
As per AS – 2, all costs incurred in bringing the inventories to present location and condition have to be included in the cost of inventories. Any enterprise that generates CER has to incur various costs set up a CDM project activity, operate the CDM project and generate CERs. But we have to be careful as to include only those expenses which are directly attributable to the generation of CERs. An illustrative list of expenses incurred by a CDM project is as follows:
- research costs arising from exploring alternative ways to reduce emissions;
- costs incurred in developing a selected alternative to reduce emissions;
- costs incurred to prepare project report or Project Design Documents;
- fees paid to DOEs for validation and verification;
- fees paid to the National CDM Authority for approval;
- fees for registering with the UNFCCC;
- costs incurred for monitoring the reductions of emissions;
- costs incurred for certification of CERs;
- operating costs incurred to run the CDM project etc..
Not all the above costs result in the generation of CERs. Out of the expenses listed above, we should be very careful to include only those expenses that are directly attributable to generation of CERs. For e.g. the research and development cost should not inventoried but treated as intangible assets under AS – 26. Effectively if we see only the certification charges paid to UNFCCC, any charges paid to a consultant in the process alone can be treated as cost.
UNFCCC charges two kinds of charges on any entity that generates CERs. The first charge is charged as a percentage of the CERs produced. UNFCCC will deduct a fixed percentage of the CERs and credit the balance CERs to the Demat Account of the entity. Presently this charge is fixed at 2% of the CERs produced. For e.g. if the entity produces 1000 CERs, UNFCCC will deduct 2% of the CERs and credit only 980 CERs to the Demat Account of the entity.
The second type of charge is collected as a fixed amount of cash payment for every CER credit to the account of the entity. This fixed payment is presently fixed at $ 0.10 per CER credited to the account of the entity. In the immediate example, the entity has to make a cash payment of $980*0.10 i.e. $98.00.
However it has to be observed that the 2% deduction in the generated CERs deducted by UNFCCC need not be considered in valuation of cost of CERs. The CERs which have been credited to the account of the entity alone need to be valued.
From the above, it is very clear that the ‘costs incurred for certification of CERs’ at which the inventory of CERs should be valued includes the consultant’s fee and the cash payment made under the second levy to the UNFCCC for obtaining the credit of CERs. Other than these two costs no other costs need to be inventorised as cost of CERS.
Net Realisable Value of CERs:
The second part of inventory valuation is the Net Realisable Value. As per AS – 2
“Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.”
Since the CERs are readily traded in stock and commodity exchanges, it is very easy to determine the estimated selling price of CERs. The selling price obtained from the exchanges less any commission that may have to be paid to execute the sale of CERs will constitute the NRV of CERs.
The cost of the CERs as previously arrived should be compared with the NRV as determined above. The lower value of the two should be recognised as the value of CERs in the books of accounts of the entity that engages in a CDM project.
That brings us to the end of debate Accounting for Carbon Credits but not on Carbon Credits. With the largest emitters i.e. US, Canada and China excluded from the provisions of emission reductions, Carbon Credits have no real impact on emission reduction. Let us positively look forward for the days when US and China would agree for emission reduction and make this world a better place to live.