Accounting and Reporting Considerations for Environmental Credits
Background
An increasing number of entities in different sectors and
industries aim to reduce global greenhouse-gas (GHG) emissions. While many are
taking steps to reduce their own carbon emissions, these efforts may not be
sufficient to achieve required or voluntary emission commitments.
Environmental credits can help entities accomplish their carbon emission
reduction targets and goals. The popularity of such credits has grown; however,
questions have emerged regarding the accounting and reporting for them since the
treatment of environmental credits is not explicitly addressed in U.S. GAAP. The
FASB therefore added to its agenda a project (see discussion below) on this
topic in May 2022. The SEC also included disclosure requirements related to
environmental credits in its March 2022 proposed rule (see discussion below) on
climate-related disclosures.
This Accounting Spotlight examines environmental credits and certain
current U.S. accounting practices, regulatory developments, and other accounting
issues associated with them.
What Are Environmental Credits?
Within this publication, the term “environmental credits”
encompasses products such as carbon credits (both allowances and offsets) as
well as renewable energy certificates (RECs) and other climate- or
emission-related credits.
In the most basic sense, a carbon credit is a market-based or legal instrument
that represents the ownership of one metric ton of carbon dioxide equivalent
(MTCO2e) that can be held, sold, or retired to meet a mandatory emissions cap or
a voluntary emissions reduction target. Carbon credits are primarily
distinguished on the basis of whether they are allowances or offsets.
Allowances (also known as “permits”) are initially issued by
regulatory agencies in carbon compliance programs (e.g., cap-and-trade programs
or emissions trading schemes). One allowance gives the holder the legal right to
emit one MTCO2e. Typically, a carbon compliance program establishes a total
volume of emissions permitted by all of its regulated entities in a given year
and a corresponding volume of allowances. Regulating agencies then allocate
(free of charge) or auction off allowances to the regulated entities. If an
entity wishes to emit more or less MTCO2e, it can purchase allowances from, or
sell them to, other entities. These allowances are often also referred to as
“carbon credits” since each allowance represents a tradeable MTCO2e.
Offsets are generated from projects in which the objective is to
produce and sell verified carbon credits for every MTCO2e reduced, avoided, or
removed from the atmosphere by the projects. Carbon credits from these projects
are ultimately used by the final entity that purchases and retires the credits
to “offset” its emissions, so they are often called “carbon offsets.” “Voluntary
carbon offsets” are used to help meet an entity’s voluntary emissions reduction
targets to compensate for emissions that it has not yet been able to abate.
In addition to carbon credits, numerous other “credits” exist.
One of the more common examples is a REC, which is issued when one megawatt-hour
(MWh) of electricity is generated and delivered to the electricity grid from a
renewable energy resource. See further discussion of RECs in the next section.
The Role of Environmental Credits
Along with investing in carbon abatement projects that directly
reduce their emissions (e.g., energy efficiency upgrades, electric vehicle
fleets), entities are showing increased interest in purchasing carbon credits
generated by projects outside their operations and value chain to offset their
unabated emissions. Such projects may involve renewable energy initiatives in
developing countries, improved forest management and reforestation, lower-carbon
agriculture or grazing practices, direct air capture and sequestration, and many
other efforts.
RECs can also play an important role for entities seeking to reduce their carbon
footprint. Owners of renewable energy sources may be entitled to receive RECs.
The number of RECs awarded is typically linked to a power production formula. By
purchasing RECs, buyers help finance and promote renewable energy generation
and, in return, are allowed to use the RECs to report lower scope 21 emissions from purchased electricity.
Acquiring Environmental Credits — Trending Transactions
While there are many ways entities can obtain environmental credits, three of the
more common methods are discussed below.
Voluntary Markets
The global voluntary carbon market is growing rapidly to
enable the generation, acquisition, trade, and tracking of environmental
credits. These markets (1) predominantly operate for environmental credits
that have been certified by leading standards such as the Verified Carbon
Standard (“Verra”) and (2) act as a mechanism through which entities can
actively trade and convert their environmental credits to cash.
Key types of participants in these ecosystems include:
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Regulatory agencies or nonprofit or for-profit organizations that set certification standards and methods as well as manage the registries to track environmental credit generation, ownership, and credit status (active or retired). The top voluntary standards and registries include Verra, the Climate Action Reserve, the American Carbon Registry, and Gold Standard.
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Project owners and developers that secure or provide financing, or implement and generate environmental credits, for initial sale. There is a growing number of very large project development firms.
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Buyers and sellers of environmental credits, which could include entities that need such credits to meet their emissions reduction goals, clean energy or fuel requirements, or mandated emissions limits. Note that a buyer of environmental credits can have various intended uses for its environmental credits. For example, an entity may plan to:
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Hold environmental credits and remit or retire them to the relevant agency.
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Immediately retire the credits to the relevant agency.
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Trade its environmental credits.
Further, it is possible for the entity’s intended uses to change during the period over which it holds them. -
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A complex web of brokers and marketplace platforms to match buyers and sellers or arrange spot trades, financing, or offtake agreements.
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An emerging array of fund managers and financial intermediaries that are creating investment vehicles or secondary markets for environmental credits.
PPAs and VPPAs
A power purchase agreement (PPA) is a contract between two parties: the
developer of a renewable energy project and a buyer. Under a PPA, the
developer will typically receive a fixed price for each MWh of renewable
energy produced and the buyer will receive the associated RECs over time as
the project produces and sells electricity. The recipient of the RECs (the
buyer) will be able to use them to reduce its gross scope 2 emissions from
purchased electricity. In a PPA contract, physical energy must also be
delivered to the buyer.
By contrast, in a virtual PPA (VPPA), the buyer does not take physical
delivery of the power produced by the renewable energy source; instead, the
power component of the transaction is financially settled while the buyer
receives all, or a predetermined amount, of the generated RECs for each year
of the contract term for an agreed-upon price.
Directly From the Regulator
A regulator issues several categories of environmental credits, including
RECs. Cap-and-trade programs may also be established in which, for example,
(1) total annual GHG emissions from regulated entities in the program are
capped and (2) the cap (i.e., emissions limit) is reduced over time. Each
year, a volume of allowances or permits equivalent to that year’s cap are
auctioned or allocated (for free) to the regulated entities. As noted
previously, each allowance gives its owner the right to emit one MTCO2e. The
entity can then trade allowances until it has the volume needed to match its
emissions for the year.
Accounting Practices Under Existing GAAP
As previously noted, the treatment of environmental credits is not explicitly
addressed in U.S. GAAP; consequently, entities have used different approaches,
and questions have emerged about how to account and report for them. In the
sections below, we describe certain approaches that exist today in practice as
well as observations regarding such approaches. Note that entities should
carefully consider all relevant facts and circumstances when selecting an
appropriate accounting model to use. They should then apply such model
consistently and, if material, disclose their selection.
Environmental Credits as Assets
When accounting for environmental credits, entities should determine whether
such credits represent assets.
Chapter 4 of FASB Concepts Statement 82 defines an asset, in part, as “a present right of an entity to an
economic benefit.” It also describes an economic benefit as “the capacity to
provide services or benefits to the entities that use them” and notes that
“[g]enerally, in a business entity, that economic benefit eventually results
in potential net cash inflows to the entity. . . . The relationship between
the economic benefit of an entity’s assets and net cash inflows to that
entity can be indirect.” Typically, an entity’s ability to sell, transfer,
or exchange an environmental credit provides evidence that the right to do
so presently exists, the entity controls access to that right, and the right
applies to an economic benefit.
Connecting the Dots
Entities must consider all relevant facts and circumstances when assessing whether their acquired or created environmental credits meet the definition of an asset. For instance, we believe that enhanced marketing, public claims regarding environmental activities, and the potential reduction of the entity’s net emissions do not, by themselves, represent an economic benefit as described in Chapter 4 of Concepts Statement 8; therefore, costs
incurred solely from obtaining these benefits would not qualify as
assets.
Although still relatively new, environmental credit markets are
continuing to grow regionally, nationally, and internationally. We
do not believe that to qualify as an asset, an environmental credit
necessarily needs to be actively traded on an exchange. However, we
believe that the ability to place the environmental credit on an
exchange where it can be bought and sold, resulting in net cash
inflows, supports a conclusion that such credit meets the definition
of an asset.
Entities will need to carefully evaluate the nature of costs incurred
in connection with environmental objectives to determine whether
such costs meet the GAAP requirements to be capitalized and recorded
as an asset.
Classification as Either Inventory or an Intangible Asset
The methods used in practice for accounting for environmental credits stem
predominately from the accounting for emissions allowances. In informal and
industry-related discussions that took place a number of years ago, the FASB
and SEC have indicated that two methods of accounting for emission
allowances are acceptable: (1) an inventory model by analogy to ASC 3303 and (2) an intangible asset model by analogy to ASC 350.
An entity’s use of an accounting model will also vary on the basis of its
role within the market.
Connecting the Dots
In practice, entities generally select an accounting model on the
basis of the intended use for the environmental credits. For
instance, when an entity plans to actively trade its environmental
credits, it often accounts for them under an inventory model.
Entities need to consider the facts and circumstances of the
underlying arrangements and their business objectives related to
environmental credits to determine which accounting model is more
appropriate to apply.
Entities also need to consider the treatment of such credits in the
income statement and statement of cash flows. For example, we would
generally expect that environmental credits accounted for as
inventory would be expensed as a cost of goods sold when “used” or
traded. Further, under an inventory model, we would usually expect
the activity related to environmental credits to be reflected as
cash flows from operations within the statement of cash flows.
Amortization Under an Intangible Asset Model
While entities that participate in compliance and voluntary programs may use
an intangible asset model to account for environmental credits, some may not
strictly apply the recognition and measurement guidance under that model.
For instance, entities that use an intangible asset model may or may not
record subsequent amortization for the environmental credits.
Connecting the Dots
Environmental credits can be finite-lived (e.g.,
RECs typically have a useful life of 18 months) or infinite-lived
(e.g., carbon offsets have a “vintage year” that represents the year
in which the emissions were offset; however, they do not have an
expiration date). Strictly speaking, under an intangible asset
model, an amortization expense is required for finite-lived assets.
However, some have observed that environmental credits are
nonwasting assets. That is, if an environmental credit represents
the removal of one MTCO2e, regardless of the credit’s age or market
value, an entity can use it to offset one MTCO2e to satisfy
voluntary or compliance goals. Accordingly, entities will need to
evaluate whether amortization of certain environmental credits is
appropriate and, if so, the amortization method to use.
Note that we have observed that a number of entities
do not record amortization for finite-lived environmental credits.
We believe that such an approach is acceptable in certain
circumstances.
Impairment Considerations
While some entities may subject environmental credits to the appropriate
impairment or lower-of-cost-or-market evaluation, others may believe that an
evaluation of impairment is not necessary. Entities in the latter group may
believe that their approach is justified because the intended benefits of
the environmental credits do not diminish until the credits are consumed
(e.g., used to offset emissions). Therefore, these entities may believe that
it is appropriate to expense the full cost of their environmental credits
upon use (e.g., retirement with the relevant regulatory agency or registry).
Connecting the Dots
We believe that under both the inventory and intangible asset models,
entities should subject environmental credits to the applicable
impairment method. The recognition of impairment adjustments under
these models is intended to reflect changes in the utility and
expected recoverability of the underlying asset.
In a manner similar to the concerns about
amortization, some may believe that there are challenges associated
with implementing an impairment model. These challenges stem from an
entity’s intended use for environmental credits and the credits’
“nonwasting” characteristic. For example, if an entity intends to
retire its environmental credits, some may argue that impairment
write-downs may not appropriately reflect the utility of the asset
because, regardless of market value declines, an environmental
credit can be used to offset one MTCO2e. However, as previously
noted, an entity’s intent related to its environmental credits may
change over time.
The decision to record an asset for an environmental credit is, as discussed above, based on the guidance in Chapter 4 of Concepts Statement 8 and specifically on the potential for generating net
cash inflows. Entities should consider projected cash inflows,
market values, and other factors, as applicable, when determining an
appropriate impairment method.
Timing of Expense
Some entities immediately retire environmental credits upon purchase and
therefore do not record such credits as assets. Other entities may announce
their intention to use or offset their environmental credits for
sustainability reporting purposes but not formally retire them, giving rise
to questions regarding the appropriate time at which they should expense
assets recorded for environmental credits.
Connecting the Dots
Generally, an entity derecognizes an environmental credit once that
credit is officially retired with the applicable agency or registry
and used to offset the entity’s current emissions to demonstrate
compliance with mandatory or internally set goals.
Although an entity may publicly announce its intention to use an
environmental credit, the credit is not considered officially
“retired” until a request is submitted to the applicable agency or
registry and subsequently removed from it. Further, since an
entity’s intent related to its environmental credits can change over
time, until an environmental credit is irrevocably retired, it still
represents a legal right that can be transferred.
We believe that the guidance in ASC 606 that describes the
circumstances in which an asset has been transferred may be helpful
in an entity’s evaluation of when to derecognize an environmental
credit.
Liabilities for Environmental Credits
Some entities participating in a compliance program only
record a liability associated with their emissions if the actual emissions
for a given period exceed the environmental credits an entity holds (i.e.,
an entity would need to acquire more environmental credits to satisfy its
obligation). However, some compliance program participants may use a model
in which a liability is recorded on the basis of an entity’s total
emissions. Under such a model, the “gross” liability associated with an
entity’s carbon emissions is based on the cost of acquiring the required
allowances and an asset is recorded for the environmental credits held by
the entity on the basis of the acquisition cost of any allowances
purchased.
Producers of Environmental Credits
Generally, in a manner similar to that of a user, a producer applies either
the inventory or intangible asset model when accounting for environmental
credits; however, there is diversity in practice. In some circumstances,
environmental credits can be an output from a producer’s operations to
generate clean energy or produce sustainable goods. Producers that elect to
account for environmental credits under an inventory model sometimes
allocate a portion of production costs to the environmental credits. Other
producers conclude that no incremental costs are incurred for generating
these environmental credits; thus, no costs are allocated to the
environmental credits. Producers that elect to account for environmental
credits under an intangible asset model generally expense all associated
production costs as incurred because they consider the environmental credits
to be internally developed intangible assets.
Connecting the Dots
Entities need to consider the accounting model selected for
environmental credits, the nature of costs incurred related to the
creation of environmental credits, and their specific facts and
circumstances in determining which, if any, costs to allocate and
capitalize.
FASB Project on Environmental Credits
While the FASB has considered addressing the accounting for environmental credits
on several occasions beginning in 2003, it has yet to finalize a project on this
topic.
In June 2021, the Board issued an invitation to comment (ITC) to seek broad
stakeholder feedback on its future standard-setting agenda, particularly
pertaining to emerging areas of financial reporting. In the ITC, the FASB
specifically requested input on the accounting requirements for transactions
related to environmental, social, and governance (ESG)-related matters and
whether they were unclear or needed improvement. Respondents commented on the
accounting for environmental credits and highlighted concerns related to the
lack of specific authoritative guidance on the accounting and disclosure
requirements for environmental credit programs. Overall, the responding
stakeholders expressed concerns about the expanded use of environmental credits
under both compliance and voluntary programs and highlighted that increased
clarity related to the appropriate accounting for environmental credits should
be prioritized to prevent further diversity in practice, particularly as the
focus on ESG-related matters increases.
In addition to issuing the ITC, the Board performed outreach to better understand
how various entities currently account for environmental credits. Through this
outreach, the Board observed significant diversity in practice among users and
producers of environmental credits as well among entities operating in voluntary
and compliance programs.
In response to stakeholder feedback on the ITC and the results of its outreach,
the FASB decided in May 2022 to add a project to its technical agenda to address the recognition,
measurement, presentation, and disclosure of environmental credits that are
legally enforceable and tradable. The project is also expected to address the
accounting for users and producers of environmental credits and participants
operating in compliance and voluntary programs. Board members noted that
financial statement consistency will benefit users and that activity within the
environmental credit market will only continue to increase, making this an
opportune time for standard setting.
The FASB staff expressed a desire to explore other potential
models that would be more representative of the unique nature of environmental
credits and the underlying economics of transactions involving them. Such models
could include fair value accounting or the creation of a new accounting model
that may reside outside of existing GAAP.
SEC’s Proposed Rule on Climate-Related Disclosures
In March 2022, the SEC issued a proposed
rule that would require registrants to disclose in their
annual audited financial statements certain climate-related financial impacts
and expenditure metrics as well as a discussion of such impacts on their
financial estimates and assumptions. Further, registrants would have to disclose
scope 1 and scope 2 GHG emissions irrespective of the impact of offsets; their
climate risk management processes, targets, and goals; and their governance and
oversight of climate-related risks. Registrants (other than smaller reporting
companies) would also need to disclose scope 3 GHG emissions if (1) they are
material or (2) the registrants have established a reduction target or goal that
includes scope 3 GHG emissions.
Entities that use environmental credits, particularly carbon offsets or RECs, in
their plan to achieve climate-related goals or targets would have to disclose
information about such use. In the proposed rule, the SEC defines a carbon
offset as “an emissions reduction or removal of greenhouse gases in a manner
calculated and traced for the purpose of offsetting an entity’s GHG emissions.”
Registrants would also be required to disclose how much of their progress toward
climate targets or goals has been attributable to these environmental credits.
The disclosures would reflect the short-term and long-term risks associated with
such progress, including the risks that the availability or value of carbon
offsets or RECs could be curtailed by regulations or changes in the market. See
Deloitte’s March 29, 2022, Heads Up for a
comprehensive discussion of the SEC’s proposed rule.
Contacts
If you have questions about the
accounting and reporting requirements for environmental credits, please contact
any of the following Deloitte professionals:
Eric Knachel
Partner
Deloitte &
Touche LLP
+1 203 761
3625
|
Katherine Donzella
Manager
Deloitte &
Touche LLP
+1 773 364
0279
|
Zachary Poncik
Senior Manager
Deloitte &
Touche LLP
+1 713 982
4104
|
Footnotes
1
See the EPA’s Web site for a discussion of scope 1, 2, and
3 inventory guidance.
2
Chapter 4, Elements of Financial Statements, of FASB Concepts
Statement No. 8, Conceptual Framework for Financial
Reporting.
3
For titles of FASB Accounting Standards Codification (ASC)
references, see Deloitte’s “Titles of Topics and Subtopics
in the FASB Accounting Standards
Codification.”