As companies turn their attention to Environmental, Social and Governance (ESG) matters, we are seeing a myriad of accounting implications arising from emerging and evolving strategies and transactions.

Many companies are trying to reduce their carbon footprint through energy efficiency and other measures. In many jurisdictions, there are also specific regulatory schemes and requirements to reduce greenhouse gas (GHG) emissions with which companies must comply. Quite often, however, companies have found that it is not possible to meet their GHG emissions reduction targets with internal reductions alone. Consequently, companies turn to other measures – such as purchasing credits – to help them meet their targets.

Transactions entered into by companies who are not the “end-user” of credits, and are instead investing in such credits or credit generation projects are often where the accounting complexities begin and is our focus here.

What are credits? How are they created? How are they used?

Credits are transferable or tradable instruments, typically certified by governments or non-governmental bodies that can eventually be purchased by an “end-user” in order to offset the electricity used from non-renewable sources or GHG emissions created by its own value chain. Credits are generated as part of a regulatory scheme or by voluntary projects (for example, distribution of lower carbon products such as fuel efficient cookstoves in developing countries, or sustainable forest management). Credits specific to electricity generation, referred to as renewable energy certificates or RECs, are generally created by solar and wind farms and measured in units of electricity, representing the renewable attributes of electricity. Credits related to reduction or removal of GHG emissions are generally measured in metric tons of CO2 or equivalent and have a variety of names but are often referred to as emissions certificates, carbon offsets or carbon credits. 

Activity in this area is expected to increase even more in the coming periods, particularly as companies turn their attention to the climate-related disclosure standards proposed by the International Sustainability Standards Board (ISSB), the US Securities and Exchange Commission (SEC) and the European Financial Reporting Advisory Group (EFRAG). Once the standards are finalized, they will increase transparency requiring companies reporting based on those standards to report their GHG emissions, as well as the use of credits.

Accounting challenges when investing in credits or credit generation projects

Accounting for credits is not a new area. In fact, regulatory credits have been around for a while in many jurisdictions that have implemented emission trading schemes. However, we are now seeing the emergence of many voluntary projects, initiated by project developers, designed to reduce or remove GHG emissions. These project developers have the expertise and technology to develop and execute the projects, however they often need financing to get these projects off the ground. Some companies, who don’t specifically need the credits for their own use, see opportunity to invest in these projects or the credits in anticipation of higher returns down the road. These investments and arrangements may take a variety of forms. They may be structured as a simple ‘prepayment’ for the future purchase of credits once they are generated, or as a stream or royalty agreement, similar to the arrangements we see in the mining space in Canada, or as some other type of collaboration arrangement.

The detailed accounting for such arrangements can be complex. To start the analysis, companies should answer an important scoping question, specifically, which IFRS Accounting Standard does the arrangement fall in? Or does it bridge multiple IFRS Accounting Standards?

Is there an executory contract?

Depending on its role, rights and obligations, the company may be implementing or executing the credit generation project itself by hiring a project developer to provide services to the company — this contract may represent a service contract with the project developer for the purchase of services received. Alternatively, the company may be providing services to the project developer, such as assistance in verification and registration process, in return for a portion of the credits generated from the project. In this case, the arrangement may result in revenue from a contract with a customer to be accounted for under IFRS 15.

Are consolidation suite of standards applicable?

In other cases, the company may need to consider the consolidation suite of standards to determine whether it obtains control or joint control over the project developer entity or the credit generation project.

Are financial instruments standards applicable?

Many are also surprised that in some circumstances the financial instruments standards may be the right place for the accounting for the arrangement. In these cases, the company may need to consider whether the arrangement provides a financial asset to the company – i.e., a contractual right to receive cash. Or, if the arrangement does not provide a contractual right to receive cash but is a contract to buy credits in the future (i.e., a non-financial item), is the arrangement scoped into IFRS 9 as a financial instrument because the arrangement does not meet the so called “own-use exemption”. Typically, this assessment is complex and is made more complex by the evolving market for credits.

The accounting may not be immediately apparent for such arrangements, and there is no single IFRS Accounting Standard dealing directly with credits for all circumstances. Consequently, as accountants like to say - “it depends on facts and circumstances”. To avoid being surprised by the impact of these transactions on financial reporting, companies should carefully consider the accounting when entering into such arrangements and reach out to their accounting advisor early in the process.

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