Long before the recent COP26 world climate conference in Glasgow, leading industrialized nations have pledged their commitment to more or less rapid climate neutrality.1 And even if major players remain well behind the key targets for 2030 by 2050 or even 2070, achieving a climate-neutral economy is increasingly gaining political and social relevance, especially in Europe and the United States.
To meet the so-called 1.5° target as an essential marker on the way to climate neutrality, it is particularly the energy sector that has been identified as a key industry for the transformation.2 However, the commitment to a carbon-neutral energy production inevitably entails a change in the processes of all industries, as the source of the required energy at least is subject to sustainable change. This can be seen in initiatives such as RE1003, in which hundreds of companies worldwide have committed themselves to the use of energy from 100% renewable sources.
This transformation of the economy has already resulted in an increased demand for reliable green power, which enables companies to achieve their goals. As a result, so-called Green Power Purchase Agreements (green PPAs) are becoming increasingly popular. With such a green PPAs, a company acquires not only the electricity from wind, water or solar power, but also the corresponding green power certificates. Currently, green PPAs are largely unstandardized and individually negotiated between facility operators and companies. Therefore, a wide variety of forms exists, ranging from purely financial transactions, quasi contracts on the difference for the electricity with simultaneous delivery of the green power certificates, to classic physical procurement transactions at the generating site.
Given that most green PPAs are heterogeneous and individual, it becomes clear that they not only require a great deal of negotiation effort, but also have widely differing effects when it comes to their inclusion in external financial reporting. The range of accounting under International Financial Reporting Standards (IFRS) includes in particular
- Leasing according to IFRS 16
Provided that a PPA is to be classified as a lease, the buyer of the generated output must recognize a lease liability for the future lease payments as well as a so-called “right-of-use asset” for the underlying future generation. Over the course of the lease term, lease payments as well as interest and depreciation must be recognized. Interest and depreciation lead to effects on the income statement.
- Derivative financial instruments according to IFRS 9
If the PPA is not a lease, it often classifies a financial instrument. In this context, PPAs regularly meet the definition of a derivate financial instrument under IFRS 9, as they are subject to the performance of an underlying (here: price for electricity and emission certificates), often require no or only a small initial payment and their settlement is in the future. Accounting as a derivative financial instrument can result in the immediate recognition of changes in fair value in the income statement of the respective period. Together with the related documentation effort, accounting entities can apply hedge accounting in accordance with IFRS 9 in order to reverse a corresponding accounting mismatch between the current procurement at fair value and the as yet unrecognized future energy requirement.
- Pending contract
If the PPA is physically fulfilled and all the criteria of the so-called “own use exemption” according to IFRS 9.2.4 are met, it can alternatively be treated as a pending contract. Under this option, which is generally favored by those preparing financial statements, the derivate is not recognized in the balance sheet, nor is the future energy requirement prior to fulfillment. Under IAS 37, however, impending losses that may go beyond a mere change in the prices for electricity and emission certificates must be recognized as a liability and expense.
- Embedded derivatives
In the case of PPAs classified as leasing or pending contracts, it is also necessary to review whether there are any embedded derivatives that must be separated from the host contract in accordance with IFRS 9.4.3, thus leading to further complexity in external reporting.
All in all, it becomes evident that the contractual structure of green PPAs can considerably affect companies' result for the period.
Along with the increasing demand for green power discussed above, the market for PPAs is expanding as well. At the same time, it is already apparent that new solutions are needed to coordinate both energy generation and demand in terms of contracts. Generating energy at one location and purchasing it in a completely different regulatory area, for example, places demands not only on power grids, but also on clever contractual arrangements. Otherwise, despite an intended physical purchase, an inadmissible resale can quickly result, with unintended accounting consequences. The objective of PPAs to achieve reliable procurement from volatile energy sources also repeatedly gives rise to problems with regard to their correct accounting treatment.
Until such time as standard trading products for green PPAs emerge in the future, it is important to take this aspect sufficiently into account when designing and negotiating Green PPAs and to analyze the possible accounting options for the contracts well in advance. Failing to do so could lead to unintended surprises in external reporting during the transformation to a green economy.
Source: KPMG Corporate Treasury News, Edition 116, November 2021
Authors: Ralph Schilling, CFA, Partner, Head of Finance and Treasury Mangement, KPMG AG; Robert Abendroth, Wirtschaftprüfer, Senior Manager, Finance and Treasury Mangement, KPMG AG