Light at the end of the tunnel?

As a follow-up to the previous discussions on the accounting treatment of power purchase agreements (see Corporate Treasury News (08/2023): Power Purchase Agreements: Is IFRS accounting on the horizon?) several staff papers were published by the IASB in March 2024 on possible adjustments to the accounting requirements under IFRS 9 with the aim of addressing the accounting challenges associated with the recognition of power purchase agreements. The IASB staff papers address the following topics: 

• scope and requirements of the own use exemption, 
• amendments to the requirements for hedge accounting, 
• proposed disclosure and transition requirements, 
• implementation and adoption requirements.

This article will focus on the accounting implications and the corresponding consequences of the proposed amendments to the IASB Staff Paper. It will not discuss the associated disclosure and transition requirements or any details on implementation and adoption requirements.

In principle, power purchase agreements (PPAs) are contracts that allow companies to secure long-term and sustainable access to and sales of electricity from renewable energy sources. PPA contracts can be structured in a variety of ways and this often leads to further complexities in terms of accounting. This calls for an individual contract analysis in order to properly account for the various design features. Broadly speaking, however, PPA contracts can be categorized into two types - physical and virtual PPA contracts. 

A physical PPA contract is a commodity futures transaction with physical fulfillment between an electricity producer and an electricity consumer. The power purchaser is obliged to purchase the electricity from a specific plant at a contractually agreed price. Essentially, a physical PPA contract entails the physical delivery of the electricity and, in most cases, the power purchaser is responsible for the purchase and transportation of the electricity. Other elements of the contract make a distinction depending on the feed-in to the electricity grid (public electricity grid: Off-site PPA; direct power purchase: On-site PPA) and depending on the quantity to be supplied (e.g. pay-as-produced, pay-as-forecasted, pay-as-consumed, etc.). The price can be agreed as either "fixed" or "variable". 

Conversely, a virtual PPA is classified as a financial commodity futures transaction, which means that there is no actual delivery of physical electricity to the electricity consumer. Instead, a net financial compensation payment (net settlement, cash settlement) is exchanged between the electricity producer and the electricity consumer depending on the agreed contract price and the variable market price. In addition, corresponding guarantees of origin (GoOs, European market) are usually also transferred from the producer to the buyer. Under a virtual PPA, the electricity generated is regularly fed into the public grid by the electricity producer, who then receives a corresponding payment at the market price. Similarly, the electricity consumer purchases its electricity needs regularly from its supplier, but also acquires Guarantees of Origin (GoOs) under the virtual PPA contract.

As such, the main difference between the two forms is that physical PPA contracts involve the actual supply of electricity, whereas a virtual PPA only involves a financial compensation payment. Considering the rapid pace at which the market for renewable energies has developed in recent years, applying the applicable accounting standards does not always result in a consistent presentation in line with the economic circumstances. One major issue here is that PPA contracts regularly qualify as derivatives with corresponding volatility in the income statement, as the criteria for applying the own use exemption are often not met. At the same time, the specific characteristics of PPAs and the restrictive requirements for the designation of hedging relationships often mean that no further hedge accounting can be applied or that significant ineffectiveness exists. Such accounting anomalies have been the subject of intense debate for some time, with the IASB Staff Paper now presenting the following amendments to the provisions of IFRS 9 for discussion:

In general, it is necessary to distinguish between two types of PPAs that (can) fulfill the derivative criteria in accordance with IFRS 9.Appendix A. Here, it is not the agreement’s subject matter (financial vs. non-financial underlying) but the purpose and form of contract fulfillment that are decisive. 

IFRS 9.2.4 provides that contracts for the purchase or sale of a non-financial item fall within the scope of IFRS 9 if there is a net settlement in cash or with other financial instruments or the contract is fulfilled by the exchange of financial instruments (net settlement, cash settlement). This means that PPAs must always be treated as derivative financial instruments in accordance with IFRS 9. As a result, virtual PPAs are within the scope of IFRS 9 due to their structure and must therefore be recognized as derivative financial instruments with corresponding volatility in the income statement (measurement category: at fair value through profit or loss). 

In contrast, physical PPAs require a more differentiated approach. Depending on the structure of the contract, physical PPAs may also have direct or indirect net settlement clauses. Insofar as physical PPA contracts already explicitly and implicitly (see detailed IFRS 9.2.6) do not have net settlement clauses and no further sales take place or are expected, they are already outside the scope of IFRS 9 as a rule. For these contracts, the own use exemption does not apply if the provisions of IFRS 16 (Leases) are not relevant and they are only recognized in the balance sheet if the provisions of IAS 37 are relevant. In practice, however, the majority of physical PPA contracts do not qualify for the own use exemption due to their market structure and trading practices and the contracts must be accounted for as derivatives. Reasons for this are, for instance, the need to sell due to volume deviations resulting from variable electricity generation from renewable energy sources or net settlement clauses in the event of volume deviations.

The IASB Staff Paper is proposing to adjust the scope of the own use exemption exclusively for contracts for electricity from renewable energy sources (such as wind, solar and hydro energy) with transfer of volume risk. As such, in contracts for electricity from renewable energy sources (and which are therefore dependent on natural conditions), sales resulting from the market structure and trading practices (design and operation of the market) should not be considered detrimental to the application of the own use exemption (see IASB Staff Paper 3A (3/2024), para. 56).

The key factor here is that in the case of PPAs, the direct sale of the electricity volume does not serve the purpose of energy trading. Rather, any sale of electricity that cannot be used directly is due to the market structure and trading opportunities, meaning that the electricity has to be sold at the prevailing market price at that time. In this regard, it should also be noted that the PPAs must also essentially provide for a transfer of the volume risk (to the buyer) (i.e. pay-as-produced) and thus result in a production-based remuneration. However, a large number of PPA contracts are not structured as pay-as-produced in practice.

When applying the own use exemption for physical PPAs, the IASB Staff Paper clarifies that a prospective and retrospective assessment of usage behavior is also required in this context. In terms of the prospective assessment, the purpose, design and structure of the contract are decisive, such that the volume of the PPA must correspond to the expected own usage over the (remaining) term and must not be exceeded under any circumstances. Along with the prospective consideration of the contract structure, a retrospective consideration of past sales must also be carried out and their reasons examined. Short-term retrospective sales may be consistent with expected usage patterns if the differences arise from the following circumstances:

• there are discrepancies between the electricity supplied and the customer's requirements in terms of the time of delivery, and
• the market structure and trading practices (design and operation) for electricity from renewable energy sources do not offer any practical means with which to determine the timing or price of sales.

Just why the IASB Staff Paper's proposed amendments relate exclusively to contracts for electricity from wind, solar and, in some cases, hydro energy will give rise to further discussion. The IASB Staff Paper clearly justifies this decision with the lack of need for adjustments to contracts from other renewable energy sources, as these do not result in any inappropriate presentation under the existing requirements. Still, this raises the question of why other renewable energy sources such as biogas or specific hydropower contracts were excluded from the scope of application and why an individual solution is only proposed for currently known renewable energy generation options. After all, it cannot be ruled out that new technologies will require another adjustment.

An additional point of criticism is that the proposals in the IASB staff paper are based exclusively on pay-as-produced contracts and do not address other forms of contract, such as pay-as-nominated. This is justified by the transfer of the volume risk to the buyer in order to enable the application of the own use exemption. It is likely that deviating contract forms will be disadvantaged regardless of their economic content, which means that accounting will not be based on the economic content, but only on the contractual structure. 

Given the far-reaching definition of derivatives in IFRS 9 (see IFRS 9.Appendix A) and the restrictive requirements of the own use exemption (see IFRS 9.2.4-6), PPA contracts currently regularly qualify as derivative financial instruments with the associated volatility in the income statement. However, PPAs are usually entered into for sustainability reasons (guarantees of origin, GoOs) and to hedge the (long-term) electricity exposure from a risk management perspective. For this reason, the designation of PPA contracts as commodity futures in the sense of hedging instruments in (cash flow) hedge accounting relationships appears to be desirable. There is, however, the challenge that PPA contracts are also subject to a volume risk in addition to the market price risk. The current application requirements for the designation of hedging relationships, conversely, do not permit the hedging of a variable volume. In many cases, a fixed hedging volume to be defined ex ante does not correspond to the hedging strategy and the design features of the PPAs, meaning that hedging relationships can currently only be designated in certain cases and with the corresponding contractual constellation. 

Accordingly, the IASB Staff Paper proposes amendments exclusively with regard to the application requirements for designating cash flow hedge accounting relationships with PPAs as hedging instruments.¹ It is important to note that the proposed amendments only affect the hedge accounting requirements under IFRS 9 and are not relevant for hedge accounting relationships under IAS 39 (see IFRS 9.7.2.21). According to the IASB staff paper's suggestions, the application of cash flow hedge accounting and the designation of PPAs as hedging instruments should be permissible if the volume of the designated hedged item is determined as a proportion of the variable volume of the hedging instrument. In this case, the hedged item is measured based on the volume assumptions on the hedging instrument, whereby the other measurement parameters of the hedged item remain unaffected. To hedge expected procurement transactions and designate a variable volume of the hedged item, evidence of a high probability of occurrence of the transaction is also required. A high probability of occurrence can be inferred where the hedged variable procurement volume is below the buyer's expected consumption capacity. By contrast, when hedging expected sales transactions (on the part of the producer), there is no need to prove a high probability of occurrence, as the forecast volume after production is certain to occur. It goes without saying that the proportionate designated variable volume for planned sales transactions should correspond to the producer's expected production capacity. In this context, the IASB Staff Paper appears to neglect issues such as non-generation for reasons of balancing group management or due to incentives from the grid operator.

As such, the volume fluctuations in both the hedging of procurement and sales transactions are not considered a risk variable in the strict sense, as these fluctuations are inevitable due to the nature and type of generation and are included congruently in the underlying and hedging instrument. As a result, there is no ineffectiveness to be recognized based on volume differences between the expected volume and the actual volume. As before, however, hedge ineffectiveness can result from other sources that must be recognized accordingly. Among other things, examples of this include price differences due to different fixing times (difference in timing) or basis risks due to differences between the reference markets for the underlying and hedging instrument.

The proposals for lower application requirements are intended to allow for a variable notional volume to be designated for PPA contracts, which is a step in the right direction. However, it is unclear why these application requirements should only apply specifically to PPAs and not to other circumstances when the same conditions apply. In light of the fact that the regulations on macro hedge accounting have not yet been further specified, circumstances remain in practice that cannot be transferred to hedge accounting relationships under IFRS 9 despite an economic hedging relationship. At least it is currently expected that a new exposure draft regarding dynamic risk management and therefore also macro hedge accounting will be published in the first half of 2025. 

Source: KPMG Corporate Treasury News, Edition 142, April 2024
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG 
Björn Beckmann, Senior Manager, Finance and Treas-ury Management, Treasury Accounting & Commodity Trading, KPMG AG

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¹ With regard to hedging instruments, the IASB Staff Paper focuses on virtual PPAs.