Light at the end of the tunnel?

Following on from previous discussions on the accounting treatment of power purchase agreements (see Corporate Treasury News (08/2023): Power Purchase Agreements: Setting the course for IFRS accounting in sight?), the IASB published several staff papers in March 2024 on possible adjustments to the accounting requirements under IFRS 9 in order to address the accounting challenges in accounting for power purchase agreements. The IASB staff paper addresses the following topics: 

• Scope and requirements of the Own Use Exemption,
• Adjustments to hedge accounting requirements,
• Proposed disclosure and transition requirements,
• Implementation and implementation requirements.

This article focuses on the accounting effects and the corresponding consequences of the proposed adjustments of the IASB staff paper. It does not deal with the associated disclosure and transition requirements or details of implementation and implementation requirements.

In principle, Power Purchase Agreements (PPAs), or power purchase agreements, are contracts with which companies 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 often lead to further challenges in terms of accounting. In this context, an individual contract analysis is required in order to properly account for the different design features. In general, however, PPA contracts can be categorised into two types - physical and virtual PPA contracts. 

A physical PPA contract is a forward commodity transaction with physical fulfilment between an electricity producer and an electricity purchaser. The power purchaser is obliged to purchase the electricity from a specific plant at a contractually agreed price. In principle, a physical PPA contract is characterised by the fact that the electricity is physically delivered and, in most cases, the power purchaser is responsible for purchasing and transporting the electricity. Further contract components provide for a differentiation depending on the feed-in into the electricity grid (public electricity grid: off-site PPA; direct electricity 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 agreement can be either "fixed" or "variable". 

In contrast, a virtual PPA contract is classified as a financial commodity futures transaction, meaning that there is no actual delivery of the physical electricity to the electricity consumer. Instead, there is a financial compensation payment (net settlement, cash settlement) 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 to the buyer by the producer. Under a virtual PPA contract, the electricity generated is regularly fed into the public grid by the electricity producer, who receives a corresponding payment at the market price. Similarly, the electricity consumer purchases its electricity requirements regularly from its supplier, but also acquires guarantees of origin (GoOs) under the virtual PPA contract.

The main difference between the two forms is that physical PPA contracts result in an actual supply of electricity, while a virtual PPA contract only involves a financial compensation payment. In light of the rapid development of the renewable energy market in recent years, the application of accounting standards does not always result in a presentation that corresponds to the economic circumstances. The main consequences of this are 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. In addition, the specific characteristics of PPA contracts and the restrictive requirements for the designation of hedging relationships often mean that no further application of hedge accounting (hedge accounting) can be made or that there is significant ineffectiveness. These 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, a distinction must be made between two types of PPA contracts that (can) fulfil the derivative criteria in accordance with IFRS 9.Appendix A. The decisive differentiation criterion is not the subject matter of the contract (financial vs. non-financial underlying), but the intended use and the form of contract fulfilment.

From IFRS 9.2.4 states that contracts for the purchase or sale of a non-financial item are 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). In this case, PPA contracts must always be treated as derivative financial instruments in accordance with IFRS 9. In this respect, virtual PPA contracts are within the scope of IFRS 9 due to their design and must therefore be recognised as derivative financial instruments with corresponding volatility in the income statement (measurement category: at fair value through profit or loss).

In contrast, a more differentiated approach is required for physical PPA contracts. Depending on how the contract is structured, physical PPA contracts may also have direct or indirect net settlement clauses. If physical PPA contracts already explicitly and implicitly (see detailed IFRS 9.2.6) do not have any net settlement clauses and no further sales take place or are expected, they are generally not currently within the scope of IFRS 9. The own use exemption applies to these contracts if the provisions of IFRS 16 (Leases) are not relevant and they are only recognised in the balance sheet if the provisions of IAS 37 are relevant. In practice, however, it can be observed that 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 recognised as derivatives. Reasons for this include, for example, necessary sales 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 proposes that the scope of the Own Use Exemption be adjusted exclusively for contracts for electricity from renewable energy sources (such as wind, solar and hydro energy) with transfer of volume risk. In this respect, 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 for contracts for electricity from renewable energy sources (and which are therefore dependent on natural conditions in each case) (cf. IASB Staff Paper 3A (3/2024), para. 56).

The decisive factor here is that in the case of PPA contracts, the direct sale of the quantity of electricity does not serve the purpose of energy trading. Rather, the sale of the quantity of electricity that cannot be utilised directly is due to the market structure and trading opportunities, meaning that the electricity must be sold at the prevailing market price at that time. In this context, it should also be noted that the PPA contracts 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, the design of PPA contracts as pay-as-produced cannot be observed in practice for a large number of contracts.

When applying the Own Use Exemption for physical PPA contracts, the IASB Staff Paper clarifies that a prospective and retrospective consideration of usage behaviour is also required in this context. With regard to the prospective assessment, the purpose, design and structure of the contract are decisive, so that the volume of the PPA contract must correspond to the expected own requirements over the (remaining) term and must not be exceeded under any circumstances. In addition to the prospective analysis of the contract structure, a retrospective analysis of past sales must also be carried out and the reasons for this must be analysed. Short-term retrospective sales may be in line with expected usage behaviour if the differences arise from the following circumstances:

• discrepancies exist between the electricity supplied and the customer's demand in terms of the time of delivery (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 of determining the timing or price of sales.

Why the proposed adjustments in the IASB Staff Paper relate exclusively to contracts for electricity from wind, solar and, in some cases, hydro energy will continue to be the subject of debate. 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. Nevertheless, the question arises as to why other renewable energy sources such as biogas or specific hydropower contracts were excluded from the scope of application and an individual solution is only proposed for currently known renewable energy generation options. It cannot be ruled out that a new adjustment will be necessary for other new technologies.

Another point of criticism is that the proposals in the IASB staff paper only focus on pay-as-produced contracts and do not take into account 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 to be expected that deviating contract forms will be penalised regardless of their economic content, so that no accounting is carried out according to the economic content, but only according to the contractual structure.

In light of 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 corresponding volatility in the income statement. However, PPA contracts are usually concluded for sustainability reasons (guarantees of origin, GoOs) and risk management aspects to hedge the (long-term) electricity exposure. In this respect, the designation of PPA contracts as commodity futures in the sense of hedging instruments in (cash flow) hedge accounting relationships appears to be desirable. However, the challenge here is that PPA contracts are also subject to volume risk in addition to market price risk. In contrast, the current application requirements for the designation of hedging relationships do not permit the hedging of a variable volume. In this sense, a fixed hedging volume to be defined ex ante in many cases does not correspond to the hedging strategy and the design features of the PPA contracts, so that hedging relationships can currently only be designated in certain cases and with a corresponding contractual constellation. 

As a result, the IASB Staff Paper proposes adjustments exclusively with regard to the application requirements for the designation of cash flow hedge accounting relationships with PPA contracts as hedging instruments.¹  It should be noted that the proposed amendments only affect the hedge accounting requirements under IFRS 9 and are not relevant for hedge accounting relationships carried forward under IAS 39 (see IFRS 9.7.2.21). According to the proposals of the IASB staff, the application of cash flow hedge accounting and the designation of PPA contracts as hedging instruments should be possible 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, but the other measurement parameters of the hedged item remain unaffected. When hedging expected procurement transactions and designating 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 if the hedged variable procurement volume is below the buyer's expected consumption capacity. When hedging expected sales transactions (on the part of the producer), on the other hand, there is no need to prove a high probability of occurrence, as the forecast volume after generation is certain to materialise. Of course, the pro rata designated variable volume for planned sales transactions should correspond to the producer's expected production capacity. It can be noted here that 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.

In this respect, the volume fluctuations in both the hedging of procurement and sales transactions are not interpreted as risk variables in the strict sense, as these fluctuations cannot be avoided due to the nature and type of generation and are included congruently in the hedged item and hedging instrument. Consequently, no ineffectiveness based on volume differences between the expected volume and the actual volume is recognised. However, hedge ineffectiveness can still result from other sources, which must be recognised accordingly. Examples of this include price differences due to different fixing times (difference in timing) or basis risks (basis risk) due to deviations in the reference markets for the underlying and hedging instrument.

The proposals for reduced application requirements are intended to enable the designation of a variable notional volume for PPA contracts, which can be seen as a step in the right direction. However, it is unclear why these application requirements should only apply specifically to PPA contracts and not to other circumstances under the same conditions. In view of the fact that the provisions on macro hedge accounting have not yet been further specified, there are still situations in practice that cannot be transferred to hedge accounting relationships under IFRS 9 despite an economic hedging relationship. After all, it is currently expected that a new exposure draft regarding dynamic risk management and thus also macro hedge accounting will be published in the first half of 2025. 

Source: KPMG Corporate Treasury News, issue 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 PPA contracts.