Power Purchase Agreements update

On 29th January 2024, the Accounting Standards Advisory Forum (ASAF) will convene with the sole purpose of discussing Power Purchase Agreements (PPAs). The agenda includes a review of preliminary thoughts on potential amendments to the 'own use' requirements in IFRS 9, along with an analysis of the challenges in applying hedge accounting requirements under the same standard.

Francisco Jimenez and Simone Aranha of our Financial Instruments team explain the implications below.

Key points from the IASB’s December 2023 meeting

• PPAs are utilised by entities in various geographical regions, industries, sizes, and sophistication levels.
• The accounting concerns regarding PPAs are specifically related to IFRS 9, not other IFRS Accounting Standards.
• A typical PPA for renewable power often encompasses the delivery of Renewable Energy Certificates (RECs). Given that the IASB has reserved a separate project on pollutant pricing mechanisms, this project will not address accounting requirements for RECs.
• Questions about PPA accounting stem from the unique characteristics of the nonfinancial item (e.g., electricity) and the legal structure of the markets where these items are traded.
• PPAs serve as crucial tools for entities, not only to hedge against future electricity sales and purchase prices but more importantly, to secure access to renewable power.
• PPAs are broadly categorised into 'physical PPAs' and 'virtual PPAs.'
• Research indicates that each PPA category faces distinct accounting challenges. For instance:
  • Physical PPAs: The challenge lies in assessing an entity’s expected usage requirements when the non-financial item is traded in markets demanding short term use post-delivery or sale at spot prices, such as in electricity markets.
  • Virtual PPAs: The focus is on designating virtual PPAs as a hedging instrument in a cash flow hedging relationship, aligning more closely with the entity’s risk management strategy.

Application of the own use exemption

The preliminary proposals suggest adding application guidance for contracts to purchase non-financial items with the characteristics of a PPA. These contracts should meet specific criteria below to be considered, and continue to be, for an entity’s expected purchase, sale, or usage requirements:

• Contract Design and Structure: The contract must be structured and designed to ensure the supply of the non-financial item in quantities aligning with the entity’s anticipated own use over the contract's lifespan. For instance, a contract would not meet the own use requirements if it entails quantities exceeding the entity's expected purchase needs.
• Handling Supply-Demand Mismatches: Sales of non-financial item shortly after delivery, which result from short-term mismatches between supply and demand, do not necessarily contradict an entity’s own usage requirements, provided that:
  • The contracted volumes for the remaining duration of the contract are still reflective of the entity’s expected usage;
  • The entity has consumed a volume equal to or greater than the volumes delivered since the contract’s inception; and
  • The sales are not executed with the intent to profit from short-term market price fluctuations of the non-financial item.
    

Potential new disclosures

In light of feedback from investors consulted informally, it's clear that specific information regarding long-term Power Purchase Agreements (PPAs), which are not accounted for under IFRS 9 and are subject to IFRS 7, is deemed valuable.

These disclosures aim to enable investors to comprehend the impact of these contracts on an entity’s future cash flows. The suggested information includes:

• Type of Pricing: Clarification on whether the pricing in the PPA is fixed or variable.
• Agreed Price Details: The price stipulated in the PPA, potentially accompanied by the market price as of the reporting date for comparison.
• Contract Proportion: The relative scale of such contracts in comparison to the total sales or purchases of the same non-financial item by the entity.
• Impact on Financial Statements: Detailed insight into how the PPA affects the entity’s revenue and expenses during the reporting period. This could include a hypothetical analysis of what the revenue and expenses might have been in the absence of the PPA.
• Fair Value Indication: An indication of the contract’s fair value as of the reporting date.

Challenges applying hedge accounting requirements

Virtual PPAs are classified as derivatives under IFRS 9, requiring their valuation at fair value through profit or loss. The valuation typically hinges on a P50 volume estimate, highlighting the uncertainty in vPPA transactions. This classification and valuation methodology present unique challenges in hedge accounting for vPPAs.

A primary challenge in applying hedge accounting to vPPAs is ensuring the alignment of the designated quantity in the hedge with the actual settled quantity. This alignment is critical for accurately reflecting the entity's economic position, as the designated quantity is fixed for a period and may not match the fluctuating settled quantities of vPPAs.

Amending hedge accounting requirements to accommodate the specifics of vPPAs requires careful consideration. The amendments must be targeted and cautious to accurately reflect the economic realities of vPPAs without leading to unintended broader implications in hedge accounting practices.

In conclusion, the ASAF's meeting and discussion on PPAs next week will highlight the complexities and evolving nature of financial reporting in the context of power purchase agreements. As entities increasingly engage in PPAs, the need for clear, consistent accounting practices becomes essential.