Entity A is a carbon offset project developer and currently has multiple carbon offset projects in its portfolio at various stages of development. As an output of its ordinary activities, entity A sells carbon offsets that are generated from its various carbon offset projects.

Entity A is embarking on a new wind energy project (project W) that aims to harness wind energy potential to balance energy needs in a particular region.

Entity A enters into a long-term contract on 1 January 20X1 to deliver a fixed number of carbon offsets in the future to entity B. Entity B will make an upfront non-refundable payment of C1 million to entity A and in return entity B will obtain the right to receive 10,000 carbon offsets annually from entity A for a period of 10 years starting from 1 January 20X5 (C10 per offset). Entity B will not receive any electricity as part of the long-term contract.

If Entity A is unable to generate sufficient carbon offsets (from project W or any of its other projects), entity A will need to purchase carbon offsets for delivery to entity B. There are no terms in the contract that permit entity A or entity B to settle the contract net in cash.

Assume that entity A readily has access to a liquid spot market for carbon offsets in which transactions take place with sufficient frequency and volume and prices are available on an ongoing basis. ¹

Also assume that there are no clauses in the contract that cause any variation of any cash flows over the contract’s term. No further payments are required over the life of the contract as the carbon offsets are delivered.

Entity A should consider the guidance in Section 4.4 to determine the relevant accounting standards that apply to its contract with entity B.

Entity A determines that the contract does not provide entity B with control, joint control or significant influence over entity A or project W because entity A makes all of the decisions related to project W, and consent from entity B is not required.

Entity A determines that the contract does not result in the sale of an interest in any of Entity A’s assets, because it does not provide Entity B with an undivided interest in any of Entity A’s projects. As such, by entering into the contract to sell carbon offsets, Entity A has not sold an intangible asset. ²

Entity A determines that the contract does not contain a lease because it does not provide entity B with the right to receive substantially all of the outputs from any identified asset linked to any of entity A’s projects.

IFRS 9 applies to contracts to buy or sell a non-financial item where the contracts can be settled net in cash or another financial instrument or by exchanging financial instruments in accordance with paragraph 2.6 of IFRS 9 (net settleable contracts). Contracts to buy or sell carbon offsets could be examples of such contracts.

Some net settleable contracts will be outside the scope of IFRS 9 where the contract to purchase or sell the carbon offsets was entered into and continues to be for the entity’s expected purchase, sale or usage requirements in accordance with paragraph 2.4 of IFRS 9. This is commonly referred to as the ‘own-use’ exception.

Assume Entity A’s accounting policy is to apply ‘interpretation B’ referred to in FAQ 41.22.1 in the PwC Manual of Accounting.

Please refer to the examples below with differing assumptions that consider whether the contract is within the scope of IFRS 9 (to be read in conjunction with the background information above).

In the past, when its own projects did not generate enough carbon offsets, entity A purchased carbon offsets in a liquid spot market and delivered these carbon offsets to settle its obligations under its contracts. Based on entity A’s expectation of the carbon offsets that will be generated by project W and its other projects, and the number of carbon offsets that it has contracted to deliver in the future, entity A anticipates that it will purchase more than an insignificant number of carbon offsets to meet its obligation to deliver 10,000 carbon offsets to entity B. In other words, the contract was not designed by entity A to be fulfilled solely by its own production. Instead, the structural mismatches in the contract will require entity A to purchase a substantial number of carbon offsets from the market to fulfil its obligation under the contract.

Would the contract described above be within the scope of IFRS 9 for entity A and what would be the initial classification considerations?

Entity A readily has access to a liquid spot market for carbon offsets, so the contract to deliver carbon offsets meets the requirement in paragraph 2.6(d) of IFRS 9; that is, the carbon offsets are readily convertible to cash, so the contract with entity B can be settled net in cash.

Entity A also anticipates that it will not generate enough carbon offsets from its projects (including project W) and will have to purchase more than an insignificant number of carbon offsets in the future to meet its obligation to deliver 10,000 carbon offsets to entity B. As noted in FAQ 40.84.2 in the PwC Manual of Accounting, ‘own-use’ means the quantity specified in the contract is expected to be sold by the entity over a reasonable period in the normal course of business. In this contract, as there are structural mismatches requiring entity A to purchase a substantial number of carbon offsets from the market to fulfil its obligation under the contract, the contract quantity is not what entity A is expected to sell over the contract period in the normal course of its business from its own production. Therefore, entity A will not be delivering all of the carbon offsets in its contract with entity B in accordance with its expected sale requirements to be derived from the output of its own production and hence the ‘own-use’ exception is not met. Therefore, the contract is scoped within IFRS 9 for entity A. The contract is accounted for as if it was a financial instrument, with cash flows imputed based on the net settlement of the delivery of carbon offsets.

As noted in PwC Manual of Accounting FAQ 40.79.4, the unit of account under IFRS 9 is the contract, hence, Entity A would not be able to split the contract into portions and assess if there is a portion of the contract which is outside of the scope of IFRS 9.

Since entity A has determined that it does not meet the ‘own-use’ exception at inception of the contract, it would not be able to reclassify the contract if circumstances change, subsequent to inception, and the entity assesses that it would subsequently meet the ‘own-use’ exception. Please refer to PwC Manual of Accounting FAQ 40.81.1 for further details.

The contract does not meet the definition of a derivative in Appendix A IFRS 9 because the investment of C1 million is fully pre-paid at inception. There is an embedded derivative in the contract as the imputed cash flows are determined so as to represent the value of the carbon offsets to be delivered. The imputed cash flows are therefore indexed to the price of the carbon offsets. The contract is a hybrid contract that contains a host contract that is a liability in the scope of IFRS 9. Entity A should assess if an embedded derivative shall be separated from the host contract and accounted for as a derivative by assessing the criteria in paragraph 4.3.3 of IFRS 9.

The separation criterion in paragraph 4.3.3 (a) of IFRS 9 requires that the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host. To apply this criterion, it is necessary to determine what the economic characteristics and risks of the host contract are. Paragraph B4.3.2 of IFRS 9 specifies that if the host contract is not an equity instrument and meets the definition of a financial instrument, then its economic characteristics and risks are those of a debt instrument.

As noted in the background above, Entity A’s accounting policy is if a contract is accounted for as if it was a financial instrument in accordance with paragraph 2.4 of IFRS 9, this means that the contract is scoped within IFRS 9 but does not automatically mean the contract includes a debt host contract for the purposes of applying paragraph B4.3.2 of IFRS 9. Instead, the entity should assess the contract further based on the substance of the arrangement.

The substance of the arrangement is that the contract can only be settled by entity A delivering physical carbon offsets to entity B which entity A sells as part of its ordinary activities. Therefore, entity A concludes the hybrid contract includes a non-financial host contract – specifically, a contract to deliver carbon offsets.

The embedded derivative is closely related to the non-financial host contract because the underlying economic characteristics and risks of the embedded derivative (which vary based on the price of the carbon offsets) are not dissimilar to the host contract’s economic characteristics and risks. Therefore, as all conditions per paragraph 4.3.3 of IFRS 9 are not met, the embedded derivative should not be separated from the host contract. ³

Assuming that the fair value option in accordance with paragraph 4.2.2 of IFRS 9 is not applied, the contract should be accounted for as a financial liability measured at amortised cost reflecting the estimated value of offsets to be delivered as an imputed cash outflow. Subsequently, the financial liability will be remeasured to reflect changes in the estimated value of offsets to be delivered in accordance with paragraph B5.4.6 of IFRS 9 (refer to PwC Manual of Accounting FAQ 42.123.3). Refer to EX 4.4.2 for an illustration of the subsequent accounting for such a contract.

This conclusion that the ‘own-use’ exception cannot be applied by entity A might differ from the conclusion reached by entity B – that is, the assessment for each counterparty is not symmetrical. Entity B’s accounting analysis will be made independently (and without the knowledge) of entity A’s accounting treatment based on its own facts and circumstances and business model for the carbon offsets. For further guidance, refer to PwC Manual of Accounting FAQ 40.84.5 – What factors should be considered when determining whether a contract meets the ‘own use’ exemption? Do both counterparties have to reach the same conclusion?.

Based on entity A’s expectation of the carbon offsets that will be generated by project W and its other projects, and the number of carbon offsets that it has contracted to deliver in the future, entity A anticipates that its projects will produce a sufficient number of carbon offsets to meet its obligation to deliver 10,000 carbon offsets to entity B. In other words, the contract was designed by entity A to be fulfilled solely by its own production.

Would the contract described above be within the scope of IFRS 9 for Entity A and what would be the initial classification considerations?

Entity A readily has access to a liquid spot market for carbon offsets, so the contract to deliver carbon offsets meets the requirement in paragraph 2.6(d) of IFRS 9; that is, the carbon offsets are readily convertible to cash, so the contract with entity B can be settled net in cash.

However, since entity A is expecting to deliver all of the carbon offsets to entity B from its own production, the contract will be fulfilled in accordance with entity A’s expected sale requirements (similar to PwC Manual of Accounting FAQ 40.84.3). Hence, entity A applies the ‘own-use’ exception. Accordingly, the contract is not within scope of IFRS 9 at inception.

If, subsequent to inception, circumstances change and the contract no longer continues to be held for ‘own-use’, the contract will subsequently be within the scope of IFRS 9. Refer to PwC Manual of Accounting FAQ 40.84.7 for further details.

Even if, at inception, the contract is not entirely within scope of IFRS 9 it should still be assessed to identify if there are any separable embedded derivatives that should be accounted for under IFRS 9. In this example, because there are no non-closely related embedded derivatives in the contract between entity A and entity B there are no separable embedded derivatives in the contract.

Instead, because carbon offsets are an output of Entity A’s ordinary activities, it should account for the contract as a revenue contract within the scope of IFRS 15. Entity A will account for the prepayment as a contract liability and will recognise revenue in the future when the carbon offsets are delivered to entity B. Entity A should evaluate whether a significant financing component exists within the revenue arrangement (see PwC Manual of Accounting paragraphs 11.95 - 11.110).