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6.3 Acquisition of emission allowances
Publication date: 20 Jul 2016
us Utilities guide
The accounting for the acquisition of emission allowances varies depending on the source of the allowances. Allowances may be obtained through government allocation, bilateral agreements, or vintage year swaps. Specific considerations for accounting for emission allowances obtained through each of these sources follow.
6.3.1 Emission allowances acquired through government allocation
Utilities and power companies often obtain emission allowances through government allocation or distribution. Emission allowances that are awarded to a company from a governmental entity free of charge are a form of nonmonetary government grant. U.S. GAAP does not specify the accounting for government grants received by “for-profit” entities. As a result, reporting entities that apply U.S. GAAP generally refer to IAS 20 when no other specific literature is on point.
IAS 20 provides guidance on the initial measurement of nonmonetary grants.
IAS 20.23
A government grant may take the form of a transfer of a non-monetary asset, such as land or other resources, for the use of the entity. In these circumstances it is usual to assess the fair value of the non-monetary asset and to account for both grant and asset at that fair value. An alternative course that is sometimes followed is to record both asset and grant at a nominal amount.
IAS 20 allows a reporting entity to make an accounting policy choice in the recognition and measurement of nonmonetary assets received in the form of a grant, such as emission allowances. Current practice in the utility and power industry is to assign no, or a nominal, value to allocated emission allowances. However, a reporting entity could alternatively record the emission allowances at fair value at inception with a corresponding deferred income amount. In accordance with IAS 20.24, the deferred income amount may be deducted from the related asset’s carrying value or recorded as a separate obligation based on the guidance in IAS 20.12.
IAS 20.12
Government grants shall be recognized in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate.
IAS 20.15(b) highlights that grants are “rarely gratuitous” and are instead intended to compensate entities for a related cost. In the case of emission allowances, the initial grant compensates a reporting entity for the expected future expense associated with emissions. Therefore, the recognition of the asset received is offset by recording a related deferred income amount representing the related grant or compliance obligation.
Regardless of the method selected, a reporting entity should apply its accounting policy consistently. Example 6-1 illustrates the accounting for allocated emission allowances.
EXAMPLE 6-1
Accounting for emission allowances allocated free of charge
Accounting for emission allowances allocated free of charge
On January 1, 20X2, Rosemary Electric & Gas Company receives an allocation of 1,000 emission allowances from the local air quality management district. The emission allowances have a five-year vintage and a fair market value of $1 million as of the grant date. REG accounts for emission allowances as intangible assets and uses them to meet its compliance requirements for emissions due to generation. During each of 20X3 and 20X4, REG uses 200 allocated emission allowances to meet its generation-related compliance obligation. At the beginning of 20X5, REG identifies that it has excess emission allowances and sells its 600 remaining allowances for $700,000.
How should REG account for the initial allocation of emission allowances and the subsequent sale?
Analysis
REG’s accounting will depend on whether it initially records the allocated allowances at a nominal value or fair value.
Initial value—$0
If REG assigns a value of $0 to the allowances when allocated on January 1, 20X2, it records the following journal entries (amounts in thousands):
Year |
Journal entries |
Cash |
Emission allowance asset |
Contra expense (or other income) |
|
1 |
Record receipt of emission allowances (number of allowances is maintained in REG’s records, but assigned a $0 value) |
$ — |
$ — |
$ — |
|
1-2 |
No expense entries are recorded for compliance because the allowances have a $0 basis |
— |
— |
— |
|
3 |
Record sale of emission allowances for $700 |
$700 |
— |
(700) |
|
TOTAL |
$700 |
$ 0 |
($700) |
Because REG is allocated enough emission allowances to cover its production, no liability or expense is recognized for its compliance obligation.
Initial value—fair value, net presentation
On day one, REG would record emission allowance assets of $1 million, offset by deferred income of $1 million (zero balance sheet impact). The remaining journal entries would be the same as under the nominal-value approach.
Initial value—fair value, gross presentation
If REG applies the fair value approach on a gross basis, the net impact on expense is the same as the nominal-value approach; however, the balance sheet would be “grossed up.” The following journal entries would be recorded (amounts in thousands):
Year |
Journal entries |
Cash |
Emission allowance asset |
Deferred income |
Contra expense (or other income) |
|
1 |
Record receipt of emission allowances |
$ — |
$1,000 |
($1,000) |
$ — |
|
1-2 |
Two years of expense ($200 per year based on usage and initial carrying value); the asset is expensed and deferred income is recognized using the same pattern |
— |
(400) |
400 |
— |
|
3 |
Record sale of emission allowances for $700 |
$700 |
(600) |
600 |
(700) |
|
TOTAL |
$700 |
$ 0 |
$ 0 |
($700) |
The use of the gross fair value method of recording emission allowances could potentially result in a different accounting impact compared with applying the two other methods if (1) the reporting entity subsequently determines that it does not have a probable liability for future emissions or (2) the amount of the liability changes. See UP 6.6 for further information on accounting for the compliance obligation.
6.3.2 Emission allowances acquired through purchase
Emission allowances that are purchased through a freestanding contract are typically recorded at the amount paid.
Allowances acquired in a business combination should be measured and recorded at fair value in accordance with ASC 805, Business Combinations.
6.3.2.1 Forward contracts for emission allowances
Reporting entities may enter into physically- or financially-settled forward contracts for emission allowances, as well as futures, options, or swaps. These transactions may be stand-alone agreements or embedded as part of a larger contract. Although emission allowances themselves are not derivatives under ASC 815, a forward contract for delivery of emission allowances may meet the definition of a derivative, as described in Figure 6-1.
Figure 6-1
Does a forward contract for emission allowances meet the definition of a derivative?
Does a forward contract for emission allowances meet the definition of a derivative?
Notional amount and underlying
|
Met
|
|
No initial net investment
|
Met
|
|
Net settlement
|
It depends
|
|
In evaluating physically-settled contracts for emission allowances, the key question typically is whether the contract has the characteristic of net settlement, which can be achieved in one of three ways.
Net settlement. The contract can be settled net by any of the following means:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
Following are factors to consider in assessing whether a forward contract for emission allowances meets the net settlement criterion. See UP 3.2.3 for further information on overall application of the net settlement criterion.
- Net settlement under contract terms
When evaluating whether the net settlement criterion is met, a reporting entity should first consider whether the contract terms explicitly or implicitly provide for net settlement of the entire contract. Forward contracts for emission allowances typically require physical delivery of the allowance and do not permit explicit net settlement. However, the reporting entity should review the type of contract and its terms to ensure net settlement is not allowed as implicit net settlement terms or liquidating damage provisions may imply that the contract could be net settled.
- Net settlement through a market mechanism
In this form of net settlement, one of the parties is required to deliver an asset, but there is an established market mechanism that facilitates net settlement outside the contract. ASC 815-10-15-110 through 15-116 provides guidance on assessing whether an established market mechanism exists.A key aspect of a market mechanism is that one of the parties to the agreement can be fully relieved of its rights and obligations under the contract. There are currently exchange-traded contracts for certain California emission allowances. Reporting entities should consider this exchange, if applicable, in making their contract assessment. Furthermore, the markets continually evolve (e.g., certain states are in the process of creating exchanges) and could increase the likelihood of a market mechanism existing as the allowances are transacted more frequently. Therefore, reporting entities should monitor this attribute on an ongoing basis.
- Net settlement by delivery of an asset that is readily convertible to cash
Whether there is an active spot market for the particular product being sold under the contract is the key factor in assessing whether an asset is readily convertible to cash. The reporting entity should consider current market conditions in this analysis. To be deemed an active spot market, a market should have transactions with sufficient frequency and volume to provide pricing information that is readily available on an ongoing basis (i.e., quoted prices are readily available).We have previously concluded that many physically settled forward contracts for emission allowances qualify as derivatives because they meet the readily-convertible-to-cash criterion. However, markets vary across the country. For example, environmental legislation proposed or enacted at the federal, regional, or state level may impact emissions trading activity. In addition, there may be no trading in some types of allowances, such as allowances issued by a specific county or air management district. See UP 3.2.3.3 for further information on the determination of whether a market is active.
A contract for emission allowances may be a derivative if it meets the net settlement criterion, depending on the type of contract and the related market. A reporting entity should evaluate all facts and circumstances in concluding on the appropriate accounting for a specific emission allowance contract and monitor its conclusion periodically because markets may evolve, potentially changing the accounting. Finally, if a contract is not a derivative in its entirety, a reporting entity should evaluate it to determine if there are any embedded derivatives that require separation.
Question 6-3
Are contracts for emission allowances that otherwise meet the definition of a derivative eligible for the normal purchases and normal sales scope exception?
Are contracts for emission allowances that otherwise meet the definition of a derivative eligible for the normal purchases and normal sales scope exception?
PwC response
It depends. A forward purchase contract for emission allowances to be used to meet the reporting entity’s compliance obligation for the expected generation of electricity could qualify for the normal purchases and normal sales scope exception, provided the reporting entity appropriately documents the election and the relevant criteria are met. Reporting entities should evaluate the nature of their contracts (e.g., will the reporting entity take delivery of the allowances, or is the contract going to net settle) and their intended use (e.g., are the allowances to be used for compliance or for trading) when determining whether the normal purchases and normal sales scope exception can be elected.
A reporting entity may also consider conditionally designating emission allowance contracts under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met (in accordance with ASC 815-10-15-22 through 15-51, as applicable). If a conditionally-designated normal purchases and normal sales contract meets the definition of a derivative at a later date, such as when an emissions market becomes readily convertible to cash, the contract would not be accounted for as a derivative since it would meet the normal purchases and normal sales scope exception. Absent the normal purchases and normal sales designation, the reporting entity would be required to record the contract at its fair value at the time it becomes a derivative. See UP 3.3.1 for further information on the normal purchases and normal sales scope exception.
6.3.3 Vintage year swaps
Reporting entities may enter into exchanges of emission allowances (commonly referred to as “vintage year swaps”). In these transactions, entities exchange emission allowances relating to a certain vintage year for another vintage year. For example, a reporting entity may swap 1,300 allowances of vintage year 20X1 for 1,000 allowances of vintage year 20X2. The reporting entity may seek such a transaction if it anticipates a shortfall in a certain year, but expects to have excess allowances in another period.
In determining the appropriate accounting for vintage year swaps, reporting entities should consider the guidance for nonmonetary transactions provided by ASC 845, Nonmonetary Transactions (ASC 845).
A reciprocal transfer of a nonmonetary asset shall be deemed an exchange only if the transferor has no substantial continuing involvement in the transferred asset such that the usual risks and rewards of ownership of the asset are transferred.
Definition from ASC 845-10-20
Exchange: An exchange (or exchange transaction) is a reciprocal transfer between two entities that results in one of the entity’s acquiring assets or services or satisfying liabilities by surrendering other assets or services or incurring other obligations.
Vintage year swaps typically meet the definition of a reciprocal exchange because the reporting entity gives up allowances from one vintage year (for which it will have no continuing involvement) in exchange for emission allowances from another vintage year.
ASC 845 requires qualifying nonmonetary exchange transactions to be accounted for based on the fair value of the assets exchanged (generally the fair value of the asset surrendered) unless certain conditions apply.
A nonmonetary exchange shall be measured based on the recorded amount (after reduction, if appropriate, for an indicated impairment of value as discussed in paragraph 360-10-40-4) of the nonmonetary asset(s) relinquished, and not on the fair values of the exchanged assets, if any of the following conditions apply:
a. The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits.
b. The transaction is an exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than the parties to the exchange.
c. The transaction lacks commercial substance (see [845-10-30-4]).
Reporting entities should consider the specific facts and circumstances surrounding any vintage year swaps in evaluating the appropriate accounting. However, in general, the application of the model may differ depending on whether the allowances are held for use or held for sale.
6.3.3.1 Held for use
As discussed in ASC 845-10-30-3, a nonmonetary exchange should be accounted for at fair value unless the transaction qualifies for certain specified exceptions. As summarized in Figure 6-2, we generally would not expect any of these exceptions to apply to emission allowances held for use.
Figure 6-2
Evaluating vintage year swaps of emission allowances held for use
Evaluating vintage year swaps of emission allowances held for use
Exception |
Met? |
Evaluation |
Fair value is not determinable |
No |
There generally are quoted prices available for emission allowances. |
Product held for sale in ordinary course of business; exchange to facilitate sales to other customers |
No |
Emission allowances held for use in operations are not held for sale in the ordinary course of business. |
Lacks commercial substance |
No |
Because exchanges of emission allowances involve swaps between vintage years, it generally would be expected that there would be a significant change in the reporting entity’s future cash flows as a result of the exchange, and thus the transaction has commercial substance. |
Because the exceptions are not typically applicable, we generally would expect vintage year swaps of emission allowances to be recorded based on the fair value of the assets exchanged. As a result, a reporting entity exchanging emission allowances with a $0 cost basis and fair value in excess of $0 will record a gain at the time of the transaction.
6.3.3.2 Held for sale
The evaluation of vintage year swaps of emission allowances held for sale generally follows the same model in UP 6.3.3.1 for swaps of allowances held for use. However, there may be limited circumstances when vintage year swaps of emission allowances held for sale may qualify for the exception in ASC 845-10-30-3(b) for exchanges that facilitate sales to customers other than the parties to the exchange, and the exchange would be recognized at the recorded amount of the emission allowances relinquished, without any gain or loss recognized.
One example may be when a reporting entity enters into a forward sale of emission allowances relating to a vintage year that it does not already hold in inventory. The reporting entity may seek to enter into a separate transaction to purchase the shortfall of allowances in exchange for excess inventory relating to another vintage year. Such a transaction would allow the reporting entity to complete its original forward sale transaction.
6.3.3.3 Considerations for regulated utilities
If a regulated utility realizes a gain or loss on a vintage year swap, it should evaluate the applicability of regulatory accounting. A regulated utility should consider its current rate recovery mechanism for emission allowance costs, as well as any specific rate orders relating to emission allowances or vintage year swaps, as applicable, to determine whether it is appropriate to record a regulatory liability (for a gain) or regulatory asset (for a loss) instead of recognizing an immediate gain or loss.
1 A current list of Issues Papers of the Accounting Standards Division of the AICPA indicates that an October 1979 paper, Accounting for Grants Received from Governments, was considered superseded by IAS 20. For detailed guidance on certain aspects of accounting for government grants in accordance with IAS 20, see UP 16.
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