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When subject to an emission allowance program, a reporting entity is obligated to surrender a certain number of emission allowances at the end of a compliance period, with the number surrendered generally based on emissions during the period. A reporting entity may not always have sufficient emission allowances to cover emissions from planned generation and could face penalties from the government or other regulatory body if its actual emissions exceed allowances held. A reporting entity can avoid penalties by purchasing more allowances or redirecting its source of supply (e.g., generating from another plant).
There is currently diversity in practice with respect to accounting for an emissions compliance obligation. In evaluating the appropriate accounting, a reporting entity should first consider whether its obligation to deliver emission allowances in the future (1) represents a derivative in its entirety or (2) contains an embedded derivative that should be separated from the host contract and accounted for at fair value. If the obligation does not contain an embedded derivative, the reporting entity should develop a recognition approach that is supportable under U.S. GAAP.

6.6.1 Evaluate whether the obligation contains an embedded derivative

Although an emission allowance obligation would not meet the definition of a derivative under ASC 815 in its entirety (because it represents an obligation equal to the value of the allowances at the time the emissions occur), it may include an embedded derivative for the forward delivery of emission allowances due but not yet surrendered.
Considerations in determining whether the obligation includes an embedded derivative that should be separated from the host contract are summarized in Figure 6-3.
Figure 6-3
Does an emissions compliance obligation contain an embedded derivative that requires separation?
Criterion in ASC 815
Economic characteristics of the embedded are not clearly and closely related to the host
• The host contract is a liability for emissions compliance (i.e., a debt host).
• Changes in the price of emission allowances are not clearly and closely related to a debt host instrument.
Hybrid instrument is not remeasured at fair value under otherwise applicable U.S. GAAP
• Although some of the measurement techniques used to measure a compliance obligation are similar to a fair value measurement, the obligation is not a fair value measurement.
A separate instrument with the same terms as the embedded derivative would be a derivative instrument subject to ASC 815
It depends
• A firm commitment to receive or deliver emission allowances in the future may meet the definition of a derivative (see UP
The third criterion, whether a stand-alone contract requiring future delivery of the specified emission allowances would meet the definition of a derivative, is the one that typically requires judgment. As discussed in UP, some contracts for delivery of emission allowances meet the definition of a derivative because they have (1) an underlying, (2) no initial net investment, and (3) the characteristic of net settlement. A contract for delivery of emission allowances may net settle under its contract terms or due to a market mechanism or spot market. This analysis is specific to the contract terms and market, and the result will vary depending on the type of emission allowance. Similarly, the reporting entity should assess the potential embedded derivative to determine if it has the characteristic of net settlement. For example, the jurisdiction may permit settlement in cash based on the value of the allowances at the settlement date, or the emission allowances to be delivered may be readily convertible to cash.
If the reporting entity concludes that the emissions allowance compliance obligation contains an embedded derivative, it should initially separate the embedded feature by recording the obligation to deliver the allowances at fair value and adjust it each period based on changes in market prices.
If a reporting entity applies ASC 980 and concludes that emission allowance compliance costs qualify for deferral under a regulatory mechanism, it should also defer unrealized gains and losses related to the embedded derivative. See UP Question 17-4. Furthermore, the amounts recorded would be subject to the fair value and derivatives disclosure requirements. These are addressed in FSP 19 and 20 and UP 21.
Question 6-7
If an emission allowance obligation contains an embedded derivative, is the derivative eligible for the normal purchases and normal sales scope exception?
PwC response
It depends. ASC 815-10-15-22 defines normal purchases and normal sales.

ASC 815-10-15-22

Normal purchases and normal sales are contracts that provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business.

In general, a compliance obligation related to emissions will be settled through the physical delivery of emission allowance certificates. In such cases, we would generally expect the obligation to be eligible for the normal purchases and normal sales scope exception if all of the criteria are met (see ASC 815-10-15-22 through 15-51, as applicable). However, in many cases, even if the delivery obligation is designated as normal, it will still be measured using current market pricing or a technique similar to fair value (see UP 6.6.2 for further discussion). As such, we generally believe that valuing the obligation following an embedded derivative model when an emissions obligation contains an embedded derivative, may be an appropriate representation of the entities obligation.

6.6.2 Apply another measurement technique

If the obligation does not contain an embedded derivative, the reporting entity should measure the emissions obligation using another relevant measurement technique. Two acceptable methods are summarized in Figure 6-4.
Figure 6-4
Methods for recognizing expense associated with emission allowance compliance
Accrue as you go
• Expense is recognized as the obligation arises; expense is based on fair value, cost, or another rational method
• Results in better matching of the expense with the related emissions
• Emissions held are offset against the compliance obligation when they are surrendered, relieving the asset and the related liability
Accrue when a shortfall occurs
• Emission allowances are expensed as used; any shortfall is accrued when it occurs
• May result in uneven expense recognition throughout the year
A reporting entity should evaluate its facts and circumstances in determining which approach to follow and should be able to support its recognition policy within U.S. GAAP. The policy adopted should be applied consistently. In addition, the reporting entity should recognize any potential penalties or fines when probable and estimable, consistent with the guidance in ASC 450, Contingencies. Considerations in applying the two methods of recognition are as follows. Accrue as you go

Due to the nature of an emissions compliance obligation, we generally believe that a related liability should be accrued as a period expense as power is generated (i.e., as the emissions occur and the obligation arises). Different approaches are acceptable for measurement of the liability, including:
  • Fair value or market price of emission allowances (because the liability could be settled by purchasing allowances from the market). If this approach is used, we believe the amounts recorded would be subject to the fair value disclosure requirements in FSP 20
  • Weighted-average cost of allowances (whether classified as inventory or intangible assets)
  • Cost of allowances to be purchased in existing forward contractual arrangements
Under this method, compliance expense is recognized based on the reporting entity’s measurement methodology. Allowances held and recorded as inventory or intangible assets are offset against the compliance liability when the allowances are surrendered to demonstrate compliance. The reporting entity would recognize any difference between the liability and the carrying value of the allowances as a gain or loss when the obligation is settled.
In some cases, a combination of these approaches or another method of measurement may be appropriate, depending on the nature of the emission program requirements and the expected settlement amount. A reporting entity should evaluate its facts and circumstances and apply a consistent approach to measure the liability. Accrue when a shortfall occurs

Under this method, a reporting entity expenses its allowances held as the obligation arises and no separate compliance obligation is recorded. The amount of expense recognized will depend on whether the allowances were allocated by the government ($0 cost basis) or purchased. The reporting entity will accrue a liability for inadequate allowances only at the time actual emission levels are in excess of emission allowances held for a particular vintage year. For example, under this approach, if a reporting entity holds sufficient emission allowances to offset its expected emissions for the first three quarters of a given fiscal year, it would not record a liability until its actual emission levels exceed allowances held (i.e., in the fourth quarter, assuming such excess emissions materialize).
This approach requires careful tracking of both the expected emission levels and the emission allowances held. In addition, management and legal counsel should review contractual commitments and an inventory of emission allowances held to determine whether and when to record obligations for emissions. This approach may also lead to an expense recognition pattern that backloads expense, even though the reporting entity’s actual emission levels may have been constant throughout the year.

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