CECL for Private Companies: What You Need to Know
Carbon Credit Accounting: Considerations for Environmental Credits
With the importance and prevalence of ESG only rising from its already lofty position in the corporate zeitgeist, CFOs and their teams have much to learn and accomplish, and not a lot of time to do so.
Take accounting for environmental credits as an example. While it's not exactly fodder for splashy headlines, it will play an increasingly critical role in an ESG-dominated landscape. And, like it or not, it's just one of several areas where CFOs must quickly become adept or risk running afoul of regulators, stakeholders, or customers.
But since Embark doesn’t want to see that happen to a fine, upstanding business like yours, we’re going to take a closer look at these credits, covering key areas like:
- What are environmental credits?
- The role of environmental credits
- How to acquire environmental credits
- Accounting considerations for environmental credits
- ESG-related insights and best practices
So on that note, let's take a closer look at this essential topic so you can hit the ground running.
What are Environmental Credits?
In the complex and critical world of environmental, social, and governance (ESG) initiatives, a carbon credit represents ownership of one metric ton of carbon dioxide equivalent (MTCO2e). Whether mandated or made through voluntary commitments, companies can hold, sell, or retire these credits to meet their emissions cap or reduction target.
Thus, think of environmental credits like vouchers, allowing companies to emit a certain amount of carbon dioxide into the atmosphere. The most popular of these credits are carbon credits, and they come in two flavors – allowances and offsets.
The government doles out allowances to companies based on how much carbon they can emit. Each allowance represents the right to emit one metric ton of carbon dioxide, and if a company needs to emit more carbon than it has allowances for, it can buy extra credits from other companies.
Alternatively, carbon offset projects avoid or reduce emissions and, therefore, actually remove carbon from the atmosphere. A company can generate these credits for each metric ton of carbon dioxide reduced, avoided, or removed. Companies that want to offset their emissions can buy these credits, hence, the term carbon offsets.
Of course, there are other types of credits, like renewable energy credits/certificates (RECs) issued when one megawatt-hour of electricity is generated from a renewable energy source and delivered to the grid. Still, despite the various types and uses, environmental credits generally act like coupons for carbon emissions, differing according to who can use them and for what purpose.
What is the Role of Environmental Credits?
The impact of carbon dioxide emissions isn't exactly earth-shattering news. Instead, it's the expectations around them that have changed significantly in recent years, with consumers, employees, governments, and regulators worldwide now actively pressuring businesses to cut emissions. Thus, the emergence of net zero emissions initiatives and similar projects aimed at balancing greenhouse gas (GHG) emissions with amounts of GHG removed from the atmosphere.
Environmental credits are tools to find this balance, helping companies with their sustainability efforts and mitigating the impact of climate change. And, of course, environmental credits also let companies display their commitment to sustainability while helping meet regulatory emissions-reduction requirements.
Even energy producers, utilities, and oil refineries – whose emissions are governed by state laws – use carbon credits, where allowance amounts are often assigned to businesses subject to regulations and based on certain target emission levels. Once again, like other assets, a corporation can trade, sell, or store the extra emissions credits it doesn't use, or buy more if it uses more than assigned.
How to Acquire Environmental Credits
Companies can earn environmental credits in several ways, most of which are certified by independent third-party organizations to ensure their credibility and transparency.
Directly From the Regulator
Companies can sometimes receive environmental credits, including RECs, directly from a regulator. In this case, a regulator would be a government agency responsible for overseeing the implementation of environmental policies and regulations.
The process for obtaining credits directly from the regulator will vary depending on regional regulations and policies. Still, it generally involves demonstrating that you have implemented measures to reduce greenhouse gas emissions.
Each year, a volume of allowances or permits equal to the cap for that year is auctioned or allocated – for free – to the regulated entities by cap-and-trade programs. The entity can trade allowances until it has enough to cover its annual emissions.
Carbon credits are traded in either voluntary or compliance markets. Businesses in a voluntary market buy carbon credits to offset their emissions without a legal obligation. In contrast, those in a compliance market must, by law, purchase carbon credits to offset their emissions.
The markets for generation, procurement, trade, and monitoring of environmental credits are exploding. In fact, the market for carbon credits alone was estimated at $760.28B in 2021, with a projected CAGR of 21.14% from 2023 to 2028. And that, to state the obvious, is nothing to sneeze at.
Similarly, traders in the European compliance market currently project carbon prices to increase by 88% – reaching about $67 per metric ton – by 2030, according to a survey from the International Emissions Trading Association.
PPAs and VPPA
Renewable energy power purchase agreements (PPAs) and the related virtual power purchase agreements (VPPAs) are both methods companies can use to acquire environmental credits by purchasing renewable energy directly from renewable energy producers. Both PPAs and VPPAs are becoming increasingly popular for businesses, helping them meet their sustainability goals while also supporting renewable energy growth. These can be a win-win for everyone involved since:
- Renewable energy producers get reliable customers for their energy
- Buyers can claim environmental credits
- Clean energy sources expand, further promoting sustainability efforts.
Accounting Considerations for Environmental Credits
All that said, there's limited guidance concerning environmental credits at the moment. However, as you’d expect, countless questions about their financial reporting and accounting have popped up recently, especially since US GAAP doesn't explicitly address the topic yet.
Heeding the call, the Financial Accounting Standards Board (FASB) took up the accounting for environmental credits mantle in May 2022. And while it's still very much a work in progress, some specific hot-button carbon accounting issues and considerations have already bubbled to the surface.
In lieu of specific authoritative guidance on environmental credits, companies will need to use judgment to apply existing US GAAP or industry practices by analogy. Further, companies must consider all relevant facts and circumstances when selecting an appropriate accounting model.
Environmental Credits – Inventory or Intangible Assets?
Carbon credits that meet the definition of an asset are generally classified as either inventory or an intangible asset, with the distinction between them lying in the intended use of the asset. Assets sold or actively traded are generally considered inventory, whereas assets held for use are considered intangible assets.
If a business will retire the environmental credits immediately – for example, as part of a company’s net-zero strategy – it wouldn’t recognize the asset but, instead, should immediately expense recognition.
Companies should evaluate all facts and circumstances for their carbon credit arrangements and apply their accounting policy consistently.
Credits Classified as Inventory
Credits accounted for as inventory would be charged to cost of goods sold (COGS) when traded or used. Cash flows associated with environmental credit activity would be classified as an operating activity.
These environmental credits would also be subject to the lower of cost or net realizable value approach to impairment for inventory under ASC 330. Judgment is also required to determine which costs, if any, should be capitalized with acquiring or producing credits classified as inventory.
Credits Classified as Intangible Assets
When environmental credits are classified as intangible assets because you hold them for use, questions often arise about whether or not to amortize the asset.
In other words, what is the useful life of an environmental credit? The short and perhaps frustrating answer – it depends. Some credits may have a finite life – e.g., the credit has an expiration date or compliance period – whereas others may not.
Even when credits are considered to have a finite life, it is an acceptable view in practice to label the credits as non-wasting. In these circumstances, the benefits of the credit – like allowances and certain carbon offsets – do not diminish until the credit is actually consumed. Therefore, no amortization expense is recognized until the credit is actually used. This is an alternative to recognizing amortization expense over the finite life of the asset to reflect the gradual consumption of the asset’s benefits.
Environmental credits classified as intangible assets should also apply the impairment model in ASC 360 to evaluate events or changes in circumstances that suggest the carrying value may not be recoverable. Some common “triggers” that may warrant the need for assessing impairment include:
- Significant decline in the price of the credits where an active market exists
- Significant change in the regulatory environment that may impact the usefulness of the credit or allowance
- Significant change in the company’s operating environment impacting the future use of the credit or allowance
Requirements for Disclosure
In a surprise to exactly no one, disclosure requirements for environmental credits are a big to-do, especially given the lack of specific authoritative guidance on the matter. The nature and classification of the credits, how you obtained them, the amortization method used, and any impairment losses recognized – it's all critical information stakeholders, investors, and regulators want to know. Keep in mind, if you classify credits as inventory, you should also include the required disclosures for inventory in the financial statements. The same holds true for intangible assets.
On a related note, the SEC is also increasing their focus on climate-related disclosures. Back in 2010, the SEC issued an interpretive release that identified four climate-related topics that registrants should consider in their filings under existing SEC disclosure requirements. In more recent years, the SEC’s Division of CorpFin has increased the number of comments issued to registrants in their filings on climate disclosure matters under these existing requirements. The Division also published a sample comment letter on the matter to serve as an early-warning sign to registrants.
This letter hones in on climate-related disclosures within the business, risk factors, and the MD&A portion of the SEC filings that registrants should place additional focus on. Likewise, don’t forget the SEC has a proposed rule that would further increase the focus on disclosures relating to climate matters. Although we've written extensively on the SEC's March 2022 proposed climate-related disclosures, some of the higher-level financial statement disclosure requirements discussed in the proposal include:
- Financial impact metrics – Separately disclose the positive and negative financial impacts of both (1) severe weather events and other natural conditions and (2) transition activities by financial statement line item unless the aggregate impact on an absolute basis is less than 1% of the total line item for the relevant fiscal year.
- Expenditure metrics – Separately disclose the aggregate amount of costs incurred for both climate-related events and transition activities that are both expensed and capitalized, unless the aggregate amount is less than 1% of the expenditures expensed or capitalized costs incurred, respectively.
- Financial estimates and assumptions – Disclose whether and how climate-related events and transition activities impacted estimates and assumptions used in preparing the financial statements.
The proposal also includes numerous climate-related disclosures outside the financial statements, such as:
- Scope 1 and Scope 2 GHG emissions separate from any offsets
- Scope 3 GHG emissions when material or where the registrant has established a target or goal based on Scope 3 emissions
- Climate risk management strategies, targets, and objectives
- Oversight and governance of climate-related risks
A Final Word from Embark
ESG is no longer optional. It's expected now, by regulators, customers, stakeholders, and just about anyone else you can think of. As such, ESG scores, methodologies, strategies, and reporting initiatives are crucial in meeting sustainability goals, complying with increasingly strict regulations, and providing critical transparency.
So, while most normies wouldn't directly associate accounting with ESG, your accounting and reporting functions are actually on the ESG frontlines. Therefore, in the case of environmental credits, properly accounting and reporting of them – recognizing them as assets, amortizing them, disclosing impairment – is essential for gauging and managing your company's ESG efforts and demonstrating your commitment to sustainability.
Remember, whether you put much credence into ESG is almost irrelevant at this point – that train left the station long, long ago. Thus, like it or not, topics like deforestation, methane production and consumption, carbon capture initiatives, human rights, and others will be sitting under a bright spotlight from here on out. And it's just a matter of time until accounting for such diverse topics is codified into the accounting principles by the FASB and IASB. In other words, US GAAP and IFRS will both have a distinct green hue to them not too far down the road.
Long story short – there's no time like the present to get to work. And we're ready when you are, so from carbon credit accounting and mandatory disclosures to data systems and processes, Embark's ESG and Sustainability team is ready to transform ESG into a competitive edge for your business. So let’s get going.