Why do companies have to consider carbon credit accounting along with their climate goals?
This question has been bouncing around the Western corporate world for several years. But its urgency began to kick in when the Securities and Exchange Commission released its initial GHG emissions disclosure rule.
The proposed regulation requires public firms, particularly the big ones, to report emissions. This includes Scopes 1 and 2 as well as Scope 3 emissions if found material.
And a big change the rule will cause is how companies will account for emissions transactions in their financial reports.
This guide will help address this concern. It will help you know how to weigh the effects of top net-zero initiatives on financial reporting.
It will also provide guidance on how carbon credit or allowance items will be accounted for with some illustrative examples.
Carbon Credit Accounting and Achieving Net-Zero
Investors, consumers, and regulators worldwide are making emissions reporting imperative for businesses.
Hence, the concept of net-zero emerged. It’s a point of balance wherein emissions produced are offset by the amount of emissions reduced and removed from the air.
A simple yet profound quote “reduce what you can, offset what you can’t” has never been vital to hit net zero. Yet, turning a company’s net-zero goal into reality is not that easy.
There’s no single approach that works for any business, big or small, to account for its climate goals. Be it a net-zero, carbon-neutral, or carbon-negative target.
The most effective strategy toward net-zero is a combination of various actions. These include:
emissions reduction across the value chain (Scopes 1, 2, and 3 emissions)
removal of unavoidable emissions (with corresponding carbon removal credits)
offsetting emissions via carbon credit investments in green / carbon / sustainable projects
Take note that a carbon credit is a tradable permit given to an entity that represents the amount of CO2 it’s allowed to emit.
So, accounting for each carbon credit that a company has is important in its journey to net zero.
Despite the confusion surrounding the three actions above, corporate net-zero pledges are ramping up. Many Fortune 500 companies have pledged to reduce their Scope 1 or direct emissions.
Firms that haven’t considered cutting their indirect emissions (Scopes 2 and 3) may be in a disadvantaged position. Their partners may look for others with clear CO2 reduction targets, for instance.
Or worse, they could be placing themselves at reputational risk or lower market value. In this sense, knowing how to create and execute a net-zero plan is crucial to do away with the risks involved.
And a sure-fire way to that is understanding the common net-zero initiatives and how they affect financial accounting.
Common Net Zero Initiatives and Their Impact on Financial Reporting
Developing a good approach to getting net-zero needs consideration of various means.
For instance, a company has to recognize what current technology is out there or what’s underway. It also has to know what others in the firm’s ecosystem are doing that may cause Scope 3 emissions.
Most important is that the costs of each selected strategy have been accounted for.
The major accounting guideline for some net-zero initiatives in the US is the GAAP. And the GAAP mostly reflects the key international accounting principles of the IASB. It’s the International Accounting Standards Board.
So, a company may use the IASB accounting guidelines which most firms do. Or it may be necessary for a firm to make its own accounting policies based on certain transactions.
Here are the three common net-zero strategies businesses are using today and their impact on financial reporting.
Technology and its impact on financial statements:
Technological solutions are a major path taken by many companies toward net-zero. They invest in capital projects that improve efficiencies of operations while reducing emissions.
Most common examples are electrification and making buildings or infrastructures greener (green certifications).
Others are focusing on research and development (R&D) to improve technology to both reduce and remove carbon. Examples include direct air capture (DAC), mineralization of captured CO2, and growing algae in deserts.
Here are major accounting considerations to make when exploring this carbon reduction initiative.
Renewable energy and its impact on financial statements:
A lot of companies and countries are investing in renewable sources (wind, solar, hydro). This net-zero strategy generates the REC or renewable energy credit. Each megawatt-hour of electricity produced from a renewable resource creates one REC.
A state or jurisdiction or an agency certifies REC. It’s also tradable same with carbon credits. A company may invest directly in renewable projects to earn RECs. It can also buy it from power generators or move to a greener facility to claim RECs.
REC holders can use the credits to offset power used from other sources and account for the reduced emissions into net-zero goals. Accounting for these carbon credit alternatives is a bit more complex.
Carbon offset program and its impact on financial statements:
Many emitters are using this net-zero initiative to offset emissions they can’t reduce. In fact, the projected growth in demand for carbon offsets in this decade looks very promising as shown in the chart below.
There are plenty of programs that generate carbon offsets. Common ones include reforestation, farming or agriculture management, and carbon capture.
Each project produces a certain amount of carbon offsets, depending on its nature and capacity to reduce or remove CO2 from the air.
Companies have to be diligent in picking the projects to source their carbon offsets. They need to consider some critical factors to ensure the quality of offsets they buy.
There must also be a credible body that verifies the program and the calculations of emissions reductions are accurate. Here’s our complete guide on how offsets are created, purchased, and used.
How is Accounting Done for Carbon Credit?
High CO2 emitting sectors (e.g. energy, aviation, and automobile) are under regulatory or compliance credit schemes. It means they have to meet a certain limit on emissions set by a government regulatory framework.
This is also called the cap-and-trade scheme or emissions trading system (ETS). Currently, there are three major ETS existing worldwide. These are the European Union ETS, California ETS (US), and Chinese National ETS (China).
These systems create the certified emissions reduction (CER) credits.
Any excess in CER credits (reductions are less than the limit or cap) are tradable. But a negative CER credit (emissions exceed the set limit) results in fines or in buying offsets.
Globally, ETS systems are the most prevalent market mechanism for carbon credits. It reached ~$850 billion in 2021, a 164% increase from 2020.
Unfortunately, there’s a variety of carbon credit accounting issues due to the lack of mandatory rules until now. So, this section provides some insights on how to tackle this matter.
Key International Accounting Bodies for Carbon Credits
After the Kyoto Protocol ratification, some initiatives in accounting for credits are from:
Emerging Issues Task Force (EITF) in 2003
International Financial Reporting Interpretations Committee (IFRIC) in 2004
International Accounting Standards Board (IASB) with Financial Accounting Standards Board (FASB) in 2007
Both accounting agendas by the EITF and IFRIC were not pursued due to controversies.
The IASB Accounting Principles
Since there’s no regulatory guidance yet, some firms made their own emissions accounting policies. But most companies are accounting for their carbon credit transactions using the IASB’s IFRS.
This accounting standard specified that:
emission allowances (CER) are intangible assets and measured following IAS 38 Intangible Assets
if the CER is from a government, an entity can treat the credits as government grants on initial recognition (IAS 20)
as an entity produces emissions, a provision for its obligation is recognized to deliver allowances as per IAS 37
CER is a non-monetary asset that has no physical substance. So, it’s treatable as an intangible asset. But it’s an asset that’s often not held for use in the production of goods or services.
Rather, it’s held for sale and self-generated by the entity in the ordinary course of business. In this case, these allowances should be accounted for as the valuation of inventories as per IAS 2.
CER as Inventory Item (IAS 2)
IAS 2: an entity must account for inventories at a lower cost and net realizable value
Net realizable value: estimated selling price less estimated costs of completion and other costs to make the sale.
The cost of inventories consists of all costs of:
purchase, conversion, and other costs incurred in bringing the inventory to its present condition.
research costs from exploring measures to reduce emissions
costs incurred in developing the selected alternative measures
cost of preparing the Project Design Documents
registration fees with the United Nations Framework Convention on Climate Change (UNFCCC)
Here’s what accounting for the costs of CER looks like when making a financial report:
Source: Gokten, S., Accounting and Corporate Reporting, 2017
Accounting for Carbon Credit under Voluntary Market
A company can also get carbon credits through a voluntary carbon project. The steps involved are identical only without the national or regulatory approving bodies.
But a third-party entity must verify the carbon credits created by the emissions reduction of the project.
Here’s how the accounting goes like for carbon credits under the voluntary market:
Source: Gokten, S., Accounting and Corporate Reporting, 2017
When it comes to accounting for the income from selling carbon credits, it may follow the IAS 9. It’s the accounting principle for revenue recognition.
In the U.S., reporting of regulatory credit sales falls under a non-GAAP treatment.
So far, Tesla is the biggest seller of carbon credits within the regulatory market. It earned billions of dollars in selling abundant excess of its CER.
It reported $679 million carbon credit sales in its Q1 2022 financial report.
Obviously, trading carbon credits proves to be so lucrative.
But more importantly, these credits created a dominant market mechanism that helps cut emissions. They give companies and countries viable options to reverse climate change effects.
Now it’s time for companies to beat the challenge of accounting for their carbon credit allowances or purchases. It’s another key to unlocking the potential of various net-zero initiatives.
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