Accounting For Environmental Credit Programs

Disclaimer: Companies should be aware that this project is only in the board deliberations stage. Consequently, all board decisions described are only tentative, and the Board could reverse them at any time. The following guidance is derived from the Board’s project meeting minutes and other sources.

Introduction

As environmental credits have gained increasing significance for companies in fulfilling compliance obligations and meeting net zero commitments, there has been a growing trend of companies acquiring them. This trend has raised important questions about how to account for these assets because current US Generally Accepted Accounting Principles (GAAP) do not offer official guidance on how companies should handle these credits. Consequently, many companies have resorted to following industry trends for guidance, leading to a diversity in practice regarding the treatment of environmental credits.

To rectify the inconsistencies in accounting for environmental credit programs, the Financial Accounting Standards Board (FASB) added the Accounting for Environmental Credit Programs project to its technical agenda on May 25, 2022. The objective of this project is to improve the recognition, measurement, presentation, and disclosure requirements for participants in compliance and voluntary programs that result in the creation of environmental credits and for the nongovernmental creators of environmental credits.

Types of Environmental Credits

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The term “environmental credits” covers a broad range of certificates, credits, and rights that are too varied to summarize in a brief overview. Nonetheless, they are generally categorized into five main types: tax credits, allowances, renewable energy certificates (RECs), renewable identification numbers (RINs), and offsets. Except for tax credits, all these environmental credits fall within the scope of the FASB's project.

Tax Credits

Tax credits are an incentive given by governments to encourage companies or individuals to take certain actions in order to receive a credit that reduces their tax liability. In the context of ESG-related matters, this could entail actions such as purchasing an electric vehicle or installing solar panels. The new project’s scope excludes these credits because Topic 740, Income Taxes, already addresses how they should be accounted for.

Emission Allowances

Some governments aiming to curb greenhouse gas emissions establish a carbon emission limit for companies in their jurisdiction. These governments then grant allowances to companies representing the permission to emit a specific amount of carbon. In some programs, these allowances are granted for free, and in others, governments mandate companies purchase them. As companies emit carbon, they surrender these allowances to the government. However, if a company needs to emit more carbon than the allotted credits allow, it can purchase allowances from other companies that did not use, or do not plan to use, all of theirs, or it can pay a fine to a regulatory body.¹ A company may be forced to pay a fine in cases where there are not enough credits available to cover all companies' collective emissions, and it is unable to secure sufficient allowances. One prominent example of an emission allowance system is the European Union’s Emission Trading Scheme (ETS). For further insight into emission allowances, please refer to our in-depth article here.

Renewable Energy Certificates

Renewable Energy Certificates certify that a company has produced one megawatt-hour of electricity from renewable energy sources. The certificate also allows the holder to claim that one mega-watt hour of energy it consumed was generated from a renewable source. This is one way companies lower their scope 2 emissions. Various renewable energy sources eligible for REC certification include hydroelectric, solar, wind, and nuclear power. Companies have the option to procure RECs independently from the actual electricity generated, allowing them to declare their use of renewable electricity even if it's not locally available. When a company seeks to assert its use of renewable electricity, it must retire the corresponding REC.² To learn more about RECs read our in-depth article here.

Renewable Identification Numbers

Renewable identification numbers are a tool the Environmental Protection Agency (EPA) uses to monitor companies’ compliance with the Renewable Fuel Standard (RFS) program. This program mandates that a certain amount of the fuel brought to market be renewable fuel. To verify compliance, the EPA requires refiners and fuel importers to surrender a designated number of RINs corresponding to the volume of gas they supply in the US. These credits are generated whenever renewable fuel is produced, thereby allowing RIN holders to assert the production of a specific quantity of renewable fuel.³

Carbon Offset Credits

Carbon offset credits are certificates issued by either a government entity or an independent certification body, verifying that one metric ton of carbon dioxide has either been removed from the atmosphere or was prevented from being emitted. Companies engage in trading these certificates among themselves and can apply the emissions reduction against their pollution levels by retiring the credits. Often, companies procure these offsets to facilitate their journey towards achieving net-zero carbon emissions. For further insight into emission allowances, please refer to our in-depth article here.

Current Accounting

As previously mentioned, there is presently no specific authoritative guidance in US GAAP for accounting for environmental credits. Consequently, companies have resorted to analogizing to existing GAAP. The first question companies must answer is when an environmental credit is considered an asset. In its report “Accounting and Reporting Considerations for Environmental Credits,” Deloitte stated that companies could generally consider their environmental credits as assets if they have the ability to sell, transfer, or exchange them. Otherwise, companies should expense the acquisition cost rather than classifying it as an asset on their balance sheet.⁴

Additional diversity in practice emerges when determining how to measure the credit if it is recognized as an asset. Companies typically fall into two broad categories: treating them like inventory or treating them like intangible assets. According to the Deloitte article mentioned previously, companies predominantly select a model based on their intended use of the credits.

Inventory Approach

Companies that acquire environmental credits, intending to hold them for sale, typically account for them using an inventory approach. Under this model, the credits are measured at their acquisition cost less impairment (if necessary) or the lower of cost or market. Additionally, companies may capitalize other indirect expenses related to acquiring the credits, with the inclusion of such costs determined on a case-by-case basis for each company. Upon selling the credit, the company also records an expense equivalent to the credit's cost, which is recognized as the cost of goods sold.

Intangible Approach

Under an intangible approach, companies also record credits at their acquisition cost. The asset is generally expensed and derecognized upon retirement. However, diversity in practice exists regarding whether to amortize the credits or not. Intangible assets with a finite life are generally amortized over their useful life. Nevertheless, according to Deloitte’s guide, some companies consider amortization inappropriate for environmental credits. This is because the benefits of the credits remain constant throughout their finite lives, resulting in no decrease in value. Consequently, these companies refrain from amortizing the credits to ensure that the full expense is recognized when the benefit is actually realized.⁵

Accounting Under IFRS

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Compliance vs Voluntary Markets

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FASB’s Project

Currently, the FASB’s Accounting for Environmental Credit Programs project splits its treatment of environmental credits into three main categories based on the reason the holder acquired them. These categories include acquiring credits to fulfill an environmental credit obligation, holding credits for sale, and obtaining credits for other voluntary purposes, such as meeting a net zero commitment.

Acquired to Settle an Environmental Credit Obligation

The Board decided at its October 2023 meeting that a company has an environmental credit obligation if it has “an obligation arising from existing or enacted laws, statutes, or ordinances represented to prevent, control, reduce, or remove emissions or other pollution that may be settled with environmental credits.” This is a broad scope that would apply to most of the compliance market for environmental credits. The one exception to this would be any obligation that arises from Subtopic 410-30, Asset Retirement and Environmental Obligations—Environmental Obligations. Obligations under that subtopic will not be included even if the obligations can be settled in environmental credits.

Companies with an environmental credit obligation will be able to recognize the credits they acquire to satisfy it on their balance sheet. These credits will be measured at cost, whether they are obtained from a regulator, purchased from a third party, or generated internally. Consequently, in scenarios where a company receives emission allowances at no cost from a regulator, they would be measured at zero.

At the end of each reporting period, the Board determined that companies would need to reassess whether it remains probable the environmental credits they acquired to satisfy environmental credit obligations or to hold for sale will still be used in either of those ways. If they determine it is no longer probable, then companies should derecognize them through earnings.

If a company determines that its credits previously held for compliance reasons are now intended for sale, then it should immediately test them for impairment. Credits held to fulfill compliance obligations will not undergo subsequent measurement, meaning they will remain at their original cost until retired. This differs from some of the prevailing methods companies use to account for environmental credits where the credits are amortized over their finite life if applicable and/or tested for impairment. However, it does align with other trends that believe these practices are unnecessary.⁸

Companies with environmental credit obligations as of a balance sheet date will also need to recognize liabilities for them on their balance sheets. These liabilities will be referred to going forward as ECO liabilities. When initially measuring the ECO liability, companies should determine the overall value by splitting the liability into two parts: the funded portion and the unfunded portion.

The funded portion of an ECO liability refers to the amount of the liability that can be covered by environmental credit assets already acquired by the company. This portion of the liability is measured equal to the carrying value of the credits that the company intends to use to settle the liability. When determining which credits it plans to use to settle the liability, the Board decided that companies should use their best estimate while being consistent with any portfolio or costing methods that they have established for compliance environmental credits.

The unfunded portion pertains to the amount of the ECO liability for which a company has not yet acquired environmental credits to cover its obligation. The Board specified that companies should measure this portion at fair value following Topic 820, Fair Value Measurement. However, there are a couple of exceptions where the company would not measure it at fair value. One exception is if the company plans to settle its ECO liability by paying the regulator directly in cash. In this case, the Board decided that the company should measure the liability at the cash settlement amount required by the program. The second exception is if the company has already committed to purchasing a number of environmental credits at a fixed price to use for the ECO liability, in which case it should measure the unfunded portion at the estimated cost of those credits.

At each balance sheet date, companies will also be required to subsequently measure the ECO liabilities according to the same principles used for initial measurement. If it is determined that a change needs to be made, the company should adjust the value of the liability, and any resulting gains or losses will be recognized in earnings. The Board also decided that companies will not be allowed to present environmental credits as offsetting their ECO liabilities on the balance sheet. Additionally, when companies derecognize their ECO liability, it should be done in line with ASC 405-20, Liabilities—Extinguishments of Liabilities. Gains and losses resulting from this will be presented in the same income statement line item as the initial measurement of the ECO liability.

Fixed Environmental Credit Programs

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‍Other Noncompliance Environmental Credits

For environmental credits acquired by companies for resale, the Board determined that companies should recognize an asset, which would be measured following the guidance outlined in ASC 805-50-30-1 through 30-4 unless the credits were obtained through a grant by a regulator or internally generated.

At the conclusion of each reporting period, the Board stipulated that companies would need to reassess whether it remains probable that the environmental credits they acquired to satisfy environmental credit obligations or to hold for sale will still be used in either of those ways. If they determine it is no longer probable, companies should derecognize them through earnings since they are now essentially being held for voluntary purposes. Furthermore, companies would also be required to subsequently measure environmental credits held for sale at the end of each reporting period. Specifically, they would need to test the environmental credit assets for impairment and recognize an impairment loss if their carrying values exceed their fair values. However, companies will not be permitted to reverse an impairment loss even if the fair value increases in the future.

When companies sell an environmental credit asset they were holding for sale to a customer, they will derecognize it following Topic 606, Revenue from Contracts with Customers. However, if the company disposes of it in a manner other than sale to a customer, it will derecognize it following Subtopic 610-20, Other Income—Gains and Losses from the Derecognition of Nonfinancial Assets. When derecognizing assets, whether held for compliance reasons or for sale, companies must also select and consistently apply a costing approach to identify which environmental credit assets are retired. Companies would be allowed to use average cost, first-in, first-out (FIFO), and specific identification methods.

Acquired Voluntarily

In its tentative decisions, the Board decided that all costs associated with acquiring environmental credits for purposes other than holding them for sale or utilizing them to fulfill an environmental credit obligation should be expensed immediately rather than capitalized as an asset. This treatment makes sense because environmental credits acquired voluntarily do not hold up well to the definition of an asset. The FASB defines an asset as “a present right of an entity to an economic benefit”.⁹ If a company purchases an ESG credit just to make a claim about how they operate that could potentially lead to a future benefit, but it involves no immediate right to a current benefit.

The Board also clarified that if a company pays a nonrefundable deposit for environmental credits, they should recognize it as an expense if it is not probable the credits will be used to settle an obligation or transferred in an exchange transaction.

Finally, the Board established that if companies later changed their intent to hold the credits for sale or use them for a compliance obligation instead of for voluntary purposes, they would still be precluded from recognizing them as an asset.

These new policies would mark a significant shift from prevailing accounting trends. Today, when a company acquires credits for voluntary purposes, they are sometimes treated as intangible assets. However, under these Board decisions, they would be expensed immediately. This could cause a change in presentation for companies that purchase large amounts of credits voluntarily in a single year and have traditionally been capitalizing them and then retiring and expensing them over future years.

Other Important Considerations

The following is a list of other tentative decisions the Board has made that may be important for companies to be aware of:

The Board decided that companies should follow Topic 230 Statement of Cash Flows when dealing with the cash flow effects of environmental credit programs.
The Board decided that companies should not use Topic 815, Derivatives and Hedging when accounting for environmental credit programs.
The Board decided to prohibit companies from using the fair value option in Topic 825, Financial Instruments when accounting for ECO Liabilities.
The Board decided to prohibit companies from capitalizing the cost of environmental credits as part of another asset in line with other GAAP if companies do not plan to use them to settle an ECO liability or sell to other entities.
The Board decided that companies should be able to elect an accounting policy of remeasuring noncompliance environmental credit assets to fair value. However, the Board has not yet made a decision about which noncompliance credits will be eligible for this treatment.

Conclusion

While the FASB’s Accounting for Environmental Credit Programs project has released only tentative decisions thus far, companies that deal with credits for compliance, sale, or voluntary purposes should monitor the project's development and begin contemplating its potential impact. Since the project diverts in some significant ways from the current accounting trends seen among US companies and requires a standardized approach, companies should carefully consider how these changes may affect their financial statements and how shareholders will perceive them after implementing this guidance. The result may alter the strategies companies are using when determining whether to purchase environmental credits and the timing of such purchases.