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Bachelor Thesis, 2018
31 Pages, Grade: 1,3
List of abbreviations
List of symbol
List of tables
2 ER, ETS and their implications for firms
2.1 Regulatory background and geographical coverage of ETS
2.2 Accounting relevance of emission rights for firms
2.3 Financial accounting vs. non-financial disclosure
3 Accounting practices for ER
3.1 Overview of possible financial accounting practices
3.2 Financial accounting approaches used in practice
3.3 Information content of the financial accounting approaches identified
3.4 Non-financial disclosure practices and their information content
4 Information needed vs. information provided
4.1 Information about ER needed on the capital market
4.2 Comparison: Information provided and information required
5 Summary and implications
7 List of legal references
Abbildung in dieser Leseprobe nicht enthalten
Abbildung in dieser Leseprobe nicht enthalten
Table 1 (p. 5): Consumption of ER as percentage of profit before tax (2008), based on Lovell et al. (2013), p. 750.
Table 2 (p. 10): Overview of the empirical results regarding accounting practices used for ER, based on Allini et al. (2018); Black (2013); Lovell et al. (2010); Warwick & Ng (2012)
Many firms have neglected the environmental consequences of their operations until policymakers, and the public intensified the pressure on them at the end of the last century (Stern, 2006, pp. 4, 7). Introducing pricing mechanisms for emissions is one of the ways in which policymakers have reacted to make firms internalize the environmental costs of their actions (Bebbington & Larrinaga-Gonzalez, 2008, p. 702; MacKenzie, 2009, p. 453). This approach is based on the work of economist R.H. Coase, who proposed “that the right to do something which has a harmful effect (such as the creation of smoke, noise, smells, etc.) is also a factor of production.” And that the “cost of exercising a right (of using a factor of production) is always the loss which is suffered elsewhere in consequence of the exercise of that right” (Coase, 2013, p. 841). To enable pricing mechanisms, emissions are standardized into units that can be exchanged on markets within emission trading schemes (ETS) (Lovell & MacKenzie, 2011, p. 704). These units are called emission rights (ER) or allowances.
ETS are part of the Kyoto Protocol Framework and so far, one of the most popular approaches for combatting climate change the international community has introduced (Lovell & MacKenzie, 2011, p. 704). Nevertheless, neither the International Accounting Standards Board (IASB), nor the Federal Accounting Standards Board (FASB) as the most important international standard setters have provided firms with mandatory guidance on this topic (Allini, Giner, & Caldarelli, 2018, p. 2204). The IASB issued an interpretation (IFRIC 3) concerning accounting for ER in December 2004, which was withdrawn only a few months later after the European Financial Reporting Advisory Group (EFRAG) recommended not endorsing it (Cook, 2009, p. 457). The only official body that has so far regulated the accounting treatment of ER is the Federal Energy Regulatory Commission (FERC), which issued requirements legally binding only for US electric utilities (Johnston, Sefcik, & Soderstrom, 2008, pp. 748, 751; Warwick & Ng, 2012, p. 56). Although affecting many preparers and users of accounting information worldwide, the treatment of ER is not as strictly regulated or standardized as most other areas of accounting (Lovell, Sales de Aguiar, Bebbington, & Larrinaga-Gonzalez, 2010, p. 22; Lovell, Bebbington, Larrinaga, & Sales de Aguiar, 2013, p. 754). As Cook (2009) states: “The Emission Rights affair is worth studying because it illustrates the problems faced by standard setters as they explore the frontiers of accounting” (p. 457).
By connecting the findings of several existing normative and empirical studies on the topic of accounting for ER, this thesis answers the following research question: Which information content do the different accounting practices have, that firms use to account for ER and which part of that information is valuable from a capital market perspective? Results from this analysis can provide insights to standard setters regarding the necessary details of a future mandatory accounting solution for ER. Although several other ETS exist in the world, this thesis focuses on the geographical regions of the European Union (EU) and the United States of America (USA), since they are home to the largest and most mature ETS.
The remainder of this thesis is structured as follows. Section two explains ER and ETS, their geographical coverage and relevance to firms, as well as financial accounting and non- financial disclosure regarding ER. Section three analyzes financial and non-financial accounting practices for ER and focuses on their information content. Section four contains empirical evidence about the financial and non-financial information needed by the capital market and a comparison of this information to the actually disclosed information. Section five concludes the paper by summarizing the most important aspects for answering the research question and explaining possible implications, e.g., for standard setters.
Governments willing to regulate harmful emissions have the choice between quantity-based mechanisms like ETS and price-based mechanisms like carbon taxes (Cook, 2009, pp. 457458). The ETS that are the foundation for the empirical papers and analyses presented in this thesis are structured as cap-and-trade systems in which the regulator sets a cap on the emission of certain gases. At the beginning of the measurement period, the ER are either allocated to the covered entities free of charge or auctioned off. Trading activities may start after all the ER representing the cap-level emissions for the respective measurement period have been allocated.
Despite their name, ER do not confer the general right to emit to the holder. Facilities need to have an emission permit to be generally allowed to emit. At the end of the measurement period, the emitting entities need to deliver ER offsetting the total amount of their emissions to the regulating body; otherwise, they incur substantial fines of, e.g., 100€ per ton of emissions not covered in the EU ETS. The total number of ER in the system is decreased gradually to set incentives for abatement (for the setup of ETS: Bebbington & Larrinaga-Gonzalez, 2008, pp. 703-704; Cook, 2009, pp. 458-459; Haupt & Ismer, 2013, pp. 73-74; MacKenzie, 2009, pp. 442-443; Schmalensee & Stavins, 2017, pp. 575-576, 581-582).
In theory, those firms with the lowest abatement costs are the first to invest in technologies for mitigating emissions. They make a profit by selling their excess ER. Firms with higher abatement costs prefer to continue emitting. Under the assumption that free allocations do not cover 100% of emissions, they are then forced to internalize at least part of the costs of their emissions by purchasing ER (Bebbington & Larrinaga-Gonzalez, 2008, p. 702; Lohmann, 2009, p. 504; MacKenzie, 2009, p. 442). The economic nature of ER is disputed: the goal of the market mechanisms introduced is to force firms to treat emissions as production inputs, which gives ER characteristics of inventory. However, they can be traded like financial instruments and have similarities to rights and other intangible assets (Lovell et al., 2010, p. 7; MacKenzie, 2009, p. 448).
The role model for most of the ETS introduced more recently is the US sulfur dioxide (SO2) trading scheme; a nation-wide scheme covering SO2 emissions from electric utilities, which was part of the 1990 Clean Air Act (Johnston et al., 2008, p. 748; Schmalensee & Stavins, 2017, pp. 575-576). The largest ETS worldwide, the EU ETS, started in 2005 and includes entities responsible for almost 50% of carbon dioxide (CO2) emissions and 40% of total greenhouse gas (GHG) emissions in the EU (Chapple, Clarkson, & Gold, 2013, p. 6; Lovell et al., 2010, p. 12). The EU ETS covers a variety of GHG. To make their emissions comparable, each ER is standardized to represent the climate change equivalent of one metric ton of CO2 emission (Bebbington & Larrinaga-Gonzalez, 2008, p. 703; Lovell et al., 2010, p. 8; MacKenzie, 2009, p. 447).
Neither the USA, nor Canada has a nation-wide CO2 or GHG ETS, but several states or provinces have introduced regional solutions (Kolk, Levy, & Pinkse, 2008, p. 723). Switzerland, Japan, South Korea, New Zealand, British Colombia, Alberta, Ontario, and Quebec have recently implemented ETS, while China, Kazakhstan, Mexico and the other Canadian provinces are in pilot phases. Australia terminated its ETS in 2014 (World Bank, 2017, pp. 27, 43-54).
The fundamental question of relevance needs to be asked because ER are instruments artificially designed by the regulator to force firms to internalize the formerly external costs of their emissions (Bebbington & Larrinaga-Gonzalez, 2008, p. 702; MacKenzie, 2009, p. 453). Even after the introduction of a market pricing mechanism like an ETS many firms typically receive sufficient ER allocated free of charge to offset all or almost all their emissions. For example, free allocations stayed on a level above 90% during the first two phases of the EU ETS (2005-07 & 2008-12) (Lovell et al., 2010, p. 12; Schmalensee & Stavins, 2017, p. 581). Companies affected by ER need to decide whether to account for them at all before determining particular approaches to use (Gallego-Alvarez, Martinez-Ferrero, & Cuadrado- Ballesteros, 2016, p. 3).
In the field of accounting the concept of materiality as a sub-concept of relevance is the deciding criterion for disclosing information (Lovell et al., 2013, p. 749; Ratnatunga, Jones, & Balachandran, 2011, p. 144; Warwick & Ng, 2012, p. 59).
A piece of information is deemed material and consequently needs to be disclosed according to the International Financial Reporting Standards (IFRS) framework (F), if its disclosure would most likely change the decisions users of the information would make (F.30). IFRS and International Accounting Standards (IAS) distinguish qualitative (particular relevance of the information for the respective firm or industry) and quantitative materiality (numerical threshold) (F.29-30). Beaver (1968) defines a piece of relevant information similarly as something that causes changes in investors' expectations and assessments (p. 69). If ER were immaterial to a firm, non-disclosure would be appropriate as every disclosure is related to costs for the preparer and the users of the information (Lovell et al., 2013, p. 750).
The lack of international guidance has led to the use of a variety of accounting treatments involving a very diverse level of disclosure with some companies reporting extensively and others not (Allini et al. 2018; Black, 2013; Lovell et al., 2010; Warwick & Ng, 2012). Critics of ER even go as far as to argue that in the light of the global importance of climate change itself, the question of accounting for ER becomes immaterial and that the focus should only be to find solutions for the underlying climate problem (e.g., Gibson, 1996, p. 664).
However, due to the increasing coverage of ER and ETS, the emission intensity of corporations is likely to give insights into the corporations’ exposure to future regulatory and competitive risk (Bebbington & Larrinaga-Gonzalez, 2008, p. 707; Haupt & Ismer, 2013, p. 81; Lovell et al., 2013, pp. 742, 753). Hence, market participants probably need financial as well as non-financial information about emissions in general and ER in specific for their decisions. Thus, qualitative materiality is likely to be given for ER and emissions covered by environmental regulations like ETS (Bebbington & Larrinaga-Gonzalez, 2008, p. 705; Lovell et al., 2013, pp. 753-754).
To quantify the relevance of ER to firms, table 1 taken from Lovell et al. (2013) shows the ER consumed as a percentage of profit or loss before tax for a sample of European firms (p. 750). A quantitative assessment of materiality is difficult due to a lack of clarity regarding which accounting number (e.g., total assets vs. operating income) to base the percentage value on. Nevertheless, the researchers conclude that the high values in this sample indicate quantitative materiality of ER at least for some European firms. Table 1 might also help to quantify the risks companies face under ETS with prices expected to rise in the EU ETS, high price volatility and caps declining both in the EU and the US (Ellerman, Marcantonini, & Zaklan, 2016, pp. 98-99, 105; Schmalensee & Stavins, 2017, pp. 575, 581; World Bank, 2017, p. 34).
Abbildung in dieser Leseprobe nicht enthalten
Table 1: Consumption of ER as a percentage of profit before tax (2008), based on Lovell et al. (2013).
Both financial and non-financial accounting information about emissions and more specifically about ER is regarded as necessary by the academic literature (e.g., Ascui & Lovell, 2011, p. 979; Bebbington & Larrinaga-Gonzalez, 2008, p. 705). Financial accounting deals with the implications of ER for the balance sheet, the income statement and the overall accounts of the firm (Stechemesser & Guenther, 2012, p. 18). Non-financial disclosure can contain information on a range of topics, e.g., on total emission levels, strategies, abatement programs, the ER the organizations receive and their use for compliance and trading. It is less formal and even less standardized than financial accounting for ER because it occurs on a mostly voluntary basis (Kolk et al., 2008, p. 725; Larrinaga et al., 2002, p. 724). Nonetheless, some degree of institutionalization has taken place with the most influential voluntary disclosure institution being the Carbon Disclosure Project (CDP). It views non-financial reporting as an indispensable part of financial accounting (Kolk et al., 2008, p. 726). Similarly, Lovell & MacKenzie (2009) identify a “grey area” (i.e., an overlap) between the financial and the non-financial part of accounting for emissions (p. 705).
Due to the argumentation of the scholars highlighting the importance of both financial and non-financial accounting, this thesis includes sections on both of these topics regarding ER.
No existing financial accounting standard issued by the IASB or the FASB explicitly covers ER (Lovell et al., 2013, p. 745). Therefore, the following section explains possible financial accounting treatments for ER to partially answer the first component of the research question: How do firms account for ER? In the USA, the US FERC approach is used nationwide irrespective of the type of emissions (SO2 or others) to be accounted for (Lovell et al., 2010, p. 16). In the EU, all listed companies must apply the endorsed IFRS for the preparation of their consolidated financial reports. For accounting issues not covered by any standard, IAS 8.10 refers to management's judgment to find an accounting practice that results in relevant and reliable information (Lovell et al., 2010, p. 14; Warwick & Ng, 2012, p. 57). It bears mentioning that many local standard setters like the Institut der Wirtschaftsprufer (IDW) in Germany or equivalent institutions in Austria, France, Italy, Spain and the Netherlands have issued guidelines for firms in their respective jurisdictions. However, empirical evidence shows that even without IFRS regulations in place, compliance with these local guidelines is low (Allini et al., 2018, pp. 2199-2200, 2203-2204). Hence, the following analysis of financial accounting practices is based on IFRS and the FERC approach even though for smaller, non-capital market-oriented EU firms the application of national accounting standards would be possible.
ER as assets
The debate about ER as assets is strongly related to the different ways for firms to acquire them. There is a large consensus that purchased ER are assets, however, since they are indistinguishable from allocated ER in their characteristics, many papers propose to include both allocated and purchased ER as assets in the balance sheet (e.g. Allini et al., 2018, p. 2204; Haupt & Ismer, 2013, p. 84; MacKenzie, 2009, p. 450). IFRIC 3 also went into this direction, probably because whether a good has a cost or not is no asset identification criterion in the IFRS framework (Cook, 2009, p. 460). ER are resources the firms control due to either free allocation or purchase and the firms can benefit from them either by using them for compliance or by selling them on the market (Cook, 2009, pp. 459-460; Haupt & Ismer, 2013, p. 76). All ER consequently fall under the IFRS framework definition of an asset.
With regard to the classification of ER, different solutions were introduced. IFRIC 3 classifies ER as intangible assets (Cook, 2009, p. 461). In the academic literature some view them as financial instruments (e.g. Allini et al., 2018, p. 2204; Giner, 2014, pp. 49-50) or as inventory (e.g. Karai & Barany, 2013, p. 194). While the initial recognition of purchased ER is uncon- troversial and should be conducted at cost, allocated ER could be recognized either at cost (which would be equal to zero) or at fair value (FV) (Haupt & Ismer, 2013, p. 76). The FV approach has the advantage of both purchased and allocated ER being treated the same way, since it is assumed that the purchase price does not differ materially from the FV at that point in time (Haupt & Ismer, 2013, p. 77; IASB, 2014, p. 7). If allocated ER are initially measured at FV, the problem of the corresponding credit-side entry emerges. Firms can either recognize an immediate income, a government grant (GG) or a liability. Part of the literature and IFRIC 3 favor the GG option (e.g. Cook, 2009, p. 461; Haupt & Ismer, 2013, pp. 85-86). A government grant is a type of deferred income that can be measured at nominal value or FV (IAS 20.23). As demanded in IAS 20.12 it is realized systematically as income, in this case with the emissions. Thereby, it neutralizes the expenses recognized when the liability is accrued (Black, 2013, p. 226; Haupt & Ismer, 2013, pp. 85, 87).
The decision about the subsequent measurement does not depend on the approach selected for the initial measurement, but on the decision about the asset classification of the ER. For intangible assets, IAS 38.72 provides the options of the cost model and the revaluation model with revaluation through equity. The papers suggesting the classification of ER as financial instruments propose them to be carried at FV with revaluations through the income statement (Allini et al., 2018, p. 2204; Giner, 2014, pp. 49-50). Under inventory classification, ER would be subsequently measured according to IAS 2.9 at the lower between cost and net realizable value at the balance sheet date. Additionally, depending on the asset classification, the firms need to conduct regular impairment tests, and intangible assets are generally amortized (Cook, 2009, p. 225).
In the literature, another approach has been recommended, which distinguishes ER according to their intended use. The initial measurement would be conducted uniformly based on FV.
Subsequently, ER held for trading purposes would be re-measured to FV through profit and loss (P&L) while ER held for compliance under ETS would be measured outside P&L, potentially using a hedge accounting construct (Haupt & Ismer, 2013, pp. 90, 93-94; Karai & Barany, 2013, p. 194).
Firms under ETS need to offset all their emissions with the corresponding number of ER at the end of the compliance period. Therefore, the emissions by the company are regarded as an obligating event resulting in the accrual of a liability (Cook, 2009, p. 461). Opposed to this view, the argument was raised that not the emissions, but the allocation of ER at the beginning of the period was the obligating event. This argument builds on the assumption that the companies would use the allocated ER to deliver them back to the authorities, which is not necessarily the case (Cook, 2009, p. 461). Due to the fact that legally the obligation only builds up with the actual emissions, the accrual option gradually recognizing the liability is favored both by IFRIC 3 and academic papers (e.g., Giner, 2014, p. 46; Haupt & Ismer, 2013, p. 79). There are two options for the measurement of the liability. On the one hand, it can be measured independently from the ER held at the FV of the ER that would be necessary to settle the obligation at the balance sheet date. On the other hand, firms could connect the measurement of the liability to the ER already held, following a cost of settlement approach and valuing any shortfall in ER at FV (Haupt & Ismer, 2013, p. 79; Karai & Barany, 2013, p. 185). The cost of settlement approach together with the valuation of granted ER at cost (zero) allows companies to offset at least part of the liability with the granted ER and only disclose a net liability when emissions exceed free allocations (Allini et al., 2018, p. 2204; Haupt & Ismer, 2013, p. 79; MacKenzie, 2009, p. 449).
FERC and IFRIC 3 approaches
Both the FERC and the IFRIC 3 approaches are not mandatory for most firms affected by ER, but they may be used directly or for orientation purposes (Allini et al., 2018, p. 2196; Haupt 6 Ismer, 2013, p. 75; Lovell et al., 2010, pp. 23, 25, 28). The FERC approach was intended to regulate the electric utilities covered by the US SO2 ETS. Under this approach, ER have to be valued at cost and need to be carried in two different accounts based on their intended use (compliance: “Allowance inventory” vs. trading: “Other investments”) (Wambsganss & Sanford, 1996, p. 645). The liability is measured based on the ER held (cost of settlement).
 Cf. Regulation (EC) 1126/2008, OJ L 320, 29.11.2008, p. 1.
 F.49 defines an asset as “a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”.
 FV is defined in IFRS 13.9 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
 According to the cost model as defined in IAS 38.74, “an intangible asset shall be carried at its cost less any accumulated amortization and any accumulated impairment losses”.
 Following IAS 38.75, “an intangible asset shall be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent amortization and any subsequent accumulated impairment losses”. ETS provide for an active market, therefore the revaluation model may be applied (Haupt & Ismer, 2013, p. 78).
 IAS 2.7 defines net realizable value as “the net amount that an entity expects to realise from the sale of inventory in the orderly course of business”.
 “Hedge accounting recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item” (IAS 39.85).
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