Companies across the globe are working on plans to reduce their carbon emissions. The popularity of environmental credits has grown as a way for companies to meet their emission reduction targets.

“Many companies are already using or plan to use environmental credits as part of their overall strategy to achieve sustainability goals,” said Eric Knachel, senior consultation partner at Deloitte & Touche. “A lot of companies that set voluntary targets for carbon emission reduction may be realizing that relying on more efficient equipment or new technologies may not be sufficient to achieve their goals.”

The basics

Environmental credits include carbon allowances and offsets, renewable energy certificates (RECs), and other credits related to climate and emissions. These arrangements and the definitions of the related credits are complex but fundamental to companies developing strategies and seeking to understand the accounting and disclosure implications.

The following are extracts from definitions provided by Deloitte in an October 2022 accounting spotlight:

  • A carbon credit is a “market-based or legal instrument that represents the ownership of one metric ton of carbon dioxide equivalent (MTCO2e) that can be held, sold, or retired to meet a mandatory emissions cap or a voluntary emissions reduction target.”
  • An REC is issued “when one megawatt hour (MWh) of electricity is generated and delivered in the electricity grid from a renewable energy resource. … Owners of renewable energy sources may be entitled to receive RECs. … By purchasing RECs, buyers … are allowed to use the RECs to report lower Scope 2 emissions from purchased electricity.”
  • An allowance is “initially issued by regulatory agencies in carbon compliance programs … (and) gives the holder the legal right to emit one MTCO2e. … [A] carbon compliance program establishes a total volume of emissions permitted by all of its regulated entities in a year and a corresponding volume of allowances. Regulating agencies allocate … or auction off allowances to regulated entities. If an entity wishes to emit more or less MTCO2e, it can purchase allowances from, or sell them to, other entities …until it has the volume needed to match its emissions for the year. … [E]ach allowance represents a tradeable MTCO2e.”
  • An offset is “generated from projects in which the objective is to produce and sell verified carbon credits. … Carbon credits from these projects are ultimately used by the final entity that purchases and retires the credits to ‘offset’ its emissions.”

Accounting and financial reporting challenges

The accounting treatment for environmental credits is not specifically addressed in U.S. generally accepted accounting principles (GAAP) today.

“For example, are environmental credits assets and, if so, how should they be classified?” Knachel asked. “Should environmental credits be subject to impairment testing, and when should entities record expenses related to their use of credits to offset their carbon emissions?”

Knachel noted without specific accounting guidance companies must clearly understand their business strategy as it relates to environmental credits and then evaluate the current accounting model that is most appropriate.

“There isn’t necessarily a ‘one-size-fits-all’ model,” he said.

In practice, environmental credits might be accounted for as assets, if they meet the GAAP definition of an asset’s providing an economic benefit that eventually results in potential net cash inflows. There are issues related to whether there is economic benefit from the credits and the ability to obtain cash flows from new environmental credit markets. In addition, there are considerations of when to derecognize a credit, based on its use or retirement.

“Many companies are already using or plan to use environmental credits as part of their overall strategy to achieve sustainability goals. A lot of companies that set voluntary targets for carbon emission reduction may be realizing that relying on more efficient equipment or new technologies may not be sufficient to achieve their goals.”

Eric Knachel, Senior Consultation Partner, Deloitte & Touche

Other methods for accounting for environmental credits are use of an inventory model, if the company plans to trade the credits, or an intangible asset model, with considerations of whether and over what period to amortize and how to assess impairment. The choice of asset model will determine how the related expenses are treated on the income statement and cash flow statement. An alternative is to expense environmental credits when they are purchased.

Producers of environmental credits might also apply either an inventory or intangible model in practice, which affects how they account for the production costs incurred in generating the credits. Environmental credits can be part of revenue arrangements, subject to Accounting Standards Codification Topic 606, if the vendor has separate performance obligations related to transferring credits or providing related services, like retiring carbon credits.

There are also potential liabilities to be recorded related to emissions. In practice, some companies record a liability if their actual emissions exceed their environmental credits, while others record a gross liability based on total emissions and the cost to acquire required allowances. There could also be consideration of whether there are financial instruments, including derivatives, to be accounted for based on the nature of the arrangement.

The accounting models applied will have direct implications on the related financial statement disclosure requirements. In addition, there are extensive disclosures required about accounting estimates and assumptions, risks, commitments, and contingencies under existing GAAP in general that will have to be applied to the area of environmental credits.

Beyond financial statements, companies will need to consider how they discuss their overall strategies and progress in reducing emissions and the use of these credits in their Securities and Exchange Commission (SEC) filings, other public statements, and corporate communications.

Regulatory agendas

Because of diversity in accounting practice and the increased use of environmental credits, the topic is on regulators’ radar. Changes are likely to come soon.

“It’s important for companies to think through the accounting and financial reporting implications, including potential disclosure requirements,” Knachel said.

The Financial Accounting Standards Board (FASB) added a project to its technical agenda in May on the recognition, measurement, presentation, and disclosure requirements for participants in compliance and voluntary programs that result in the creation of environmental credits. The preliminary scope of the project is environmental credits that are legally enforceable and can be traded.

The project intends to address the lack of consistency in accounting practice. Credits include both regulatory (e.g., RECs) that track compliance and voluntary (e.g., carbon offsets) categories. FASB is continuing its deliberations; no timetable for an exposure draft has been announced.

The SEC’s proposed rule to require climate-related disclosures includes the use of environmental credits and how these credits have contributed to the company’s progress in meeting climate targets. In addition, there are proposed disclosures about related risks in using the credits and in their availability.

The timing of this rulemaking is not known, but the SEC is evaluating feedback from approximately 15,000 public comments before adopting the rule. The agency is reportedly considering scaling back certain aspects of the proposal in response to significant opposition.

Maria L. Murphy, CPA, is a regular contributor to Compliance Week's accounting & auditing coverage. She is a senior content management analyst, accounting and auditing products, CCH tax and accounting North America for Wolters Kluwer and a freelance writer and editor.

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