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  Accounting and Reporting Considerations for Environmental Credits (October 7, 2022)
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  Accounting Spotlight
  Accounting and Reporting Considerations for Environmental Credits (October 7, 2022)
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  Accounting Spotlight
  October 7, 2022
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  Accounting and Reporting Considerations for Environmental Credits
  Background
  An increasing number of entities in different sectors and industries aim to reduce global greenhouse-gas (GHG) emissions. While many are taking steps to reduce their own carbon emissions, these efforts may not be sufficient to achieve required or voluntary emission commitments.
  Environmental credits can help entities accomplish their carbon emission reduction targets and goals. The popularity of such credits has grown; however, questions have emerged regarding the accounting and reporting for them since the treatment of environmental credits is not explicitly addressed in U.S. GAAP. The FASB therefore added to its agenda a project (see discussion below) on this topic in May 2022. The SEC also included disclosure requirements related to environmental credits in its March 2022 proposed rule (see discussion below) on climate-related disclosures.
  This Accounting Spotlight examines environmental credits and certain current U.S. accounting practices, regulatory developments, and other accounting issues associated with them.
  What Are Environmental Credits?
  Within this publication, the term “environmental credits” encompasses products such as carbon credits (both allowances and offsets) as well as renewable energy certificates (RECs) and other climate- or emission-related credits.
  In the most basic sense, 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. Carbon credits are primarily distinguished on the basis of whether they are allowances or offsets.
  Allowances (also known as “permits”) are initially issued by regulatory agencies in carbon compliance programs (e.g., cap-and-trade programs or emissions trading schemes). One allowance gives the holder the legal right to emit one MTCO2e. Typically, a carbon compliance program establishes a total volume of emissions permitted by all of its regulated entities in a given year and a corresponding volume of allowances. Regulating agencies then allocate (free of charge) or auction off allowances to the regulated entities. If an entity wishes to emit more or less MTCO2e, it can purchase allowances from, or sell them to, other entities. These allowances are often also referred to as “carbon credits” since each allowance represents a tradeable MTCO2e.
  Offsets are generated from projects in which the objective is to produce and sell verified carbon credits for every MTCO2e reduced, avoided, or removed from the atmosphere by the projects. Carbon credits from these projects are ultimately used by the final entity that purchases and retires the credits to “offset” its emissions, so they are often called “carbon offsets.” “Voluntary carbon offsets” are used to help meet an entity’s voluntary emissions reduction targets to compensate for emissions that it has not yet been able to abate.
  In addition to carbon credits, numerous other “credits” exist. One of the more common examples is a REC, which is issued when one megawatt-hour (MWh) of electricity is generated and delivered to the electricity grid from a renewable energy resource. See further discussion of RECs in the next section.
  The Role of Environmental Credits
  Along with investing in carbon abatement projects that directly reduce their emissions (e.g., energy efficiency upgrades, electric vehicle fleets), entities are showing increased interest in purchasing carbon credits generated by projects outside their operations and value chain to offset their unabated emissions. Such projects may involve renewable energy initiatives in developing countries, improved forest management and reforestation, lower-carbon agriculture or grazing practices, direct air capture and sequestration, and many other efforts.
  RECs can also play an important role for entities seeking to reduce their carbon footprint. Owners of renewable energy sources may be entitled to receive RECs. The number of RECs awarded is typically linked to a power production formula. By purchasing RECs, buyers help finance and promote renewable energy generation and, in return, are allowed to use the RECs to report lower scope 21 emissions from purchased electricity.
  Acquiring Environmental Credits — Trending Transactions
  While there are many ways entities can obtain environmental credits, three of the more common methods are discussed below.
  Voluntary Markets
  The global voluntary carbon market is growing rapidly to enable the generation, acquisition, trade, and tracking of environmental credits. These markets (1) predominantly operate for environmental credits that have been certified by leading standards such as the Verified Carbon Standard (“Verra”) and (2) act as a mechanism through which entities can actively trade and convert their environmental credits to cash.
  Key types of participants in these ecosystems include:
  Regulatory agencies or nonprofit or for-profit organizations that set certification standards and methods as well as manage the registries to track environmental credit generation, ownership, and credit status (active or retired). The top voluntary standards and registries include Verra, the Climate Action Reserve, the American Carbon Registry, and Gold Standard.
  Project owners and developers that secure or provide financing, or implement and generate environmental credits, for initial sale. There is a growing number of very large project development firms.
  Buyers and sellers of environmental credits, which could include entities that need such credits to meet their emissions reduction goals, clean energy or fuel requirements, or mandated emissions limits. Note that a buyer of environmental credits can have various intended uses for its environmental credits. For example, an entity may plan to:
  Hold environmental credits and remit or retire them to the relevant agency.
  Immediately retire the credits to the relevant agency.
  Trade its environmental credits.
  Further, it is possible for the entity’s intended uses to change during the period over which it holds them.
  A complex web of brokers and marketplace platforms to match buyers and sellers or arrange spot trades, financing, or offtake agreements.
  An emerging array of fund managers and financial intermediaries that are creating investment vehicles or secondary markets for environmental credits.
  PPAs and VPPAs
  A power purchase agreement (PPA) is a contract between two parties: the developer of a renewable energy project and a buyer. Under a PPA, the developer will typically receive a fixed price for each MWh of renewable energy produced and the buyer will receive the associated RECs over time as the project produces and sells electricity. The recipient of the RECs (the buyer) will be able to use them to reduce its gross scope 2 emissions from purchased electricity. In a PPA contract, physical energy must also be delivered to the buyer.
  By contrast, in a virtual PPA (VPPA), the buyer does not take physical delivery of the power produced by the renewable energy source; instead, the power component of the transaction is financially settled while the buyer receives all, or a predetermined amount, of the generated RECs for each year of the contract term for an agreed-upon price.
  Directly From the Regulator
  A regulator issues several categories of environmental credits, including RECs. Cap-and-trade programs may also be established in which, for example, (1) total annual GHG emissions from regulated entities in the program are capped and (2) the cap (i.e., emissions limit) is reduced over time. Each year, a volume of allowances or permits equivalent to that year’s cap are auctioned or allocated (for free) to the regulated entities. As noted previously, each allowance gives its owner the right to emit one MTCO2e. The entity can then trade allowances until it has the volume needed to match its emissions for the year.
  Accounting Practices Under Existing GAAP
  As previously noted, the treatment of environmental credits is not explicitly addressed in U.S. GAAP; consequently, entities have used different approaches, and questions have emerged about how to account and report for them. In the sections below, we describe certain approaches that exist today in practice as well as observations regarding such approaches. Note that entities should carefully consider all relevant facts and circumstances when selecting an appropriate accounting model to use. They should then apply such model consistently and, if material, disclose their selection.
  Environmental Credits as Assets
  When accounting for environmental credits, entities should determine whether such credits represent assets.
  Chapter 4 of FASB Concepts Statement 82 defines an asset, in part, as “a present right of an entity to an economic benefit.” It also describes an economic benefit as “the capacity to provide services or benefits to the entities that use them” and notes that “[g]enerally, in a business entity, that economic benefit eventually results in potential net cash inflows to the entity. . . . The relationship between the economic benefit of an entity’s assets and net cash inflows to that entity can be indirect.” Typically, an entity’s ability to sell, transfer, or exchange an environmental credit provides evidence that the right to do so presently exists, the entity controls access to that right, and the right applies to an economic benefit.
  Connecting the Dots
  Entities must consider all relevant facts and circumstances when assessing whether their acquired or created environmental credits meet the definition of an asset. For instance, we believe that enhanced marketing, public claims regarding environmental activities, and the potential reduction of the entity’s net emissions do not, by themselves, represent an economic benefit as described in Chapter 4 of Concepts Statement 8; therefore, costs incurred solely from obtaining these benefits would not qualify as assets.
  Although still relatively new, environmental credit markets are continuing to grow regionally, nationally, and internationally. We do not believe that to qualify as an asset, an environmental credit necessarily needs to be actively traded on an exchange. However, we believe that the ability to place the environmental credit on an exchange where it can be bought and sold, resulting in net cash inflows, supports a conclusion that such credit meets the definition of an asset.
  Entities will need to carefully evaluate the nature of costs incurred in connection with environmental objectives to determine whether such costs meet the GAAP requirements to be capitalized and recorded as an asset.
  Classification as Either Inventory or an Intangible Asset
  The methods used in practice for accounting for environmental credits stem predominately from the accounting for emissions allowances. In informal and industry-related discussions that took place a number of years ago, the FASB and SEC have indicated that two methods of accounting for emission allowances are acceptable: (1) an inventory model by analogy to ASC 3303 and (2) an intangible asset model by analogy to ASC 350.
  An entity’s use of an accounting model will also vary on the basis of its role within the market.
  Connecting the Dots
  In practice, entities generally select an accounting model on the basis of the intended use for the environmental credits. For instance, when an entity plans to actively trade its environmental credits, it often accounts for them under an inventory model. Entities need to consider the facts and circumstances of the underlying arrangements and their business objectives related to environmental credits to determine which accounting model is more appropriate to apply.
  Entities also need to consider the treatment of such credits in the income statement and statement of cash flows. For example, we would generally expect that environmental credits accounted for as inventory would be expensed as a cost of goods sold when “used” or traded. Further, under an inventory model, we would usually expect the activity related to environmental credits to be reflected as cash flows from operations within the statement of cash flows.
  Amortization Under an Intangible Asset Model
  While entities that participate in compliance and voluntary programs may use an intangible asset model to account for environmental credits, some may not strictly apply the recognition and measurement guidance under that model. For instance, entities that use an intangible asset model may or may not record subsequent amortization for the environmental credits.
  Connecting the Dots
  Environmental credits can be finite-lived (e.g., RECs typically have a useful life of 18 months) or infinite-lived (e.g., carbon offsets have a “vintage year” that represents the year in which the emissions were offset; however, they do not have an expiration date). Strictly speaking, under an intangible asset model, an amortization expense is required for finite-lived assets. However, some have observed that environmental credits are nonwasting assets. That is, if an environmental credit represents the removal of one MTCO2e, regardless of the credit’s age or market value, an entity can use it to offset one MTCO2e to satisfy voluntary or compliance goals. Accordingly, entities will need to evaluate whether amortization of certain environmental credits is appropriate and, if so, the amortization method to use.
  Note that we have observed that a number of entities do not record amortization for finite-lived environmental credits. We believe that such an approach is acceptable in certain circumstances.
  Impairment Considerations
  While some entities may subject environmental credits to the appropriate impairment or lower-of-cost-or-market evaluation, others may believe that an evaluation of impairment is not necessary. Entities in the latter group may believe that their approach is justified because the intended benefits of the environmental credits do not diminish until the credits are consumed (e.g., used to offset emissions). Therefore, these entities may believe that it is appropriate to expense the full cost of their environmental credits upon use (e.g., retirement with the relevant regulatory agency or registry).
  Connecting the Dots
  We believe that under both the inventory and intangible asset models, entities should subject environmental credits to the applicable impairment method. The recognition of impairment adjustments under these models is intended to reflect changes in the utility and expected recoverability of the underlying asset.
  In a manner similar to the concerns about amortization, some may believe that there are challenges associated with implementing an impairment model. These challenges stem from an entity’s intended use for environmental credits and the credits’ “nonwasting” characteristic. For example, if an entity intends to retire its environmental credits, some may argue that impairment write-downs may not appropriately reflect the utility of the asset because, regardless of market value declines, an environmental credit can be used to offset one MTCO2e. However, as previously noted, an entity’s intent related to its environmental credits may change over time.
  The decision to record an asset for an environmental credit is, as discussed above, based on the guidance in Chapter 4 of Concepts Statement 8 and specifically on the potential for generating net cash inflows. Entities should consider projected cash inflows, market values, and other factors, as applicable, when determining an appropriate impairment method.
  Timing of Expense
  Some entities immediately retire environmental credits upon purchase and therefore do not record such credits as assets. Other entities may announce their intention to use or offset their environmental credits for sustainability reporting purposes but not formally retire them, giving rise to questions regarding the appropriate time at which they should expense assets recorded for environmental credits.
  Connecting the Dots
  Generally, an entity derecognizes an environmental credit once that credit is officially retired with the applicable agency or registry and used to offset the entity’s current emissions to demonstrate compliance with mandatory or internally set goals.
  Although an entity may publicly announce its intention to use an environmental credit, the credit is not considered officially “retired” until a request is submitted to the applicable agency or registry and subsequently removed from it. Further, since an entity’s intent related to its environmental credits can change over time, until an environmental credit is irrevocably retired, it still represents a legal right that can be transferred.
  We believe that the guidance in ASC 606 that describes the circumstances in which an asset has been transferred may be helpful in an entity’s evaluation of when to derecognize an environmental credit.
  Liabilities for Environmental Credits
  Some entities participating in a compliance program only record a liability associated with their emissions if the actual emissions for a given period exceed the environmental credits an entity holds (i.e., an entity would need to acquire more environmental credits to satisfy its obligation). However, some compliance program participants may use a model in which a liability is recorded on the basis of an entity’s total emissions. Under such a model, the “gross” liability associated with an entity’s carbon emissions is based on the cost of acquiring the required allowances and an asset is recorded for the environmental credits held by the entity on the basis of the acquisition cost of any allowances purchased.
  Producers of Environmental Credits
  Generally, in a manner similar to that of a user, a producer applies either the inventory or intangible asset model when accounting for environmental credits; however, there is diversity in practice. In some circumstances, environmental credits can be an output from a producer’s operations to generate clean energy or produce sustainable goods. Producers that elect to account for environmental credits under an inventory model sometimes allocate a portion of production costs to the environmental credits. Other producers conclude that no incremental costs are incurred for generating these environmental credits; thus, no costs are allocated to the environmental credits. Producers that elect to account for environmental credits under an intangible asset model generally expense all associated production costs as incurred because they consider the environmental credits to be internally developed intangible assets.
  Connecting the Dots
  Entities need to consider the accounting model selected for environmental credits, the nature of costs incurred related to the creation of environmental credits, and their specific facts and circumstances in determining which, if any, costs to allocate and capitalize.
  FASB Project on Environmental Credits
  While the FASB has considered addressing the accounting for environmental credits on several occasions beginning in 2003, it has yet to finalize a project on this topic.
  In June 2021, the Board issued an invitation to comment (ITC) to seek broad stakeholder feedback on its future standard-setting agenda, particularly pertaining to emerging areas of financial reporting. In the ITC, the FASB specifically requested input on the accounting requirements for transactions related to environmental, social, and governance (ESG)-related matters and whether they were unclear or needed improvement. Respondents commented on the accounting for environmental credits and highlighted concerns related to the lack of specific authoritative guidance on the accounting and disclosure requirements for environmental credit programs. Overall, the responding stakeholders expressed concerns about the expanded use of environmental credits under both compliance and voluntary programs and highlighted that increased clarity related to the appropriate accounting for environmental credits should be prioritized to prevent further diversity in practice, particularly as the focus on ESG-related matters increases.
  In addition to issuing the ITC, the Board performed outreach to better understand how various entities currently account for environmental credits. Through this outreach, the Board observed significant diversity in practice among users and producers of environmental credits as well among entities operating in voluntary and compliance programs.
  In response to stakeholder feedback on the ITC and the results of its outreach, the FASB decided in May 2022 to add a project to its technical agenda to address the recognition, measurement, presentation, and disclosure of environmental credits that are legally enforceable and tradable. The project is also expected to address the accounting for users and producers of environmental credits and participants operating in compliance and voluntary programs. Board members noted that financial statement consistency will benefit users and that activity within the environmental credit market will only continue to increase, making this an opportune time for standard setting.
  The FASB staff expressed a desire to explore other potential models that would be more representative of the unique nature of environmental credits and the underlying economics of transactions involving them. Such models could include fair value accounting or the creation of a new accounting model that may reside outside of existing GAAP.
  SEC’s Proposed Rule on Climate-Related Disclosures
  In March 2022, the SEC issued a proposed rule that would require registrants to disclose in their annual audited financial statements certain climate-related financial impacts and expenditure metrics as well as a discussion of such impacts on their financial estimates and assumptions. Further, registrants would have to disclose scope 1 and scope 2 GHG emissions irrespective of the impact of offsets; their climate risk management processes, targets, and goals; and their governance and oversight of climate-related risks. Registrants (other than smaller reporting companies) would also need to disclose scope 3 GHG emissions if (1) they are material or (2) the registrants have established a reduction target or goal that includes scope 3 GHG emissions.
  Entities that use environmental credits, particularly carbon offsets or RECs, in their plan to achieve climate-related goals or targets would have to disclose information about such use. In the proposed rule, the SEC defines a carbon offset as “an emissions reduction or removal of greenhouse gases in a manner calculated and traced for the purpose of offsetting an entity’s GHG emissions.”
  Registrants would also be required to disclose how much of their progress toward climate targets or goals has been attributable to these environmental credits. The disclosures would reflect the short-term and long-term risks associated with such progress, including the risks that the availability or value of carbon offsets or RECs could be curtailed by regulations or changes in the market. See Deloitte’s March 29, 2022, Heads Up for a comprehensive discussion of the SEC’s proposed rule.
  Contacts
  If you have questions about the accounting and reporting requirements for environmental credits, please contact any of the following Deloitte professionals:
  Eric Knachel
  Partner
  Deloitte & Touche LLP
  +1 203 761 3625
  eknachel@deloitte.com
  Katherine Donzella
  Manager
  Deloitte & Touche LLP
  +1 773 364 0279
  kdonzella@deloitte.com
  Zachary Poncik
  Senior Manager
  Deloitte & Touche LLP
  +1 713 982 4104
  zponcik@deloitte.com
  Footnotes
  1
  See the EPA’s Web site for a discussion of scope 1, 2, and 3 inventory guidance.
  2
  Chapter 4, Elements of Financial Statements, of FASB Concepts Statement No. 8, Conceptual Framework for Financial Reporting.
  3
  For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”
  The Spotlight series is prepared by members of Deloitte’s National Office. New issues in the series are released as developments warrant. This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.
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