Guidance Note on Accounting for Self- generated Certified Emission eductions (CERs) (Issued 2012.)

(The following is the text of the Guidance Note on Accounting for Self- generated Certified Emission Reductions (CERs), issued by the Council of the Institute of Chartered Accountants of India.)

Introduction

1. One challenge facing the human race is that of global warming. To address the issue of global warming, the United Nations Framework Convention on Climate Change (UNFCCC) was adopted in 1992, with the objective of limiting the concentration of Green House Gases (GHGs1) in the atmosphere. Subsequently, to supplement the Convention, the Kyoto Protocol came into force in February 2005, which sets limits to the maximum amount of emission of GHGs by countries. The Kyoto Protocol at present commits 41 developed countries (known as Annex I countries) to reduce their GHG emissions by at least 5% below their 1990 baseline emission by the commitment period of 2008-2012. As per the Kyoto Protocol, at present, developing and least-developed countries are not bound by the amount of

GHG emissions that they can release in the atmosphere, though they too generate GHG emissions.

2. Under the Kyoto Protocol, countries with binding emission reduction targets (which at present are applicable to developed countries) in order to meet the assigned reduction targets are issued allowances (carbon credits) equal to the amount of emissions allowed. An allowance (carbon credit) represents an allowance to emit one metric tonne of carbon dioxide equivalent. To meet the emission reduction targets, binding countries in turn set limits on the GHG emissions by their local businesses and entities. Further, in order to enable the developed countries to meet their emission reduction targets, Kyoto Protocol provides three market-based mechanisms –

1 GHGs refer to polluting gases including carbon dioxide which cause global warming.

Joint Implementation (JI), Clean Development Mechanism (CDM), and

International Emission Trading (IET).

3. Under JI, a developed country with a relatively high cost of domestic

GHG reduction can set up a project in another developed country that has a

relatively low cost and earn carbon credits that may be applied to their

emission targets. Under CDM, a developed country can take up a GHG

reduction project activity in a developing country where the cost of GHG

reduction is usually much lower and the developed country would be given

carbon credits for meeting its emission reduction targets. Examples of

projects include reforestation schemes and investment in clean technologies.

In case of CDM, entities in developing/least developed countries can set up a

GHG reduction project, get it approved by UNFCCC and earn carbon credits.

Such carbon credits generated can be bought by entities of developed

countries with emission reduction targets. The unit associated with CDM is

Certified Emission Reduction (CER) where one CER is equal to one metric

tonne of carbon dioxide equivalent. Under IET, developed countries with

emission reduction targets can simply trade in the international carbon credit

market. This implies that entities of developed countries exceeding their

emission limits can buy carbon credits from those whose actual emissions

are below their set limits. Carbon credits can be exchanged between

businesses/entities or bought and sold in international market at the

prevailing market price.

4. These mechanisms serve the objective of both the developed

countries with emission reduction targets, who are the buyers of carbon

credits as well as of the developing and least developed countries with no

emission targets (at present), who are the sellers/suppliers of carbon credits.

The non-polluting companies from less developed countries can sell the

quantity of carbon dioxide emissions they have reduced (carbon credits) and

earn extra money in the process. This mechanism of buying and selling

carbon credits is known as carbon trading.

Clean Development Mechanism and CERs

5. The Clean Development Mechanism is a flexible mechanism to enable

countries with GHG emission reduction commitments, i.e., Annex I countries

to meet their commitments by paying for GHG emission reductions in

developing countries (non- Annex I countries). Such CDM projects earn

saleable Certified Emission Reduction (CER) units, each equal to one metric

tonne of carbon dioxide equivalent, which can be counted towards meeting

Kyoto targets (given in Annexure B of Kyoto Protocol). This mechanism

encourages the non-Annex I countries, i.e., developing and least developed

countries which at present are not bound by Kyoto Protocol to reduce GHG

emissions. India, being a non-Annex I country, has emerged to be a

beneficiary as Indian entities can set up CDM projects which reduce GHG

emissions and thereby generate CERs which can be sold to Annex I

countries and used by the latter to meet their binding emission reductions.

6. To be eligible for CDM benefits, the proposed project must have the

feature of additionality, i.e., the CDM project must provide reductions in

emissions that are additional to that would occur in the absence of the

project. For example, an entity can generate CERs under CDM, if it installs a

waste heat boiler that saves energy. This is because reduced fuel use

reduces the amount of carbon dioxide emitted. However, if an entity has to

undertake the project activity because of law, for example, if the industry is

legally mandated to have a waste-heat recovery boiler, such a project is

generally not eligible for CDM benefits.

7. An entity desirous of undertaking a CDM project activity, generate

carbon credits there from, and earn revenue needs to go through several

stages. These are described below:

(i) Registration/Accreditation of the project

As a first step, an entity desirous of setting up a CDM project

needs to get the project registered with the CDM Executive

Board of the UNFCCC. To do so, it needs to develop a Project

Design Document (PDD) which contains the description of the

proposed CDM project. The entity also needs an approval from

the Designated National Authority (DNA) which is an office,

ministry or other official entity appointed by a Party to the Kyoto

Protocol to review and give national approval to projects

proposed under the CDM. India’s DNA is the National CDM

Authority (NCDMA). Once approved by the DNA, the proposed

project is required to be validated by a Designated Operational

Entity (DOE). A DOE is a company/organisation accredited by

the CDM Executive Board that checks whether the project

meets the CDM criteria. The DOE checks the PDD and hosts

the same on UNFCCC’s website for public comments for a

period of 30 days. Upon the expiry of this period, the DOE

makes a determination as to whether on the basis of the

information provided and taking into consideration the

comments received, the project should be validated. Once

satisfied, the DOE submits the validation report and all the other

necessary documents to the CDM Executive Board along with

the request for project registration, and all these documents are

hosted on UNFCCC’s website. If within 8 weeks no request for

review of the proposed CDM project is received by UNFCCC,

the project is automatically registered.

(ii) Monitoring, Verification and Issuance of CERs

Once the project is registered and becomes operational, the

performance of the CDM project is monitored and verified

periodically (usually once a year) to determine whether emission

reductions have taken place before the CDM Executive Board

can issue CERs. For this, the entity having got itself

successfully registered appoints a DOE which is different from

the one involved in the first stage. The DOE assesses the

quality/quantity of GHG emission reductions and compliance

with all CDM criteria. After successful verification, the DOE

submits the verification report and other relevant documents to

the Executive Board and requests for issuance of CERs.

UNFCCC hosts all these documents on its website and if within

15 days from the date of making the request for issuance no

request for review is received, CERs are certified and issued to

the entity. Certification is a written assurance by UNFCCC that a

project activity achieved the emission reductions as verified.

(iii) Sale/Trade

The CERs obtained by the entity may be sold to those who need

it.

8. From the above, it follows that there are various parties involved in the

carbon trading process. These include (i) Generating entity/generator, i.e.,

the entity which undertakes CDM project activity to generate CERs; (ii) CDM

Executive Board of UNFCCC which approves the CDM projects and issues

CERs; (iii) Designated National Authority as defined above and in India it

refers to National CDM Authority; (iv) Designated Operational Entities as

defined above which validate and verify the CDM project and its operations;

and (v) the buying entity/buyer which buys the CERs generated by the

generator and for the purpose of this Guidance Note it refers to the entity of a

developed country which is bound by the Kyoto Protocol emission reduction

targets.

Objective

9. With large number of entities in India generating carbon credits and

the carbon credits being a relatively new area, a need was felt to provide

guidance on accounting in this area. There is no specific accounting

Standard or interpretation provided by the International Accounting Standard

Board (IASB) in relation to the accounting for Certified Emissions Reductions

(CERs).The debate is still on for an appropriate treatment for Carbon

Emission Reductions (CERs) in the international forum.

There are, however, existing Accounting Standards (AS) that deal with the

principles that should govern accounting for Certified Emissions Reductions

(CERs). But the lack of specific guidance furthers the scope for judgement

and results in varying treatments.

Scope

10. Kyoto Protocol provides three market-based mechanisms – Joint

Implementation (JI), Clean Development Mechanism (CDM), and

International Emission Trading (IET). The accounting issues and the

consequent accounting treatment involved in the three different mechanisms

may be different. However, since at present the Clean Development

Mechanism is the relevant mechanism in India and with India currently not

being under the obligation to reduce its GHG emissions as per the Kyoto

Protocol, this Guidance Note provides guidance on accounting for carbon

credits, i.e., CERs generated under the Clean Development Mechanism. This

Guidance Note provides guidance on matters of applying accounting

principles relating to recognition, measurement and disclosures of CERs

generated by the entity that has obtained the same under the Clean

Development Mechanism (hereinafter referred to as ‘self-generated CERs’).

This Guidance Note does not address the accounting issues involved in

carbon credits under Joint Implementation and International Emission

Trading ­­the other two mechanisms under the Kyoto Protocol.

This Guidance Note also does not deal with purchased CER’s or with the use

of CER’s in own business.

Accounting Treatment

Whether CER is an ‘asset’

11. An issue that arises in accounting for carbon credits is that whether

the carbon credits generated under the Clean Development Mechanism, i.e.,

CERs, can be considered as assets of the generating entity.

12. The ‘Framework for the Preparation and Presentation of Financial

Statements’, issued by the Institute of Chartered Accountants of India,

defines an ‘asset’ as follows:

“An asset is a resource controlled by the enterprise as a result of past

events from which future economic benefits are expected to flow to the

enterprise.”

CER is an ‘asset’ as per the definition given in the

Framework

13. From the above-mentioned definition of ‘asset’ it follows that for a CER

to be considered as an asset of the generating entity, it should be a resource

controlled by the generating entity arising as a result of past events, and from

which future economic benefits are expected to flow to the generating entity.

14. In order to generate CERs, an entity undertakes a CDM project activity

and thereby reduces carbon emissions. It is mentioned in paragraph 9 above

that various stages are involved in a CDM project activity to generate CERs.

After a successful registration, as the CDM project is operated, carbon

emission reductions are generated and these continue to be generated over

the course of the project. However, at this stage, i.e., when the emission

reductions are taking place, CERs do not arise. It may be argued that as

soon as emission reductions take place these should be considered as

assets since certification thereof subsequently in the form of CERs is a

procedural aspect. In this regard, it is noted that issuance of CERs is subject

to the verification process, i.e., CERs are applied for and on the expiry of 15

days having received no request for review and after having satisfied all

requirements, a communication is received from UNFCCC thereby crediting

CERs to the generating entity. It is, thus, possible that emission reductions

may not eventually result in to creation of CERs. Accordingly, at this stage

when emission reductions are taking place, CERs can, at best, be said to be

contingent assets as per Accounting Standard (AS) 29, Provisions,

Contingent Liabilities and Contingent Assets, which defines a contingent

asset as “a possible asset that arises from past events the existence of

which will be confirmed only by the occurrence or non-occurrence of

one or more uncertain future events not wholly within the control of the

enterprise”. This is because when the generating entity reduces carbon

emissions by way of a CDM project, the generating entity becomes eligible to

receive CERs from UNFCCC. However, whether CERs will actually arise and

be received by the generating entity or not will depend on a future uncertain

event, i.e., certification of the same by UNFCCC.

15. It follows from the above that a CER comes into existence and meets

the definition of an asset only when the communication of credit of CERs is

received by the generating entity. This is because only at this stage the CER

becomes a resource controlled by the generating entity and therefore leads

to expected future economic benefits in the form of cash and cash

equivalents which would arise on the future sale of CERs. As stated above,

at other earlier stages of the CDM project activity, there is no resource in

existence for the generating entity, and hence the question of ‘resource

controlled’ and ‘expected future economic benefits’ therefore do not arise.

Accordingly, CER is an ‘asset’, when it comes into existence as stated

aforesaid.

Recognition of CERs

16. According to the ‘Framework for the Preparation and Presentation of

Financial Statements’, once an item meets the definition of the term ‘asset’, it

has to meet the criteria for recognition of an asset as laid down in the

Framework so that it may be recognised in the financial statements. In other

words, it has to be seen when the CERs should be recognised in the

financial statements. As per paragraph 88 of the Framework, the criteria for

recognition of an asset are as follows:

“88. An asset is recognised in the balance sheet when it is probable

that the future economic benefits associated with it will flow to the

enterprise and the asset has a cost or value that can be measured

reliably.”

17. From paragraph 15 it follows that CERs come into existence when

these are credited by UNFCCC in a manner to be unconditionally available to

the generating entity. Therefore, CERs should not be recognised before that

stage. Further, from the above it follows that for CERs to be recognised in

the financial statements of the generating entity as assets, the two criteria

with regard to probable future economic benefits flowing from the CERs and

CERs possessing a cost or value that can be measured with reliability should

be met as follows:

(a) As regards the probability criterion for recognition of CERs, it

may be mentioned that the concept of probability refers to the

degree of certainty that future economic benefits associated

with CERs will flow to the entity. Therefore, the probability

criterion is said to be met when there is a reasonable assurance

that future economic benefits will flow from the CERs to the

entity. As the market for CERs is relatively new, the future

economic benefits may not always be assured. Thus, an entity

needs to make an assessment for the probability of future

economic benefits. Accordingly, if there is a probable market for

the self-generated CERs ensuring flow of economic benefits in

the future, CERs should be recognised.

(b) As regards the criterion for measurement of cost or value, there

are certain costs which are incurred to generate CERs, and

therefore the cost of CERs can be measured reliably. The value

at which CERs are to be measured is discussed in later

paragraphs.

For reasons stated above, the recognition of CER’s as an asset at any

earlier or later stage than when they are credited by UNFCCC is not justified

in the following cases:

(a) CERs are recognised upon execution of a firm sale contract for

the eligible credits

(b) CER’s are recognised on an entitlement basis based on

reasonable certainty after making adjustments for expected

deductions.

What type of asset is a CER

18. Having agreed that a CER is an asset as per the ‘Framework for the

Preparation and Presentation of Financial Statements’ and also having

determined when a CER meets the recognition criteria, its nature is to be

examined. Keeping in view the non-physical form of CERs, the definition of

‘intangible asset’, as per Accounting Standard (AS) 26, Intangible Assets, is

noted as follows:

“An intangible asset is an identifiable non-monetary asset,

without physical substance, held for use in the production or

supply of goods or services, for rental to others, or for

administrative purposes.”

19. From the above, it is noted that though CERs are non-monetary assets

without a physical form, they do not strictly fall within the meaning of

‘intangible asset’ as per AS 26. The reason is that CERs are not held for use

in the production or supply of goods or services, and neither are CERs used

for administrative purposes nor are they used for the purpose of renting to

others. Instead, CERs generated by the generating entity are held for the

purpose of sale.

However, it may be mentioned that though the definition of ‘intangible asset’

does not mention assets held for sale, the other requirements of AS 26, such

as the following, indicate that intangible assets include assets which are

developed by an entity for sale:

“44. An intangible asset arising from development (or from

the development phase of an internal project) should be

recognised if, and only if, an enterprise can demonstrate all of the

following:

(a) the technical feasibility of completing the intangible asset

so that it will be available for use or sale;

(b) its intention to complete the intangible asset and use or sell

it;

(c) its ability to use or sell the intangible assets;

(d) …

(e) the availability of adequate technical, financial and other

resources to complete the development and use or sell the

intangible asset; and

(f) …” [Emphasis supplied]

20. Further, though CERs are intangible assets as mentioned above, AS

262 scopes out those intangible assets from its purview which are specifically

2 Reference may be made to paragraph 2 of AS 26.

dealt with in another Accounting Standard and requires them to be accounted

for in accordance with that Standard. For instance, intangible assets held for

the purpose of sale in the ordinary course of business are excluded from the

scope of AS 26 (paragraph 2) and, therefore, are to be accounted for as per

Accounting Standard (AS) 2, Valuation of Inventories. In this context, the

definition of the term ‘inventories’ as given in AS 2 is noted below:

“Inventories are assets:

(a) held for sale in the ordinary course of business;

(b) in the process of production for such sale;

(c) in the form of materials or supplies to be consumed in the

production process or in the rendering of services.”

21. From the above, it follows that CERs are inventories of the generating

entity as they are generated and held for the purpose of sale in the ordinary

course of business. Therefore, even though CERs are intangible assets

these should be accounted for as per the requirements of AS 2.

Measurement

Measurement of CERs

22. As stated above, CERs are inventories for an entity which generates

the CERs. Therefore, the valuation principles as prescribed in AS 2 should

be followed for CERs. As per AS 2, inventories should be valued at the lower

of cost and net realisable value. Accordingly, CERs should be measured at

cost or net realisable value, whichever is lower.

Cost of Inventories

23. AS 2 prescribes the composition of cost of inventories as follows:

“6. The cost of inventories should comprise all costs of

purchase, costs of conversion and other costs incurred in

bringing the inventories to their present location and condition.”

24. Various costs are incurred by the generating entity to set up a CDM

project activity, operate the CDM project and generate CERs. These may

include the following:

(i) research costs arising from exploring alternative ways to reduce

emissions;

(ii) costs incurred in developing the selected alternative as a

process/device to reduce emissions;

(iii) costs incurred to prepare the Project Design Documents;

(iv) fees paid to DOEs for validation and verification and to the

National Authority for approval;

(v) fees of registering with UNFCCC;

(vi) costs incurred for monitoring the reductions of emissions;

(vii) costs incurred for certification of CERs; and

(viii) operating costs incurred to run the CDM project.

25. As already mentioned earlier, CERs do not come into existence and,

therefore, do not become the assets of the generating entity till the UNFCCC

certifies and credits the same to the generating entity. Accordingly, not all

costs incurred by the generating entity give rise to CERs and therefore not all

costs can be considered as the costs of bringing the CERs to existence (i.e.,

their present location and condition). For example, the research and

development costs as mentioned above are the pre-implementation costs of

the CDM projects which do not result in CERs. Accordingly, these should be

treated as per Accounting Standard (AS) 26, Intangible Assets (refer also to

paragraph 30 below) when they bring into existence a separate intangible

asset such as a patent of a process to reduce carbon emissions. Similarly,

the other costs such as those incurred for preparation of PDD and

registration of the CDM project with UNFCCC, etc., do not result in CERs

coming into existence, and therefore these costs cannot be inventorised. It is

only the costs incurred for the certification of CERs by UNFCCC which bring

the CERs into existence by way of credit of the same by UNFCCC to the

generating entity. Thus, the costs incurred by the generating entity for

certification of CERs, are the costs of inventories of CERs.

26. In order to certify and issue CERs, UNFCCC imposes two types of

levies on the generating entity. The first type of levy is in kind whereby a

specified percentage of the CERs earned are deducted at the point of

issuance by the UNFCCC. In other words, the generating entity is issued

CERs net of this levy. For example, if this levy is 2% and if 1000 CERs are to

be issued, then after deducting 20 CERs, 980 CERs will be credited. This

levy is applied to all projects other than those of the Least Developed

Countries. The second type of levy imposed is in the form of a cash payment

which is charged by the UNFCCC towards meeting administrative costs of

UNFCCC. In this levy, a fixed payment per unit of CER is charged for the

total CERs credited to the generating entity. Taking the above example

further, if USD 0.10 per CER is charged towards the second levy, then the

generating entity will need to make a payment at this rate for the 980 CERs

credited to it, i.e. USD 98. Apart from these two levies, the generating entity

normally pays a fee to the consultant for the services rendered to obtain the

certification of CERs by UNFCCC.

27. From the above, it follows that the ‘costs incurred for certification of

CERs’ at which the inventory of CERs should be valued include the

consultant’s fee and the cash payment made under the second levy to the

UNFCCC for obtaining the credit of CERs. The deduction of CERs by

UNFCCC under the first levy is in kind which increases the per unit cost of

the CERs credited to the generating entity.

Net Realisable Value

28. AS 2 defines net realisable value as follows:

“Net realisable value is the estimated selling price in the ordinary

course of business less the estimated costs of completion and

the estimated costs necessary to make the sale.”

29. In the determination of the net realisable value of CERs, paragraph 22

of AS 2 reproduced below should be used as guidance:

“22. Estimates of net realisable value are based on the most reliable

evidence available at the time the estimates are made as to the

amount the inventories are expected to realise. These estimates take

into consideration fluctuations of price or cost directly relating to

events occurring after the balance sheet date to the extent that such

events confirm the conditions existing at the balance sheet date.”

Income Recognition

30. Since CERs are recognised as inventories, the entity should apply AS

9 to recognise revenue in respect of sales of CERs .

Measurement of underlying assets related to CERs

31. For the generation of CERs, the generating entity may create certain

intangible and tangible assets. For example, for reducing emissions, an

entity may carry out some research and development which may result into

creation of an intangible asset. Insofar as expenditure on research and

development is concerned, the entity should apply AS 26, Intangible Assets.

32. In some cases, an entity may use a tangible asset to reduce

emissions. For example, an entity may use incinerators for the purpose of

reducing carbon emissions. In respect of such equipments/devices, the

provisions of the Accounting Standard (AS) 10, (Revised) Tangible Fixed

Assets3 will apply, as is evident from the following paragraph thereof:

“8.1A. Items of tangible fixed assets may be acquired for safety or

environmental reasons. The acquisition of such tangible fixed assets,

although not directly increasing the future economic benefits of any

particular existing item of tangible fixed asset, may be necessary for

an enterprise to obtain the future economic benefits from its other

assets. Such items of tangible fixed assets qualify for recognition as

assets because they enable an enterprise to derive future economic

benefits from related assets in excess of what could be derived had

those items not been acquired. For example, a chemical manufacturer

may install new chemical handling processes to comply with

environmental requirements for the production and storage of

dangerous chemicals; related plant enhancements are recognised as

an asset because without them the enterprise is unable to

manufacture and sell chemicals. However, the resulting carrying

amount of such an asset and related assets is reviewed for impairment

in accordance with AS 28, Impairment of Assets.”

33. From the above, it is clear that any pollution control/emission reduction

devices installed by the generating entity for the purpose of generating CERs

are fixed assets and therefore they shall be accounted for as per AS 10

(Revised).

3 AS 10( revised), Tangible Fixed Assets is being formulated.

Presentation

34. An entity should present certified emission rights as part of

Inventories, in the balance sheet, separately from other categories of

Inventories such as Raw Materials, Work-in-process, Finished goods and

others.

Disclosure

35. An entity should disclose the following information relating to certified

emission rights in the financial statements:

a) No. of CERs held as inventory and the basis of valuation.

b) No. of CERs under certification.

c) Depreciation and operating and maintenance costs of Emission

Reduction equipment expensed during the year.

Effective date

36. An entity should apply this Guidance Note for accounting periods

beginning on or after April 01, 2012.

Transition

37. On the first occasion this Guidance Note is applied, the entity should

recognise in the financial statements certified emission rights earned as on

that date with corresponding credit to revenue reserves.