Demystifying the carbon markets landscape and the associated accounting implications has been saved
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Demystifying the carbon markets landscape and the associated accounting implications
4 insights that can better position your company for success
In the quest to curb global greenhouse-gas emissions, the role of the carbon markets has become increasingly important, albeit somewhat controversial. Carbon markets can be contentious as some question whether these markets lead to genuine incremental carbon reduction. Despite the perceived shortcomings, it’s clear that the carbon markets can provide a relatively efficient mechanism for entities in hard-to-abate industries, and entities seeking to take immediate action, to offset their carbon footprint and finance direct emission reduction projects.
Initially, carbon markets were driven by governmental regulations enacted to reduce emissions primarily through cap-and-trade or similar programs which drove industries towards specific carbon reduction goals1. This provided a framework for the emergence of voluntary carbon markets, where entities transact not out of regulatory compulsion but in order to achieve emission reduction commitments to stakeholders. Along with compliance markets, the voluntary markets have helped fuel the demand and supply of environmental products like carbon credits, offsets, and other environmental attributes. These can be generated through technology- or nature-based carbon avoidance, abatement, sequestration, or reduction activities. The evolving societal expectations around corporate social responsibility, especially among the new generation of talent, consumers, and investors, are impacting how many companies approach their carbon reduction activities. As the source, nature, and use of environmental credits expands in volume and breadth across industries, entities should understand and navigate the related operational and accounting challenges.
Accounting and reporting complexities of carbon markets
The accounting landscape for entities engaged in the carbon markets can vary significantly. The transactions can involve complex structures in which traditional commodities are bundled with carbon credits or environmental attributes and may include bespoke mechanisms for sharing the related revenue. Additionally, the generation, sale, and consumption of environmental credits can present peculiar logistical, legal, and financial considerations, often making the landscape for accounting and reporting of environmental credits challenging.
The challenges can be distinct to the different carbon market participants:
- For producers, the classification and recognition of environmental credits can be complex. An entity's intent for generating environmental credits often plays an important role in determining how these credits are accounted for, valued, and reported. There are logistical challenges associated with generating and transferring environmental attributes that are created in conjunction with a physical commodity, particularly in 'book and claim' systems where the environmental attributes are transferred and/or sold separately from the related physical commodity. The mechanisms imposed by different carbon registries to mitigate invalidation risk, such as obligations to contribute environmental attributes to a buffer pool, can present additional challenges for producers in complying with the requirements, while ensuring complete and accurate financial reporting.
- Intermediaries focus on facilitating market activities including developing innovative transaction structures. They are often instrumental in addressing the complexities of invalidation risk associated with carbon credits. These intermediaries' functions are diverse and can include consulting on carbon offset strategy, managing the 'book and claim' logistics, verifying and registering environmental attributes, and facilitating the sale of credits to consumers. These roles present challenges in determining the appropriate revenue recognition for the related activities. Carbon registries can play an important role in helping to ensure the integrity of the carbon markets, in particular the validity and existence of carbon credits traded through their platforms including establishing rules for managing the risks of invalidation of carbon credits. This complexity could be exacerbated by the use of blockchain technology to facilitate either the settlement of transactions or the effective transfer of carbon credit through tokenization. As the carbon markets evolve, these intermediaries are often tasked with continuously adapting their accounting practices to accommodate new transaction types and structures while maintaining both compliance and market efficiency.
- From the consumers’ perspective, the focus is often on the selection and acquisition of the right credits. Consumers face the challenge of selecting the most suitable credits, a task that can become arduous in less standardized voluntary markets. A key concern for consumers is understanding the validity, effectiveness and value of the credits.
Key considerations in developing effective accounting and reporting practices for evolving carbon markets
As entities look to establish relevant accounting and reporting policies and internal controls for the evolving carbon markets, four considerations may help position entities for success:
- Understanding stakeholder preferences: Stakeholders' expectations should influence the choice of environmental credits entities produce or procure based on relevant attributes (e.g., technology-based or nature-based, vintage, project type, project location). The preference for certain types of credits can impact the recognition and measurement of related assets and liabilities.
- Lifecycle of a credit: Understanding the full lifecycle of a credit, from production to retirement, and the entity’s role in the credit lifecycle, are important for accurate accounting and reporting. Producers, for instance, should establish appropriate policies for allocating development costs, including costs related to the development of buffer credits, and revenue recognition policies related to bespoke revenue share arrangements.
- Processes, systems and controls: Entities with existing systems, processes and controls over physical commodity transacting assets face the challenge of adapting their existing processes and controls to accommodate environmental credits and attributes. The commercially optimal deployment of existing transportation and storage assets for maximizing profits from environmental credits, including through book-and-claim systems, may conflict with the optimal use of such assets solely for the physical commodities. Entities need to balance between leveraging these established assets and investing in additional assets specifically curated for carbon market transactions. Similarly, in evaluating the need for new systems, processes and internal controls, entities should undertake careful cost-benefit analyses, weighing the opportunity cost of modifying legacy systems, which may not be inherently suited for the intricacies of environmental attributes, against the incremental benefits derived from optimal potential environmental credits transacting.
- Impact of technology: The use of technology, including blockchain, in tracking and verifying credits adds a layer of complexity to the accounting process, particularly for entities engaged in the tokenization of credits. The value of tokenized carbon credits may be impacted by factors beyond the carbon markets particularly the overall market for cryptocurrencies and fungible tokens. Entities will need to consider the existing accounting practices and policies for such cryptocurrencies and tokens in developing accounting policies, processes and internal controls for affected carbon credits.
Navigating the carbon market, with its intricate accounting and reporting challenges, typically requires judgment and analogizing to existing guidance for comparable activities. As of the date of this publication, the Financial Accounting Standards Board (FASB) is deliberating a change in generally accepted accounting principles that could affect how companies account for assets and liabilities such as carbon credits within their environmental credit programs.2 As the carbon markets evolve, it’s important to consider how the related opportunities and challenges can shape an organization’s business strategy and investments, selection of appropriate systems and accounting policies, and development of effective processes and internal controls. Deloitte professionals understand the complexities of carbon markets and can advise companies through the related accounting, financial reporting, internal controls, and processes and systems.
The services described herein are illustrative in nature and are intended to demonstrate our experience and capabilities in these areas; however, due to independence restrictions that may apply to audit clients (including affiliates) of Deloitte & Touche LLP, we may be unable to provide certain services based on individual facts and circumstances.
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 adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.
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1Jill Gregorie, Ricardo Martinez, Val Srinivas, “The world needs carbon markets. Here’s how to make them better,” Deloitte Insights, accessed December 12, 2023.
2Brianna Butterfield, Eric Knachel,“#DeloitteESGNow – FASB Makes Tentative Decisions Related to the Accounting for Environmental Credit Programs,” Heads Up, Volume 30, Issue 20 (2023).”
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