Minimising Volatility For The Airline Industry -part Two:emissions Trading Scheme & Hedge Accounting

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Contribution from Kush Patel, Deloitte:

Emissions Trading Scheme and Hedge Accounting

For airlines in scope of the European Emissions Trading Scheme (ETS) there is a range of issues to consider. The purpose of this paper is to shed some light on the IFRS1 accounting considerations, and in particular, discuss when hedge accounting (under IAS 392) could be beneficial.

Hedge accounting will be a key consideration for those airlines with contracts to buy or sell carbon credits treated as trading derivatives and measured at fair value through profit or loss (FVTPL).

This paper discusses the accounting considerations for the following:

Forward contracts to buy or sell carbon credits (both gross settled and net settled);

Carbon credit assets (both granted and purchased) ; and

Liabilities to submit carbon credits (arising from carbon emissions).

Whether hedge accounting will be beneficial depends on the interaction of the accounting for the items above. Therefore hedge accounting is the final consideration.

It should be noted that under IFRS there is no explicit guidance for the accounting of emission rights and liabilities. In December 2004, the IASB issued IFRIC 3 Emission Rights to deal with the accounting by participants in an emissions trading scheme. The Interpretation specified that the scheme gives rise to an asset for allowances held, a government grant in respect of any allowances granted free of charge, and a liability for the obligation to deliver allowances, equal to the emissions made. However, the accounting required by IFRIC 3 led to a perceived mismatch: assets would either be recognised at historic amounts or revalued through equity (i.e. through other comprehensive income), whereas liabilities would be remeasured to fair value through the income statement. Thus, an entity holding precisely the level of assets required to settle its liabilities would nevertheless report gains or losses if there were changes in fair value.

As a result of the perceived problems with IFRIC 3, EFRAG was unable to recommend that it be endorsed for use in the EU. Subsequently, at its meeting in June 2005, the IASB voted to withdraw IFRIC 3. In the absence of explicit guidance, entities participating in an emissions trading scheme will need to give careful thought to having developed accounting policies that state how they account for the assets and liabilities arising.

Forward contracts to buy or sell credits

By design, airlines are not expected to be issued with sufficient carbon credits to cover their usual carbon emissions. As a result, in many cases it will be necessary to buy these credits in the secondary market. Such purchases may be spot purchases settled on (or very near) the transaction date. Alternatively, the purchase may be a forward purchase to be settled in the future. In the case of fixed price forward purchases, the contract would meet the definition of a derivative under IAS 39. Whether such derivatives are measured at FVTPL depends on whether they are in scope of IAS 39. The relevant scope exemption is commonly referred to as the "own use exemption". The general purpose of this scope exemption is to avoid derivative accounting for contracts over non-financial items where the underlying non-financial item is expected to be received or delivered as part of the entity's business. However, because of strict qualifying criteria, measurement at FVTPL may still be required.

The scope exemption does not apply to contracts that are not gross physically settled. In other words, if the contract is a net settled contract, its purpose cannot be to receive the underlying item as it is not delivered under the contract. Hence any net settled contracts to buy, or indeed sell, carbon credits are in scope of IAS 39 and measured at FVTPL. The same would apply for contracts that are entered into for trading purposes (i.e. to profit from price changes), regardless of whether those contracts are gross physically settled or not.

Gross physically settled contracts that are not intended for net settlement or trading purposes may also be required to be measured at FVTPL. For example, if the entity has early net settled some gross delivery contracts in the past (e.g. because the carbon credit was no longer needed), this may be construed as a past practice of net settlement, rendering any subsequent contracts as trading derivatives even if it intended to hold to take physical delivery. In some cases the application of the accounting requirements will require careful judgement.

In cases where derivative accounting does apply, volatility will arise in profit or loss from remeasuring the contract, unless the remeasurement is matched by an equal and opposite remeasurement of the emission liability (in cases of forward contracts to buy credits) or carbon credit asset (in cases of forward contracts to sell credits).

Carbon credit assets

An entity can receive carbon credits granted to it under the scheme as part of its initial allocation by the government or it may purchase them in the secondary market (under a spot or forward contract as described above).

Carbon credits held meet the definition of an intangible asset under IAS 38 Intangible Assets (i.e. an identifiable non-monetary asset without physical substance'). The initial and subsequent measurement of carbon credits depends on:

(i) whether the carbon credits were granted or purchased, and if they were granted,

(ii) what the entity's accounting policy choice is to account for the grant.

Initial recognition

Where the credits are purchased in the secondary market, they are initially recognised at the purchase price (or at fair value on settlement if purchased under a forward contract measured at FVTPL as described above).

Where credits are granted by a government, IAS 20 Accounting for Government Grants and Disclosure of Government Assistance applies. Under this standard there are two alternatives for the initial measurement of the grant. Either it is measured initially at

fair value (which becomes the deemed cost of the credit)3; or

nominal value.

The corresponding carbon credit asset would be recognised at the same amount as the grant. Hence the policy choice made between fair value and nominal value for the grant affects the initial recognition of the carbon credit asset under IAS 38.

Subsequent recognition

Subsequent to initial recognition, the general requirements for intangible assets in IAS 38 would apply.

IAS 38 would permit an intangible carbon credit asset to be remeasured at fair value when this can be measured by reference to an active market (which would likely be the case for European Union Allowance carbon credits). Remeasurements are recognised outside of profit or loss in other comprehensive income (except for decreases in value below cost). This accounting treatment precludes any reclassification to profit or loss of fair value increments accumulated in equity.

IAS 38 would also permit the asset to be measured at cost less impairment. As discussed above, the cost amount for credits granted by the government would depend on the accounting policy choice between recognising the grant initially at fair value or nominal value.

Emission liability

A liability for emissions would be captured under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Under this standard it would be recognised as incurred and measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. In this case it would be based on the credits that would need to be submitted.

Fair value

If an airline measured its carbon credit assets at fair value, the liability would also be measured at the same amount, because this would be the best estimate of the expenditure required to settle the obligation.

Cost

If an airline measured its carbon credit assets at cost then, provided that it had sufficient credits to satisfy the emission liability, the liability would be measured at the same amount (i.e. as the sum of the cost of the initial credits received and the cost of any additional credits purchased).

Nominal value

If an entity measured carbon credit assets granted at nominal value and credits purchased at cost then,provided that it had sufficient credits to satisfy the emission liability, the liability would be measured at the same amount (i.e. as the sum of the nominal value of the credits granted to it and the cost of any additional credits purchased).

Shortfall when using cost or nominal value

If at the end of the reporting period the liability to deliver credits exceeds the amount of credits held, then the shortfall would be measured at the current fair (market) value of the short position. Consequently, if an entity chose to sell credits during the year, and in doing so created a shortfall in the number of credits held as compared to the total emissions liability at that date, it would remeasure the portion of the obligation related to the shortfall at the current market value of the credits.

Hedge accounting

The above analysis highlights the varied accounting that can apply for items arising from participating in the ETS. It is evident from this that there are some scenarios which give rise to volatility in profit or loss. In some of these cases hedge accounting may be possible to reduce some of this volatility. Below are two examples of when hedge accounting could be beneficial to reduce profit or loss volatility.

The examples show that hedge accounting can be beneficial when a forward contract to buy (or sell) carbon credits is caught in the scope of IAS 39 and measured at FVTPL (i.e. it is treated as a derivative, causing volatility in profit or loss) and there is no natural offset in profit or loss in the period.

In both of these examples, the type of hedge accounting applied is cash flow hedge accounting. Under this approach, the effective component of the change in fair value of the forward contract (i.e. the "hedging instrument") is deferred in an equity reserve (via other comprehensive income) and later reclassified to profit or loss when the hedged expense or income is recognised in profit or loss. The examples assume that all of the IAS 39 conditions for hedge accounting are met (e.g. hedge documentation, hedge effectiveness testing, etc.)

e.g. 1 Hedge of forecast emissions expense

Airline X, whose year end is 31 December 20X1, has carbon emissions liability equal to the credits held; hence it does not have any surplus credits to cover future emissions. On 1 September 20X1, it enters into a contract to purchase 10,000 carbon credits to be settled on 31 March 20X2. The contract allows net settlement; however, the airline's objective is to physically receive the credits in order to surrender them on 30 April 20X2 to satisfy its anticipated emissions liability which has a high probability of being incurred during Q1 20X2.

The airline has previously net settled forward purchase contracts due to over-purchasing credits. Hence it has a "past practice" of net settling some contracts rather than taking physical delivery. As a consequence, its forward contracts over carbon credits are recognised as derivatives at FVTPL as they do not qualify for the IAS 39 own use scope exemption. The emissions liability that it will eventually settle has not yet been recognised as it is to be incurred in the future.

To avoid the profit or loss volatility in its 20X1 financial statements arising from the forward contract, the entity decides to apply hedge accounting. It designates the highly probable emissions expense arising in Q1 20X2 as the hedged item in a cash flow hedge. It determines that the emissions expense is an eligible hedged item that will affect profit or loss when incurred.

When it receives the carbon credits, its accounting policy choice is to recognise the credits at cost. Because the forward contract is recognised at FVTPL, the cost of the credits will be determined when the contract settles.

The entity has also elected to account for the emissions liability at the cost of the carbon credits it will surrender to discharge the liability. When the emissions expense is recognised in profit or loss, the amounts accumulated in reserves are reclassified to profit or loss to match the hedged expense.

Once the carbon credits are received under the forward contract this fixes the cost of the credits and also satisfies the shortfall. As a result of this and the accounting policy choice adopted, neither the asset nor the liability is remeasured from this date.

It should be noted that in this example, the purchase of the carbon credits would not have been an eligible hedged item because the surrender of the credit does not affect profit or loss. Instead the recognition of the emissions liability that it will settle does affect profit or loss on initial recognition and hence is designated as the hedged item.

e.g. 2 Hedge of forecast carbon credit sale

Airline Y has been allocated carbon credits by the government based on its past volumes of carbon emissions. The entity has elected to record the government grant and the corresponding credit at their nominal value (assumed to be nil for illustrative purposes) which will not subsequently be revalued.

Due to changes in its business operations, the entity does not expect to utilise all of its carbon credits allocated and enters into forward contracts to sell its excess carbon credits. The entity has a past practice of buying and selling credits to generate a profit from short term price fluctuations. Because of its past practices, its forward contracts to sell its excess of allocated credits are recognised at FVTPL. The forward contracts settle in a subsequent accounting period.

To avoid the profit or loss volatility arising from these forward contracts the entity chooses to designate the contracts in a cash flow hedge of the forecast sale of credits arising from the contracts themselves (i.e. an all in one hedge as described in the implementation guidance of IAS 39 IG.F.2.5). The forecast sale is an eligible hedged item as without the forward contract the entity is exposed to price changes of the credits which will affect profit or loss on sale. As a result of applying cash flow hedge accounting, fair value changes of the contract are recognised in other comprehensive income and reclassified to profit

or loss on sale of the credits under the forward contract. This results in a net profit on sale equivalent to the price of the carbon credit that was fixed by the forward contract (i.e. the contracted forward price that was received on settlement).

It should be noted that if the entity had elected to hold the carbon credit asset at a revalued amount under IAS 38 instead of cost, then the sale would not have been an eligible hedged item for increases in value because these are recognised permanently in equity through other comprehensive income without recycling to profit or loss (i.e. the hedged item does not affect profit or loss). Decreases in value below cost would however be eligible as these are recognised in profit or loss.

Deloitte refers to Deloitte LLP, the United Kingdom member firm of Deloitte Touche Tohmatsu Limited (DTTL'), a UK private company limited by guarantee, whose network of member firms are legally separate and independent entities. Please see www. deloitte.co.uk/ for a detailed description of the legal structure of DTTL and its member firms.

This article has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice

before acting or refraining from acting on any of the contents of this article. Deloitte LLP would be pleased to advise readers on how to apply the principles set out in this article to their specific circumstances. Deloitte LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this article.

Copyright 2012 Deloitte LLP. All rights reserved. For additional information, please visit www.deloitte.co.uk.

by: Reval

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