From the July-August 2009 issue of Treasury & Risk magazine

Carbon Trading Is on the Horizon, Ready or Not

The American Clean Energy and Security Act (the Waxman-Markey Clean Energy Security Act) narrowly squeezed through the House in June and is now working its way through the Senate. Regardless of the outcome, carbon markets will be at the top of the agenda at the United Nations Climate Change Conference in Copenhagen this December, as governments discuss climate change measures, such as cap-and-trade, similar to the European Union Emission Trading Scheme. Meanwhile, the carbon-trading market is expected to double worldwide this year. The Obama administration has projected $646 billion in sales of emissions allowances or credits through 2019. And at least one major U.S. city has hired consultants and scheduled roundtables to map out a strategy on how best to build on the opportunity in carbon trading and related activities. While the requirements to hold allowances do not come into effect until 2012 under current federal proposals and not fully for a number of years thereafter, the development of cross-border carbon markets raises the question of what this means for businesses. In a white paper, Confronting the Carbon Challenge, Pat Concessi, global climate change leader for Deloitte, recently provided some answers. Here are some (but not all) the implications the report outlines.

Substantial incremental costs for entities in regulated carbon markets. Since the details of emissions trading programs are still evolving, understanding and projecting the costs for a given business means grappling with such uncertainties as determining the point of regulation, the industries to be included in trading and the options for offsetting. The ability to pass carbon costs to customers can determine the effect on profitability.

Business strategy. Companies may find it important to integrate the price of carbon into their overall strategy. Given the regulatory uncertainty, using scenarios can be important. These scenarios need to be internally consistent, recognizing the correlations among regulatory options, pace of technology implementation and resulting commodity prices. Strategies should incorporate related policies, such as low carbon fuel standards, renewable electricity standards and incentives for clean energy.

Governance and organization. Understanding of carbon markets should flow through organizational decision making. New policies and procedures may be needed to govern management of this new commodity, as well as appropriate internal controls. Definition of roles and responsibilities should address which functions are centralized and which are carried out by the business units.

Capital allocation decisions. Understanding the cost of carbon and including it in an analysis of future capital allocations can be a game-changer. Even the simplest energy contracts should consider carbon, both in terms of outright cost and issues such as ownership of environmental assets or obligations. Companies should understand the extent to which they will be able to recover carbon costs under the terms of existing contracts.

Carbon as a commodity. Hedging may entail simply buying tradeable allowances. However, many businesses may also find themselves buying carbon offsets. Legislative efforts to date have incorporated offsets as a key price control mechanism but supply, particularly in the early years, is uncertain. Companies intending to actively participate in cap-and-trade markets should assemble systems to develop, buy and trade offsets (a somewhat complicated procedure, more akin to project finance than plain-vanilla commodities trading). Market designs may include multiyear emission compliance periods, although many companies will want to hedge exposures over shorter periods, either to address financial statement volatility, or to manage risk associated with passing costs to customers.

Accounting policy elections. Some companies account for emission rights by treating them as inventory, others as intangible assets. Since the effects on the balance sheet and income statement may differ depending on the treatment and what degree of regulatory recoverability applies, comparability among entities may be difficult. This could have significant implications not only for reporting financial performance, but also on companies' strategic decisions on how to participate in cap-and-trade programs. Companies should explain their related accounting policies to the market to ensure that the effects on the financial statement of their use of emission rights and related contracts are properly understood. Forwards, swaps and options would likely be accounted for as derivatives if financially settled, although deal structure and market liquidity should be considered in assessing an entity's ability to truly settle these positions on a net basis.

Financial statement implications. These include, but are not limited to, five major areas: 1) accounting for carbon regulatory obligations, 2) accounting for held emissions rights and offsets, 3) accounting for forward contracts to buy and sell credits (including futures and over-the-counter forwards, swaps and options), 4) issues of impairment for emissions credits, and 5) regulatory treatment for recovery of the cost of emissions credits. The accounting for obligations resulting from a cap-and-trade scheme, as well as the accounting treatment of credits and offsets, could be material for many U.S. companies and will require specialized skills, including fair value competency and measurement credentials.

Tax implications. Limited guidance has been issued regarding the tax consequences of transactions involving emission allowances. While the accounting treatment for these allowances is not necessarily the right treatment for tax purposes, it does affect the information available for tax reporting purposes. The tax treatment of emission allowances depends in part on how the allowances are acquired (e.g., granted, acquired separately or acquired as part of a business), how the holder intends to use them (e.g., in its generation operations or speculation) and how the holder disposes of the allowances (e.g., sale or exchange). Tax issues include, but are not limited to, character of gain or loss, timing of gain or loss, tax treatment of penalties imposed for violation of standards, transfer pricing and international tax issues, as well as apportionment for state tax reporting purposes.

Reporting and disclosure. Carbon market designers, registries, states and the Environmental Protection Agency are developing protocols for regulatory reporting, and these protocols may create a need for additional infrastructure in order for companies to comply. The requirements for regulatory reporting begin as early as January 2010. In addition to regulatory reporting, businesses should address management and corporate reporting needs. Will management, and the hedging function, need more frequent reports than the annual regulatory reports? Shareholders and regulators are also making additional requests for disclosure, which could require risk assessment and a discussion of strategy.

Non-carbon trading companies.Businesses that are not required to comply with a carbon market cap may still see significant implications, since carbon costs will cause an increase in the price of other commodities, particularly electricity and natural gas. Companies should include a range of carbon prices in their scenario planning.