This publication is the third and final in our three part series dealing with “Minimising volatility for the airline industry”. In the first publication we dealt with the Issue at hand now that airlines are being included in the European Union Emissions Trading Scheme and the consequences this was leading to for airlines. The aim of the EU-ETS is to reduce emissions in a cost effective manner allowing companies to trade emission allowances and thereby determine how and where they reduce emissions. From 1st January 2012 all airlines flying to and from the European Union are required to match their carbon emissions with carbon credits. Although each airline receives an allowance on an annual basis this is unlikely to match actual emissions and hence the airline will be exposed to this very volatile commodity. In the first publication we highlighted the facts of this scheme, some initial views on what we are seeing in the market as well as touching on the opposition to this scheme in various countries.
The second publication dealt with the accounting considerations and implications as expressed by Kush Patel, a Director at Deloitte in London specialising in the accounting for financial instruments under IFRS1 and UK Gaap2. The accounting considerations are important as there is not a single accounting standard that deals with emissions rights and liabilities and therefore there may be different application in practice. As you will have noted from this paper depending on the accounting treatment adopted hedge accounting may or may not be beneficial and applicable for every airline.
The third and final part in the series deals with a leading Airline sharing their strategy, thoughts and comments on the EU-ETS. Again this paper highlights the inconsistency that may be achieved between different airlines applying different accounting treatment. This article was written by a Senior Finance Controller at one of Reval’s clients in the industry.
About Jacqui Drew
Jacqui Drew joined Reval at the end of 2011 as a Solution Consultant and is part of our elite team of Subject Matter Experts. Jacqui specializes in the valuation, hedge accounting and risk management modules of Reval. Prior to this, Jacqui was a Senior Manager at Deloitte where she managed the audit support function in relation to the valuation of derivative financial instruments and the application of hedge accounting. There, Jacqui managed a team of over 80 financial instrument specialists across the UK. Jacqui is actively involved in advising clients on valuation and hedge accounting issues, presenting at seminars and conferences and delivering training internally and externally on financial instruments in all asset classes. Jacqui can be reached at Jacqui. Drew@Reval.com.
Reval is a leading, global Software-as-a-Service (SaaS) provider of comprehensive and integrated Treasury and Risk Management (TRM) solutions. Our cloud-based software and related offerings enable enterprises to better manage cash, liquidity and financial risk, and includes specialized capabilities to account for and report on complex financial instruments and hedging activities. The scope and timeliness of the data and analytics we provide allow chief financial officers, treasurers and finance managers to operate more confidently in an increasingly complex and volatile global business environment. Using Reval, companies can optimize treasury and risk management activities across the enterprise for greater operational efficiency, security, control and compliance. Founded in 1999, Reval is headquartered in New York with regional centers across North America, EMEA and Asia Pacific. For more information, please visit www. reval.com or contact email@example.com.
EMISSIONS TRADING SCHEME IN PRACTICE
Introduction on ETS directive for airline industry
In December 2008 the EU decided to extend the ETS directive with international aviation. The scope of EU ETS covers all flights to, from and within the EU, starting in 2012. It is expected that this will lead to a situation that European airlines will have to buy additional emission rights (on top of the free allocated rights) to mitigate their shortage in rights. This article describes the certificates that are available in the market to mitigate the shortage and describes how emission accounting has been applied in our business.
The Quantity exposure (and by this the potential shortage that an airline faces) is calculated by using the fuel consumption in tons multiplied by a factor 3.15 (average factor for CO2 emission via jet fuel) to get CO2 tons.
The shortage can be covered by the following certificates: AEUAs, EUAs, CERs, ERUs or Bio Fuel. In terms of our business coverage we use CER’s to the maximum (15%) and EUA’s to fill the remaining shortage. EUA’s are widely available since these are also linked to the utilities market whereas CER’s are slightly less expensive than EUA’s.
AEUAs – Aviation European Union Allowance
A total of 214.8 mln CO2 ton will be created in 2012 (annually between 2013 and 2020: 210.3mln CO2 ton), 82% will be allocated for free, 15% will be auctioned and 3% will be for special reserve. Each country will have an AEUA auction, and can decide on the frequency, the volume and the auction platform to be used. There are no limitations on the amount of AEUAs, which can be used, however only airlines may submit AEUAs to cover their exposure.
EUAs - European Union Allowance
Created for the ground station emitters, such as utilities and power plants. The current market has a size of 2.4bln CO2 tons per year (factor 10 of the aviation market). Unlimited use is possible.
CERs – Certified Emission Reductions
These certificates come from CO2 reduction projects in developing countries. There are Green and Grey CERs. Green are from sustainable projects, such as hydropower, waste to energy projects. Grey come from the reduction of chemical gas projects, such as HFC-23 gas reductions. The latter is roughly 60-70% of the total CER market. In phase III (2013-2020), these certificates are no longer EU compliant as per the regulatory rules. Furthermore there is a limitation of 15% of the yearly consumption in 2012 and 1.5% per year in phase III. However this is cumulative and bankable, meaning that if the 15% has not been delivered in 2012, in 2013, it is possible to surrender 16.5%, etc.
ERUs – Emission reductions
The same as CERs, however these certificates originate from non-developing countries.
Each traceable drop of 100% bio fuel will reduce the emission exposure. 1 ton of Jet fuel is equal to 3.15 ton of CO2. Currently it is possible to fly on a maximum of 50% bio fuel. For example the 350 ton Bio Jet (50% blend), which we purchased for a specific European flight, will generate an exemption for 551 CO2 tons (350x50%x3.15).
ETS – accounting treatment in practice
The accounting treatment for emission rights has been a topic which is extensively discussed within the IASB3. The initially issued IFRIC4 3 Emission rights (released per December 2004) was withdrawn already per June 2005. Up to today no specific IFRS guidelines are additionally given on emission rights accounting. Below it is described how within our current business practice we deal with the accounting of the CO2 emission rights. Our practice breaks the accounting part into two elements:
- accounting for the CO2 rights accounting itself;
- accounting for the hedging of CO2 exposure.
CO2 rights accounting
Carbon quotas meet the definition of an intangible asset, as defined in IAS 385 paragraph 8: “An intangible asset is an identifiable non-monetary asset without physical substance”. In fact:
- The quota is identifiable (it’s a right to pollute)
- Without physical substance
- Non-monetary because monetary assets are defined as: “money held and assets to be received in fixed or determinable amounts of money”.
Carbon quotas are therefore recognized as intangible assets, as soon as the state gives quotas to the airline or when the airline purchases them on the market before the emission period. Free quotas given by the state will be valued at net value after allowances (IAS 206, paragraph 27), so at a nil value, bought quotas will be taken in consideration to calculate a weighted average price. The intangible asset will be not amortized.
While the airline emits carbon, a provision for charge (operating) will be constituted linearly based on the budget or updated budget. This provision represents the debt of the airline with the state. The valuation of the provision is made as follows:
- At the level of attributed and purchased quotas (spot or forward), an intangible asset is recognized. As the price is determined, the provision should be valued at Weight Average Unit Cost of quotas.
- For the part not covered by purchase of quotas, there is no intangible asset in the Balance Sheet. The provision is revalued, at each closing date, according to the price of quotas. The counterpart of this revaluation will be accounted in operating result.
At the date of the restitution of the quotas, the intangible asset will be derecognized and the provision will be reversed.
Accounting for CO2 hedging
To avoid the fluctuation of value of carbon quotas, the airline uses hedging instruments, mainly forward contracts. Forward contracts of quotas meet the definition of a derivative instrument (IAS 397:9):
- No initial investment or a small initial net investment
- Variation according to an underlying
- Settlement at a future date
The forwards are accounted at their fair value. These forward contracts are designated as the hedging instrument in a cash flow hedge of the variability of the consideration to be paid in the future transaction: purchase of quotas which are also the hedging instrument. As the underlying asset is also the hedging instrument, these contracts can be seen as a specific cash flow hedge, namely “All in one” hedge (IAS 39 – IG F2.5).
As can be noted from the above and read in conjunction with the other three papers in this series the accounting applied by organisations can be quite varied in application due to the lack of accounting guidance. In addition as more companies look to apply hedge accounting in practice practical issues may arise such as challenges faced with basis risk, issues around liquidity of instruments and availability of market data and tools used for assessment and measurement of hedge effectiveness.
1 International Financial Reporting Standards
2 Generally Accepted Accounting Principles
3 International Accounting Standards Board
4 International Financial Reporting Interpretations Committee
5 International Accounting Standard 38: Intangible assets
6 International Accounting Standard 20: Accounting for Government Grants and Disclosure
7 International Accounting Standard 39: Financial Instruments: Recognition and Measurement