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Winds of change

Climate change has become a major issue for FDs as they prepare for the effects of the EU's new carbon dioxide emissions trading scheme. The impact on accounting is almost as significant as the effect on the environment.

On 1 January 2005, the EU’s carbon dioxide (CO2) emissions trading scheme (ETS) came into effect as part of the EU’s efforts to abide by the Kyoto Protocol, which itself came into effect on 16 February 2005. Companies covered by the scheme will be issued with allowances based on their historical emission of CO2, which they can then buy or sell.

For the first three years of the scheme, companies that don’t have enough allowances to cover their emissions will face a EUR40 fine for each excess tonne of CO2 they emit. For 2008-2012, the fine will rise to EUR100.

The ETS covers all power generation installations above 20 megawatts, plus most heavy industries, including the production of coke, steel, iron, glass, paper and ceramics. Transport industries, including airlines, are not included in the scheme.

The scheme will affect many areas of financial reporting and taxation. There is still a degree of uncertainty in some areas, and many UK companies covered by the scheme still haven’t grasped them all. “We have been looking at state of readiness across the industry,” says Richard Gledhill, head of climate change services and emissions trading at PricewaterhouseCoopers. “In the production operations and systems and monitoring side, the work is either done or well in progress. There has been less progress on the accounting financial reporting and legal side,” he says.

“IFRIC 3 (the International Financial Reporting Interpretations Committee guidance on emissions trading) was only finalised in December, and finance teams have had a lot on their plate with IFRS,” says Gledhill.

A major source of uncertainty is the fact that the UK still hasn’t finalised its allocations of allowances to individual emitting entities, so firms don’t know whether they will need to acquire more permits, or have a surplus to sell. Final details will not appear before the end of March.

Emissions allowances will also have a major impact on reported profits. When issued, emissions allowances are granted free of charge. Under international accounting standards, allowances will be shown at fair value on the balance sheet, and as intangible assets with an equal and opposite credit to liabilities for deferred income. (As intangible assets they may only be revalued through equity, not through the p&l account).

The deferred income initially recognised is released to the p&l as grant income in line with the actual emissions of CO2 made by the entity.

At any balance sheet date, the company must make provisions for the actual emissions it makes. This provision is based on the market price of allowances at the balance sheet date under IAS 37. If the market value rises between the date of issuance of allowances and the balance sheet date, the company will report a loss. If the value falls, it will recognise a gain.

When the allowances are remitted to government at the end of April the following year, the company recognises a reversal of the excess provision. Thus the p&l impact is entirely accounting-driven and doesn’t reflect the underlying performance of the business.

“A 20% movement in the price of allowances can have a big impact on the p&l,” says Andrew Pearson, chief operating officer at Climate Change Capital, a specialist merchant bank dealing in markets related to climate change. “We have seen the forward price drop by 20% over a two-day period during early 2005.”

There are other potential issues to consider. “A significant uncertainty exists over whether profits from the sale of allowances will be treated for corporation tax as profits or potentially as chargeable gains,” says Pearson.

If allowances are treated as intangible assets for tax purposes, tax treatment may follow book treatment and taxable profits arising from allowances, and could be subject to volatility in the same way as the p&l. If allowances are considered chargeable assets for tax purposes, a significant tax liability would be incurred when they are sold since they were, in essence, granted for free.

Trading emissions allowances within the EU will also mean that companies need to consider carefully the VAT position which arises, says Pearson. “It is going to be crucial for any company that is not 100% recoverable for VAT to ring-fence their allowances trading to ensure full recoverability,” he says.

Financial Director asked a number of large UK companies how they had prepared for the climate change programme. Only E.ON UK (formerly Powergen) felt it had the matter in hand. “E.ON UK has been running a long project to ensure it is ready for the introduction of the EU ETS,” the company said.

“It is a big issue for the sectors that are affected,” says Gledhill. “We have seen a lot of activity from companies that have suddenly realised there is a hell of a lot to do.”

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