As surprising as it may seem, the fight against climate change has one of its cornerstones in corporate accounting. And it is that accountants play a fundamental role in three key factors of sustainability: the requirement that companies regularly disclose their environmental risks and performance, known as sustainability reporting; consolidating the emission allowance schemes that set the price polluters must pay, and establishing common measurement and reporting standards for all schemes.
There is no doubt that the pressure on companies to be accountable for their carbon footprint and environmental impact will increase, which is why transparency is important. However, there is an information asymmetry between what is happening inside each company and what is perceived from the outside. With more and better sustainability reports, accounting can make a significant contribution to closing this gap.
All companies that have a negative impact on the environment have to bear the costs. The key here is the determination of these costs, that is, the way in which pollution is priced. There are currently two mechanisms: the carbon tax and capped emission trading, such as that of the European Union, the most liquid and developed carbon market in the world.
Essentially, such schemes impose a cost on pollution by capping greenhouse gas emissions, forcing companies to report their own verified data and get rights to cover those emissions. After a certain number of rights have been allocated to market participants free of charge, the remainder are auctioned off at a price set by the bidders with their bids.
On the secondary market, companies can sell the rights they have acquired to others whose pollution is more expensive. The idea is that trading rights helps determine the price of pollution, a price that changes dynamically as regulators lower the cap and companies take action to reduce their emissions.
But there is a problem. I found this with Donald N’Gatta and my IESE colleague Robert Raney after researching a broad sample of companies in the European carbon market. From our research, we found that those with liquidity needs tend to sell them. Likewise, we observe that others do this to increase their profits and thus avoid accounting losses, behavior that occurs particularly when the price of carbon is higher and at the end of the year, before the end of the fiscal year.
The root of these financial tensions – as we have called them – lies in a lack of regulatory clarity about how emissions allowances should be accounted for in financial statements. Of course, rights are a new good, but what kind? Without a precise definition, companies disagree: for some it is a financial asset, for others it is an intangible asset, and for others it is inventory.
Amidst this confusion, and thanks to a special form of accounting, some companies have created a pool of off-balance sheet rights, assets that they can sell to improve their bottom line. This opportunistic sale is worrying because it distorts the price of pollution and reduces the effectiveness of the system. In addition, the gap created by the lack of clear guidelines results in inconsistent sustainability reporting by companies.
It is time for the regulator to fix this issue and clarify how allowances should be accounted for. Some academic research recommends that results be presented at fair value in each period of presentation of results.
If the rights are accounted for at historical cost because the regulator grants them at zero cost, they become invisible assets in the financial statements. However, when they are measured at fair or market value, it becomes more difficult for entities to disclose the proceeds of their sale when it is most convenient for them. The reason? For example, if they sold the rights the same day they received them, the price of the transaction could be observed directly in the market: that would be their fair value. Some already account for their entitlements this way, which gives visibility to their impact on their financial position and prevents them from “managing” their earnings when they have a bad quarter.
On the other hand, a fair value would complicate the adoption of measurement and reporting standards, which are important because they facilitate the monitoring and control of companies’ green initiatives and help investors assess the risks associated with climate change. Reporting based on fair value would result in greater volatility related to the price of pollution, and this is beyond the control of the companies. But as difficult as the change is, it still seems like the most robust solution.
On the other hand, it would also be helpful if the regulator would shed more light on the market. Currently, the data from the registration of the rights sale is published in May each year, but three years after the compliance deadline. Thus, a sale that took place today would be published in May 2027. Such a length of time makes it difficult to monitor the transactions of the companies in a timely manner.
In short, it is not our intention to prescribe how allowances should be accounted for. We just want to draw your attention to one important shortcoming. As the European Union system is a model for the rest of the world and climate change is a global reality, the lack of regulatory clarity could spill over into other markets. And since many are not as liquid as Europe’s, they would face even greater problems if financial tensions disrupted the normal functioning of their own system.
Gaizka OrmazabalIESE Professor and Grupo Santander Chair in Management of Financial Institutions and Corporate Governance
Follow all information from Business And Business on Facebook and Twitteror in our weekly newsletter
Five Day Agenda
The day’s major economic dates, with the keys and context to understand their scope.
RECEIVE IT BY MAIL