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Business Implications of the Developing North American Carbon Markets

April 20, 2009 (SmartPros) Momentum for development of North American carbon markets continues to grow, driven by the need to participate in international negotiations to be held in Copenhagen later this year, by the commitments and actions of the new U.S. administration, and by the steady progress of the Western Climate Initiative (WCI), among other influences.

Business has accordingly been prompted to react to these existing and emerging U.S., Canadian and cross-border carbon markets. A new whitepaper by Deloitte provides a comprehensive overview of these carbon markets and the implications of cap-and-trade for business, including:

Substantial incremental costs for entities in regulated carbon markets. President Obama’s projections assume 100 percent auctioning of credits, meaning businesses would have to pay for every ton of carbon emitted. Since the details of the emissions trading programs are still evolving, understanding and projecting the cost for a given business means grappling with such uncertainties as PoR, industries to be included in trading, and options for offsetting. The ability to pass carbon cost through to customers can, to a large extent, determine the effect on profitability.

Business strategy. Companies may find it important to integrate the price of carbon into their overall business strategy. Given the significant uncertainty with respect to implementation of both carbon markets and low-carbon technologies, use of scenarios can be an important approach to development of business strategy. It is important that these scenarios be internally consistent, recognizing the correlations among regulatory options, pace of technology implementation and resulting commodity prices. Business strategies should also take into account related policies such as low carbon fuel standards, renewable electricity standards and incentives for clean energy.

Risk Identification. Carbon markets can introduce a broad range of risk types, including price risk, credit risk, operational risk and regulatory risk, among others. Companies could use a structured approach to risk identification so that significant risks are identified and managed appropriately.

Governance and organization design. Understanding of carbon markets should flow through organizational decision making. Accordingly, companies may need to develop policies and procedures, and appropriate internal controls to govern management of this new commodity. Definition of roles and responsibilities should address which functions are centralized and which are carried out by the business units. Policies should put into place the correct guidelines and incentives to optimize carbon decisions throughout the organization.

Carbon price impacts on contracting and capital allocation decisions. Understanding the cost of carbon and including it in an analysis of future capital allocations can be a game-changer in these decisions. Moreover, 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 new commodity — companies may need a hedge strategy. Hedging may entail simply buying tradeable allowances, however, if the European experience is any indication, many businesses may also find themselves buying carbon offsets. Legislative efforts to date have incorporated offsets as a key price control mechanism. 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 time periods, either to address financial statement volatility, or to manage risk associated with passing costs to customers.

Reconsidering accounting policy elections. The accounting treatment of emission credits is challenging, since there is divergence in practice in how companies account for emission rights with some treating them as inventory and some as intangible assets. Since the effects on the balance sheet and income statement may differ depending on which treatment is applied and by 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-andtrade programs. Companies should explain their related accounting policies to the market to ensure that the financial statement effects 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.

Significant financial statement implications. Financial statement implications 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 skill sets including fair value competency and measurement credentials.

Tax implications. The tax implications of emission allowances begin with the adopted accounting treatment. Sounds simple? It is not. As highlighted above, clear guidelines for accounting do not exist. Are emissions credits counted under the inventory model, such as products in a warehouse, or the intangible model, akin to goodwill or intellectual property? This choice directs the tax treatment, with a special effect when credits are bought and sold. Other accounting questions also shift the tax treatment, such as whether or not emissions allowances fall under a derivative contract and whether the company trading them is doing so for hedging or speculation. What about penalties? Are the penalties treated as punitive and therefore not deductible for tax purposes, or is the penalty a remedial penalty as part of the company’s business? The answers to these questions can have significant tax implications.

Reporting and disclosure. Carbon market designers, registries, states and the EPA are developing protocols for regulatory reporting, and these protocols may create a need for additional infrastructure in order for companies to comply. 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? Will the need for financial statement evidence be satisfied by the regulatory reports? Shareholders and regulators are also making additional requests for disclosure, which could require risk assessment and a discussion of strategy. Coordination within a business to make sure that these different reporting requirements are met without duplicating work, misrepresenting information, or creating any apparent discrepancies to be explained to the marketplace will be essential.

Implication on companies that are not regulated by the carbon trading program. 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.

Cost of carbon in asset valuations. Once regulated, carbon will have a value associated with it. Wherever transactions occur involving carbon-related assets, businesses will need to record the fair value of their carbon positions to present a fair picture to the market and investors, as well as to gain a fair return on any asset sales. Valuing these assets fairly will create challenges, particularly during the early stages of market development when markets may be illiquid or have few players.

Fraud risk related to carbon. As markets evolve, instances of fraud related to carbon may emerge. Fraud may be especially prevalent during the early stages of regulation by those looking to take advantage of naive market participants. Fraud can occur in various places in the carbon market and for various reasons, including underreporting of carbon emissions expenses in order to increase asset values, overreporting of offset purchases in order to reduce investments in carbon reduction mechanisms, and exaggeration of the carbon reductions associated with offset projects are all schemes that could occur. Assuming there is market trading, the markets will also be susceptible to market manipulation and excessive speculation. Therefore, just as businesses guard against financial fraud, carbon fraud will similarly have to be monitored and guarded against within businesses’ operations.

The need to be actively involved in shaping the details. As the markets evolve, a myriad of details will need to be considered when formulating how the markets will operate and businesses will participate and report. The uniqueness of carbon regulation and the political environment under which new carbon regulations will go into effect mean that there are no precedents that can be easily copied. Lawmakers and regulators are putting together complex and inter-related requirements for reporting, tracking, and trading. Now is the time for businesses to be active participants in the market rules formulation — not just to advocate on overall position, but to understand the finer details of how the markets are designed to work and to respond appropriately with comments and observations.

All in all, as carbon markets develop in North America, businesses are challenged to manage a wide variety of effects. How nimbly they respond will perhaps define competitive positions in the cap-and-trade era that becomes more imminent with each passing day.

The full whitepaper is available online.

2009 SmartPros Ltd. All rights reserved.

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