Research Report
Ⅰ. Background and Purpose
□ Discussion about the accounting system concerning free or auction-based emission allowances in connection with the implementation of the emissions trading system as a means of dealing with global warming.
○ Major developed countries, including the EU, are discussing the accounting system but have not yet reached an agreement on clear-cut criteria.
○ With the implementation of the emissions trading system, it will be necessary for businesses and stakeholders to set up a proper accounting method concerning the acquisition, use, and transfer of emissions allowances.
Ⅱ. Major content
2. Emissions Trading Scheme and the Legal Nature of Emissions Allowance
□ It is urgently necessary to set clear-cut accounting methods based on discussion of the legal nature of emissions allowances in order to ensure the emissions trading system is implemented in earnest and firmly takes root.
○ Emissions allowances may or may not be viewed as assets, depending on their legal nature and whether ultimately they are free or auction-based, which will determine what kind of accounting methods to be used.
3. Accounting Standards for Emissions Allowances
□ There is no internationally-agreed guidance on accounting standards for emissions allowances and diverse accounting standards emerge in different countries.
○ The International Financial Reporting Interpretations Committee (IFRIC) of the International Accounting Standards Board (IASB) withdrew IFRIC 3 and different European countries use different standards. For example, the Netherlands, France, and Portugal record emissions allowances as intangible assets and Germany and Austria record them as inventory.
○ In U.S., some states have emissions allowances. Following accounting standards for sulfur dioxide (SO2), allowances are recorded as inventory. Free-granted allowances are recorded at cost and purchased allowances are recorded as fair value. There is no guidance from FASB.
□ We review the draft of accounting standards for emissions allowance issued by Korea Accounting Standards Board from the perspectives of an impact on financial statements, reality of trading market for emissions allowance, distortion on cost of goods sold, and consistency of accounting standards.
○ Free granted allowances are recorded at a zero basis, which minimizes the impact on financial statements compared to an alternative of recording it at fair value
○ Revaluation of allowances are not allowed considering inactive trade market of allowances.
○ The difference between purchased price and sales price of allowances is recorded as deferred income (a liability). This minimizes distortion of cost of goods sold.
○ Borrowing of allowance are recorded at fair value. This increases cost of goods sold in a borrowing year and reduces cost of goods sold in a lending year, which minimizes distortion of cost of goods sold.
○ Value of liability is matched at the value of allowances except insufficient allowances in which case liability is recorded at fair value.
4. The Economic Implications of Applying Different Allocation Rules and Accounting Standards to Emission Allowances in Emissions Trading System
□ The Act on Allocation and Trading of Greenhouse Gas Emissions Allowances, which legally binds the implementation and operation of the Korean Emissions Trading Scheme (K-ETS) scheduled to begin on January 2015, explicitly mandates that trading of emissions allowances in the market be done in a way of fairness and transparency.
○ It implies that neither the participants’ decision-making or market position should not be affected by the K-ETS.
□ If a firm, however, behaves in an imperfectly competitive fashion, then the participation in the K-ETS might change its financial position by changing debt-capital ratio, due to the way of allocating, recognizing, and appropriating emissions allowances, resulting in that the firm might face a different borrowing rate in capital market compared to the one without the scheme.
○ Considering the fact that there is no internationally-agreed guidance on accounting standards for emissions allowances, it is very likely that the firms in the scheme would apply different accounting standards from one to another, leading to different as well as unanticipated consequences in market outcomes.
□ In Chapter 4, we investigate theoretically how the allocation, recognition, and appropriation of allowances could affect the firms’ financial structure in the scheme using a Cournot duopoly model. Our theoretical results are as follows:
○ As firms’ borrowing rates increase, both their production and reduction investment decrease (Theorems 1 and 2).
○ The effects of increase in borrowing rate are, however, not clear. On one hand, the increase in production costs due to higher borrowing rate suppresses production, resulting in smaller emissions. On the other hand, the increase in investment costs due to higher borrowing rate hiders firms’ emissions reduction efforts (Theorem 3).
○ In the case that firms do not retain revenue from selling allowances, borrowing rate becomes higher as the initial debt ratio is higer, the quantity of free allowances is smaller, or firms appropriate the value of allowances higher (Theorem 4).
○ The higher the borrowing rate is, the smaller the consumer surplus becomes due to the increase in marginal cost (Theorems 5 and 6).
○ The producer surplus also becomes smaller as firms’ borrowing rates get higher. Moreover, the magnitude of decreased producer surplus becomes larger, as imperfect competitiveness worsens and the price elasticities of demand and supply are inelastic (Theorem 7).
○ The effects of higher borrowing rate on environmental damages is not clear. On one hand, higher rate decreases production and emissions. On the other hand, higher rate increases the costs of reduction investment, leading to smaller effectiveness in per unit emissions reduction (Theorem 8).
○ Finally, the ultimate effects of increased borrowing rate is not theoretically clear, because both consumer and producer surpluses decrease while the direction of change in environmental damages (Theorem 9).
□ We also compare the theoretical results with the numerical simulation results for several scenarios stylized from the various characteristics of the scheme. The results strongly show that the way of implementing and operating the scheme could indeed affect the participating firms’ competitive positions by changing their financial status in capital market. Some important results from the analysis are as follows:
○ Compared to the case with no scheme, introduction of the K-ETS unanimously decreases market production. The decrease comes disproportionately more from the firm with higher emission coefficient, which confirms that the scheme achieve the optimal results in a cost-effective way.
○ In the case of free allocation of allowances, if a firm recognizes them as intangible assets and appropriates them to have ‘zero’ value, its debt ratios remains unaffected, therefore experiences no change in its borrowing rate in capital market. However, If a firm appropriates the allowances for a non-zero market price, its debt ratio gets lower, resulting in a lower interest rate in capital market. With free allocation of allowances, the higher a firm appropriates them for a market price, the larger the effect on its financial position would be.
○ If allowances are freely allocated using a benchmarking method rather than a grandfathering one, the firm with relatively lower emission coefficient could secure more allowances than it actually needs, leading it to make profits by selling them in the market, therefore improving its financial position.
○ In the case of auctioning allowances, if a firm sells them and keeps a part of the revenue as retained earnings, the higher the proportion of retained earnings is, the lower the debt ratio would become, resulting in its favourable position in capital market.
□ Our numerical simulation also shows some pertinent results about how strong the behavioral incentives for firms in the scheme are. They are as follows:
○ Auctioning allowances give firms the strongest incentives to use accounting system in a consistent way.
○ Firms’ emissions reduction efforts would be highest when allowances are auctioned or freely given with appropriation of a non-zero market price.
○ The borrowing rates for firms in capital market are most sensitive in the case of auctioning allowances, while free allocation with appropriation of zero value gives the weakest signal to capital market.
□ In conclusion, the K-ETS is very likely to change the financial positions of the firms in the market, depending on the ways of allocating, recognizing, and appropriating allowances, therefore resulting in changes in the price and quantity of individual firms as well as of market equilibrium and firms’ emissions reduction efforts. These results are first derived from the theoretical model and then are confirmed by numerical simulation. Therefore, it is very likely that the K-ETS would place some firms in more favourable situations over other firms in capital market by changing their borrowing rates differently. As a result, the social welfare are highly likely to be affected, against the original intentions of the regulatory authority.
Ⅲ. Expected effects
□ It is expected that discussions concerning the establishment of a new concept of emissions allowances, the accounting methods to be adopted for the relevant transactions, and the economic effects thereof will contribute to the preparation of accounting criteria for businesses.
○ Establishment of emissions allowance-related accounting criteria is a precondition for invigoration of the emissions allowance-based carbon market and could ensure the emissions trading system takes root and is operated actively.
○ Establishment of emissions allowance-related accounting criteria will lead to transparent and fair transactions by business entities.