Carbon accounting must change to meet green investment evolution

Carbon accounting standards must be updated to reflect the rapidly changing nature of climate investment, Nick Gibson writes.

Carbon accounting standards need to reflect emerging global carbon markets and new investable assets such as certified carbon offset credits in order to achieve full transparency in the fight against climate change.

In 2021 global carbon markets grew to a record €760 billion ($851 billion). With discussions around greenhouse gas emissions reduction central at COP27 accounting standards particularly around carbon credits are crucial to scaling up carbon markets and achieving net zero by 2050.

The changing investment landscape demands new accounting standards. In particular, certified carbon offset credits (also known as carbon offsets) remain misunderstood as financial instruments which create a barrier to standard setting.

The current lack of clarity and guidelines around carbon markets’ financial accounting and risk management has significant implications for banks’ regulatory capital requirements in their role as intermediaries in the emissions trading system, according to a new report, Financial Accounting for Carbon Finance: A New Standard for a New Paradigm, from Imperial’s Centre for Climate Finance & Investment.

Carbon accounting standards must evolve

New carbon accounting standards are urgently needed, say report authors Dr Raúl Rosales, senior executive fellow at the Centre for Climate Finance & Investment at Imperial College Business School and María Angeles Peláez, global head of accounting & regulatory reporting at Spanish bank BBVA.

Dr Rosales suggests that a change in accounting standards that amplifies the importance of developing a new category of financial instruments at fair value that reflects the management and goals of financial entities in their financial statements is needed.

Achieving all of this, Rosales notes, starts with re-thinking the definition of carbon offsets. Rather than being classed as intangible assets or inventories, carbon offsets should be considered as investable assets used as part of a bank’s offering to corporate clients for ‘offsetting’ and ‘hedging’ purposes.

The report was created with the support of the Singapore Green Finance Centre, which is co-managed by Imperial and Singapore Management University, and strategic insights from financial firms, banks, asset managers, and senior officials from policymakers.

“We need accounting standards that reflect both the market at present as well as the direction that it is going in,” Dr Rosales says. “With such markets evolving rapidly, there is an urgent need for the establishment of a carbon instruments accounting project in the near term. This report is timely as it coincides with the new sustainability reporting standards being developed by the International Sustainability Standards Board (ISSB). It is crucial to develop new financial accounting standards alongside these, to achieve global harmonization. The International Accounting Standards Board (IASB) is in our opinion the most qualified international body to address this.”

 Carbon markets and investable assets

While  the  emergence  of  global  carbon  markets  has  created  numerous opportunities,  it  also  presents  significant  challenges.  In  particular,  the  new  investable  assets  that  this  shift  has  created,  in  the  form  of  carbon offsets,  call  for  a  specific  standard  for  this  new  asset  class.

Relatedly, there is a need to review and expand the existing definition of financial instruments in this context. A transparent and faithful accounting representation is needed sooner rather than later,  as  currently,  there  is  no  specific  accounting  definition  for  carbon  offsets  as  financial  instruments in the financial accounting regulations, nor standard guidelines for this.

The  reason  for  this  absence  of  detailed  standards  and  regulation  is  the  widespread lack  of  understanding about carbon offsets as new financial instruments and investable assets. While it is important to highlight the efforts of the IFRS Foundation to improve the sustainability standards focused on reporting, these efforts have not yet encompassed financial accounting.

Thus, there is still a strong need for a project that addresses how to reflect the financial accounting of these new instruments in the financial statements. Notably, such a project would offer a solution for both sustainability standards and accounting.

The report proposes a simple, clear, and robust accounting regulatory framework with just a  few  measures  that  will  help  achieve  the  required  transparency  in  global  carbon  markets.  In terms  of  governance  and  leadership  to  tackle  this  project,  we  believe that  the  International Accounting Standard Board (IASB) is the most appropriate regulatory body, as it is both more qualified to work on this initiative and more influential than other organisations.

Clear and consistent guidance required

The rationale is that the IASB, as the accounting standard-setting board of the IFRS Foundation, should retake the  “Emissions  Trading  Schemes  Project”  and  provide  clear  and  consistent  guidance  on  its  carbon markets accounting rules. Regulatory initiatives and debates have started, and some local regulators have issued different technical approaches. However, we need an international standard to establish a level playing field to avoid regulatory arbitrage.

The research findings

Carbon  offsets  should  not  be  considered  intangible  assets  or  inventories,  but  rather, investable  assets  used  within  the  bank’s  offering  for  its  corporate  clients  as  derivatives  or  other financial instruments for offsetting and hedging purposes.

A  specific  standard  for  carbon  offsets  is  required  to  establish a  level  playing  field  in  the  carbon market’s financial accounting framework. Regulators should also revisit the definition of  “financial  instruments”  under IAS  32  as  financial  assets  in  the  context  of  global  carbon  markets.  At  present,  a  spot  carbon  offset  does  not  comply  with  the  IAS  32 definition  of  a  financial instrument, which is why it is typically accounted for as inventory or an intangible asset.

This inaccuracy is the reason why we advocate for a change in the standards to amplify the definition of the financial instrument or to develop a new category of instruments at fair value through an identifiable reported line item in the income statement that would reflect the actual management and goals of financial entities with these instruments.

In  sum,  based  on  the  “faithful  representation  principle”, good  reporting on these  products  would mean including them among the financial instruments and applying “fair value criteria” as defined in IFRS 13 as a separate reported line item both in the balance sheet and within the income statement.

The current lack of clarity and guidelines about carbon markets’ financial accounting and risk management has  an  impact  on  regulatory capital  requirements  for  banks  through  the Fundamental Review of the Trading Book (FRTB)45, which includes higher capital charges for  carbon  trading  under  the  standardised  approach  to  market  risk.  This  impact  has implications for banks in their role as intermediaries in the global emissions trading system (ETS).

The report is published a year on from the IFRS Foundation’s unveiling of the ISSB at COP26, which took place in Glasgow in late 2021. Aware of this timeline, Dr Rosales adds: “Last year, we witnessed a major milestone moment: the announcement of the ISSB at COP26. A year later, now is the time to build on that development.

“As this report highlights, markets are changing. As such, standards too are evolving. This report offers policymakers and those operating within the industry a number of valuable recommendations to ensure that, amongst all of this change, transparency remains.”