There is No Accounting for Carbon

Scott Pruitt, Trump’s administrator for the Environmental Protection Agency, explained on the CNBC financial news program that carbon dioxide is not a primary contributor to global warming.  He claimed ‘tremendous disagreement about the degree of impact” by human activity on planetary systems.  Pruitt declined to state that factor that actually IS the primary contributor to global warming, but he remains steadfast in his view that there is no need to account for carbon, at least the kind generated by humans.

Pruitt is right on one point at least.  There is no accounting for carbon, just maybe not in the way that the new EPA head suggests.  Carbon remains largely illusive to measure and valuation by analysts and shareholders.  As a consequence fouling our planet with greenhouse gases such as carbon dioxide remains an externality -   a cost that is left to payment by third parties, most of whom do not choose to incur that cost, through poor health, shortened life spans, reduced food chain, and loss of habitat, among other reductions in fortune.

Accounting standards institutions have been reluctant to recognize on balance sheets either the liability of emissions or assets built in avoiding those adverse effects.  Companies are driven by competition into a downward spiral of avoidance and denial.  Such myopic thinking persists despite a preponderance of scientific evidence links human generated greenhouse gas emissions. The National Academy of Sciences has been sounding ever louder alarms over the impact of a warming planet is having on weather systems and the consequent adverse impacts on food chains around the world.  Humans are literally destroying the environmental systems that have sustained humanity from the beginning of time.  Of course, the EPA has had a long standing view that human activity is indeed the cause of global warming  -  a position that supported by sister federal agencies the National Oceanic and Atmosphere Administration (NOAA) and the National Aeronautics and Space Administration (NASA). 

Pruit rightly identified that the Paris Agreement signed by then President Obama in 2015, leaves U.S. companies at a disadvantage competitively.  He points to lower profits for U.S. companies to comply with greenhouse gas emissions standards.  What that argument fails to recognize is that by doing nothing  -  by pretending the global warming phenomenon is unrelated to human activity  -  leaves our entire country at an unprecedented disadvantage against those countries that take the lead.  For the sake of protecting short term profits, Pruitt would leave U.S. companies and the entire country at a disadvantage in the long-term.  U.S. companies could be left behind technologically.  As noted in the earlier post “U.S. Stepping Back as Rivals Plan Job-creating Investments” on February 3, 2017, investors in Asia and the Middle East are planning ever larger investments in renewable energy to replace fossil fuel sources.

The capital markets are frustrated in analyzing business risk and competitive threats related to greenhouse gas emissions by the lack of transparent accounting.  In their joint report “Accounting for Carbon”, the International Emissions Trading Association (IETA) and Association of Chartered Certified Accountants (ACCA) revealed that accounting practices by large greenhouse gas emitters in Europe “vary widely, with no discernible pattern in accounting treatment.”  

For example, both granted and purchased emissions allowances  -  the closest accounting vehicle to ‘carbon’  -  were not recognized at all by as many as 27% of respondents to a survey completed by IETA and ACCA.  About 42% of respondents indicated emissions allowances were included in intangible assets and not otherwise disclosed in footnotes.  As tangible assets, the allowances are recorded and remain on the balance sheet at cost.  Few of the respondents provide any disclosure on the amortization or depreciation of emissions allowances.  With no accounting standards or practices for emissions allowances, companies are allowed to choose their own path.  This frustrates company comparisons by analysts and leaves wanting fair valuation of operations with an exposure to greenhouse gas emissions risks.

The International Energy Accounting Forum (IEAF) was formed to promote best practices by companies active in the energy industry.  The group has published a guideline for members and the public on accounting for emissions allowances. 

In the United States, the Clean Air Act established a cap-and-trade system for sulfur dioxide and nitrous oxide.  Since the 1995, electric power producers have been able to generate or acquire emissions credits to cover these emissions.  However, over a decade later the Federal Accounting Standards Board (FASB) has yet to set generally accepted accounting standards (GAAP) for emissions programs.  To its credit FASB did undertake studies of emissions trading schemes and made certain preliminary views public.  It concluded purchased and allocated allowances should be recognized as assets and that the allocation of allowances meets the definition of a liability. 

Otherwise the guidance contained in the Federal Energy Regulatory Commission’s (FERC) Uniform System of Accounts is the only accounting guidance available in the U.S. that explicitly addresses greenhouse gas emissions.  Allowances are reported at historical cost and classified as inventory.  Purchased allowances are recorded at cost while those received from the EPA are considered to have zero cost.  This inventory-based, historical cost approach remains the primary source of U.S. GAAP for emitters of greenhouse gases.  Some might consider this sufficient except for the distortion of balance sheet figures and operating income that arises from the preponderance of zero-cost allowances that have originated from the EPA.

The EPA itself directs emitters to guidance issued by the World Resources Institute (WRI) and the World Business Council for Sustainable Development (WBCSD) called “The Greenhouse Gas Protocol:  A Corporate Accounting and Reporting Standard.”  The GHG standard was set up to help companies build a GHG inventory that presents a fair representation of its emissions.  The standard covers seven of the most prevalent gases. Over 170 international companies are members of the World Business Council, a coalition that should aid adoption. 

Interestingly, Volkswagon (VOW:  DE or VLKAY:  OTC) is identified as an early adopter of the WRI-WBCSD protocol as the company attempted to standardize its emissions inventory.  A less obvious adherent is International Business Machines (IBM:  NYSE).  IBM adopted the protocol to help account for the consumption of electricity, which is a major source of GHG emissions.  However, users of IBM’s financial reports will find no reference to greenhouse gas emissions.  The protocol has been simply an analytical tool to facilitate facility costs.  IBM claims meaningful reduction in lowering the company’s carbon dioxide emissions from electricity by making spending decisions using analysis inclusive of GHG costs.

Members of the Trump administration, including Pruitt, are in a minority as deniers of climate change.  The vast majority of scientists and corporate decision makers see the impact greenhouse gas emissions on atmospheric temperatures.    It has become widely recognized that a concerted effort needs to be vigorously undertaken to shift the global economy from fossil fuel dependency to more environmentally sustainable energy sources.  While there is only piecemeal recognition of the costs of greenhouse gas emissions, the bell has been rung on the consequences.  We expect from these early and halting steps that eventually, there will be widely adopted standards and that every company will eventually be faced with accounting for its roll in warming our planet, whether it be through finished goods or internal processes.

 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.