On Rose Hill

Where   : Road from Jugiong to Cootamundra, New South Wales
When    : Monday 21st July, 1-00pm
Weapon : Panasonic Lumix TZ3

Here's a beautiful spot, up in the range on the winding road from Cootamundra to Jugiong, 400kms west-south-west of Sydney.

It's lambing time.  Beautiful, just stunning ... distant hint of mint sausce.

XXX

Wilson Pharaoh is Finance Director of one of the ASX Top 200 listed companies.  Just like 999 other Finance Directors,

Wilson

is getting his knickers in a twist, and may be hung out to dry unless he can make some serious investment in accounting systems to cope with the demands of the Rudd Government's emerging Emissions Trading System.

Suddenly, bean counters like our Wilson Pharaoh are recognising that within between 5 and 17 months they will have to introduce front-end costing systems to calibrate the drivers and report the financial impact of greenhouse gas emissions and market trading. This requires a big commitment to new costing, financial accounting, reporting, auditing and computer systems right now.

Wilson

remembers the Y2K fiasco, when the smartly suited management consultants convinced him to spend up big on ERP (Enterprise Resource Planning) systems, which just resulted in a big investment in pushing the same dross around faster. Now, the same guys accompanied by bimbo graduates are back - the same serious financial advisers, accountants and I.T. consultants with their flash suits, fillings and 'phones.

This time though,

Wilson

can see that the drive for reduction of emissions through the Green Paper style of cap and trade system, requires accountants to measure and match the costs of reducing those emissions with the financial benefits of that investment and expense.

What is not so clear to him, is how to establish the costs of creating emissions, in terms of materials, labour and expense. The most sensible approach might be to adopt a standard costing approach to account for expected and actual emissions using transfer pricing across each of his company?s business units and subsidiaries.

Wilson

breaks out into a cold sweat when he starts to think about what all this may mean for his company's factories in

Malaysia

, his service centre in

New Zealand

and Call Centre in

Bangalore

.

 

To properly calibrate expenditure, Wilson believes it will be necessary to establish the standard unit costs and capture the actual associated non-financial data related to emissions, as well as the financial data, for example like this :-

• Electricity, taking the electricity consumed in kWh and multiplying that by a conversion factor that will yield CO2, NOx and SO2 emissions in tonnes of CO2 equivalent;



• Natural gas, taking the gas consumed in kWh and multiplying that by conversion factors that will yield tonnes of CO2 equivalent;



• Fuel oil, taking the fuel consumed in mega litres and multiplying that by conversion factors that will yield tonnes of CO2 equivalent emissions;



• Waste water, taking output megalitres converted to a CO2 equivalent;



• Vehicles (e.g. trucks, cars, delivery, forklifts, cranes, conveyors, vans ? classified into function and purpose - based on kilometres traveled, M3 carried, GTKs), multiplied by conversion factors to derive the yield of emissions according to engine size or kW of power ? by CO2, NOx, HCs and particulates; and



• Air travel, CO2 and NOx based on air kilometres.

In the absence of a more robust foundation for the derivation of unit data, a proxy standard cost per tonne of CO2 equivalent could then be set initially at

(a)   the European benchmark rate, being geared to Mid May 2006 at 8.6 Euros per tonne of CO2 equivalent; or

(b)   a local market value for the trade of allowances, perhaps between $5 and $8 a tonne; or

(c)    the price rate set by the Australian regulator (whoever that may be) as the fine or penalty for exceeding the allowance ? in the EU the fine has been set at 40 Euros per tonne of CO2 equivalent, against a Mid 2006 EUETS market price 8.6 Euros per tonne (destined to rise to 100 Euros at some time in the future). 

Pharaoh can see that there is another accounting dilemma here - he may start with a zero coupon certificate or allowance, and end the year either meeting that allowance in which case there is a nil result, or he ends up with either creating more CO2 equivalents in emission, or a shortfall.

That is, it should be possible to gradually build up an asset or a liability from a zero start. He will have to make a provision for a future "penalty" or "benefit" ? perhaps on a monthly accrual basis.

After some thought, Pharaoh has concluded that costing of emissions should take place outside of the books, with summary entries transferred from offline stand-alone systems.

These entries would be generated by extrapolation, multiplying the tonnes of CO2 equivalent by the proxy standard unit costs, with the variances being booked to the P&L monthly, just as in a common standard costing system. By year end any under or over emission can be identified as a tradable asset if emissions have fallen short of the allowances provided or, if emissions have exceeded the allowance, written off to cost of sales or taken to the Balance Sheet as a liability.

In this scenario, there would be (a) acquittal variances caused by the difference between the value and quantity of emissions allowances (b) output variances caused by the difference between the quantity and source mix of CO2 equivalents generated by the resources consumed.

Pharaoh still has many questions as there is a lack of clarity around the financial nature of emission allowances, permits and certificates.

For example :-

1.      Are they financial or negotiable instruments, or both ?

2.      Are they assets ?

3.      Can they be traded internationally ?

4.      Can they be securitised - eventually into CDOs and junk bonds ?

5.      Are they androgynous, neither assets nor liabilities - but establish their final orientation during the financial year ?

6.      Are they to be defined during a financial year for example for ASX reporting, like so many capital items in emerging market economies, particularly in the state owned corporations of developing countries, as "Balance Sheet Items of a Nature Yet to be Determined" ?

7.      Can they be carried forward ?

8.      Can they be used as collateral ?

9.      Are they all homogeneous - or are they infinitely inter-changeable ?

Pharaoh is finding it really difficult to deal with instruments that on acquisition have an unknown future status or value ? they may be assets if they can be sold or they may be liabilities if they have to be treated like an invoice or demand notice, fine, penalty or tax assessment.

Certainly at year end, they may have a value, but what about on Day 1 ? 

?        If an asset, is it similar to a licence to operate within certain parameters? 
?        Is it an economic incentive to reduce emissions? 
?        Is it a derivative ?
?        Is it a negotiable instrument ?
?        Can it be hedged ?

Finally, Wilson Pharaoh is aware that there has been a great deal of churning in the world of Accounting Standards about treatment of the allowances held (as an asset) and the treatment of the obligation to deliver allowances for emissions that have been made (as a liability).  The current wisdom seems to be that the allowances should be measured at "fair value" (whatever that means) and any changes in value put through the Profit and Loss account as they emerge. 

Pharaoh is also aware that his own Big 4 firm of auditors has been participating internationally in all sorts of international forums, yet still does not have the answers and certainly will not give any guarantees on what will happen from the audit point of view ... Y2K all over again.

So far,

Wilson

is of the view that emissions that arise from a company's general business operations cause ETS liabilities, and will require a charge to expenses in the Profit and Loss Account and a corresponding credit to liabilities in the Balance Sheet. This will recognise an obligation to eventually at some time in the future, surrender its allowance certificates or permits by means of a cash payment to discharge those liabilities at some market or pre-determined price.

If the company does not hold enough certificates, it will be forced to go to the spot market to buy them - which raises the possibility of a secondary market in hedged instruments - or cop a fine at some penalty rate. During the accounting period, it appears that it would be prudent to accrue any emerging liability or asset (if the emissions actually being generated are short of the expected amount or allowance).

Should a company buy allowances on the market "just in case", the treatment is still to be determined, as this investment may be in the nature of insurance, speculation or good business caution.

This is why Y2.01K is looking so very good to consulting accountants - and why it has got Wilson Pharaoh worried about his knickers.