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November 10, 2009
Forest Carbon Offset Market Needs Consistent Accounting Standards
    by Robert Kropp

The market for offset credits to mitigate deforestation is growing, but investors and other stakeholders require that guidance be provided in accounting for them.

Over the last 20 years, as the forestry carbon market has matured, it has developed into an alternative investment asset class. Forestry carbon projects typically address deforestation of the tropical forests lining the Equator, where deforestation occurs at a rate of 32 million acres per year. Deforestation accounts for approximately 20% of annual global greenhouse gas (GHG) emissions.

A recently published report, entitled Financial Accounting for Forestry Carbon Offsets, serves both as an introduction to forestry carbon offsets as an alternative asset class, and an analysis of the methods of accounting for forestry carbon offsets. The report was
authored by Gabriel Thoumi, a consultant with Forest Carbon Offsets, and Talitha Haller of the Social Carbon Company in Brazil.

The authors assert that by providing economic incentives for achieving emissions reductions through such means as cap-and-trade programs, "we can develop a financial asset from an environmental liability." Companies purchase forestry carbon offset credits for a number of reasons, according to the report, including regulatory compliance, investing for financial return, and public relations.

Recent significant purchases of forestry carbon offset credits include the purchase in July of 600,000 metric tons by Pacific Gas and Electric (PG&E), for a price of $9.71 per ton. PG&E purchased the emission reductions from The Conservation Fund, which is sustainably managing the growth of 16,000 acres of redwood and Douglas fir forests on the Mendocino Coast in California.

Yet at present, "The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) offer no guidance on how entities should account for voluntary emissions reductions, including forestry carbon offsets," according to the report.

Howard of Social Carbon said, "Financial accounting methods are important for investors looking for the credibility of projects."

Successful forestry carbon offset projects have four major components. They need to be adaptive to the requirements of the environment in which the project occurs. Companies must work with local communities in order to gain support for their projects. Business is advised to work with national and regional governments as well, to develop international standards of best practice that mitigate legal risk. Finally, in structuring risk, companies must keep in mind that a successful project focuses on mitigating risks, as opposed to maximizing profits.

According to the report, "Because forestry carbon projects should directly improve carbon sequestration and indirectly improve other ecosystem services, it is possible to discuss forestry carbon assets as value creation projects." Since forestry carbon projects usually span 20 to 100 years, they can be described as intergenerational in scope.

As an alternative investment asset class, forestry carbon projects have specific risk and return profiles, depending on the long-term sustainability of the project. Investors may be attracted to the idea of reducing emissions, while enjoying tax breaks that may come with forestry investment.

Unfortunately, while the role of financial institutions in the growth of forestry carbon projects is critical, their operations are too seldom congruent with sustainability. The report identifies three critical flaws in current financial analysis: "discounting without a rational time horizon, accounting for natural resources that does not reflect ecological resources, and the separation of growth and development as applied to infinite and finite resources."

Observing that global forestry carbon projects are growing in number and size, the report states that the market has yet to develop consistent institutional and regulatory frameworks. "Appropriate and uniform classification of forestry carbon offsets in the financial statements is imperative both for internal decision-making and for external stakeholders such as investors," because "Without clear accounting guidance for forestry carbon or voluntary offsets, comparability across projects will remain vague."

"If the market is really going to become active and viable," said Howard, "Then we're going to need uniform accounting principles across all stakeholders."

In order to provide guidance for a uniform system of accounting principles, the report compares the classification methods of inventory and intangible assets. "If an entity sells forestry carbon offsets as part of its normal operations, or uses them to settle emissions liabilities in its ordinary course of business, offsets could classify as inventory," according to the report.

The report says of the inventory classification, "If an entity is concerned with analyst following and attractiveness to investors, it may consider accounting for credits as inventory."

Because future benefits are expected to flow to an entity as a result of forestry management, forestry carbon offsets can be classified as intangible assets as well. Accounting for forestry assets as intangibles results in no balance sheet recognition, but in expenditures on the income statement instead.

"When offsets are recorded as off-balance sheet intangibles, costs are expensed as incurred; these expenses are not matched with relevant sales proceeds," the report states. "As a result, accounting for forestry offsets as intangibles will lead to greater earnings volatility."

"With intangibles, you don't have those assets on your balance sheet," Howard said. "You may lack credibility with outside stakeholders."

To gain an understanding of how emission reductions have been accounted for thus far, he report makes reference to a 2007 survey of 26 European organizations affected by the EU Emissions Trading Scheme (ETS), conducted by PricewaterhouseCoopers and the International Emissions Trading Association (IETA). The survey found that 29% of participants accounted for Certified Emission Reductions (CERs) as inventory, while 13% recorded them as intangible fixed assets.


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