Accounting for tomorrow's pollution control.

When the Clean Air Act was signed by President Bush in 1990, many accountants with no professional interest in the electric utility industry-the target of that environmental law--examined the legislation carefully. They were interested because they suspected the law's unusual procedures for attacking industrial pollution would be precursors of environmental laws that will have a major impact on their clients or employers.

The provision of specific interest to accountants was the government's authorization to grant airpollution emission rights--in effect, a limited license to pollute-- and the eventual creation of a market in which these rights can be sold or traded. (For details on the law's schedule, see the sidebar on page 71.) In fact, several states, including California and Washington, have already implemented similar regulations affecting local industry, and the United Nations is now considering implementing some type of worldwide pollution allowance system.

As a result, the law opens a Pandora's box of accounting problems for industry nationwide. The major question faced by utility accountants today, and probably other accountants tomorrow, is, How should these emission rights, which in many ways resemble securities, property and inventory, be accounted for? For example, are they assets? What should their cost basis be? Can they be amortized?

To date, there are no definitive answers to these questions. This article, however, explores some of the complexities the law raises and offers some solutions. Also, the article may inspire fresh thinking on what surely will be a topic many accountants will have to address in the years ahead.

To understand the accounting issues, accountants must first understand this background on air pollution and its regulation.

WHAT'S BEING REGULATED

Sulfur dioxide emission, a by-product of electric-generating utilities that burn fossil fuels (coal and oil), has been a target of federal regulators for decades. The first Clean Air Act, passed in 1970, set pollution standards, but they were applied with only moderate regard for their economic consequences. Some utilities were forced to make very costly plant modifications that did not yield equivalent benefits to air quality. Others could have improved air quality at modest cost, but the law gave them no incentive to do so. Consequently, many utilities missed deadlines for air-quality improvements, and sulfur dioxide emitted by electric utilities was nearly as high in 1985 as it was the year the law was passed.

The Environmental Protection Agency (EPA) always has regulated sulfur dioxide emission by setting emission standards. The 1990 law, which begins to go into effect in 1993, continues that process. Utilities currently operating will be granted rights to release sulfur dioxide emissions, but only in amounts based on those of the period from 1985 to 1987. New power plants will not be granted such rights. The goal is to reduce total emissions for all U.S. power plants to about two-thirds of their 1985-87 level.

The law bundles emission rights into units called "allowances," which are authorizations to emit one ton of sulfur dioxide in a given year. The law also directs the EPA to establish a market and a bank for the allowances. An allowance may not be used before the authorized year but may be carried forward to a later year.

The EPA goal is to hold back 2.8% of those allowances in order to develop the bank. Beginning in 1993, it will sell some of these allowances directly, and in 1993, in addition to its direct sale, the EPA will auction allowances to the highest bidder. Auction and sale proceeds will be distributed pro rata to the existing companies from which allowances were withheld. Qualifying sources also may trade allowances directly.

The auction and direct sale

* Will allow new companies to produce electricity using fossil fuels.

* Will allow existing companies to purchase additional allowances for planned expansion.

* By promoting a trading market, will reduce hoarding incentives and mitigate the partial monopoly the law confers on existing utilities.

The law's carry-forward provision encourages companies to lower emissions below mandated levels and makes allowances granted for that year available for use in a later year. Under regulations to be promulgated soon by the EPA (and by individual state environmental protection authorities), companies may bank these allowances and later sell them to companies unable to reduce their emissions efficiently. Such sales may be direct or through the EPA auction.

Two relatively simple methods for freeing up allowances are aggressive conservation and installation of pollution-control equipment. More complex methods include replacing "dirty" fuels, such as coal, with "clean" fuels, such as natural gas; burning coal of lower sulfur content; and replacing old generating stations with modern, cleaner-burning plants.

ACCOUNTING FOR ALLOWANCES

What exactly is an allowance, from an accounting point of view, and how should it be treated?

An allowance confers a specific right on its holder: the license to emit pollution at a specified time. Without that license, most utilities would be forced to close down their generating plants. Allowances evidently fit the definition of an asset in Financial Accounting Standards Board Concepts Statement no. 6, Elements of Financial Statements: "Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events."

The act says allowances are "limited authorizations" and not "property rights." Nevertheless, the law intends those authorizations to be marketable and provides holders with substantial protection against expropriation. An allowance is obtained or controlled by one of the following three past events: (1) the EPA grants to existing companies, (2) purchases by companies at auction or directly from the EPA or other companies and (3) receipts of bonus allowances from the EPA because of qualified emission reduction. Thus an allowance seems to meet all criteria for an asset and should be recognized as such.

The market value of an allowance isn't known at this time because the market hasn't been established yet. The Chicago Board of Trade recently filed to establish a futures market before the first EPA auction in 1995. It is known, however, that the offering price of allowances in the EPA's direct sales is set at $1,500 per ton of sulfur dioxide, adjusted for inflation and discounted for the time between year of sale and authorized year.

COST OR MARKET?

Clearly, allowance assets and related expenses will be very material items in a company's financial statement. But how should the value be recognized--at current market or historical cost? Each has advantages and disadvantages.

Because there will be a futures market for the allowances, market values always will be available. An allowance's economic value will be its value when it's used for electricity production or when it's exchanged, whichever is greater. After all, a rational manager who cannot derive more value from internal use of an allowance will choose to sell it; thus current market value is useful for management planning and control. Obviously, use values will be different for different companies and will depend on management decisions, production technologies and rate regulators' decisions. Market value is an opportunity cost that must be considered in evaluating any plan to use an allowance internally.

Current market valuation for financial reporting purposes, however, conflicts with traditional principles of realization and historical cost. Historical cost valuation is the norm for financial reporting. For an EPA allowance granted to an existing company, the original cost is zero; for a purchased allowance, it is the purchase price.

Use of a zero-cost basis for granted allowances leads to difficulty when a utility intends to offer its own allowances for sale in the market. How should costs (the price of a scrubber installation or plant conversion, for example) be treated if they are incurred entirely so that a utility can sell an allowance? The reasonable solution is to allocate such costs to the allowances freed up for trade.

This presents some problems. Different authorization dates for different allowances create a need for discounting and prevent equal allocations to each allowance. Also, most costs of installation or conversion probably are incurred for multiple purposes. What fraction of such costs should be charged to the allowances they free up for sale? Should such allowances be charged with a share of increased maintenance or operating costs of plants with lower emissions? Costing allowances made available for trade by changes in policy or technology suffer from all the usual hazards of costing joint processes and may not lead to valuations useful in management decision making.

While historical cost valuation of allowances is ambiguous and of limited relevance to management decisions, the traditional concept of realization requires some use of historical cost when a utility issues financial reports. Just how historical cost is to be used depends on which of many financial reporting principles currently apply. That, in turn, depends on how the allowance asset is classified.

INVENTORY, SECURITY OR INTANGIBLE?

A case can be made for classification of allowances as inventory, marketable securities or intangible operating assets.

Inventory. If classified as inventory, allowances are carried as current assets at the lower of cost or market, and their cost is expensed as they are sold or consumed. Some cost-flow assumption (for example, first-in first-out accounting) is required to choose those costs to expense in each period.

The definition of inventory in Accounting Research Bulletin no. 43, Restatement and Revision of Accounting Research Bulletins, is "items of tangible personal property which... are held for sale in the ordinary course of business... or... are to be currently consumed in the production of goods or services to be available for sale."

Clearly, an allowance is held either for sale or for consumption. Unfortunately, it is neither obviously tangible nor necessarily held for current consumption. So, is it actually a tangible asset?

Allowances are conferred as "pieces of paper" whose physical characteristics are wholly unrelated to the fight to emit sulfur dioxide. Nevertheless, they are just as tangible as certificates of deposit (CDs) and marketable securities. As with CDs, companies will be able to bank or transfer emissions allowance certificates, and each represents a specific quantity of future benefit.

Allowances may be held for sale. As the Clean Air Act is implemented, allowances will become essential for a utility to operate, and certainly they will be held in the "ordinary course of business." Allowances held for internal use are certainly consumed in the production of goods or services to be made available for sale. Indeed, the law requires companies to possess sufficient emissions allowances before fuel can be legally consumed. Sanctions for burning fuel without appropriate allowances include fines, offsets in the next producing year and criminal prosecution.

The problem with inventory classification is most allowances booked at a particular time will be authorized for future years and cannot plausibly be regarded as current assets. The act calls for sale of allowances many years before authorized use and many utilities may want to purchase a stream of allowances to cover the entire service life of a new installation.

Marketable security. If classified as marketable securities, allowances are carried in two distinct portfolios, one current and one noncurrent. Each is valued at the lower of cost or market. Sales and some value changes flow through income.

An allowance is a specific, marketable right to a certain form of consumption. This makes the marketable security classification plausible. However, allowances may be consumed and nothing quite like that happens to ordinary marketable securities. Of course, some securities (for example, bonds) mature and at maturity their proceeds may be consumed, and other securities (for example, options and warrants) expire. To be sure, the analogy between allowances and marketable securities is imperfect.

Intangibles. If classified as intangibles, emission allowances are carried as noncurrent operating assets at cost less amortization, according to the provisions of Accounting Principles Board Opinion no. 17, Intangible Assets.

Allowances possess certain characteristics of intangible operating assets. The rights conferred by allowances are unrelated to physical form. Allowances enable companies to continue operations at a given level of emissions, which is characteristic of a franchise or license. They may be held for future production and purchased many years before they are used.

An allowance is a right to a specific quantity of consumption. In fact, an EPA pollution certificate conveys more information about the physical character and service potential of an allowance than a bulldozer's certificate of title conveys about its physical character and service potential.

Intangibles rarely refer to such specific quantities. For example, a patent permits a company to produce a specific product exclusively for a specific period but does not limit the number of units that may be produced. For this reason, straight-line amortization, although not mandated by Opinion no. 17, is the customary method of allocating intangible cost to expense. By contrast, it makes no sense to amortize the cost of emissions allowances over time. The only reasonable method of charging allowance costs to expense is in proportion to sulfur dioxide emission. Presumably, pursuant to the requirements of Opinion no. 17, companies could demonstrate the appropriateness of a units-of-production method of amortization.

DESERVING SPECIAL TREATMENT

Ultimately, both internal and external reporting of allowances should reflect the underlying economic events, and the consequences of those events must be reported to a company's management. FASB Concepts Statement no. 2, Qualitative Characteristics of Accounting Information, says, "The overriding criterion by which all accounting choices must be judged [is that]... the better choice is the one that... produces from among the available alternatives information that is most useful for decision making."

After careful consideration, we have concluded reporting allowances at current market value best meets this criterion. Accordingly, we advocate this reporting for internal planning and control.

However, we also believe current market value is not satisfactory for external financial reporting. No matter what asset classification we select, we find current market value reporting is inconsistent with current accounting standards. Moreover, it raises a specter of "windfall profits" arising from the original "free" EPA grants and might lead to retaliation by state and local regulators. Thus our external financial reporting recommendation begins with historical cost valuation.

Classification. The classification problem is critical. The new asset does not fit comfortably into any existing asset classification, and we believe that fact, along with the materiality of allowances both in market value and in their necessity for operations, justifies special treatment.

Uncommitted allowances should be given some descriptive name such as "sulfur dioxide emission allowances'' and divided into current and noncurrent portfolios by an authorized date. Each portfolio should be carried at the lower of cost or market with disclosure of current market value. This treatment is intended to resemble closely the treatment of marketable securities; we believe that uncomreitted allowances most resemble such assets.

The cost of committed allowances should be regarded as an element of fuel cost. It is a cost that must be incurred to bring fuel into readiness for burning. For a given technology and fuel, charging allowances consumed to expense in proportion to sulfur dioxide emitted is equivalent to charging in proportion to fuel consumption.

Allowance accounting would be simplified if all allowance costs could be attached to fuel, but this is unsatisfactory for several reasons.

1. Fuel covered by allowances may not be available; for example, when it has yet to be delivered to cover even currently authorized allowances. Further, adding allowance costs to fuel that does not require allowances would adversely affect comparability and consistency of financial statements.

2 . Decisions involving changes in fuel-consumption technology require separation of allowance cost from fuel cost, and such decisions are critical to rational use of uncommitted allowances.

3. Allowances may be held only for resale, with no intent to consume.

In addition to fully disclosing the number of allowances held and projected annual usage, we suggest that accountants attach committed allowance cost to fuel cost and carry uncommitted allowance cost as a separate balance sheet item, classified as current or noncurrent by the date of authorized use.

This threefold classification is complex, but nothing simpler captures adequately the economic substance of transactions in this newly created asset.

EXECUTIVE SUMMARY

* WHILE FEW companies will be affected directly by the Clean Air Act of 1990, CPAs should be familiar with its provisions because it likely is a precursor of future environmental laws that will have a major impact on many businesses.

* THE LAW PROVIDES for the granting of airpollution emission rights and creating a market in which these rights can be sold or traded.

* THE MAJOR QUESTION faced by electricpower utility accountants today, and probably other accountants tomorrow,-is, How should these emission rights, which in many ways resemble securities, property and inventory, be accounted for? While there are no definitive answers, accountants should begin to explore this issue.

* REPORTING ALLOWANCES at current market value best meets current accounting standards. Although this reporting may be suitable for internal planning and control, current market value is not satisfactory for external financial reporting.

* THE CLASSIFICATION question is more complex since the new asset does not fit comfortably into any existing asset classification. As a result, it justifies special treatment.

TIMETABLE FOR CLEAN AIR

1990: The Clean Air Act of 1990 is signed into law.

1992-93: Within 18 months of enactment, the Envh-onmental Protection Agency (EPA) is to promulgate the necessary procedures to establish an emission allowance market.

1993: The EPA will conduct annual auctions of the emission allowances.

1994: By January 1, the EPA will submit to Congress an evaluation of the law with the view to extend its regulations to include nitrogen oxides.

1995: Compliance begins on January 1 for 110 specifically named power plants that are considered the worst pollution offenders. In order to emit sulfur dioxide, these facilities must possess sufficient emission allowances.

2000: Compliance begins on January 1 for all U.S. power plants.