Carbon Offsets Explained

Intro

Many companies around the world have pledged to go “Net Zero'' sometime within the next 30 years. “Net Zero” means that the total carbon the company emits into the atmosphere will be offset by the amount of carbon they are putting back into the earth, netting to a zero-carbon impact. These pledges are highly dependent on the ability to reduce and offset carbon emissions. Many consumers may even start to notice an option to offset carbon emissions when purchasing an item online. But what exactly does all this mean? This article discusses carbon offsets in more detail along with their accounting and reporting implications.

What Are Carbon Offsets?

A carbon offset is a broad term defined as a reduction in greenhouse gas (GHG) emissions, or an increase in carbon storage, used to compensate for the emission of carbon dioxide into the atmosphere. Simply put, a carbon offset puts carbon back in the earth (carbon storage) or reduces carbon being emitted from the earth, whereas normal business activities almost always put carbon into the atmosphere. Companies will either host carbon offset projects themselves or pay for another company to perform the projects in order to claim the reduction in carbon that cancels out their carbon pollution. Carbon offsets are useful for companies that wish to go carbon neutral, and which have already reduced their emissions as much as possible through operating changes. Companies that have not attempted to reduce their emissions through operating changes will potentially end up paying more for offsets than they would pay to reduce their emissions by changing their business practices.

Carbon offsets are quantified and traded in the form of carbon offset credits. A carbon offset credit, sometimes referred to as a carbon offset certificate (or simply “carbon offset”), represents a reduction in emissions of one metric ton of carbon dioxide or other high-potency greenhouse gas. The purchaser of a carbon offset credit can retire it to claim the underlying reduction against their actual carbon emissions. These credits are certified by governments or independent certification bodies.

Carbon offset credits differ from carbon credits resulting from emission allowances. While the terms “carbon credits” or “carbon offsets” are sometimes used interchangeably to describe carbon offset credits and emission allowances, the two are distinct in nature. Emission allowances function as “permission” to pollute and are usually issued by a government trying to put a cap on emissions. The government sets a cap on an organization’s total allowed emissions for a given period and issues credits to participants in an amount necessary to settle the cap for that period. Click here to learn more about emission allowances. Carbon offsets may also be viewed by some as a similar “permission” to pollute but only from a social perspective, as companies looking to “go green” value the social benefit that comes with having reduced net carbon emissions. 

Since the terms carbon offsets, carbon credits, and emissions allowances are used by some companies interchangeably, a person interested in a company’s carbon emission status and progress should understand the substance of carbon-related programs to understand their real meaning and impact.

How Do Carbon Offsets Work?

There are a few different ways companies can pay for or allow customers to pay to “offset” the carbon created from their purchase. Some of the most common types of projects that produce carbon offsetting and associated carbon offset credits are forestry, renewable energy, and high-potency GHG capture.

Forestry and land use

Forestry and land use are among the most common types of carbon projects. These types of projects include things such as afforestation, reforestation, and preventive deforestation. Although all trees absorb carbon dioxide and use it to grow, carbon projects involving planting “new” forests require careful scrutiny to prevent these new forests from falling victim to disease or inadvertently damaging existing ecosystems. This is why reforestation—restoring viral ecosystems that were lost to deforestation—is a safer and more effective forestry project. Furthermore, some offset programs aim to prevent deforestation by using funds to purchase or lease forest areas that were otherwise due to be cut down by local landowners.

Renewable energy

Renewable energy offsets target fossil fuel emissions and aim to reduce reliance on fossil fuels by using renewable energy sources such as solar, wind, hydroelectric power, or biofuel. These include projects such as building wind turbines, using solar panels, constructing electric turbines, and using or producing biofuel. For example, the Bokhol Senegal Solar Project, a carbon offset project provided by funders in 2016,  produced a 75,000 solar panel power plant that supplies electricity to 160,000 people in the country of Senegal.

Many renewable energy projects also create renewable energy credits/certificates (RECs). RECs are market-based certificates and are issued by a state or other agency when a renewable energy source generates and delivers one megawatt-hour (MWh) to the grid. The REC allows the owner to claim that its operations use or are being powered by the renewable energy associated with the REC. Projects that involve RECs may have additional accounting and tax considerations that are different than the accounting for carbon offsets. While some renewable energy projects result in the creation of both RECs and carbon offsets, other projects may only provide RECs, while still others may focus only on providing carbon offset credits. This is highly dependable on the nature of the project and the qualifications of the various certification agencies.

Greenhouse gas capture

These types of carbon offset projects involve the capture and destruction of high-potency greenhouse gasses such as methane, nitrous oxide, or hydrofluorocarbons. Even though these types of gasses are not CO2, they have an even greater global warming effect than CO2 which is why capture and destruction of these gasses is still considered carbon offsetting. Some common examples of greenhouse gas capture projects include on-site methane capture and combustion at landfills and waste plants. Take, for example, the Elk Creek Coal Mine Methane Destruction and Utilization Project which collects waste methane from a coal mine in Colorado and converts it into usable electricity.

Other Projects

There are many types of other carbon offset projects that are not discussed above. For example, some projects aim to use energy more efficiently, such as the Darfur Sudan Cookstove Project, a community project that replaced traditional wood and charcoal stoves with liquified petroleum gas stoves in Darfur, Sudan. Most projects aim to prevent carbon from being emitted into the atmosphere that would have been emitted had the carbon offset market not existed. This is known as “additionality,”³ meaning that a project or activity that reduces GHGs would not have occurred without the offset buyer or collective buyers in the market. For example, the Renaturation of the Moorlands Project is funded through the sale of carbon offsets and aims to rewet a moorland in Germany that if otherwise dried up, would release a large amount of carbon into the atmosphere.

Carbon Capture

Carbon capture, also called carbon sequestration, is a new technology being implemented by various plants around the world.⁴ These plants sequester carbon directly from the atmosphere. It can then be stored in the ground or be used to produce materials containing carbon dioxide. Similar to carbon offset projects, carbon sequestration plants also generate credits and, since the end result is the same, funding these plants could yield a similar PR benefit to investing in carbon offsets. Most companies that have future zero-carbon emission goals are looking toward technologies such as carbon capture on top of carbon offsetting to be able to achieve these goals.

Accounting Considerations for Carbon Offsets

Entities that invest in carbon offset projects face a range of different accounting issues. Some entities structure their involvement through investment in other entities, or through participating in new structures such as joint ventures, entities that entitle investors to tax benefits, etc. These entities need to determine whether the structure requires consolidation or another method of accounting such as the equity method or fair value method. Entities that engage in carbon projects in house need to determine what and how to capitalize, i.e., what costs represent property, plant and equipment, inventories, research and development (which is expensed), startup activities (also expensed), etc. Other entities purchase, receive, and/or sell carbon offsets. These entities need to determine how to account for these transactions for which there is currently no guidance under U.S. GAAP.

The lack of accounting guidance on the purchase and sale of carbon offsets has caused some diversity in practice. Similar to the accounting for credits resulting from emission allowances, most companies that purchase carbon offset credits tend to classify a carbon offset credit as either inventory or an indefinite-life intangible asset. Classifying the carbon offset as an intangible asset seems to be the most common approach used by companies. On the other hand, carbon offsets created (received) through the entity’s own activities typically do not have an attributed cost and therefore are not reflected as assets on the entity’s balance sheet. Regardless of the either approach, the chosen approach should be applied consistently across all carbon offset purchases and be properly disclosed.

When a carbon offset is “used” by the company—i.e., when the company applies it to its compliance or voluntary goals—it is retired. If it is reflected as an asset on the company’s balance sheet, the prevailing practice is that it is removed from the books and expensed at that time. In other words, the carbon offset credit is removed when the offset is surrendered to the state or other applicable agency to demonstrate compliance, or when the company voluntarily surrenders it if compliance is not required.⁵ The offset would not be amortized over a period of time. Entities that generate their own carbon offsets have no associated costs or expenses to record when the related carbon offset is used.

If the entity sells a credit offset, revenue or income is recognized pursuant to the applicable guidance, and the offset is expensed to the extent of any associated cost. Entities that hold both purchased and their own generated carbon offsets also need to establish whether the carbon offsets they sold or used were purchased or internally generated. Detail tracking may be required.

It is important to note that the accounting treatment for the purchase of carbon offset credits is essentially the same for other types of regulatory or environmental credits, not just those related to carbon offsetting. Prevalent programs and common environmental credits include credits from cap-and-trade emission programs, credits from baseline and emission allowance programs, RECs, and carbon offsets. However, preparers and practitioners should understand the nature of their environmental program and the associated credits to determine the proper accounting treatment as different types of credits may involve additional tax and accounting considerations.

With the increasing investor interest in ESG activities and the expanded use of environmental programs to reduce emissions, many companies have requested specific accounting guidance for environmental credits from the FASB.

Quality and Reporting Issues with Offsets

There are many critics of the carbon offsetting system, with most of them pointing to the greenwashing that occurs. Greenwashing is the practice of using deceptive reporting to create an undeserved positive environmental reputation. In other words, within the imprecise world of carbon emissions reporting, some organizations may abuse the system to make themselves look better than they are. Because this area is new and evolving, it has been difficult for companies to account for the true amount of carbon they are offsetting with these projects. Engineers struggle to calculate how many tons of carbon are being offset when there are so many unknowns about the future. 

Take for example, a company trying to determine the amount of carbon being offset from an afforestation project. The company plants large quantities of baby trees that will eventually grow and offset carbon. To value the total amount of carbon being offset by the project for purposes of including in its sustainability reports, the company must calculate the future estimated amount of carbon that will eventually be offset. They also have to consider the possibility that these same trees get cut down in ten years for wood or get burned down in a forest fire. These possibilities and unknown futures make it difficult to calculate the true value of carbon offset projects.

Another problem is the previously mentioned lack of authoritative accounting guidance regarding carbon offset credits. This lack of guidance has created a diversity in practice among companies who purchase these items. For example, in addition to the accounting methods discussed above, according to feedback received by the FASB, some companies expense carbon offsets at the time of purchase (no matter when retirement occurs) since their intention is to retire them. Others have capitalized carbon offsets as finite-life intangible assets and subsequently amortized them in full at the time of actual retirement (use). This demonstrates that the lack of clear accounting guidance has led to instances of inconsistent accounting treatments and incomparable financial reporting regarding carbon offset accounting.

Additionally, another issue that has occurred is the “double counting” of carbon offsets or carbon credits by two parties.⁶ Double counting occurs most often when the host country of a carbon offset project sells the carbon offset to a company in a different country. It is not infrequent that both countries claim the credit in their efforts to reach their national climate target. In order to prevent this, companies may consider purchasing offsets through organizations that offer unclaimed credit offsets only, such as high-quality offsets.

The quality of an offset is determined by the accuracy of emission reductions or removals achieved by the carbon offset projects. A high-quality offset is associated with reductions in carbon emissions that are additional, permanent, not overestimated, not claimed by another entity, and not associated with significant social or environmental harms.⁷ In order to determine if a carbon offset is of high-quality, companies turn to third-party verifiers such as Gold Standard, Verified Carbon Standard (VCS), American Carbon Registry (ACR), or Climate Action Reserve (CAR). These third parties verify that carbon offset projects are of high-quality. It is important for companies to purchase high-quality carbon offsets in order to determine the value of their purchase, since purchasing low-quality carbon offsets may do more harm than good to the environment.

Conclusion

The carbon offset market has grown exponentially the last few years and will continue to grow as more companies turn to stakeholders and make net-zero carbon emission pledges. It will become increasingly more valuable for companies to learn how these carbon offsets work and how to account for them. While there are many issues with carbon offsets, more guidance and standards are expected to come in the near future as we all look to do our part to reduce carbon emissions.

Resources

• https://www.greenbiz.com/article/quest-carbon-offsets-almost-anything-goes
• https://8billiontrees.com/carbon-offsets-credits/most-popular-types/
• https://www.offsetguide.org/understanding-carbon-offsets/carbon-offset-projects/
• https://www.eic.co.uk/4-types-of-carbon-offset-projects/
• https://viewpoint.pwc.com/dt/us/en/pwc/in_the_loop/in_the_loop_US/zeroing_in_on_net_zero.html
• https://www.offsetguide.org/high-quality-offsets/
• https://terrapass.com/blog/carbon-offsets-trust
• https://www.harmonyfuels.com/how-it-works/carbon-offsets-vs-carbon-credit
• https://www.greenworldwide.com/what-is-a-certified-carbon-offset-credit/
• https://www.offsetguide.org/understanding-carbon-offsets/what-is-a-carbon-offset/
• FASB Board Meeting Handout, Accounting for Regulatory Credits, May 25, 2022