Net zero commitment: Need to recognize provision?

Net zero commitment: Need to recognize provision?

The efforts to reduce society’s impact on climate change have never been greater. Climate change is impacting the economy and businesses at large with an increased frequency and intensity all over the world, including India. Investors have highlighted the importance of reducing entities’ impact on the environment in their investment-making decisions and their assessment of management’s stewardship. In November 2021, through the Glasgow Financial Alliance for net zero, over US$130 trillion of private capital has been committed to accelerating the transition to a zero-emissions economy by 2050.

Countries across the globe have declared their own targets for reducing carbon emissions as well as for achieving the target of net zero emissions. India has also set a target to halve its carbon emissions by 2030 and achieve net zero status by 2070. In line with the targets at the country level, corporate entities have also set targets for carbon emission reduction and becoming net zero for themselves. These entities are taking various steps to achieve these targets.

As climate-related matters continue to evolve and entities make further commitments and take additional actions to tackle climate change, it is important for them to ensure that their financial statements reflect the most up-to-date assessment of climate-related risks and their impact on the f inancial statements. Although, there is no single explicit standard on climate-related matters under IFRS Accounting Standards, climate risk and other climate-related matters may impact a number of areas of accounting. Some relevant examples include assessment/ reassessment of useful life, residual value, overhaul and decommissioning obligations of property, plant and equipment (PPE), impairment of assets, recognition of provisions and disclosure of contingent liabilities, fair value measurement of financial and non financial assets, measurement of expected credit losses on financial assets, accounting for carbon/ renewable energy credits, appropriate presentation and disclosure in the financial statements. Depending on facts and circumstances of each entity, one or more of these areas may be particularly impacted. It is imperative that each entity evaluates and addresses such impact carefully.

In this Article, we address one critical area of accounting likely to be impacted by climate change. This Article deals with evaluation whether and when an entity needs to recognize provision for obligation arising from its net zero commitment.

Net zero commitment – What is the issue and related guidance?

Many entities have publicly pledged to reduce their carbon footprint and achieve other sustainability goals. As they enhance their sustainability disclosures in the annual report and via other means, there is now a growing focus on the connectivity between sustainability information and financial information. This, among other matters, requires companies to evaluate whether their commitment to reduce or offset greenhouse gas emissions creates a constructive obligation and whether there is a need to create a provision for the same under Ind AS 37 Provisions, Contingent Liabilities, and Contingent Assets.

Whilst Ind AS 37 does not directly deal with accounting for obligations arising from net zero commitments, it prescribes below accounting, which may be relevant:

• Ind AS 37 requires a provision to be recognized when an entity has a present obligation (legal or constructive) as a result of a past event, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and a reliable estimate can be made of the obligation. At the same time, Ind AS 37 does not allow an entity to recognize a provision for future operating losses.
• Except in the case of an onerous contract, the amount required to be recognized as a provision is the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. In the case of an onerous contract, the amount required to be recognized as a provision is not based on an estimate of an expected outcome. Instead, the provision reflects the lower of the costs of fulfilling the contract and any compensation or penalties from a failure to fulfill it (regardless of what the entity expects to do).
• If any of the conditions for recognition are not met, no provision is recognized, and an entity may instead have a contingent liability. Contingent liabilities are not recognized, but explanatory disclosures are required, unless the possibility of an outflow in settlement is remote.
• Ind AS 37 requires disclosures to enable users to understand the nature, timing, and amount of provisions and contingent liabilities. For both provisions and contingent liabilities, this includes an indication of the uncertainties relating to the amount or timing of any outflow.

We believe that the application of the above principles to net zero commitments may require the exercise of significant judgment.

Net zero commitment – Recent developments

In November 2023, the IFRS Interpretations Committee (IFRIC) discussed a submission related to climate-related (net zero) commitments made by an entity. In the fact pattern submitted to the IFRIC, a manufacturer of household products publicly states its commitment to gradually reduce its annual greenhouse gas emissions by at least 60% of their current level by a specific year and to offset its remaining annual emissions in that year and subsequently, by buying carbon credits and retiring them from the carbon market. To support its statement, the Company publishes a transition plan setting out how it will gradually achieve the 60% reduction in its annual emissions by modifying and investing in more energy-efficient manufacturing processes and sourcing alternative materials with a lower-carbon footprint. Management is confident that the Company can make all of these modifications and continue to trade profitably. In addition to publishing the transition plan, the Company takes several other actions that publicly affirm its intention to fulfill its commitments.

The IFRIC discussed the requirements of IAS 37 (corresponding to Ind AS 37) in detail. The IFRIC noted that to recognize a provision for net zero commitment, the following two tests need to be met:

• The entity’s commitment to reduce or offset its greenhouse gas emissions creates a constructive obligation for the entity.
• Constructive obligation created by the commitment meets IAS 37 criteria for recognition of provision.

The IFRIC decided that an entity should recognize the liability when both the tests are met. The IFRIC concluded that the principles and requirements in IFRS Accounting Standards provide an adequate basis for an entity to deal with the matter. Consequently, the IFRIC decided not to add a standard-setting project to the work plan. The agenda decision was ratified by the IASB in April 2024.

Based on the IFRIC Agenda Decision, below is a diagram that may help entities to evaluate whether a provision for net zero commitment needs to be recognized:

Does the entity have a constructive obligation?

An entity will have a constructive obligation if its public statement has created a valid expectation that the entity will fulfill its commitment to reduce or offset emissions. Determining whether the entity has created a valid expectation will depend on the facts of the commitment and the circumstances surrounding it. Therefore, management needs to apply judgement to reach a conclusion. If those facts or circumstances change over time, the conclusion could do so as well. There are several factors which an entity should consider in making this analysis. Given below is an inclusive list of factors which can be relevant:

• What language is used in the statement? If statements describe the actions an entity ‘will take’, ‘is committed to taking’ or ‘pledges to take’, they are more likely to indicate that an entity will fulfill the commitment than statements that describe the entity’s ‘ambitions’, ‘targets’ or ‘aspirations.’
• What is the specificity and status of plans supporting the statement? Statements are more likely to raise a valid expectation that the entity will achieve its greenhouse gas emission reductions target if they are supported by formally approved plans detailing, for example:
• The nature and timing of the actions an entity will take to achieve the reductions.
• Milestones an entity has committed to achieve on the path to the longer-term goals.
• How management will measure progress towards the milestones and longer-term goals (for example, the metrics an entity will use).
• What is the expected timing of the actions required to fulfill the commitment? Plans for short- and medium-term actions are less likely to be changed than those for longer-term actions.
• Is evidence of progress to date publicly available? Evidence that an entity has achieved milestones it committed to in previous statements may enhance expectations that it will achieve milestones and longer-term goals it currently declares to commit to in its statement. Conversely, evidence that an entity has failed to achieve previous milestones may reduce those expectations.

Management would apply judgement to reach a conclusion at each reporting date considering all relevant facts and circumstances existing at that date.

Present obligation as a result of a past event

Even if net zero commitment related statements indicate to the public that an entity has accepted responsibility for reducing or removing greenhouse gas emissions, it does not automatically mean that a provision can, or must, be recognized. Rather, the financial reporting consequences and the applicable requirements in IFRS Accounting Standards/Ind AS will depend on the planned actions. For example, an entity that plans to replace certain assets with low-emitting ones will need to consider whether, or when, it has a capital commitment under Ind AS 16 Property, Plant and Equipment. Retiring existing assets could affect both impairment assessments and reassessments of useful life. In some cases, while called a ‘commitment’, the planned actions might be subject to change without penalty or contingent on future events; they might also be covered by other liabilities, such as decommissioning provisions. Therefore, understanding the specific planned actions underlying the entity’s net zero commitment is crucial to the appropriate application of IFRS accounting standards/ Ind AS.

If the entity’s actions are to be accounted for under Ind AS 37 (for example, if the entity determines it will need to pay a penalty), it is important to determine the existence of a present obligation, which may trigger recognition of a provision. Ind AS 37 requires the existence of a present obligation in order to recognize any liability. A past event can lead to a present obligation only if “the entity has no realistic alternative to settling the obligation created by the event.” As under the general requirements of Ind AS 37, the enactment of a law is not sufficient to give an entity a present legal obligation, and the publication of a policy or statement is not sufficient to give an entity a present constructive obligation — an entity has a present legal or constructive obligation only when the event to which the law, policy, or statement applies has occurred. For example, as illustrated in Illustrative Example 2B accompanying IAS 37, an entity with a widely published policy of cleaning up land it contaminates incurs a present obligation only when it contaminates land — publishing the policy is necessary but not sufficient to give the entity a present obligation.

In the context of climate-related (net zero) commitments, it may be noted that:

• When the entity publishes a climate-related (net zero) commitment that requires future action (e.g., modifying its manufacturing methods, purchasing and retiring carbon credits in the future), the related costs need to be incurred to operate in the future. The obligations to incur those costs do not exist independently of the entity’s future actions. Accordingly, there is no present obligation for those costs when the entity publishes its commitment.
• An entity will have a present obligation for the modifications to its manufacturing methods once it has to pay for resources it purchases to modify its methods — for example, to pay for new plant or equipment or for renewable energy — but only when it receives those resources. Similarly, in the case of commitment to offset greenhouse gas emissions, the entity will have a present obligation only when the entity emits the gases it has committed to offset.

Probable outflow of resources

The second criterion for recognizing a provision is that it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation. In the context of climate-related (net zero) commitments, it may be noted that:

• Settling the constructive obligation to reduce the entity’s annual greenhouse gas emissions will not require an outflow of resources embodying economic benefits. As the company carries out its transition plan to reduce emissions, it will receive other resources (such as property, plant, and equipment and inventories) in exchange, and will be able to use these resources to manufacture products it can sell at a profit.
• In case of commitment to offset greenhouse gas emissions, the entity will have a present obligation only when the entity emits the gases it has committed to offset. The entity will be required to buy and retire carbon credits without receiving any resources embodying economic benefits in exchange.

Sustainability developments in recent years have also highlighted emerging accounting issues including those related to net zero commitments. Based on the requirements of Ind AS 37, a commitment to reduce emissions is accounted for differently than a commitment to offset emissions. Management will need to monitor standard setting developments on these issues and follow related regulatory actions as sustainability remains a hot topic in the foreseeable future.

Reliable estimate

The final criterion for recognizing a provision is that a reliable estimate can be made of the amount of the obligation. Paragraph 25 of IAS 37/ Ind AS 37 states that ‘except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognizing a provision.’

Hence, it is likely that the entity would be able to make a reliable estimate of the amount of a constructive obligation that satisfies the other recognition criteria.

Concluding remarks

The rising public emphasis by businesses on net zero goals increases the demand for integrated sustainability and financial information. The IFRS Interpretations Committee’s decision on whether a company’s statement of its commitment to cut or offset its future carbon emissions from their current level creates a constructive obligation for the company, and, if so, whether a provision needs to be recognized by the company will require judgment of facts and circumstances.

Since an entity’s specific plans are key to appropriately accounting for such commitments, entities need to consider including appropriate explanatory disclosures to assist users of financial statements to understand the impact. Furthermore, entities should be careful to ensure that clear language is used in describing their aspirations, targets, and intended actions in response to the climate change challenge. For example, a reader may have difficulty understanding the extent to which the entity can realistically withdraw from a course of action described in its transition plan.

Since an entity’s specific plans are key to appropriately accounting for net zero commitments, entities need to consider including appropriate explanatory disclosures to assist users of financial statements to understand the impact.