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Pollution allowances and their place amongst accounting

Emission's trading is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. A governmental body will set a cap on the total amount of pollutant that can be emitted and the total amount of allowances cannot exceed this limit. Firms are required to hold a number of 'allowances' which are equivalent to their emissions. Firm's that need further allowances are able to purchase them from those who require fewer allowances (Stavins 2001:4).

Although this system has become fundamentally popular particularly in Europe and the United States because it is a preferred method of reducing pollution for the benefit of society, questions have arisen with regards to the pollution allowances themselves, and their place amongst accounting methods and terminology.

Allowances as Assets?

Both the International Accounting Standards Board (IASB) and the Federal Accounting Standards Board (FASB) regard two important aspects in the definition of an 'asset'. The first is that there has to be control which results from past events. The definitions also stipulate future economic benefits as being of importance. This can certainly hold true with allowances as a firm controls the allowances that are issued to them by a governmental body. The pollution allowances can also bring economic benefit as they give the firm a 'license to pollute' (Wambsganns) without being penalised in the way of fines. They can also be sold for financial gain on the Emissions market. A good example of this is when Tennessee Valley Authority and Duquesne light purchased a combined total of 25'000 allowances from Wisconsin Power and Light, who gained the sum of $6 million from the transactions.

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There seems to be a view amongst writers and analysts that under the trading system, these allowances are best suited as 'assets', but categorising these assets into a certain type are proving troublesome for many. (Schaltegger and Burritt) claim that pollution permits possess characteristics of intangible operating assets because pollution allowances have no physical form. If pollution permits are recognised as intangible then they should be carried as non-current operating assets (Ewer et al,1992:71). (Wambsgans and Sanford) also state that as 'assets', pollution allowances have the characteristics similar to inventories, marketable securities, intangible assets and donated assets, but each category has problems. For example, pollution allowances do not expire after a given time, so to amortize them on a time basis like other intangibles would be considered unwise. Wambsganns have taken the stance that these allowances would be best suited as 'donated assets' but this has drawn criticism from various writers including Gibson and Milne.

(Mackenzie) shares a similar caution with regards to defining the characteristics of these allowances particularly since accountants have had limited success in making 'emission rights' equivalent. While (Hatherly et al) argue that a 'finitist' perspective is useful in defining these allowances from an accounting perspective because they seem "to classifiers to be unfamiliar" and therefore, make implicit choice explicit. (Chua 1986) has similar views and refers to accounting and taxation law institutions as being 'social phenomena that are "created, practiced and perpetuated by their members". Chua claims that this 'finite thing', the carbon permit, must be understood within the context that it is created (Chua,1986:619). This is especially true in capital markets where an intangibles intrinsic value is a set of expectations (Andrew 2008:394).

View of the boards

The International Financial Reporting Interpretations committee (IFRIC) in the run up to the EU emissions trading scheme, discussed how to apply standards to these new items. They did not regard them as 'rights' because an allowance itself does not confer a right to permit, but it is an "instrument that must be delivered in order to settle the obligation that rises from emissions" (IFRIC 2004:19). The IFRIC do view these allowances as an asset, but the nature of the asset remains a source of confusion. The IFRIC did view emission allowances as an 'intangible asset' and stated that the difference in price for allowances issued to firms by government at less than their market value should be perceived as a government grant as stated in 'IFRIC 3'. However the IFRIC received strong opposition by those who felt that the move would create accounting mismatches to relevant standards, especially 'IAS 20' which stated that "non-repayable government grants have to be recognised when they are received" (Cook 2009). This would mean that a company which received these allowances for free would have to recognise them immediately as income, while the costs of corresponding emissions would only be recognised as they accumulated. (MCkenzie). IFRIC acknowledged that this move 'creates unsatisfactory measurement and reporting mismatches' and withdrew IFRIC 3.

The following information provides subsequent implications following the withdrawal of 'IFRIC 3'

An Illustration is shown of how diversity can affect financial statements.

This gives us clear differences in results among the three accounting methods, and these are indicative of the lack of comparability among companies within the EU, and between the EU and US. These distortions as well as others, say in profitability measures would diminish the relevance of these financial statements for their users.


The paper by (wambsganns) brought up debate about the consistency associated with the allowances. The paper argues that there are problems with the Federal Energy Regulatory Commission (FERC) guidelines because they use a historic cost basis. Therefore those allowances issued by the Environmental Protection Agency (EPA) to firms are given without costs, and as a result, they are not represented on subsequent financial statements. In comparison, allowances purchased on the market will be recognised on financial statements at the amount paid. (Wambsganns) state that this results in a lack of consistency as purchased allowances have visibility (book value) in the financial statements but EPA issued allowances are not presented".

This leads to an important issue regarding recognition. The withdrawal of IFRIC 3 meant that the issue with carbon would remain "inside an economic frame, but in a sense invisibly so" (MCkenzie) because no accounting recognition would be needed if a company was to receive X number of allowances, forecast X tonnes of pollution and emit X tonnes. (Grinnel and Hunt) state that since gifted allowances represent the bulk of total pollution allowances, their non recognition in financial statements of affected firms would be seriously misleading to users of those statements. This is certainly true, as financial statements are created to bring clarity, not shadow important aspects of an entities dealings.

More Than Just Numbers

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Furthermore, (Wambsganns) argue that the consequences of this inconsistency are deeper than merely numbers and statements, but involve the basis of such a system in the first place. The reasoning behind the market system is seen as an economic mechanism which regulates pollution, but if financial statements do not recognise EPA issued allowances then pollution's economic substance is only partially recognised and thus issued pollution allowances won't be expensed when they are used in production. This omission fails to report the true cost of pollution.

These sentiments are echoed by (Allenby and Fullerton 1992) from a management perspective. As historical costs do not reflect market value, nor the contribution of emission allowances to the value of the company, management is given no incentive to realise pollution prevention at lower costs or to make profit from selling unused permits. This is because no recognition is given in financial statements to the allowances, whether it be cost savings if pollution was reduced, or any gains made from trading pollution allowances. Thus if management of firms were to take this mentality, these actions could go directly against what the system is trying to achieve in the first place, which is to reduce levels of pollution.

Of course, although (Allenby and Fullerton 1992) have a somewhat cautious view of management interaction, it can also be argued that there are various penalties which commit firm's to comply with the Trade scheme. The implication of being unable to buy allowances to cover excess emissions for example, is quite significant. In the EU ETS, "directive 2003/87/EC sets a penalty of 100 Euro's for each unit uncovered by purchased allowances". These entities would also need to purchase further allowances to offset uncovered emissions. Therefore a 'double penalty' would be issued if a firm was unable to keep up with their emission allowances. Therefore although management may not have incentive due to lack of recognition on financial statements, the possibility of substantial fines can be considered an incentive to management to keep track of their allowances and emissions.

Pollution Allowances as Assets - A good idea?

Perhaps there is a common acceptance of pollution allowances being regarded as assets, but (Kathy Gibson) questions this view. Gibson states that although it is a worthy idea to issue pollution allowances with the aim of control or reduction of pollution, the notion of holding and reporting these allowances as 'investments' is contradictory to this aim. This is because the maintenance of the values of these assets would be dependant on the continuation of polluting practices. Companies that clean up their production processes would not need these allowances in the first place, and therefore demand would fall, as well as their market value.

Gibson therefore states that a "perverse" incentive is created to maintain the level of demand of such permits by maintaining or increasing production in the more polluting plants, and this has the potential of being manipulated within the industry, particularly between associated companies. Treating such allowances as an expense and not an asset will remove the incentive to accumulate allowances which provide a disincentive to adopt clean technology as quickly as otherwise might occur. This is certainly a valid claim and brings question as to whether pollution allowances should indeed be referred to as 'assets'.

An example of manipulation practices that can be deemed unfair are exemplified by figures from Carbon Market Data (Gardner, Stefan). It states that power firms are given fewer emissions permits than necessary to meet their needs, therefore they need to purchase extra allowances on the carbon market. However, large industrial concerns such as steelmakers have been given large emission permit surpluses. Carbon market goes onto state that the largest beneficiary has been ArcelorMittal, who in 2007 had a "huge surplus" of 18.5m tonnes of CO2 in allowances. ArcelorMittal's power in negotiating additional carbon subsidies was demonstrated in Belgium in 2008, when the firm stated that they would be unwilling to reopen a blast furnace in Liege unless they were given "significant extra emissions permits". The Belgian Authorities, concerned about lost jobs, freed extra permits up by stripping carbon allowances from electricity generation plants.

A solution beyond conventional accounting

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Lehman (1999) had proposed to extend social and environmental accounting "through a communitarian lens". He spreads caution to those accounting theorists which are committed to change, that they must go beyond trying to fit environmental reporting into existing accounting models. This can be exemplified in the (wambsganns) paper as it used an existing accounting model to characterise pollution as 'donated assets'. The criticism here is that Authors will only explore options that come to mind under those accounting and reporting models which are currently implemented. Lehman goes on to say that such "social and environmental accounting frameworks have the potential to perpetuate the destruction of the natural world that they are meant to protect (Lehman 1999:21).

Beder 2006 argues that any approach that simply encourages the market to put a price on the environment is inadequate as a response to environmental problems since this does not sufficiently orient business or society in general towards the environmental issues that we face. Further, Beder believes that neoliberal ideology uses the market to solve problems that the market created, without reconsidering the market itself. Lohmann (2009) has argued that the market is the root of environmental problems, yet is mistaken as a solution.

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