Recently, "net zero” has gained significant attention in the context of climate change and efforts to reduce greenhouse gas (GHG) emissions. Net zero refers to achieving a balance between the amount of greenhouse gases emitted into the atmosphere and the amount removed or offset. It means that the overall emissions of an entity, such as a company, organization, or country, are effectively neutralized so that there is no additional contribution to the accumulation of greenhouse gases in the atmosphere. Net zero is different from carbon neutrality, which refers to a balance of removing or offsetting an equivalent amount of CO2 from the atmosphere as opposed to all greenhouse gases.
To achieve net-zero emissions, organizations can implement a myriad of strategies, including reducing emissions from their operations, transitioning to renewable energy sources, and adopting energy-efficient technologies. However, it can be challenging to eliminate all emissions completely, especially in high emissions and hard-to-abate sectors with long-lived capital assets like heavy industry or transportation, or companies with high scope 3 emissions in their value chains. In such cases, carbon offsets and purchasing carbon credits play a role.
When companies are obligated by law to reduce GHG emissions, they are sometimes allowed to purchase offsets in compliance markets. For example, California’s cap-and-trade regulations permit allowances for a company’s tradable portion of the total GHG emissions. These regulations also allow offsets to reduce emissions outside the cap for qualifying projects that reduce or sequester GHG emissions and are aligned to the scheme’s Compliance Offset Protocols. The European Union, similarly, has an Emissions Trading System, but imposes limits on the number of allowances and as of 2021 doesn’t permit offsets. Outside of compliance markets, companies may purchase offsets in voluntary carbon markets (VCM), where brokers, traders, exchanges, and private standard-setters are involved in the process.
Carbon offsets involve reducing emissions (“avoided emissions”) such as increasing energy efficiency in operations, using renewable energy farms or removing emissions either through natural solutions (e.g., planting trees) or technological ones (such as carbon capture and storage) to compensate for emissions occurring elsewhere.
However, there are widespread concerns about the effectiveness and unintended consequences of certain carbon offset initiatives and the use of carbon credits. Accountants need to be aware of the opportunities carbon offsetting and credits provide as a strategy to achieve net zero, the challenges with their use, how to ensure high-quality carbon credits, and how to enhance transparency. Recent controversies regarding carbon offset misuse have exacerbated the negative perception of the VCM, including the Verra scandal where Verra, a large greenhouse gas certification program, was accused of overstating the emission reductions associated with its deforestation credits.
This article explores and highlights key principles and strategies to improve the efficiency and effectiveness of carbon offsetting and the use of carbon credits, new disclosure requirements to enhance transparency on how they have been deployed, and how accountants can play a role in improving the credibility and trust in their use.
Enhancing the Quality of Carbon Offsets
Accountants will increasingly be involved in determining the quality of carbon offsets. Rigorous and transparent practices are important to avoid offset projects falling short of their intended emission reductions. One factor is the project's additionality, i.e., whether a specific offset leads to emission reductions that would not have occurred otherwise. Moreover, concerns arise regarding the long-term sustainability of offset projects. For example, wildfires and deforestation undermine the permanence of removing GHG emissions from the atmosphere. It is essential to ensure that once an offset is purchased, the corresponding emissions reduction is not resold or left on someone else's balance sheet, particularly when dealing with international offsets.
The carbon offset market is divided into two main categories: compliance and voluntary. The compliance category operates on a mandatory and regulated basis, while the voluntary category is driven by choice. Despite being relatively new, the Voluntary Carbon Market (VCM) has provided financing for numerous sustainable projects in developing and emerging countries. In its report, Voluntary Carbon Markets, A Critical Piece of the Net Zero Puzzle, Citi GPS reports that the voluntary carbon market is valued at around $2 billion but is expected to rapidly scale in the coming years and help countries in the Global South raise finance to reduce emissions. While the VCM has faced scrutiny, leading some buyers to question its credibility, it looks likely to evolve as an essential mechanism for companies to achieve their climate neutrality targets. For example, many companies, particularly those in hard-to-abate sectors, find it challenging to achieve net zero emissions without investing in carbon credits. To ensure the VCM offers an avenue to reduce emissions, the efficacy of VCMs will depend on greater transparency and the utilization of quality offsets.
Key Principles for Effective Carbon Offsetting and Enhancing the Carbon Offset Market
To address the inefficiencies and challenges associated with carbon offsets and credits, the Oxford Principles for Net Zero Aligned Carbon Offsetting (University of Oxford) can help guide corporate decision-making and enhance the overall market for net zero-aligned offsetting. These principles include recommendations to:
- Prioritize emissions reduction and removal: Companies should focus on reducing their emissions and scaling up removals, minimizing the reliance on offsets to achieve net zero targets. Where deployed, high-quality offsets should be used that are verifiable and correctly accounted for, and have a minimal risk of non-additionality, reversal, or unintended negative consequences. This requires stringent evaluation and certification processes and regularly reviewing a company’s offsetting strategy as best practice evolves. Transparent reporting of current emissions, accounting practices, and targets is vital for accountability and effective offsetting strategies.
- Shift to carbon removal offsetting: While emission reductions are necessary, they are insufficient to achieve net zero overall. Carbon removals directly scrub carbon from the atmosphere, countering ongoing emissions and enabling the possibility of net removal for entities that choose to remove more carbon than they emit. Investors are more likely to evaluate the quality of carbon removal projects than those of emissions avoidance which must meet an additionality threshold.
- Shift to long-lived storage: Prioritizing options for long-term storage of carbon, such as geological reservoirs or carbon mineralization that have a low risk of reversal over centuries. Long-term storage can ensure the permanence of emissions reductions. These offsets are challenging to procure and require significant investment in the technologies and scaling. Numerous challenges that make carbon sequestration difficult include finding suitable storage sites, preventing leakage risks, and continuous monitoring and verification. Carbon capture and storage (CCS) projects that involve injecting CO2 into geological formations, such as depleted oil and gas reservoirs or deep saline aquifers, are designed to store the CO2 for thousands of years. The goal is to permanently sequester the captured CO2 deep underground.
- Support the development of net zero-aligned offsetting: Early adopters should drive the evolution of the market for high-quality offsets that align with the principles to spur investment, and project creation. This involves:
- Aggregating supply and demand by being more proactive and entering into long-term offset purchase agreements, similar to the power purchase agreements which supercharged solar and wind deployment. Such agreements provide long-term guaranteed revenue streams that allow developers to finance carbon projects upfront, and they provide price certainty for offset users.
- Forming sector-specific alliances by establishing sector-based alliances to deliver sector-based solutions for absolute emissions reductions and addressing sector-specific offsetting commitments and rules.
- Supporting the restoration and protection of a wide range of natural ecosystems in their own right to contribute to carbon storage over the long-term. High-quality nature-based offsets can embed additional value, such as enhancements to biodiversity, local incomes, climate-change resilience.
The Integrity Council for the Voluntary Carbon Market also espouses 10 Core Carbon Principles to ensure high-integrity carbon credits that build on the Oxford Principles in some key areas including governance and transparency, robust independent third-party validation and verification of mitigation activities.
In VCMs, carbon credits must generally adhere to the criteria set out by a standards body and be subject to robust independent third-party validation and verification before a credit can be issued to ensure integrity. Citi GPS outlines the process involved in VCMs in Voluntary Carbon Markets. Typically, a project developer prepares a Project Design Document to set out the methodology against a standard, and the process for achieving goals. An independent verification body determines if the project meets the requirements of the standard. Companies like Verra, Gold Standard, American Carbon Registry, and Climate Action Reserve develop and certify projects. Verified credits are used in quasi-compliance markets like CORSIA and Emission Trading Schemes.
Auditors can have an important role in validating an offset project and related emissions reductions. They ensure due diligence in relation to the validity of disclosures about the existence of carbon assets underpinning the offset project, and apply professional skepticism when assessing risks associated with the assets, including assessing controls over assets and assumptions made.
By implementing the key principles outlined above, accounting and finance professionals can help their organizations improve the quality and impact of their offsetting strategies and use of carbon credits. The path to net zero requires a comprehensive approach that combines emissions reduction, carbon removal, and the development of a robust offset market aligned with transparent standards and accountability.
Disclosure and Accounting for Carbon Offsets
The evolution from voluntary sustainability reporting to mandatory requirements will lead to greater transparency on carbon offsets and credits. Accountants will need to be aware of the disclosure requirements at global and jurisdictional levels. They will need to know how to improve sustainability-related financial disclosure in relation to accounting for emissions and the actions to reach net zero or emissions reduction targets.
In its IFRS Sustainability Disclosure Standards, the International Sustainability Standards Board (ISSB), which has established a global baseline for sustainability-related financial disclosures, requires disclosure of the use of offsets to improve transparency and understanding of their use and purchase. IFRS S2 Climate-related Disclosures (IFRS S2) asserts that an entity shall disclose information that enables users of general-purpose financial reporting to understand the effects of significant climate-related risks and opportunities on its strategy and decision-making, including its transition plans. Specifically in relation to the planned use of carbon credits to offset GHG emissions to achieve any net GHG emissions target, a company needs to disclose:
- The extent to which, and how, achieving any net GHG emissions target relies on the use of carbon credits.
- Which third-party scheme(s) will verify or certify the type of carbon credit, including whether the underlying offset will be nature-based or based on technological carbon removals, and whether the underlying offset is achieved through carbon reduction or removal; and any other factors necessary for users of general-purpose financial reports to understand the credibility and integrity of the carbon credits the entity plans to use (for example, assumptions regarding the permanence of the carbon offset).
It is important to note that IFRS S2 requires disclosure on whether the target is a gross GHG emissions target or net GHG gas emissions target. For net targets, IFRS S2 requires disclosure on the entity’s planned use of carbon credits to offset greenhouse gas emissions to achieve any net GHG emissions target. If an entity has a net GHG emissions target, it must also disclose a gross GHG emissions target. Gross GHG emissions targets reflect the total changes in GHG emissions planned within the entity’s value chain. Net GHG emissions targets are the entity’s targeted gross GHG emissions minus any planned offsetting efforts.
In contrast, under the European Sustainability Reporting Standards, ESRS E1 General Requirements asserts that the GHG emission reduction targets shall be gross targets, which means that the entity shall not include GHG removals, carbon credits, or avoided emissions as a means of achieving the GHG emission reduction targets. However, E1 allows for carbon credits where the entity has made a public claim of GHG neutrality that involves them. The requirement is to explain:
- Whether and how these claims are accompanied by GHG emission reduction targets as required by Disclosure requirement ESRS E1-4;
- Whether and how these claims and the reliance on carbon credits neither impede nor reduce the achievement of its GHG emission reduction targets, or, if applicable, its net zero target; and
- The credibility and integrity of the carbon credits used, including by reference to recognized quality standards.
ESRSs also incorporate disclosure requirements specifically on GHG removals and GHG mitigation projects financed through carbon credits.
The US SEC’s proposed rule on climate disclosure requirements also included reference to the use of offsets where a registrant has publicly disclosed climate-related targets or goals. Under the initial proposal, if carbon offsets or renewable energy certificates have been used as part of the plan to achieve climate-related targets or goals, information about the carbon offsets or certifications, including how much of the progress made is attributable to offsets or certificates would be required.
GHG Protocol – Accounting for Emissions and Offsets
The GHG protocol, a Corporate Accounting and Reporting Standard, and the de facto standard for accounting for GHG emissions, includes guidance on how to deal with carbon offsets in accounting for emissions. Project reductions that are to be used as offsets should be quantified using a project quantification method that addresses the following accounting issues: baseline scenario (what would have happened in the absence of the project), additionality, secondary effects, reversibility, and double counting.
To address the challenges of measuring the emissions and the impact of offsets and enhancing accountability in offset markets, Robert S. Kaplan, Karthik Ramanna, and Marc Roston have proposed five principles in Accounting for Carbon Offsets in the Harvard Business Review, which is based on a novel proposal for an accurate and auditable accounting framework for companies to measure and manage GHG emissions. The principles extend this framework by specifying how accurately measured and verified carbon offsets can be recognized as E-assets on organizations’ environmental balance sheets.
Challenges in Financial Accounting for Carbon Offsets
Accountants need to consider the appropriate accounting treatment before purchasing or generating carbon offsets. Currently, there are no specific accounting requirements under IFRS Accounting Standards specific to carbon offsets or credits, which has led to inconsistency in financial reporting for carbon offsets related to their use in achieving emission reduction targets. Some users and companies have suggested that divergence in accounting practices for emission allowances used in compliance markets in Europe and internationally can also make it difficult to compare financial statements.
The complexity and variety of arrangements in VCMs is generating questions on how IFRS Accounting Standards apply. In reality, more than one standard typically needs to be considered. A key starting point is understanding the nature of the item being accounted for. Various terms can be used in compliance and voluntary markets such as carbon offsets, carbon credits, renewable energy credits or certificates, or emissions permits or allowances. In VCMs, companies are buying and/or selling carbon offsets or credits, and these terms have been defined in IFRS Sustainability Disclosure Standards and ESRSs in the EU.
Additionally, the complex nature of carbon credit arrangements and the lack of specific accounting guidance and consistent terminology can further complicate the accounting process and treatment. The accounting treatment in terms of the classification, treatment and measurement of offsets depends on a company’s business model and reason for holding them. It is necessary to consider whether a carbon credit/offset meets the definition of a separate asset (i.e., can be considered a present economic resource that has the potential to produce economic benefits and controlled by the company as a result of past events) or expense.
IFRS Reporting considerations for entities participating in the VCM are available from PwC , KPMG, and other sources including Carbon Accounting FAQs from Chartered Accountants Australia and New Zealand. Specific guidance for the buyers and sellers of specific offsets can also be found, such as EY’s Accounting for Trees to Generate Carbon Offsets for Use or Sale.
In enabling organizations to plan and execute their emissions reduction transition plans, accountants have a critical role in enabling the use of high-quality offsets and credits and enhancing disclosure about their use in reaching climate neutrality targets to deliver confidence to investors and to other stakeholders. Consistent and transparent disclosure and financial reporting are needed for tracking progress in reducing GHG emissions and ensuring accountability in achieving climate goals.