The Accounting Earthquake

Post 4 set out what an institution requires before it can hold a particular asset. One of those requirements was an accounting treatment that does not punish holding it. Raw carbon credits are subject to an accounting regime so punitive that it is effectively impossible for a fiduciary to justify holding them.

In May, FASB issued Topic 818, the first authoritative US standard for environmental credits. A credit is recognized as an asset only if one of three qualifying uses is probable: settling a compliance obligation, selling it, or transferring it to someone else. Anything else, including credits bought for a voluntary claim, is expensed when purchased, and cannot become an asset later even if circumstances change. Credits held for sale are carried at cost less impairment: written down when the price falls, never written up when it rises, and the write-downs cannot be reversed. That is worse than the expense treatment, a known cost taken once and planned around. This is an asset whose reported value can only fall.

An asset whose carrying value can only fall is not an investment, and no fiduciary can hold one. Allocators and committees decide on reported results, and there is no argument to be made for something that reports badly by rule, however well it performs. The raw carbon credit is not an unattractive investment. It is not an investment at all.

So the question becomes what form institutional carbon exposure can be held in, and the answer was described in Post 5: the wrapper. The wrapper is a security. The credit inside it stays a commodity, unaltered. But the thing the institution owns is a security, and a security is a financial asset, and financial assets are carried at fair value with changes running through the accounts.

Changing the credit’s form changes the accounting treatment, and the accounting treatment controls what institutions report. Nothing about the underlying moves: the environmental benefit is the same benefit, the sovereign covenant is the same covenant, the asset is the same asset. What changes is that it can now be carried on the balance sheet at fair market value, and carrying value on the balance sheet is how investment performance is measured.

Institutions that hold carbon will hold it in the form of securities, because that is the only form that lets them take the position and report the underlying carbon asset at its true fair market value.

The covenant, the wrapper, and a workable accounting treatment are now in place. What that combination makes possible is market making: someone willing to quote a price in both directions and hold inventory in between. That is where transactions come from, and where liquidity comes from.

Next up: Who Makes the Market?

Part of No New Parts, a sixteen-part series by Andrew Gilmour.