NARUC Staff Subcommittee Accounting and Finance Accounting for Emission Allowances Bob Ford Ernst & Young LLP Octobe

1. NARUC Staff SubcommitteeAccounting and FinanceAccounting for Emission AllowancesBob FordErnst & Young LLPOctober 8, 2007

2. Background – History of the Emission Allowance • Acid Rain Program under Title IV of the 1990 Clean Air Act Amendments • Established to achieve significant reductions in the emissions of sulfur dioxide (SO2) and nitrogen oxide (NOx) • Basically, every major fossil fuel-burning energy production facility in the U.S. is affected

3. Background (Continued) • Based upon a “cap and trade” program design • In the SO2 Allowance Program, affected utility units are allocated allowances, based upon their historic fuel consumption (1985-1987) and a specific allowance rate. • Each allowance permits a unit to emit one ton of SO2 during or after a specific year. • Tracking performed in a central Database called the Allowance Tracking System (ATS.)

4. Background (Continued) • Units with a shortfall of allowances may buy them from sources that have reduced emissions below their allocated level. • Unused allowances of a given “vintage” year may also be “banked forward” to the next or future years. • SO2 program is the most liquid of the environmental markets and trades actively on a daily basis.

5. History of Accounting for EA’s • International Financial Reporting Interpretations Committee (“IFRIC”) took up the fight initially and issued IFRIC 3, Emission Rights, in December 2004. • IFRIC 3 called for intangible asset treatment, with income statement recording for any difference between the amount granted by government and the fair value amount of the allowance at date of delivery. • IFRIC 3 was withdrawn in June 2005 after considerable pressure from both business and political community.

6. History of Accounting (Continued) • In the U.S., the Emerging Issues Task Force (“EITF”) made an attempt by issuing EITF Issue 03-14, Participants’ Accounting for Emissions Allowances under a “Cap and Trade” Program. • EITF was never finalized and eventually was pulled from EITF agenda. • Since this time, the FASB and the SEC have informally discussed their views. • In February 2007, this project was added to the FASB Agenda in line with its push for Fair Value accounting.

7. What to do, What to do? • Obviously, the lack of authoritative guidance is creating diversity in accounting practices. • Current practice has companies treating as either inventory or intangible assets. • FERC requires recording under historical cost basis as inventory with income statement recognition as pollution occurs based upon weighted-average method. • Both allowable, but must be applied consistently and adequately disclosed. • Also, may have two categories: • Held for use • Trading

8. Inventory Model • Full recognition on sale to third party (unless SFAS 71 would require gain be deferred as a regulatory liability). • Carryover basis on vintage year swaps. • Balance sheet classification based upon the year of expected use. • Cash flow statement inflows and outflows classified as operating. • Lower of cost or market approach to impairment.

9. Intangible Asset Model • Full recognition on sale to third party (unless SFAS 71 would require gain be deferred as a regulatory liability). • Fair value basis for vintage year swaps, if readably determinable. • Balance sheet classification as long-term. However, some have recorded based upon expected year of usage per language in SFAS 142. • Cash flow statement inflows and outflows classified as investing. • Impairment assessed under SFAS 144. • Follow SFAS 142 disclosure requirements for intangibles.

10. Expense Model – Inventory Method • For inventory accounting method, cost recorded as cost of production as allowances are utilized. • Cost usually weighted-average of all allowances purchased in open market and allocated allowances. • Any LCM impairments recorded immediately through income statement. With significant market fluctuations, this can be a bit dicey!!!!

11. Expense Model – Intangible Asset Method • Apply appropriate amortization method under SFAS 142, paragraph 12: • A recognized intangible asset shall be amortized over its useful life to the reporting entity unless that life is determined to be indefinite. If an intangible asset has a finite useful life, but the precise length of that life is not known, that intangible asset shall be amortized over the best estimate of its useful life. The method of amortization shall reflect the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. If that pattern cannot be reliably determined, a straight-line amortization method shall be used. • Such as the units of production basis or even specific identification.

12. Conclusion – Clear as Mud!!! • Companies need to select a method and STICK TO IT! • Disclose, disclose, disclose. Both accounting policy and effects on Q’s and K’s. • More to come in this Fair Market Value World we live in!!!

13. Questions? ey.com/global/content.nsf/International/Utilities_Overview