Financial Reporting for Cap-and-Trade Emissions Reduction Programs

Author(s): Yonca Ertimur, Jennifer Francis, Amanda Gonzales, and Katherine Schipper

Published: December 2009

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This paper describes certain financial reporting issues associated with so-called cap-and-trade programs, one of several mechanisms that might be used to reduce certain emissions designated by policy-makers. In general, a cap-and-trade program has two distinctive elements. The first element is an overall limit (a cap) on the amount of emissions of a specified type that are permitted during a compliance period. The government sets the cap to achieve its emissions reduction goals and enforces the cap by requiring entities in the program to surrender emission allowances to cover their emissions during the compliance period. The second element of a cap-and-trade arrangement is a market that arises because the allowances are exchangeable. The idea behind a cap-and-trade arrangement is to create a price for emissions (for example, CO2) that will serve as a signal for emitters to make emissions-reducing expenditures. An emitter will purchase allowances (real options that allow the emitter to defer emissions-reducing expenditures) until the price of allowances reaches the point where those expenditures become cost-effective.