Recent changes to the ‘own use’ requirements applicable to nature-dependent power purchase agreement

As discussed previously, the catalyst for the IASB issuing Contracts Referencing Nature-dependent Electricity was a constituent’s query on the application of the own use exemption in paragraphs 2.4-2.6 of IFRS 9 to PPAs involving nature-dependent electricity.

Own use exemption

Paragraph 2.4 clarifies that IFRS 9 must be applied to those contracts to buy or sell a non-financial item that can, among other things, be settled net in cash. However, IFRS 9 is not applied to contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.

To facilitate the consistent application of paragraph 2.4 in IFRS 9, paragraph 2.6 provides examples of the various ways in which a contract to buy or sell a non-financial item can be settled net in cash, including:

• When the terms of the contract permit either party to settle it net in cash
• When the ability to settle net in cash is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse)
• When, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin, and
• When the non-financial item that is the subject of the contract is readily convertible to cash.

Challenges in applying the own-use exemption to contracts referencing nature-dependent electricity (CRNEs)

For many entities (both suppliers and purchasers), the inherent features of nature-dependent electricity and the markets for such electricity has to date, limited their capacity to account for CRNEs as supply contracts outside of the scope of IFRS 9. Currently, nature-dependent electricity is:

• Highly susceptible to unexpected variations in supply. For example, a solar farm operator cannot estimate or plan precisely how much electricity would be generated on any particular day in the future or over extended periods of time, and
• Not readily storable (particularly in large quantities) for future consumption, in which case entities generating nature-dependent electricity are generally compelled to sell excess electricity into the most accessible electricity grid. Likewise, purchasers of nature-dependent electricity are obliged to buy electricity from other generators through the grid in the event of any shortfalls in supply under CRNEs.

The structures of some markets for electricity also impact the capacities of some entities to treat CRNEs as supply contracts outside the scope of IFRS 9. 

As discussed in our previous article, various jurisdictions, including Australia, utilise gross pool market arrangements to facilitate the distribution of electricity to consumers. A key feature of gross pool markets is that all purchases and sales are cleared through a government-appointed market operator. Consequently, all sales and purchases of electricity in Australia are settled at spot prices, and any difference between the fixed price in a CRNE, and the spot price, is settled net in cash (rather than the contract being settled physically) between the electricity generator and the customer.

Accordingly, when entities attempt to mitigate physical supply risks through CRNEs, the contractual terms will require or permit both the electricity producer and purchaser to settle net in cash as anticipated by paragraphs 2.4 and 2.6 of IFRS 9.

IASB’s amendments to IFRS 9

The IASBs amendments to IFRS 9 add separate criteria that only apply to CRNEs when assessing whether the contracts are entered into and continue to meet the own use exemption. These separate criteria reduce the significance of unpredictable supply and unavoidable electricity sales to the own use assessment by introducing the concept of a ‘net purchaser of electricity’. These separate criteria, however, cannot be applied to virtual PPAs (VPPAs).

As discussed in our previous article, VPPAs do not involve delivery of electricity and therefore do not meet the definition of a CRNE. VPPAs are financial instruments with ‘contract for difference’ (derivative) components. Due to the gross pool nature of the Australian market for electricity, VPPAs are relatively common among participants in the Australian market.

To qualify as a net purchaser of electricity, an entity must:

• Be exposed to the risk of buying electricity during a delivery interval in which the entity cannot use the electricity
• Have no practical ability to avoid making sales of unused electricity because of the design and operation of the electricity market. Accordingly, when assessing the applicability of paragraph 2.4 of IFRS 9 (own use exemption) to a CRNE, compulsory sales of unused electricity are not necessarily inconsistent with the CRNE being held in accordance with the entity’s expected usage requirements
• Expect to be a net purchaser of electricity for the CRNE period in the same market. In making this assessment, an entity would: 
  • Consider reasonable and supportable information (that is available without undue cost or effort) about its past, current and expected future electricity transactions over a reasonable amount of time, and
  • Make the net purchaser assessment at the level of a particular market. That is, an entity is a net purchaser of electricity only if it buys sufficient electricity in the same market in which the entity originally took delivery of and then sold the electricity, and
• Buy sufficient electricity over the term of the CRNE to offset the sales of any unused electricity in the same market in which the entity sold the electricity.

PPAs that are CRNEs can take a number of different forms, including:

• Pay-as-produced PPA – the purchaser is required to buy a fixed share of energy production by the seller
• Baseload PPA – the purchaser is required to purchase a fixed amount of electricity instead of a specific proportion of the electricity generated
• Pay-as-consumed PPA – purchaser pays for the electricity consumed rather than for a specified proportion of the electricity generated, and
• Shaped PPA – electricity to be purchased is determined based on the expected electricity requirements of the purchaser, and can be distinguished from a Baseload PPA, with the purchaser’s requirements being determined on a daily, weekly or monthly basis.

As the IASB’s amendments to IFRS 9 do not specify the types of CRNEs covered, any CRNE that requires an entity to buy and take delivery of electricity as and when it is produced, which, in turn, means the purchaser might be compelled to sell any unused electricity into the grid at the spot rate, falls within the scope of the amendments.

In future editions of Corporate Reporting Insights, we will take a closer look at the hedging and disclosure implications for CRNEs arising from the IASB’s amendments to IFRS 9 and IFRS 7. 

Need assistance?

You can find more information about accounting for PPAs in our webinar. If you need assistance accounting for PPAs, reach out to our IFRS & Corporate Reporting team for help.