The International Accounting Standard Board (IASB) is currently discussing potential limited scope amendments to IFRS 9 Financial Instruments to address issues arising from renewable energy Power Purchase Agreements (PPAs).

Why is the IASB looking into PPA accounting?

Imagine an international technology company, let’s call it Technotastic, that is growing rapidly and is always looking for new investors. Technotastic’s servers use huge amounts of electricity and potential investors want to understand, as part of their decarbonisation plans, how Technotastic is sourcing its electricity from renewable sources. At the same time, a new offshore wind farm is being planned, Project WindyDay. The wind farm will cost £1bn to build and investors will only give the final go-ahead if it can secure a long-term agreement to fix the price at which the wind farm can sell its electricity, thus ensuring the long-term viability of the business plan. 

The solution to these two separate problems seems obvious: Technotastic and WindyDay can agree to enter into a PPA, securing revenue at a fixed price for WindyDay, while giving Technotastic both price certainty and the knowledge that a significant portion of their power needs will come from renewable energy. 

The problem, however, is that Technotastic might decide not to go ahead with the deal if it learns that it will have to account for the PPA as a derivative (measured at fair value through profit or loss), leaving Technotastic exposed to significant volatility in net income unless hedge accounting can be applied.

Why might a PPA be a derivative?

PPAs are complex contracts, and several different classifications are possible depending on the specific circumstances of the contract. For example, in some circumstances, a PPA could be a lease within the scope of IFRS 16 Leases. In this article, however, we will concentrate on PPAs that meet the definition of a derivative. 

Even if a PPA is economically a derivative, it may be scoped out of IFRS 9 if it is held for the entity’s own sale, purchase, or usage requirements, resulting in the contract being accounted for as an off-balance sheet revenue or purchase contact (ie, as an ‘own use’ contract). Contracts where some of the volume has a history of being settled net, however, do not qualify for this exemption. 

The specific challenge with renewable energy PPAs is that wind farms produce energy when the wind blows, and solar farms produce energy when the sun shines. Indeed, delivery of the electricity could arise when the purchaser does not need electricity – for example, when the purchaser’s factories are closed for the night. Consequently, when a PPA requires power to be purchased as it is produced, it may be challenging for the purchaser to apply the ‘own use’ exemption.

Furthermore, the physical delivery of electricity from a particular producer to a particular purchaser may not be possible in all electricity markets. In such markets, virtual power purchase agreements, or vPPAs, are often used. These contracts attempt to replicate the same economic outcome as a physically settled PPA via a net settlement mechanism, meaning that these contracts by their very nature do not qualify for the ‘own use’ exemption. 

What about hedge accounting?

If a PPA is accounted for as a derivative within the scope of IFRS 9, an entity can choose to mitigate the net income volatility by applying hedge accounting, provided that qualifying criteria – including evidence of an economic relationship – are met. Cash flow hedge accounting requires the designation of a specified volume of purchases or sales as the hedged item. For example, you might designate the first 10,000MWH of electricity purchased in the calendar month as being hedged. It is common, however, for renewable PPAs to be linked to the production of the underlying asset (say a wind farm), meaning that the notional element of the contract for a particular month varies and cannot be known in advance. It is difficult to prove an economic relationship between a variable notional hedging instrument and a fixed notional hedged item – how can you evidence that the economic relationship will not be broken by unexpected changes in production volume? 

What’s next?

Application of the ‘own use’ exception to PPAs was discussed by the IFRS Interpretations Committee in June 2023, with it recommending that the IASB undertake a narrow-scope standard-setting project, which is now underway. An exposure draft of limited scope amendments to IFRS 9 is expected as early as May 2024.

Kern Roberts, Managing Director – Global Accounting Practice Lead, Chatham Financial