A growing number of jurisdictions have introduced different carbon pricing policies such as carbon taxes or emission trading schemes (ETS) in response to emission reduction targets established by the Kyoto Protocol. An ETS probably is the most widely adopted carbon market system in the world affecting corporate carbon activities and disclosure. The European Union (EU ETS) was the first - and is still by far the biggest - international system for trading GHG emission allowances. However, moves have also been made in Australia, USA (California), China and South Korea among others and different countries have divergent practices on establishing and implementing an ETS. Pinkse and Kolk (2009) argued that "an emission trading scheme is a new type of institution, which sets boundaries on the amount of GHG that companies can emit into the atmosphere and defines how this burden is shared among market participants through a price mechanism."

An ETS normally takes the form of ‘cap-and trade' system. In a cap and trade scheme, the level of the scheme cap determines the environmental contribution of the scheme: the lower the cap, the more abatement (reduction in emissions) required. The cap is the limit on GHG emissions which must be consistent with national longer term targets for carbon reduction. Once the cap is established, the government then issues allowances that are equal to the cap. Allowances can be allocated for free by government, or auctioned, and subsequently traded in the market. With each tonne of emissions, the firm is required to acquire and surrender an allowance. If companies emit more than allocated allowances, they must either purchase additional allowance or pay a fine. However, if firms have less emissions than allocated allowances, they can sell the remaining allowances in an active market.

Required:

Write a report (maximum 2,000 words) to discuss the accounting treatment of the emission allowances and its effect on the financial statements. The appropriate accounting treatment for emission allowances is important for the implementation of ETS and one of the purposes of the assignment is to improve students' research skill.

In your report you are required to:

- Identify relevant accounting issues associated with an emission trading scheme and emission allowances;

- Discuss the nature of emission allowances and provide justification.
- Discuss how emission allowances should be measured initially and subsequently. Provide journal entries for these transactions.
- Discuss the consequences of emission allowances on the financial statements, including balance sheet, income statement and cash flow statement.