An obscure climate accounting decision with billion-dollar consequences

And as interpretation decisions from this Board also inform public sector accounting, it also provides guidance for how public entities, councils and countries financially account for the cost of meeting climate targets. It has potential billion-dollar consequences for the New Zealand government’s financial statements. That will be of particular interest to Climate Change Minister Hon Simon Watts, who was recently welcomed into Cabinet and also happens to be an accountant, and to Associate Climate Change and Finance Minister Hon Nicola Willis.

The decision makes two key clarifications. First, that a climate target does not have to be legally enforceable to matter: even an entirely voluntary target can create a financial obligation if the company is sufficiently committed to its delivery (that is, there can be a “constructive obligation” in accounting-speak). Second, when use of carbon credits is part of meeting a target (offsetting a company’s excess annual emissions), the cost of those credits should be financially provisioned for, as a liability, when the emissions occur each year.

These clarifications come at a helpful moment for New Zealand. There has been increasing interest in the legal and financial accounting status of New Zealand’s international emissions reductions target – or nationally determined contribution (NDC) – under the Paris Agreement that covers the 2021 to 2030 period, for example; Risks Hiding in Plain Sight by the McGuinness Institute and the related analysis by Compass Climate.

New Zealand is now more than three years into the NDC, and there is a growing gap between our domestic emissions levels and what we have agreed to achieve. The gap that has already occurred will need to be bridged by the purchase of offshore carbon credits. How much we close the gap in each of the remaining years to 2030 (and therefore how many offshore credits will be needed in future years) depends on how much action we choose to take to reduce emissions.

That there is a gap should not be a surprise: the ambition of New Zealand’s NDC was set by the Key government in 2015 and updated by the Ardern government in 2021 with the expectation that it would partly be met by paying for reductions in other countries. The assessment of both governments was that New Zealand’s fair share of the collective global climate effort is greater than what we will realistically achieve domestically. The estimated cost of the offshore component has dropped since 2015 but is still very substantial: Treasury estimated that it could reach $4 billion cumulatively for cooperation with developing countries, or $9 billion if ETS linking is used. Those numbers could well rise further.

Based on the International Accounting Standards Board’s interpretation, there should be a provision (liability) in the government’s financial statements now for the portion of this cost that covers excess emissions that have already occurred. Failure to acknowledge this cost is hard to reconcile with the foundational accounting principle of presenting a “true and fair view” of the financial situation.

The only remaining accounting question is whether the government is sufficiently committed to our Paris Agreement NDC, and therefore whether an “obligation” formally exists. The briefest scan of the evidence should put that to rest. Besides the repeated and unwavering statements by successive governments since 2015 domestically and internationally, governments have signed on to implementation decisions in the UN process, amended our climate legislation to put the Paris Agreement at its heart, set the level of legally-binding domestic budgets with the assumption these would be complemented by offshore credits,written it into trade agreements, and leaned on the commitment to delivering the NDC in court cases. The current government is now taking steps toward implementing cooperation with Singapore, Thailand, and the Philippines.

Failure to deliver the NDC would have serious trade and financial risks. Article 19.6.3 of the EUNZ FTA requires the Parties to refrain from any act or omission that “materially defeats the object or purpose” of the Paris Agreement-opening the door not only to dispute resolution proceedings if there were a breach but arguably more importantly European lobby groups who represent industries producing goods that compete with New Zealand imports under the FTA could bring material political pressure to bear on European governments to restrict market access for New Zealand companies.

What might the view of ratings agencies be if New Zealand were to walk away from a billion-dollar obligation, given their definition of creditworthiness as the “capacity and willingness to meet financial commitments as they come due”?

With ratings agencies increasingly highlighting the importance of transparent reporting and proper management of climate change risk, they will undoubtedly take an interest. For a country that trades on its green brand and reputation as a trustworthy international counterpart, there is no realistic alternative but to follow through.

And more simply, the success of collective global action to reduce emissions matters to all of us in securing a liveable climate. Successive New Zealand governments have not supported the international climate process because we are required to, but because a stable climate is in New Zealand’s own interest.

The size of New Zealand’s NDC liability in future years will depend on how much action is taken domestically. Every extra tonne that we can reduce at a reasonable cost is one that we will not need to purchase offshore. All of this helps make the case for investment in ambitious initiatives such as accelerated electrification proposed by Rewiring Aotearoa, and Recloaking Papatūānuku which will deliver high quality, verifiable, co-beneficial carbon sequestration at low cost through the restoration and reforestation of our degraded indigenous forests.

We must also ensure that the offshore emissions reductions New Zealand supports have integrity and impact. In their just-completed mission to SouthEast Asia, Prime Minister Luxon and Hon Watts heard about a project where the Singapore Monetary Authority is funding the early retirement of coal-fired power stations in the Philippines and their replacement with renewable energy and batteries. If done well, the offshore component of New Zealand’s NDC could build on this type of approach and have a transformative impact.

The government has said that it will consult on its plans for domestic policy and NDC implementation mid-year. That is welcome. It’s time to face up to the challenge, make our actions add up to deliver the targets, and get on with it.