IS POWER PURCHASE AGREEMENT A LEASE OR NOT IN ACCORDANCE WITH IND AS – 116, ‘LEASES’
Introduction
Companies across the globe are evaluating their impact on the environment. As part of sustainability strategies, companies across the globe are striving to reduce their greenhouse gas emissions. In order to achieve sustainability goals, renewable energy is becoming more cost competitive and the Companies are entering into power purchase agreements (PPAs) with renewable energy producers.
A Power Purchase Agreement (PPA) often refers to a long-term electricity supply agreement between two parties, usually between a ‘power producer’ and a ‘customer’ (an electricity consumer or off-taker) for the sale and supply of energy. The PPA defines the conditions of the agreement, such as the amount of electricity to be supplied, negotiated prices, accounting, and penalties for non-compliance. Since it is a bilateral agreement, a PPA can take many forms and is usually tailored to the specific application. PPAs can be used to reduce market price risks, which is why they are frequently implemented by large electricity consumers to help reduce investment costs associated with planning or operating renewable energy plants.
Below are some of the main benefits of PPAs for companies: –
1. Cost Stability and Predictability:-
Companies can enter into long-term fixed price contracts, helping them to avoid energy fluctuations and making energy costs more predictable.
2. Emissions and Environment Responsibility:-
By entering into PPAs for renewable energy, Companies can reduce their carbon emissions and meet their sustainability goals. This can also enhance brand image and foster customer loyalty.
3. Financial Benefits:
PPAs can provide financial advantages as companies often gain access to renewable energy at more favourable rates compared to traditional energy sources.
PPAs can also help reduce operational costs by avoiding investments in and maintenance of their own energy infrastructure.
4. Energy Independence and Security:
PPAs enable companies to hedge against energy supply risks, especially in regions with uncertain or unreliable energy supply.
5. Promotion of Innovation:
PPAs can support and promote innovative projects, such as the construction of new wind farms or solar plants, contributing to the advancement of renewable energy.
Types of Power Purchase Agreements
Majorly, there are two primary types of PPAs:
1. Physical PPAs
A physical PPA holds that the energy that is produced is physically delivered to the Buyer either directly or indirectly through a power grid. This type of PPA is commonly used by utility companies and large industrial consumers.
2. Synthetic or Virtual PPAs
A synthetic or virtual PPA does not involve the physical delivery of power. It is a financial arrangement where the Buyer and Seller settle the difference between the agreed PPA price and the market price. If the market price is higher than the PPA price, the Seller pays the difference to the Buyer and vice versa.
Accounting Treatment of Power Purchase Agreement under Indian Accounting Standards
The Power Purchase Agreements entered by the companies are often extensive contracts and include a myriad of clauses and advanced price mechanisms that can increase accounting and financial reporting complexity.
Companies usually prefer to consider a PPA as a “normal” supply contract and account for the energy costs based on invoices received (executory contract). However, pricing mechanisms, the way the power purchased is used and the designation of a specific asset can cause the contract to be classified as a lease (which results in recognition of the power generation assets on the balance sheet and in an increase in debt resulting in lower solvency ratios) or a financial instrument (which has to be fairly valued in every reporting period and can cause undesired volatility in companies’ financial results).
In this article, we are going to discuss the accounting treatment of Power Purchase Agreements from the perspective of Ind AS -116, ‘Leases’.
A. Is the PPA a lease in accordance with Ind AS-116, ‘Leases’
In accordance with Ind AS 116, arrangements that convey the right to control the use of an identified asset for a period of time in exchange for consideration meet the definition of a lease, even if the arrangement does not take the legal form of a lease.
1. Does the PPA identify a specific asset?
The first assessment in determining whether a contract contains a lease is the identification of a specific asset.
An asset is typically identified by being explicitly specified in a contract (for example, the PPA specifies particular wind or solar plant). However, an asset can also by being implicitly specified at the time the asset is made available for use by the lessee (e.g. the power supplier has no other facility that can be used to fulfil the contract).
Substantive substitution rights
Even if an asset is specified, a customer does not have the right to use an identified asset if, at inception of the contract, a supplier has the substantive right to substitute the asset throughout the period of use, then there is no identified asset. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
1) The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and
2) The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
2. Right to obtain economic benefits from use
To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the identified asset throughout the period of use. The arrangement must convey the right to obtain substantially all of the potential economic benefits that can be obtained from directing the use of the asset throughout the period of use to be a lease. Economic benefits generally include the primary output/power produced by the asset. An off-taker has the right to obtain substantially all of the economic benefits from the use of the asset if, for example, the PPA indicates that substantially all power that the asset of the supplier produces during its useful life is purchased by the off-taker. However, a plant’s capacity to produce output might not always be the only means from its use.
3. Right to direct the use of asset
Direct the use of the asset
A customer has the right to direct the use of an identified asset where it has the right to direct how and for what purpose the asset is used throughout the period of use.
When evaluating whether an off taker has the right to direct how and for what purpose the asset is used throughout the period of use, the focus is on whether the off taker has the decision-making rights that will most affect the economic benefits that will be derived from the use of the power plant. The decision‑making rights that are most relevant are likely to depend on the nature of the asset and the terms of the contract.
Ind AS 116 provides the following examples of decision‑making rights that grant the right to direct how and for what purpose an asset is used:
a. The right to change the type of output that is produced by the asset. (for example, with respect to power generating assets, the type of output produced is normally predetermined by the nature of the asset, as it is designed and constructed to produce a specific type of electricity).
b. The right to change when the output is produced (for example, deciding when to produce power from a power generating asset).
c. The right to change where the output is produced (for example, deciding where a wind or solar farm is located). This is normally predetermined by where the power generating asset is constructed.
d. The right to change whether the output is produced and the quantity of that output (for example, deciding whether to produce energy from a power plant and how much energy to produce from that power plant).
Ind AS 116 specifies that the maintenance and operation of the asset are examples of decision-making rights that do not grant the right to change how and for what purpose an asset is used. Although the decisions about maintaining and operating the asset are often essential to the efficient use of that asset, they are not rights to direct how and for what purpose the asset is used. However, rights to operate an asset may grant the customer to direct the use of the asset if the relevant decisions about how and for what purpose the asset is used are predetermined.
Decisions determined during and before the period of use
The relevant decisions about how and for what purpose the asset is used can be determined in a number of ways like predetermined contractual restrictions on the use of the asset. This could also be the case when the most relevant decisions about how and for what purpose an asset is used are, in effect, predetermined by the design of the asset (for example, the decisions about the use of the asset are agreed to by the customer and the supplier during the negotiation of the contract, and those decisions cannot be changed).
The relevant decisions about how and for what purposes an identified asset is used are predetermined, an off taker is deemed to have the right to direct the use of an identified asset throughout the period of use when the off taker either
i. has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or
ii. designed or influenced the design of the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
Design is expected to be a much more important indicator of the right to direct the use of the power plant when the economies are effectively fixed in an arrangement prior to use. It is prerequisite that the design of power production facilities predetermines how and for what purpose the assets will be used throughout the period of use because it determines the resulting economics. If the off-taker designed or influenced the design of the power plant, it is assumed that the off taker has the right to direct the use of the power plant and this condition is met.
Example I: – Customer has economic benefits of power plant, predetermined the use and designed the asset
A manufacturing company enters into a contract with a power producing company for sale and supply of electricity produced by a new solar plant for twenty years. The solar plant is explicitly specified in the contract and the power producing company has no substitution rights. The manufacturing company was involved in the design and specifications of construction of the solar plant and the electricity produced from the solar plant will be consumed by the manufacturing company. The power producing company is responsible for the operation and maintenance of the plant and will produce the electricity in accordance with pre-determined terms of the contract.
The contract contains a lease. There is an identified asset without the possibility of substitution by the power producing company. The manufacturing company has the right to obtain substantially all of the economic benefits as the entire electricity will be consumed by the Company generated from the solar plant.
Example II: – Customer has economic benefits of power plant, predetermined the use but did not design the asset
A manufacturing company enters into a contract with a power producing company for sale and supply of electricity produced by a new solar plant for twenty years. The solar plant is explicitly specified in the contract and the power producing company has no substitution rights. The power plant is owned, operated and maintained by the power producer company in accordance with industry practices. The power plant was constructed and designed by the power producer company few years ago before entering into the contract with the manufacturing company.
The contract does not contains a lease. There is an identified asset without the possibility of substitution by the power producing company. The manufacturing company has the right to obtain substantially all of the economic benefits as the entire electricity will be consumed by the Company generated from the solar plant.
However, the manufacturing company does not have the right to direct or change how and for what purpose the plant is used, i.e. when and how much power the plant would produce.
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