The mark-to-market of commodity supply contracts, such as power purchase agreements and related derivatives, can create significant volatility in profit and loss. But are these gains and losses meaningful, and should you remove them from performance measures as many companies do in their non-GAAP reporting?
There are 4 methods of accounting for power purchase agreements and, confusingly, you could find all of them applied by one company. We explain how each method works, when fair value gains and losses arise, the implications for your analysis, and how all this will be affected by a recent change to IFRS 9.
Many companies seek to fix the future cost of purchases that are subject to commodity price changes. This could be an airline fixing the cost of jet fuel, a food manufacturer fixing the cost of cocoa purchases, or almost any company fixing the cost of electricity supplies. The price fixing (or hedging) may be for a short period of months through to, for example, long-term power purchase agreements that could be used to fix electricity costs for periods of 20-years or more.
Prices can be fixed through an agreement with a supplier that provides for the physical delivery of a certain volume of purchases in return for a fixed price paid per unit. Alternatively, prices can be fixed by using derivatives. In this case purchases are made in the spot market at the prevailing spot price, but the increase or decrease in that price is offset by cash flows from the settlement of a separate derivative contract, such as a virtual power purchase agreement.
In our analysis below, we focus on electricity purchase contracts and derivatives. It is for (some of) these that the IASB has recently changed the accounting. However, the accounting methods and analytical challenges apply to any situation where a company wishes to fix the price of commodity purchases.
Supply contracts may be measured at cost or fair value
Although we describe 4 methods of accounting that are applied under IFRS1In this article we focus on IFRS reporting. US GAAP has similar analytical challenges, but the accounting is not exactly the same., the key factor that affects financial statements is whether contracts that fix the price of commodity purchases are measured at fair value or cost. Additionally, if fair value applies, how are fair value gains and losses recognised in the statement of comprehensive income; in other words, when and how do they impact net profit?
The default accounting for all derivatives, including forward purchase contracts at a fixed price, is fair value through profit and loss. However, for commodity purchases, this is modified in two ways. Firstly, some contracts for physical delivery of a commodity are scoped out of IFRS 9 and cost accounting is applied instead of fair value. Secondly, if cash flow hedge accounting is applied, derivative gains and losses are initially recognised in Other Comprehensive Income (OCI) with only later ‘recycling’ to profit and loss.
Profit volatility due to the application of fair value through profit and loss can be significant. This is illustrated by the profit and loss statement of electricity supply company OVO Energy shown below. In 2022, the company suffered a large mark-to-market loss of £1,438m on its energy supply contracts, which resulted in an operating loss of £1,581m. In 2023 a mark-to-market gain of £1,086m contributed to an operating profit of £1,121m.
OVO Energy profit and loss statement and accounting policy extract
OVO Energy 2023 financial statements (highlighting added)
The company removes these remeasurements as part of their non-GAAP or “underlying business performance” reporting. Had these contracts been accounted for at cost the financial statements would have been very different. Indeed, as we explain later, it is possible that a recent change to IFRS 9 will result in OVO Energy changing its accounting.
Despite the volatility challenge and the prevalence of non-GAAP exclusions, we do not think mark-to-market gains and losses should be ignored. We believe they provide important information for investors, and that this applies even if the mark-to-market effect is not reported in profit and loss. Nevertheless, these volatile items should be analysed differently from other ‘flows’ that impact profit and loss.
Before we discuss the analysis, it is important to understand how the different accounting methods work, why there are so many, and when each is applied.
Alternative accounting for fixed price commodity supply contracts
The 4 methods of accounting are:
- Cost (or ‘own-use’) accounting
- Fair value (sometimes called derivative) accounting
- Fair value accounting, but with the additional application of cash flow hedge accounting
- Lease accounting
Two of these methods are clearly used by OVO Energy. In the accounting policy note we show above, the company says, “Derivative commodity contracts which are not designated as own-use contracts [i.e. method 1] are accounted for as trading derivatives [i.e. method 2] …”.
It is even possible to find all 4 methods used by one company. The extract below is from the financial statements of industrial company Saint-Gobain, where it describes its use of power purchase agreements (PPAs) and how these are reflected in its financial statements.
Saint-Gobain accounting for power purchase agreements
Saint-Gobain 2024 interim financial statements (highlighting added)
Saint-Gobain uses the term “purchase contract” to describe cost accounting, “IFRS 9 (derivatives)” for fair value accounting and simply “IFRS 16” for lease accounting. It also identifies an IFRS 9 contract to which it applies hedge accounting – so 4 different methods in all.
It is a combination of the nature of the contracts, actions of the company and an accounting policy choice that determines which accounting method is applied. This is a complex area of financial reporting – our explanations below are certainly not comprehensive and are primarily aimed at investors trying to understand financial statements.
Normal purchases or commodity trading?
The most important factor that affects the accounting is whether the contracts are measured at cost or at fair value. At a very high-level, cost accounting applies when commodities are purchased for use in an operating activity, where physical delivery takes place and there is no ‘trading’ of the commodity itself. In other words, the transaction is just a normal purchase of materials, often referred to as ‘own-use’. This is often the case for simple forward commodity supply contracts. Although these contracts are derivatives2Although these contracts are derivatives in a financial sense, under IFRS they are not regarded as financial instruments (assuming no net settlement) and are therefore not within the scope of IFRS 9 or IFRS 7, which deal with the accounting and disclosures for financial instruments respectively., the normal application of fair value accounting is not applied due to an exception in IFRS 9 – the so-called own-use exception. For Saint-Gobain, all its physically settled PPA supply contracts qualify for cost accounting, although this will not always be the case.
However if, in effect, the contract and actions by the company result in the trading of that commodity, such as by net settling3Net settlement is where the difference between the spot and fixed contract price results in a cash payment between the counterparties. There is no physical delivery of the commodity. the transaction, then the default fair value accounting is deemed appropriate. Notice that Saint-Gobain applies fair value accounting to its ‘virtual’ PPAs which are net cash-settled derivatives.
The problem is that while many transactions are obviously normal purchases or commodity trading, identifying the dividing line is not so easy if transactions have some characteristics of both. Indeed, OVO Energy highlights this as an “area of significant accounting judgement”.
What is perhaps most important for investors is understanding the accounting methods themselves and how to use the resulting performance and balance sheet data in each case.
Method 1: Cost (own-use) accounting
The first method of accounting is the simplest. Under cost accounting, when purchases are made at the fixed price, the amount payable is simply reported as an expense (or capitalised as inventory if not consumed at the balance sheet date). There is no fair value measurement of the contract (even though the contract could have a fair value that is positive or negative) nor is fair value disclosed in the footnotes.
In our interactive model, we illustrate the accounting for a 10-year contract to buy 100 units of a commodity at a fixed price of 10. Under cost accounting the expense recognised is simply 1,000 each year.
Commodity purchase contracts example
See below for the full embedded interactive model where the input cells can be modified. We assume commodity delivery and related cash flows occur at the end of each year.
Although initially the spot price of the commodity is assumed to be the same as the purchase price in our example, this is likely to change over the course of the contract. Assuming a flat forward curve, the value of this contract at inception is zero. However, as the spot price changes the contract value also changes. For example, if the spot price rises to 12 at the end of year 1, the value of the contract becomes positive. The value is essentially the present value of the difference in the cost of materials at the (now favourable) fixed price compared with the spot price. In this example it equals 1,422 (see the next model extract below). However, under cost accounting this value change is (mostly) ignored.
Onerous contract provision is a (partial) recognition of a negative fair value change
A value change is only recognised under cost accounting if the contract is regarded as ‘onerous’. An onerous contract provision is required if commodity price changes mean that the company can no longer make a profit when purchasing at the fixed purchase price. This would occur if the spot purchase price has fallen to an extent that the sale price (of whatever the purchases are used in) declines to a level where the activity makes a loss. However, onerous contract losses are not common due to the protection afforded by other margins.
In our model we have a separate input for the spot price at which the contract becomes onerous – we assume 7. Our input spot price for year 2 is 6, which results in the onerous contract loss of 646. Try changing the inputs in the interactive version below to see how they impact the resulting accounting.
The problem with onerous contract losses is that they are incomplete and subjective. In our example, the actual economic loss (the change in contract fair value) due to the change in spot price in year 2 is 4,407. This is not evident under cost accounting – to see this economic loss we need fair value accounting.
Method 2: Fair value (derivative) accounting
Under fair value accounting, the fixed price supply contract, or stand-alone derivative that achieves the same result, is measured at fair value, with changes in value reported in profit and loss. The profit and loss expense (or income) is the sum of the commodity’s purchase price plus or minus the change in fair value of the derivative.
Fair value gains (losses) arise when the spot price increases (decreases) and the fixed contract purchase price becomes more or less favourable.
Commodity purchase contracts example (cont.)
See below for the full embedded interactive model where the input cells can be modified
The change in fair value can itself be disaggregated into a cash flow effect (the cash settlement of the difference between the spot and fixed price), an unrealised value change and an interest accretion4The fair value of a forward contract is a present value calculation. Therefore, part of the value change in a period is due to the unwinding of the discounting.. This leads to different ways of disaggregating the overall expense or income, as we demonstrate.
Under fair value accounting, the expected future gain or loss due to the favourable or unfavourable fixed price is recognised (in present value terms) immediately. This means that the expected future expense is the spot price (plus an interest accretion for the derivative), as can be seen for year 4 in our illustration. In contrast, under cost accounting only the current period cash flow effect of the contract affects profit, with future cash flow effects recognised in future periods. Compare the cost and fair value accounting results in our model to see this in action.
Due to the volatility in profit that a fair value approach generates, many companies will additionally provide non-GAAP adjusted performance measures, from which the mark-to-market effect is removed. The general problem with non-GAAP is that exactly what adjustments are made is up to management and there is no guarantee of comparability between companies. Furthermore, in our view, you should not ignore fair value changes.
Method 3: Fair value with the additional application of cash flow hedge accounting
Where a hedging instrument (normally a derivative) hedges a future flow, such as the variable price paid for a commodity, a company may apply cash flow hedge accounting. This means that the fair value change for the derivative is initially recognised in Other Comprehensive Income (OCI) and then reclassified (or recycled) to profit and loss to offset the variations in that future flow.
In effect, cash flow hedge accounting results in cost accounting being applied in profit and loss, with fair value accounting applied in the balance sheet and for comprehensive income.
Commodity purchase contracts example (cont.)
See below for the full embedded interactive model where the input cells can be modified
Optional application of cash flow hedge accounting creates comparability issues
There are strict eligibility criteria for hedge accounting such that not all derivatives will qualify. In addition, even if these criteria are met, the application of hedge accounting is optional. Some companies may prefer not to apply hedge accounting, even if it is available, and deal with the mark-to-market volatility through adjusted non-GAAP performance metrics. This obviously creates comparability challenges for investors.
Not all hedges offer a perfect offset. For example, if a virtual power purchase agreement references electricity in a different market from where purchases take place, the flows from the net cash settlement of the derivative may differ from the spot price variation experienced for the physical electricity purchases. In this case, the ineffective portion of the fair value change is recognised in profit and loss. For simplicity, we assume there is no ineffectiveness in our model.
Method 4: Lease accounting
Sometimes a company may contract to receive most or all the output from a specific asset, such as a wind farm. This may, in effect, result in the purchaser assuming control of that asset, with the transaction therefore meeting the definition of a lease. The fixed payments under what is legally a purchase contract become, in substance, lease payments, to which lease accounting (IFRS 16) should be applied.
Depreciation and interest instead of commodity purchase expense
Under lease accounting, the present value of fixed contractual payments5If contracts result in variable payments no asset and liability would be recognised and the payments reported as an expense when incurred. is recognised as a lease liability and corresponding right-of-use asset. Subsequently, in profit and loss, an interest expense and fixed asset depreciation are recognised. Lease accounting is a form of cost accounting and there is no remeasurement of either asset or liability when prices change (unless the right-of-use asset is impaired); however, the outcome is presented quite differently compared with method 1 above.
Lease accounting may seem an odd way to account for commodity purchases, but the underlying economics of these contracts is no different from a company owning a wind farm outright and using the electricity it produces in its own operations. Although Saint-Gobain identifies one of its PPAs as “IFRS 16”, you will not often see lease accounting applied to purchase contracts in practice.
Here is the full interactive model which we hope will help you understand the 4 methods we have described. Try changing the input data and see how different commodity prices affect the financial statements under each method of accounting.
Interactive model: Accounting for fixed-price commodity purchases
The Footnotes Analyst
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Notice that the aggregate profit and loss (and comprehensive income) expense over the life of the contract is the same irrespective of the accounting method. All accounting (with a couple of notable exceptions6For example, the expense recognised for equity settled share-based payments does not equal cash flow.) eventually pulls to match cash flow. The difference is how the expense is allocated between different periods, how this is classified, and what assets and liabilities are recognised in the balance sheet. The idea is that, even though the cash payment might be the same, there can be different underlying economics that justify the different accounting.
Implications for equity analysis
It is important that investors understand the different accounting methods applied to contracts to fix the cost of commodity purchases. However, it is also important to understand the underlying economics. Although fixing the purchase price may appear to reduce risk, this may not always be the case – lower volatility of profit under cost accounting may hide higher economic value volatility.
Although fixing input prices may reduce cost volatility profit volatility may increase
For example, if revenue fluctuates in line with a change in input costs (i.e. the industry can pass on a commodity price increase in the form of higher selling prices) then fixing input costs will actually increase profit volatility. If purchases are fixed but revenue falls due to competitors (who perhaps did not ‘hedge’) reducing sales prices, then profit will fall. However, fixing input prices makes sense if the selling price is also fixed (perhaps due to contractual arrangements), or if price increases are difficult to pass on to customers. In this case fixed price supply contracts will reduce operating risk.
Of course, this is all highly complex and very industry specific. The point is that just because a company uses fixed price contracts or hedges using derivatives, risk is not necessarily reduced. This is one reason why the fair value change of contracts that fix purchase prices is important, even if cost accounting, cashflow hedge accounting or non-GAAP reporting means that fair value changes are excluded from key performance metrics.
When a fixed purchase price is reflected in profit and loss, always try and identify how far out this ‘hedging’ extends and how profitability will change once the period of price fixing finishes. All the accounting does is reflect what is happening currently and not how profitability will change in the future. For that you need to focus on understanding the business and reading the separate disclosures about risk management.
A further analysis challenge specific to renewable energy contracts relates to price risk when excess electricity is sold, or a deficiency has to be covered by market purchases. Supply and demand dynamics mean that market price changes will often be unfavourable, where prices are likely to fall when excess electricity is sold but rise when electricity must be purchased.
Nature dependent PPAs and the recent change to IFRS 9
Companies are increasingly using power purchase agreements for wind and solar generated electricity as part of a transition to net zero and to obtain renewable energy certificates. However, the intermittent nature of renewable power has resulted in some of these contracts failing the IFRS 9 own-use exception and therefore being reported at fair value.
One reason for this failure is that there is a greater likelihood that surplus power will have to be sold immediately in the spot market such that, under the old IFRS 9 rules, these contracts were regarded as a commodity trading activity. For many companies this results in unwelcome fair value measurement and profit and loss volatility, even though they do not regard themselves as commodity traders.
Expect a move from fair value to cost for some companies in 2025
To deal with these supposed shortcomings of IFRS 9, the IASB has changed the standard so that it is less likely these contracts will fail the own-use test. Changes have also been made to cash flow hedge accounting so that it is more likely this can be applied to derivatives, such as virtual power purchase agreements.
The new rules will apply from 2026, but companies may choose to use them earlier than this (subject to endorsement of the amendment by the relevant jurisdiction). Be prepared to see a change in interim financial statements soon. This will include the restatement of prior periods.
Insights for investors
- Commodity purchase contracts at a fixed price could be accounted for at either cost or fair value, depending on whether they equate to normal purchases or are, in effect, linked to commodity trading.
- Cost, or own-use, accounting means no fair value information, even though contracts may have a significant positive or negative value due to favourable or unfavourable fixed prices. Onerous contract provisions will only partially show negative economic effects.
- Fair value accounting provides better information about economic gains and losses due to commodity price changes, but can present challenges for investors seeking to interpret profit metrics that combine flows with value changes.
- Fair values combined with the application of cash flow hedge accounting provides performance metrics from both a cost and fair value perspective.
- Management adjusted or non-GAAP metrics may not be comparable between companies, nor the same as either cost accounting or the result of cash flow hedge accounting.
- Just because the cost of materials may be ‘hedged’ in accounting terms, it does not mean that economic risk or profit volatility has been reduced. Consider the underlying economics and consult the risk management disclosures for a better understanding of operational risks.