ESG in the mining industry - Ep3

Transcript

Kyla: Hello and welcome to the third segment of the podcast series 'Engaging ESG'.

In this episode we are going to be focusing on mining companies which follows on from episode 1 which provides an introduction to this series. So if you haven’t heard that episode, please make sure you do as it simply sets the scene.

Joining me in this segment is Saaleha Moolla, welcome to the discussion today.

Saaleha: Hi Kyla, thank you, it’s good to be here chatting to you today on such a topical matter.

Kyla: Topical indeed! Taking a step back, I presume the E-S-G considerations is not a new concept to these entities  and in particular mining entities solely based on the nature of the industry and their related operations.

Saaleha: That’s correct. Most entities within this sector have been transparent enough to provide analysis, updates and commitments on its contribution to ESG. 

This has however mainly been included in the front half of annual reports (and not necessarily in the annual financial statements itself). 

The focus from these entities has to a large extent been on more of the social factors such as safe and healthy working environments, community development and upliftment, stakeholder relationships and remuneration structures to name a few. 

With the current global emphasis on ESG, the E and G factors are equally important which requires the same degree of focus and transparency for entities within the industry in their annual reports as well as their annual financial statements.

Kyla: That’s a very good point. I’m sure there are endless matters pertaining to this industry that have an impact on the E and G aspects.The environmental impacts for example is broader than the industry emitting a high level of CO2 but also includes waste dumps, water pollution and high electricity and water consumption.

PwC’s SA Mine 2021 - Harvest season report highlights South Africa’s strategy, inline with its international commitments, to mitigate climate change and reduce greenhouse gas emissions because some of the most polluting industries are also significant players in the South African economy.

Now with all this being said, let’s put on our accounting hats. For purposes of performing impairment assessments of non-financial assets such as  cash-generating units,  what are some of the key points to consider and incorporate when it comes to ESG, especially for the commonly used fair value less costs of disposal method?

Saaleha: Now that’s a very broad question. I’m glad you mentioned the SA Mine 2021 publication though as there are some examples we can use from there to answer your question.

In order to address climate change, social vulnerability and biodiversity, and to remain competitive within the global economy, South Africa has approved a goal for the country to reduce greenhouse gas emissions to net zero by the year 2050.

What this means for entities is that in order to support the net zero agenda, they would need to, for example, decarbonise their energy supply, reduce reliance on the current state-owned power utility and invest in renewable energy supply, etc. In order to achieve this, restructuring and transition plans need to be put in place whereby affected entities would incur future costs of restructuring, enhancements and investments.

Now tying this back to the impairment considerations, when calculating the fair value less cost of disposal by using a discounted cash flow (in short DCF) model for example, capex for enhancements to assets should only be included if a market participant would reasonably expect such enhancements to take place. When considering what information a market participant would take into account, it is typically all information readily available in the market in which the entity normally transacts. Therefore, these type of  valuation models should be reviewed to ensure they adequately represent market participant assumption for the particular item being valued.

In terms of any future capex investments for future restructuring the related cash flows should also be included if a market participant would reasonably expect such restructurings to take place.

On the other hand though, when it comes to the value-in-use model, enhancements, and the inflows they are expected to generate, should be excluded from the cash flows until they are incurred. Similarly, the effects of restructuring should be excluded too, unless the entity is committed to the restructure and a related provision has been recognised.  Therefore, the cash flows used for a VIU DCF model might be different from the cash flows used  in the FVLCD DCF model.

Kyla: That's insightful, thanks. What about the considerations when it comes to carbon tax being factored into the cash flows used in the impairment assessment for non-financial assets? From what I understand, the first phase has already been introduced in South Africa with the second to follow from 2023. Emitters of greenhouse gases will be subject to paying over this tax in order to reduce the impact of climate change.

Saaleha: That’s a very interesting point you’ve raised Kyla. Where the recoverable amount in an impairment assessment is the FVLCD, entities should assess whether a market participant would incorporate the impact of carbon tax or not when determining the fair value of an individual asset or a CGU.

Entities should also think about the reasons for including or not including the impact of carbon tax in their impairment calculations, they should consider how other applicable regulations are dealt with within the group and also consider whether the entity should provide relevant disclosure of their carbon tax implications.

In addition to this, when it comes to performing an impairment assessment using the VIU model, PwC has recently published an In Depth on the Impact of ESG matters on IFRS financial statements which clarifies that legislation relating to Carbon taxes does not need to be enacted or substantially enacted in order to be included in cash flow forecasts for impairment purposes as this is not considered to be an income tax as defined by the IFRS standard governing income taxes. Assumptions relating to carbon pricing need to simply be a reasonable and supportable estimate to be included in a VIU calculation. In assessing whether assumptions and estimates are reasonable and supportable, greater weight should be given to external evidence that’s available which means that judgement would need to be applied when making this assessment.

Kyla: Those are definitely valuable points to consider. I guess there is no one size fits all and each entity would be impacted by ESG in different ways and would need to apply these considerations to their specific scenarios when performing various impairment assessments for their non-financial assets. 

Moving on from impairment, another hot topic currently is power purchase arrangements, also known as PPA’s. With the net zero agenda quickly becoming a priority area for many entities, there is increased pressure to adopt low emission energy sources which has resulted in an increased demand in such renewable energy sources.  PPA’s are essentially contracts entered into between 2 parties, one party which generates power, for example electricity and the other party which is looking to purchase the power or renewable energy infrastructure. 

This relationship sounds like there could be a potential lease. Can you please elaborate on some of the accounting consequences for PPAs that entities should look out for?

Saaleha: Yes, sure. These types of arrangements may take various forms whereby the renewable energy infrastructure could be purchased outright, where an entity has a right to use certain parts of the infrastructure or where only the output is purchased. These arrangements could become more complex where there are situations in which excess power is available and the arrangement could either allow or restrict the power purchaser from on-selling the excess or moving the excess power for its own use at various other sites. 

While a contract may not be legally worded as a lease, the substance of the arrangement between the parties should be assessed. In instances where the renewable energy infrastructure is not purchased outright,  the substance of the arrangement may contain a lease. 

A PPA is considered to be a lease or contains a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. 

There are various steps to follow in assessing whether a contract contains a lease or not.

Kyla: Can you please take us through the steps you mentioned and perhaps highlight what to look out for when performing the assessment?

Saaleha: With pleasure. 

The first step is to consider whether there is an identified asset. An asset can be identified either explicitly or implicitly. In these scenarios we would expect a contractual agreement to have been entered into between the parties which explicitly set out the assets which would be used.

Seeing that typically the power purchaser has exclusive use of the assets,  this assessment generally requires little judgement. 

The second step is to consider whether the entity has the right to obtain substantially all the economic benefits from the use of the asset throughout the period of use. Benefits include the primary output (e.g. power) and any consequential benefits received from using the asset (e.g.  renewable energy credits).

In arrangements where the power purchaser has exclusive rights to use all the power produced it is clear that the client has the right to obtain substantially all of the economic benefits and this criterion will be met. However, judgement will need to be applied where less than full capacity is taken by the power purchaser as the  term “substantially all” is not defined numerically.

Then the third step is to determine who has the right to direct how and for what purpose the asset will be used throughout the period. Here, there are three possible outcomes, where either the power purchaser or supplier determines the rights or the third outcome is where the rights are pre-determined. 

What we mean by having the “right” would include for example the right to change when the power will be delivered, the right to change where the power will be delivered and the right to change how much of power will be delivered.

If the power purchaser has the right to direct how and for what purpose the asset is used, the arrangement would typically contain a lease but where the supplier has those rights, then the arrangement typically does not contain a lease.

Kyla: Those are very helpful points to keep in mind. What happens in the case where those rights you just mentioned are pre-determined?

Saaleha: An important principle to remember is that either one of the parties to the arrangement  directs how and for what purpose the asset is used during the period of the lease, or these decisions are pre-determined. It cannot be both. Therefore the starting point for the assessment of who directs the use of the asset is during the period of the lease.  If a conclusion can be reached that the supplier or the purchaser directs the activities, then the conclusion is reached and the lease assessment stops. If there are no decisions about how and for what purpose the asset is used during the period of the lease, only then is the predetermined guidance considered.

In a case where the rights are pre-determined, the contract may pre-specify a lot of detail regarding capacity and how any excess power is dealt with for example, and as a result there are no decisions to be made once the contract is entered into. 

This means that in assessing whether the contract contains a lease, one should assess whether the power purchaser in this case has the right to direct the use of an asset by either it:

• having the right to operate the identified asset throughout the period of use, without the supplier having the right to change the operating instructions; or
• having designed the identified 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.

In summary, the conclusion of whether PPAs contain a lease depends very much on the specific facts and circumstances of each arrangement and may sometimes require significant judgement to be applied.

Kyla: Thanks for that, clearly it is not a quick assessment in determining whether such contracts contain a lease or not and it is imperative for entities to assess each step carefully. 

Just thinking ahead, if the whole lease assessment has been performed and the conclusion is reached that the power purchaser is not the party to a lease. Then it has entered into a contract to buy electricity. This is a typical supply agreement which will need to be assessed to determine if the own use criteria is met or if the contract might be a derivative in its entirety, or might contain embedded derivatives.

Saaleha: Yes, exactly! But that’s another beast in its entirety, so perhaps we can unpack those concepts in more detail in future sessions.

Kyla: We’ve covered a lot in today’s podcast. We’ve started with some considerations around what’s included and what’s excluded in impairment assessments of non-financial assets taking into account the impact of ESG on entities within the mining industry. We’ve then also discussed the steps to follow in determining whether power purchase arrangements contain a lease. 

Thank you for all your insights Saaleha!

Saaleha: It’s a pleasure, it was great chatting today.

Kyla: “This podcast is brought to you by PwC. All rights reserved. PwC refers to the South African member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This podcast is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.”