The Impact of the ASC 842 Lease Accounting Standards on a Toll Agreement for Stand-Alone BESS

Introduction

The Financial Accounting Standards Board’s (FASB) recent lease accounting standards (ASC 842) are impacting toll agreements for stand-alone battery energy storage systems (BESS). These standards require offtakers (lessees) to recognize assets and liabilities arising from an operating lease with a term greater than 12 months, which affects the lessees’ initial measurement of the lease liability. Such lease liability is the present value of the unpaid lease payments, discounted using the rate implicit in the lease (if readily determinable), or otherwise using the lessee’s incremental borrowing rate (FASB 842-20-30-1 – 30-3). For public companies, these standards applied to fiscal years starting after December 15, 2018. For private companies and nonprofit organizations, these standards applied to fiscal years starting after December 15, 2021. 

With the increased development of BESS and, consequently, the use of toll agreements for such BESS, some offtakers who enter into these toll agreements seek to avoid being subject to lease accounting standards. It would be important for the BESS owners to understand the consequences of lease accounting, offtakers’ intentions and to anticipate some creative provisions in future toll agreements to respond accordingly.

Definitions of Lease, Financial Lease and Operating Lease

A contract is 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 (FASB 842-10-15-3). If the lessee has the rights to both (a) obtain substantially all of the economic benefits from use of the identified asset and (b) direct the use of the identified asset, a contract would be deemed to “convey the right to control the use of an identified asset for a period of time” (FASB 842-10-15-4).

An operating lease is a lease that is not a financing lease (FASB 842-10-25-3(a)). A lease will be classified as a finance lease if the asset is, or will be, transferred to the lessor; more specifically, if any of the following criteria is met:

• The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
• The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
• The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
• The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
• The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

(FASB 842-10-25-2)

An operating lease requires not only a lessor but also a lessee to recognize assets and liabilities arising from the leases on the balance sheet. For the lessee, the initial measurement of the lease liabilities will essentially be the present value of the lease payments remaining through the end of the term, discounted using the discount rate for the lease established at the commencement date (FASB 842-20-30-1(a)).

Toll Agreement for Stand-Alone BESS – Typically Classified as an Operating Lease

A typical toll agreement is not a finance lease since neither of the above finance lease criteria is met. For example, the ownership of the BESS would remain with the owner and not be transferred to the offtaker by the end of the agreement, nor does the offtaker have an option to purchase the BESS. However, many offtakers classify it as an operating lease satisfying both rights set forth in 842-10-15-4 because the offtaker controls (subject to negotiated parameters) whether to charge or discharge the BESS (receiving the economic benefit of such operation) and, in exchange, the offtaker provides a monthly payment to the sponsor based on the size of the BESS.

The Impact of the New ASC 842 Lease Accounting Standards

Under the new lease accounting standards, which now applies to all companies*, lessees are required to recognize assets and liabilities arising from all leases (including operating leases) on the balance sheet. When applied to the toll agreement for stand-alone BESS, the offtakers (lessees) must initially list the lease liability, which is the present value of the unpaid toll payment (i.e., lease payment), discounted using the rate implicit in the toll agreement (if readily determinable), or otherwise using the offtaker’s incremental borrowing rate. This may negatively impact the financial metrics for the offtakers.

*Effective dates – For public companies, the fiscal years starting after December 15, 2018. For private companies and nonprofit organizations, the fiscal years starting after December 15, 2021.

Method to Avoid Being Subject to the New Lease Accounting Standards

In an effort to avoid being subject to the lease accounting standards, we are seeing the following two methods being advanced:

The first method is to have the BESS owner (typically the sponsor) be the market participant, which results in the owner paying for discharging energy and receiving charging energy to and from the independent system operator (ISO). However, the net ISO payments are deducted from the tolling fee. Although the offtaker may direct the charge or discharge of the BESS, some lessees are viewing it as the owner (not the offtaker) who receives the economic benefit derived from the use of the BESS. Offtakers may view this method as preventing the toll agreement from meeting FASB 842-10-15-4(a) (i.e., the lessee has the right to obtain substantially all of the economic benefits from use of the identified asset). However, with the net economic benefit acting as a credit against the toll payment (i.e., lease payment), taking a position that the lessee is not receiving the economic benefit from use of the asset is questionable.

Another method is to create a “virtual” toll where the owner is not required to actually charge or discharge the BESS when it receives such an order from the offtaker. Instead, a “deemed” energy charge occurs whether or not an actual charge occurred (and, similarly, a “deemed” energy discharge occurs when there’s a discharge order). Thus, the offtaker does not have a right to control the use of the BESS. Offtakers may view this method as preventing the toll agreement from meeting FASB 842-10-15-4(b) (i.e., the lessee has the right to direct the use of the identified asset).

This method satisfies offtakers’ desire to avoid lease accounting through an effort to not convey the right to control the use of the BESS to the offtaker. At the same time, this method enables the parties to keep essentially the same underlying structure of the traditional stand-alone toll agreement for BESS—the BESS owner allows the offtaker to obtain the benefit of daily energy price arbitrage (and, if applicable, any associated capacity attributes) in exchange for a tolling fee. It should be noted that, while potentially solving the lease accounting issue, a separate question arises from this structure as to whether it requires Commodity Futures Trading Commission (CFTC) reporting as a swap.

Conclusion

It is worth considering to include some creative provisions in any forthcoming toll agreement in order to meet the offtaker’s objectives and to make full use of the BESS.