On December 4, 2023 and during the initial days of COP 28, the US Commodity Futures Trading Commission (CFTC) issued proposed guidance (the Proposed Guidance) intended to standardize and promote integrity in the voluntary carbon credit (VCC) derivatives markets, but which may have impacts on the physical VCC markets as well.
The Proposed Guidance discusses certain issues and concerns that have arisen with the VCC markets, including concerns as to whether VCCs accurately reflect the reductions in greenhouse gas (GHG) emissions they are intended to represent; challenges with pricing VCCs; challenges with ascertaining VCC quality; whether claims related to VCCs are misleading; and whether businesses are seeking out low qualify VCCs to reduce costs. The CFTC stated that standards that “assist market participants in making informed evaluations, and comparisons, of VCC quality may promote accurate pricing and enhance confidence that the voluntary carbon markets can serve as a tool to assist in emissions reduction efforts.” Moreover, the CFTC believes that setting forth factors that futures exchanges must consider when listing VCC derivatives may help to advance such standardization.
The Proposed Guidance therefore outlines several factors that US futures exchanges, as well as swaps trading platforms, should consider when listing VCC derivatives contracts. Futures exchanges and swaps trading platforms have long been required to ensure that their contracts meet certain standards prior to listing them, including that such contracts are not readily susceptible to manipulation and that the derivatives platforms are able to monitor trading to prevent manipulation, price distortion, and disruptions of the delivery or cash settlement process. Given the new and evolving nature of VCC derivatives markets and VCC markets generally, the Proposed Guidance is intended to set forth certain standards for how derivatives platforms should satisfy these existing obligations in connection with the new and novel VCC products.
The Proposed Guidance is primarily focused on physically-settled VCC contracts that are listed on futures exchanges, but notes that this is in part because there are not currently any other types of VCC derivatives traded on electronic platforms. The CFTC noted, however, that the factors described in the guidance should also be considered for any future cash-settled derivatives, including those listed on swap execution facilities.
Contracts May not be Readily Susceptible to Manipulation
The CFTC first discussed the factors that futures exchanges should consider when determining that their listed contracts are not readily susceptible to manipulation. Existing CFTC guidance states that in order to comply with this requirement for physical delivery contracts, futures exchange must describe the economically significant attributes of the underlying commodity. The CFTC stated that, to comply with this requirement, futures exchanges should explain that standardization and accountability mechanisms for VCCs are still being developed.
Additionally, the CFTC stated that futures exchanges should consider the following, at a minimum, prior to listing VCC derivatives:
- Quality standards of the VCC
- Transparency –the crediting programs used for VCCs, and whether the crediting program makes publicly available and searchable detailed information about the crediting program’s policies and procedures and the projects or activities that it credits.
- Additionality – whether the underlying VCCs represent GHG emission reductions or removals that would not have been developed and implemented in the absence of the added monetary incentive created by the revenue from the sale of carbon credits. Futures exchanges should also consider whether the crediting program has policies and procedures in place to ensure additionality.
- Permanence and accounting for the risk of reversal - whether the crediting program for a VCC has measures in place that provide reasonable assurance that, in the event of a reversal (i.e., VCCs bring recalled or cancelled), the VCC will be replaced by a VCC of comparably high quality that meets the contemplated specifications of the contract, such as through the use of “buffer reserves.”
- Robust quantification - whether the crediting program for the underlying VCCs can demonstrate that the quantification methodology or protocol that it uses to calculate emission reductions or removals for the underlying VCCs is robust, conservative, and transparent. Futures exchanges should also derive a quantitative estimate of the deliverable supplies of the underlying commodity in order to quantify position limit requirements.
- Delivery points and facilities
- Governance - whether the crediting program can demonstrate that it has a governance framework that effectively supports the crediting program’s independence, transparency and accountability.
- Tracking - whether the crediting program can demonstrate that it has processes and procedures in place to help ensure clarity and certainty with respect to the issuance, transfer, and retirement of VCCs
- No double counting - whether the crediting program can demonstrate that it has effective measures in place that provide reasonable assurance that credited emission reductions or removals are not double counted.
- Inspection provisions
- The CFTC stated that any inspection or certification procedures for verifying compliance with quality requirements or any other related delivery requirements for physically-settled VCC derivatives contracts should be specified in the contract’s terms and conditions. Additionally, futures exchanges should consider whether the crediting program has up-to-date, robust and transparent validation and verification procedures, including whether those procedures contemplate validation and verification by a reputable, disinterested party or body.
Monitoring a Derivative Contract’s Terms as they Relate to the Underlying Market
Futures exchanges are required to prevent manipulation, price distortion, and disruptions of the physical delivery or cash-settlement process through market surveillance, compliance, and enforcement practices and procedures. For physically-settled contracts, this includes an obligation to monitor the terms as they relate to the underlying market.
In this regard, the CFTC stated that this should include continual monitoring to ensure that the underlying VCC conforms or, where appropriate, updates to reflect the latest certification standard(s) applicable for that VCC.
The CFTC discussed the information that futures exchange are required to submit to the Commission in connection with any new product listing (e.g., an explanation and analysis of the contract and its compliance with applicable regulatory requirements; supporting documentation; and any additional evidence, information or data demonstrating compliance).
The Proposed Guidance states that, given the relatively new nature of the VCC asset class, the CFTC expects that futures exchanges will provide complete and thorough information related to the proposed contracts in order to satisfy these listing requirements.