During COP28, the Commodity Futures Trading Commission (CFTC) issued proposed guidance applicable to voluntary carbon credit (VCC) derivative contracts listed on designated contract markets (DCMs). DCMs are self-regulating exchanges that operate under the oversight of the CFTC. By law, they must take measures to protect market participants from abusive practices, promote fair and equitable trading, and ensure that listed contracts are not susceptible to fraud or manipulation.
CFTC’s latest guidance sets the expectation that when regulated exchanges list voluntary carbon credit futures contracts, that the credit represents an actual ton of carbon dioxide removed or reduced, and there is no double counting. The draft guidance adapts terminology, concepts and standards from the Integrity Council for the Voluntary Carbon Market’s Core Carbon Principles, a global benchmark for high-integrity carbon credits that set rigorous thresholds on disclosure and sustainable development. The CFTC guidance also suggests that designated contract markets assess carbon crediting programs and registry policies to source only high-integrity carbon credits.
Carbon market oversight by financial market regulators like the CFTC is a new—but promising—development in a market that has experienced increased media and public scrutiny in the past year.
This oversight can help boost integrity, improve transparency and build back trust in the voluntary carbon market as a viable tool for carbon finance.
While there’s more to be done, this is a significant step in the right direction.
How could the CFTC’s guidance help accomplish these goals? We break down the guidance in this blog and answer key questions about the impact it might have:
Why Does the Guidance Focus on Futures Contracts and DCMs and How does this relate to the VCM?
CFTC has jurisdiction over secondary or futures markets and oversees them through regulation and guidance applicable to designated contract markets. Futures contracts are legal agreements to buy or sell assets (usually commodities or shares) at a fixed price for delivery at some later date.
Futures allow sellers and buyers to manage risk by locking in prices, and then scheduling delivery around actual needs. Because futures contracts are accessible to a diverse group of investors, and due to their forward-looking nature, futures markets can be more liquid than spot markets. This means they provide important price signals for buyers and sellers in a given asset class.
The voluntary carbon market, as typically understood, represents the primary, or spot market. The majority of voluntary carbon credits trade “over the counter” (i.e. party to party in private transactions) or to a more limited extent on platforms that connect sellers with prospective buyers. In most jurisdictions, including the U.S., these markets are not regulated except for limited enforcement of fraud and misrepresentation.
The secondary market for voluntary carbon credits, in which traders buy and sell credits that meet certain criteria at a set price for delivery on a future date, is nascent but projected to grow. Last month, 18 futures contracts featuring voluntary carbon credits had been submitted to the Commission for listing, including NYMEX CBL’s Global Emissions Offset (GEO), Nature-Based Global Emissions Offset (N-GEO) and .Core Global Emissions Offset (C-GEO).
Companies that make net zero commitments may use voluntary carbon credit futures contracts to lock in guaranteed prices for carbon credits, with delivery scheduled to coincide with target commitments. Project developers and brokers may also use futures markets to predict carbon credit sale prices for use in financing, or to predict future revenue and supply availability. For all stakeholders, the specific characteristics of the voluntary carbon credits eligible for delivery into a futures contract will affect the price, its ability to satisfy the intention motivating purchases, and ultimate environmental impact.
What does the CFTC’s Draft Guidance Do?
CFTC’s proposed guidance for the voluntary carbon market sets forth the Commission’s expectations for how DCMs should develop terms and conditions for carbon credit derivatives contracts. Building on existing CFTC guidance, which requires that the terms and conditions of a listed futures contract “describe or define all of the economically significant characteristics or attributes of the commodity underlying the contract,” the latest guidance suggests that those characteristics include, among other things, (1) the quality of the underlying carbon credit; (2) delivery point(s) and facilities; and (3) inspection provisions.
For each of these characteristics, the CFTC outlines considerations and criteria that can help promote fair and equitable trading, ensure high integrity, and avoid fraud and manipulation.
Quality of the Underlying VCC
Listed futures contracts must outline the characteristics or attributes of whatever asset is being promised, in an effort to ensure the buyer gets to assess whether they are paying a fair price and ultimately receive what they expect. In the draft guidance, the Commission clarified its expectation that DCMs provide detailed information about voluntary carbon credits that are eligible for delivery under listed futures contracts. It also defined the economically and environmentally significant traits that determine a carbon credit’s quality, including transparency, additionality, permanence and risk of reversal, and robust quantification.
Notably, the Guidance suggests that DCMs can assess and articulate the quality of the carbon credits through eligible carbon crediting programs and project categories. The Commission offers factors that DCMs should consider when evaluating the sufficiency of carbon crediting programs to deliver specified carbon credits, such as whether the crediting programs:
- make policies and procedures publicly available and transparent;
- assess credits for additionality, and whether methods for assessing additionality are sufficiently rigorous and reliable;
- provide reasonable assurance that, in the event of a reversal, the voluntary carbon credits will be replaced, potentially through the use of buffer pools; and
- demonstrate that the quantification methodology or protocol used to calculate emission reductions or removals is “robust, conservative and transparent.”
With these expectations, the Commission aligned the quality standards for listed VCC contracts on regulated exchanges with the generally recognized principles for high-integrity carbon credits, including ICVCM Core Carbon Principles 3, 5, 6, and 7.
Delivery points
For physical commodities such as corn, soy or oil, the delivery point location can dramatically impact pricing, and is therefore a critical component of any futures contract. For the first time publicly, the Commission clarified in this draft guidance that registries operated by carbon crediting programs may be construed as “delivery points” to facilitate settlement of carbon credit futures transactions.
CFTC suggests that in selecting the eligible delivery point (or registry) in a VCC futures contract, designated contract markets should evaluate the registry’s governance framework, tracking mechanisms and measures to prevent double counting. These expectations align with ICVCM’s Core Carbon Principles 1, 2, and 8.
Inspection Provisions
Inspection provisions in futures contracts outline the methods used to verify compliance with quality standards. In the draft Guidance, the CFTC suggests that designated contract markets use the inspection provision terms and conditions to incorporate robust independent third-party validation and verification procedures to ensure that the voluntary carbon credits accurately reflect the quality intended. This expectation aligns with ICVCM Core Carbon Principle 4.
What’s the takeaway? Will it work?
CFTC’s proposed guidance is an important step towards more transparent, liquid, and robust markets that trade in carbon credits, and may build confidence in the market at a time when its potential to deliver on climate finance potential is in doubt. While the CFTC’s leadership in this area appears to be universally welcomed, the draft guidance has pros and cons.
Pros:
- Speed. The draft Guidance carefully interprets – but does not change, amend or expand on – existing CFTC authority, statutory Core Principles or established regulations. This means that the Commission can act quickly, without requiring additional Congressional approval or lengthy regulatory review processes. Speed has value. If finalized as anticipated in early 2024, the CFTC will have rapidly responded to legitimate concerns about VCM integrity, and if successful may help catalyze investment to contribute to the estimated $6.2 trillion of climate finance required annually between now and 2030 to deliver on net zero targets.
- Consistency with Existing Integrity Efforts. The VCM is evolving rapidly, and so are stakeholders’ understanding of, and strategies for, achieving environmental and social integrity. Because the draft Guidance is written in such a way to dovetail with ICVCM’s Core Carbon Principles, DCMs may be able to use ICVCM’s Assessment Framework, CCP-eligibility and eventually the CCP label to demonstrate that contracts comply with CFTC expectations for listed contracts. Leveraging ICVCM’s CCP assessment and label should significantly streamline the burden of compliance for DCMs, as well as the supervisory and oversight obligation of the Commission, eliminating the need for extensive new subject matter expertise and capacity.
Cons:
- Additional Market Infrastructure Issues Remain Unaddressed. In the preamble, CFTC cites Core Principle 12, which requires DCMs to establish and enforce rules to protect markets and market participants from abusive practices, and to promote fair and equitable trading on the DCM. This statutory obligation closely aligns with ICVCM Core Carbon Principle 9, which pertains to sustainable development benefits and safeguards. However, the body of the draft Guidance, and specific expectations for DCMs, did not articulate CFTC’s expectation that carbon crediting programs eligible to generate and deliver voluntary carbon credits into listed derivatives contracts have clear guidance, tools and compliance procedures to ensure mitigation activities conform or exceed best practices on social and environmental safeguards. This is a significant omission. Social safeguards and transparency around benefit sharing provisions and broker/intermediary fee structures are economically significant attributes of the carbon credits. Sustainable development benefits and safeguards materially influence contract pricing, directly impact the extent to which the credit will be delivered and influence the political durability of those credits. In omitting guidance around Core Principle 12, CFTC is missing a critical opportunity to ensure that farmers, foresters, ranchers and local community members are protected from abusive practices including conflicts of interest and misrepresentation.Additionally, as Commissioner Kristin Johnson articulated in her statement accompanying the draft guidance release, climate-related financial risk assessment is an important component of market oversight. See here for more on EDF’s work on climate related financial risk at CFTC.
- Enforcement and Efficacy to Be Determined. Compliance with the expectations expressed in the draft Guidance is voluntary and subject to interpretation of, and application by, DCMs. CFTC reminds DCMs that contract submission for CFTC approval must include “an explanation and analysis of the contract and its compliance with applicable [laws] … and the documentation relied upon to establish the basis for compliance.” Whether DCMs will submit requested information, whether that information will be sufficient or rigorously assessed by the Commission, and what the Commission will do in the event terms and conditions are inadequate are outstanding questions. Tracking will be essential to assess whether the caliber of carbon credits delivered into VCC futures contracts improves, and whether this results in a spill over improvement in carbon credit quality in the broader markets.
- Reliance on Carbon Crediting Programs. The approach outlined in the draft Guidance relies heavily on assessment of carbon crediting programs, and to a lesser degree categories of carbon credits, rather than due diligence performed on specific carbon credits or project/program development. Given the integrity questions levied around specific registries, this approach indicates that carbon crediting programs and registries are systemically important entities. Success will thus depend on whether these entities are fit for purpose. Seven major carbon crediting programs recently announced plans to coordinate approaches; they would be wise to heed this guidance, lest DCMs lack viable sources for VCCs that satisfy expectations for terms and conditions specifying quality standards, delivery points and inspection.
Overall, this is a strong proposal, and we welcome the CFTC’s acknowledgment of the importance of high-integrity carbon credits in a robust, transparent and well-functioning market. EDF will continue to engage with stakeholders across the VCM to develop feedback to the Commission, due February 16, 2024.