CFTC Issues Final Guidance on Listing Voluntary Carbon Credit Derivative Contracts

The Commodity Futures Trading Commission on September 20 issued final guidance aimed at strengthening market integrity, transparency, and liquidity for derivatives with underlying voluntary carbon credits (VCCs). The nonbinding final guidance addresses an emerging class of climate-related derivative contracts listed for trading by designated contract markets (DCMs). The CFTC chairman described the final guidance as “a critical step in support of the development of high-integrity voluntary carbon markets.”

The final guidance outlines VCC characteristics for DCMs to consider in connection with VCC derivative contract design and listing. These characteristics are (1) transparency, additionality, permanence, and accounting for the risk of reversal and robust quantification of emissions reductions or removals for consideration when addressing quality standards, (2) governance, tracking mechanisms, and measures to prevent double counting for consideration when addressing delivery procedures, and (3) third-party validation and verification for consideration when addressing inspection or certification procedures. Consideration of these characteristics is intended to promote accurate pricing, reduce susceptibility of the contract to manipulation, prevent price distortion, and promote confidence in the VCC contracts.

BACKGROUND

The Commodity Futures Trading Commission (CFTC) has exclusive jurisdiction over futures contracts, options on futures contracts, and swap transactions pursuant to the Commodity Exchange Act (CEA). The CFTC also has spot market anti-fraud and anti-manipulation authority under the CEA.

DCMs—CFTC-regulated exchanges that enable derivatives markets participants to execute or trade derivative contracts—have listed nearly 200 derivative contracts related to carbon reduction, including dozens for voluntary carbon markets. DCMs are required to comply with statutory “core principles” that are set forth in the CEA and associated CFTC regulations, including a specific statutory obligation to list for trading only derivative contracts that are not readily susceptible to manipulation. The CFTC has adopted guidance in 17 CFR Part 38 Appendix C (Appendix C) for DCMs to consider when designing a derivative contract and addressing its terms and conditions.

Voluntary carbon markets provide a voluntary mechanism for individuals, businesses, and nonprofit organizations to offset carbon dioxide emissions through VCCs. VCCs are tradeable, intangible instruments issued by a carbon crediting program that represent a greenhouse gas (GHG) emissions reduction to or removal from the atmosphere equivalent to one metric ton of carbon dioxide. Although VCCs have existed for more than 20 years, there is no standardized methodology to quantify emissions reduction or removal levels. The CFTC explains that a key recent focus of VCCs has been on ensuring their quality and accuracy, and due to the differences in methodologies to quantify reductions represented by a VCC, the CFTC sees a possibility that VCCs will be calculated differently for identical projects. Such an outcome would erode confidence in voluntary carbon markets and undermine their purpose.

This final guidance follows the CFTC’s efforts beginning in 2022 to enhance the integrity of the voluntary carbon market. As discussed in our December 8, 2023 LawFlash, the CFTC issued proposed guidance last year, which the CFTC has now finalized after evaluating public comment. Relatedly, as discussed in our June 4, 2024 blog post, several government agencies jointly promulgated seven principles to create high-integrity voluntary carbon markets.

FINAL GUIDANCE ON VCC DERIVATIVE CONTRACTS

The CFTC’s final guidance outlines VCC characteristics for consideration by DCMs when listing VCC derivative contracts for trading to ensure compliance with requirements under the CEA and CFTC regulations. Although the final guidance focuses primarily on the listing by DCMs of physically settled VCC derivative contracts, the CFTC noted that the guidance is relevant for cash-settled derivative contracts or swap contracts that settle to the price of a VCC.

The final guidance is not a binding rule and thus does not create new obligations for DCMs, nor does it modify or supersede any existing CFTC guidance (including the Appendix C guidance). Rather, the final guidance is intended to convey CFTC’s current views and “addresses how certain aspects of the Appendix C Guidance may be considered in the specific context of VCC derivative contracts.” The CFTC also noted that given the continuing evolution and development of VCC derivatives products and voluntary carbon markets, the CFTC may revisit this guidance or issue additional guidance in the future.

The final guidance addresses factors for DCMs to consider in designing and listing VCC derivative contracts including Core Principle 3, which requires DCMs to list only contracts that are not readily susceptible to manipulation; Core Principle 4, which requires DCMs to have the capacity and responsibility to prevent manipulation, price distortion, and other market disruptions through market surveillance, compliance, and enforcement practices and procedures; and the product submission provisions.

DCM Core Principle 3

DCM Core Principle 3 requires that DCMs list for trading only derivative contracts that are not readily susceptible to manipulation. The CFTC’s Appendix C guidance provides that for a physically settled derivative contract, contract terms and conditions “should describe or define all of the economically significant characteristics or attributes of the commodity underlying the contract.” The final guidance acknowledges that standardization and accountability mechanisms are still being developed for VCCs, but notes that both voluntary and mandatory carbon markets have identified certain broadly applicable characteristics. Accordingly, the CFTC believes that a DCM should consider these characteristics when designing a VCC derivative contract and describing significant characteristics or attributes.

Specifically, the CFTC believes that DCMs, at a minimum, should consider the characteristics of VCCs in addressing the following when designing a VCC derivative contract: (1) quality standards, (2) delivery points and facilities, and (3) inspection provisions. CFTC believes that addressing these criteria clearly in the contract’s terms and conditions held ensures that trading in the contract is based on accurate information in the underlying VCC.

Regarding quality standards, the CFTC suggests that DCMs consider four factors:

• Transparency: DCMs should ensure that the terms and conditions of a physically settled VCC derivative contract should clearly identify what is deliverable under the contract, including by providing information that readily specifies the issuing crediting program or programs and, if applicable, the associated specific category of mitigation or activity.
• Additionality: DCMs should consider whether the crediting program has procedures to ensure that credited reductions or removals would not have occurred but for the VCC. The CFTC, however, declined to define the term due to the varying and developing ways that additionality is characterized and assessed, but suggested that DCMs look to industry recognized standards for high-integrity VCCs.
• Permanence and risk of reversal: DCMs should consider whether the crediting program issuing the VCC accounts for the risk that the credited reduction or removal will not come to fruition or will be reversed through events including recall, cancellation, or leakage. Most crediting programs have established buffer pools from which reserved VCCs can be drawn upon in the event of a reversal. DCMs should consider whether the crediting program has a buffer reserve and/or other measures in place to address the risk of reversal.
• Robust quantification of GHG emission reductions or removal: DCMs should consider whether the level of assurance that the quantified reduction or removal underlying the VCC is “robust, conservative, and transparent,” i.e., an accurate reflection of the amount of GHG emissions reduced or removed by the project or activity that generated the VCC.

Regarding delivery points and facilities, the CFTC suggests that DCMs consider the governance framework and tracking mechanisms of crediting programs. The governance evaluation should consider whether the crediting program exhibits independence, transparency, and accountability. For tracking, DCMs should consider whether the crediting program ensures “clarity and certainty” regarding the issuance, transfer, and retirement of VCCs, and makes use of a registry to track issuance, transfer, retirement, and ownership.

DCMs should further consider whether the crediting program can assure VCCs are not double-counting removals or reductions; a VCC must be uniquely traceable to a single reduction or removal of a metric ton of carbon dioxide equivalent. The CFTC further advises that an effective crediting program governance framework can help to ensure that the crediting program operates or uses a registry to track mitigation projects or activities and associated VCCs.

Regarding inspection provisions, DCMs should consider whether any inspection or certification procedures to confirm compliance with the quality requirements and applicable delivery requirements are specified in the contract terms and conditions and are consistent with the latest procedures in the voluntary carbon markets. Independent, third-party validation and verification help ensure the accuracy and quality of the underlying VCCs.

DCM Core Principle 4

DCM Core Principle 4 requires a DCM to prevent manipulation, price distortions, and disruptions of the physical delivery or cash-settlement process through market surveillance, compliance, and enforcement activities. Pertaining to VCCs, the CFTC suggests that DCMs’ monitoring of the terms and conditions of physically settled VCC derivative contracts ensure that the VCC conforms to the latest applicable certification standard. And where there are changes to the crediting program or activities associated with the underlying VCC, the DCM should amend contract terms to reflect the update.

Product Submission Requirements

DCMs can list contracts by either self-certifying with the CFTC that the contract complies with the CEA or seeking prior CFTC approval. As relevant to VCC derivative contracts, information that must be submitted to the CFTC for either listing option include (1) an explanation and analysis of the contract and the contract’s compliance with the CEA, (2) documentation or references to the documentation relied upon to establish the basis for compliance with applicable law, and (3) if requested by CFTC staff, additional evidence or information demonstrating compliance.

Because VCCs are a new and evolving class of products whose standardization and accountability mechanisms are being developed, the CFTC notes that a DCM can provide “qualitative explanations and analysis to assist in addressing” these three requirements and expects that DCMs provide “complete and thorough” information to describe CEA compliance.

TAKEAWAYS

The final guidance is the first guidance issued by a US financial regulator for DCMs that list derivative contracts with VCCs as the underlying commodity. Although nonbinding, the final guidance provides CFTC’s current views on VCC derivative contracts and factors that the CFTC will look to when assessing compliance with the core principles and CFTC’s regulations. In addition, the final guidance may be used to inform the voluntary carbon markets. Thus, participants in the voluntary carbon markets should be aware of and consider the factors outlined in the final guidance to help ensure that the VCCs held, transacted, and/or retired are accurate, additional, permanent, and verifiable.

CFTC is expected to continue to pursue potential fraud and manipulation in the voluntary carbon markets through its Division of Enforcement and its Environmental Fraud Task Force. Market participants transacting in the voluntary carbon markets and VCC derivative contracts should ensure that they have the appropriate compliance policies and measures in place to ensure compliance and mitigate risk.