The Commodity Futures Trading Commission (CFTC) issued proposed guidance on December 4 intended to increase the transparency and bolster the integrity of voluntary carbon credits that underlie derivative contracts subject to CFTC jurisdiction.
The CFTC’s proposal is the latest effort in its push during 2023 to regulate the carbon markets. As more derivative contracts on voluntary carbon market products are traded on CFTC-regulated exchanges, the CFTC has taken steps to identify ways in which it can address climate-related financial risk in the derivatives markets and underlying spot markets.
The proposed guidance identifies criteria that should be addressed clearly in the design of a voluntary carbon credit derivative contract to help ensure that trading in the contract is based on accurate information about the underlying voluntary carbon credit. It identifies quality standards, delivery points and facilities, and inspection provisions as the criteria that exchanges should address to promote accurate pricing and to help to reduce the susceptibility of the contract to manipulation.
The proposed guidance follows the CFTC’s novel whistleblower alert, issued in June, describing the types of misconduct that market participants should be on the lookout for in the carbon markets. In this alert, the CFTC asked market participants to voluntarily provide the CFTC with original information about such misconduct. The same month, the CFTC announced the establishment of the Environmental Fraud Task Force to combat environmental fraud and misconduct in relevant derivatives and spot markets.
On the heels of these announcements, the CFTC held its second Carbon Markets Convening in July 2023 to discuss ways to enhance the integrity of voluntary carbon markets, among other initiatives. At this convening, Chairman Behnam previewed that the CFTC was working on carbon market guidance. The proposed guidance and its implications for futures exchanges are described below.
The Commodity Exchange Act (CEA) gives the CFTC exclusive jurisdiction over futures contracts, options on futures contracts, and swap transactions, but limits the CFTC’s jurisdiction over commodities in the spot market to antifraud and antimanipulation jurisdiction.[1]
Keenly aware of its jurisdictional limitations, the CFTC explicitly states that the guidance is “not intended to modify or supersede existing statutory or regulatory requirements, or existing Commission guidance that addresses the listing of derivative products by CFTC-regulated exchanges, including the Appendix C Guidance.”
The CFTC finds support for its proposal in various Core Principles set forth in the CEA that require futures exchanges to have rules to prevent market manipulation and to adopt position limits or accountability levels for contracts that they offer.[2]
The proposed guidance applies solely to exchanges that offer derivatives on voluntary carbon credits. The CFTC distinguishes between mandatory, or compliance, markets (e.g., cap-and-trade programs, emissions trading systems, and allowance trading systems established by national, regional, or international governmental bodies) and voluntary carbon markets that are not established by any governmental body.
Voluntary carbon credits are tradeable, intangible instruments issued by a carbon crediting program that represent a greenhouse gas emissions reduction to or removal from the atmosphere equivalent to one metric ton of carbon dioxide.
Currently, NYMEX is the only US exchange that offers futures contracts on voluntary carbon credits with open interest, but ICE Futures US offers futures contracts on carbon credits issued under mandatory markets.
Voluntary carbon credits have existed for more than 20 years, but there is no standardized methodology or protocol to quantify emissions reduction or removal levels. The lack of standardization makes it possible for different levels in reductions to be calculated, creating incentives for project developers to use the methodology or seek the certification from the crediting program that results in the issuance of a greater number of credits.
According to the CFTC, the integrity and purpose of voluntary carbon markets are undermined when calculation methodologies lack transparency. It is the CFTC’s belief that the proposed guidance may create standardization of voluntary carbon credits, thereby promoting transparency and liquidity.
To achieve its goals to enhance the transparency, market integrity, accurate pricing, and liquidity of voluntary carbon credit markets, and to help ensure that position holders will receive underlying carbon credits with the expected quality and other characteristics, the CFTC has proposed that futures exchanges apply Appendix C to Part 38 of the CFTC’s regulations (i.e., guidance on the requirement that a designated contract market list for trading contracts that are not readily susceptible to manipulation) to derivatives on voluntary carbon credits when developing such derivatives’ contract terms and conditions.[3]
When determining whether a crediting program for a voluntary carbon credit is a reliable source of high-integrity credits, an exchange should evaluate (1) quality standards; (2) delivery points and facilities; and (3) inspection provisions. The proposed guidance elaborates on how an exchange should evaluate these characteristics.
The proposed guidance also explains that exchanges should monitor deliverable supply as well as changes to a crediting program’s standards and amend the relevant contract’s terms and conditions to reflect any changes. The CFTC also reiterates its expectation that contract certifications that exchanges make under Part 40 of the CFTC’s regulations will be complete and thorough.
Limited Jurisdiction, Limited Guidance
Despite the increased attention the CFTC has paid to the carbon markets, starting in 2019 with the establishment of the Climate-Related Market Risk Subcommittee, and the committee meetings and convenings held to discuss the integrity of the carbon markets and initiatives to address climate risk, the CFTC’s proposed guidance is less developed and robust than expected.
However, the proposed guidance and the comments provided in response are expected to garner further discussion toward developing a regulatory framework to oversee the carbon credit markets.
The CFTC aims to increase transparency in the underlying voluntary carbon credit markets by recommending that exchanges “consider” various factors about crediting programs’ standards. The CFTC does not go so far as to prohibit exchanges from listing derivatives on carbon credits issued by a crediting program that does not provide the level of transparency necessary for an exchange to consider these factors. However, the CFTC may reject contract certifications that do not provide the level of detail that the CFTC expects an exchange to provide or delay the introduction of new contracts by requesting additional information or evidence that demonstrates that the contract meets the requirements of the CEA and the CFTC’s regulations or policies thereunder (e.g., the proposed guidance).
CFTC Request for Comment
The CFTC has solicited input from the industry on its proposed guidance. Many of these questions ask whether there are particular factors or criteria that exchanges should take into account when considering the quality, delivery, and inspection standards that the CFTC has proposed.
The CFTC also asks whether an exchange should consider whether a crediting program has implemented best practices on social and environmental safeguards to inform the level of the voluntary carbon credit’s integrity. Notably absent from the CFTC’s questions for comment is whether the CFTC could have gone further by proposing regulations applicable to intermediaries and other market participants that trade these types of environmental contracts, or whether the CFTC could have expanded the standards to disclosure requirements for non-exchange traded contracts.
What’s Next?
The proposed guidance is likely just the first step in the CFTC’s strategy to enhance the integrity of the voluntary carbon credit markets. The proposed guidance is likely to be adopted largely as proposed, without additional exchange responsibilities beyond what has been proposed.
Commissioners Johnson and Goldsmith Romero expressed their desire for the CFTC to play a greater role in overseeing voluntary carbon credit markets. [4] Intermediaries should monitor developments in this space, particularly in light of Commissioner Johnson’s view that the proposed guidance is “insufficient” and her concern over the narrow scope of the proposed guidance, which does not encompass swaps that are not traded on a swap execution facility and environmental forwards that are not swaps.[5]
In addition, noting that swap dealers are subject to disclosure and fair dealing requirements, Commissioner Johnson explained that disclosure of the underlying voluntary carbon credit’s material information, material risks, material characteristics, material incentives, and conflicts of interest are important and could be applied to all environmental derivatives products to ensure that a counterparty “has adequate information to understand how observed volatility and inherent risk in the nascent and evolving carbon credit market could impact the price of the derivative.”
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[1] Section 2(a)(1)(A) of the CEA; 7 U.S.C. § 2(a)(1)(A). Specifically, the CFTC has exclusive jurisdiction over “accounts, agreements (including transactions of the character of or commonly known to the trade as an ‘option’, ‘privilege’, ‘indemnity’, ‘bid’, ‘offer’, ‘put’, ‘call’, ‘advance guaranty’, or ‘decline guaranty’), and transactions involving swaps or contracts of sale of a commodity for future delivery” that are traded or executed on a designated contract market or swap execution facility or other board of trade, exchange, or market.
[2] For example, Core Principle 4 imposes on a futures exchange, or designated contract market (DCM), the responsibility for preventing manipulation, price distortion, and disruptions of the delivery or cash settlement process through market surveillance, compliance, and enforcement practices and procedures. 7 U.S.C. § 7(d)(4). The CFTC also supports the issuance of the guidance by citing to Core Principle 3 (providing that a DCM shall only list contracts that are not readily susceptible to manipulation), Core Principle 5 (requiring a DCM to adopt for each contract position limits or position accountability levels for speculators), and Core Principle 12 (requiring a DCM to have rules to protect markets and market participants from abusive practices and to promote fair and equitable trading on the exchange). 7 U.S.C. §§ 7(d)(3), (5), (12).
[3] The CFTC notes that the proposed guidance could be leveraged by swap execution facilities that offer swaps that settle to the price of a voluntary carbon credit or that are physically settled.
[4] Statement of Commissioner Christy Goldsmith Romero on Exchange Listing Standards for Voluntary Carbon Credit Derivative Contracts (Dec. 4, 2023). Commissioner Goldsmith Romero expressed a desire to know whether market participants believe that the CFTC adapted the appropriate portions of the Integrity Council on Voluntary Carbon Markets standards and whether the proposal establishes clear expectations. Importantly, Commissioner Goldsmith Romero asked if an exchange should conduct additional due diligence into specific projects, protocols, or categories.
[5] Statement of Commissioner Kristin Johnson: Commission Guidance Regarding Listing of Voluntary Carbon Credit Derivative Contracts (Dec. 4, 2023).