The CFTC Proposes "Guidance" for Derivatives Markets on Listing Voluntary Carbon Credit Derivatives
The Background: As voluntary carbon credits ("VCCs") have grown in popularity, questions about their integrity and quality have arisen for investors and among regulators and lawmakers. For this reason, many have sought clarity around standards for financial markets seeking to list derivative contracts on VCCs.
The Guidance: The Commodity Futures Trading Commission's ("CFTC") recently proposed VCC guidance identifies specific factors that designated contract markets ("DCMs") and swap execution facilities ("SEFs") should consider when dealing with VCCs. The proposed guidance focuses on specific characteristics of VCCs that the CFTC believes are critical to ensuring that contracts provide accurate pricing, reduce the contracts' susceptibility to manipulation, and foster confidence that the contracts will be liquid.
Looking Ahead: While there has been notable industry demand for clarity around listing VCC derivatives, it is still highly unusual for the CFTC to issue guidance that is focused specifically on a certain type of commodity. The CFTC leadership has expended considerable resources on addressing the voluntary carbon market. Market participants therefore should not be surprised to find that, once finalized, the "guidance" may be treated as if it has the force of law.
As noted earlier, the voluntary carbon markets and energy transition more broadly have been a priority under Chairman Rostin Behnam. Indeed, prior to his appointment, then-Commissioner Behnam saw to the issuance of a report on managing climate risk in the financial system in September 2020. In June 2022, the CFTC held its first voluntary carbon market convening and took formal public comments on the role it could play in the VCC derivatives markets. In October 2022, eight U.S. senators sent a letter to the chairman requesting that the CFTC establish "rules governing the carbon market." In July 2023, the CFTC held a second convening on VCCs to discuss the CFTC's potential role in promoting standardization and integrity in the VCC derivatives markets.
The CFTC's proposed guidance is a culmination of these efforts, and it naturally builds on existing "core principles" that apply by law to derivatives markets—i.e., DCMs and SEFs—regulated by the CFTC. The guidance also builds on an existing appendix to the CFTC's rules for DCMs on listing derivatives contracts that are not readily susceptible to manipulation. The core principles are central to how the CFTC regulates DCMs and SEFs, which underscores the significance of this guidance to those markets in proceeding to list VCC derivatives.
On December 4, 2023, the CFTC released proposed guidance that outlines factors that DCMs and SEFs should consider when listing VCCs. The proposed guidance generally interprets the relevant CFTC core principles and applies them to VCC contracts. The guidance focuses on four quality attributes that DCMs should consider as they relate to VCCs: (1) transparency; (2) additionality; (3) permanence and risk of reversal; and (4) robust quantification.
Transparency. The guidance emphasizes that more information about VCC products should be disclosed in the terms and conditions section of the contracts. Among other things, DCMs and SEFs should include information about the crediting program and the specific types of projects or activities that are eligible for delivery under the contract.
Additionality. DCMs and SEFs should consider whether the underlying VCCs represent GHG emission reductions that are "additional," meaning that "the VCCs are credited only for projects or activities that result in 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." DCMs and SEFs should also consider whether registry procedures are sufficiently rigorous and reliable to provide reasonable assurance that GHG emission reductions or removals are credited only if they are additional.
Permanence and Accounting for the Risk of Reversal. DCMs and SEFs should verify that VCCs have measures in place to address and account for the risk of reversal, which is "the risk that VCCs issued for a project or activity may have to be recalled or cancelled due to carbon removed by the project or activity being released back into the atmosphere, or due to a reevaluation of the amount of carbon reduced or removed from the atmosphere by the project or activity."
Robust Quantification. The CFTC acknowledged in the proposed guidance that there is no standard industry methodology for counting GHG reductions, and it is not attempting to impose any particular methodology. However, the CFTC expects that DCMs and SEFs will consider whether the registry can demonstrate that its emission quantification methodology is "robust, conservative, and transparent."
In addition to the four quality standards, the proposed guidance directs DCMs and SEFs to consider VCC governance structure, tracking standards, double counting prevention processes, and third-party validation and verification. DCMs and SEFs are also expected to monitor VCCs as they relate to the underlying commodity to ensure the products tend to converge with underlying VCC spot prices at contract expiration.
In many respects, the proposed guidance borrows from existing industry practice. Registries typically focus on many of the same things that the guidance covers. On the one hand, this may simplify what DCMs and SEFs must do in seeking to list VCC derivatives. But on the other, the guidance may evince an expectation that those markets not simply take what registries say about their processes at face value. Read in that light, under the circumstances, DCMs and SEFs could have to get "underneath the hood" to verify that registries do what they say, that the relevant standards for VCC quality are meaningful, and so on. The guidance also does not foreclose the possibility that markets may need to assess individual carbon reduction projects included in registries. And it certainly makes clear that DCMs and SEFs will need to monitor such matters on an ongoing basis once they do list VCC derivatives.
While the guidance may be welcome to some in the industry, participants on registered markets—and the registered markets themselves—should anticipate that it will likely be treated as if it has the force of law. Climate transition is a signature issue for the current CFTC leadership, the guidance draws on DCM (and SEF) core principles, and it stands out from past precedents by focusing on a specific underlying commodity. It may well be that the guidance seeks to enshrine certainty in a market and asset class that continues to evolve. And while clear standards are helpful, they often tend to set regulatory expectations.
Where the CFTC's expectations are not met, enforcement action often follows. There have been similar patterns in recent cases where the CFTC has brought actions against Asset Risk Management, LLC and Symphony Communication Services, LLC for failing to register as SEFs. Those cases were premised on CFTC staff guidance, which was treated as a current statement of law and enforced as such. While we are not predicting anything here, it is certainly fair for commenters to consider the potential impact of the proposed guidance with these points in mind. The comment period closes on February 16, 2024.
Four Key Takeaways
- If the proposed guidance is finalized, DCMs and SEFs may be functionally required to apply the "core principles" to VCC contracts in a manner that is consistent with how the CFTC believes the principles should be interpreted, as described in the guidance.
- The CFTC has rarely issued guidance on listing other specific commodities on DCMs or SEFs, underscoring how important the agency believes VCCs are.
- Because VCC registries already review the four quality attributes described in the proposed guidance, it is unclear in what circumstances DCMs and SEFs must essentially double check the registry's work when evaluating the rigorousness of its procedures as it relates to particular contracts.
- Interested parties have until February 16, 2024, to submit comments about the CFTC guidance. The CFTC will consider comments prior to finalizing the guidance.