CFTC announces proposed guidance and a request for comments regarding voluntary carbon credit derivative contracts

The proposed guidance is the latest development in a multi-year focus on the VCC market during which the CFTC called numerous convenings and took the unusual step of issuing a call for whistleblowers. According to CFTC Chairman Rostin Benham, the proposed guidance takes the significant step of “promot[ing] fundamental standards for high integrity VCCs” and underpins that the CFTC “has a significant role to play in the VCC market.”² 

The CFTC has requested comment on 17 questions, attached in Appendix A. The CFTC will accept comments until February 16, 2024 at this link. We invite any entity interested in this proposal or seeking to submit comments to contact one of the attorneys listed at the end of this memo.

The proposed guidance

The CFTC has broad authority to regulate VCC derivative contracts along with anti-fraud and anti-manipulation authority over the cash and spot market for VCCs under the Commodity Exchange Act (“CEA”).3 The proposed guidance outlines factors that Designated Contract Markets (“DCMs”), CFTC-regulated exchanges, should consider when addressing obligations relevant to listing VCC derivative contracts. The guidance is not intended to modify or supersede existing, statutory or regulatory guidance, or prior CFTC guidance on the listing of derivative contracts.⁴ It emphasizes three factors that DCMs should adhere to when listing VCC derivatives:

• DCMs shall only list derivative contracts that are not susceptible to manipulation; Core Principle 3,
• DCMs shall monitor a derivative contract’s terms and conditions as they relate to the underlying commodity market; Core Principle 4, and
• DCMs must satisfy the Product Submission Requirements under Part 40 of the CFTC’s Regulations and CEA section 5c(c).

Contracts cannot be susceptible to manipulation

Under the CEA, DCMs must comply with various “Core Principles” which define general standards and requirements for how the registered entity conducts its business. Core Principle 3 states that a DCM “shall only list for trading derivative contracts that are not readily susceptible to manipulation.”⁵ While the CFTC recognizes that the typical standardization and accountability mechanisms are still being developed for the VCC market, it identifies several broad characteristics that DCMs should consider to help maintain market integrity when developing a VCC derivative contract.⁶

• Quality standards such as:
  • Transparency – The ability for the public to see the types of programs and activities that are eligible under the contract.
  • Additionality – Does the contract remove additional greenhouse gas emissions that would not have been removed if not for the additional monetary incentive? This is a requirement to be a “high quality” VCC.
  • Permanence and risk of reversal – Will the VCC contract be cancelled because greenhouse gasses are released back into the atmosphere, due to a reevaluation of the effectiveness of the contract or some practice or behavior at the project site?
  • Robust quantification – DCMs should consider the methodology or protocol used to calculate the level of greenhouse gas emission reduction and removal associated with projects.
• Delivery Procedures:
  • Governance – Does the VCC demonstrate that it has a governance framework that supports the crediting program’s independence, transparency, and accountability? Who is responsible for the administration of the program? Are key functions independent? What are the decision making procedures?
  • Tracking – Does the crediting program have the processes and procedures to ensure clarity and certainty with regards to the issuance, transfer, and retirement of VCCs?
  • No double counting – Does the crediting program have reasonable measures to ensure that credit emission reductions or removals are not double counted?
• Finally, DCMs should consider provisions related to the inspection of VCCs, such as:
  • How does the crediting program require validation and verification that credited mitigation projects meet the crediting program requirements?

Monitor the terms and conditions as they relate to the underlying market

Under CFTC DCM Core Principal 4, DCMs shall have the capacity and responsibility to prevent manipulation, price distortion, and disruption of the physical delivery or cash settlement process through surveillance, compliance, and enforcement.⁷ The CFTC has read this Core Principal to mean that a DCM must monitor the terms and conditions of contracts as they relate to the underlying market conditions, and the convergence of the price of the contract and the underlying commodity so that the DCM can identify instances that may lead to harm.⁸

Satisfaction of Part 40 of the CFTC’s regulations and CEA Section 5c(c)

When a contract is listed for trading the DCM must either (a) submit a self-certification to the CFTC that the contract complies with the CEA, or (b) seek prior approval by the CFTC. In making these submissions, the CFTC highlights three submission requirements for VCC contracts. These are not new requirements but are requirements the CFTC felt was necessary to remind market participants.

• A contract submitted to the CFTC must include an explanation and analysis of the contract and its adherence to the CEA and any related Core Principles.
• The explanation and analysis of the contract must be accompanied by the documentation relied on.
• If requested, the DCM must provide additional evidence that demonstrates that the contract adheres to the CEA.

Takeaways

Climate change, environmental markets, and VCCs continue to be areas of focus of the CFTC.

The CFTC previously drew attention to the prospect of fraud in the voluntary carbon credit markets with its public plea to potential whistleblowers. This more recent notice of proposed guidance to designated contract markets looking to list VCC-related derivatives serves as a further reminder of the CFTC’s determination to address potential abuse in this still evolving market.

^Footnotes

^{1. CFTC Issues Proposed Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts, CFTC, Dec. 4, 2023, Release Number 8829-23, https://www.cftc.gov/PressRoom/PressReleases/8829-23?utm_source=govdelivery
 2. Statemen of Chairman Rostin Behnam on the Proposed Commission Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts, CFTC, Dec. 4, 2023,
https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement120423
 3. Help Wanted: CFTC invites whistleblowers to look for fraud and manipulation in carbon markets, Allen & Overy, July 3, 2023, https://www.allenovery.com/en-gb/global/blogs/investigations-insight/help-wanted---cftc-invites-whistleblowers-to-look-for-fraud-and-manipulation-in-the-carbon-markets
 4. Federal Register at 19.
 5. CEA section 5(d)(3), 7 U.S.C. 7(d)(3)
 6. Federal Register at 22.
 7. CEA Section 5(d)(4), 7 U.S.C. 7(d)(4). See also 17 CFR §§ 38.250-258
 8. Federal Register at 34.}

Appendix A

General:

1. In addition to the VCC commodity characteristics identified in this proposed guidance, are there other characteristics informing the integrity of carbon credits that are relevant to the listing of VCC derivative contracts? Are there VCC commodity characteristics identified in this proposed guidance that are not relevant to the listing of VCC derivative contracts, and if so, why not?
2. Are there standards for VCCs recognized by private sector or multilateral initiatives that a DCM should incorporate into the terms and conditions of a VCC derivative contract, to ensure the underlying VCCs meet or exceed certain attributes expected for a high-integrity carbon credit?
3. In addition to the criteria and factors discussed in this proposed guidance, are there particular criteria or factors that a DCM should consider in connection with monitoring the continual appropriateness of the terms and conditions of a VCC derivative contract?
4. In addition to the criteria and factors discussed in this proposed guidance, are there particular criteria or factors that a DCM should consider which may inform its analysis of whether or not a VCC derivative contract would be readily susceptible to manipulation?
5. Should the VCC commodity characteristics that are identified in this proposed guidance as being relevant to the listing by a DCM of VCC derivative contracts, also be recognized as being relevant to submissions with respect to VCC derivative contracts made by a registered foreign board of trade under CFTC regulation 48.10?

Transparency:

6. Is there particular information that DCMs should take into account when considering, and/or addressing in a VCC derivative contract’s terms and conditions, whether a crediting program is providing sufficient access to information about the projects or activities that it credits? Are there particular criteria or factors that a DCM should take into account when considering, and/or addressing in a contract’s terms and conditions, whether there is sufficient transparency about credited projects or activities?

Additionality:

7. Are there particular criteria or factors that DCMs should take into account when considering, and/or addressing in a VCC derivative contract’s terms and conditions, whether the procedures that a crediting program has in place to assess or test for additionality provide a reasonable assurance that GHG emission reductions or removals will be credited only if they are additional?
8. In this proposed guidance, the Commission recognizes VCCs as additional where they are credited for projects or activities that would not have been developed and implemented in the absence of the added monetary incentive created by the revenue from carbon credits. Is this the appropriate way to characterize additionality for purposes of this guidance, or would another characterization be more appropriate? For example, should additionality be recognized as the reduction or removal of GHG emissions resulting from projects or activities that are not already required by law, regulation, or any other legally binding mandate applicable in the project’s or activity’s jurisdiction?

Risk of reversal:

9. Are there particular criteria or factors that DCMs should take into account when considering, and/or addressing in a VCC derivative contract’s terms and conditions, a crediting program’s measures to avoid or mitigate the risk of reversal, particularly where the underlying VCC is sourced from nature-based projects or activities such as agriculture, forestry or other land use initiatives?
10. How should DCMs treat contracts where the underlying VCC relates to a project or activity whose underlying GHG emission reductions or removals are subject to reversal? Are there terms, conditions or other rules that a DCM should consider including in a VCC derivative contract in order to account for the risk of reversal?

Robust quantification:

11. Are there particular criteria or factors that a DCM should take into account when considering, and/or addressing in a contract’s terms and conditions, whether a crediting program applies a quantification methodology or protocol for calculating the level of GHG reductions or removals associated with credited projects or activities that is robust, conservative and transparent?

Governance:

12. In addition to a crediting program’s decision-making, reporting, disclosure, public and stakeholder engagement, and risk management policies, are there other criteria or factors that a DCM should take into account when considering, and/or addressing in a VCC derivative contract’s terms and conditions, whether the crediting program can demonstrate that it has a governance framework that effectively supports the program’s transparency and accountability?

Tracking and no double counting:

13. In addition to the factors identified in this proposed guidance, are there other factors that should be taken into account by a DCM when considering, and/or addressing in a VCC derivative contract’s terms and conditions, whether the registry operated or utilized by a crediting program has processes and procedures in place to help ensure clarity and certainty with respect to the issuance, transfer, and retirement of VCCs?
14. Are there particular criteria or factors that a DCM should take into account when considering, and/or addressing in a VCC derivative contract’s terms and conditions, whether it can be demonstrated that the registry operated or utilized by a crediting program has in place measures that provide reasonable assurance that credited emission reductions or removals are not double-counted?

Inspection provisions:

15. Should the delivery procedures for a physically-settled VCC derivative contract describe the responsibilities of registries, crediting programs, or any other third-parties required to carry out the delivery process?

Sustainable development benefits and safeguards:

16. Certain private sector and multilateral initiatives recognize the implementation by a crediting program of measures to help ensure that credited mitigation projects or activities meet or exceed best practices on social and environmental safeguards, as a characteristic that helps to inform the integrity of VCCs issued by the crediting program. When designing a VCC derivative contract, should a DCM consider whether a crediting program has implemented such measures?
17. Certain private sector and multilateral initiatives recognize the implementation by a crediting program of measures to help ensure that credited mitigation projects or activities would avoid locking in levels of GHG emissions, technologies or carbon intensive practices that are incompatible with the objective of achieving net zero GHG emissions by 2050, as a characteristic that helps to inform the integrity of VCCs issued by the crediting program. When designing a VCC derivative contract, should a DCM consider whether a crediting program has implemented such measures?