On December 4, 2023, the Commodity Futures Trading Commission (CFTC) approved Voluntary Carbon Market Proposed Guidance (the Proposed Guidance)1 and requested public comment regarding the listing for trading of voluntary carbon credit derivative contracts. The Proposed Guidance sets out factors that a CFTC-regulated exchange (a designated contract market (DCM)) should analyze when considering Commodity Exchange Act (CEA) and CFTC regulations concerning the contract design and listing process. According to CFTC Chairman Rostin Benham, the CFTC’s goal with the Proposed Guidance is to “help shape standards in support of integrity, which will lead to transparency, liquidity, and ultimately price discovery.” Further, the CFTC explains in its press release2 concerning the Proposed Guidance that it “may help to advance the standardization of voluntary carbon credit derivative contracts in a manner that fosters transparency and liquidity, accurate pricing, and market integrity.”
This Proposed Guidance follows the CFTC’s information gathering process on the voluntary carbon market (VCM) that included two public meetings and a request for information “to better inform the Commission on how, consistent with its statutory authority, to address climate related financial risk as pertinent to the derivatives markets and underlying commodities markets.”3 DCMs should consider carefully the Proposed Guidance to assess the practicality of the guidance and determine whether to comment.
1. DCM general requirements
A DCM is a CFTC-regulated exchange that must comply with statutory “Core Principles” set forth in the CEA to maintain its designation.4 These Core Principles include, among other requirements, that a DCM impose certain position limits, make publicly available information on settlement prices, and establish rules and procedures ensuring the financial integrity of transactions.5 For some of the Core Principles, the CFTC has adopted rules that explain how a DCM must act to comply, and the Proposed Guidance seeks to accomplish the same.6
2. Overview of voluntary carbon markets
A VCM is not established by any governmental body and typically refers to a market for the buying and selling of voluntary carbon credit (VCC) commodities that represent greenhouse gas emission reductions from the atmosphere that purchasers obtain to get credit for such reductions rather than, or in addition to, reducing their own. VCCs are issued by carbon crediting programs according to each program’s standards and requirements, which can differ significantly from program to program. This lack of standardization introduces variance to the quality of each VCC. The Proposed Guidance provides guidance to DCMs listing physically settled VCC-derivative products to promote the trading of high-quality VCCs.7
3. Proposed guidance regarding the listing of VCC-derivative contracts
The CEA and CFTC regulations require a DCM to
(A) only list derivative contracts that are not readily susceptible to manipulation
(B) monitor a derivative contract’s terms and conditions as they relate to the underlying commodity market
(C) satisfy the product submission requirements under Part 40 of the CFTC’s regulations and CEA Section 5c(c)
The Proposed Guidance introduces factors that DCMs should consider when determining whether they satisfy the foregoing requirements with respect to the listing of a VCC-derivative contract.
Each of these requirements and the CFTC’s guidance with respect to compliance by DCMs with the requirement with respect to the listing of VCC derivatives is discussed below.
a. A DCM shall only list derivative contracts that are not readily susceptible to manipulation
Core Principle 3 provides that DCMs may only list derivative contracts that are not readily susceptible to manipulation.9 For physically settled derivative contracts, the CFTC has published guidance that states that terms and conditions of the contract “should describe or define all of the economically significant characteristics or attributes of the commodity underlying the contract.”10 The specific qualities of a derivative contract that must be listed depends on “the individual characteristics of the commodity.”11 The Proposed Guidance sets forth certain qualities of VCC-derivative contracts that should be included in their terms and conditions and considered when listing a VCC-derivative contract. In addition to acknowledging that standardization and accountability mechanisms for VCCs are still developing, the Proposed Guidance provides that a DCM should consider the following:
- Quality standards
- Transparency
- The contract’s terms and conditions should specify the carbon crediting program responsible for the VCCs eligible for delivery.
- The DCM should consider whether the carbon crediting program publishes enough information for market participants to evaluate the quality of the underlying VCCs.
- Additionality
- A VCC is considered “additional” when it is credited only for emission reductions that would not have occurred but for the monetary incentive created by the revenue from the sale of carbon credits.
- High-quality VCCs are typically “additional.”
- DCMs should consider whether a relevant carbon crediting program assesses additionality and whether its procedures for doing so are adequate.
- Permanence and risk of reversal
- The risk of reversal is the risk that a VCC will need to be recalled, canceled, or reduced because the project responsible for the reduced emission failed to achieve its emission targets.
- DCMs should evaluate carbon crediting programs’ measures to mitigate VCC reversals and should use VCCs tied to carbon crediting programs that “provide reasonable assurance that, in the event of a reversal, the VCC will be replaced by a [similar] VCC.”
- Robust quantification
- DCMs should consider whether a carbon crediting program’s quantification methodology or protocol for determining the level of emission reductions or removals associated with a project or activity is “robust, conservative, and transparent.”
- A carbon crediting program’s quantification methodology or protocol should be set forth in a VCC derivative contract’s terms and conditions.
- DCMs should consider the carbon crediting program’s quantification methodology or protocol when selecting mandatory exchange-set position limits.12
- Transparency
- Delivery point and facilities
- CFTC guidance states that the delivery process for physically settled derivatives should, among other things, “seek to minimize or eliminate any impediments to making or taking delivery ... to help ensure convergence of cash and derivative contract prices at” expiration.13
- A DCM should consider the governance framework, tracking mechanisms, and measures to prevent double-counting of any carbon crediting programs relevant to its VCC-derivative contracts.
- Governance
- A DCM should consider whether a carbon crediting program “has a governance framework that effectively supports the crediting program’s independence, transparency and accountability.”
- In undertaking this evaluation, a DCM should consider
- who is responsible for the administration of the program
- how the independence of key functions is ensured
- reporting and disclosure procedures
- public and stakeholder engagement processes
- risk management policies
- The CFTC explains that it “may be appropriate” to include the carbon crediting program’s governance details in the terms and conditions of the VCC derivative contract.
- Tracking
- A DCM should consider whether a carbon crediting program “can demonstrate that it has processes and procedures in place to help ensure clarity and certainty with respect to the issuance, transfer, and retirement of VCCs.”
- Double-counting
- A DCM should consider whether a carbon crediting program “can demonstrate that it has effective measures in place that provide reasonable assurance that credited emission reductions or removals are not double counted.”
- Inspection provisions
- Any inspection or certification procedures for verifying compliance with quality requirements or any other related delivery requirements for physically settled VCC derivatives contracts should be specified in the contract’s terms and conditions.
- The inspection or certification procedures should be in line with the latest procedures in the VCC market.
- A DCM should consider whether a carbon crediting program has sufficient measures in place to ensure that credited mitigation projects or activities for which it awards VCCs meet the program’s standards and whether the program uses best practices with respect to using third-party validators.
b. A DCM shall monitor a derivative contract’s terms and conditions as they relate to the underlying commodity market
Core Principle 4 requires that DCMs “prevent manipulation, price distortion, and disruptions of the physical delivery or cash-settlement process through market surveillance, compliance, and enforcement practices and procedures. The CFTC has explained that this requirement includes (i) an obligation to monitor the contract’s terms and conditions as they relate the underlying commodity market and to the convergence between the contract price and the price of the underlying commodity and (ii) to monitor the supply of the underlying commodity in light of the contract’s delivery requirements.14
For physically settled VCC derivative contracts, the CEA and CFTC regulations explain that DCMs should continually monitor the appropriateness of the terms and conditions of a contract to ensure that, among other items, the underlying VCC conforms or updates to the latest applicable certification standard(s).
c. A DCM must satisfy the product submission requirements under Part 40 of the CFTC’s regulations and CEA Section 5c(c)
Generally, a DCM may list a derivative contract by providing the CFTC with a written certification that the contract meets the CEA and CFTC’s requirements or by seeking CFTC’s preapproval of the contract. The Proposed Guidance does not introduce any additional listing requirements but emphasizes three existing submission requirements. First, when submitting a contract for preapproval to the CFTC or delivering a self-certification, the DCM must include an “explanation and analysis of the contract and its compliance with applicable provisions of the [CEA], including core principles and the Commission’s regulations thereunder.”15 Second, the “explanation and analysis of the contract” must be accompanied by the facts and materials that were relied upon.16 Finally, the DCM must respond to the CFTC’s request for additional information.17
The Proposed Guidance describes considerations for DCMs that list or seek to list physically settled VCC derivatives. Any final guidance issued by the CFTC will have a significant effect on how the VCC derivative market develop and therefore also on how the VCC markets themselves develop. The CFTC has requested comments by February 16, 2024.
1 Commission Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts; Request for Comment (Proposed Guidance Release).
3 See Proposed Guidance Release at 16-17.
5 Id.
6 Unless otherwise determined by the commission by rule or regulation, a DCM has reasonable discretion in establishing the manner in which it complies with a Core Principle. 7 U.S.C. § 7(d)(1)(B).
7 The Proposed Guidance focuses on physically -settled derivatives because to date all VCC derivatives listed by DCMs have been physically settled. The CFTC has indicated that many aspects of the Proposed Guidance would also apply to the listing of cash-settled derivatives.
8 The CFTC also notes that “while this proposed guidance focuses on the listing of VCC derivative contracts by DCMs, the [CFTC] preliminarily believes that the proposed guidance also should be considered by any [Swap Execution Facility] that may seek to permit trading in swap contracts that settle to the price of a VCC, or in physically-settled VCC swap contracts.” Proposed Guidance Release at 20.
10 Appendix C to Part 38 (“Appendix C Guidance”), paragraph (b)(2)(i)(A).
11 Id.
12 7 U.S.C. § 7(d)(5). See also 17 CFR §§ 38.300-301.
13 Appendix C Guidance, paragraph (b)(2)(i)(B).
14 17 CFR § 38.252.
15 See 17 CFR §§ 40.2(a)(3)(v) (for self-certification) and 40.3(a)(4) (for commission approval).
16 See id.
17 See 17 CFR §§ 40.2(b) (for self-certification) and 40.3(a)(10) (for commission approval).
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