The Final 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 in relation to potential fraud, manipulation, and other forms of misconduct in the carbon markets.
According to CFTC Chairman Rostin Behnam, by issuing the Final Guidance, the CFTC has taken the significant step of being the first U.S. financial regulator to issue regulatory guidance for contract markets that list financial contracts aimed at providing tools to manage risk, promote price discovery, and foster the allocation of capital towards decarbonization efforts.[2]
What is a VCC?
- A VCC is a tradeable intangible instrument that is issued by a carbon crediting program (a “Crediting Program”)[3]
- Typically, a VCC represents a greenhouse gas (“GHG”) emissions reduction to, or removal from, the atmosphere equivalent to one metric ton of carbon dioxide
Who is involved in the issuance of a VCC?
- A developer of a mitigation project or activity intended to reduce or remove GHG emissions
- A Crediting Program that, among other things, issues VCCs for mitigation projects or activities that satisfy its standards[4]
- An independent third party that verifies and validates the mitigation project or activity
Once registered, VCCs associated with a certified mitigation project or activity may be bought and sold to end users (businesses or individuals) or to intermediaries (brokers or aggregators) that provide liquidity to voluntary carbon market participants.
What does the Final Guidance say?
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”).[5] DCMs, which are CFTC-regulated exchanges that provide derivatives market participants with the ability to execute or trade derivatives contracts, are subject to statutory “Core Principles” set forth in the CEA – which define general standards and requirements for how a DCM conducts its business[6] – and to CFTC rules and regulations that, among other things, implement the Core Principles.[7] The CFTC has also previously adopted guidance and acceptable practices for DCMs to consider with respect to certain of the Core Principles.[8]
The Final Guidance is not intended to modify or supersede existing statutory or regulatory obligations of DCMs, or existing CFTC guidance on the listing of derivative contracts.4 Instead, the Final Guidance outlines factors that DCMs should consider when addressing their obligations relevant to listing VCC derivative contracts.
The Final Guidance focuses on three overarching factors that DCMs should adhere to when listing VCC derivatives:
- A DCM shall only list derivative contracts that are not readily susceptible to manipulation (Core Principle 3)
- A DCM shall monitor a derivative contract’s terms and conditions as they relate to the underlying commodity market (Core Principle 4)
- DCMs must satisfy the CFTC’s Product Submission Requirements[9]
1. Contracts cannot be readily susceptible to manipulation
Core Principle 3 states that a DCM “shall only list for trading derivative contracts that are not readily susceptible to manipulation.”[10] The CFTC has adopted further guidance that outlines how a DCM may demonstrate compliance with Core Principle 3.[11]
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. The CFTC noted that, at a minimum, a DCM should consider the following VCC commodity characteristics:
- Quality standards: (1) transparency, (2) additionality, (3) permanence and risk of reversal, (4) robust quantification, (5) social and environmental safeguards and net-zero alignment
- Delivery points and facilities: (1) governance, (2) tracking, (3) double-counting
- Inspection procedures
In response to several comments received in connection with the proposed guidance published on December 19, 2023 (the “Proposed Guidance”),[12] the CFTC acknowledged that DCMs may not possess the same specialized technical expertise in the complexities of VCC issuance and certification as those that are directly involved in the voluntary carbon market infrastructure, such as Crediting Programs or other standard-setting bodies.
In the Final Guidance, the CFTC acknowledged that given there are already industry-recognized standards for high-integrity VCCs and recommended that DCMs look to these industry-recognized standards as they consider each of these VCC commodity characteristics set out below. In particular, the CFTC noted that a DCM can have regard to whether a particular Crediting Program has been approved or certified as adhering to an industry-recognized standard setting program.[13]
1(a) Quality standards
(1) Transparency – are the types of programs and activities that are eligible under the contract sufficiently clear to the public?
The terms and conditions of a VCC derivative contract should make clear to market participants:
- What is, and what is not, deliverable under the contract, including by providing information that readily specifies the Crediting Program from which eligible VCCs may be issued
- Where a VCC is associated with a specific category of mitigation project or activity
As part of the contract design process, a DCM should consider whether the Crediting Program is making detailed information about its policies and procedures, and the projects or activities that it credits, publicly available in a searchable and comparable manner.
(2) Additionality – does the project remove additional GHG emissions that would not have been removed if not for the additional monetary incentive?
A DCM should consider whether:
- A Crediting Program has procedures in place to assess or test for additionality
- Those procedures provide a reasonable assurance that GHG emission reductions or removals are credited only if they are additional
Recognizing that industry consensus on how to characterize and assess additionality continues to evolve, the Final Guidance does not define “additionality.” Instead, the Final Guidance pointed to certain industry-recognized standards as suggested definitions for DCMs to refer to.
(3) Permanence and accounting for the risk of reversal – will the VCC contract be cancelled because GHGs are released back into the atmosphere, due to a re-evaluation of the effectiveness of the contract or some other practice or behavior at the project site?
A DCM should consider whether:
- A Crediting Program has measures in place to address and account for the risk of reversal
- A Crediting Program has measures in place to provide reasonable assurance that, in the event of a reversal, the VCCs intended to underlie a derivative contract will be replaced by VCCs of comparably high quality that meet the contemplated specifications of the contract
The CFTC suggested industry-recognized standards for high-integrity VCCs, and whether a particular Crediting Program has been approved or certified as adhering to an industry-recognized standards setting program, can serve as tools for a DCM, in connection with these considerations.
(4) Robust quantification – is there reasonable assurance that the quantification methodology or protocol used by a Crediting Program for calculating emission reductions or removals for underlying VCCs is robust, conservative, and transparent?
(5) Social, environmental and net-zero – has the Crediting Program implemented (i) social or environmental safeguards or (ii) a net-zero alignment strategy?
In response to several comments received in connection with the Proposed Guidance, the CFTC did not specifically recommend that DCMs should consider certain social, environmental and net-zero matters. However, the CFTC noted that a DCM may also consider it appropriate to consider whether a Crediting Program has implemented measures to:
- Help ensure that underlying projects meet or exceed best practices on social and environmental safeguards
- 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
1(b) Delivery Procedures
(1) Governance – does the Crediting Program have a governance framework that supports its independence, transparency, and accountability?
A DCM should consider:
- The Crediting Program’s decision-making procedures, reporting and disclosure procedures, public and stakeholder engagement processes, and risk management policies
- Whether such procedures and policies should be publicly available
(2) Tracking– is there reasonable assurance that a Crediting Program has processes and procedures to ensure clarity and certainty with regards to the issuance, transfer, and retirement of VCCs?
(3) No double counting – does the Crediting Program have effective measures to ensure that credit emission reductions or removals are not double counted?
For the purposes of the Final Guidance, the CFTC has clarified that this double counting consideration is focused on double issuance—i.e., the issuance of the same VCC more than once.
1(c) Inspection Procedures
Robust independent third-party validation and verification– does a Crediting Program require validation and verification that credited mitigation projects meet its requirements, and how?
Any Crediting Program’s inspection or certification procedures for verifying compliance with quality requirements or any other related delivery requirements for VCC derivative contracts should be specified in the contract’s terms and conditions.
A DCM should consider whether there is reasonable assurance that a Crediting Program’s validation and verification procedures reflect industry-recognized best practices.
The CFTC made clear that it does not expect the DCM to conduct reviews of such procedures itself.
2. Monitor the terms and conditions as they relate to the underlying market
Under Core Principle 4, DCMs must 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.[14]
The CFTC has read this Core Principle 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.[15]
Applying this principle to VCCs, the Final Guidance recommends that:
- DCMs monitor on an ongoing basis to ensure that the underlying VCC conforms, or, where appropriate, updates to reflect the latest certification standard(s) applicable for that VCC
- Where there are changes to either the Crediting Program or the types of projects associated with the underlying VCC, then the DCM should amend the contract’s terms and conditions to reflect such update
3. Satisfaction of product submission requirements under 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 requirements for VCC derivative contracts. While such requirements are not new, the CFTC felt was necessary to remind market participants in the context of VCCs:
- 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
To support DCMs in adhering to the recommendations proposed in the Final Guidance, the CFTC relies heavily on “industry-recognized standards of high integrity VCCs.” By not specifying specific sources of the industry-recognized standards, the CFTC leaves the door open for broad interpretation and flexibility for DCMs when applying the Final Guidance in practice.
As a step beyond the Proposed Guidance, in the Final Guidance, the CFTC recommended a new quality standard relating to social and environmental safeguards, and net zero alignment. Commissioner Summer Mersinger notably dissented to this additional consideration, stating that “ESG and Net Zero in evaluating derivatives contracts is a backdoor attempt to inject and memorialize certain political ideologies into CFTC regulatory decisions.”[16]
The CFTC previously drew attention to the prospect of fraud in the VCC markets with its public plea to potential whistleblowers. This Final Guidance to DCMs 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.
On October 2, 2024, the CFTC brought its first enforcement action against a carbon credit project developer, charging that the developer had produced false, misleading, or inaccurate reports relating to voluntary carbon credits. A&O Shearman will be publishing a separate Client Alert on this enforcement action in the coming days.[17]
The Final Guidance and recent enforcement action show that climate change, environmental markets, and VCCs look to continue to be areas of focus of the CFTC.
Footnotes
[1] 89 Fed. Reg. 83378 (Oct. 15 2024)
[2] Statement of Chairman Rostin Behnam on the Final Commission Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts, CFTC, Sept. 20, 2024
[3] Final Guidance, at 9.
[4] Currently, the four main Crediting Programs in the voluntary carbon markets are the American Carbon Registry, the Climate Action Reserve, the Gold Standard and the Verified Carbon Standard.
[5] CFTC Mission Statement see also See CEA section 3(b), 7 U.S.C. 5(b).
[6] See, generally, CEA Section 5(d), 7 U.S.C. 7(d). There are 23 statutory Core Principles for DCMs.
[7] See 17 CFR part 38.
[8] See, e.g., 17 CFR part 38, Appendices B and C.
[9] CEA section 5c(c), 17 CFR 40.
[10] CEA section 5(d)(3), 7 U.S.C. 7(d)(3).
[11] See 17 CFR part 38, Appendix C. Guidance set forth in Appendix B to Part 38 states that a DCM may use the Appendix C Guidance as guidance in meeting DCM Core Principle 3 for both new product listings and existing listed contracts. 17 CFR part 38, Appendix B, Core Principle 3 Guidance.
[12] CFTC Issues Proposed Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts, CFTC, Dec. 4, 2023, Release Number 8829-23
[13] In the Final Guidance, the CFTC did not specify particular industry standards. Instead, the CFTC referred to certain recommendations provided in response to its Request for Information on Climate-Related Financial Risk, 87 FR 34856 (June 8, 2022) (“RFI on Climate-Related Financial Risk”)’ see e.g., the International Swaps and Derivatives Association response to the RFI on Climate-Related Financial Risk dated Oct. 7, 2022; the International Emissions Trading Association response to the RFI on Climate-Related Financial Risk and the Verra response to the RFI on Climate-Related Financial Risk dated Jan. 23, 2023
[14] CEA Section 5(d)(4), 7 U.S.C. 7(d)(4). See also 17 CFR 38.250-258.
[15] 17 CFR 38.252.
[16] Dissenting Statement of Commissioner Summer K. Mersinger on Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts, CFTC, Sept. 20, 2024
[17] CFTC, “CFTC Charges Former CEO of Carbon Credit Project Developer with Fraud Involving Voluntary Carbon Credits”, Press Release No. 8994-24 (Oct. 2, 2024)
