CFTC proposes guidance on listing for trading of voluntary carbon credit derivatives – including those based on tokenized VCCs

On December 4, 2023, the Commodity Futures Trading Commission (CFTC) announced proposed guidance for the listing of voluntary carbon credit derivative contracts on regulated exchanges or execution facilities, as well as requested public comment on the release.

Although derivative contracts on environmental commodities have been trading on CFTC-regulated exchanges for decades, and derivative contracts on mandatory emissions program instruments have been trading since 2005, the increasing prevalence of voluntary carbon credits (VCCs) has pushed the CFTC to work towards developing standards for the trading of financial instruments based on these VCCs.

In releasing its proposed guidance, the CFTC aims to promote integrity, transparency, liquidity, and price discovery in the markets for derivatives of such VCCs. It additionally aims to bolster the integrity of VCCs underlying the derivative contracts subject to CFTC jurisdiction.

As Chairman Rostin Behnam noted in his public statement on the proposed guidance, the issuance is “the most significant step of a financial regulatory to promote fundamental standards for high integrity VCCs.” 

Scope of guidance

Although the proposed guidance primarily focuses on physically settled VCC derivative contracts, the CFTC expresses within the text that the VCC commodity characteristics that designated contract markets (DCMs) should consider when developing terms and conditions for a physically settled VCC derivative should also be considered for cash-settled derivative contracts settling to the price of a VCC.

Moreover, CFTC states that swap execution facilities (SEFs) should consider the guidance when permitting trading in swap contracts settling to the price of a VCC or a physically settled VCC swap contract.

Factors referenced within the guidance

The CFTC’s guidance outlines factors that DCMs should consider when addressing certain provisions of the Commodity Exchange Act (CEA), and CFTC regulations thereunder, that are relevant to the listing for trading of VCC derivative contracts. 

More specifically, the guidance provides details on how DCMs can demonstrate adherence to the core principles with which DCMs must comply in order to obtain and maintain their CFTC designation, in addition to outlining how DCMs can demonstrate compliance with the CEA and CFTC regulations regarding the self-certification, registration, and listing of new products.

A few key points of the guidance include the following:

• DCMs are not to list derivative contracts readily susceptible to manipulation. DCMs should provide – within the terms and conditions of a VCC derivative contract – information specifying the crediting program or programs of a VCC and the specific types of projects or activities from which VCCs eligible for delivery under the contract may be issued. The DCM should consider, when developing terms and conditions of a VCC derivative contract, whether the crediting program for the underlying VCCs is making certain detailed information publicly available. The DCM should also consider the additionality of the underlying VCCs (ie, whether the VCCs are credited only for projects or activities resulting in GHG emission reductions or removals that would not have happened absent the relevant monetary incentive). Further, the DCM should account for the risk of reversal of VCCs and the methodology or protocol used by a crediting program to calculate the level of GHG emission reductions or removals as part of the DCM’s contract design market research.
  
  
• DCMs are to prevent manipulation, price distortion, and disruptions of the physical delivery or cash-settlement process. The guidance provides that the DCM’s monitoring of terms and conditions of physically settled VCC derivative contracts should include continual monitoring of the appropriateness of the contract’s terms and conditions that include, inter alia, monitoring to ensure that the delivery instrument conforms or updates to reflect latest certification standards applicable for VCCs.
  
  
• When submitting a self-certification, DCMs are to ensure that a VCC-based contract complies with the CEA and provides qualitative explanations and analysis in meeting the submission requirements under the relevant submission provisions of the CEA. This is a result of the new and evolving nature of VCCs and VCC derivative markets, and the CFTC expects a DCM to provide complete and thorough information to assist the Commission and its staff in their understanding of the contracts at issue.

The CFTC is accepting public comments on the guidance until February 16, 2024. The CFTC has specifically requested public comment on several matters, including:

• Additional VCC commodity characteristics not yet identified in the proposed guidance relevant to the listing of VCC derivative contracts
  

   

• Standards for VCCs recognized by private-sector or multilateral initiatives that DCMs should incorporate into terms and conditions of VCC derivative contracts
  
  

• Criteria and factors that DCMs should consider in monitoring continual appropriateness of the terms and conditions of a VCC derivative contract, and
  
  

• 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.

Potential impact

The potential impacts of the listing for trading of VCC derivative contracts have multiple layers. At the market level, VCC derivative contracts will allow market participants to hedge their risk exposure on underlying VCC positions and/or VCC projects. Such VCC derivative contracts may provide market participants with more transparent information as to the pricing, and value, of the underlying VCCs.  With greater price transparency, there may be more entities willing to finance projects that generate VCCs.

Additionally, the CFTC’s fraud and market-manipulation authority extends to reach all manipulative or deceptive conduct in connection with the purchase, sale, solicitation, execution, pendency, or termination of any swap; contract of sale of any commodity in interstate commerce; or contract for future delivery on or subject to the rules of any registered. This authority also extends to the VCC derivative contracts and the underlying VCC markets.

By exercising its authority over the DCMs through the guidance, the CFTC effectively requires compliance by the underlying VCC market and expressly empowers the DCMs to conduct market surveillance to prevent manipulation, price distortion, and disruptions in the physical delivery and cash-settlement process of those spot markets.

Although the potential impacts listed above are directly related to the listing of VCC derivative contracts, the impact could extend to the environment and the economy at large.

If you have any questions about the CFTC proposed guidance and/or the commodities or carbon markets, please contact the authors of this Commodities Alert.