On December 4, 2023, the Commodity Futures Trading Commission (CFTC) issued proposed guidance relevant to “designated contract markets” (DCMs) and “swap execution facilities” (SEFs)1 as they develop standardized derivative products referencing voluntary carbon credits (VCCs). The proposal is one part of the CFTC’s ongoing focus on the regulation of voluntary carbon markets.
The proposed guidance is unusual in its detailed focus on the attributes of a commodity—in this case VCCs—underlying derivatives subject to CFTC regulation, and is another indication of the emphasis on policy addressing climate change and the regulation of VCC markets by the Biden administration. Indeed, the proposed guidance was spotlighted by Treasury Secretary Janet Yellen, who issued a concurrent coordinated press release lauding the proposals and commending CFTC efforts to support the development of high-integrity VCC markets. As Secretary Yellen’s statement indicates, the CFTC’s efforts are part of a collaborative effort by multiple federal agencies aimed at “the development of responsible, high-functioning, and high-integrity” VCC markets.
While the CFTC’s proposed guidance is narrowly focused on the listing requirements of VCC derivatives by regulated DCMs and SEFs, we believe it is likely to have further effect on over-the-counter (OTC) derivates and cash market transactions in VCCs.
Summary of the CFTC’s Proposed Guidance
The proposal sets out detailed guidance on the criteria for VCC contracts that DCMs and SEFs should consider when developing or evaluating standardized derivatives referencing VCCs for listing or trading. It also clarifies certain ongoing obligations of DCMs with respect to listed VCC derivatives and the process for submitting VCC derivative products for CFTC review, a required step in the listing process.
Though framed as guidance to assist DCMs and SEFs in meeting a core regulatory requirement that standardized products not be readily susceptible to manipulation, the CFTC’s discussion of key criteria for listed VCC derivatives is relevant to participants in off-exchange OTC and cash markets. Because off-exchange markets are often linked to and influenced by exchange trading, the proposal is likely to have impacts beyond CFTC-regulated VCC markets.
The CFTC proposed guidance sets forth the following criteria that DCMs and SEFs should consider when developing VCC derivatives for listing and trading on an exchange or platform:
- Transparency and publicly available data regarding the source of credits eligible for delivery under a contract, including the terms and conditions for the crediting program issuing the VCC, detailed information about the project underlying a VCC, and associated project documentation, which is readily available in a searchable manner.
- Demonstrated procedures to assess or test for “additionality”—that is, the idea that the underlying VCC represents actual emission reductions or removals that would not have been realized in the absence of the added monetary incentive created by the revenue from the sale of the VCC. The CFTC notes that additionality is viewed as a necessary element of a high-quality VCC. The DCM or SEF, as a gatekeeper, should consider whether crediting program procedures are sufficiently rigorous and reliable to provide reasonable assurance to market participants that emission reductions or removals are credited only if they are, in fact, additional. The proposed guidance does not specifically outline what further diligence DCMs and SEFs should perform in order to evaluate whether the additionality claims of a given VCC type or related project are justified.
- Measures for estimating, monitoring, and addressing “permanence” and “risk of reversal”—that is, the risk that the VCCs issued for a project may be recalled or cancelled due to either removed carbon being released back into the atmosphere or revaluation of the amount removed. The proposal states that that the DCM or SEF should consider whether the crediting program for a VCC has measures in place that provide reasonable assurance that—in the event of a reversal—the VCC will be replaced by a VCC of comparably high quality that meets the specifications of the derivative contract. This may include assessing whether a crediting program utilizes “buffer pools” or other replacement strategies and reviewing the methodologies for sizing such buffer pools and auditing their continued sufficiency, particularly where VCCs are issued for projects with higher reversal risk (e.g., forestry projects).
- Demonstrably robust, conservative, and transparent methods of quantifying greenhouse gas reduction or removal underlying a VCC, including considerations of whether the emissions quantification methodology is appropriately tailored to a particular type of emission-reducing project or activity, and whether the quantification methodology should be included in the terms and conditions of the listed VCC derivative contract.
- Effective, transparent, and accountable governance of the crediting program. Among other things, governance standards should ensure that the crediting program operates or makes use of a registry that has appropriate measures in place to facilitate the physical settlement of the listed VCC derivative contract.
- Clarity and certainty of issuance, transfer, and retirement, including unique and secure registry identification of each VCC and its owner.
- Effective measures to prevent double counting, including procedures for conducting cross-checks across multiple registries.
- Third-party verification and inspection procedures to verify compliance with quality requirements.
What Does This Mean for Carbon Market Technology and Other Enterprise Clients and Other Participants in the OTC Markets?
The great majority of contracts for the issuance and purchase of VCCs by technology enterprises are structured as bilateral agreements and do not involve listing or trading on a DCM or SEF. These contracts are typically structured to fit within the “forward” exclusion from the definition of a “swap” under the Commodity Exchange Act, in that they are purchase and sale agreements for deferred delivery that contemplate actual delivery of VCCs, and generally are only subject to CFTC regulation with respect to its anti-fraud and anti-manipulation authority over the underlying VCC. Alternatively, some of these contracts may constitute a “trade option” under relevant CFTC guidance—and thus are regulated as “swaps” under CFTC regulation, but only with respect to certain reporting requirements.
The proposed guidance as drafted would not cover these types of contracts or any other type of bilateral swap not listed or trading on a DCM or SEF, as they are OTC derivatives between bilateral parties.
From our perspective, however, the proposed guidance has potential implications for carbon market technology enterprise clients and other market participants:
VCC Accreditation Standards. The proposed guidance is part of the broader collaborative effort of federal agencies to foster the development of a robust market for high-quality VCCs, and potentially represents an avenue to indirectly influence accreditation standards. In recent public statements, the CFTC and individual CFTC commissioners have noted the absence of clear statutory authority for the CFTC to regulate VCCs and their attributes, including by adopting accreditation standards for VCCs. The CFTC has, however, repeatedly noted its general anti-fraud and anti-manipulation authority over the underlying commodity spot markets as a basis for potentially undertaking enforcement actions that reach OTC and spot transactions in VCCs.
Adoption of DCM standard by OTC market. The proposed guidance over time may result in the migration of these DCM contract standards and market practices from the regulated DCM exchange and SEF platform markets to the less regulated bilateral OTC market. By encouraging DCMs and SEFs to monitor compliance with the carbon credit criteria discussed in the proposed guidance, CFTC is attempting to support the development of market practices that participants in bilateral, off-exchange OTC transactions may find efficient and practical to adopt.
Greater Clarity Surrounding OTC Enforcement Risk. The standards outlined by the CFTC will also effectively provide more certainty to general market participants concerning practices around, and transactions in, VCCs that would not be considered fraudulent or manipulative. If a VCC is suitable as the underlying commodity for a derivative listed and/or trading on regulated DCMs and SEFs, similar OTC derivative and cash market transactions are also unlikely to be viewed as fraudulent or manipulative. Conversely, otherwise exempt VCC forwards or trade options that are inconsistent with CFTC guidance to, and any related market practices that develop through, DCMs and SEFs will likely be at higher risk of CFTC anti-fraud or anti-manipulation enforcement action.
Open questions. One significant question arising from the CFTC’s proposed guidance is whether existing DCMs or SEFs have the capability or sufficient incentives to perform the analysis and carry out ongoing monitoring and compliance obligations suggested by the proposed guidance, given the emerging character of the nascent VCC market and the scientific sophistication required to analyze the various methodologies used to confirm the integrity of VCCs. An unintended consequence of the proposed guidance, if finalized, might be to decrease regulated entities’ interest in listing and facilitating trading of VCC derivative products due to the expectations set by the CFTC with respect to the complexity of complying with existing regulatory requirements.
The guidance also does not address whether and how purchasing, selling, or trading VCCs might trigger other forms of regulation, including those applicable to commodity trading advisors (CTAs), commodity pool operators (CPOs), or other CFTC-regulated entities. As an example, the adviser to a fund that purchases VCCs could, in certain circumstances, be required to register as a CTA and/or CPO. It is unclear exactly when that might be required and if so, what the CTA/CPO’s additional obligations might be when managing a pool of assets that includes VCCs and/or VCC derivatives.
Finally, as CFTC Commissioner Kristin Johnson has conspicuously noted in her December 4, 2023, statement, the current focus of the CFTC is narrow, and begs the question of whether it should or will be applied in other circumstances:
The Proposed Guidance provides much-needed direction to DCMs (and SEFs) to facilitate their compliance with core principles when they list futures contracts (and swaps contracts) on VCCs. However, the Commission is only addressing one small aspect of the market for derivatives on these underlying assets. There is also a segment of the swaps market that is not traded on a SEF for which VCCs are underliers and an even more significant volume of environmental forwards that are not considered to be swaps.
The Proposed Guidance suggests the potential for a broader and more comprehensive regulatory framework. Applying the approach adopted in the Proposed Guidance, there may be several interventions that may bring similar needed reforms to over-the-counter traded environmental commodities—material risk disclosures, good faith and fair dealing, and clearing.
If the CFTC ultimately attempts to explicitly expand the scope of its guidance to OTC and cash market transactions, one open question (among many) will be what legal entity or process in the OTC markets will undertake the gatekeeping, monitoring and compliance function that the proposed guidance would assign to DCMs and SEFs in the regulated exchange markets.
The CFTC has requested public comment on the proposed guidance by February 16, 2024.
For more information on the proposed guidance, please contact any member of Wilson Sonsini’s derivatives, energy and climate solutions, or fintech and financial services practices.
[1] A DCM is a commodity derivatives exchange regulated by the CFTC that must comply with specified statutory “core principles” and other CFTC regulations. These core principles include, among other things, 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. A SEF is a CFTC-regulated electronic trading platform that enables participants to execute and trade standardized swaps in compliance with CFTC regulations.
