CFTC Guidance: A Potential Integrity Backstop for Evolving Voluntary Carbon Market

In late September, the Commodity Futures Trading Commission (Commission or CFTC) approved final guidance regarding the listing of voluntary carbon credit (VCC) derivative contracts on CFTC-regulated designated contract markets (Final Guidance). Commission observers had anticipated issuance of the Final Guidance for several months, as it follows proposed guidance issued by CFTC in December 2023. The Final Guidance also follows the Biden Administration's Joint Policy Statement on Voluntary Carbon Market Principles, discussed in our post earlier this year. The Final Guidance, while applicable to derivative (or futures) contracts, represents the first official action by a U.S. regulator to help validate the integrity of the VCCs underlying such contracts. In this vein, as the derivative contract and underlying VCC markets continue to expand and evolve, the Final Guidance may represent an integrity backstop of sorts for U.S. VCC market participants.

VCC Derivative Contracts

As explained in the Final Guidance, VCC derivative contracts are a relatively new and evolving class of products, not unlike VCCs themselves. Physically-settled VCC derivative contracts base their price on the spot price of the underlying VCCs issued by carbon crediting programs. At the expiration of trading in the contract, the open position holder must make or take delivery of VCCs that meet the contract's rules for delivery eligibility.

In the Final Guidance, the Commission acknowledges that only 29 VCC derivative contracts were listed on designated contract markets (DCMs) as of August 2024, with three offering open positions. That stands in comparison to the more than 150 derivative contracts for mandatory emissions reductions instruments listed on DCMs, as noted in the Final Guidance. Such contracts have become important tools of price discovery for market participants, as well as price-risk mitigation for many compliance entities. The Commission intends for the Final Guidance to help advance the standardization of VCC derivative contracts in a manner that promotes transparency and liquidity, generating increased interest from market participants, particularly as buyers increasingly demand high-integrity VCCs.

Final Guidance

The Final Guidance, while non-binding, is intended to assist DCMs in complying with the Commodities Exchange Act and existing CFTC regulations with respect to the design and listing of VCC derivative contracts. The Final Guidance specifically addresses Core Principles 3 and 4 of Part 38 of CFTC's regulations, concerning contract manipulation and price distortions, as well as certain contract submission provisions of other regulations. While the Final Guidance directly addresses VCC derivative contracts, the substance of many of the provisions addresses the characteristics of the underlying VCCs and their respective crediting programs. Importantly, these provisions mirror standards and recommendations regarding VCC quality issued by several leading non-governmental organizations. At a high level, the Final Guidance provides for consideration of what it describes as the "commodity characteristics" of VCCs in three areas of derivative contract design: (1) Quality Standards, (2) Delivery Procedures, and (3) Inspection Provisions.

1. Quality Standards

When addressing quality standards in a VCC derivative contract, the Final Guidance states that DCMs should consider the following VCC commodity characteristics: (i) transparency, (ii) additionality, (iii) permanence and risk of reversal, and (iv) robust quantification. Guidance related to each of these characteristics is provided further below. While the first characteristic, transparency, concerns identifying the underlying VCCs, the remaining characteristics, at a high level, focus on the integrity of the credit issuance processes for those VCCs.

• Transparency. The contract terms and conditions should clearly identify what is deliverable under the contract, including by providing information that readily specifies the crediting program or programs from which underlying VCCs may be issued. To the extent that underlying VCCs are associated with a specific category of mitigation project or activity-such as nature-based projects-this also should be evident from the contract's terms and conditions.
• Additionality. A DCM should consider whether the crediting programs for the underlying VCCs have procedures in place to assess or test for additionality, and provide reasonable assurance that greenhouse gas (GHG) emission reductions or removals will be credited only if they are additional.
• Permanence and Risk of Reversal. A DCM should consider whether the crediting program for underlying VCCs has measures in place to address and account for the risk of reversal (i.e., a release of captured emissions or a revision to emissions methodology that reduces VCCs for a project). A DCM should also consider whether a crediting program has a buffer reserve and/or other measures in place to address such risk.
• Robust Quantification. A DCM should consider whether there is reasonable assurance that the quantification methodologies or protocols used by the crediting programs for calculating emission reductions or removals for underlying VCCs is robust, conservative, and transparent. A robust, conservative, and transparent quantification methodology or protocol helps to ensure that the number of VCCs that are issued for a project or activity accurately reflects the level of GHG emission reductions or removals associated with the project or activity.

2. Delivery Procedures

When addressing delivery procedures in VCC derivative contracts, the Final Guidance again focuses on the crediting programs for the underlying VCCs, and states that a DCM should consider such programs' governance framework and tracking mechanisms, as well as their measures to prevent double counting. Factors relevant to the governance framework could include the program's decision-making procedures, conflict of interest measures, public and stakeholder engagement processes, and risk management policies. With regard to tracking mechanisms, a DCM should consider whether a program operates or makes use of a registry that has effective measures in place to track the issuance, transfer, and retirement of VCCs. The registry should also ensure that each VCC is uniquely identified and associated with a single emission reduction or removal of one metric ton of carbon dioxide equivalent. The Final Guidance notes that effective measures to prevent double counting may include, among other things, procedures for conducting crosschecks across multiple VCC registries. Lastly, a DCM should also ensure that it is monitoring the adequacy of the supply of the underlying VCCs to satisfy the contract's delivery requirements.

3. Inspection Provisions

When addressing inspection provisions in VCC derivative contracts, the Final Guidance focuses on the procedures of the crediting program for the underlying VCCs. A DCM should consider whether there is reasonable assurance that the crediting programs for underlying VCCs have up-to-date, robust and transparent procedures for validating and verifying that credited projects or activities meet applicable rules and standards. A DCM should also consider whether there is reasonable assurance that the crediting program's procedures reflect best practices with respect to third party validation and verification. Any inspection or certification procedures for verifying compliance with quality requirements or any other delivery requirements should be specified in the derivative contract's terms and conditions.

Implications for Voluntary Carbon Market

As noted above, the CFTC intends that the final guidance will help bring standardization to the VCC derivative contracts potentially listed by DCMs, in an effort to boost interest from potential buyers and thus market liquidity. However, as explained above, much of the Final Guidance directs DCMs to scrutinize the policies and procedures of the crediting programs for VCCs underlying derivative contracts. It is likely that many of the leading VCC crediting programs are undertaking efforts internally to digest the Final Guidance, and to ensure that their credit issuance processes (and all issued VCCs) are in material compliance.

Yet, as with mandatory emissions reductions instruments, interests in a certain category of VCCs, or VCCs recognized as high-quality by an independent and well-respected industry organization, may also drive interest in derivative contracts for such VCCs, as buyers seek protection against potential future price spikes. In addition to the provisions outlined above with respect to transparency, importantly, the final guidance advises DCMs to consider clearly indicating whether the crediting programs for the underlying VCCs has been approved or certified by an "industry-recognized standards program for high-integrity VCCs."

The most prominent such program to-date is the Integrity Council for the Voluntary Carbon Market's Core Carbon Principles (CCP) labeling program. As of the IC-VCM's last publicly released assessment, only 3.6% of all unretired VCC's had been approved for CCP labelling. It is likely that as supply of CCP-labeled VCCs steadily grows in the market, the interest in derivatives contracts with CCP-labeled underlying VCC's, and other VCCs identified as high integrity by well-respected organizations, will continue to expand as well.