New CFTC Guidance on Voluntary Carbon Credit Derivative Contracts Signals Best Practices and Foreshadows Future Standardization

On September 19, 2024, the CFTC approved final guidance (the Guidance)¹ regarding the listing for trading of VCC derivative contracts by CFTC-registered DCMs.² The Guidance, which follows a December 2023 proposal³ and public comment period, outlines factors for DCMs to consider in the design and listing process for VCC derivative contracts. The Guidance does not apply to VCCs themselves or address the regulatory treatment of any underlying VCC or associated offset project or activity. It also does not affect the CFTC’s interpretation of whether agreements, contracts, or transactions in environmental commodities fall within the forward exclusion from the “swap” definition.⁴

The CFTC anticipates the Guidance, although nonbinding⁵, will help advance the standardization of VCC derivative contracts while promoting transparency and liquidity⁶ — a likely foreshadowing of future efforts to enhance the validity of VCCs and the VCC market. In publicizing the Guidance, the CFTC reiterated its “unique mission” at the front lines of the “global nexus between financial markets and decarbonization efforts,” underscoring the CFTC’s role in a global endeavor to build confidence in the VCC market and ensure that market participants are achieving or gaining actual carbon emissions reductions.⁷ And in light of potentially conflicting rules applicable to VCCs depending on the market — for example, the validity of an underlying credit or accuracy of a purchaser’s carbon reduction claims — the Guidance serves as a possible foundation for criteria to which market participants could voluntarily adhere, furthering the VCC market and their carbon mitigation goals.

Background on VCCs and VCC Derivatives

VCCs are environmental commodities representing greenhouse gas (GHG) emission reductions or removals from the atmosphere by various mitigation projects or activities, such as renewable energy, energy efficiency, or forest conservation. VCCs are traded in voluntary carbon markets, which are distinct from mandatory or compliance carbon markets established by governmental regulations or policies. Voluntary carbon markets are driven by the demand from businesses, individuals, or organizations that seek to voluntarily offset their GHG emissions or achieve other environmental or social goals.

VCC derivatives contracts are derivatives contracts, such as futures, with VCCs as underlying assets. VCC derivatives are typically used by market participants to hedge their risk exposure on underlying VCC positions and/or VCC projects. The CFTC has broad regulatory authority with respect to VCC derivatives contracts and the trading platforms that offer them, such as DCMs.

Overview of the Guidance

The Guidance identifies several key factors for DCMs to consider when addressing certain provisions of the Commodity Exchange Act (CEA), and CFTC regulations thereunder, relevant to the design and listing for trading of VCC derivative contracts. These include the items set out below, which address DCM Core Principle 3, requiring a DCM to list only derivative contracts that are not readily susceptible to manipulation, and DCM Core Principle 4, requiring a DCM to monitor a contract’s terms and conditions as they relate to the underlying commodity market.

While the Guidance focuses on the listing of physically settled VCC derivative contracts by DCMs, it is also relevant for the listing by DCMs of cash-settled VCC derivatives contracts and for consideration by CFTC-registered swap execution facilities (or SEFs) that may seek to permit trading in swap contracts that settle to the price of a VCC or in physically settled VCC swap contracts.⁸

• Quality Standards:

• Transparency: The contract terms and conditions should clearly identify what is deliverable under the contract. DCMs should consider whether there is transparency in the crediting program’s policies, procedures, and credited projects to support accurate pricing.

• Additionality: DCMs should consider whether the carbon crediting program evaluates additionality adequately. The Guidance does not define additionality but acknowledges variations in its characterization across voluntary carbon markets.

• Permanence and Risk of Reversal: DCMs should consider whether the carbon crediting program has a VCC “buffer reserve” or other mechanisms to address risk of reversal of a VCC.

• Robust Quantification: Quantification methodologies used by the carbon crediting program should be robust, conservative, and transparent to ensure that the number of VCCs issued accurately reflects the emission reductions or removals, supporting reliable deliverable supply estimates and effective speculative position limits.

• Delivery Points and Facilities: DCMs should consider the governance framework and tracking mechanisms of the crediting program for underlying VCCs to eliminate impediments for delivery of a VCC as well as measures to prevent double counting.

• Inspection Provisions — Third-Party Validation and Verification: Any inspection or certification procedures for physically settled VCC derivative contracts should be specified in the contract’s terms.

• Monitoring: DCMs should monitor the appropriateness of the contract’s terms and conditions is an ongoing basis, including monitoring to ensure that the underlying VCC conforms or, where appropriate, updates to reflect the latest certification standard(s) applicable for that VCC.

The Guidance reflects the CFTC’s recognition of the growing demand and potential for VCC derivative products as well as the challenges and opportunities for enhancing the standardization, integrity, and transparency of VCCs and VCC derivative markets. Although the Guidance is nonbinding, its explicit intent to promote transparency and liquidity in this evolving market underscores a larger, global effort to standardize VCCs and build confidence in both the market and the market’s underlying carbon reduction claims.