New CFTC Guidance Signals Need for Better Understanding of Voluntary Carbon Credits Underlying Derivative Contracts, Warning for Market Players

At a Glance

• This alert offers insights regarding the Commodity Futures Trading Commission’s (CFTC) newly finalized guidance about the listing of voluntary carbon credit (VCC) derivatives on CFTC regulated exchanges.
• This guidance is intended to ensure that CFTC regulated exchanges list only derivatives where the underlying VCCs meet certain standards.
• In conjunction with CFTC enforcement guidance regarding carbon markets issued in 2023, the final guidance shows that, despite limitations to its statutory authority, the CFTC is actively attempting to set standards for VCC markets.
• There are also important antitrust and additional consumer protection considerations intersecting with the subject matter underlying CFTC’s guidance — all of which warrant careful attention.

Introduction

Designated contract markets (DCMs) and participants in voluntary carbon markets would do well to evaluate new guidance from the Commodity Futures Trading Commission (CFTC) aimed at preventing manipulation of physically settled voluntary carbon credit (VCC) derivative contracts listed on DCMs. While this guidance does not establish new requirements for DCMs, it draws heavily from the Commodity Exchange Act’s (CEA) “Core Principles,” including Core Principle 3 (not listing derivative contracts “readily susceptible to manipulation”) and Core Principle 4 (market surveillance to prevent manipulation, price distortion and delivery/settlement disruption).

To reduce the risk of manipulation, increase transparency, and improve the quantity and quality of VCCs, the CFTC’s guidance focuses on the processes by which VCCs are issued because those processes correlate to VCC quality and the general function of the voluntary carbon markets and any DCMs offering physically settled VCC derivatives contracts. CFTC’s emphasis on quality VCCs also corresponds to the critical importance of VCCs accomplishing their marketed purpose (i.e., accurately reflecting the type and quantity of greenhouse gas (GHG) emission reductions or removals they are intended to represent). From CFTC’s perspective, appropriate requirements may help address challenges in the voluntary carbon markets that stem from various standards and methodologies producing inconsistent quantities and qualities of GHG emission reductions or removals that make up the VCC.

Considerations for Preventing Manipulation of VCC Derivative Contracts 

One of the first lines of defense for addressing manipulation of VCC derivative contracts includes the terms and conditions of the contract itself. The CFTC’s guidance notes that such terms and conditions should describe or define all of the “economically significant” characteristics or attributes of the commodity (in this case, VCC) underlying the contract. At a minimum, economically significant characteristics include: (i) quality standards that address things like transparency, additionality, permanence, risk of reversal and accurate (conservative) quantification of GHG emission reductions; (ii) delivery points and facilities, including governance, tracking and accurate accounting to ensure no double-counting; and (iii) inspection provisions to facilitate third-party validation and verification.

The CFTC’s acknowledgement of these items in its guidance signals the growing significance of incorporating key terms and conditions into VCC derivative contracts as a best practice. Crafting provisions to meet these standards is a nuanced exercise. Examples include, at a minimum, ensuring appropriate “reserve buffers” or insurance to help account for the reversal of underlying VCC, tailored delivery and tracking mechanisms, procedures and controls for assessing additionality, and incorporating provisions governing registry use, governance around decision-making, reporting, disclosure and risk management. Accomplishing these best practices is often complex, requiring coordination between sustainability professionals, GHG modeling experts and legal counsel.

Monitoring of Derivative Contract Terms and Conditions Relevant to Voluntary Carbon Markets

Keying in on Core Principle 4, which requires market surveillance as another tool to help prevent manipulation, price distortion and disruption of physical delivery, the CFTC’s guidance strongly suggests monitoring the terms and conditions of a physically settled VCC derivative contract. Such monitoring would include assessing the appropriateness of a contract’s terms and conditions and ensuring that the underlying VCC aligns with the most recent applicable certification standards (or needs to be updated accordingly). Changes to VCC crediting programs or the types of activities, including new standards or certifications, may warrant amending the VCC derivative contract’s terms and conditions. As a practical matter, accomplishing this type of market surveillance and monitoring means that a derivative contract needs to include provisions requiring monitoring of certification standards, and allowing amendments to be made to the derivative contract to reflect material changes in such standards.

Document Submission Requirements for Listing Derivative Contract

DCMs listing new derivative contracts are required to submit information regarding the contract’s terms and conditions (and amendments to existing derivative contracts). The CFTC’s new guidance emphasizes three document/information submission requirements for the listing of VCC derivative contracts, including: (i) explanation and analysis of the contract and the contract’s compliance with the CEA and its Core Principles; (ii) documentation or information relied upon to establish the basis for compliance with applicable law with citation to data sources; and (iii) if requested by the CFTC, additional evidence or information showing that the contract meets CEA/CFTC regulations and policies. In short, the CFTC expects that information, documentation and data submitted will be thorough. The implication is that gaps could increase risk of exposure (e.g., enforcement, litigation, etc.).

Compliance with Applicable Antitrust, Consumer Protection, and Enforcement Agency Laws, Rules and Regulations

A robust mix of state, federal and international antitrust, competition, and consumer protection laws, rules, regulations and related agency guidance, including, but not limited to, Section 5 of the Federal Trade Commission Act, 15 USC § 45, and the Federal Trade Commission’s 2012 Guides for the Use of Environmental Marketing Claims (Green Guides) also apply to derivative contracts and voluntary carbon market marketing materials. The Green Guides require sellers of voluntary carbon offsets to, for example, “employ competent and reliable scientific and accounting methods to properly quantify claimed emission reductions and to ensure that they do not sell the same reduction more than one time.” In addition, the Green Guides provide that it is “deceptive to misrepresent, directly or by implication, that a carbon offset represents emission reductions that have already occurred or will occur in the immediate future.”   

Moreover, any agreements or information exchanges between competitors (or potential competitors) must be assessed under applicable state, federal and international antitrust and competition laws. Defense of antitrust lawsuits and/or enforcement agency investigations is time consuming, expensive, potentially damaging to reputations and detracts firm personnel from mission-critical work. And private plaintiffs as well as enforcement agencies are using the antitrust laws to attack a variety of different sustainability initiatives. To avoid these outcomes, antitrust counsel should review marketing materials, contracts, standard communications and other related documents to minimize any risk that competing participants in voluntary carbon markets are, or could — directly or indirectly — exchange sensitive competitive information or be perceived as forming anticompetitive agreements with respect to their carbon market activity. 

Looking Around the Corner

The CFTC’s new guidance signals an increasing importance of the voluntary carbon markets, VCCs and the role that DCMs could play in further solidifying the voluntary carbon markets. This is consistent with current trends in the U.S. and globally requiring substantiation of climate-related products and environmental benefit claims. Entities “punting on substantiation” and/or lacking appropriate controls and procedures to ensure sufficient data gathering are facing increasing risk in the space ranging from government enforcement, class action litigation, reputational damage and/or less favorable access to capital.