2023-28532
[Federal Register Volume 88, Number 247 (Wednesday, December 27, 2023)]
[Notices]
[Pages 89410-89428]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-28532]
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COMMODITY FUTURES TRADING COMMISSION
RIN 3038-AF40
Commission Guidance Regarding the Listing of Voluntary Carbon
Credit Derivative Contracts; Request for Comment
AGENCY: Commodity Futures Trading Commission
ACTION: Proposed guidance; request for comment.
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SUMMARY: The Commodity Futures Trading Commission (the ``Commission''
or ``CFTC'') is issuing for public comment this proposed guidance
regarding the listing for trading of voluntary carbon credit (``VCC'')
derivative contracts. Specifically, the Commission is proposing to
issue guidance to outline factors that designated contract markets
(``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.
The Commission recognizes that VCC derivatives are a comparatively new
and evolving class of products, and believes that guidance that
outlines factors for a DCM to consider in connection with product
design and listing may help to advance the standardization of such
products in a manner that promotes transparency and liquidity. The
Commission requests comment on this proposed guidance and further
invites comment on specific questions related to the listing for
trading of VCC derivative contracts.
DATES: Comments must be received on or before February 16, 2024.
ADDRESSES: You may submit comments, identified by ``Commission Guidance
Regarding the Listing of Voluntary Carbon Credit Derivative Contracts''
and RIN 3038-AF40, by any of the following methods:
CFTC Comments Portal: https://comments.cftc.gov. Select
the ``Submit Comments'' link for this release and follow the
instructions on the Public Comment Form.
Mail: Send to Christopher Kirkpatrick, Secretary of the
Commission, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW, Washington, DC 20581.
Hand Delivery/Courier: Follow the same instructions as for
Mail, above.
Please submit your comments using only one of these methods.
Submissions through the CFTC Comments Portal are encouraged.
All comments must be submitted in English, or if not, accompanied
by an English translation. Comments will be posted as received to
https://comments.cftc.gov. You should submit only information that you
wish to make available publicly. If you wish the Commission to consider
information that you believe is exempt from disclosure under the
Freedom of Information Act (``FOIA''), a petition for confidential
treatment of the exempt information may be submitted according to the
procedures established in Sec. 145.9 of the Commission's
regulations.\1\
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\1\ 17 CFR 145.9.
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The Commission reserves the right, but shall have no obligation, to
review, pre-screen, filter, redact, refuse, or remove any or all of
your submission from https://www.comments.cftc.gov that it may deem to
be inappropriate for publication, such as obscene language. All
submissions that have been redacted or removed that contain comments on
the merits of the guidance will be retained in the public comment file
and will be considered as required under the Administrative Procedure
Act and other applicable laws, and may be accessible under FOIA.
FOR FURTHER INFORMATION CONTACT: Lillian A. Cardona, Assistant Chief
Counsel, (202) 418-5012, [email protected]; Steven Benton, Industry
Economist, (202) 418-5617, [email protected]; Nora Flood, Chief Counsel,
(202) 418-6059, [email protected]; Division of Market Oversight,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street NW, Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
I. Background
A. The Regulatory Framework for DCMs
The CFTC's mission is to promote the integrity, resilience, and
vibrancy of the U.S. derivatives markets through sound regulation.\2\
An independent agency of the U.S. federal government, the CFTC
exercises the authorities granted to it under the CEA to promote market
integrity, prevent price manipulation and other market disruptions,
protect customer funds, and avoid systemic risk, while fostering
responsible innovation and fair competition in the derivatives
markets.\3\
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\2\ CFTC Mission Statement, available at: https://www.cftc.gov/About/AboutTheCommission.
\3\ See CEA section 3(b), 7 U.S.C. 5(b).
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DCMs are CFTC-regulated exchanges that provide participants in the
derivatives markets with the ability to execute or trade derivative
contracts
[[Page 89411]]
with one another.\4\ In order to obtain and maintain designation with
the CFTC, DCMs must comply with statutory ``Core Principles'' that are
set forth in the CEA,\5\ as well as applicable CFTC rules and
regulations.\6\ The statutory Core Principles for DCMs reflect the
important role that these exchanges play in promoting the integrity of
derivatives markets. DCMs are self-regulatory organizations, and each
DCM has Core Principle obligations to, among other things, establish
and enforce rules for trading on the DCM; \7\ provide a competitive,
open and efficient market for trading; \8\ and monitor trading
activity.\9\ For example, DCM Core Principle 4 requires a DCM to have
the capacity and responsibility to prevent manipulation, price
distortion, and disruptions of the delivery or cash settlement process,
through market surveillance, compliance, and enforcement practices and
procedures.\10\ DCM Core Principle 5 requires a DCM to adopt for each
contract that it lists for trading, as is necessary and appropriate,
position limitations or position accountability for speculators, in
order to reduce the potential threat of market manipulation or
congestion, especially during trading in the delivery month.\11\ DCM
Core Principle 12 requires a DCM to establish and enforce rules to
protect markets and market participants from abusive practices, and to
promote fair and equitable trading on the DCM.\12\
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\4\ See CEA section 1a(6), 7 U.S.C. 1a(6). (The term ``board of
trade'' means any organized exchange or other trading facility); CEA
section 1a(51)(A), 7 U.S.C. 1a(51)(A) (The term ``trading facility''
means a person or group of persons that constitutes, maintains, or
provides a physical or electronic facility or system in which
multiple participants have the ability to execute or trade
agreements, contracts, or transactions--(i) by accepting bids or
offers made by other participants that are open to multiple
participants in the facility or system; or (ii) through the
interaction of multiple bids or multiple offers within a system with
a pre-determined non-discretionary automated trade matching or
execution algorithm); and CEA section 5(d)(1)(A), 7 U.S.C.
7(d)(1)(A) (To be designated, and maintain a designation, as a
contract market, a board of trade shall comply with--(i) any core
principle described in this subsection; and (ii) any requirement
that the Commission may impose by rule or regulation pursuant to CEA
section 8a(5)).
\5\ See, generally, CEA Section 5(d), 7 U.S.C. 7(d). There are
23 statutory Core Principles for DCMs.
\6\ CEA section 5(d)(1)(A), 7 U.S.C. 7(d)(1)(A).
\7\ DCM Core Principle 2 requires, among other things, that a
DCM establish, monitor, and enforce compliance with the rules of the
DCM, including access requirements, the terms and conditions of any
contracts to be traded on the DCM, and rules prohibiting abusive
trade practices on the DCM. DCM Core Principle 2 also requires a DCM
to have the capacity to detect, investigate, and apply appropriate
sanctions to any person that violates any rule of the DCM. CEA
section 5(d)(2), 7 U.S.C. 7(d)(2). See also 17 CFR 38.150-160. DCM
Core Principle 13 requires that a DCM establish and enforce
disciplinary procedures that authorize the DCM to discipline,
suspend, or expel members or market participants that violate the
DCM's rules. CEA section 5(d)(13), 7 U.S.C. 7(d)(13). See also 17
CFR 38.700-712.
\8\ DCM Core Principle 9 requires, among other things, that a
DCM provide a competitive, open, and efficient market and mechanism
for executing transactions that protects the price discovery process
of trading in the centralized market of the DCM. CEA section
5(d)(9), 7 U.S.C. 7(d)(9). See also 17 CFR 38.500.
\9\ See, e.g., DCM Core Principles 4, 5, and 12, discussed
infra.
\10\ CEA section 5(d)(4) 7 U.S.C. 7(d)(4). See also 17 CFR
38.250-258.
\11\ CEA section 5(d)(5), 7 U.S.C. 7(d)(5). See also 17 CFR
38.300-301.
\12\ CEA section 5(d)(12), 7 U.S.C. 7(d)(12). See also 17 CFR
38.650-651.
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Additionally, each DCM has a specific statutory obligation, under
DCM Core Principle 3, to only list for trading contracts that are not
readily susceptible to manipulation.\13\ As discussed in greater detail
below, a DCM may generally elect to list a new derivative contract for
trading either by certifying to the Commission that the contract
complies with the CEA and CFTC regulations,\14\ or by seeking
Commission approval of the contract.\15\ In either case, the DCM must
submit the contract's terms and conditions, and other prescribed
information relating to the contract, to the Commission prior to
listing.\16\
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\13\ CEA section 5(d)(3), 7 U.S.C. 7(d)(3). See also 17 CFR
38.200-201.
\14\ CEA section 5c(c)(1), 7 U.S.C. 7a-2(c)(1). See also 17 CFR
40.2.
\15\ CEA sections 5c(c)(4)-(5), 7 U.S.C. 7a-2(c)(4)-(5). See
also 17 CFR 40.3.
\16\ See, generally, 17 CFR 40.2 and 40.3. Amendments to
contract terms and conditions also must be submitted to the
Commission in accordance with procedures set forth at CEA section
5c(c), 7 U.S.C. 7a-2(c), and Part 40 of the Commission's
regulations.
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For a number of the statutory Core Principles for DCMs, the
Commission has adopted rules that establish the manner in which a DCM
must comply with the Core Principle.\17\ These implementing rules are
set forth in Part 38 of the Commission's regulations.\18\ The
Commission has also adopted, in Appendix B to Part 38,\19\ guidance and
acceptable practices for DCMs to take into consideration with respect
to certain of the Core Principles.\20\
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\17\ Unless otherwise determined by the Commission by rule or
regulation, a DCM has reasonable discretion in establishing the
manner in which it complies with a Core Principle. CEA section
5(d)(1)(B), 7 U.S.C. 7(d)(1)(B).
\18\ 17 CFR part 38.
\19\ 17 CFR part 38, Appendix B.
\20\ Guidance provides contextual information regarding a Core
Principle, including important concerns which the Commission
believes should be considered in complying with the Core Principle.
The guidance for a DCM Core Principle is illustrative only of the
types of matters that a DCM may address, and is not intended to be
used as a mandatory checklist. Acceptable practices are more
detailed examples of how a DCM may satisfy particular requirements
of a DCM Core Principle. Similar to guidance, acceptable practices
are for illustrative purposes only, and do not establish a mandatory
means of Core Principle compliance. 17 CFR part 38, Appendix B.
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With respect to the DCM Core Principle 3 requirement that a DCM
only list for trading contracts that are not readily susceptible to
manipulation, the Commission has adopted guidance that is set forth in
Appendix C to Part 38 of the Commission's regulations (the ``Appendix C
Guidance'').\21\ The Appendix C Guidance outlines certain relevant
considerations for a DCM when developing derivative contract terms and
conditions, and providing supporting documentation and data in
connection with the submission of the derivative contract to the
Commission.\22\ The Commission takes these considerations into account
when determining whether, with respect to the contract, the DCM is
satisfying its Core Principle obligation only to list contracts that
are not readily susceptible to manipulation.
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\21\ 17 CFR part 38, Appendix C. Guidance set forth in Appendix
B to Part 38 states that a DCM may use the Appendix C Guidance as
guidance in meeting DCM Core Principle 3 for both new product
listings and existing listed contracts. 17 CFR part 38, Appendix B,
Core Principle 3 Guidance.
\22\ See Core Principles and Other Requirements for Designated
Contract Markets, 77 FR 36612 at 36632 (June 19, 2012). The Appendix
C Guidance is also relevant to swap execution facilities (``SEFs''),
another category of CFTC-regulated exchange that provides eligible
contract participants with the ability to execute or trade, with one
another, derivative contracts that are swaps. Like DCMs, SEFs are
obligated by statute only to permit trading in contracts that are
not readily susceptible to manipulation. See CEA section 5h(f)(3), 7
U.S.C 7b-3(f)(3); 17 CFR 37.301.
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Among other things, the Appendix C Guidance outlines, for both
physically-settled and cash-settled derivative contracts, certain
considerations in connection with the design of the contract's rules
and terms and conditions.\23\ With respect to physically-settled
derivative contracts, the Appendix C Guidance states, among other
things, that the contract's terms and conditions should conform to the
most common commercial practices and conditions in the cash market for
the underlying commodity.\24\ The Appendix
[[Page 89412]]
C Guidance also states that the contract's terms and conditions should
be designed to avoid impediments to the delivery of the underlying
commodity, so as to promote convergence between the price of the
contract and the cash market value of the underlying commodity at the
expiration of trading in the contract.\25\ The Appendix C Guidance
outlines certain criteria that should be addressed in the contract's
terms and conditions, including contract size, the period for making
and taking delivery under the contract, delivery points, quality
standards for the underlying commodity, and inspection/certification
procedures for verifying compliance with those quality standards or any
other related delivery requirements under the contract.\26\
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\23\ Physically-settled derivative contracts are contracts that
may settle directly into the commodity underlying the contract. If
the holder of a position in a physically-settled derivative contract
still has an open position at the expiration of trading in the
contract, then the position holder must, in accordance with the
rules for delivery set forth in the contract, make or take delivery
(as applicable) of the underlying commodity. By contrast, cash-
settled derivative contracts are, at the expiration of trading in
the contract, settled by way of a cash payment instead of physical
delivery of the underlying commodity.
\24\ Appendix C Guidance, paragraph (b)(1).
\25\ Id.
\26\ Appendix C Guidance, paragraph (b)(2).
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The criteria outlined in the Appendix C Guidance that relate to the
quality and other attributes of the underlying commodity that would be
delivered under a physically-settled contract upon the expiration of
trading, inform the pricing of the contract. Addressing these criteria
clearly in the contract's terms and conditions, in a manner that
reflects the individual characteristics of the underlying commodity,
helps to ensure that trading in the contract is based on accurate
information about the underlying commodity. This, in turn, helps to
promote accurate pricing and helps to reduce the susceptibility of the
contract to manipulation. Further, when a contract's terms and
conditions help to ensure that, upon delivery, the quality and other
attributes of the underlying commodity will be as expected by position
holders, this helps to prevent price distortions and fosters confidence
in the contract that can incentivize trading and enhance liquidity.
With respect to cash-settled derivative contracts, the Appendix C
Guidance states that an acceptable specification of the cash settlement
price would, among other things, include rules that fully describe the
essential economic characteristics of the underlying commodity, as well
as how the final settlement price is calculated.\27\ The Appendix C
Guidance states that the utility of a cash-settled contract for risk
management and price discovery purposes would be significantly impaired
if the cash settlement price is not a reliable or robust indicator of
the value of the underlying commodity.\28\ The Appendix C Guidance
states that, accordingly, careful consideration should be given to the
potential for manipulation or distortion of the cash settlement price,
as well as the reliability of that price as an indicator of cash market
values.\29\ Appropriate consideration also should be given to the
commercial acceptability, public availability, and timeliness of the
price series that is used to calculate the cash settlement price.\30\
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\27\ Appendix C Guidance, paragraph (c)(1).
\28\ Appendix C Guidance, paragraph (c)(2).
\29\ Id.
\30\ Id.
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B. Voluntary Carbon Markets
1. Overview of Voluntary Carbon Markets
As discussed further below, this proposed guidance addresses an
emerging class of climate-related derivative contracts listed for
trading by DCMs, where the underlying commodity is a VCC.\31\
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\31\ This proposed guidance uses the term ``voluntary carbon
credits'' rather than ``verified carbon credits,'' as the proposed
guidance is focused on the quality and other attributes of the
intangible commodity underlying a derivative contract. The
Commission recognizes that market participants in the cash or
secondary market for voluntary carbon credits may choose to use a
set of standardized terms for the trading and retirement of
``verified carbon credits,'' as defined by the International Swaps
and Derivatives Association (``ISDA''), in the market participants'
physically-settled spot, forward or option transactions. See 2022
ISDA Verified Carbon Credit Transactions Definitions (``VCC
Definitions'') Frequently Asked Questions, available at: https://www.isda.org/a/jBXgE/2022-ISDA-Verified-Carbon-Credit-Transactions-Definitions-FAQs-061323.pdf.
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In addition to direct greenhouse gas (``GHG'') emissions reduction
initiatives, market-based mechanisms, such as carbon markets,\32\ have
developed to support emissions reduction efforts. A carbon market
generally refers to an economic mechanism to support the buying and
selling of environmental commodities \33\ that represent GHG emission
reductions or removals from the atmosphere. Carbon markets are intended
to harness market forces to incentivize carbon mitigation activities.
Carbon markets generally fall into two categories: (i) mandatory (or
compliance) markets, and (ii) voluntary carbon markets.
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\32\ While the term ``carbon'' is generally intended to also
include other greenhouse gases, such as methane, nitrous oxide,
sulfur hexafluoride, hydro fluorocarbons and perfluorocarbons, most
emissions trading involves emissions trading of carbon dioxide.
\33\ An agreement, contract or transaction in an environmental
commodity may qualify for the forward exclusion from the ``swap''
definition set forth in section 1a(47) of the CEA, 7 U.S.C. 1a(47),
if the agreement, contract or transaction is intended to be
physically settled. For further discussion of the Commission's
interpretation of whether agreements, contracts, or transactions in
environmental commodities fall within the forward exclusion from the
swap definition, see Further Definition of ``Swap,'' ``Security-
Based Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;
Security-Based Swap Agreement Recordkeeping; Final Rule, 77 FR 48208
(August 13, 2012).
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Mandatory markets, such as cap-and-trade programs, emissions
trading systems and allowance trading systems, are established and
regulated by national, regional, or international governmental
bodies.\34\ Entities subject to the requirements of a mandatory market
generally must demonstrate compliance by directly reducing their
emissions from their own operations or activities, or by purchasing
eligible compliance credits representing emission reductions or
removals achieved by others.
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\34\ See, for example, the United Nation's Clean Development
Mechanism (``CDM''), the California Compliance Offset Program, the
Regional Greenhouse Gas Initiative (``RGGI''), the Alberta Emission
Offset System (``AEOS''), and the EU Emissions Trading System
(``ETS'').
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Voluntary carbon markets are not established by any government
body. They enable market participants to purchase, on a voluntary
basis, carbon credits that upon retirement represent reductions or
removals of GHG emissions. A voluntary carbon credit, or ``VCC,'' is a
tradeable intangible instrument that is issued by a carbon crediting
program (``crediting program'').\35\ The general industry standard is
for a VCC to represent a GHG emissions reduction to, or removal from,
the atmosphere equivalent to one metric ton of carbon dioxide.\36\
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\35\ See, e.g., The Integrity Council for the Voluntary Carbon
Market Carbon Core Principles, Section 5 Definitions, available at:
https://icvcm.org/wp-content/uploads/2023/07/CCP-Section-5-R2-FINAL-26Jul23.pdf.
\36\ This is calculated as the difference in GHG emission
reductions or removals from a baseline scenario, to the emission
reductions or removals occurring under the carbon mitigation project
or activity, with any adjustments for leakage. See The Integrity
Council for the Voluntary Carbon Market Carbon Core Principles,
Section 5 Definitions, available at: https://icvcm.org/wp-content/uploads/2023/07/CCP-Section-5-R2-FINAL-26Jul23.pdf.
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A participant in the voluntary carbon markets may purchase a VCC,
representing an emissions reduction or removal by another party, to
supplement emissions reductions or removals achieved from the
participant's own operations or activities. Liquid and transparent
markets in high-integrity VCCs may serve as a tool to facilitate
emissions reduction efforts.\37\
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\37\ The Board of the International Organization of Securities
Commissions (``IOSCO'') published a Voluntary Carbon Markets
consultation for public comment. The IOSCO consultation paper sought
feedback on a potential approach that regulatory authorities and
market participants could take to foster sound and well-functioning
voluntary carbon market structure and, as a consequence, scale up
these markets to allow them to achieve their environmental
objectives. Voluntary Carbon Markets, Discussion Paper, CR/06/22,
November 2022, available at: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD718.pdf.
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[[Page 89413]]
The process by which VCCs are issued deserves careful
consideration, as that process informs VCC quality and, by extension,
the overall integrity and effective functioning of voluntary carbon
markets. Generally, parties that play a role in the issuance of a VCC
include: (1) the developer of a mitigation project or activity that is
intended to reduce or remove GHG emissions from the atmosphere
(``project developer''); (2) a crediting program that, among other
things, issues VCCs for mitigation projects or activities that satisfy
the crediting program's standards; \38\ and (3) an independent third
party that verifies and validates the mitigation project or activity.
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\38\ Currently, the four largest crediting programs in the
voluntary carbon markets are the American Carbon Registry, the
Climate Action Reserve, the Gold Standard and the Verified Carbon
Standard.
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A project developer must first select the crediting program with
which it seeks to certify its mitigation project or activity. The
crediting program will certify the project or activity if it satisfies
the crediting program's standards for issuing VCCs. A crediting program
generally engages an independent third party to review project or
activity documentation, including, among other things, to verify the
accuracy of the estimated amount of emission reductions or removals
that are expected to be associated with the project or activity, based
on the project's or activity's baseline scenario \39\ and the crediting
program's methodology or protocol for quantifying reduction or removal
levels. The estimated emission reductions or removals serve as the
basis for the determination of the number of VCCs to be issued for the
project or activity.
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\39\ A baseline scenario is the predicted or assumed outcome in
the absence of the incentives created by carbon credits, holding all
other factors constant.
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Once the crediting program determines that the mitigation project
or activity satisfies the crediting program's standards for issuing
VCCs, the project or activity will be certified. The crediting program
typically operates or makes use of a registry, which serves as a
central repository for tracking certified mitigation projects or
activities and their associated VCCs. Once registered, VCCs associated
with a mitigation project or activity may be bought and sold to end
users (businesses or individuals) or to intermediaries such as brokers
or aggregators that provide liquidity to voluntary carbon market
participants.\40\
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\40\ Funding by investors for a mitigation project or activity
could begin as early as the planning stage. Early investors may
enter into agreements with a project developer for funding in
exchange for discounted VCCs, once issued.
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2. Initiatives To Promote Transparency, Integrity and Standardization
in the Voluntary Carbon Markets
As the voluntary carbon markets have continued to develop and
mature, private sector and multilateral initiatives have sought to
address certain issues--relevant to both the supply side (generation of
VCCs from carbon mitigation projects or activities), and the demand
side (businesses or individuals purchasing VCCs)--impacting the speed
at which transparent, robustly traded markets for high-integrity VCCs
are scaled.
On the supply side, a key focus has been on the quality of VCCs,
particularly, whether they accurately reflect the nature and level of
GHG emission reductions or removals that they are intended to
represent. Given the current absence of a standardized methodology or
protocol to quantify emissions reduction or removal levels, there is a
possibility that methodologies or protocols of differing degrees of
robustness may calculate different reduction or removal impacts for two
projects that are identical in type and size (or even for the same
project). This could result in different amounts of carbon credits
being issued for each project, despite their actual reduction or
removal impact being the same. It may also create incentives for
project developers to seek to apply the quantification protocol or
methodology, or to seek to certify with the crediting program, that
would result in the issuance of the most credits. Among other things,
these possibilities create challenges for accurately pricing VCCs.
Further, it can be difficult to discern the extent to which the price
of any particular VCC reflects the price of one metric ton of carbon
dioxide equivalent reduced or removed from the atmosphere, and the
extent to which the price reflects understandings or concerns relating
to the mitigation project or activity for which the VCC was issued, or
other aspects of the process for issuing the VCC.\41\
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\41\ Factors that may affect the price of VCCs issued for any
particular mitigation project or activity may include the type of
the project or activity, the geographic location of the project or
activity, and the methodology or protocol used to measure the levels
of emissions reductions or removals associated with the project or
activity. Types of carbon mitigation projects or activities for
which VCCs are issued include renewable energy, industrial gas
capture, energy efficiency, forestry initiatives (avoiding
deforestation), regenerative agriculture, wind power, and biogas.
The location of a mitigation project or activity may, for example,
impact the cost of implementing and/or operating the project or
activity. Mitigation projects and activities for which VCCs are
issued are located in countries worldwide. See Berkeley Voluntary
Registry Offsets Database, available at: https://gspp.berkeley.edu/research-and-impact/centers/cepp/projects/berkeley-carbon-trading-project/offsets-database.
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Challenges with respect to accurately ascertaining VCC quality, and
associated pricing challenges,\42\ can erode confidence in voluntary
carbon markets. Furthermore, opaque or inadequate calculation
methodologies or protocols, which can obscure or mischaracterize the
carbon impact of a mitigation project or activity, can undermine both
the integrity and purpose of those markets.
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\42\ Observed trading of VCCs is not as readily transparent as
for other financial instruments. Spot markets for VCCs are still
largely bespoke, with buyers purchasing directly from project
developers or via intermediaries. Some exchanges for trading VCCs
have been established and are evolving. For example, the AirCarbon
Exchange (https://acx.net/acx-singapore/), located in Singapore;
Carbon Trade Exchange (https://ctxglobal.com/), located in the
United Kingdom; and Xpansiv CBL (https://xpansiv.com/cbl/), located
in the United States.
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On the demand side, concerns have been raised that, in connection
with meeting their carbon mitigation goals, businesses or individuals
may be utilizing low integrity VCCs which do not accurately reflect the
nature or level of GHG emission reductions or removals that are
associated with the mitigation projects or activities for which the
VCCs have been issued.\43\ This can raise questions not only about the
business's or individual's progress towards their goals, but also about
whether any claims related to those goals are misleading.\44\ Market
participants that are purchasing VCCs to help meet their mitigation
goals may be focused largely or primarily on price, and also may not
have ready access to all of the information that they need to make
informed evaluations, and comparisons, of VCC quality. All of this may
incentivize, intentionally or not, the purchase of lower quality VCCs.
This may be facilitated by the opaque pricing of VCCs, as described
above--and by the fact that, recently, supplies of VCCs are generally
considered to be high relative to demand.\45\
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\43\ See, e.g., Forbes, Carbon Neutral Claims Under
Investigation In Greenwashing Probe (June 16, 2023), available at:
https://www.forbes.com/sites/amynguyen/2023/06/16/carbon-neutral-claims-under-investigation-in-greenwashing-probe/?sh=2a6170466431.
\44\ Federal Trade Commission, Guides for the Use of
Environmental Marketing Claims, Regulatory Review Notice and Request
for Public Comment, 87 FR 77,766 (December 20, 2022) (Federal Trade
Commission request for public comment on updating its Green Guides
to include claims made regarding carbon offsets).
\45\ Transcript of Commission's Second Voluntary Carbon Markets
Convening (July 19, 2023), Kyle Harrison, stating, ``Because you
have an oversupply, you have a surplus of cheaper credits and
companies can go ahead and use those in many cases as a band-aid
solution, as opposed to de-carbonizing and reducing their gross
emissions,'' available at: https://www.cftc.gov/sites/default/files/2023/11/1700165549/SVCMC_transcript071923.pdf.
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[[Page 89414]]
Private sector and multilateral efforts have spearheaded the
development of various initiatives to address the above challenges, and
to promote transparency, integrity and standardization in the voluntary
carbon markets. To support and promote VCC quality, these private
sector and multilateral initiatives have focused on developing
standards for high-integrity VCCs.\46\ Among other things, these
standards are intended to help provide assurance that the VCCs that
have been issued for a carbon mitigation project or activity accurately
reflect the actual GHG emissions reduction or removal levels associated
with that project or activity. These standards also generally highlight
the importance of effective crediting program processes, procedures,
and governance arrangements, in ensuring that a crediting program is
issuing high integrity VCCs.
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\46\ See, e.g., The Integrity Council for the Voluntary Carbon
Market's Core Carbon Principles (July 2023), available at: https://icvcm.org/wp-content/uploads/2023/07/CCP-Book-R2-FINAL-26Jul23.pdf;
the International Civil Aviation Organization's Carbon Offsetting
and Reduction Scheme for International Aviation (``CORSIA'') (2023),
available at: https://www.icao.int/environmental-protection/CORSIA/Pages/default.aspx; the G7 Principles of High Integrity Carbon
Markets (2023), available at: https://www.meti.go.jp/information/g7hirosima/energy/pdf/Annex004.pdf.
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Standards that assist market participants in making informed
evaluations, and comparisons, of VCC quality may promote accurate
pricing and enhance confidence that the voluntary carbon markets can
serve as a tool to assist in emissions reduction efforts. Such
standards can thereby play a valuable role in supporting market
transparency and liquidity, and the scaling of high-integrity voluntary
carbon markets.
Such standards may also support initiatives being developed to
address concerns about the accuracy of claims made by purchasers of
VCCs regarding the role that VCCs play in the purchasers' progress
toward carbon mitigation goals.\47\ Such standards could serve as a
foundation or reference for criteria that purchasers of VCCs could
voluntarily adhere to, in order to demonstrate their commitment to
using high integrity VCCs to support their mitigation goals, and to
being transparent in their progress towards those goals.
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\47\ See, e.g., the World Wildlife Fund (WWF-US), Environmental
Defense Fund (EDF) and Oeko-Institut's Carbon Credit Quality
Initiative (https://carboncreditquality.org/); the Tropical Forest
Credit Integrity Guide for Companies: Differentiating Tropical
Forest Carbon Credit by Impact, Quality, and Scale (https://tfciguide.org/); and the Voluntary Carbon Markets Integrity
Initiative's Claims Code of Practice (https://vcmintegrity.org/vcmi-claims-code-of-practice/).
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C. The Commission and Voluntary Carbon Markets
1. Derivative Contracts on Environmental Commodities, Including VCCs
Derivative contracts on environmental commodities have been trading
on CFTC-regulated exchanges for decades. Derivative contracts on
mandatory emissions program instruments have been trading since 2005,
with GHG emissions-related instruments first listed in 2007.\48\ There
are currently over 150 derivative contracts on mandatory emissions
program instruments listed on DCMs.\49\ As of November 2023, eighteen
futures contracts on voluntary carbon market products have been
submitted by DCMs to the Commission for listing.\50\ Three of those
contracts currently have open interest.\51\
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\48\ The Chicago Climate Futures Exchange (``CCFE'') listed a
Sulfur Financial Instruments Current Vintage Delivery futures
contract in 2005. In 2006, the New York Mercantile Exchange
(``NYMEX'') listed a nitrogen oxide (``NOX'') Emissions
Allowance futures contract. In 2007, CCFE listed the first Carbon
Financial Instrument futures contract and other emission contracts.
In 2008, NYMEX listed the first RGGI futures contract. In 2011,
Green Exchange listed its European Union Allowance futures contract.
In 2012, NYMEX listed its California Carbon Allowance futures
contract. To date, there have been over 1,500 mandatory emissions-
related futures and options contracts listed for trading on various
DCMs. The vast majority of those contracts are no longer listed for
trading.
\49\ Examples of derivatives contracts on mandatory emissions
program instruments, such as renewable energy credits (``RECs'') and
renewable fuel standards (``RFS''), that currently have open
interest include: the ICE Futures U.S. (``ICE U.S.'') PJM Tri
Qualified Renewable Energy Certificate Class I futures contract; the
ICE U.S. Texas Compliance Renewable Energy Certificate from CRS
Listed Facilities Front Half Specific futures contract; the ICE U.S.
New Jersey Compliance Renewable Energy Certificate Class II futures
contract; the Chicago Mercantile Exchange (``CME'') Ethanol T2 FOB
Rotterdam Including Duty (Platts) futures contract; the ICE U.S.
Biofuel Outright--D4 RINS (OPIS) futures contract; the ICE U.S. RGGI
Vintage 2024 futures contract; and the ICE U.S. California Carbon
Allowance Current Auction futures contract.
\50\ For example, NYMEX lists the following physically-settled
futures contracts based on voluntary carbon market products: (1) CBL
Global Emissions Offset (GEO) futures contract; (2) CBL Nature-Based
Global Emissions Offset (N-GEO) futures contract; (3) CBL Core
Global Emissions Offset (C-GEO) futures contract; (4) CBL Nature-
Based Global Emissions Offset Trailing futures contract; and (5) CBL
Core Global Emissions Offset Trailing futures contract. Nodal
Exchange lists the following physically-settled futures and options
contracts based on voluntary carbon market products: (1) Verified
Emission Reduction--Nature-Based Vintage 2017 futures and options
contracts; (2) Verified Emission Reduction--Nature-Based Vintage
2018 futures and options contracts; (3) Verified Emission
Reduction--Nature-Based Vintage 2019 futures and options contracts;
(4) Verified Emission Reduction--Nature-Based Vintage 2020 futures
and options contracts; (5) Verified Emission Reduction--Nature-Based
Vintage 2021 futures and options contracts; (6) Verified Emission
Reduction--Nature-Based Vintage 2022 futures and options contracts;
(7) Verified Emission Reduction--Nature-Based Vintage 2023 futures
contract; (8) Verified Emission Reduction--Nature-Based Vintage 2024
futures contract; (9) Verified Emission Reduction--Nature-Based
Vintage 2025 futures contract; (10) Verified Emission Reduction--
Nature-Based futures and options contracts; (11) Carbon Removal
futures contract; (12) Verified Emission Reduction--CORSIA-Eligible
futures and options contracts; and 13) Global Emission Reduction
futures contract.
\51\ The NYMEX CBL Global Emissions Offset (GEO) futures
contract; the NYMEX CBL Nature-Based Global Emissions Offset (N-GEO)
futures contract; and the NYMEX CBL Core Global Emission Offset (C-
GEO) futures contract are currently the only listed futures contacts
with open interest and trading volume. Information is available at:
https://www.cmegroup.com/markets/energy/emissions/cbl-global-emissions-offset.volume.html.
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Derivative contracts on VCCs base their prices on the spot price of
VCCs. For example, NYMEX's CBL Global Environmental Offset futures
contracts, and Nodal Exchange's Verified Emission Reduction futures and
options contracts, are physically-settled contracts. If the holder of a
position in the contract still has an open position at the expiration
of trading in the contract, then the position holder must, in
accordance with the rules for delivery set forth in the contract, make
or take delivery (as applicable) of 1,000 VCCs that meet the contract's
rules for delivery eligibility.\52\
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\52\ The CME Group CBL contracts permit VCCs to be delivered
from the Verified Carbon Standard (``VCS'') Verra Registry, the
American Carbon Registry (``ACR''), and the Climate Action Reserve
(``CAR''). The Nodal contracts permit VCCs to be delivered from
VCS's Verra Registry and from the Gold Standard Impact Registry, as
well as from the American Carbon Registry for certain contracts.
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2. Initiatives Relating to Voluntary Carbon Markets
First Voluntary Carbon Markets Convening
In June 2022, Chairman Behnam held the first-ever Voluntary Carbon
Markets Convening to discuss issues related to the supply of and demand
for high quality carbon credits, including product standardization and
the data necessary to support the integrity of carbon credits' GHG
emissions removal and reduction claims.\53\ A further goal of this
convening was to gather information from a wide variety of
[[Page 89415]]
market participants in the voluntary carbon markets to better
understand the potential role of the official sector in these markets,
particularly in connection with the emergence of CFTC-regulated
derivatives referencing VCCs. The convening included participants from
carbon credit standard setting bodies, a crediting program, private
sector integrity initiatives, spot platforms, DCMs, intermediaries,
end-users, public interest groups, and others.
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\53\ For the official announcement of the convening and related
materials, See https://www.cftc.gov/PressRoom/Events/opaeventcftccarbonmarketconvene060222.
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Commission Request for Information
In June 2022, the Commission issued for public comment a Request
for Information (``RFI'') \54\ in order to better inform the Commission
on how, consistent with its statutory authority, to address climate-
related financial risk as pertinent to the derivatives markets and
underlying commodities markets.\55\
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\54\ Request for Information on Climate-Related Financial Risk,
87 FR 34856 (June 8, 2022).
\55\ In addition to soliciting feedback on all aspects of
climate-related financial risk as it may pertain to the derivatives
market, the RFI also specifically requested feedback on ten
categories of information: 1. Data, 2. Scenario Analysis and Stress
Testing, 3. Risk Management, 4. Disclosure, 5. Product Innovation,
6. Voluntary Carbon Markets, 7. Digital Assets, 8. Financially
Vulnerable Communities, 9. Public-Private Partnerships/Engagement,
and 10. Capacity Coordination. The RFI stated that the Commission
may use responsive information to inform potential future actions
including, but not limited to, the issuance of new or amended
guidance, interpretations, policy statements, or regulations, or
other potential Commission action.
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The responsive comments that the Commission received included
feedback on specific questions relating to product innovation and
voluntary carbon markets.\56\ Several commenters expressed support for
the Commission to take steps that could support transparency and
confidence in the voluntary carbon markets, particularly through
recognition or support of private sector and multilateral initiatives
to promote standardization and integrity.\57\ In connection with
product innovation, certain commenters expressed the view that the
Commission's current statutory framework and regulations are sufficient
to regulate voluntary carbon market derivatives products.\58\ While
there were comments expressing different views on the reach of the
Commissions' jurisdiction to regulate voluntary carbon markets,\59\
many commenters supported the Commission utilizing its spot market
anti-fraud and anti-manipulation authority in the voluntary carbon
market space.\60\
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\56\ Twenty-five commenters on the RFI responded to questions
regarding product innovation and 44 commenters on the RFI responded
to questions regarding the voluntary carbon markets.
\57\ International Swaps and Derivatives Association (``ISDA'')
at 6; American Petroleum Institute (``API'') at 4; Center for
American Progress at 10; Environmental Defense Fund at 12; Futures
Industry Association (``FIA'') at 9; Intercontinental Exchange, Inc.
(``ICE'') at 4.
\58\ CME Group at 10, FIA at 3; ISDA at 7.
\59\ Heritage Foundation at 7.
\60\ See, e.g., API at 3; ISDA at 6; Verra at 2. With respect to
the Commission's spot market anti-fraud, false-reporting, and anti-
manipulation authority, see, e.g., CEA section 6(c)(1), 7 U.S.C.
9(1), which prohibits any person from using or employing, or
attempting to use or employ, in connection with a contract for sale
of any commodity in interstate commerce, any manipulative or
deceptive device or contrivance, in contravention of rules and
regulations promulgated by the Commission; CEA section 9(a)(2), 7
U.S.C. 13(a)(2), which among other things makes it a felony for any
person to manipulate or attempt to manipulate the price of any
commodity in interstate commerce; and implementing Commission rules
at Part 180 of the CFTC's regulations, 17 CFR part 180. In June
2023, the CFTC's Whistleblower Office issued an alert notifying the
public on how to identify and report potential CEA violations
connected to fraud or manipulation in the carbon markets. See CFTC
Whistleblower Alert, available at: https://www.whistleblower.gov/sites/whistleblower/files/2023-06/06.20.23%20Carbon%20Markets%20WBO%20Alert.pdf. Also in June 2023,
the CFTC's Division of Enforcement announced the creation of an
Environmental Fraud Task Force to combat environmental fraud and
misconduct. Specifically, the Task Force's mission is to address
fraud and other misconduct in both the derivatives markets and the
relevant spot markets (e.g., voluntary carbon markets) and to
examine, among other things, fraud with respect to the purported
environmental benefits of purchased carbon credits. See CFTC Release
Number 8736-23 (``CFTC Division of Enforcement Creates Two New Task
Forces'') available at: https://www.cftc.gov/PressRoom/PressReleases/8736-23.
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Second Voluntary Carbon Markets Convening
In July 2023, Chairman Behnam held the Second Voluntary Carbon
Markets Convening. The purpose of this convening was to discuss recent
private sector initiatives for high quality carbon credits; current
trends and developments in the cash and derivatives markets for carbon
credits; public sector initiatives related to carbon markets; and
market participants' perspectives on how the CFTC can promote integrity
for high quality carbon credit derivatives.\61\
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\61\ For the official announcement of the convening and related
materials, see https://www.cftc.gov/PressRoom/Events/opaeventvoluntarycarbonmarkets071923.
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II. Guidance Regarding the Listing of VCC Derivative Contracts
The Commission is proposing guidance that outlines factors that
DCMs should consider when addressing certain requirements under the CEA
and CFTC regulations that are relevant to the listing for trading of
VCC derivative contracts. The Commission recognizes that VCC
derivatives are a comparatively new and evolving class of products,\62\
and believes that guidance that outlines factors for a DCM to consider
in connection with product design and listing may help to advance the
standardization of such products in a manner that promotes transparency
and liquidity.
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\62\ In 2022, ISDA published a whitepaper providing background
on the cash and derivatives markets for voluntary carbon credits.
See Voluntary Carbon Markets: Analysis of Regulatory Oversight in
the US. (2022), available at: https://www.isda.org/2022/06/02/voluntary-carbon-markets-analysis-of-regulatory-oversight-in-the-us/.
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This proposed guidance addresses certain Core Principle compliance
considerations, as well as certain requirements relating to the
submission of new contracts, and contract amendments, to the
Commission. This proposed guidance is not intended to modify or
supersede existing statutory or regulatory requirements, or existing
Commission guidance that addresses the listing of derivative products
by CFTC-regulated exchanges, including the Appendix C Guidance. Rather,
taking into account certain unique attributes of VCC derivatives and
voluntary carbon markets, this proposed guidance outlines particular
matters that a DCM should consider, to help ensure compliance with
existing requirements when listing a VCC derivative contract. Among
other things, this proposed guidance addresses how certain aspects of
the Appendix C Guidance should be understood to apply in the specific
context of VCC derivative contracts.
This proposed guidance focuses primarily on the listing by DCMs of
physically-settled VCC derivative contracts. In part, this focus
reflects the fact that all VCC derivative contracts that are currently
listed for trading on DCMs are physically-settled contracts. To date,
no DCM has listed for trading a cash-settled VCC derivative contract.
In addition, the Commission believes that at this juncture in the
evolution of VCC derivatives as a product class, it may be of
particular benefit to outline considerations for a DCM, when developing
contract terms and conditions, that can help to ensure that, upon
delivery, the quality and other attributes of the underlying VCC will
be as expected by position holders. This will support accurate pricing,
help reduce the susceptibility of the contract to manipulation, and
foster confidence in the contract that can enhance liquidity.
While this proposed guidance focuses primarily on physically-
settled VCC derivative contracts, the Commission continues to believe
that, with respect to cash-settled derivative contracts, an acceptable
specification of the cash
[[Page 89416]]
settlement price would include rules that fully describe the essential
economic characteristics of the underlying commodity.\63\ Accordingly,
the Commission preliminarily believes that discussions in this proposed
guidance of VCC commodity characteristics that a DCM should consider
when developing the terms and conditions of a physically-settled VCC
derivative contract, should also be considered for cash-settled
derivative contracts that settle to the price of a VCC, unless
otherwise noted.\64\
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\63\ Appendix C Guidance, paragraph (c)(1).
\64\ As noted herein, and for the avoidance of doubt, this
proposed guidance is not intended to modify or supersede the
Appendix C Guidance, which outlines considerations for both cash-
settled and physically-settled derivative contracts--including
considerations that are not touched on in this proposed guidance.
DCMs are reminded to consult and consider the Appendix C Guidance
when developing terms and conditions, and contract submissions to
the Commission, for all derivative product types--including VCC
derivative products.
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Further, while this proposed guidance focuses on the listing of VCC
derivative contracts by DCMs, the Commission preliminarily believes
that the proposed guidance also should be considered by any SEF that
may seek to permit trading in swap contracts that settle to the price
of a VCC, or in physically-settled VCC swap contracts.\65\
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\65\ As noted above, the Appendix C Guidance is also relevant to
SEFs, which, like DCMs, are obligated by statute only to permit
trading in contracts that are not readily susceptible to
manipulation. CEA section 5h(f)(3), 7 U.S.C.3 7b-3(f)(3). Like DCMs,
SEFs also are subject to a statutory obligation to monitor trading
in swaps to prevent manipulation, price distortion, and disruptions
of the delivery or cash settlement process through surveillance,
compliance, and disciplinary practices and procedures. CEA section
5h(f)(4) 7 U.S.C 7b-3(f)(4). See also 17 CFR 37.400-408.
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In developing this proposed guidance, the Commission has considered
those public comments on the RFI that addressed product innovation and
voluntary carbon markets. Taking into account those public comments,
the Commission believes that this proposed guidance furthers the
agency's mission and may help to advance the standardization of VCC
derivative contracts in a manner that fosters transparency and
liquidity, accurate pricing, and market integrity.\66\
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\66\ See also, e.g., International Emissions Trading Association
comment in response to the Second Voluntary Carbon Markets Convening
at 5-6 (stating that the CFTC is in a fortunate position to leverage
the evolving work of existing initiatives to support the drive for
quality and integrity in the voluntary carbon markets), and BP
America, Inc. comment in response to the Second Voluntary Carbon
Markets Convening at 3 (supporting guidance for CFTC regulated
exchanges.)
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The Commission recognizes that VCCs and voluntary carbon markets
are evolving and that it may therefore be appropriate for the
Commission to revisit this guidance or to issue additional guidance in
the future,\67\ as VCCs and voluntary carbon markets continue to
develop and mature.\68\
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\67\ For example, the Commission may in the future revisit this
guidance, or issue additional guidance, to further address the
listing of cash-settled VCC derivatives contracts, including index-
based contracts, or to further address the listing of VCC derivative
contracts by SEFs.
\68\ For the avoidance of doubt, this proposed guidance does not
address the regulatory treatment of any underlying VCC or associated
offset project or activity, including whether any such product,
project or activity may qualify as a swap or be eligible for the
forward contract exclusion under Commission's ``swaps'' definition.
See Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping; Final Rule, 77 FR 48208 (August 13, 2012).
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A. A DCM Shall Only List Derivative Contracts That Are Not Readily
Susceptible to Manipulation
As discussed above, DCM Core Principle 3 provides that a DCM shall
only list for trading derivative contracts that are not readily
susceptible to manipulation.\69\ With respect to DCM Core Principle 3,
the Appendix C Guidance outlines certain relevant considerations for a
DCM when developing contract terms and conditions and providing
supporting documentation and data in connection with the submission of
a contract to the Commission.\70\
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\69\ CEA section 5(d)(3), 7 U.S.C. 7(d)(3).
\70\ As noted above, the Appendix C Guidance is also relevant to
SEFs, which are similarly obligated by statute only to permit
trading in contracts that are not readily susceptible to
manipulation. CEA section 5h(f)(3); 7 U.S.C. 7b-3(f)(3).
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With respect to a physically-settled derivative contract, the
Appendix C Guidance states that the terms and conditions of the
contract ``should describe or define all of the economically
significant characteristics or attributes of the commodity underlying
the contract.'' \71\ Among other things, failure to specify the
economically significant attributes of the underlying commodity may
cause confusion among market participants, who may expect a commodity
of different quality, or with other features, to underlie the contract.
This may render the precise nature of the commodity that the contract
is pricing ambiguous, and make the contract susceptible to manipulation
or price distortion.
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\71\ Appendix C Guidance, paragraph (b)(2)(i)(A).
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The Appendix C Guidance states that, for any particular contract,
the specific attributes of the underlying commodity that should be
described or defined in the contract's terms and conditions ``depend
upon the individual characteristics of the commodity.'' \72\ Where the
underlying commodity is a VCC, the Commission recognizes that
standardization and accountability mechanisms for VCCs are currently
still developing. The Commission believes that the fact that
standardization and accountability mechanisms for VCCs are currently
still developing is, itself, an ``individual characteristic of the
commodity'' that should be taken into account by a DCM when designing a
VCC derivative contract and addressing the underlying commodity in the
contract's terms and conditions.
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\72\ Id.
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To that end, the Commission recognizes that, while standardization
and accountability mechanisms for VCCs are currently still being
developed, there are certain characteristics that have been identified
broadly--across both mandatory and voluntary carbon markets--as helping
to inform the integrity of carbon credits. The Commission preliminarily
believes that a DCM should take these characteristics--referred to in
this proposed guidance as ``VCC commodity characteristics,'' and
discussed more fully below--into consideration when designing a VCC
derivative contract, and addressing in the contract's terms and
conditions the underlying VCC. The Commission believes that
consideration of these VCC commodity characteristics will help the DCM
to ensure that it understands, and is clearly specifying in the
contract's terms and conditions, the economically significant
attributes of the underlying VCC.
As a general matter, the Commission believes that a DCM should
consider the VCC commodity characteristics when selecting one or more
crediting programs from which eligible VCCs, meeting the derivative
contract's specifications, may be delivered at the contract's
expiration. The Commission believes that this will help the DCM
evaluate whether the crediting program is a reliable source of high
integrity VCCs.
More specifically, the Commission preliminarily believes that, at a
minimum, a DCM should consider the VCC commodity characteristics when
addressing the following criteria in the design of a VCC derivative
contract:
Quality standards,
Delivery points and facilities, and
Inspection provisions.
These are among the criteria identified in the Appendix C Guidance
as criteria that should be addressed in the terms and conditions of a
physically-delivered derivative contract.
[[Page 89417]]
As discussed above, addressing these criteria clearly in the contract's
terms and conditions helps to ensure that trading in the contract is
based on accurate information about the underlying commodity. This, in
turn, helps to promote accurate pricing and helps to reduce the
susceptibility of the contract to manipulation.
1. Quality Standards
The Commission preliminarily believes that a DCM should consider
the following VCC commodity characteristics when addressing quality
standards in the development of the terms and conditions of a VCC
derivative contract: (i) transparency, (ii) additionality, (iii)
permanence and risk of reversal, and (iv) robust quantification.\73\
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\73\ As is the case for physically-settled VCC derivative
contracts, for cash-settled derivative contracts that settle to the
price of a VCC, it is important to clearly specify the VCC quality
standards in the contract's terms and conditions to help ensure that
the pricing of the contract reflects the quality of the VCC
underlying the contract.
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a. Transparency--Publicly Available Data to Promote Transparency
As a threshold matter, the Commission believes that a DCM should
provide, in the terms and conditions of a VCC derivative contract,
information about the VCCs that are eligible for delivery under the
contract. The contract terms and conditions should include information
that readily specifies the crediting program or programs--and, as
applicable, the specific types of projects or activities--from which
VCCs that are eligible for delivery under the contract may be issued.
Specifying which crediting programs, and as applicable, which types of
projects or activities, are eligible for purposes of delivery will help
to provide clarity to market participants regarding the VCCs that can
be expected to deliver under the contract, and will thereby help to
ensure that the pricing of the contract accurately reflects the
intended quality of the underlying VCCs. Where there is ambiguity or
confusion about the quality of the VCCs that may be delivered under the
contract, this may render the contract susceptible to manipulation or
price distortion.
The Commission preliminarily believes that, in developing the terms
and conditions of a VCC derivative contract, DCMs should also consider
whether the crediting program for the underlying VCCs is making
detailed information about the crediting program's policies and
procedures and the projects or activities that it credits, such as
relevant project documentation, publicly available in a searchable and
comparable manner. Making such information publicly available would
assist market participants in understanding how GHG emission reductions
or removals are calculated by the crediting program--including how
additionality, which is discussed further below, is assessed--and how
GHG emission reductions or removals are quantified. This would assist
market participants in making informed evaluations, and comparisons, of
the quality of the VCCs that underlie derivative contracts, which would
help to support accurate pricing. Accordingly, information regarding
the crediting program's policies and procedures for making program
information publicly available may constitute an economically
significant attribute of the underlying VCC that should be described or
defined in the terms and conditions of the VCC derivative contract.
b. Additionality--The Underlying VCC Represents GHG Emission Reductions
or Removals That Would Not Have Been Developed and Implemented in the
Absence of the Added Monetary Incentive Created by the Revenue From the
Sale of Carbon Credits
The Commission preliminarily believes that, in developing the terms
and conditions of a VCC derivative contract, a DCM should consider
whether the underlying VCCs represent GHG emission reductions or
removals that are ``additional''--in other words, whether the VCCs are
credited only for projects or activities that result in GHG emission
reductions or removals that would not have been developed and
implemented in the absence of the added monetary incentive created by
the revenue from the sale of carbon credits.\74\ Additionality is
viewed by many as a necessary element of a high quality VCC: if a VCC
does not represent emission reductions or removals that would not have
occurred in the absence of the added monetary incentive created by the
revenue from the sale of carbon credits, then the VCC will not serve a
market participant's goals of contributing to emissions mitigation.
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\74\ For example, a project or activity may not be considered to
be ``additional'' if the project or activity is already required by
law, regulation, or any other legally binding mandate applicable in
the project's or activity's jurisdiction.
---------------------------------------------------------------------------
Accordingly, as part of its contract design market research, a DCM
should consider whether a crediting program can demonstrate that it has
procedures in place to assess or test for additionality. A DCM should
consider whether those procedures are sufficiently rigorous and
reliable to provide a reasonable assurance that GHG emission reductions
or removals are credited only if they are additional. If holders of
positions in a VCC derivative contract understand and intend for VCCs
that are eligible for delivery under the contract to be additional, but
in fact they may not be, then the pricing of the contract may not
accurately reflect the quality of the VCCs that may be delivered under
the contract: the cheapest-to-deliver VCC,\75\ that otherwise meets the
contract's specifications, may not have additionality.
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\75\ The term ``cheapest-to-deliver'' refers to the least
expensive commodity that can be delivered under the derivative
contract that otherwise meets the contract's specifications.
---------------------------------------------------------------------------
Given that additionality is viewed by many as a necessary element
of a high quality VCC, information regarding a crediting program's
procedures for assessing or testing for additionality may constitute an
economically significant attribute of the underlying VCCs, which should
be described or defined in the terms and conditions of a VCC derivative
contract.
c. Permanence and Accounting for the Risk of Reversal
The Commission preliminarily believes that, in developing the terms
and conditions of a VCC derivative contract, a DCM should consider
whether the crediting program for the underlying VCCs can demonstrate
that it has measures in place to address and account for the risk of
reversal (i.e., the risk that VCCs issued for a project or activity may
have to be recalled or cancelled due to carbon removed by the project
or activity being released back into the atmosphere, or due to a
reevaluation of the amount of carbon reduced or removed from the
atmosphere by the project or activity). Understanding and evaluating
the measures that a crediting program has in place to address and
account for the risk of reversal may be particularly important where
the underlying VCCs are issued for project or activity types with a
higher reversal risk.
The risk of reversal may impact the risk management needs of VCC
derivative market participants. Market participants that are utilizing
physically-settled VCC derivative contracts to help meet their carbon
mitigation goals have an interest in ensuring that, upon physical
settlement, the underlying VCCs will actually reduce or remove the
amount of emissions that they were intended to
[[Page 89418]]
reduce or remove. Accordingly, the risk of reversal--and the manner in
which it is accounted for by a crediting program--is tied to the
quality of the underlying VCCs and, by extension, to the pricing of the
derivative contract. As a result, information regarding a crediting
program's measures for estimating, monitoring, and addressing the risk
of reversal may constitute an economically significant attribute of the
underlying VCCs that should be described or defined in the terms and
conditions of a VCC derivative contract.
As part of its contract design market research, the Commission
preliminarily believes that a DCM 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 contemplated
specifications of the contract. Most crediting programs have
established VCC ``buffer reserves'' to address the risk of credited GHG
emission reductions or removals being reversed. Under this approach,
VCCs are set aside into a common buffer reserve (or ``pool''). Reserved
VCCs can be drawn upon to compensate for reversals associated with a
project or activity. If a reversal occurs, VCCs are drawn upon from the
buffer reserve to replace VCCs that are canceled, proportional to the
size of the reversal.
A DCM should consider whether a crediting program has a buffer
reserve or other measures in place that provide reasonable assurance
that, in the event of a reversal, the VCCs intended to underlie the
derivative contract would be replaced by VCCs of comparable high
quality that meets the contemplated specifications of the contract. The
DCM could also consider whether the crediting program regularly reviews
the methodology by which the size of its buffer pool is calculated in
order to address evolving climate risks that may heighten the risk of
reversal, and whether there is a mechanism in place to audit the
continuing sufficiency of the buffer pool.
d. Robust Quantification--GHG Emission Reductions or Removals Should be
Conservatively Quantified
The Commission preliminarily believes that, as part of its contract
design market research, a DCM should consider the methodology or
protocol used by a crediting program to calculate the level of GHG
emission reductions or removals associated with credited projects or
activities. Given the current absence of a standardized methodology or
protocol to quantify GHG emission reduction or removal levels \76\--not
only across crediting programs, but even by a particular crediting
program, with respect to different types of projects or activities--the
Commission believes that a DCM that lists a VCC derivative contract
should consider whether the crediting program for the underlying VCCs
can demonstrate that the quantification methodology or protocol that it
uses to calculate emission reductions or removals for the 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. Accordingly, information about
the quantification methodology or protocol used by the crediting
program to calculate GHG emission reductions or removals for projects
or activities associated with the underlying VCCs may constitute an
economically significant attribute of the underlying VCCs that should
be described or defined in the terms and conditions of a VCC derivative
contract.
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\76\ Related specifically to the agriculture and forest sector,
the U.S. Department of Agriculture's Office of the Chief Economist
has published a Request for Information on the Federal Strategy to
Advance Measurement and Monitoring Greenhouse Gas Measurement and
Monitoring for the Agriculture and Forest Sectors. This Request for
Information was issued on behalf of the Administration's Greenhouse
Gas Monitoring and Measurement Interagency Working Group (``GHG
IWG''). See, 88 FR 44251 (July 12, 2023).
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For the derivative contracts that they list, DCMs are required to
adopt, as is necessary and appropriate, exchange-set position limits
for speculators.\77\ To establish exchange-set position limits, a DCM
should derive a quantitative estimate of the deliverable supplies of
the underlying commodity for the delivery period specified in the
contract.\78\ A DCM's estimate of a VCC's deliverable supplies is
likely to be informed by understanding how the relevant crediting
program determines the amount of VCCs that are issued for credited
projects or activities. Where the quantification methodology or
protocol used to calculate the amount of VCCs is robust, conservative,
and transparent, the DCM should have a more reliable basis from which
to form its deliverable supply estimate. That deliverable supply
estimate, in turn, can be used as the basis for effectively setting the
DCM's exchange-set speculative position limits to help reduce the
possibility of corners or squeezes that may distort or manipulate the
price of the derivative contract.\79\
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\77\ CEA section 5(d)(5), 7 U.S.C. 7(d)(5). See also 17 CFR
38.300-301.
\78\ Guidance on estimating deliverable supply can be found in
the Appendix C Guidance.
\79\ For a cash-settled VCC derivative contract, a DCM may
similarly consider the deliverable supply of the underlying VCCs
when setting exchange-set speculative position limits or historical
open interest when establishing non-spot month position
accountability levels. See, 17 CFR 150.5 and Appendix F to Part 150,
Title 17.
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2. Delivery Points and Facilities
The Appendix C Guidance states that the delivery procedures for a
physically-settled derivative contract should, among other things, seek
to minimize or eliminate any impediments to making or taking delivery
by both deliverers and takers of delivery, to help ensure convergence
of cash and derivative contract prices at the expiration of the
derivative contract.\80\ When addressing delivery procedures for a
physically-settled VCC derivative contract, the Commission
preliminarily believes that a DCM should consider the governance
framework and tracking mechanisms of the crediting program for the
underlying VCCs, as well as the crediting program's measures to prevent
double-counting.\81\
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\80\ Appendix C Guidance, paragraph (b)(2)(i)(B).
\81\ While cash-settled VCC derivative contracts do not result
in the delivery of a VCC, the Commission preliminarily believes that
considering the VCC commodity characteristics of governance,
tracking and no double-counting when developing the terms and
conditions of a cash-settled VCC derivative contract will help to
ensure that the contract terms and conditions address essential
economic characteristics of the underlying VCC in a manner that
promotes accurate pricing and helps to reduce the susceptibility of
the contract to manipulation.
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a. Governance
The Commission preliminarily believes that a DCM should consider
whether the crediting program for the underlying VCCs can demonstrate
that it has a governance framework that effectively supports the
crediting program's independence, transparency and accountability. As a
threshold matter, a governance framework that effectively supports
transparency and accountability helps to ensure the overall quality of
the VCCs issued by a crediting program. Furthermore, it is the
Commission's understanding that a crediting program's registry may be
used as a delivery point to facilitate physical settlement for a VCC
derivative contract. As discussed above, a registry is a repository for
tracking mitigation projects or activities and associated VCCs. An
effective crediting program governance framework can help to ensure
that the crediting program operates or makes use of a registry that has
appropriate measures in place to
[[Page 89419]]
facilitate the physical settlement of a VCC derivative contract.
In reviewing a crediting program's governance framework, the
Commission preliminarily believes that a DCM should consider, among
other things, the program's decision-making procedures, including who
is responsible for administration of the program and how the
independence of key functions is ensured; reporting and disclosure
procedures; public and stakeholder engagement processes; and risk
management policies, such as financial resources/reserves, cyber-
security, and anti-money laundering policies. The DCM also should
consider whether information regarding these procedures and policies is
made publicly available.
Given the importance of a crediting program's governance framework
in ensuring the overall quality of the VCCs issued by the program, as
well as the potential importance of a crediting program's registry in
facilitating delivery, it may be appropriate for the DCM to include
information about the crediting program's governance framework in the
terms and conditions of a physically-settled VCC derivative contract.
b. Tracking
The Commission preliminarily believes that a DCM should consider
whether the crediting program for the underlying VCCs can demonstrate
that it has processes and procedures in place to help ensure clarity
and certainty with respect to the issuance, transfer, and retirement of
VCCs. The DCM should consider whether the crediting program operates or
makes use of a registry that has measures in place to effectively track
the issuance, transfer, and retirement of VCCs; to identify who owns or
retires a VCC; and to make sure that each VCC is uniquely and securely
identified and associated with a single emission reduction or removal
of one metric ton of carbon dioxide equivalent. In circumstances where
the registry will serve as the delivery point for a physically-settled
VCC derivative contract, it may be appropriate for the DCM to include
as a condition of the contract that the registry have such measures to
address tracking in place, as well as effective measures to address
double-counting, as discussed below.
c. No Double Counting
The Commission preliminarily believes that a DCM should consider
whether the crediting program for the underlying VCCs can demonstrate
that it has effective measures in place that provide reasonable
assurance that credited emission reductions or removals are not double
counted. That is, that the VCCs representing the credited emission
reductions or removals are issued to only one registry and cannot be
used after retirement or cancelation. As discussed above in connection
with the VCC commodity characteristics of additionality and permanence,
market participants that are utilizing physically-settled VCC
derivative contracts to help meet carbon mitigation goals have an
interest in ensuring that, upon physical settlement, the underlying
VCCs will actually reduce or remove the emissions that they were
intended to reduce or remove. In order for VCCs to effectively further
carbon mitigation goals, it is important for each credited VCC to be
uniquely associated with a single emission reduction or removal of one
metric ton of carbon dioxide equivalent--and a crediting program should
have effective measures in place that provide reasonable assurance of
this. If there is not a reasonable assurance that the VCCs underlying a
derivative contract are each unique, then, among other things, this
could distort or obscure the accuracy of the derivative contract's
pricing.
In the context of evolving national and international carbon
markets and emissions trading frameworks, effective measures to ensure
that emission reductions or removals are not double counted may
include, among other things, procedures for conducting cross-checks
across multiple carbon credit registries.
3. Inspection Provisions--Third-Party Validation and Verification
Consistent with the Appendix C Guidance, the Commission believes
that any inspection or certification procedures for verifying
compliance with quality requirements or any other related delivery
requirements for physically-settled VCC derivatives contracts should be
specified in the contract's terms and conditions.\82\ The Commission
believes that these inspection or certification procedures should be
consistent with the latest procedures in the voluntary carbon markets.
To that end, the Commission preliminarily believes that the DCM should
consider, among other things, how the crediting program for the
underlying VCCs requires validation and verification that credited
mitigation projects or activities meet the crediting program's rules
and standards.
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\82\ Appendix C Guidance, paragraph (b)(2)(i)(G) (To the extent
that formal inspection procedures are not used in the cash market,
an acceptable specification would contain provisions that assure
accuracy in assessing the commodity, that are available at a low
cost, that do not pose an obstacle to delivery on the contract and
that are performed by reputable, disinterested third-party or by
qualified designated contract market employees.).
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The Commission preliminarily believes that, when designing a VCC
derivative contract, a DCM should consider whether the crediting
program has up-to-date, robust and transparent validation and
verification procedures, including whether those procedures contemplate
validation and verification by a reputable, disinterested party or
body. By providing independent confirmation that mitigation projects or
activities are achieving the claimed GHG emission reductions or
removals, third-party validation and verification can help to ensure
that the underlying VCC accurately reflects the quality intended by the
DCM and supports voluntary carbon market integrity.\83\
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\83\ Id.
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A DCM should consider whether the crediting program is employing
best practices with respect to third-party validation and verification,
which may include conducting reviews of the performance of validators,
procedures for remediating performance issues, not using the same third
party validator to verify every project type or project category, and
using a separate third party to conduct ongoing validation and
verification from the third party that completed the initial validation
and verification process.
B. A DCM Shall Monitor a Derivative Contract's Terms and Conditions as
They Relate to the Underlying Commodity Market
DCM Core Principle 4 requires a DCM to prevent manipulation, price
distortion, and disruptions of the physical delivery or cash-settlement
process through market surveillance, compliance, and enforcement
practices and procedures.\84\ For physically-settled derivative
contracts, the Commission has recognized DCM Core Principle 4 to
include, among other things, an obligation to monitor the contract's
terms and conditions as they relate the underlying commodity market,
and to the convergence between the contract price and the price of the
underlying commodity, and to monitor the supply of the underlying
commodity in light of the contract's delivery requirements.\85\ Such
monitoring will help a DCM identify circumstances that may cause the
contract to become susceptible to price manipulation or distortions,
and
[[Page 89420]]
to assess whether the terms and conditions of the contract continue to
be appropriate--or whether a change in circumstances should be
addressed, for example, through changes to the contract's terms and
conditions.\86\
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\84\ CEA Section 5(d)(4), 7 U.S.C. 7(d)(4). See also 17 CFR
38.250-258.
\85\ 17 CFR 38.252.
\86\ The Commission has, similarly, recognized that a DCM has a
responsibility to monitor the continued appropriateness of the terms
and conditions of a cash-settled derivative contract. See, e.g., 17
CFR 38.253(a)(2).
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Given that VCC derivatives are a comparatively new and evolving
class of products, and given that standardization and accountability
mechanisms for VCCs are still being developed, the Commission
preliminarily believes that the monitoring by a DCM of the terms and
conditions of a physically-settled VCC derivative contract should
include continual monitoring of the appropriateness of the contract's
terms and conditions that includes, among other things, monitoring to
ensure that the delivery instrument--that is, the underlying VCC--
conforms or, where appropriate, updates to reflect the latest
certification standard(s) applicable for that VCC. For example, where
there are changes to either the crediting program or the types of
projects or activities associated with the underlying VCC, due for
example to new standards or certifications, then the DCM should amend
the contract's terms and conditions to reflect this update. In such
circumstances, the DCM should also ensure that it is monitoring the
adequacy of the estimated deliverable supply of the underlying VCC to
satisfy the contract's delivery requirements.
Finally, the Commission reminds market participants that Commission
regulations implementing DCM Core Principle 4 require DCMs to have
rules requiring their market participants to keep records of their
trading that include records of their activity in the underlying
commodity and related derivatives markets.\87\ A DCM's rules also must
require market participants to make such records available upon request
to the DCM.\88\ As such, DCM market participants are required, upon
request, to make records of their trading in underlying VCC cash
markets available to the DCM, in order to assist the DCM in fulfilling
its market monitoring obligations. These records also are subject to
Commission inspection under applicable Commission recordkeeping rules.
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\87\ 17 CFR 38.254(a).
\88\ Id.
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C. A DCM Must Satisfy the Product Submission Requirements Under Part 40
of the CFTC's Regulations and CEA Section 5c(c)
There are generally two processes by which a DCM may list a new
derivative contract for trading.\89\ The DCM may elect to list the
contract for trading by providing the Commission with a written
certification--a ``self-certification''--that the contract complies
with the CEA, including the CFTC's regulations thereunder.\90\
Alternatively, the DCM may elect voluntarily to seek prior Commission
approval of the contract.\91\ In each case, the DCM must submit
prescribed information to the Commission, including but not limited to
the contract's terms and conditions.\92\ Amendments to an existing
derivative contract also must be submitted to the Commission, along
with prescribed information, either by way of self-certification or for
prior Commission approval.\93\
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\89\ SEFs also may generally list new contracts by way of either
of these two processes. See, generally, CEA section 5c(c), 7 U.S.C.
7a-2(c).
\90\ CEA section 5c(c)(1), 7 U.S.C. 7a-2(c)(1). See also 17 CFR
40.2 The Commission must receive the DCM's self-certified submission
at least one business day before the contract's listing. 17 CFR
40.2(a)(2).
\91\ CEA sections 5c(c)(4)-(5), 7 U.S.C. 7a-2(c)(4)-(5). See
also 17 CFR 40.3.
\92\ 17 CFR 40.2-40.3.
\93\ 17 CFR 40.5-40.6.
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This proposed guidance highlights three submission requirements in
connection with the listing of VCC derivative contracts. These
requirements apply regardless of whether a DCM elects to list the
contract by way of self-certification, or with prior Commission
approval. These requirements generally apply with respect to the
listing by a DCM of a derivative contract, regardless of the underlying
asset class. However, the Commission wishes to remind DCMs of the
importance of fully complying with these requirements in a submission
for a VCC derivative contract.
The relevant requirements provide, first, that a contract
submission to the Commission must include an explanation and analysis
of the contract and its compliance with applicable provisions of the
CEA, including core principles and the Commission's regulations
thereunder.\94\ Second, the relevant requirements provide that the
explanation and analysis of the contract either be accompanied by the
documentation relied upon to establish the basis for compliance with
applicable law, or incorporate information contained in such
documentation, with appropriate citations to data sources.\95\ Third,
the relevant requirements provide that, if requested by Commission
staff, a DCM must provide any additional evidence, information or data
that demonstrates that the contract meets, initially or on a continuing
basis, the requirements of the CEA or the Commission's regulations or
policies thereunder.\96\
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\94\ 17 CFR 40.2(a)(3)(v) (for self-certification) and
40.3(a)(4) (for Commission approval). The ``explanation and
analysis'' requirement for self-certified contracts provides for
such explanation and analysis to be ``concise.'' The ``explanation
and analysis'' requirement for contracts submitted for prior
Commission approval does not include the ``concise'' qualifier. The
Commission requires DCMs to provide a more detailed explanation and
analysis of contracts that are submitted for affirmative Commission
approval.
\95\ 17 CFR 40.2(a)(3)(v) (for self-certification) and
40.3(a)(4) (for Commission approval).
\96\ 17 CFR 40.2(b) (for self-certification) and 40.3(a)(10)
(for Commission approval).
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Since VCC derivatives are a comparatively new and evolving class of
products, and since standardization and accountability mechanisms for
VCCs are still being developed, the Commission anticipates that in
connection with the submission for a VCC derivative contract, a DCM may
provide qualitative explanations and analysis to assist in addressing
the three above-described requirements. The Commission expects that the
information--including supporting documentation, evidence and data--
provided by the DCM to describe how the contract mcomplies with the CEA
and applicable Commission regulations, will be complete and thorough.
Given unique and developing aspects of VCCs and VCC derivative markets,
including complete and thorough information in a submission for a VCC
derivative contract will assist the Commission and its staff in their
understanding of the contract and their analysis of the contact's
compliance with applicable statutory and regulatory requirements,
including whether or not the contract is readily susceptible to
manipulation.
III. Request for Comment
The Commission requests comment from the public on all aspects of
the Commission's proposed guidance regarding the listing of VCC
derivative contracts, and further invites comments on specific
questions related to the listing of such contracts. The Commission
encourages all comments including background information, actual market
examples, and best practice principles. Specifically, the Commission
requests comment on the following questions:
[[Page 89421]]
General
1. In addition to the VCC commodity characteristics identified in this
proposed guidance, are there other characteristics informing the
integrity of carbon credits that are relevant to the listing of VCC
derivative contracts? Are there VCC commodity characteristics
identified in this proposed guidance that are not relevant to the
listing of VCC derivative contracts, and if so, why not?
2. Are there standards for VCCs recognized by private sector or
multilateral initiatives that a DCM should incorporate into the terms
and conditions of a VCC derivative contract, to ensure the underlying
VCCs meet or exceed certain attributes expected for a high-integrity
carbon credit?
3. In addition to the criteria and factors discussed in this
proposed guidance, are there particular criteria or factors that a DCM
should consider in connection with monitoring the continual
appropriateness of the terms and conditions of a VCC derivative
contract?
4. In addition to the criteria and factors discussed in this
proposed guidance, are there particular criteria or factors that a DCM
should consider, which may inform its analysis of whether or not a VCC
derivative contract would be readily susceptible to manipulation?
5. Should the VCC commodity characteristics that are identified in
this proposed guidance as being relevant to the listing by a DCM of VCC
derivative contracts, also be recognized as being relevant to
submissions with respect to VCC derivative contracts made by a
registered foreign board of trade under CFTC regulation 48.10?
Transparency
6. Is there particular 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 that it credits? Are there particular criteria or factors
that a DCM should take into account when considering, and/or addressing
in a contract's terms and conditions, whether there is sufficient
transparency about credited projects or activities?
Additionality
7. Are there particular criteria or factors that DCMs should take
into account when considering, and/or addressing in a VCC derivative
contract's terms and conditions, whether the procedures that a
crediting program has in place to assess or test for additionality
provide a reasonable assurance that GHG emission reductions or removals
will be credited only if they are additional?
8. In this proposed guidance, the Commission recognizes VCCs as
additional where they are credited for projects or activities that
would not have been developed and implemented in the absence of the
added monetary incentive created by the revenue from carbon credits. Is
this the appropriate way to characterize additionality for purposes of
this guidance, or would another characterization be more appropriate?
For example, should additionality be recognized as the reduction or
removal of GHG emissions resulting from projects or activities that are
not already required by law, regulation, or any other legally binding
mandate applicable in the project's or activity's jurisdiction?
Risk of Reversal
9. Are there particular criteria or factors that DCMs should take
into account when considering, and/or addressing in a VCC derivative
contract's terms and conditions, a crediting program's measures to
avoid or mitigate the risk of reversal, particularly where the
underlying VCC is sourced from nature-based projects or activities such
as agriculture, forestry or other land use initiatives?
10. How should DCMs treat contracts where the underlying VCC
relates to a project or activity whose underlying GHG emission
reductions or removals are subject to reversal? Are there terms,
conditions or other rules that a DCM should consider including in a VCC
derivative contract in order to account for the risk of reversal?
Robust Quantification
11. Are there particular criteria or factors that a DCM should take
into account when considering, and/or addressing in a contract's terms
and conditions, whether a crediting program applies a quantification
methodology or protocol for calculating the level of GHG reductions or
removals associated with credited projects or activities that is
robust, conservative and transparent?
Governance
12. In addition to a crediting program's decision-making,
reporting, disclosure, public and stakeholder engagement, and risk
management policies, are there other criteria or factors that a DCM
should take into account when considering, and/or addressing in a VCC
derivative contract's terms and conditions, whether the crediting
program can demonstrate that it has a governance framework that
effectively supports the program's transparency and accountability?
Tracking and No Double Counting
13. In addition to the factors identified in this proposed
guidance, are there other factors that should be taken into account by
a DCM when considering, and/or addressing in a VCC derivative
contract's terms and conditions, whether the registry operated or
utilized by a crediting program has processes and procedures in place
to help ensure clarity and certainty with respect to the issuance,
transfer, and retirement of VCCs?
14. Are there particular criteria or factors that a DCM should take
into account when considering, and/or addressing in a VCC derivative
contract's terms and conditions, whether it can be demonstrated that
the registry operated or utilized by a crediting program has in place
measures that provide reasonable assurance that credited emission
reductions or removals are not double-counted?
Inspection Provisions
15. Should the delivery procedures for a physically-settled VCC
derivative contract describe the responsibilities of registries,
crediting programs, or any other third-parties required to carry out
the delivery process?
Sustainable Development Benefits and Safeguards
16. Certain private sector and multilateral initiatives recognize
the implementation by a crediting program of measures to help ensure
that credited mitigation projects or activities meet or exceed best
practices on social and environmental safeguards, as a characteristic
that helps to inform the integrity of VCCs issued by the crediting
program. When designing a VCC derivative contract, should a DCM
consider whether a crediting program has implemented such measures?
17. Certain private sector and multilateral initiatives recognize
the implementation by a crediting program of measures to help ensure
that credited mitigation projects or activities would avoid locking in
levels of GHG emissions, technologies or carbon intensive practices
that are incompatible with the objective of achieving net zero GHG
emissions by 2050, as a characteristic that helps to inform the
integrity of VCCs issued by the crediting program. When designing a VCC
derivative contract, should a DCM
[[Page 89422]]
consider whether a crediting program has implemented such measures?
Issued in Washington, DC, on December 21, 2023, by the
Commission.
Christopher Kirkpatrick,
Secretary of the Commission.
NOTE: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Commission Guidance Regarding the Listing of Voluntary
Carbon Credit Derivative Contracts; Request for Comment--Voting Summary
and Chairman's and Commissioners' Statements
Appendix 1--Voting Summary
On this matter, Chairman Behnam and Commissioners Johnson,
Goldsmith Romero, and Pham voted in the affirmative. Commissioner
Mersinger voted to concur. No Commissioner voted in the negative.
Appendix 2--Statement of Support of Chairman Rostin Behnam
The CFTC as a market regulator has a significant role to play in
the voluntary carbon markets (VCMs). As we have seen the listing of
listed futures on voluntary carbon credits (VCCs), the Agency's
relationship and responsibility is real. These markets present an
opportunity for the agricultural economy that historically underpins
the need for derivatives markets for risk management and price
discovery, but they also provide a useful tool throughout the financial
markets and the real economy. And today, the Agency takes the most
significant step of a financial regulator to promote fundamental
standards for high integrity VCCs.
Market participants from across all asset classes will increasingly
turn to the derivatives markets as they manage the impact of physical
and transition risks related to extreme weather events and climate-
related financial risk. The CFTC's role is to ensure that these
developing derivatives markets, including those for VCCs, have
integrity, adhere to basic market regulatory requirements, and remain
resilient as we most certainly will continue to experience extreme and
dramatic weather events that will impact pricing and volatility.
The Commission's proposed guidance for designated contract markets
(DCMs) that list derivatives contracts with voluntary carbon credits
(VCC) as the underlying commodity is an important step in shaping the
development of high-integrity voluntary carbon markets. For the first
time ever, the CFTC is proposing regulatory guidance for exchanges
listing products aimed at providing tools to manage risk, promote price
discovery, and help channel capital to support decarbonization. The
publication of this proposed guidance and request for public comment
marks the culmination of years of work with stakeholders such as
farmers, foresters, end users, energy traders and associations,
emission-trading focused entities, carbon-credit rating agencies,
crediting programs, CFTC-registered exchanges and clearinghouses, and
derivatives trade associations. This proposal also represents a whole-
of-government approach in coordination with our partners across the
federal complex.
Each step has been intentional. My sponsorship of the Market Risk
Advisory Committee's Climate-Related Market Risk Subcommittee, which
issued a report on Managing Climate Risk in the U.S. Financial System
Report in 2020 identified putting a price on carbon as a fundamental
element for financial markets to efficiently channel capital to reduce
greenhouse gas emissions (GHGs).\1\ My establishment of the CFTC's
Climate Risk Unit in March 2021 allowed the Commission to build its
subject matter expertise regarding the role that climate-related
derivatives will have in pricing and managing climate-related financial
risk.\2\ I hosted two VCM Convenings to gather information from a wide
variety of market participants to better understand the potential role
of the official sector in these markets, particularly as we began to
see the emergence of listed futures products that reference VCC cash
markets.\3\ The CFTC, with the support of my fellow commissioners,
issued a Request for Information on Climate-Related Financial Risk that
received 80 comments on ten priority areas of interest including VCMs
and product innovation.\4\ I have also testified before Congress on
several occasions specifically on the role of financial markets in
addressing the climate crisis and my views on the CFTC's role in
supporting solutions.\5\
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\1\ Managing Climate Risk in the U.S. Financial System, Sept. 9,
2020, https://www.cftc.gov/sites/default/files/2020-09/9-9-20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20-%20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf.
\2\ CFTC Acting Chairman Behnam Establishes New Climate Risk
Unit, Mar. 17, 2021, https://www.cftc.gov/PressRoom/PressReleases/8368-21.
\3\ CFTC, Event: Commission Meetings, CFTC Announces Voluntary
Carbon Markets Convening (Jun. 2, 2022), https://www.cftc.gov/PressRoom/Events/opaeventcftccarbonmarketconvene060222; and CFTC,
Event: Commission Meetings, CFTC Announces Second Voluntary Carbon
Markets Convening, (July 19, 2023), https://www.cftc.gov/PressRoom/Events/opaeventvoluntarycarbonmarkets071923.
\4\ Request for Information on Climate-Related Financial Risk,
87 FR 34856 (Jun. 8, 2022), available at https://www.cftc.gov/sites/default/files/2022/06/2022-12302a.pdf.
\5\ See, e.g., Rostin Behnam, Chairman, CFTC, Testimony by
Chairman Rostin Behnam Before the Subcommittee on Agriculture, Rural
Development, Food and Drug Administration and Related Agencies
Committee on Appropriations, U.S. House of Representatives (Mar. 28,
2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam35;
Rostin Behnam, CFTC, Testimony of Commissioner Rostin Behnam before
the House Select Committee on the Climate Crisis (Oct. 1, 2020),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opabehnam16.
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The primary takeaway from this research and public engagement is
clear; the Commission should act, consistent with its statutory
authority under the Commodity Exchange Act (CEA), to strengthen market
integrity, transparency, and liquidity for derivatives with an
underlying VCC that are real, additional, permanent, verifiable, and
represent unique metric tons of GHG emissions reduced or removed from
the atmosphere.
While VCC derivatives are a comparatively new and evolving class of
products, DCMs must ensure that any listed derivatives comply with the
CEA and Commission regulations. The proposed guidance outlines factors
that DCMs should consider when listing products including: DCM Core
Principle 3, which requires DCMs to list only contracts that are not
readily susceptible to manipulation; DCM Core Principle 4, which
requires DCMs to have the capacity and responsibility to prevent
manipulation, price distortion, and other market disruptions through
market surveillance, compliance, and enforcement practices and
procedures; the Commission's regulations promulgated for these DCM Core
Principles; and the product submission provisions set forth in CEA
section 5c(c) and Part 40 of the Commission regulations.
The proposed guidance is not intended to modify or supersede
existing statutory or regulatory requirements, or existing Commission
guidance that addresses the DCMs' listing of derivative contracts, such
as Appendix C to Part 38 of the Commission's regulations. Instead, the
proposed guidance outlines particular VCC commodity characteristics
that a DCM should consider in the design of a VCC futures contract's
terms and conditions such (i) quality standards, which include
transparency, additionality, permanence and accounting for the risk of
reversal, and
[[Page 89423]]
robust quantification of emissions reductions or removals; (ii)
delivery points and facilities which include effective governance at
the carbon crediting program, tracking the issuance, transfer, and
retirement of VCCs, and no double counting; and (iii) inspection
provisions which includes independent third-party validation and
verification. A DCM's consideration of these factors during the design
of a derivative product's terms and conditions should promote accurate
pricing, reduce susceptibility of the contract to manipulation, help
prevent price distortions, and foster confidence in the VCC contracts.
Consistent with the current statutory and regulatory requirements, DCMs
would retain reasonable discretion in establishing the manner in which
it complies with a DCM Core Principles and the Commission's
regulations.
I believe the proposed guidance outlines well-researched VCC
commodity characteristics that build on several private sector and
multilateral initiatives that have made great strides to strengthen VCC
credit integrity standards. I also believe the proposed guidance
supports transparency, liquidity, and market integrity. This effort is
the product of a strong public-private partnership that I have strived
to achieve with the CFTC's traditional stakeholders as well as those
VCM stakeholders that may be newer to the derivatives markets.
The Commission is cognizant that the derivatives markets are global
markets and has crafted this proposed guidance to be complementary to
the important work underway by the International Organization of
Securities Commissions (IOSCO) through its Sustainable Finance Task
Force's Carbon Market Workstream, which I co-chair with Verena Ross,
the Chair of ESMA. While this proposed Commission guidance focuses on
the due diligence that DCMs should undertake when designing and
monitoring their proprietary listed VCC derivative contracts, IOSCO's
work over nearly two years is focused on how regulators can promote
sound market structure and enhance financial integrity in the VCMs so
that high-quality carbon credits can be traded in an orderly and
transparent way. I invite our stakeholders to also provide comment on
IOSCO's December 2023 publication of its VCM Consultation Report.\6\
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\6\ International Organization of Securities Commissions
(IOSCO), CR06/2023 Voluntary Carbon Markets, Consultation Report
(Dec. 2023), https://www.iosco.org/library/pubdocs/pdf/IOSCOPD749.pdf.
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The proposed guidance is not intended to suggest that the
Commission has a role in creating or mandating compliance with any kind
of climate policy. The CFTC's unique mission focused on risk mitigation
and price discovery, however, puts us on the front lines of the now
global nexus between financial markets and decarbonization efforts.
Leveraging the CFTC's personnel and expertise demonstrates our
commitment to taking thoughtful and deliberate next steps toward
building a financial system that provides effective tools in achieving
emission reductions.
I thank my fellow commissioners for enabling the Commission to
publish this proposed guidance for public comment. I greatly appreciate
the expertise and all of the hard work done by the staff in my office,
the Division of Market Oversight, and the Office of the General Counsel
on this proposed guidance. I look forward to reviewing the public
comments on all aspects of the guidance as well as on the seventeen
specific questions relating to the listing for trading of VCC
derivative contracts.
Appendix 3--Statement of Commissioner Kristin Johnson
Today, the Commodity Futures Trading Commission (Commission or
CFTC) adopts proposed Guidance and a Request for Comments regarding the
listing of voluntary carbon credit (VCC) derivative contracts on
designated contract markets (DCMs)--boards of trade that operate under
the regulatory oversight of the CFTC (Proposed Guidance). I support the
Proposed Guidance as it advances important transparency and market
integrity efforts.
However, evidence suggests that environmental commodity markets,
specifically the underlying spot markets for carbon credits, are rife
with fraud. Consequently, I find the Proposed Guidance to be necessary,
but insufficient. I am hopeful that the Proposed Guidance ushers in
discussion and the development of a comprehensive regulatory initiative
to address the deeply concerning, and nearly indisputable,
proliferation of fraud in the carbon credit markets.
As I noted, in a recent speech at a joint convening of the
Environmental Advisory Council and the Financial Sector Advisory
Council of the Dallas Federal Reserve Bank:
While the issues and concerns regarding climate risks are
endemic, complex, and inherently require multi-lateral solutions
effectuated by an international coalition of stakeholders--let's
call it: a coalition of the willing--I strongly believe that
financial market regulators and committed market participants may
play a pivotal role in developing and implementing some basic,
foundational market reforms.\1\
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\1\ Kristin Johnson, Commissioner, CFTC, Keynote Address at The
Federal Reserve Bank of Dallas: All Hat, No Cattle: The Need For
Market Structure Reforms in the Voluntary Carbon Markets (Nov. 29,
2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson10. In October, the United Nations Sustainable Stock
Exchanges (UN SSE), in collaboration with the International
Organization of Securities Commissions (IOSCO), hosted a roundtable
on Carbon Markets at the 8th UNCTAD World Investment Forum to engage
in dialogue on the future of carbon markets and the role exchanges
and securities market regulators can play in making these markets
work effectively in combating climate change. Sustainable Stock
Exchanges initiative, Carbon markets action framework launched at
UNCTAD World Investment Forum (Oct. 18, 2023), https://sseinitiative.org/all-news/carbon-markets-action-framework-launched-at-unctad-world-investment-forum/.
I anticipate and look forward to the public engagement regarding
the Proposed Guidance and responses to the Request for Comments,
particularly as relates to the efforts of the Proposed Guidance to
address transparency, additionality, risk of reversal, robust
quantification, governance, tracking and double counting, inspection
provisions, and sustainable development benefits and safeguards. In
developing a formal framework to support the VCC markets, I strongly
believe that a comprehensive approach that addresses the diversity of
environmental derivatives emerging in our markets will improve
visibility, enhance integrity, and promote carbon neutrality.
The Market for Carbon Credits
A VCC is a tradeable intangible instrument that is issued by a
carbon crediting program. Once registered, VCCs associated with a
mitigation project or activity may be acquired by end users (businesses
or individuals) or intermediaries who act as brokers. While the number
of VCC exchanges continues to increase, the spot market for such
products remains largely bespoke, with buyers purchasing directly from
mitigation project developers or via intermediaries. A carbon credit
market creates a forum that enables buyers and distributors to engage
in the purchase and sale, respectively, of environmental commodities.
Each environmental commodity represents the acquisition or distribution
of a credit that contributes to the reduction or sequestration
(capturing and storage) of greenhouse gas emissions. Carbon markets are
either mandatory (compliance) markets or voluntary. VCC markets are not
established by any government authority.
The VCC market serves as an important tool, among many needed
[[Page 89424]]
tools, designed to address mounting evidence of climate change and the
attendant, significant effects on the global economy. Under Chair
Behnam's leadership, in 2020, the Climate-Related Market Risk
Subcommittee of the Commission's Market Risk Advisory Committee (an
Advisory Committee that I currently sponsor), released a report
identifying actions the Commission could take to address climate change
and finding that climate-related financial risks pose a major risk to
the stability of the U.S. financial system.\2\
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\2\ Release Number 8234-20, CFTC's Climate-Related Risk
Subcommittee Releases Report, https://www.cftc.gov/PressRoom/PressReleases/8234-20.
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A report by the U.S. Department of the Treasury released in
September explains that ``[t]he impacts of climate change are
significant and escalating, including through more frequent and severe
weather events, rising sea levels, and higher temperatures.'' \3\ The
report details how climate risks are impacting individual household
finances, U.S. financial markets, and supply chains. ``In 2022 alone,
the cost of climate and weather disasters in the United States totaled
more than $176 billion--the third most costly year on record.'' \4\
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\3\ U.S. Dep't of the Treasury, The Impact of Climate Change on
American Household Finances 1 (2023), https://home.treasury.gov/system/files/136/Climate_Change_Household_Finances.pdf.
\4\ Id.
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There are deep and persistent concerns regarding the integrity,
credibility, and lack of visibility in the market for carbon credits.
Indisputably, challenged efforts to establish universally-adopted and
enforceable integrity standards has further stymied attempts to scale
carbon credit markets.
Just last fall, U.S. Senators Elizabeth Warren, Cory Booker, and
Kirsten Gillibrand alongside several other Senators, encouraged the
CFTC to use its enforcement jurisdiction aggressively to investigate
and prosecute fraud and manipulation in spot and forward environmental
commodity markets.\5\
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\5\ Letter from Cory A. Booker, et al., U.S. Senators, to Rostin
Behnam, Chairman, CFTC (Oct. 13, 2022).
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On June 29, 2023, the Commission announced the Environmental Fraud
Task Force, which was created to address misconduct in the regulated
derivatives markets and to investigate fraud in the spot market for
VCCs, in particular with respect to the purported environmental
benefits of purchased carbon credits, and registrants'
misrepresentations regarding purported environmental benefits and
environmental, social, and governance (ESG) products or strategies.\6\
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\6\ Release Number 8736-23, CFTC Division of Enforcement Creates
Two New Task Forces, https://www.cftc.gov/PressRoom/PressReleases/8736-23.
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These issues have become so much a part of the cultural dialogue
that The New Yorker featured an article titled ``The Great Cash-For-
Carbon Hustle,'' which detailed the rise and fall of South Pole, led by
its forty-four-year-old CEO Rant Heuberger, and the revelation that it
sold carbon credits that were not real.
In recent speeches at the Federal Reserve Banks in Atlanta and
Dallas and Rice University's Baker Institute for Public Policy Annual
Energy Summit, I outlined the necessity for market structure reforms in
the VCC markets as well as derivatives on VCCs.\7\ As I have previously
stated:
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\7\ Kristin Johnson, Commissioner, CFTC, Keynote Address at Rice
University's Baker Institute for Public Policy Annual Energy Summit:
Credibility, Integrity, Visibility: The CFTC's Role in the Oversight
of Carbon Offset Markets (Oct. 5, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson7; Kristin Johnson,
Commissioner, CFTC, Keynote Address at The Federal Reserve Bank of
Atlanta: Policing the (Token) Economy: Introducing Corporate
Governance and Market Structure Reforms in Crypto and Environmental
Commodities Markets (Nov. 13, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson8; Kristin Johnson, Commissioner, CFTC,
Keynote Address at The Federal Reserve Bank of Dallas: All Hat, No
Cattle: The Need For Market Structure Reforms in Voluntary Carbon
Markets (Nov. 29, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson10.
in order for the carbon offset markets to have any significance
(and, arguably, for such markets to avoid extinction), we must
ensure the integrity of the market.\8\ Financial market regulators
and committed market participants play a pivotal role in developing
and implementing some basic, foundational market reforms.\9\
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\8\ Kristin Johnson, Commissioner, CFTC, Keynote Address at The
Federal Reserve Bank of Dallas: All Hat, No Cattle: The Need For
Market Structure Reforms in Voluntary Carbon Markets (Nov. 29,
2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson10.
\9\ Id.
Today's Proposed Guidance marks a step in the right direction.
Commission Regulatory Authority
The Proposed Guidance applies to the listing of futures with VCCs
as the underlying assets. DCMs that list and offer derivatives on VCCs,
which are commodities, must be registered with the Commission prior to
offering such contracts. Pursuant to the Commodity Exchange Act (CEA),
to be designated, and maintain a designation, as a contract market, a
board of trade must comply with all core principles and any requirement
that the Commission may impose by rule or regulation.
Core principle 3 requires a DCM to demonstrate that listed
contracts are not readily subject to manipulation. Core principle 4
requires a DCM to prevent manipulation, price distortion, and
disruptions of the physical delivery or cash-settlement process through
market surveillance, compliance, and enforcement practices and
procedures.\10\ Guidance and acceptable practices provide contextual
information regarding the core principles and detailed examples of how
a DCM must satisfy a core principle. Additionally, DCMs must comply
with ``submission requirements . . . prior to listing a product for
trading,'' including by way of self-certification or Commission
approval of such products.
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\10\ 17 CFR part 38, Appendix B to Part 38 (Guidance on, and
Acceptable Practices in, Compliance With Core Principles), and
Appendix C to Part 38 (Demonstration of Compliance That a Contract
Is Not Readily Susceptible to Manipulation).
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The Commission reviews the product specifications, including
information about the underlying asset, as part of this review process.
Futures on VCCs: Great Interest, Limited Volume
Over the last several years, the Commission authorized the listing
of futures contracts on certain environmental instruments, including
mandatory emissions and voluntary carbon program instruments. There are
almost two hundred derivative contracts on environmental commodities
although at this time only three contracts have open interest. As of
November 2023, DCMs submitted eighteen futures contracts on voluntary
carbon market products the Commission for listing. Derivative contracts
on VCCs base their prices on the spot price of VCCs,\11\ and therefore
the integrity of the underlying spot market is critical to the
stability of the derivatives market for those underlying VCC
commodities.
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\11\ For example, NYMEX's CBL Global Environmental Offset
futures contracts, and Nodal Exchange's Verified Emission Reduction
futures and options contracts, are physically-settled contracts. If
the holder of a position in the contract still has an open position
at the expiration of trading in the contract, then the position
holder must, in accordance with the rules for delivery set forth in
the contract, make or take delivery (as applicable) of 1,000 VCCs
that meet the contract's rules for delivery eligibility.
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General Summary of the Proposed Guidance
Endemic fraud in the VCC spot market impacts the integrity of
environmental derivative contracts that reference spot market projects.
While the Commission's authority to introduce regulation is limited to
commodity
[[Page 89425]]
derivatives, the Commission has broad authority to address fraud and
market manipulation in the spot market.
The Proposed Guidance outlines factors that DCMs should consider
when addressing certain requirements under the CEA and CFTC regulations
that are relevant to the listing for trading of VCC derivative
contracts, as previously mentioned, without providing a qualitative
element in terms of identifying how the Commission expects the DCM to
weigh those factors to create a certain aspirational goal.
Specifically:
When addressing quality standards in the development of
the terms and conditions of a VCC derivative contract, the Proposed
Guidance states that a DCM should consider transparency, additionality,
permanency and risk of reversal, and robust quantification in
connection with the underlying VCC. The governance framework and
tracking mechanisms of the crediting program for the underlying VCCs
and the crediting program's measures to prevent double-counting are all
additional considerations. Inspection or certification provisions
should be specified in the terms and conditions.
DCMs should actively monitor the terms and conditions of
VCC derivative contracts to ensure conformity with current standards
and should require their market participants to keep records of their
trading, including activity in the underlying spot market, and make
such records available upon request to the DCM.
As part of the product review process, a DCM is required
to submit the contract's terms and conditions and any contract
amendments and must also include an explanation and analysis of the
contract and its compliance with applicable CEA provisions. The
submitted information--including supporting documentation, evidence and
data--provided by the DCM should describe how the contract complies
with the CEA and applicable Commission regulations and should be
complete and thorough.
DMO suggests that the Proposed Guidance should be considered by a
swap execution facility (SEF) that proposes to trade swaps with VCCs as
underlying commodities. Similar to DCMs, SEFs are directly subject to
core principles, guidance, acceptable practices, and product listing
requirements.\12\
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\12\ 17 CFR part 37 and Appendix B to Part 37 (Guidance on, and
Acceptable Practices in, Compliance with Core Principles).
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The Proposed Guidance may help to improve the integrity of the VCC
markets. Yet, there are additional and significant issues that the
Proposed Guidance does not address.
On November 13, 2023, I delivered a keynote speech at the Federal
Reserve Bank of Atlanta. During that discussion, I noted:
There are certain principles that must guide the development of
market structure for [VCC markets] including the introduction of
transaction reporting; secondary market regulation including, where
relevant, clearing and settlement guidance; accountability standards
for intermediaries to ensure integrity and reliability (and in the
context of environmental commodities additionality); business
conduct standards, including standardized documentation (and
requirements for certification of environmental commodities); and
appropriate guardrails for any retail market participation.\13\
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\13\ Kristin Johnson, Commissioner, CFTC, Keynote Address at The
Federal Reserve Bank of Atlanta: Policing the (Token) Economy:
Introducing Corporate Governance and Market Structure Reforms in
Crypto and Environmental Commodities Markets (Nov. 13, 2023),
https://www.cftc.gov/PressRoom/SpeechesTestimony/opajohnson8.
On November 29, 2023, I delivered keynote remarks at a joint
convening of the Energy Advisory Council and Financial Sector Advisory
Council of the Dallas Federal Reserve Bank. There, I outlined
additional interventions that may mitigate the proliferation of fraud
in VCC markets and foster innovation and competition, while ensuring
the integrity of our markets.
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 framework. Applying the approach adopted in the Proposed
Guidance, there may be several interventions that may introduce similar
needed clarifications--material risk disclosures, good faith and fair
dealing, and clearing.
A Comprehensive Approach To Regulating VCC Markets
A comprehensive framework enhances the integrity of futures and OTC
markets enabling risk transfer, investment, hedging, and price
discovery.
Material Risk Disclosures
The CEA and CFTC regulations impose material risk disclosure
requirements on registered market participants in connection with their
communications, solicitations, and negotiations of transactions and
material contractual terms.
These material risk disclosure requirements reduce information
asymmetries and improve transparency. The requirements obligate certain
parties to disclose material information sufficient to enable
counterparties to make informed decisions about the appropriateness of
entering into a transaction.
In the swaps market,\14\ a swap dealer is required to disclose to
its non-swap dealer counterparty material information concerning the
swap in a manner reasonably designed to allow the counterparty to
assess the material risks, material characteristics, material
incentives and conflicts of interest that the swap dealer may have in
connection with a particular swap.\15\
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\14\ For reference, in futures markets, futures commission
merchants are required to provide comprehensive disclosures under
CFTC Regulation 1.55 where all materials risks are specifically are
addressed. Registered commodity pool operators and commodity trading
advisors are also required to provide disclosures on risks of
trading futures and swaps.
\15\ 7 CFR 23.431. This provision requires the disclosure of
market, credit, liquidity, foreign currency, legal, operational, any
other applicable risks; the material economic terms of the swap, the
terms relating to the operation of the swap, and the rights and
obligations of the parties during the term of the swap; and the
price of the swap, the mid-market mark of the swap, and any
compensation or other incentive from any source other than the
counterparty that the swap dealer may receive in connection with the
swap.
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In the adopting release for the material risk disclosure
requirement, the Commission clarified that the material risk disclosure
requirement reaches disclosures regarding the risks associated with the
economic terms of the product and risks associated with the underlying
asset. The Commission noted that:
The Commission believes that for most swaps information about
the material risks and characteristics of the swap will relate to
the risks and characteristics of the economic terms of the swap. For
certain swaps, however, where payments or cash-flows are materially
affected by the performance of an underlying asset for which there
is not publicly available information (or the information is not
otherwise accessible to the counterparty), final Sec. 23.431 would
require disclosures about the material risks and characteristics
that affect the value of the underlying asset to enable a
counterparty to assess the material risks of the swap.\16\
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\16\ Business Conduct Standards for Swap Dealers and Major Swap
Participants With Counterparties (Business Conduct Standards), 77 FR
9734, 9760 (Feb. 17, 2012).
[[Page 89426]]
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In my view, the concepts of material information, material risks,
material characteristics, material incentives and conflicts of interest
of a derivative must necessarily include the underlying commodity on
which a derivative is priced. In light of the lack of visibility into
pricing in the VCC markets and the dearth of publicly available
information regarding pricing methodologies, such disclosures are
particularly important.
Using the risk disclosure requirement as a framework, the
Commission should provide guidance that applies to all environmental
derivative products. In the context of derivatives on VCCs or other
environmental products, where the risk of loss may be magnified because
of leverage, the sellers must ensure its counterparty has adequate
information to understand how observed volatility and inherent risk in
the nascent and evolving VCC market could impact the price of the
derivative.
For certain forward contracts on VCCs, it is possible that no
material risk disclosure requirement applies; however, the CFTC does
have enforcement jurisdiction if there is fraud, including where
incorrect or misleading information is provided. CFTC regulations do
not require parties to make affirmative statements about nonpublic
information--but if a party does speak, CFTC Regulation 180.1(b)
specifically requires that a materially misleading statement be
corrected, including nonpublic information that may be material to the
market price, rate, or level of the commodity transaction.\17\
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\17\ 17 CFR 180.1(b) (stating that nothing in that section shall
be construed to require any person to disclose to another person
nonpublic information that may be material to the market price,
rate, or level of the commodity transaction, except as necessary to
make any statement made to the other person in or in connection with
the transaction not misleading in any material respect).
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The Commission may not need to prescribe the precise language of
the disclosures. The material risk disclosure rule is principles-based.
Instead, the Commission may identify factors that a market participant
must consider in a risk disclosure, including all the factors that
could lead to significant losses. Information about a carbon credit,
including information about the environmental project and market
structure, is material because there is a substantial likelihood that a
reasonable counterparty would consider it important in making a trading
decision.
Guidance on Good Faith and Fair Dealing
The principles of good faith and fair dealing are well-established
in the futures, swaps and securities industries. The National Futures
Association's customer communication rule also imposes a duty to
communicate in a fair and balanced manner.
In the swaps market, the risk disclosure requirement is closely
linked to the swap dealer's obligation to communicate in a fair and
balanced manner. Swap dealers have a duty to communicate with all of
their counterparties in a fair and balanced manner based on principles
of fair dealing and good faith.\18\ This duty, the Commission notes,
``is designed to ensure a balanced treatment of potential benefits and
risks.'' \19\
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\18\ 7 CFR 23.433.
\19\ Business Conduct Standards, 77 FR at 9769.
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In the adopting release for the fair dealing requirement, the
Commission noted:
In a complex swap, where the risks and characteristics
associated with an underlying asset are not readily discoverable by
the counterparty upon the exercise of reasonable diligence, the swap
dealer or major swap participant is expected, under both the
disclosure rule and fair dealing rule, to provide a sound basis for
the counterparty to assess the swap by providing information about
the risks and characteristics of the underlying asset.\20\
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\20\ Id. at 9770.
The Commission should offer guidance as to its expectations of how
the fair dealing requirement should be considered in the context of an
underlying asset that is a VCC. The fair dealing rule provides an
independent basis for enforcement proceedings--for example where the
swap dealer makes exaggerated or unwarranted claims, opinions, or
forecasts in violation of the fair dealing requirement.\21\
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\21\ Id. at 9769.
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Such a requirement may not apply to certain forward contracts on
VCCs. Yet, the Commission maintains broad enforcement jurisdiction in
the event that there is an allegation of fraud, including where
incorrect or misleading information is provided. CFTC Regulation
180.1(a)(2) makes unlawful the making of an untrue or misleading
statement of a material fact or omitting a material fact necessary to
make a statement made not untrue or misleading.\22\
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\22\ 17 CFR 180.1(a)(2) (providing that it is unlawful for any
person in connection with any contract of sale of any commodity in
interstate commerce to intentionally or recklessly make, or attempt
to make, any untrue or misleading statement of a material fact or to
omit to state a material fact necessary in order to make the
statements made not untrue or misleading).
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Guidance on Product Eligibility for Clearing
In the future, should the market evolve and become more
standardized, the clearing framework may also provide valuable risk
reduction benefits for derivatives on environmental commodities.
Clearing, by way of novation, reduces counterparty credit risk because
a DCO serves as a seller to every buyer and a buyer to every seller,
remaining neutral. DCOs are highly regulated by the Commission, are
subject to core principles, and have significant, mutualized financial
resources. At settlement, DCOs may facilitate the physical delivery of
the actual underlying commodity or cash payments based on the final
price of the underlying commodity in connection with the derivatives
contract.
In the context of environmental derivatives, DCOs would facilitate
delivery of the VCC or determine the cash amount based on the price of
the VCC in the cash market. For purposes of physical settlement, a
well-functioning carbon credit cash market is essential.
Core principle C sets out product eligibility requirements. A DCO
must have appropriate requirements for determining the eligibility of
contracts submitted to the DCO for clearing, taking into account the
DCO's ability to manage the risks associated with such contracts.
Some factors the DCO must consider include the availability of
reliable prices, the ability of the DCO and clearing members to gain
access to the relevant market for purposes of creating, liquidating,
transferring, auctioning, and/or allocating positions, and the
operational capacity of the DCO and clearing members to address any
unique risk characteristics of a product clearing members.\23\ A DCO
should take care not to clear transactions that present an unacceptable
level of risk.
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\23\ 17 CFR 39.12(b).
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In the context of the current VCC market, significant questions
arise as to whether certain elements of the DCO core principles would
be easily established, including whether there are reliable prices for
these carbon credits, the access to carbon credit markets, and whether
there is material information about the carbon credit. Additional
Commission guidance perhaps could facilitate the market, increase
volumes and promote sound risk management, reasonably-designed policies
and procedures, and robust rules.
The development of rules that facilitate the clearing of
derivatives
[[Page 89427]]
based on environmental commodities would be greatly advanced by
Commission guidance on the application of those principles to the
clearing of such products. Forwards on carbon credits are not required
to be cleared at a DCO; but clearing and settlement provide critical
counterparty credit risk management.
Conclusion
It is difficult to overstate the significance of today's announced
Proposed Guidance. Once again, the CFTC is demonstrating leadership in
the novel carbon credit markets and contemporaneously enhancing the
integrity of carbon-credit markets.\24\
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\24\ In June 2022, the Commission held the first-ever Voluntary
Carbon Markets Convening to discuss issues related to the supply and
demand for high quality carbon offsets. Then in July 2023, the
Commission held the second Voluntary Carbon Markets Convening to
discuss recent private sector initiatives for high quality carbon
credits, among other topics.
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I believe the Commission has taken an important step forward by
announcing the Proposed Guidance advanced today. However, I am hopeful
that this step is the first on a long journey to introduce effective
market structure reforms in VCC markets.
Appendix 4--Statement of Commissioner Christy Goldsmith Romero
I am pleased to support today's proposed guidance regarding the
listing of voluntary carbon credit derivatives. I want to recognize
Chairman Behnam's leadership in the voluntary carbon credit space. The
proposed guidance follows efforts by the Commission to develop capacity
in understanding and regulating voluntary carbon credits.\1\
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\1\ The Commission has held two convenings to gather information
from a range of carbon market stakeholders and last year conducted a
request for information on climate-related risks, which asked
several questions about carbon markets. The Commission received
significant comments on voluntary carbon credit products and
markets.
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The physical effects of climate change are amplifying. 2023 is
likely to go down as the warmest year on record.\2\ The intensifying
physical impacts of climate change pose serious risks to commodities
derivatives markets and potentially systemic risk to the financial
system if not effectively managed. Our mission includes promoting
resilience in derivatives markets that can play a critical role in
managing climate risk.
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\2\ National Oceanic and Atmospheric Administration, Topping the
charts: September 2023 was Earth's warmest September in 174-year
record (Oct. 13, 2023).
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Many market participants are seeking opportunities in derivatives
markets to promote resilience to climate risk, including through
voluntary carbon credits. The CFTC oversees voluntary carbon credit
derivatives listed and trading on CFTC-registered exchanges. In
addition to regulatory authority over derivatives, the CFTC also has
antifraud authority in the spot voluntary carbon credit markets given
the potential for impact to the derivatives markets.
In response to our public consultation, various market
participants, public interest groups, and U.S. Senators have asked the
CFTC to take a leading role in promoting the integrity of voluntary
carbon markets.\3\ I was pleased to help launch the CFTC's
Environmental Fraud Task Force that will pursue individual cases of
fraud related to carbon credits, weeding out bad actors, and promoting
market integrity.\4\ Today's proposed guidance is the next step in
promoting market integrity.
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\3\ See Letter from Senators Booker, Warren, Markey, Blumenthal,
Sanders, Merkley and Gillibrand (Oct. 13, 2022); see also ISDA
Comment Letter on CFTC Request for Information on Climate-Related
Financial Risk (Oct. 7, 2022) (``We believe that the Commission
should take a leading role in supporting and enhancing the integrity
of voluntary carbon markets.''); see also Intercontinental Exchange
Inc. Comment Letter on CFTC Request for Information on Climate-
Related Financial Risk (Oct. 7, 2022) (``ICE supports the Commission
taking a leadership role in supporting and enhancing the integrity
of project-based carbon markets.''); see also Environmental Defense
Fund Comment Letter on CFTC Request for Information on Climate-
Related Financial Risk (Oct. 7, 2022) (``EDF respectfully welcomes
CFTC's interest in identifying the potential for fraud and market
manipulation in voluntary carbon markets. Enhanced quality and
integrity in voluntary carbon markets can help mobilize carbon
finance, help cut emissions and facilitate the achievement of
corporate and national greenhouse gas reduction goals.''); see also
bp Comment Letter on CFTC Request for Information on Climate-Related
Financial Risk (Oct. 7, 2022) (``bp believes the CFTC should focus
on simultaneously enhancing its oversight role in derivatives and
futures markets while allowing these markets to become deeper and
more liquid.'').
\4\ Commissioner Christy Goldsmith Romero, Remarks of
Commissioner Christy Goldsmith Romero at ISDA's ESG Forum on
Promoting Market Resilience: A Thoughtful Approach to the Daunting
Challenge of Climate Financial Risk, (Mar. 7, 2023); See
Commissioner Christy Goldsmith Romero, Adjusting the Sails for Cyber
and Climate Resilience (Feb. 10, 2023).
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I have met with exchanges to discuss their process for listing
these emerging products, and found differing approaches to these
products and due diligence in the underlying credit. CFTC-registered
exchanges have certain requirements under the Commodity Exchange Act
including to list only contracts that are not readily susceptible to
manipulation, to have the capacity and responsibility to prevent
manipulation, price distortion and other market disruptions, and other
requirements aimed at market integrity.
Commission guidance, like what is proposed today, can help
exchanges understand what compliance means in a still rapidly evolving
market for voluntary carbon credits, one where there can be concerns
about integrity, including for carbon credits listed on some of the
largest registries,\5\ a lack of transparency, and uncertainty related
to pricing. These concerns in the spot market could affect the
regulated derivatives market. For a market to work well, market
participants need to be confident they have credible information about
the product, that there are appropriate levels of pricing, and that the
market has integrity, so that they do not face legal, reputational and
regulatory risks.
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\5\ In one relevant example, several press sources reported
serious allegations about a project developed by the market's
largest firm, a project that has been among the leading sources of
carbon credits globally. Blake, Heidi, The Great Cash-for-Carbon
Hustle, The New Yorker (Oct. 16, 2023); Ben Elgin, Alastair Marsh,
and Max de Haldevang, Faulty Credits Tarnish Billion-Dollar Carbon
Offset Seller, Bloomberg (Mar. 24, 2023). The allegations were
sufficiently credible that the project's registry put on hold
issuance of credits from the project, pending an investigation.
Verra Statement on the New Yorker Article of October 16, 2023, Verra
(Oct. 17, 2023).
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I continue to believe that bringing more of this market onto
regulated exchanges could increase integrity, transparency, and bring
greater confidence to the market. I agree with a response to our
consultation which said that ``the expansion of exchanges offering
products . . . would help grow liquidity and therefore the value of the
market for price discovery and risk shifting.'' \6\ CFTC-regulated
exchanges have important responsibilities under the Commodity Exchange
Act, and stand as the first line of defense to ensure market integrity
The market should signal through pricing which carbon credits are high
quality compared to credits reflecting projects that do not achieve the
requisite level of one ton of greenhouse gases removed or reduced.
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\6\ See Ceres Comment Letter on CFTC Request for Information on
Climate-Related Financial Risk (Oct. 7, 2022).
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However, one of the biggest challenges in voluntary carbon markets
is fragmentation which different projects, registries, and standards,
that can impact derivatives markets and harm market confidence. A lack
of transparency through consistent, comparable data can present
challenges to proper functioning of markets, including price discovery.
There are important and welcome efforts by voluntary bodies like the
Integrity Council on Voluntary Carbon Markets (``ICVCM'') to create
voluntary
[[Page 89428]]
standards to address concerns about credibility and to develop a common
understanding of a high-quality credit, efforts that are ongoing.
In March, I proposed that the Commission work with regulated
exchanges to develop common baseline standards for listing voluntary
carbon credit derivatives.\7\ At a conference held by ISDA, I proposed
that the Commission consider requiring exchanges to take certain
actions to increase confidence that underlying voluntary carbon credits
reliably remove or avoid the amount of carbon claimed of one ton of
greenhouse gases per credit. I proposed that such actions could include
information sharing agreements with carbon registries and baseline
standards for carbon credits that could reference either the ICVCM core
carbon principles once they became final or the basic principles on
which they are based. I thank the Chairman for working with me on these
efforts.
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\7\ Commissioner Christy Goldsmith Romero, Remarks of
Commissioner Christy Goldsmith Romero at ISDA's ESG Forum on
Promoting Market Resilience: A Thoughtful Approach to the Daunting
Challenge of Climate Financial Risk (Mar. 7, 2023).
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Today's guidance adapts terminology, concepts and standards from
the ICVCM's Core Carbon Principles and its recently issued Assessment
Framework. I support the Commission's recognition of the efforts made
by this body that could improve integrity, transparency, and price
discovery, and thereby improve confidence in these markets.
The Commission's guidance adapts ICVCM concepts and standards that
commenters told us were needed for integrity in voluntary carbon
markets. The guidance sets an expectation for exchanges to ensure that
underlying VCC's represent an actual ton of carbon dioxide removed or
reduced and that there is no double counting of those reductions or
removals.\8\ It also sets an expectation that underlying VCC's are
subject to a meaningful independent evaluation and verification before
issuance.\9\ Aligning the CFTC's expectations with the ICVCM's work
also recognizes the global nature of this market and of the challenges
posed by climate-related financial risk.
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\8\ See ISDA Comment Letter on CFTC Request for Information on
Climate-Related Financial Risk (Oct. 7, 2022) (``In order for these
markets to flourish, there can be no room for greenwashing, double-
counting of credits or any other types of fraud and manipulation . .
.''); See also EDF Comment Letter on CFTC Request for Information on
Climate-Related Financial Risk (Oct. 7, 2022) (``One particular
concern in carbon markets is that traded reductions might be
``double counted,'' a situation in which a single GHG emission
reduction or removal (i.e. credit) is counted more than once towards
achieving mitigation targets or goals.'').
\9\ See Ceres Comment Letter on CFTC Request for Information on
Climate-Related Financial Risk (Oct. 7, 2022) (``The best way to
guard against the risk of market disruption because of the lack of
the integrity of the underlying credits would be to require all
credits underlying derivative instruments be subject to a meaningful
evaluation and certification process by an outside, neutral, and
expert third party.'').
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I am interested in hearing from commenters if the guidance adapts
the right parts of the ICVCM standards to encourage integrity and
transparency in these markets and if the Commission's adaptation
provides clear, workable expectations. As the ICVCM standards have only
been recently released, it will be important to monitor the adoption of
these standards.
I am also interested in hearing more from commenters about whether
market integrity can be improved by exchanges relying on a crediting
program's processes and diligence, as assumed in the proposed guidance,
or if there is a benefit to exchanges conducting additional due
diligence into specific categories, protocols, or projects.
I am interested to hear from commenters, including participants in
our previous public consultation if this guidance meets their needs and
helps address concerns they have raised. I especially hope to hear from
farmers and others in the agricultural community, several of whom
encouraged the CFTC to play a role in ensuring integrity in carbon
markets in response to last year's public consultation.\10\
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\10\ See Blue Diamond Farming Company Comment Letter on CFTC
Request for Information on Climate-Related Financial Risk (Oct. 7,
2022); see also Bryan Agricultural Enterprises Comment Letter on
CFTC Request for Information on Climate-Related Financial Risk (Oct.
7, 2022).
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As derivatives markets evolve, it is important that the Commission
remain nimble and aware of changes, and continue to work with exchanges
in listing products. I applaud the staff for their hard work on this
guidance and I thank them for working with me to incorporate feedback I
have heard in meetings with exchanges, market participants and public
interest groups over the past 18 months.
[FR Doc. 2023-28532 Filed 12-26-23; 8:45 am]
BILLING CODE 6351-01-P