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Commodity Futures Trading Commission Final Guidance

September 30, 2024 Uncategorized

COMMODITY FUTURES TRADING COMMISSION FINAL GUIDANCE

OVERVIEW

For questions on the note below, please contact Ruth Lunsford at (434) 238-7224. 

On September 20, the Commodity Futures Trading Commission (CFTC) issued finalized guidance regarding the listing of voluntary carbon credit (VCC) derivatives that ensure CFTC-regulated exchanges only list derivatives based on underlying VCCs that meet specific standards.   

Below is a summary of changes made from the proposed guidance in the final guidance prepared by Delta Strategy Group.  It includes several high-level takeaways and comparisons between the initial and final guidance issued.  

KEY TAKEAWAYS

The following is a summary of the main topics addressed in the final guidance as well as a comparison of changes made.   

  • The final guidance on the non-binding guidance to designated contract markets (“DCMs”) regarding listing of voluntary carbon credits (“VCCs”) aims to ensure integrity in voluntary carbon markets (VCMs). 
  • While the proposed and final guidances both aim for transparency and liquidity, the final guidance explicitly mentions driving standardization and efficient capital allocation to support high integrity voluntary carbon credits, suggesting a broader goal of improving the underlying cash market. 

Commission Statements 

  • Chairman Behnam’s supporting statement framed the final guidance as a significant advancement in fostering high-integrity voluntary carbon markets that emphasizes risk management and capital allocation for decarbonization by outlining essential VCC characteristics, such as transparency and permanence, to ensure market integrity.  Behnam emphasized how this initiative could promote effective pricing and prevent manipulation, enhancing the role of financial markets in addressing climate change. 
  • Commissioner Mersinger’s dissenting statement regards the guidance as a “solution in search of a problem.”   Mersinger states that the CFTC is prioritizing political agendas over regulatory clarity, as the guidance focuses on environmental and social governance (ESG) issues that do not pertain to the contracts’ regulatory compliance or the CFTC’s regulatory purview.   Mersinger calls for treating VCC products like any other derivatives contract, emphasizing that the current focus appears more ideological than practical. 

FINAL GUIDANCE MAIN TOPICS

Transparency  

  • Exchanges should ensure that information is readily available detailing the crediting programs and specific types of projects underlying the VCC derivatives.  VCCs must accurately reflect the nature of the greenhouse gas (GHG) emission reductions or removals they claim to represent.  Contracts should clarify which types of VCCs are deliverable and the extent of their connection to categories of mitigation activities, such as nature-based solutions or carbon capture technologies. 

Additionality  

  • The final guidance emphasizes that additionality is a key feature of high-quality VCCs to demonstrate that emissions reductions are not merely the result of regulatory compliance.  While the CFTC sought input on defining additionality as emissions reductions or removals from projects not mandated by law, it opted against finalizing a definition due to varying interpretations in voluntary carbon markets.  The final guidance tasks exchanges and crediting programs with implementing rigorous verification procedures to assess additionality, which may lead to inconsistencies. 

Permanence and Risk of Reversal 

  • Exchanges should investigate whether the crediting program for VCCs includes measures to manage reversal risk where emissions previously accounted for may be released back into the atmosphere or the reductions reevaluated. The final guidance advises exchanges to consider whether the program maintains a buffer reserve or other risk management strategies to mitigate this issue. 

Robust Quantification 

  • The CFTC stresses the importance of conservatively quantifying GHG reductions or removals for VCC derivatives to ensure that the value of carbon credits reflects their true environmental impact and prevent inflated credit values that could mislead investors and buyers.  Exchanges must implement position limits for speculators as needed for listed derivative contracts.  

Governance 

  • Exchanges should assess whether the crediting program has a governance structure that ensures independence, transparency, and accountability, and whether this framework is made publicly accessible.  The program’s registry may serve as a delivery point for physical settlements of VCC derivatives.  Exchanges should review the decision-making processes, independence of key functions, reporting protocols, stakeholder engagement, risk management strategies, appeals mechanisms, and financial resources. 

Tracking 

  • Exchanges should evaluate whether the crediting program has adequate systems in place to track the issuance, transfer, and retirement of VCCs. This includes identifying ownership and ensuring each VCC is associated with a specific metric ton of carbon dioxide equivalent. 

Prevention of Double-Counting 

  • Exchanges should ensure that the crediting program has effective safeguards to prevent double-counting of credited emissions reductions or removals, ensuring that each VCC is issued to only one registry and cannot be reused post-retirement or cancellation. “Reasonable assurance” involves conducting cross-checks across multiple carbon registries. 

Inspection Provisions, Including Third-Party Validation and Verification 

  • The terms and conditions for VCC derivatives should clearly outline any inspection or certification processes needed to verify compliance with quality standards and delivery requirements. Exchanges must confirm that these terms align with current best practices in voluntary carbon markets, considering whether validation and verification procedures are conducted by a reputable, impartial entity. 

Monitoring 

  • The final guidance instructs exchanges to actively monitor the terms and conditions of derivatives in relation to the underlying commodity market, employing robust market surveillance, compliance, and enforcement practices. 

FINAL GUIDANCE DIFFERENTIATIONS

Definitions 

  • Proposed Guidance: Defined voluntary carbon credits primarily as credits generated from projects that reduce or remove greenhouse gas emissions, emphasizing the need for standardization in methodologies. 
  • Final Guidance: Clarified definitions to include specific types of credits (e.g., nature-based solutions versus technological solutions) and refined the criteria for what constitutes a legitimate carbon credit, potentially including additional metrics like permanence and leakage. 

Compliance Requirements 

  • Proposed Guidance: Suggested that market participants maintain detailed records and adhere to existing CFTC regulations, with an emphasis on rigorous documentation of emissions reductions. 
  • Final Guidance: Introduced more specific compliance frameworks, including tiered reporting requirements based on the size and scope of the carbon credit projects. This might allow smaller projects to follow a more simplified compliance pathway. 

Market Integrity Measures 

  • Proposed Guidance: Emphasized the need for robust verification processes and third-party audits, along with mechanisms to prevent fraud, such as mandatory disclosures. 
  • Final Guidance: Specified the types of verification bodies that are acceptable and outlined a more structured approach to auditing, including frequency and standards for third-party audits. Introduced penalties for non-compliance to enhance accountability. 

Stakeholder Engagement 

  • Proposed Guidance: Acknowledged the importance of public comments but had a more prescriptive tone regarding regulatory expectations. 
  • Final Guidance: More responsive to stakeholder feedback and integrates suggestions from public comments to enhance clarity and usability of the guidance. 

FINAL GUIDANCE OVERVIEW

  1. Background – Page 3
    1. The Regulatory Framework for DCMs – Page 3 
    2. Voluntary Carbon Markets – Page 8
      1. Overview of Voluntary Carbon Markets – Page 8 
      2. Initiatives to Promote Transparency, Integrity and Standardization in the Voluntary Carbon Markets – Page 11 
    3. The Commission and Voluntary Carbon Markets – Page 14
      1. Derivative Contracts on Environmental Commodities, Including VCCs – Page 14 
      2. CFTC Initiatives Relating to Voluntary Carbon Markets – Page 16 
        1. First Voluntary Carbon Markets Convening – Page 16 
        2. Commission Request for Information – Page 16 
        3. Second Voluntary Carbon Markets Convening – Page 18 
    4. Proposed Guidance Regarding the Listing of VCC Derivative Contracts – Page 18 
  2. Comments on the Proposed Guidance – Page 23 
    1. Overview – Page 23 
    2. Specific Comments – Page 25 
      1. Scope and Application of Guidance – Page 25 
      2. A DCM Shall Only List Derivative Contracts That Are Not Readily Susceptible to Manipulation – VCC Commodity Characteristics – Page 31 
        1. General – Page 31 
        2. Social and Environmental Factors – Page 31 
        3. Quality – Page 36  
          1. Transparency – Page 36 
          2. Additionality – Page 41 
          3. Permanence and Accounting for the Risk of Reversal – Page 48 
          4. Robust Quantification – Page 54 
        4. Delivery Points and Facilities – Page 59 
          1. Governance – Page 59  
          2. Tracking – Page 63 
          3. No Double-Counting – Page 67 
        5. Inspection Provisions – Third-Party Validation and Verification – Page 70  
      3. A DCM Shall Monitor a Derivative Contract’s Terms and Conditions as They Relate to the Underlying Commodity Market – Page 74 
      4. A DCM Must Satisfy the Product Submission Requirements Under Part 40 of the CFTC’s Regulations and CEA Section 5c(c) – Page 76
      5. Foreign Boards of Trade – Page 78 
  3. Guidance Regarding the Listing of VCC Derivative Contracts – Page 80 
    1. A DCM Shall Only List Derivative Contracts That Are Not Readily Susceptible to Manipulation – Page 82 
      1. Quality Standards – Page 85 
        1. Transparency – Publicly Available Data to Promote Transparency – Page 86 
        2. Additionality – Page 87 
        3. Permanence and Accounting for the Risk of Reversal – Page 88 
        4. Robust Quantification – GHG Emission Reductions or Removals Should be Conservatively Quantified – Page 90 
      2. Delivery Points and Facilities – Page 91 
        1. Governance – Page 92  
        2. Tracking – Page 93 
        3. No Double-Counting – Page 93 
      3. Inspection Provisions – Third-Party Validation and Verification – Page 94 
    2. A DCM Shall Monitor a Derivative Contract’s Terms and Conditions as They Relate to the Underlying Commodity Market – Page 95 
    3. A DCM Must Satisfy the Product Submission Requirements Under Part 40 of the CFTC’s Regulations and CEA section 5c(c) – Page 97