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CFTC ISSUES PROPOSED GUIDANCE REGARDING THE LISTING OF VOLUNTARY CARBON CREDIT
DERIVATIVE CONTRACTS

December 21, 2023

Click for PDF

The VCC Proposal enumerates certain factors that a CFTC-regulated exchange, such
as a designated contract market or a swap execution facility, should consider.

On December 4, 2023, the Commodity Futures Trading Commission (the “CFTC” or the
“Commission”) approved proposed guidance and a request for public comment
regarding the listing for trading of voluntary carbon credit (“VCC”) derivative
contracts (the “VCC Proposal”).[1] The VCC Proposal enumerates certain factors
that a CFTC-regulated exchange, such as a designated contract market (“DCM”) or
a swap execution facility (“SEF”)[2] should consider in connection with the
relevant Commodity Exchange Act (“CEA”) requirements and CFTC regulations
applicable to the design and listing of contracts. Comments on the VCC Proposal
are due on or before February 16, 2024.

This alert provides a high-level summary of the VCC Proposal and related
considerations for participants in the voluntary carbon markets.

Overview

The VCC Proposal represents the most recent development in the CFTC’s interest
in the voluntary carbon markets and explains how the statutory “Core
Principles”[3] apply to VCC[4] derivatives. In particular:

 * Recognizing that VCC derivatives are a relatively new set of products that
   continue to receive an increasing amount of attention, the CFTC issued the
   VCC Proposal as guidance for DCMs and SEFs to consider in the context of
   product design and listing.
 * The CFTC builds on private sector initiatives that are designed to foster the
   standardization of VCC derivatives and promote transparent and liquid
   markets. The CFTC specifically requested comment on whether it should require
   DCMs to incorporate any VCC standards set by the private sector into the
   terms and conditions of a VCC derivative contract.[5]
 * The CFTC referenced its regulatory authority over environmental commodity
   derivatives, as established in a joint product definition rulemaking with the
   Securities Exchange Commission following the passage of the Dodd-Frank Wall
   Street Reform and Consumer Protection Act.[6]
 * Critically, the CFTC does not have regulatory authority over the spot trading
   of VCCs. However, the CFTC does have enforcement authority over fraud and
   manipulation in the spot VCC market.[7] The VCC Proposal is an effort by the
   CFTC to promote integrity in the voluntary carbon markets by requiring more
   diligence on VCC derivatives, which can indirectly influence behavior in the
   spot market.[8]
 * DCM Core Principle 3 (a requirement that a DCM only list for trading
   contracts that are not readily susceptible to manipulation) and DCM Core
   Principle 4 (a requirement that a DCM prevent manipulation, price distortion,
   and disruptions of the physical delivery or cash-settlement process through
   market surveillance, compliance, and enforcement practices and procedures)
   form the foundation of the VCC Proposal.
 * The VCC Proposal addresses the product submission requirements under Part 40
   of the CFTC’s regulations and CEA section 5c(c), as such requirements relate
   to VCC derivatives.
 * The VCC Proposal is limited in scope. As Commissioner Johnson stated, the
   CFTC “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 VCC Proposal suggests the potential
   for a broader and more comprehensive regulatory framework… there may be
   several interventions that may bring similar needed reforms to
   over-the-counter traded environmental commodities—material risk disclosures,
   good faith and fair dealing, and clearing.”[9]

The CFTC and Voluntary Carbon Markets

The VCC Proposal states that there are now more than 150 derivative contracts on
mandatory emissions program instruments listed on DCMs.[10] Eighteen futures
contracts on voluntary carbon market products have been submitted to the CFTC by
DCMs as of November 2023. Three of those eighteen contracts currently have open
interest.[11]

Chairman Benham has increased the CFTC’s attention on carbon markets and
environmental aspects of the derivatives and commodities markets in recent
years.[12] For example:

 * In June 2022, Chairman Behnam held the first-ever Voluntary Carbon Markets
   Convening to address product standardization, integrity, and other matters
   related to the supply of and demand for high quality carbon credits.
 * Also in June 2022, the CFTC issued for public comment a request for
   information regarding the CFTC’s ability to regulate climate-related
   financial risk relevant to the derivatives markets and underlying commodities
   markets.
 * In July 2023, Chairman Behnam held the Second Voluntary Carbon Markets
   Convening to discuss private sector efforts on developing high quality carbon
   credits, market trends and developments, public sector initiatives, and to
   hear market participants’ concerns.

CFTC Guidance for DCMs Regarding the Listing of VCC Derivative Contracts

The VCC Proposal is not meant to modify or supersede the existing regulatory
framework regarding the listing of derivative products by CFTC-regulated
exchanges. The VCC Proposal focuses mainly on physically-settled VCC derivative
contracts because, to date, all listed VCC derivative contracts are
physically-settled. However, the CFTC noted that it “continues to believe that,
with respect to cash-settled derivative contracts, an acceptable specification
of the cash settlement price would include rules that fully describe the
essential economic characteristics of the underlying commodity.”[13]

1. A DCM Shall Only List Derivative Contracts That Are Not Readily Susceptible
to Manipulation.

The requirement that a DCM only list derivative contracts that are not readily
susceptible to manipulation follows DCM Core Principle 3.[14] While the
Commission acknowledges that “standardization and accountability mechanisms for
VCCs are currently still being developed,” it has identified certain criteria,
present in both mandatory and voluntary carbon markets, as critical to assessing
the integrity of carbon credits. The VCC Proposal explains that the Commission
“preliminarily believes” that a DCM should take into consideration quality
standards, delivery points and facilities, and inspection provisions (which the
CFTC refers to as “VCC commodity characteristics”) when designing a VCC
derivative contract.

(A) Quality Standards

A DCM should consider transparency, additionality, permanence and risk of
reversal, and robust quantification when addressing quality standards in the
development of the terms and conditions of a VCC derivative contract.[15]

 * Transparency. The contract terms and conditions should include information
   that readily specifies the crediting program(s)[16] – and, as applicable, the
   specific types of projects or activities – from which VCCs that are eligible
   for delivery under the contract may be issued. Whether the crediting
   program(s) make such information publicly available is an important
   consideration.
 * Additionality. It is critical that the greenhouse gas emission reductions or
   removals of the underlying VCC would not have occurred but for the monetary
   incentive created by the sale of carbon credits. Information on the crediting
   program(s) assessment and testing of 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.
 * Permanence and Risk of Reversal.
   * The crediting program(s) should be able to demonstrate that it has measures
     in place to adequately address 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.
   * A DCM should consider whether the crediting program for a VCC has measures
     in place, such as “buffer reserves” or other mechanisms, 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. (The risk of reversal may impact the risk
     management needs of VCC derivative market participants.)
 * Robust Quantification.
   * A DCM should consider the methodology or protocol used by a crediting
     program to calculate the level of greenhouse gas emission reductions or
     removals associated with credited projects or activities.
   * Given the current absence of a standardized methodology or protocol to
     quantify greenhouse gas emission reduction or removal levels (both across
     crediting programs and within 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 greenhouse
     gas emission reductions or removals for the underlying VCCs is robust,
     conservative, and transparent.
   * A quantitative estimate of the deliverable supplies can be used as the
     basis for effectively setting the DCM’s exchange-set speculative position
     limits.

(B) Delivery Points and Facilities

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.[17]

With respect to a physically-settled VCC derivative contract, the CFTC
“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. In particular:

 * Governance. The CFTC stated that it may be appropriate for a DCM to include
   information about the crediting program’s governance framework in the terms
   and conditions of a physically-settled VCC derivative contract. Accordingly,
   in reviewing a crediting program’s governance mechanisms, a DCM should
   assess, at a minimum:
   * 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;
   * Risk management policies (including financial resources/reserves,
     cyber-security, and anti-money laundering policies); and
   * Whether information regarding such procedures and policies is made publicly
     available.
 * Tracking.
   * A DCM should ensure that 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.
   * A 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. The
     CFTC suggested additional considerations would apply in the event that the
     registry also serves as the delivery point.
 * No Double Counting. The CFTC 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 (i.e., VCCs cannot be issued to more than one registry and cannot be
   used after retirement or cancelation).
   * 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.

(C) Inspection Provisions – Third Party Validation and Verification

Any inspection or certification procedures for verifying compliance with quality
requirements or any other related delivery requirements for physically-settled
VCC derivative contracts should be specified in the contract’s terms and
conditions and should be consistent with the latest procedures in the voluntary
carbon markets.

 * A 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.
 * Additionally, in 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, and – more broadly – whether they reflect best practices.

2. 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. With
respect to a DCM’s monitoring of the terms and conditions of a
physically-settled VCC, the CFTC preliminarily believes that such monitoring
would include, at a minimum:

 * Ensuring that the underlying VCC reflects the latest certification standard
   applicable for that VCC by, among other things, amending the contract’s terms
   to correspond to any such update and monitoring the available deliverable
   supply in connection with the developments regarding new standards or
   certifications and
 * Maintaining rules that require their market participants to (i) keep records
   of their trading, including records of their activity in the underlying
   commodity and related derivatives market, and, importantly, (ii) make such
   records available to the DCM upon request.

3. A DCM Must Satisfy the Product Submission Requirements Under Part 40 of the
CFTC’s Regulations and CEA section 5c(c).

The VCC Proposal highlights three submission requirements in connection with the
listing of VCC derivative contracts.

 1. The contract submission must include an explanation and analysis of the
    contract and its compliance with applicable provisions of the CEA, including
    the DCM Core Principles and CFTC regulations.
 2. The explanation and analysis of the contract must “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.”[18]
 3. 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 CFTC’s regulations or policies
    thereunder.[19]

The information provided to the CFTC in connection with the above may include
qualitative explanations and analysis and is expected to be “complete and
thorough.”

Conclusion

While the VCC Proposal’s scope is limited to exchange-traded VCC derivatives, it
suggests implications for the over-the-counter VCC derivatives markets, as well
as the VCC spot markets, including by providing DCMs and the CFTC greater
insight into trading activity in the VCC spot markets. Accordingly, the comment
process and the Commission’s guidance should play an important role in shaping
the future of the voluntary carbon markets.

__________

[1]  The VCC Proposal and statements by the Chairman and Commissioners are
available at: https://www.cftc.gov/PressRoom/PressReleases/8829-23.

[2]  As discussed in the body of the alert, the CFTC focuses on
physically-settled VCC derivative contracts but “preliminarily believes that the
[VCC Proposal] 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.” VCC Proposal at 20.

[3]  See, generally, CEA Section 5(d), 7 U.S.C. 7(d).

[4]  In footnote 31 of the VCC Proposal, the CFTC clarifies its use of the term
“voluntary carbon credits” rather than “verified carbon credits.” The VCC
Proposal concerns itself with “the quality and other attributes of the
intangible commodity underlying a derivative,” while recognizing that the cash
and secondary markets for voluntary carbon credits may avail themselves of the
standard terms and templates published by the International Swaps and
Derivatives Association (ISDA) for the trading and retirement of “verified
carbon credits,”. 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.

[5]  VCC Proposal at 38.

[6]  Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based
Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping; Final
Rule, 77 Fed Reg 48208, 48233-48235 (August 13, 2012). (“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.”)

However, the VCC Proposal “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….” See VCC Proposal at footnote 68.

[7]  See 7 U.S.C. § 9; 17 CFR § 180.1.

[8]  This approach – providing guidance to DCMs for the listing of new or novel
products – is similar to the CFTC’s approach to regulating Bitcoin futures and
other digital assets. See e.g., “CFTC Backgrounder on Self-Certified Contracts
for Bitcoin Products” (2017), available here.

[9]  We note that swap dealers are subject to CFTC Regulation 23.600(c)(3)’s
“New Product Policy” requirement and the external business conduct standards
applicable to swap dealers (17 CFR Part 23 Subpart H).

[10]  The CFTC explains that derivative contracts on mandatory emissions
products have been trading since 2005, with greenhouse gas emissions-related
products first listed in 2007.  See VCC Proposal at 14.

[11]  See VCC Proposal at footnote 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.”)

[12]  In his statement accompanying the VCC Proposal, Commissioner Benham stated
that “The publication of this [VCC Proposal] 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.”

[13]  VCC Proposal at 19.

[14]  CEA section 5(d)(3), 7 U.S.C. 7(d)(3). See also 17 CFR §§ 38.200-201.

[15]  The VCC Proposal should be considered in light of recent issues involving
the verification of carbon credits. For more detail on one issue, involving
Verra, please refer to Gibson Dunn’s Carbon Markets Update – Q2 2023 at page 1,
available here:
https://www.gibsondunn.com/wp-content/uploads/2023/07/carbon-markets-update-q2-2023.pdf.

[16]  Commissioner Goldsmith Romero focused on the role of crediting programs in
her remarks, asking commenters to address “whether market integrity can be
improved by exchanges relying on a crediting program’s processes and diligence,
as assumed in the [VCC Proposal], or if there is a benefit to exchanges
conducting additional due diligence into specific categories, protocols, or
projects.”

[17]  See Appendix C to Part 38 of the CFTC’s regulations, paragraph
(b)(2)(i)(B)

[18]  17 CFR §§ 40.2(a)(3)(v) (for self-certification) and 40.3(a)(4) (for
Commission approval).

[19]  17 CFR §§ 40.2(b) (for self-certification) and 40.3(a)(10) (for Commission
approval).

--------------------------------------------------------------------------------

The following Gibson Dunn attorneys prepared this update: Jeffrey Steiner, Adam
Lapidus, and Hayden McGovern.

Gibson Dunn’s lawyers are available to assist in addressing any questions you
may have regarding the issues discussed in this update. Please contact the
Gibson Dunn lawyer with whom you usually work, any member of the firm’s
Derivatives practice group, or the following authors:

Jeffrey L. Steiner – Washington, D.C. (+1 202.887.3632, jsteiner@gibsondunn.com)

Adam Lapidus – New York (+1 212.351.3869, alapidus@gibsondunn.com)

© 2023 Gibson, Dunn & Crutcher LLP.  All rights reserved.  For contact and other
information, please visit us at www.gibsondunn.com.

Attorney Advertising: These materials were prepared for general informational
purposes only based on information available at the time of publication and are
not intended as, do not constitute, and should not be relied upon as, legal
advice or a legal opinion on any specific facts or circumstances. Gibson Dunn
(and its affiliates, attorneys, and employees) shall not have any liability in
connection with any use of these materials.  The sharing of these materials does
not establish an attorney-client relationship with the recipient and should not
be relied upon as an alternative for advice from qualified counsel.  Please note
that facts and circumstances may vary, and prior results do not guarantee a
similar outcome.

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