Significant Changes in CFTC's Final Guidance on Listing Voluntary Carbon Credit Derivatives

The Commodity Futures Trading Commission (CFTC) released its final guidance regarding Designated Contract Markets' (DCMs) listing of voluntary carbon credit (VCC) derivative contracts for trading, marking a pivotal development in the regulation of carbon markets. This final guidance, issued on September 20, 2024, incorporates several significant changes from the proposed guidance released in December 2023. Here, we highlight the most notable adjustments from the proposed guidance and their implications for market participants.

Key Changes From Proposed to Final Guidance

1. Emphasis on both physically settled and cash-settled contracts. The final guidance expands its focus to include both physically settled and cash-settled VCC derivative contracts, while the proposed guidance primarily concentrated on physically settled contracts. This change reflects the CFTC's recognition of the diverse nature of VCC markets and the need for comprehensive oversight.
2. Enhanced core principle compliance. The final guidance provides more detailed considerations for compliance with DCM Core Principles, particularly Core Principle 3 (contracts not readily susceptible to manipulation) and Core Principle 4 (monitoring trading activity). The final guidance incorporates feedback from public comments emphasizing the necessity for transparency and integrity in VCC markets.
3. Standardization efforts. The final guidance places greater emphasis on standardization efforts and acknowledges private sector initiatives aimed at ensuring high-integrity VCCs. The proposed guidance was less explicit about these efforts, focusing more on contract-specific considerations.

Specific Factors for Designing and Listing VCC Contracts

The final guidance details several factors to consider when designing and listing VCC derivative contracts to ensure compliance with CFTC regulations.

1. Contract design. Contracts should align with common commercial practices in the underlying cash market to promote convergence between contract prices and cash market values at expiration. Terms should clearly define quality standards for underlying commodities to avoid delivery impediments. As we noted in our analysis of the proposed guidance, that means DCMs need to track the fast-evolving standards of the voluntary carbon market (VCM) overall.
2. Manipulation susceptibility. Contracts must be designed to minimize susceptibility to manipulation by ensuring transparency in pricing and delivery processes. DCMs should monitor contract terms in relation to underlying commodity markets to prevent price distortions.
3. Submission requirements. DCMs must satisfy product submission requirements under Part 40 of CFTC regulations, ensuring all necessary information is provided for new contracts or amendments.
4. Market integrity. Emphasize high-integrity VCCs by aligning with private sector standards that promote accurate reflection of greenhouse gas emission reductions or removals. Ensure that contract specifications support risk management and price discovery purposes effectively.

Voluntary Carbon Market-Specific Changes From Proposed Guidance

With minor changes, the final guidance retains the proposed guidance's alignment with many ongoing VCC quality efforts, like the first eight Core Carbon Principles from the Integrity Council for the Voluntary Carbon Market, as we discussed in our earlier analysis. In one noteworthy change, the CFTC dialed back the amount of detail and rigor expected from DCMs with respect to the assurances—and even definition—of "additionality" of greenhouse gas reductions represented by VCCs.

In addition, the final guidance notes the importance of social and environmental safeguards in some market participants' assessment of VCC quality. The CFTC therefore states clearly that a DCM may consider whether the crediting systems for underlying VCCs take account of projects' social and environmental safeguards and alignment with long-term net-zero greenhouse gas goals, issues addressed by Core Carbon Principles 9 and 10. This may give comfort to DCMs choosing to emphasize those issues but stops short of fully importing these "co-benefit" quality factors for purposes of VCC derivatives contracts.

Broader Context and Next Steps

Commissioner Mersinger dissented from the final guidance, expressing concerns about singling out VCC derivative contracts as compared to other derivative products and criticizing the final guidance for providing little clarity and not fostering transparency. She argues that "[f]ocusing on ESG and Net Zero goals in evaluating derivatives contracts is a backdoor attempt to inject and memorialize certain political ideologies into CFTC regulatory decisions."

Notably, the SEC has disbanded its Climate and ESG Enforcement Task Force, which had been active for over three years. This decision reflects a broader trend of distancing from ESG initiatives amid industry resistance and legal challenges, although the SEC maintains that it will continue to monitor ESG-related disclosures and enforce compliance using strategies developed by the task force.

Meanwhile, on October 2, 2024, the CFTC brought its first action alleging fraud in the voluntary carbon credit market. The CFTC filed a complaint in the Southern District of New York against Kenneth Newcombe while settling charges against CQC Impact Investors LLC and Jason Steele over allegations of fraud and false, misleading, or inaccurate reports relating to voluntary carbon credits. The SEC and DOJ brought parallel actions against these same entities. CQC Impact Investors LLC agreed to a civil monetary penalty of $1 million to settle the charges with the CFTC.

Taken together, the increased scrutiny in the voluntary carbon credit market demonstrates the CFTC's proactive stance in shaping a robust regulatory framework for carbon markets, even as it lets voluntary efforts continue to develop the standards for quality in the underlying carbon credits. By emphasizing standardization and collaboration, the CFTC aims to create a more transparent and reliable market environment that can effectively contribute to emission reduction goals. Market participants should closely review these updates to ensure their compliance with the new guidelines and leverage opportunities arising from increased market integrity and standardization efforts. As the voluntary carbon markets continue to evolve, staying informed about regulatory developments will be crucial for navigating this dynamic landscape.

Finally, with the reelection of former President Donald Trump, changes in direction at the CFTC are likely, as in much of the federal government. It remains to be seen how durable this VCC derivative contracts guidance will prove as adopted, but even if repealed, it remains a valuable and detailed analysis of how U.S. commodity market regulations apply to the novel products and issues in the VCM.

Please reach out to our team if you have questions or need help keeping ahead of changes as they occur.