In March 2021, when the Securities and Exchange Commission (SEC) released questions on climate-related financial disclosures for public input, it received thousands of responses, albeit mostly in form letters. The Commodity Futures Trading Commission (CFTC or “Commission”) had received 77 responses by October 12 to their 34 multi-part questions about climate-related financial risk in the derivatives (futures, options, swaps) markets. The CFTC regulates contracts and markets that manage short term (generally, 90 days to one year) price risks in physical commodities (e.g., wheat, oil) and financial commodities (e.g., interest rates) that affect the daily lives of people around the world. The Commission asked an appropriately broad range of questions, since climate change’s multiple and repeated impacts will affect every asset class under its authority. Because the CFTC is a member of the Financial Stability Oversight Council (FSOC), one question concerns how the impacts of climate change in the derivatives markets could contribute to systemic financial instability, such as that of global banks in 2007-2008 prior to their rescues by central banks. (FSOC, chaired by the Secretary of Treasury, has representatives from all federal financial regulators, except for the Farm Credit Administration. In 2021, FSOC published a report on climate-related financial risk.)
Despite the relatively small response rate to the CFTC questions, the range of answers was huge in terms of what the CFTC should or not do to help manage climate-related financial risks in the contracts, market participants, trading exchanges and clearing (transaction completion) organizations that the CFTC oversees. This summary of responses tries to represent some of that huge range.
IATP response to the CFTC
First, a short summary of IATP’s 20-page response letter. We reiterated a September 2021 request that the CFTC issue a comprehensive and up-to-date study of greenhouse gas emissions offset markets and the underlying assets of emissions offset futures contracts, including land based offset projects (mostly forestry or agriculture) claiming to avoid or reduce emissions. Responding to Commission questions about data needs, we advised the staff to consult studies that projected climate change impacts on agricultural production, transportation and energy contracts. These impacts would require changes in CFTC rules concerning the definitions of deliverable supply and delivery points for physically based derivatives contracts. We recommended the Voluntary Registry Offsets Database as an authoritative source, including concerning emissions offset quality problems. IATP advocated that the Commission’s stress testing of the financial ability of trading exchanges and clearing organizations to remain solvent after major climate shocks focus on the impact of irreversible and major climate “tipping points” in 2030, rather than on more distant scenarios. Regarding the CFTC’s responsibilities as a FSOC member, we recommended that the staff conduct a “worst case economics” assessment of how widespread private Voluntary Carbon Market (VCM) offset futures price collapses and defaults would impact U.S. financial stability. IATP concluded the letter by urging the CFTC to monitor the Paris Agreement Article 6 market mechanism implementation negotiations. The Article 6 debate over “Share of Proceeds” (SOPs) from international offset trading could result in SOP collection by exchanges overseen by the Commission.
IATP summarized agribusiness opposition to the proposed SEC climate-financial disclosure rule, which included veiled threats to litigate to prevent the rule’s implementation. Because the CFTC has not yet proposed a rule, study or even a data collection on climate risk in the derivatives markets, the few farm and agriculture organizations that responded to the questions, such as Blue Diamond Farming Company, were mostly concerned about ensuring high quality carbon emissions offset credits for trading on VCMs. (Bryant Agriculture Enterprises sent an identical letter.) The National Family Farm Coalition wrote, “Carbon markets should not be a substitute for strong federal programs that bolster the practices and people already in place that have been committed to sustainability and land stewardship for years.” Apart from these written communications, agribusiness, like every other interest group, can and will express their views on managing climate financial risk in private meetings with CFTC staff without addressing any of the CFTC’s questions directly.
Summary and some analysis of additional responses to the CFTC
At one end of the spectrum is a letter from 20 Republican attorneys general threatening to take legal action if the CFTC does anything, even if within the CFTC’s statutory authority, “under the major questions doctrine.” According to this doctrine invented and applied by the Supreme Court, e.g., in West Virginia v. EPA to limit the Environmental Protection Agency’s authority to implement the Obama administration’s Clean Power rule, Congress must give agencies explicit and detailed regulatory authority over matters having significant economic and/or political consequences. Furthermore, if the CFTC requires brokers and other intermediaries to disclose the climate-related financial risks of investing in futures, options or swaps contracts, the CFTC would be sued for “compelled speech” under a novel interpretation of the First Amendment to the U.S. Constitution. Furthermore, the AGs predicted, “courts would find climate-related Commission action to be arbitrary and capricious” under the Administrative Procedures Act. These threats are very similar to those made by the West Virginia Attorney General even before the SEC proposed its climate-related financial disclosure rule.
A more subtle warning comes from industry associations that might join a Republican lawsuit or file a separate lawsuit. For example, the CME Group, which owns exchanges that comprise the largest trading platform in the world, wrote, “The Commission’s principles-based regulatory foundation enables market stakeholders to create and innovate and should not be compromised by the temptation to reach into policy areas best addressed by regulators with different competencies, history, and expertise.” (p. 2) Principles based regulation, particularly as practiced during the Trump administration, delegated most CFTC authority to the exchanges, market participants, intermediaries and clearing organizations to self-regulate. For example, CME writes, “The Commission has repeatedly recognized that while a DCO [Derivatives Clearing Organization] should address all the risk types to which it is exposed, it was not necessary, in fact harmful, to explicitly list them in the regulation.” (p. 7) The footnote for this sentence refers to a January 2020 Trump administration rule that reversed a Dodd Frank Act authorized 2011 rule that required DCOs to list the kinds of risks that could cause DCO members or their clients to default on paying for trades already executed on CME Group and other exchanges. If you list those risks, then you are obliged to monitor them and report them to the Commission when they occur.
The Center for American Progress (CAP) offered a more granular assessment of climate-related risk for DCO members: “DCOs must know whether their members’ operations face climate risk not reflected by collected initial margin [collateral required to trade]. Each DCO should similarly know whether its counterparties’ transactions are so concentrated in one instrument subject to climate risk (such as corn futures) that climate caused natural disasters one season would threaten the party’s solvency.” (p. 4) Although CME makes short-term weather-related adjustments to its risk models (p. 8), they do not take into account the repeated hits to solvency portended by climate risk scenario analysis and stress testing guided by the U.S. National Climate Assessment, as recommended by CAP. (p. 3)
The CME letter referred, almost in passing, to the controversies over the integrity of VCMs and offset credits that underlie offset emissions futures contracts, including those of the CME Group: “the framework for the spot market for voluntary carbon is continuing to evolve. At this point, we believe that the CFTC should facilitate ongoing discussion while being mindful that imposing regulation too early may impede innovation.” (p. 11) The analysis among respondents to the three questions about VCMs is too varied to characterize easily. However, the poles of analysis are: 1) the CFTC should cooperate with industry efforts, above all the Integrity Council for Voluntary Carbon Markets (ICVCM), by allowing industry to standardize and improve the quality of Voluntary Carbon Credits (VCCs) and the VCM protocols that produce them; 2) if the VCCs cannot be improved and those improvements cannot be enforced, the VCCs should not be allowed for use as the underlying assets of emissions offset derivatives contracts.
Ceres is an NGO that works with “more than 220 institutional investors that collectively manage over $60 trillion in assets.” Ceres advocates for CFTC collaboration with the ICVCM “to ensure rigorous evaluation and meaningful certification of all carbon credits by outside, neutral, and expert third parties,” such as the expert group advising ICVCM. Ceres also advocates for technology-based carbon removals, such as Direct Air Capture, that “will be essential if we are to avoid the worst impacts of climate change,” a position shared by ICVCM.
Carbon Plan argues that the ICVCM standard setting process to develop a Core Carbon Principle standard to which major offset verification protocols will adhere is far from a done deal: “Verra’s reaction [to the draft CCP and Assessment Framework of verification protocols] portends the continued absence of consensus over voluntary carbon market quality standards. For one thing, Verra’s dominant market share gives it enormous influence with the ICVCM process, even beyond its CEO’s seat on the ICVCM Governing Board: Verra issues two out of every three credits in the voluntary carbon markets today.” (p. 2) How do you persuade that elephant in the room to come along quietly? Even if ICVCM members convince Verra that agreeing to the ICVCM standard is in Verra’s self-interest, continued self-regulation of VCMs is not in their own interest: “the apparent inability of key ICVCM stakeholders to agree even on whether the ICVCM’s Expert Panel should review the quality of incumbent registry standards is evidence that continued self-regulation is not in the best interest of the voluntary carbon markets going forward.” (p. 9)
CarbonPlan urges the CFTC to take a very active role in defining offset credit types in a way that distinguishes the durability of temporary emissions reductions from the very nascent, very expensive technology-based emissions removals. If the CFTC were to follow CarbonPlan’s advice, self-regulation advocates might start to plan their lawsuits.
Alternatively, what happens if the evidence of offset fraud, human rights violations and lack of environmental integrity in VCMs and VCCs, documented in great detail in the AFR/Amazon Watch coordinated letter, continues to grow? It would be an extremely high stakes gamble for institutional investors to bet big on offset futures contracts built on the hope that someday VCMs will resolve the integrity issues that continue to plague them. The AFR/Amazon Watch letter recommends several actions that the CFTC should undertake to investigate the state of the VCMs, including those that provide credits underlying emissions offset futures that the CFTC has allowed exchanges to self-certify as compliant with Commission rules. However, the letter states (and IATP agrees) “If CFTC finds that integrity issues within the underlying carbon offsets markets cannot be resolved, it should disallow carbon offset derivatives trading.” To ban the trading of offset futures would require revoking self-certifications of at least three CME contracts, revolutionary acts that would almost certainly trigger industry litigation.
Let’s assume that the CFTC continues to allow the trading of offset futures regardless of reports of integrity failures in the offset projects and offset verification protocols. What else could the CFTC do to regulate VCMs? Several NGO responders proposed that the CFTC require the verification protocols that sell credits directly to private parties or on exchanges to register with the CFTC. Registration would trigger recordkeeping and reporting rules and would facilitate investigation of VCMs if their VCCs were discovered to misstate claimed emissions reduction or were based on fraudulent emissions offset projects.
The Futures Industry Association (FIA) argues “the CFTC not [to] establish a registration framework for market participants specific to the voluntary carbon markets. Such registration requirements could inhibit the growth of these emerging markets, which are in need of liquidity,” i.e., more capital. Rather than focus on the registration of the protocols verifying and selling VCCs, FIA pivots to the registration of market participants. FIA contends that such registration would prevent farmers from selling offset credits to VCMs. However, farmers would not be registered, nor do they sell offset credits to VCMs nor do they provide significant offset liquidity to VCM or to offset futures contracts. Farmer emission offsets are too small to become VCCs, so they are aggregated by soil carbon accountants, such as Nori and Indigo, for sale without verification about the integrity and durability of the offset.
The Better Markets letter proposes that the CFTC set a position limit for a lithium futures contract and possibly for other metals critical to the future of renewable energy and battery storage capacity. (pp. 8-9) Indeed, Better Markets calls for an overall strengthening of the position limit regime to prevent excessive speculation. The CME, FIA and other industry groups persuaded the Trump administration CFTC to set a sky-high position limit on financial speculation in physical commodity futures and to allow the exchanges to determine which positions counted towards the limit. Legalized excessive speculation, unrestrained by unregulated automated trading systems, could threaten price risk management of the costs of renewable energy. Better Markets has many other responses as to what the Commission should do concerning climate-related financial risk management, but IATP concurs with the final sentence in their letter: “In no case can the Commission allow an entity marketing low-quality VCCs to invoke the imprimatur of Commission approval, even implicit approval.” (p. 25)
Commission staff will now evaluate the responses and advise the Chair and four Commissioners whether to take an active role in regulating climate-related financial risks or to follow industry advice and allow industry to self-regulate those risks. IATP wants the CFTC to use its congressional authorities and regulations to be proactive about climate-related financial risks. However, Congress has not reauthorized the CFTC since 2008 and a reauthorization bill in the next session of Congress could extend CFTC authority explicitly to act on those risks. Or not. IATP responded to a 2013 Senate agriculture committee request on reauthorization. If the Senate and/or House agriculture committees request information about reauthorization, IATP will surely recommend authorities and resources for the CFTC to help manage climate-related financial risks.