IATP sent the following comment to secretary of the Commodity Futures Trading Commission on February 16, 2024.
The Institute for Agriculture and Trade Policy (“IATP”)2 appreciates the opportunity to respond to some of the questions in the proposed Guidance. With one exception we note, the Guidance is well anchored in the referenced Core Principles, particularly regarding the obligations of Designated Contract Markets (DCMs).
The proposed Guidance must clearly state the public interest
The Guidance does not include any questions concerning the public interest in Voluntary Carbon Credit (VCC) derivatives and their underlying assets, so we propose a question here: How is the public interest served by provisions proposed in the Guidance? IATP is concerned that under the pressure of the carbon credit “gold rush”3 mindset the Commission may assume the public interest as co-terminus with rules to support the growth of the VCM market. We are signatory to a letter to the Commission regarding a proposed rule on “Investment of Customer Funds by Futures Commission Merchants and Derivatives Clearing Organizations.”4 The letter states, “The CFTC must not embed revenues and profits of exchanges and brokers into the fabric of its definition of the public interest.”5
Industry advocates claim that with “the right rules,” VCC trading will increase exponentially, with one econometric study projecting a $1 trillion annual market already by 2037.6 The Guidance statement on the public interest on VCC derivatives listing requirements must make crystal clear that the public interest provisions of the Commodity Exchange Act and the Core Principles, such as the prevention of fraud, market manipulation and market disruption, must take precedence over adapting Integrity Council for the Voluntary Carbon Market (ICVCM) rules and other private sector guidance to enable exponential VCM growth. The CFTC has announced that its long-standing authority to investigate fraud, price manipulation and market disruption in the underlying assets of derivatives contracts will be applied to VCCs).7 The Guidance must ensure that the adaptation of the ICVCM standards to the Core Principles structure of regulation does not diminish or impede the Commission’s ability to apply this authority under the lobby pressure to exponentially grow VCMs.
Possible future Guidance regarding VCMs
The proposed Guidance suggests that the Commission may offer future guidance documents pertaining to VCC spot markets and VCC derivatives. (Federal Register (FR), p. 89416) IATP recommends that the Commission develop guidance about VCC-related market participant material risk disclosures, taking as a point of departure Commissioner Kristin Johnson’s statement on this proposed Guidance:
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. . . 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.8
Material disclosures, even at a principles-based level, by market participants about their VCC spot market and derivatives activities could reduce information asymmetries in VCMs and in doing so reduce the likelihood of fraud, price manipulation and market disruption. IATP is particularly concerned about the material risk to market participants of low-quality VCCs tokenized in cryptocurrencies, which two researchers have characterized as “zombies on the blockchain.”9 If VCC spot and derivatives trading scale exponentially as forecast, material disclosures, particularly by highly leveraged market participants, will become even more necessary and urgent.
The Commission proposes to adapt the ICVCM standards and accountability mechanisms to fit CFTC Core Principles
In IATP’s response to the Commission’s Request for Information about climate-related financial risk, we wrote, “The Commission should develop its own [emissions] offset trading definitions, rules and guidance, even if it recognizes that the work of private standards may increase the current level of environmental, social and accounting integrity in emissions offset credits.”10 The proposed Guidance has adapted the ICVCM’s Core Carbon Principles (CCPs) standards for VCCs and its Assessment Framework (AF) and Assessment Procedure (AP) accountability mechanisms for the crediting programs that issue the VCCs. The adaptation is not in granular detail but broadly fits part of the Commission’s Core Principles. This letter analyzes some provisions of the ICVCM standards and accountability mechanisms to inform the Commission of how the proposed Guidance might be finalized to advise DCMs to design and list VCC derivatives with a granular analysis of ICVMC work, including its shortcomings.
The proposed Guidance poses questions in a framework that would adapt the Core Principles definitions of “commodity characteristics” developed for tangible commodities to the intangible commodities of greenhouse gas emissions reductions and removals. Indeed, as (Carbon)Plan wrote to the Commission, at the June 2022 Convening on Voluntary Carbon Markets, “Some [panelists and moderators] even suggested the ICVCM would offer a framework for the CFTC and other financial regulators around the world to adopt.”11 The International Organization for Securities Commission (IOSCO)’s consultation paper on Good Practices for Voluntary Carbon Markets likewise advises its 131 member government regulators to support the ICVCM framework.12 The CCP standards and accountability mechanisms have been preliminarily adopted and adjusted to fit the Commission’s Core Principles structure for DCM self-certification or Commission approval or disapproval of new derivatives contracts.
There are several reasons as to why the Guidance takes its point of departure from the ICVCM’s work. As was evident at the Commission’s two VCM Convenings,13 the ICVCM’s members have wide representation among the different actors in the carbon credit trading industry. At the close of the United Nations Framework Convention on Climate Change’s 28th Conference of the Parties (COP28), ICVCM announced, “Carbon-crediting programs with a 98% share of the market have now applied for assessment against the CCPs. . . Exchanges will play a key role in creating a deep, liquid and transparent market for CCP-labelled credits, and they signaled significant support.”14 The ICVCM review of carbon crediting documentation and the preparation of exchanges to trade CCP labeled VCCs are necessary steps to realize the ICVCM theory of change, represented in the “Build Integrity and Scale Will Follow” motto.
Furthermore, the ICVCM announced at COP28 that it is “pleased that the draft guidance published by the Commodity Futures Trading Commission is in accord with the CCPs.”15 The ICVCM has quasi-regulatory momentum. On January 31, the ICVCM announced it “will now begin assessing more than 100 active carbon credit methodologies for adherence to the high integrity Core Carbon Principles (CCPs) with the aim of announcing the first decisions by the end of March.”16 In theory, CCP labeled VCCs could be issued for bilateral purchase and spot market exchange trading by April. If the Guidance for VCC derivatives contract design is finalized to enable CCP labeled credits in spot markets to serve as underlying assets of the DCM carbon derivatives contracts, the ICVCM will have received the de facto imprimatur of the Commission, even if the Commission does not delegate certain of its authorities to ICVCM as a self-regulatory organization. Whether finalization of the Commission’s Guidance for the DCM VCC contract design and listing will confer legitimacy and likely boost market participant confidence in both spot and derivatives carbon markets depends not only on market demand for CCP labeled credits, but also on the environmental and social integrity of the ICVCM standards.
Carbon Direct identified five problems with the state of the VCMs in 2022, including a “quality problem with the continued proliferation of risky [offset] project types.”17 The Guidance proposes that the DCMs should design VCC derivatives contracts by documenting their compliance with the Core Principles to ameliorate the VCC quality problem. The DCMs are to include in the VCC derivatives “terms and conditions” requirements that the underlying VCCs be based on ICVCM derived carbon crediting standards. DCM adoption of these standards in “terms and conditions” are intended to preclude the use of risky project types as in the underlying assets of these contracts. The main contract design benefit of precluding risky project types is to reduce rampant VCC misrepresentation, some of it fraudulent, of climate benefits claimed by VCC project developers and often verified by a third-party hired by the crediting program.18
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