A recent series of meetings of the Commodity Futures Trading Commission’s (CFTC) Energy and Environmental Markets Advisory Committee (EEMAC) highlighted the risks of a forecast boom in offset emissions futures contract trading. The underlying assets of offset futures are projects to reduce, avoid or that claim to permanently remove greenhouse gas emissions. IATP and co-authors John Kostyack, of Kostyack Strategies, and Lee Reiners of the Global Financial Markets Center of the Duke University School of Law, responded to the CFTC request for public input, outlining several emissions market issues the CFTC should study to prevent a diversion of corporate capital from investments to directly reduce emissions into a boom and bust futures market.
The role of government regulators in the private sector Task Force on Scaling Voluntary Carbon Markets (TSVCM) phase II report is peripheral to the elaborate draft TSVCM plan for industry self-governance. The TSCVM was among the organizations at last week’s United Nations Climate Week showing their wares to government officials at the U.N. General Assembly. If you are a cash-strapped developing country government interested in being paid to host greenhouse gas emissions offset projects, then you might be interested in buying what TVSCM is selling without robust government regulation. If projects are verified as reducing, removing or avoiding new emissions by a TSVCM approved standards organization, the projects result in tradeable emissions offset credits that can be sold to corporations seeking to offset their emissions without having to physical reduce them. The credits can also become the underlying assets of futures contracts.
The CFTC is among government agencies that already regulate emissions permit or allowance contracts that are tied to caps on emissions for specific industries, e.g., the California Air Resources Board compliance market. (Voluntary carbon markets are not tied to mandatory, industry wide emissions caps.) IATP has written about how the CFTC allows exchanges to self-certify new contracts, including the Chicago Mercantile Exchange’s Global Emissions Offset (GEO™) futures contract, as consistent with CFTC regulations and the Commodity Exchange Act that authorizes those regulations. We had hoped that that the CFTC staff would require a more formal approval process for the CME’s Nature Based Emissions Offset (N-GEO™) futures contract, which, according to CME, is based on “using high-quality, nature-based offsets sourced exclusively from agriculture, forestry, and other land use (AFOLU) projects.”
The CFTC formal approval process would review the potential for the prices of the underlying emissions offset project credits, and hence the corresponding emissions offset futures contracts, to be susceptible to market manipulation, in violation of CFTC rules. Unfortunately, the CFTC allowed the CME to self-certify N-GEO™ on July 16, and CME announced the first N-GEO™ trades on August 3. The self-certification of two futures contracts do not, of course, constitute a trading boom. But the Institute for International Finance (IIF), which hosts the TSVCM, projects $100 billion annually in offset futures contract trading by 2050. (By contrast, according to the Ecosystem Marketplace 2020 annual report (Table 1), the aggregate value of all voluntary offset projects credits in 2019 was $281.67 million.) The IIF views agreement on “market mechanisms” in November at the U.N. climate summit in Glasgow, Scotland, as a launching pad for that projected voluntary offset futures market.
Once a contract is widely traded, it is very difficult to get the contract withdrawn by the CFTC, even if it is demonstrably susceptible to market manipulation. Self-certification provides the legal basis for an emissions market boom, anticipated by presenters at a June 3 EEMAC meeting. And a bust, if trading positions in GEO™, N-GEO™ and like contracts are held by large institutional investors, such as hedge funds, endowments, pension funds and investment banks, and the contract price collapses. Such collapses could happen and have happened, for example, due to deceptive reporting of emissions reductions or avoidance in the offset projects. In our September 22 letter to the CFTC, we referenced that 45% of market participants surveyed by TSVCM were concerned about the “lack of environmental and social integrity of certain [offset] projects” (slide 50) that underlie the futures contracts. The CFTC has allowed exchanges to self-certify futures contracts involving minor changes to the terms of a traditional contract, such including a new breed in a live cattle futures contract. But offset futures contracts are novel and not suited for self-certification.
Improper use of self-certification and susceptibility of the CME offset futures contracts to market manipulation were among the topics of our September 22 letter to the CFTC. Our letter also responded to the September 15 EEMAC vote to create a subcommittee that would issue a report with recommendations to the CFTC on principles for regulating environmental markets. We supported EEMAC member Tyson Slocum’s remarks, particularly his call for “robust representation of public interest stakeholders” among the subcommittee’s membership.
We further called for the CFTC to update the 2011 interagency carbon market report, using a public notice and comment process, as proposed by Better Markets. The letter outlines issues for the CFTC to consider including in the updated study. One concerns the CFTC’s role as a member of the Financial Stability Oversight Council (FSOC). FSOC, according to its chair, Secretary of the Treasury Janet Yellen, will “outline a whole-of-government process to assess climate risk to the U.S. financial system and federal government” in a report due in November. We asked the CFTC to consider in the updated study whether a boom in emissions offset derivatives trading would divert corporate capital away from investing in direct climate action to reduce emissions and adapt to climate change. Such capital diversion could increase the cost of responding later to extreme weather events and longer-term climate change trends to such an extent as to destabilize the financial system, e.g., during irreversible climate tipping points forecast to occur as early as 2030. Furthermore, an emissions’ offset contract price collapse could destabilize the financial system if counterparties to the contracts were highly indebted, interconnected and could not offload their contract positions at a remunerative price.
Our research found that price discovery in the GEO™ futures contract was very difficult, in part because price information in the CME approved offset credit registries for GEO™ was not available in the timely fashion required by traders. We wrote, “We can think of no other commodity derivatives contract where the price of the underlying asset is not readily accessible to the public. Price opacity is frowned upon by regulators because it facilitates speculation.” A futures contract derived from an underlying cash market that does not make its offset prices available to the public is one that requires a formal CFTC review, not a CME self-certification. This is a critical issue for analysis in the updated CFTC carbon market report.
A decision on whether to update the 2011 carbon market report and undertake other climate finance action at the CFTC may be delayed by the lack of a full Commission. The acting CFTC chair Rostin Behnam sponsored the Market Risk Advisory Committee report, “Managing Climate Risk in the U.S. Financial System.” President Biden has nominated him to become CFTC chair. He and two Democratic nominees for commissioners await Senate confirmation hearings. EEMAC sponsor Commissioner Dan Berkovitz announced on September 9 that he would leave the Commission on October 15. The remaining Republican commissioner, Dawn Stump, praised Commissioner Berkovitz, along with many other participants at the September 15 EEMAC meeting. Commissioner Brian Quintenz had announced his departure on August 19, so a Republican candidate will be nominated for Senate confirmation to fulfill the statutory obligation of having three members of the majority party and two of the minority party on the full Commission.
Regardless of the timing of the Senate confirmations to bring together a full Commission, we committed in our September 22 letter to continue to provide input for an updated CFTC study of and robust CFTC regulation of environmental markets.