Commissioner Summer Mersinger dissented from the Guidance, stating that “[t]he VCC Guidance includes veiled attempts to propagate controversial political ideologies best left to debate by voters and elected officials” and that “the only explanation [for the Guidance] is to set the stage for the Commission to promote a political agenda.”⁷ Highlighting certain aspects of the Guidance that require DCMs and SEFs to evaluate whether the crediting program for underlying VCCs meets or exceeds best practices on social and environmental safeguards (among other things), Commissioner Mersinger wrote that such considerations are “completely immaterial to the ability of the listed derivatives products to meet their regulatory obligations.”⁸

Below, we explain the standards set forth in the Guidance applicable to VCC contracts.

Contracts may not be readily susceptible to manipulation

DCM Core Principle 3 requires that DCMs only list derivative contracts for trading that are not readily susceptible to manipulation.⁹ In 2012, the CFTC provided guidance to DCMs (and, to a more limited extent, SEFs) as to compliance with Core Principle 3 with respect to any listed derivative. This guidance from 2012 is found in Appendix C to Part 38 of the CFTC’s regulations.¹⁰ Among other things, Appendix C includes guidance indicating that DCMs should provide detailed descriptions of the economically significant characteristics of the underlying markets, evaluate the deliverable supply of an underlying commodity, analyze and describe quality standards of an underlying commodity, include specifications as to delivery locations, and describe the inspection/certification procedures for a DCM to verify compliance with quality requirements.

Applying the requirement to describe economically significant characteristics of the underlying commodity to VCCs, the CFTC recognized that standardization and accountability mechanisms for VCCs are currently still developing. The CFTC therefore stated that DCMs should describe the developing nature of the markets because that is itself an “individual characteristic of the commodity.¹¹

Additionally, the CFTC stated that DCMs should consider the following, at a minimum, prior to listing VCC derivatives:

• Quality standards of the VCC
  • Transparency – DCMs should describe the crediting programs used for VCCs; which types of projects or activities are eligible for purposes of delivery; and whether the crediting program makes publicly available and searchable detailed information about the crediting program’s policies and procedures and the projects or activities that it credits.
  • Additionality – DCMs should describe whether the underlying VCCs represent GHG emission reductions or removals that would not have been developed and implemented in the absence of the added monetary incentive created by the carbon credits (although the CFTC noted that there may be other ways to measure additionality). DCMs should also consider whether the crediting program has policies and procedures in place to test for additionality.
  • Permanence and accounting for the risk of reversal – DCMs should describe whether the crediting program for a VCC has measures in place that provide reasonable assurance that, in the event of a reversal (i.e., VCCs being recalled or cancelled), the VCC will be replaced by a VCC of comparably high quality that meets the contemplated specifications of the contract, such as through the use of “buffer reserves.”
  • Robust quantification – DCMs should describe whether the crediting program for the underlying VCCs can demonstrate that the quantification methodology or protocol that it uses to calculate emission reductions or removals is robust, conservative, and transparent. DCMs should also derive a quantitative estimate of the deliverable supplies of the underlying commodity in order to quantify position limit requirements.
• Delivery points and facilities
  • Governance – DCMs should describe whether the crediting program can demonstrate that it has a governance framework that effectively supports the crediting program’s independence, transparency and accountability in order to ensure appropriate measures are in place to facilitate physical delivery of VCCs.
  • Tracking – DCMs should describe whether the crediting program can demonstrate that it has processes and procedures in place to (1) help ensure clarity and certainty with respect to the issuance, transfer, and retirement of VCCs; (2) identify who owns or retires a VCC; and (3) make sure that each VCC is uniquely and securely identified and associated with a single emission reduction or removal of one metric ton of carbon dioxide equivalent.
  • No double counting – DCMs should describe whether the crediting program has effective measures in place that provide reasonable assurance that credited emission reductions or removals are not double counted. According to the CFTC, it is important for each VCC to be associated with a single GHG reduction project in order to effectively further carbon mitigation goals, which is in turn important to prevent distortions in the derivative contract’s pricing.
• Inspection provisions
  • The CFTC stated that DCMs should specify in their terms and conditions any inspection or certification procedures for verifying compliance with quality requirements. These procedures should be consistent with third-party validation best practices, which may include crediting program reviews of the performance of its validators; procedures for remediating performance issues; not using the same third-party validator to verify every project type or project category; and using a separate third party to conduct ongoing validation and verification from the third party that completed the initial validation and verification process.

Monitoring a derivative contract’s terms as they relate to the underlying market

DCM Core Principle 4 requires DCMs to prevent manipulation, price distortion, and disruptions of the physical delivery or cash-settlement process through market surveillance, compliance, and enforcement practices and procedures.¹² This includes monitoring the derivative contract’s terms as they relate to the underlying market and monitoring the convergence between the contract price and the price of the underlying commodity.

With respect to physical-delivery VCC contracts, the CFTC stated that such ongoing monitoring should ensure that the underlying commodity conforms or, where appropriate, is updated to reflect the latest certification standard(s) applicable to that VCC (e.g., when there are changes to the types of projects or activities associated with the underlying VCC). The CFTC also states that DCM rules must require market participants to make records of their physical VCC trading available to the DCM upon request.

Listing procedures

The Guidance states that, given the relatively new nature of the VCC asset class, the CFTC expects DCMs to provide complete and thorough information related to the proposed contracts in order to satisfy applicable listing requirements, regardless of whether they list such contracts via self-certification or by seeking prior Commission approval. The CFTC particularly noted that (1) it expects DCMs to provide qualitative explanations and analysis to accompany a DCM’s explanation of the contract’s compliance with the Commodity Exchange Act and CFTC regulations; (2) a DCM’s explanation of the contract should be accompanied by supporting documentation or incorporate documentation by reference, including appropriate citations to data sources; and (3) DCMs must provide additional supporting documentation to the CFTC upon request.

Conclusion

The CFTC’s mission is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets, and it has clearly been concerned that the lack of standardization and potential for malfeasance in the physical (or cash) markets underlying VCC derivatives could affect the integrity of such VCC derivatives or provide new avenues for potential market manipulation. The Guidance is therefore the CFTC’s first official step toward protecting the VCC derivatives markets (which are within its regulatory authority) by imposing rules or guidance that directly or indirectly relate to the physical markets (which are not).

More developments are likely to come in this area, both in the form of regulatory requirements and enforcement actions.

1. See our earlier post on the proposed guidance online.
2. Commission Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts, RIN 3038-AF40 (Sept. 20, 2024) (to be codified in 17 C.F.R. pt. 38 appx. C).
3. The three contracts with open interest are the NYMEX CBL GEO futures contract; the NYMEX CBL N-GEO futures contract; and the NYMEX CBL C-GEO futures contract.
4. See 17 C.F.R. pt. 38 appx. B and C.
5. See, e.g., Guidance at 5 n.21.
6. Id. at 18.
7. Dissenting Statement of Commissioner Summer K. Mersinger on Guidance Regarding the Listing of Voluntary Carbon Credit Derivative Contracts (Sept. 20, 2024).
8. See id.
9. CEA Section 5(d)(3), 7 U.S.C. § 7(d)(3). See also 17 C.F.R. §§ 38.200–201.
10. See 17 C.F.R. pt. 38 appx. C; Core Principles and Other Requirements for Designated Contract Markets; Final Rule, 77 Fed. Reg. 36612 (June 19, 2012).
11. See Guidance at 84.
12. CEA Section 5(d)(4), 7 U.S.C. § 7(d)(4). See also 17 C.F.R. §§ 38.250–258. 

In-depth 2024-209