Today, the Commodity Futures Trading Commission (Commission or CFTC) adopts proposed Guidance and a Request for Comments regarding the listing of voluntary carbon credit (VCC) derivative contracts on designated contract markets (DCMs)—boards of trade that operate under the regulatory oversight of the CFTC (Proposed Guidance). I support the Proposed Guidance as it advances important transparency and market integrity efforts.

However, evidence suggests that environmental commodity markets, specifically the underlying spot markets for carbon credits, are rife with fraud. Consequently, I find the Proposed Guidance to be necessary, but insufficient. I am hopeful that the Proposed Guidance ushers in discussion and the development of a comprehensive regulatory initiative to address the deeply concerning, and nearly indisputable, proliferation of fraud in the carbon credit markets.

As I noted, in a recent speech at a joint convening of the Environmental Advisory Council and the Financial Sector Advisory Council of the Dallas Federal Reserve Bank:

While the issues and concerns regarding climate risks are endemic, complex, and inherently require multi-lateral solutions effectuated by an international coalition of stakeholders—let’s call it: a coalition of the willing—I strongly believe that financial market regulators and committed market participants may play a pivotal role in developing and implementing some basic, foundational market reforms.[1]

I anticipate and look forward to the public engagement regarding the Proposed Guidance and responses to the Request for Comments, particularly as relates to the efforts of the Proposed Guidance to address transparency, additionality, risk of reversal, robust quantification, governance, tracking and double counting, inspection provisions, and sustainable development benefits and safeguards. In developing a formal framework to support the VCC markets, I strongly believe that a comprehensive approach that addresses the diversity of environmental derivatives emerging in our markets will improve visibility, enhance integrity, and promote carbon neutrality.

The Market for Carbon Credits

A VCC is a tradeable intangible instrument that is issued by a carbon crediting program. Once registered, VCCs associated with a mitigation project or activity may be acquired by end users (businesses or individuals) or intermediaries who act as brokers. While the number of VCC exchanges continues to increase, the spot market for such products remains largely bespoke, with buyers purchasing directly from mitigation project developers or via intermediaries. A carbon credit market creates a forum that enables buyers and distributors to engage in the purchase and sale, respectively, of environmental commodities. Each environmental commodity represents the acquisition or distribution of a credit that contributes to the reduction or sequestration (capturing and storage) of greenhouse gas emissions. Carbon markets are either mandatory (compliance) markets or voluntary. VCC markets are not established by any government authority.

The VCC market serves as an important tool, among many needed tools, designed to address mounting evidence of climate change and the attendant, significant effects on the global economy. Under Chair Behnam’s leadership, in 2020, the Climate-Related Market Risk Subcommittee of the Commission’s Market Risk Advisory Committee (an Advisory Committee that I currently sponsor), released a report identifying actions the Commission could take to address climate change and finding that climate-related financial risks pose a major risk to the stability of the U.S. financial system.[2]

A report by the U.S. Department of the Treasury released in September explains that “[t]he impacts of climate change are significant and escalating, including through more frequent and severe weather events, rising sea levels, and higher temperatures.” [3] The report details how climate risks are impacting individual household finances, U.S. financial markets, and supply chains. “In 2022 alone, the cost of climate and weather disasters in the United States totaled more than $176 billion – the third most costly year on record.”[4]

There are deep and persistent concerns regarding the integrity, credibility, and lack of visibility in the market for carbon credits. Indisputably, challenged efforts to establish universally-adopted and enforceable integrity standards has further stymied attempts to scale carbon credit markets.

Just last fall, U.S. Senators Elizabeth Warren, Cory Booker, and Kirsten Gillibrand alongside several other Senators, encouraged the CFTC to use its enforcement jurisdiction aggressively to investigate and prosecute fraud and manipulation in spot and forward environmental commodity markets.[5]

On June 29, 2023, the Commission announced the Environmental Fraud Task Force, which was created to address misconduct in the regulated derivatives markets and to investigate fraud in the spot market for VCCs, in particular with respect to the purported environmental benefits of purchased carbon credits, and registrants’ misrepresentations regarding purported environmental benefits and environmental, social, and governance (ESG) products or strategies.[6]

These issues have become so much a part of the cultural dialogue that The New Yorker featured an article titled “The Great Cash-For-Carbon Hustle,” which detailed the rise and fall of South Pole, led by its forty-four-year-old CEO Rant Heuberger, and the revelation that it sold carbon credits that were not real.

In recent speeches at the Federal Reserve Banks in Atlanta and Dallas and Rice University’s Baker Institute for Public Policy Annual Energy Summit, I outlined the necessity for market structure reforms in the VCC markets as well as derivatives on VCCs.[7] As I have previously stated:

in order for the carbon offset markets to have any significance (and, arguably, for such markets to avoid extinction), we must ensure the integrity of the market.[8] Financial market regulators and committed market participants play a pivotal role in developing and implementing some basic, foundational market reforms.[9]

Today’s Proposed Guidance marks a step in the right direction.

Commission Regulatory Authority

The Proposed Guidance applies to the listing of futures with VCCs as the underlying assets. DCMs that list and offer derivatives on VCCs, which are commodities, must be registered with the Commission prior to offering such contracts. Pursuant to the Commodity Exchange Act (CEA), to be designated, and maintain a designation, as a contract market, a board of trade must comply with all core principles and any requirement that the Commission may impose by rule or regulation.

Core principle 3 requires a DCM to demonstrate that listed contracts are not readily subject to manipulation. Core principle 4 requires a DCM to prevent manipulation, price distortion, and disruptions of the physical delivery or cash-settlement process through market surveillance, compliance, and enforcement practices and procedures.[10] Guidance and acceptable practices provide contextual information regarding the core principles and detailed examples of how a DCM must satisfy a core principle. Additionally, DCMs must comply with “submission requirements . . . prior to listing a product for trading,” including by way of self-certification or Commission approval of such products.

The Commission reviews the product specifications, including information about the underlying asset, as part of this review process.

Futures on VCCs: Great Interest, Limited Volume

Over the last several years, the Commission authorized the listing of futures contracts on certain environmental instruments, including mandatory emissions and voluntary carbon program instruments. There are almost two hundred derivative contracts on environmental commodities although at this time only three contracts have open interest. As of November 2023, DCMs submitted eighteen futures contracts on voluntary carbon market products the Commission for listing. Derivative contracts on VCCs base their prices on the spot price of VCCs,[11] and therefore the integrity of the underlying spot market is critical to the stability of the derivatives market for those underlying VCC commodities.

General Summary of the Proposed Guidance

Endemic fraud in the VCC spot market impacts the integrity of environmental derivative contracts that reference spot market projects. While the Commission’s authority to introduce regulation is limited to commodity derivatives, the Commission has broad authority to address fraud and market manipulation in the spot market.

The Proposed Guidance outlines factors that DCMs should consider when addressing certain requirements under the CEA and CFTC regulations that are relevant to the listing for trading of VCC derivative contracts, as previously mentioned, without providing a qualitative element in terms of identifying how the Commission expects the DCM to weigh those factors to create a certain aspirational goal.

Specifically:

• When addressing quality standards in the development of the terms and conditions of a VCC derivative contract, the Proposed Guidance states that a DCM should consider transparency, additionality, permanency and risk of reversal, and robust quantification in connection with the underlying VCC. The governance framework and tracking mechanisms of the crediting program for the underlying VCCs and the crediting program’s measures to prevent double-counting are all additional considerations. Inspection or certification provisions should be specified in the terms and conditions
• DCMs should actively monitor the terms and conditions of VCC derivative contracts to ensure conformity with current standards and should require their market participants to keep records of their trading, including activity in the underlying spot market, and make such records available upon request to the DCM.
• As part of the product review process, a DCM is required to submit the contract’s terms and conditions and any contract amendments and must also include an explanation and analysis of the contract and its compliance with applicable CEA provisions. The submitted information—including supporting documentation, evidence and data—provided by the DCM should describe how the contract complies with the CEA and applicable Commission regulations and should be complete and thorough.

DMO suggests that the Proposed Guidance should be considered by a swap execution facility (SEF) that proposes to trade swaps with VCCs as underlying commodities. Similar to DCMs, SEFs are directly subject to core principles, guidance, acceptable practices, and product listing requirements.[12]

The Proposed Guidance may help to improve the integrity of the VCC markets. Yet, there are additional and significant issues that the Proposed Guidance does not address.

On November 13, 2023, I delivered a keynote speech at the Federal Reserve Bank of Atlanta. During that discussion, I noted:

There are certain principles that must guide the development of market structure for [VCC markets] including the introduction of transaction reporting; secondary market regulation including, where relevant, clearing and settlement guidance; accountability standards for intermediaries to ensure integrity and reliability (and in the context of environmental commodities additionality); business conduct standards, including standardized documentation (and requirements for certification of environmental commodities); and appropriate guardrails for any retail market participation.[13]

On November 29, 2023, I delivered keynote remarks at a joint convening of the Energy Advisory Council and Financial Sector Advisory Council of the Dallas Federal Reserve Bank. There, I outlined additional interventions that may mitigate the proliferation of fraud in VCC markets and foster innovation and competition, while ensuring the integrity of our markets.

The Proposed Guidance provides much-needed direction to DCMs (and SEFs) to facilitate their compliance with core principles when they list futures contracts (and swaps contracts) on VCCs. However, the Commission is only addressing one small aspect of the market for derivatives on these underlying assets. There is also a segment of the swaps market that is not traded on a SEF for which VCCs are underliers and an even more significant volume of environmental forwards that are not considered to be swaps.

The Proposed Guidance suggests the potential for a broader and more comprehensive framework. Applying the approach adopted in the Proposed Guidance, there may be several interventions that may introduce similar needed clarifications—material risk disclosures, good faith and fair dealing, and clearing.

A Comprehensive Approach To Regulating VCC Markets

A comprehensive framework enhances the integrity of futures and OTC markets enabling risk transfer, investment, hedging, and price discovery.

Material Risk Disclosures

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.

These material risk disclosure requirements reduce information asymmetries and improve transparency.  The requirements obligate certain parties to disclose material information sufficient to enable counterparties to make informed decisions about the appropriateness of entering into a transaction.

In the swaps market,[14] a swap dealer is required to disclose to its non-swap dealer counterparty material information concerning the swap in a manner reasonably designed to allow the counterparty to assess the material risks, material characteristics, material incentives and conflicts of interest that the swap dealer may have in connection with a particular swap.[15]

In the adopting release for the material risk disclosure requirement, the Commission clarified that the material risk disclosure requirement reaches disclosures regarding the risks associated with the economic terms of the product and risks associated with the underlying asset. The Commission noted that:

The Commission believes that for most swaps information about the material risks and characteristics of the swap will relate to the risks and characteristics of the economic terms of the swap. For certain swaps, however, where payments or cash-flows are materially affected by the performance of an underlying asset for which there is not publicly available information (or the information is not otherwise accessible to the counterparty), final § 23.431 would require disclosures about the material risks and characteristics that affect the value of the underlying asset to enable a counterparty to assess the material risks of the swap.[16]

In my view, the concepts of material information, material risks, material characteristics, material incentives and conflicts of interest of a derivative must necessarily include the underlying commodity on which a derivative is priced. In light of the lack of visibility into pricing in the VCC markets and the dearth of publicly available information regarding pricing methodologies, such disclosures are particularly important.

Using the risk disclosure requirement as a framework, the Commission should provide guidance that applies to all environmental derivative products. In the context of derivatives on VCCs or other environmental products, where the risk of loss may be magnified because of leverage, the sellers must ensure its counterparty has adequate information to understand how observed volatility and inherent risk in the nascent and evolving VCC market could impact the price of the derivative.

For certain forward contracts on VCCs, it is possible that no material risk disclosure requirement applies; however, the CFTC does have enforcement jurisdiction if there is fraud, including where incorrect or misleading information is provided. CFTC regulations do not require parties to make affirmative statements about nonpublic information—but if a party does speak, CFTC Regulation 180.1(b) specifically requires that a materially misleading statement be corrected, including nonpublic information that may be material to the market price, rate, or level of the commodity transaction.[17]

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.

Guidance on Good Faith and Fair Dealing

The principles of good faith and fair dealing are well-established in the futures, swaps and securities industries. The National Futures Association’s customer communication rule also imposes a duty to communicate in a fair and balanced manner.

In the swaps market, the risk disclosure requirement is closely linked to the swap dealer’s obligation to communicate in a fair and balanced manner. Swap dealers have a duty to communicate with all of their counterparties in a fair and balanced manner based on principles of fair dealing and good faith.[18] This duty, the Commission notes, “is designed to ensure a balanced treatment of potential benefits and risks.”[19]

In the adopting release for the fair dealing requirement, the Commission noted:

In a complex swap, where the risks and characteristics associated with an underlying asset are not readily discoverable by the counterparty upon the exercise of reasonable diligence, the swap dealer or major swap participant is expected, under both the disclosure rule and fair dealing rule, to provide a sound basis for the counterparty to assess the swap by providing information about the risks and characteristics of the underlying asset.[20]

The Commission should offer guidance as to its expectations of how the fair dealing requirement should be considered in the context of an underlying asset that is a VCC. The fair dealing rule provides an independent basis for enforcement proceedings—for example where the swap dealer makes exaggerated or unwarranted claims, opinions, or forecasts in violation of the fair dealing requirement.[21]

Such a requirement may not apply to certain forward contracts on VCCs. Yet, the Commission maintains broad enforcement jurisdiction in the event that there is an allegation of fraud, including where incorrect or misleading information is provided. CFTC Regulation 180.1(a)(2) makes unlawful the making of an untrue or misleading statement of a material fact or omitting a material fact necessary to make a statement made not untrue or misleading.[22]

Guidance on Product Eligibility for Clearing

In the future, should the market evolve and become more standardized, the clearing framework may also provide valuable risk reduction benefits for derivatives on environmental commodities. Clearing, by way of novation, reduces counterparty credit risk because a DCO serves as a seller to every buyer and a buyer to every seller, remaining neutral. DCOs are highly regulated by the Commission, are subject to core principles, and have significant, mutualized financial resources. At settlement, DCOs may facilitate the physical delivery of the actual underlying commodity or cash payments based on the final price of the underlying commodity in connection with the derivatives contract.

In the context of environmental derivatives, DCOs would facilitate delivery of the VCC or determine the cash amount based on the price of the VCC in the cash market. For purposes of physical settlement, a well-functioning carbon credit cash market is essential.

Core principle C sets out product eligibility requirements. A DCO must have appropriate requirements for determining the eligibility of contracts submitted to the DCO for clearing, taking into account the DCO's ability to manage the risks associated with such contracts.

Some factors the DCO must consider include the availability of reliable prices, the ability of the DCO and clearing members to gain access to the relevant market for purposes of creating, liquidating, transferring, auctioning, and/or allocating positions, and the operational capacity of the DCO and clearing members to address any unique risk characteristics of a product clearing members.[23] A DCO should take care not to clear transactions that present an unacceptable level of risk.

In the context of the current VCC market, significant questions arise as to whether certain elements of the DCO core principles would be easily established, including whether there are reliable prices for these carbon credits, the access to carbon credit markets, and whether there is material information about the carbon credit. Additional Commission guidance perhaps could facilitate the market, increase volumes and promote sound risk management, reasonably-designed policies and procedures, and robust rules.

The development of rules that facilitate the clearing of derivatives based on environmental commodities would be greatly advanced by Commission guidance on the application of those principles to the clearing of such products. Forwards on carbon credits are not required to be cleared at a DCO; but clearing and settlement provide critical counterparty credit risk management.

Conclusion

It is difficult to overstate the significance of today’s announced Proposed Guidance. Once again, the CFTC is demonstrating leadership in the novel carbon credit markets and contemporaneously enhancing the integrity of carbon-credit markets.[24]

I believe the Commission has taken an important step forward by announcing the Proposed Guidance advanced today. However, I am hopeful that this step is the first on a long journey to introduce effective market structure reforms in VCC markets.