The scale of the pressure to get the rules right for carbon markets is reflected in this January 2023 headline: “Carbon offset market could reach $1 trillion with right rules.” Ecosystem Marketplace reported the global value of the voluntary trading of carbon emissions offset credits with no government regulation at about $2 billion in 2022. If the “right rules” give legal certainty and clarity to prospective investors, the annual value of the Voluntary Carbon Market (VCM) is projected to spike by up to 500% by 2037, according to the Bloomberg NEF study referenced in the headline. But what are the right rules, and who makes them?
In December 2023 the U.S. Commodity Futures Trading Commission (CFTC) released for comment a proposed guidance document to advise exchanges (“Designated Contract Markets” or DCMs) on what information they needed to include for trading new derivatives contracts whose underlying assets are Voluntary Carbon Credits (VCCs). Almost simultaneously, the private sector Integrity Council for the Voluntary Carbon Market (ICVCM) announced at the 28th Conference of the Parties (COP28) to the United Nations Framework Convention on Climate Change that it is “pleased that the draft guidance published by the Commodity Futures Trading Commission is in accord with the CCPs [Core Carbon Principles].”
The ICVCM rule book, completed in July 2023, sets out the requirements for VCC programs, such as Verra and American Carbon Registry, to receive the “high integrity” CCP label for their credits. The ICVCM theory of change is that investors in CCP-labeled credits will scale up the VCM volume and value of trades and “catalyze” investment in land-based emissions offset projects, mostly in developing countries. Certain categories of VCCs, such as Carbon Capture and Storage projects involving “enhanced oil recovery” (i.e., fracking), are ineligible for the CCP label. (p. 43)
With so much private sector backing and anticipated investor demand for high integrity VCCs that is threatened by a massive growth in investor lawsuits associated with low integrity and/or fraudulent credits, why does the ICVCM need the imprimatur of CFTC guidance? In two words, legitimacy and enforcement.
If exchanges offer VCC derivatives contracts that are consistent with the CFTC voluntary guidance and these contracts have CCP labeled credits as their underlying assets, voluntary carbon offset trading becomes a legitimated investment activity with some protection against litigation. However, if the ICVCM rulebook, as adapted by the CFTC, fails to prevent carbon market fraud or misrepresentation of emissions reductions or removals, the CFTC has established a Task Force on Environmental Fraud and issued a Whistle Blower Alert for Tips on Carbon Market Misconduct.
IATP’s response to the proposed CFTC guidance
On February 26, IATP responded to the CFTC guidance document. Because there is no legislation to authorize the trading of VCC derivatives, the CFTC had to extrapolate rules developed for tangible commodities, such as wheat, to cover the intangible VCCs. The guidance takes the information categories of the CFTC’s Core Principles “commodity characteristics” that exchanges must use to describe the “terms and conditions” of new contracts and applies them to the ICVCM Core Carbon Principles regulatory structure. For example, the guidance considers the 10 CCPs to describe quality standards comparable to those for oil or corn derivatives contracts.
Although the CCPs, such as “robust quantification of emissions reductions and removals,” (p. 18) are short and simple, the Assessment Framework requirements that describe what the crediting programs must do to qualify their VCCs for the CCP label are numerous and, in some major cases, not finished. (The proposed guidance would make the ICVCM “continuous improvement” process itself a commodity characteristic unlike any other in CFTC requirements for DCMs to document that a new contract is not susceptible to market manipulation. IATP contends that making “continuous improvement” a commodity characteristic requirement should require a regulatory amendment.) The Assessment Procedure sets out how the crediting programs are to apply for CCP labeling and how their applications will be processed.
Our response asked the CFTC to begin the finalized guidance with a clear statement about the public interest in trading VCCs. There was no question in the proposed guidance about protecting the public interest, a requirement of the Commodity Exchange Act (CEA). IATP insisted that the guidance would not be consistent with the CEA if the CFTC subordinated the public interest to the industry goal of exponentially increasing VCC trading.
IATP supported Commissioner Kristin Johnson’s proposal that the CFTC develop guidance on how registered market participants should make material risk disclosures about their VCC derivatives trading activities. Commissioner Johnson said such disclosures are required for trading in other asset classes, to ensure that market participants documented their understanding of what risk factors could lead to losses. She said that the disclosure requirements need not be prescriptive, but high level and based on principles. (Federal Register, pp. 89425-89426)
IATP advises more CFTC due diligence about the ICVCM rulebook
Commissioner Christy Goldsmith Romero asked commenters whether the final Guidance should include DCM due diligence measures to evaluate the integrity of VCCs beyond what the ICVCM offered. (Federal Register, p. 89427) IATP explained why further due diligence was necessary, despite ICVCM rulebook improvements on the current failings of the VCC crediting programs rules and environmental performance.
IATP described the ICVCM rulebook as “diplomatically robust” because its Assessment Framework requirements were “in addition to” the VCC eligibility requirements of the CORSIA [Carbon Offsetting and Reduction Scheme for International Aviation] created and managed by the intergovernmental International Civil Aviation Organization (ICAO). (p. 26) If VCCs of the crediting programs already eligible under CORSIA comply with additional ICVCM requirements, and DCMs list their VCC contracts with those requirements, litigation against the crediting programs is unlikely to be successful. As of June 2023, there were at least 2,340 lawsuits concerning market participant emissions offsetting claims, VCC fraud and misrepresentation of emission reductions. Because lawsuits against intergovernmental organizations seldom are won, benchmarking the high integrity VCC with the ICAO’s CORSIA eligibility standard will act as a litigation shield for buyers or sellers of the ICVCM high integrity credits.
However, CORSIA is not a scientifically robust benchmark. Our letter cited one of many criticisms made of CORSIA: “While CORSIA is the first international agreement to address emissions for a sector, it has also been heavily criticised for its shortcomings, including the lack of ambition of its goal of ‘carbon-neutral growth,’ the coverage of CO2 emissions only, the limited [airline company] participation in the voluntary phase, the quality of the eligible carbon credits, and its weaknesses in terms of ensuring compliance and enforceability.” (p. 5) Despite these and other shortcomings, ICVCM, which claims its rules are based on the “best available science and expertise,” (p. 3) strategically decided to base the ICVCM Assessment Framework on CORSIA because the crediting programs were already CORSIA eligible.
ICVCM does not follow its Expert Group’s advice
The ICVCM failed to follow the advice of its Expert Group to develop a science-based definition of a VCC. According to an October 2022 letter from (Carbon)Plan to the CFTC, the ICVCM Governing Body decided to ignore its Expert Group to accommodate the interests of the crediting programs to maximize the VCCs that would qualify for the ICVCM’s CCP label. (p.2) The ICVCM’s major strategic error leaves the future iterations of its rule book to struggle with the consequences of ignoring the advice of its Expert Body.
Our letter cited a Carbon Market Watch criticism of the ICVCM rulebook; “The ICVCM’s most obvious weakness lies in its treatment of activities that rely on the storage of carbon in non-permanent sinks, such as forests. The requirements for permanence are not in line with scientific evidence that carbon dioxide in biological systems and CO2 released from the combustion of fossil fuels are not equivalent or interchangeable.” Notwithstanding climate science to the contrary, the ICVCM carbon accounting and crediting math still assumes that a tonne of fossil fuel emissions can be offset on a 1:1 ratio by a tonne of emissions reductions from land-based offset projects.
IATP advised the CFTC to consult the academic literature on “a tonne is not a tonne” carbon accounting and crediting and write guidance that would urge DCMs to use science-based carbon accounting and crediting to design their VCC derivatives contracts. Current VCC derivatives contracts, such as the Nodal Exchange’s Global Emissions Reduction Futures contract (GER), appear to be defined in terms of “one tonne equals one tonne” math, at least for the forestry carbon component of the contract. (We say “appear” because part of the GER contract description is not publicly disclosed in its self-certification documentation.) It is urgent that the CFTC provide the exchanges with due diligence about the state of science carbon accounting and crediting even if that due diligence results in VCC derivatives contract “terms and conditions” that attract fewer investors.
We reminded the CFTC that governments and corporations are planning to increase their oil and gas production and fossil fuel emissions. As a result, the asymmetry between fossil fuel emissions and biogenic emissions reductions will grow greater, as will the average global increase in temperature. According to a Financial Times climate graphic, from February 2023 to January 2024, the global average temperature breached for the first time the UNFCCC Paris Agreement target of limiting global average temperature to 1.5⁰C above the pre-industrial benchmark.
ICVCM, like many private and public sector organizations, emphasizes the priority of deep decarbonization, with VCC trading being one “complementary” way (p. 7) of achieving a global net-zero emissions future by 2050. However, if the CFTC does not do due diligence on the ICVCM’s shortcomings and does not advise DCMs of those shortcomings, the consequences could be bad for market participants and worse for the climate. Absent an overhaul of emissions offset accounting and crediting methodologies, an exponential increase in trading temporary emissions reduction VCCs in the spot and futures markets will contribute to a fatal delay in achieving Paris Agreement objectives.
Nor should the CFTC count on long duration emissions removal credits, such as Carbon Capture and Storage based VCC credits, to scale up in time to salvage the Paris Agreement objectives. A UNFCCC Secretariat information note for the Paris Agreement market mechanism negotiations states, “Land-based activities currently provide most of the removals and are expected to be the main driver of removal in the near-term (i.e., to 2030) and possibly even until 2050.”
The CFTC must take the time necessary to do due diligence about the ICVMC rulebook and related initiatives, such as the Voluntary Carbon Market Initiative that advises VCC buyers on the use of their credits. The guidance must not be fast-tracked to accommodate the ICVCM’s fast-tracking of CORSIA eligible credits to apply the ICVCM high integrity label to increase the volume and value of VCC trading in the spot and futures markets. The CFTC cannot fulfill its public interest obligations under the Commodity Exchange Act by allowing DCMs to self-certify as derivatives contracts consistent with CEA that mimic the ICVCM’s scientifically deficient carbon accounting and crediting methodologies.
