In this Q&A, Alex Rau of Environmental Commodity Partners discusses new proposed guidance for verifying the quality of carbon offsets, the implications for voluntary carbon markets, and what the verification standards will look like for offsets.
The US Commodity Futures Trading Commission (CFTC) recently proposed guidance for verifying the quality of carbon offsets that are traded in voluntary carbon markets in the United States. Companies that have pledged to reduce emissions frequently purchase carbon offsets that count toward and help meet their pledges. These offsets should represent an agreed-upon specific reduction in greenhouse gas emissions and can be purchased directly from projects that have been verified to reduce or remove emissions, or on market exchanges where a third party promises to deliver offsets at a future time.
However, a persistent problem with carbon offsets has been verifying that the offsets actually represent the agreed-upon amount of emissions reductions. If a seller’s carbon offsets are spurious, then any claims of reduced emissions will be inaccurate from a company that purchased those offsets. The proposed guidance from the CFTC may help address this issue of verifying carbon offsets in markets that the CFTC oversees.
In this Q&A, Alex Rau of Environmental Commodity Partners discusses the proposed CFTC guidance, along with the implications for voluntary carbon markets and what the verification standards will look like for carbon offsets.
Can you break down the new guidance for carbon offsets from the Commodity Futures Trading Commission (CFTC)?
Alex Rau: The CFTC’s guidance on carbon offsets aims to uphold the environmental integrity of voluntary carbon offset products (primarily futures contracts or other similar financial instruments) that may be traded on derivatives exchanges that are regulated by the CFTC. While the CFTC acknowledges that it does not have jurisdiction to regulate voluntary carbon markets themselves, the CFTC nonetheless has ultimate jurisdiction over all US-based futures exchanges and listed products. Thus, the CFTC is exerting its authority over voluntary offsets, when those offsets are listed as the underlying deliverable commodity in futures contracts by regulated exchanges.
The CFTC rulemaking attempts to specify the underlying quality criteria that must be addressed by exchange operators (in this case, designated contract markets) when authorizing the eligibility of voluntary carbon offset products. As such, the CFTC guidance does not prescriptively regulate the standards, methodologies, project types, or geographies for voluntary carbon markets.
The new guidance focuses on general, high-level, “quality”-related principles such as additionality, a conservative approach to baselines and calculating quantities of reductions/removals, permanence, and double-counting. The guidance also covers the rules of transparency and governance that the standards bodies and registries would need to follow in the carbon markets that issue voluntary carbon offsets.
How much of the market for carbon offsets is traded on platforms or markets that the CFTC regulates?
Currently, only a fraction of the market for carbon offsets (both compliance and voluntary markets) trades on designated contract markets or regulated futures exchanges, a situation that reflects the heterogeneity and lack of standardization in the underlying voluntary carbon market. The cumulative volume of these exchange-traded offsets (in both compliance and voluntary markets, not counting the certified emission reduction contract from Intercontinental Exchange described below) amounts to less than 10 percent of issuances or retirements in the voluntary carbon market. The overwhelming majority of carbon offset transactions are conducted in the over-the-counter spot market, with some volumes trading on “spot exchange” platforms like CBL Markets or AirCarbon Exchange in Singapore, which are not considered regulated exchanges.
From a liquidity and volume perspective, only one successful exchange contract for offsets has ever been traded: a now-delisted futures contract by Intercontinental Exchange for certified emission reductions from 2007 to 2020, which were issued by the Clean Development Mechanism established as the compliance offset mechanism of the Kyoto Protocol. This contract was subject to additional quality constraints to ensure compliance in the EU Emissions Trading System. The contract traded hundreds of millions of tons of carbon dioxide emission reductions, primarily in 2007–2014, until the market became oversupplied, and the EU Emissions Trading System reached its quota for tradable carbon allowances during phase 3 of the system.
Since then, Intercontinental Exchange and others have listed a dozen or so voluntary carbon offset futures contracts, including Global Emissions Offset and Nature-Based Global Emissions futures contracts from the Chicago Mercantile Exchange, along with a suite of voluntary futures contracts from Nodal Exchange and Intercontinental Exchange. None of these contracts has seen much success yet in terms of liquidity, utility, or hedging price risks, and these types of generic voluntary carbon contracts are not likely to gain value, irrespective of the CFTC guidance.
Really only one actionable futures contract exists for compliance carbon offsets: those eligible for use in California’s cap-and-trade program. But this California carbon offset futures contract has not achieved meaningful liquidity levels, either, because regulators in California can retroactively cancel and invalidate offsets that have been issued. The rules for offsets in California allow such invalidation procedures in cases when offsets are found to be noncompliant with program requirements. This risk of retroactive invalidation constitutes a “hot potato” liability that’s borne by the buyer; aversion to this risk prevents wide-scale secondary trading.
But more tradable contracts are coming for carbon offsets. Intercontinental Exchange and Nodal Exchange both are developing listed futures contracts for carbon offsets (and removal credits) under the Technology Innovation Emissions Reduction compliance carbon market in Alberta, Canada. The Intercontinental Exchange recently has launched a contract for compliance instruments, under Article 6 of the Paris Agreement, for use by airlines to meet their offsetting requirements. And a listed futures contract in Australia’s compliance market is anticipated soon.
How does the new CFTC guidance change how these offset markets currently operate?
Aside from the positive impacts from the CFTC more closely observing and scrutinizing ongoing transactional activity and actor conduct in the voluntary carbon markets, the CFTC guidance likely won’t meaningfully change how the carbon offset markets currently operate. For one thing, the CFTC guidance spells out high-level considerations that exchanges already have largely incorporated into their existing contracts for the voluntary carbon market. In addition, the guidance neither establishes quality standards themselves nor ensures any level of interchangeability or commoditization of the underlying offsets that would be necessary for a futures contract to succeed in terms of liquidity and utility.
These limitations of the new guidance are a challenge that can be overcome only through market consensus on standards for quality in the voluntary market. But I’m skeptical that the market will reach consensus, given the infinite diversity of buy-side actors, quality preferences, project types, and geographies in the voluntary carbon market. More likely, regulators beyond the CFTC will need to step in to shape supply-side requirements around eligible projects, quantification methods, and standardization procedures. Such regulatory activity can be a catalyst for establishing standards in the offsets market for both demand and supply—whether at the international level (e.g., Articles 6.2 and 6.4 in the Paris Agreement), at the national or subnational level (e.g., federal compliance protocols in Canada and Australia), or through sector-specific protocols approved by or developed in conjunction with regulators (e.g., soil carbon projects through the US Department of Agriculture). Once those standards are established and met, then viable futures contracts can be listed and approved by the CFTC.
Some carbon offsets are traded through derivatives contracts, which can fix the price of a given carbon offset based on the expected value of that offset. How might the CFTC guidance affect the nascent market for these derivatives contracts?
This is the direct domain of the CFTC rulemaking; namely, that the futures and options contracts listed in markets require the delivery of carbon offsets that are robust, from the perspective of quality and transparency. On this point, the CFTC guidance provides welcome but incremental progress.
The guidance ensures a minimum and harmonized set of requirements that exchanges should follow when developing new carbon offset contracts. Well-designed futures contracts, which specify clear requirements and transparent procedures for delivery, could help promote the confidence of corporate buyers in using these contracts to procure high-quality offsets for their climate commitments.
The CFTC is right to focus on ensuring that futures contracts converge on the market value (i.e., the “spot price”) at the time of delivery. This convergence is critical to developing a forward price curve (i.e., hedging price risk over the long term of an investment or operational decision) and accurately reflecting the dynamic supply and demand outlooks over time, the transaction costs, and the financing costs. (Carbon offsets and other traded environmental attributes are unique among commodities in that they have no storage or transportation costs.) The more confidence the market has in the integrity of futures contracts, the greater the ability for developers and producers to hedge price risk over a longer investment or operational period, which is critical for reducing the cost of financing at scale for decarbonization projects. Additionally, because futures contracts require the delivery of guaranteed volumes of eligible offsets, the use of these contracts reduces volumetric risk to buyers, which is one of the main sources of risk when investing directly into primary offtake agreements with projects or developers.
What is less clear is how the CFTC guidance will yield any practical improvements to the problems with quality and uncertainties that have plagued voluntary carbon markets to date. High-level guidance on offset integrity considerations, such as additionality or quantification methods, is helpful in terms of directing the trajectory of the voluntary market, even if the current proposed guidance is not specific enough to have a practical, positive impact on the quality and standardization challenges. But the CFTC cannot be expected to wade through and understand the many nuances and technical complexities on which the broader global carbon markets have been struggling to achieve consensus for more than two decades. These questions need to be adjudicated in a broader public-policy process that’s driven by other regulatory agencies which have jurisdiction over compliance carbon markets, laws that cover things like emissions and the environment, particular sectors like agriculture or extractive industries, or international sovereigns that are responsible for their greenhouse gas inventories and national commitments. On the other hand, the regulated exchanges and designated contract markets like Intercontinental Exchange and Chicago Mercantile Exchange already are sophisticated in their understanding of these issues; these exchanges are investing resources to help build the markets and have related in-house expertise and technical resources.
Will the CFTC guidance affect carbon offsets that are used in nonvoluntary carbon markets (also known as compliance markets) that are operated by governments?
The CFTC already exerts oversight on carbon offset futures contracts that are listed in compliance markets, primarily for the California carbon offset futures offered by Intercontinental Exchange and Nodal Exchange. In compliance markets, the voluntary guidance from the CFTC generally will be met readily by the regulation-driven standards for compliance offsets, so no real impact on these markets would be expected.
In any case, the mandate for oversight is simpler, as the CFTC guidance can revert to ensuring that carbon offset products conform to the regulatory specifications. However, considerations and questions of quality will depend on the regulatory process that develops and implements compliance offset mechanisms. Because the voluntary carbon market cannot revert to regulatory guidance regarding quality, the market likely will continue to be constrained in its ability to standardize and scale.