Slicing, dicing, securitizing…

Slicing, dicing, securitizing: more strategies to scale voluntary carbon markets

2024 is shaping up as a critical year for setting global rules on carbon market trades. In the last few months, the US Commodity Futures Trading Commission (CFTC) and the International Organization for Securities Commissions (IOSCO) each held open consultations on documents that they propose to issue this year: “Good Practices to promote the integrity and orderly functioning of the voluntary carbon market” (IOSCO); and “Guidance regarding the listing for trading of voluntary carbon credit derivative contracts” (CFTC).

IOSCO comprises the regulators of the world’s securities and futures markets of 131 countries, and is recognized as “the global standard setter for the securities sector.” The CFTC regulates the US derivatives markets.[1] The chairman of the CFTC, Rostin Behnam, co-chaired the carbon markets workstream of the IOSCO Sustainable Finance Taskforce whose work produced the “Good Practices” consultation document.

Derivatives and carbon markets

Most voluntary carbon emissions offset credits are currently traded bilaterally and non-transparently. For example, a crediting program such as Verra sells credits directly to a company seeking to claim that it is offsetting its emissions by buying the credits. One clear requirement for scaling up the voluntary carbon market will be verifiable price and transaction volume transparency, of which there is little to none in the market as it is currently operating.

Additionally, the last few years have confirmed that carbon markets are actually pretty risky, with significant price volatility and outright project failures. But where there is deal-making risk, there will be firms seeking to address it by slicing, dicing, and selling that risk on to other parties, in the form of derivatives, such as forwards, futures, options, and swaps. These are mostly financial instruments that bet on the future price of something. Options and futures markets are seen as essential for scaling up the carbon markets.

In 2021, the Chicago Mercantile Exchange (CME) launched its Global Emissions Offset (GEO) futures contract. The contract’s underlying asset is a price index of sales of CORSIA[2] -eligible offset credits issued by three crediting programs recognized by the International Civil Aviation Organization. GEO’s price derives from that underlying asset. CME provides liquidity to enable buyers and sellers to trade at will and provides price and transaction volume transparency. However, the GEO price and volume remain very low because the environmental and accounting integrity of CORSIA credits remain low.  

Those attempting to build a scaled-up carbon-offset market, including the Task Force on Scaling Voluntary Carbon Markets (TSVCM), which turned into the Integrity Council for the Voluntary Carbon Market (IC-VCM), have already put quite some effort into designing higher quality credits to attract buyers in both the cash and futures markets. Not coincidentally, CORSIA credit eligibility is the platform from which ICVCM promises “continuous improvement” in credit quality. The Technical Appendix of the TSVCM final Phase 2 report provided a number of non-exhaustive examples of use cases for carbon offset futures and other derivatives.

The International Swaps and Derivatives Association (ISDA), which “fosters safe and efficient derivatives markets to facilitate effective risk management for all users of derivatives products,” elaborates further on the role of derivatives in carbon markets. In their analysis they point to the role of carbon derivative contracts as a price hedging tool and note that “[e]stablishing an active secondary market would allow market participants to manage and hedge risks from carbon projects.”

But in the wake of the significant number of carbon market scandals coming to light in the past few years, ISDA has warned that “secondary markets rely on confidence in the underlying [asset (i.e., carbon offset credits)] to facilitate high frequency trading and optimum price discovery. Without that confidence, efficient and liquid primary markets will not develop and the advantages of standardization in the secondary market will not be realized.” They point to the need for market reforms, positively referencing the CFTC and IOSCO consultation processes, and the standardization attempts by ICVCM with its Core Carbon Principles.

ISDA notes in its submission on the IOSCO consultation that “clear legal and regulatory categorization of voluntary carbon credits [VCCs] is key to building liquidity in order to support scaling VCMs and to develop safe, efficient markets in VCC derivatives.” In their contribution to enhancing clarity on the legal nature of the underlying assets of derivatives, ISDA is “working to increase standardization in the VCM secondary market by developing standardized documentation,” including standard definitions for verified carbon credit transactions.

CLARA’s take?

CLARA members had something to say to the CFTC and IOSCO in these consultations. The Berkeley Carbon Trading Project (BCTP), Carbon Market Watch (CMW), the Center for International Environmental Law (CIEL), and the Institute for Agriculture and Trade Policy (IATP) all submitted comments to the CFTC. IATP also submitted comments to IOSCO.

For a more detailed analysis of the CFTC draft guidance and its implications, see the blog on CFTCs “high stakes bet” written by CLARA member, Steve Suppan of IATP, here. The final guidance is expected from the CFTC by the end of the summer.

Looking ahead

The CFTC guidance is just one element of U.S. government contributions to the effort to shore up credibility of the sputtering carbon market, which also includes the U.S. Treasury’s Principles for Net-Zero Financing and Investment and the recently released interagency Joint Policy Statement and Principles for Responsible Participation in Voluntary Carbon Markets.  

The carbon-offset market is clearly an important part of the U.S. government strategy to “mobilize” private funding for climate action, rather than commit public funds. The strategy includes contributing to the supply of voluntary carbon credits on global markets with its LEAF coalition and Energy Transition Accelerator initiatives.

But the supply of credits is just one half of the market. Demand needs to grow in step with supply. There are few obvious reasons why buyers in the voluntary market in the short term will increase purchases at the rate that econometric projections seem to indicate. At some point in the past, offsets brought reputational gain. With ongoing and unabated critique of the quality and integrity of carbon offsets, a growing number of lawsuits and laws against corporate claims made based on purchases of offsets, and the growing recognition that offsets actually are the antithesis of climate action, buying offsets has brought reputational and legal risks instead.

So it should come as no surprise that major market players are working hard on other fixes to the current demand challenge, beyond these new CFTC and IOSCO initiatives towards secondary markets, such as CORSIA’s phase I compliance period and VCMI’s proposed scope 3 flexibility claim. We will be addressing these all in future blogs.

[1] Both the CFTC and the Securities and Exchange Commission (SEC) of the United States are members of IOSCO. In the US, there is a division of labor between securities (SEC) and derivatives (CFTC) regulation.

[2] Carbon Offsetting and Reduction Scheme for International Aviation. https://www.icao.int/environmental-protection/CORSIA/Pages/default.aspx