Documentation Platforms for Emission Linked Trading - ISDA, IETA and EFET Platforms Use of Derivatives in Carbon Markets Options • Options are bilateral contracts between an option holder and an option writer. The option writer, in consideration for a premium, grants the option holder the right but not the obligation, to buy or sell an agreed quantity of carbon credits at a fixed price on a future date. • The most common options are “put” and “call” options. – Put option holders have the right to sell or deliver carbon credits at an agreed price on a future date. – Call option holders have the right to buy or receive carbon credits at an agreed price on a future date. • The most commonly used types of carbon derivatives in the OTC market include forwards, option and swaps. 3 4 3Use of Derivatives in Carbon Markets Forwards • In forward and futures contracts, the parties agree to buy and sell carbon credits at a future date at an agreed price. • Forwards differ from options in that the buyer of a forward contract is obliged to pay the agreed purchase price even if the carbon credits are worth less than the purchase price on the settlement date, while the buyer of an option is not obliged to exercise the option and pay the purchase price. Use of Derivatives in Carbon Markets OTC Trading • When entering into a carbon trade in the OTC markets, parties have three options as regards the documentation platforms they use: 1. ISDA, 2. IETA, and 3. EFET. Trading through climate exchanges • The development of exchange trading is helping the carbon credit market to reduce credit risk by providing a central counterparty, as well as liquidity, through matching counterparties, trading standardised and simple contracts, and publishing prices. • There are currently more 10 European exchanges with exchange traded allowance contracts, and nearly 40 worldwide. These include the European Climate Exchange in the United Kingdom, Powernext in France and Nordpool in Germany. • The European Climate Exchange coordinates the marketing, listing and sales of ECX Carbon Financial Instruments: futures and cash contracts for EU ETS allowances. These are listed on ICE Futures (an electronic trading platform). Trades are cleared through LCH. Clearnet Ltd, which acts as a central counterparty guaranteeing financial and physical performance. 5 6 4Use of Derivatives in Carbon Markets Carbon Pools • Carbon pools are spot trading platforms. Their members are small emitters that have been allocated allowances under the EU ETS. The pool matches their buy and sell orders together in an order book. After placing an order, the parties transfer their funds or allowances into their pool account and these are then transferred within the pool. • Advantages of carbon pools include: – counterparty anonymity; – the grouping of small buy and sell orders into larger orders together; and – increased liquidity. Structured Notes: Types of transactions, issues related to taking securities, use of custodians. OTC Trading: Documenting Emissions Trading Transactions 7 8 5ISDA 9 10 6Areas Covered by Part 7 to Schedule How to buy, sell and physically settle transactions What happens if only some of the allowances are delivered? Fallbacks for when settlement is disrupted or suspended What happens if the EU ETS is abandoned? Terms and fallbacks for when the seller fails to deliver the allowances and/or this results in the buyer being finedWarranties, representations, taxes, provisions and definitions Fallbacks for failed settlement/ delivery Settlement Disruption Suspension Events Failure to deliver 11 12 7Calculation of Replacement Cost Where There is Failure to Deliver: Three Possible Elections • Election 1 – Excess emissions penalty does not apply • Election 2 – Excess emissions penalty does apply • Election 3 – Failure to deliver (alternative method) Penalty Penalty 13 14 815 16 9IETA IETA cont’d 17 18 10IETA cont’d EFET European Federation 19 20 11EFET European Federation cont’d Key Differences Between ISDA, IETA and EFET Platforms • Excess emissions penalties • Force majeure • Settlement disruption and failure to deliver • Differences in payment and delivery dates • Opting out of physical settlement of delivery obligations • Suspension events 21 22 12IETA cont’d An overview of carbon markets 23 24 13Why? Source: World Economic Forum Recent updates • There had been some recent years of impressive growth global markets for CO2 • 164% to a record 760 bn euros in 2021 • Macroeconomic challenges • Revenues from carbon taxes and ETS grew by over 10% in 2022 (almost USD 95bn globally) – Increasing number of compliance carbon programs are expected to be implemented in the coming years – New investors / products / service providers – Rise of voluntary initiatives – Corporate demand for voluntary offsets Source: World Bank, State and Trends of Carbon Markets, 202225 26 14Kyoto Protocol vs. Paris Agreement Kyoto Protocol Paris Agreement Reduction of emissions of 5% (2008-2012) and 18% (2013-2020), in relation to 1990 emission levels Containing global warming at well below 2ºC, in relation to pre-industrial levels, with efforts to limit global warming to 1,5ºCTop-down: Mandatory goals (for industrialized countries – Annex I), actual Carbon Budget Bottom-up: Nationally Determined Contributions (NDC) • Emissions Trading, Joint Implementation and Clean Development Mechanism (“CDM”) • Assigned Amount Units (“AAU”), Emission Reduction Unit (“ERU”) and Certified Emission Reduction (“CER”) Art 6 Carbon Pricing • Price per tonne of CO2 e • Social Cost of Carbon • Tragedy of the Commons • Polluter pays principle • Internalization of climate externality • Alternatives: taxation or market? – Smaller transaction costs in taxation vs. Greater institutional cost in markets (monitoring, reporting, verification) – Price vs. reduction target – What to do with the income? – The choice is a matter of technical opinion and political economics 27 28 15Carbon Pricing Initiatives (including markets) Source: The World Bank, State and Trends of Carbon Markets, 2023Emissions Trading vs. Carbon Crediting Source: The World Bank, State and Trends of Carbon Markets, 2020Source: Vox 29 30 16Regulated Carbon Markets: EU ETS European Carbon Market (EU ETS) • European Union Emissions Trading System (EU ETS): launched in 2005 – Other than countries from the European Union, Iceland, Liechtenstein and Norway also participate– Over 10,000 installations (power plants and industrial plants), as well as aircraft operators operating within the EU– 45% of the total GHG emissions of the European Union • Typical “cap and trade” – A maximum threshold of emissions was established, and this “cap” reduces over time – 1 allowance corresponds to 1 tonne of CO2 e – Compliance entities (and third parties) trade allowances, which can be bought by those who do not have enough allowances – A fine will be applied (100 euros per ton of CO2 ) if a compliance fails to surrender an allowance for every tonne of its emissions 31 32 17EU ETS – compliance cycle Source: Environment and Climate Regional Accession Network (ECRAN) EU ETS – First and Second Phases • First Phase (2005 - 2007) – 3 year long pilot project (“learning by doing”) – Broad range of sectors (energy sector and high emitters, no transport) – The fine for failing to surrender allowances was of 50 euros per tonne of CO2 – Allowances were over-allocated (for free) and the price fell to zero • Phase 2 (2008 - 2012) – Cap 6.5% lower in relation to 2005 – The fine for failing to surrender allowances rose to 100 euros per tonne of CO2 – Companies were authorized to buy carbon credits from international project sunder the Kyoto Protocol in order to meet their targets (1.4 billion tons of CO2 e) – The 2008 crises led to a reduction on CO2 emissions, which led to a surplus of carbon credits and allowances in the market, which lowered prices 33 34 18EU ETS – Third and Fourth Phases • Phase 3 (2013 - 2020) – EU-wide allocation and caps, rather than national plans – Allowances distributed mainly through auctions, but there still was still free allocation of allowances to some sectors, especially industrial sectors subject to carbon leakage • Phase 4 (2021-2030) – Steeper reductions in cap – Creation of the Innovation and Modernization Fund, which focus on the market transitioning to a low-carbon economy • Phase 4 (recent changes) – Reduce emissions by 62% by 2030 (from a 2005 baseline) – Phase in emissions from the maritime industry between 2024 and 2026 – Changes to aviation coverage – Free allowances phased out – Carbon Border Adjustment Mechanism – New ETS II will cover fuels for transportation and heating Voluntary Carbon Markets 35 36 19Voluntary Carbon Markets - Background• Voluntary carbon markets allow companies, private investors, governments, and NGOs to acquire carbon credits in order to compensate for or offset their emissions – Many companies cannot fully reduce their own emissions – Reputational and socio-environmental concerns – Supplementarity Role? – Finance projects aimed at GHG reductions – Carbon credits can also be acquired as a form of investment Voluntary Carbon Markets - Facts and figures37 38 20Voluntary Carbon Markets - Standards • Verified Carbon Standard / Verra • Gold Standard • American Carbon Registry • Climate Action Reserve • Plan Vivo Project cycle Methodology •Select a methodology for proposed project •Procedures for quantifying the real GHG benefits of a project •Assessment of additionality (“but for” test) •Many different sectors eg energy / waste / agriculture Validate •Project proponents develop a project description using template •Validated by an approved validation/verification body •Determines whether a project meets all rules Verify •Project proponents monitor and measure GHG emission reductions or removals •Monitoring report must be verified by an approved verifier 39 40 21Project cycle Registry • Projects must open an account and submit all required documents to registry operator in order to be registered on the registry • Projects can register upon validation or wait until they are ready to issue creditsIssuance • Reviews of issuance request from project proponent • Units credited to account Transfer/ Retirement • Once issued, credits can be transferred / retired Voluntary Emissions Reduction Purchase Agreement (VERPA) 41 42 22Paris Agreement: Article 6 Paris Agreement: Article 6 Cooperation in the Implementation of NDCs • Article 6.2 – Internationally Transferred Mitigation Outcomes (“ITMOs”) – Transferring of Mitigation Units between countries • Article 6.4 – Mechanism (“SDM”) – Transferring of mitigation units from projects conducted by private entities to countries or other private actors • Corresponding adjustment: assures environmental integrity and that no double counting is conducted; sturdy accounting system 43 44 23Recent developments Recent trends • What is “net zero”? • Greenwashing • Climate Transition Plans • Sustainability Disclosures • Controversies • Increasing scrutiny of VCM 45 46 24The CFTC’s Role in the Voluntary Carbon Markets Voluntary Carbon Markets (VCMs) • Compliance markets refer to cap-and-trade systems regulated by national, regional, or international carbon reduction regimes (e.g., the Kyoto Protocol), while VCMs function outside of the compliance market where participation is voluntary. VCMs use a project-based system, rather than a cap-and-trade system. • VCMs allow carbon emitters to offset their emissions by purchasing carbon credits emitted by projects targeted at removing or reducing GHG from the atmosphere. • Each credit can be used to compensate for the emission of one ton of CO2 or equivalent gases. When a credit is used for this purpose, it becomes an offset and is moved to register for retired credits. It is no longer tradable. • VCMs include brokers and traders, like other commodity markets. Traders, for example, purchase credits directly from the supplier (sometimes via a broker), and may bundle those credits into portfolios, and then sell the credits to buyers (either those who need the credits or other traders). • Many such transactions are executed in the OTC market and documented via ISDA master agreements, but exchanges also exist, such Xpansiv CBL, as well as futures exchanges, such as ICE and CME Group. • The voluntary carbon credit market is currently estimated to be $2 billion and is forecasted to grow to $250 billion by 2050, according to Morgan Stanley. 47 48 25CFTC’s Focus on VCMs • VCM regulation and enforcement is a major priority for the CFTC. According to CFTC Chairman Rostin Behnam: “The CFTC is one of the regulators at the forefront of climate-related risk management as firms and individuals will increasingly turn to the derivatives markets to manage and mitigate climate change-induced physical and transition risk. We are making great progress at the CFTC to better understand our role in adapting the derivatives markets to withstand increasing climate-related financial risk.” “The voluntary carbon markets are at a critical point in their development. The CFTC has an important policy responsibility to promote product innovation, price discovery, and liquidity for highquality carbon credits that are the underlying commodity for derivatives products listed on CFTC-registered exchanges. The CFTC also has an increasingly critical role in policing for fraud and manipulation in underlying and related markets.” Role of CFTC • The Commodity Futures Trading Commission (CFTC) regulates “commodity interest” transactions and activities—that is, the CFTC may establish and require compliance with registration and day-to-day obligations. “Commodity interests” include swaps and futures contracts, among other products. (Derivatives) Example: CME’s Voluntary Carbon Emissions Offset futures contracts • The CFTC does not regulate, but has enforcement authority over, spot and forward (non-derivative) transactions involving a “commodity” (or a commodity interest) if the CFTC believes that fraud or manipulation may be involved. Why? Because spot prices may impact/inform the prices of commodity interest. A “commodity” is broadly defined to include various agricultural products and “and all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.” 49 50 26Carbon as a Commodity • Based on the definition of a “commodity,” the CFTC treats environmental carbon products as a commodity within its jurisdiction. – The CFTC recognizes that this market is growing quickly and is seeking to define its role. The voluntary carbon credit market is currently estimated to be $2 billion and is forecasted to grow to $250 billion by 2050, according to the Morgan Stanley. • CFTC Chairman Behnam has proposed that the CFTC follow a similar oversight and approach to environmental products as those adopted for digital assets. – This would include education related to the qualities of a high-quality carbon credit, asserting the CFTC’s anti-fraud legal authority, including in spot carbon credit markets, increasing intelligence in the market, robust enforcement, and government-wide and international coordination. – Also, the CFTC should adopt a heightened review framework of any self-certified environmental products that are listed on exchanges, including those related to carbon credits, as it has done for digital asset derivatives. CFTC Carbon Trading Initiatives • 2011 – Joint CFTC/SEC Product Release, which discussed the regulatory characterization of carbon products. – Certain carbon products may be forwards rather than swaps if there is an intent to make and take delivery, a transfer of ownership, and consumption of the commodity. • 2019 – CFTC Report of the Climate-Related Market Risk Subcommittee, Market Risk Advisory Committee of the Commodity Futures Trading Commission—”Managing Climate Risk in the US Financial System”– Consider appropriate and targeted exemptions to promote market development. – Support the study and adoption of alternative execution methods, such as block trading, auction style markets, or incentive programs, to attract liquidity providers to make climate-related markets. – Coordinate with other regulators to support the development of a robust ecosystem of climaterelated risk management products. 51 52 27CFTC Carbon Trading Initiatives • 2021 – Climate Risk Unit, which seeks to support the CFTC’s mission by focusing on the role of derivatives in understanding, pricing, and addressing climate-related risk and transitioning to a lowcarbon economy. • 2022 – the CFTC hosted its first Voluntary Carbon Markets Convening and followed it with a Commission issued Request for Information on Climate-Related Financial Risk. – Since then, the CFTC received comments from over 80 stakeholders expressing views from members of Congress to farmers, ranchers, and others along the traditional agricultural value and supply chains, as well as from traditional financial market participants. – According to CFTC Chairman Behnam, two main takeaways from the input the CFTC received are: • the CFTC should use its anti-fraud and anti-manipulation enforcement authority to the fullest extent possible; and • the CFTC should support the development of standards to promote the growth of high integrity carbon offsets. CFTC Carbon Trading Initiatives • 2023 – the CFTC took an important step forward in promoting the integrity of spot voluntary carbon markets by announcing an Environmental Fraud Task Force. The Task Force: – sits within the Enforcement Division. – addresses fraud and other misconduct not only in regulated commodity interest markets, but also in relevant spot markets (such as voluntary carbon credit markets), relating to purported efforts to address climate change and other environmental risks. – Examines fraud with respect to the purported environmental benefits of purchased carbon credits, as well as registrants’ material misrepresentations regarding ESG products or strategies. 53 54 28Takeaways • Carbon trading is and will continue to be a high priority for the CFTC. • The CFTC wants to have a more significant role in the voluntary carbon trading market. • The CFTC believes that additional regulatory oversight is needed—and sees a framework developing that is similar that of digital assets. However, a formal agency rulemaking does not appear likely in the near-term. • The CFTC intends to develop and bring more enforcement actions. Expect the Task Force to produce robust enforcement actions involving spot carbon transactions. • Expect the CFTC to team with the DOJ (Main Justice) on appropriate matters (akin to actions involving commodities insider trading, spoofing and digital assets).