Nature-based global emissions offset futures contracts are a new type of standardized futures contract being offered on the Chicago Mercantile Exchange that can be used by companies to lock in the cost of carbon offset credits that they expect to need to offset future carbon emissions.

The carbon offset market matches companies that have reduced carbon emissions with others who want to buy credits to cover the emissions they are unable to eliminate.

A private market has developed in carbon offset credits.

The Chicago Mercantile Exchange, or CME, is attempting this year to standardize the trading contracts. Each futures contract is a contract for delivery of a specific quantity of offset credits on a future date at an agreed price. The contracts provide greater transparency for carbon offset trades and make it easier for companies that know they will need offset credits in the future to lock in the price.

Nature-based global emissions futures—called N-GEO futures—require delivery of a specific quantity of carbon offset credits on a future date that the seller will have earned for planting trees, preserving a forest that would otherwise be cut down and similar actions. N-GEO futures began trading on the CME earlier this month.

They are similar in construct to global emissions offset futures contracts, called GEO futures, that began trading on the CME in March.

Standardized contracts and a publicly available spot price significantly lower the barrier to entry for companies looking to buy and sell carbon offsets.

Some companies with carbon emissions have started expressing a preference for certain types of offset credits over others.

The number of carbon offset credits arising from nature-based projects has been increasing at a faster rate in recent years than from other actions. This is perhaps predictable given the higher cost and difficulty of using technology to remove carbon from the atmosphere or of altering a company's operations to reduce carbon emissions.

However, it also fits with the priorities of climate scientists who want to preserve vital ecosystems before it is too late.

GEO futures cover all qualified carbon offset types, and the spot price listed on the CME for GEO futures is a single price that does not differentiate among the offset methodologies. N-GEO futures let companies buy and sell nature-based carbon offsets exclusively if they prefer, for a price that reflects that particular type of offset rather than all carbon offsets.

Improved transparency

This is an area filled with acronyms and its own jargon.

Carbon offsets traded in the N-GEO futures market must meet two standards. They must qualify as "VCS AFOLU projects," and they must be certified under climate, community and biodiversity standards, called "CCB standards," that are administered by an alliance of industry groups.

In contrast, emissions credits traded using GEO futures contracts merely need to be eligible under a "carbon offsetting and reduction scheme for international aviation," called "CORSIA."

VCS AFOLU projects are those that qualify for offset credits under a standard administered by Verra, a non-profit organization devoted to regulating quality in carbon offset markets. Verra stands for "Verified Carbon Standard," and is sometimes shortened to VCS.

"AFOLU" stands for agriculture, forestry and other land use.

The following types of forestry projects qualify as VCS AFOLU projects: afforestation (the act of creating a forest where none previously existed), reforestation (the process of shoring up depleted forests) and revegetation (the act of restoring soil and natural vegetation on barren land), improved forest management and reduced emissions from deforestation and degradation (commonly abbreviated as "REDD").

The following other projects also qualify: agricultural land management, avoided conversion of grasslands and shrub lands, and wetlands restoration and conservation.

VCS AFOLU projects must involve certain approved carbon reduction methodologies. Any methodology approved or developed by either the Climate Action Reserve, an environmental organization in Los Angeles that focuses on the integrity the North American carbon offset market, other than its forest protocols, or the United Nations clean development mechanism is acceptable. Project developers can also develop their own methodologies and submit them to Verra for approval.

The CCB standards were developed by numerous industry groups that refer to themselves collectively as the Climate, Community & Biodiversity Alliance, or "CCBA" for short. Any project design must be approved by the Alliance in advance, and the CBBA sends auditors to visit the project after implementation to confirm that the project provides the benefits claimed by the developer. The auditors also visit with the local communities and invite their comment.

Carbon offsets from projects as far back as 2016 are eligible to be traded under N-GEO futures contracts.

Contract specifications

N-GEO futures contracts are structured like futures for any other commodity. When a buyer purchases a future, that buyer is agreeing to purchase the commodity on the specified future date. The price of the commodity is locked on the date of the trade. Any upward movement in the market price of the commodity after trade date is considered beneficial to the buyer, as the buyer will ultimately be delivered the commodity for a below-market price. Downward movement in the market price is a boon to the seller, as the seller will presumably offload the commodity on the sale date for an above-market price.

Many traders enter into secondary and tertiary trades by re-selling futures contracts before the maturity date when the commodity must either be physically delivered or the contract must be financially settled. This type of trading require a liquid market with transparent pricing and robust reporting and tracking mechanisms to ensure that commodities are not double counted.

The specific terms of N-GEO futures contracts are similar to those of GEO futures contracts.

N-GEO futures are a right to 1000 environmental offsets per contract. An offset is equal to one metric ton of carbon removed or reduced from the atmosphere. The tick, or smallest increment of price movement permitted with respect to a trade, is $10. This is equal to 1¢ per carbon offset unit per contract. The contracts are available for all month-end dates in the current year and the next three calendar years.

N-GEO futures are subject to customary limits on trading. For example, all participants in the market are subject to position limits to prevent a single entity from controlling too great a share of the market. These position limits are governed by the New York Mercantile Exchange and can be found on the CME website.

Counterparties are permitted to undertake "block trades." A "block trade" is a trade that is privately negotiated between two parties rather than in the public auction market. Block trades are typically subject to minimum transaction size requirements. Both parties must be "eligible contract participants" under the Commodity Exchange Act in order to execute a block trade. Block trades must be reported to the CME.

Unlike GEO futures, for which three different registries may be used, N-GEO futures must all be reported to the Verra registry.

Market impact

The ability to trade N-GEO futures contracts should lead to a more efficient market. Companies desiring to buy and sell nature-based offsets specifically, as opposed to carbon offsets generally, will now have an avenue to do so. The market will be able to assign a value to nature-based offsets specifically as reflected by the CME spot price, rather than lumping all carbon offsets under a single market price that may not fully reflect the diversity of the underlying offsets.

The CME plans to list spreads for GEO and N-GEO futures, which will allow for inter-commodity spread transactions. This may prove useful for traders looking to manage (or capitalize on) price volatility between the two types of contracts.

Because the standards for sourcing carbon offsets for N-GEO futures are high, companies can be assured that the offsets are of good quality. The fact that the projects are audited by the CCBA may bring comfort to companies apprehensive about accusations of "greenwashing."

However, nature-based projects also have critics. Critics argue that nature-based offsets will do little to curb climate change if not paired with efforts to reduce fossil-fuel usage and its harmful effects, for example by wider adoption of carbon capture technology.

There is some concern that nature-based offsets permit companies to tout their carbon reduction efforts without critically examining how their own practices contribute to a global rise in temperatures.