Regulating the Voluntary Carbon Market Mechanism for a fair and transparent functioning

Voluntary Carbon Markets (VCMs) are growing rapidly, and they offer various financial and social benefits. As with any other traded asset market, it is crucial to ensure that VCMs are fair and functional. To achieve this, it is necessary to provide appropriate consumer protections, economic soundness in pricing and information flow, and structural resilience. Furthermore, VCMs must be sufficiently liquid and transparent while ensuring the quality and integrity of the traded asset.

Currently, most jurisdictions lack direct government or regulatory oversight frameworks for VCMs. Although some countries regulate voluntary markets under financial services regulation, in most countries, only derivative contracts and participants in derivatives markets are subject to regulatory oversight. However, it is crucial to consider whether similar principles and standards applicable to financial markets are applicable to these markets. Some of the IOSCO’s Objectives and Principles of Securities Regulation and Principles for the Regulation and Supervision of Commodity Derivatives Markets may be useful in promoting sound markets.

To promote market integrity in VCMs and overcome some of the current limitations of these markets, it is essential to consider some of the best practices developed in other regulated traded markets. Here are some key considerations for regulators to develop frameworks that would promote fair, efficient, stable, and liquid markets for carbon credits:

Open access: A key consideration for VCMs is the degree to which, and how, to allow for open, broad market participation. Appropriately broad access to a trading market by buyers and sellers promotes price efficiency and fairness, liquidity, and transparency. Implementing fairness and access rules in decentralized OTC markets can be challenging. Access and eligibility rules could be more easily applied by centralized trading platforms. A significant degree of trading in carbon credits currently occurs off-exchange, so moving these transactions to centralized trading platforms in VCMs could promote access by participants meeting appropriate suitability criteria and provide greater knowledge about the transactions and terms. VCMs may consider incorporating criteria and procedures for membership that are robust, impartial, transparent, and non-discriminatory.

Market Integrity: A key consideration for VCMs is how to ensure that the market has sufficient integrity to operate without fraud, manipulation, or disruption. Orderly markets apply measures aimed at protecting market participants and the public by fostering markets free from manipulative and disruptive conduct. VCMs may benefit from rules and practices that help ensure that legitimate transactions and fundamental supply and demand information are accurately reflected in market prices. Deterrence of improper and abusive conduct promotes confidence in market prices and enables the market to operate more efficiently. Orderly markets tend to demonstrate a regular process of economically-grounded bids and offers and the smooth execution of transactions. Surveillance and enforcement also remain key considerations.

Liquidity and Price Discovery: A related key consideration for VCMs is how to provide market participants with sufficient liquidity and price discovery to execute trades on a timely basis with minimal price dislocation. VCMs must be adequately liquid to ensure that sellers can find buyers and vice versa, and that the market remains efficient. To achieve this, it may be necessary to develop measures such as market-making programs, bid-offer spreads, and quote depths to ensure that sufficient trading activity takes place. This liquidity will attract more participants and, in turn, enhance the quality of price discovery.

Transparency: Adequate levels of transparency, with appropriate record-keeping and reporting, is another critical consideration. Publicly available data helps market participants make informed decisions and enhances market integrity. VCMs should ensure that market participants have access to data on trading activity, pricing, and contract terms to promote transparency.