Carbon credits (also known as carbon offsets) were devised as a mechanism to reduce greenhouse gas emissions, by creating a market for companies to trade in permits (“Credits”) that can be used to offset emissions. Credits are purchased from entities that claim to engage in practices that remove or reduce greenhouse gas emissions.

In this article, Matt Caples and Francesca Bugg outline the two types of markets in which carbon credits are traded or used, before looking at litigation risk identified in the case of Global Carbon Opportunity (Cayman) Ltd and others v CME Group Inc and New York Mercantile Exchange Inc in respect of carbon credit-derived derivatives.

Mandatory vs. voluntary carbon markets

Broadly, the market for carbon credits is divided into voluntary and mandatory markets.

Mandatory carbon markets are regulated by governments or international bodies. These primarily include cap-and-trade programs (also known as emissions trading schemes (“ETS”)) and carbon taxes, with governments setting limits (or caps) on both the amount of greenhouse gases industries can emit and the number of Credits that can be used to offset emissions. Caps are then reduced over time to force a reduction in net emissions, as companies subject to such regimes are incentivised to reduce their emissions and not just offset them as the supply of Credits reduces.

The voluntary carbon market, by contrast, allows companies, organisations and individuals to purchase Credits voluntarily, often driven by corporate sustainability commitments. These markets operate outside regulatory frameworks and are primarily driven by entities looking to enhance their environmental reputation or support sustainability projects. Morgan Stanley projects that voluntary carbon markets will grow fifty-fold within a decade, with the value of the market predicted to increase from approximately $2bn in 2022 to nearly $100bn in 2030, owing in part to increasing demands for companies to manage their carbon footprint.

The complaint filed by Global Carbon Opportunity (Cayman) Ltd and others concerns a type of mandatory credit in relation to international air travel. The market is mandatory insofar as flights made by airlines subject to the Carbon Offsetting and Reduction Scheme for International Aviation (“CORSIA”) regime can only use credits that meet specific criteria set by CORSIA to offset emissions on those flights.

There is, therefore, value in producing or purchasing a CORSIA-compliant Credit; that compliance is, consequently, material to the value of a derivative linked to that Credit.

CORSIA

The CORSIA regime is managed by the International Civil Aviation Organization (the “ICAO”). While the regime has been active for some years, it has been and continues to be developed incrementally in multiple phases. The initial phase was designed to gather information before moving to a pilot phase in which countries volunteered to participate in the regime, bringing international flights between those countries within the remit of the CORSIA regime.

The pilot phase is the first of two voluntary phases, during which time the regime would continue to develop with a view to becoming mandatory, ie for all countries from 2027. At the end of the pilot phase, the requirements for CORSIA compliance changed, and some Credits that were formerly CORSIA compliant in the pilot phase may have ceased to be compliant during the first phase, ie as of 2024. Therefore, those holding CORSIA Credits of pilot phase vintage may now be holding non-compliant Credits that have suffered a loss in value.

As both the carbon markets and the need for companies to manage their carbon risk in cost-effective ways have grown, the scope for creating and selling derivative financial instruments in carbon markets has also grown. The case of Global Carbon Opportunity (Cayman) Ltd (“GCO”) and others v CME Group Inc and New York Mercantile Exchange Inc (“CME” and “NYMEX”) concerns a CORSIA-derived derivative said to have been affected by the change to CORSIA described above.

Litigation risk: GCO v CME and NYMEX

The complaint filed by GCO against CME and NYMEX revolves around a dispute over a global emissions offset (“GEO”) futures contract. It is alleged that CME and NYMEX arbitrarily altered a key requirement regarding the eligibility of Credits under the GEO contract without proper notice or adherence to established rules.

The GEO contracts required that Credits be CORSIA–eligible at the time of delivery, meaning the Credits had to comply with updated standards set by ICAO. However, it is said that CME and NYMEX changed this requirement in May 2023, allowing only older, Pilot Phase (2016-2020 vintage) Credits to settle contracts in 2024 and 2025, despite those credits no longer meeting the CORSIA eligibility. The funds argue that this was a fundamental term to the contract, which meant that only Credits that were CORSIA eligible at the time of delivery in December 2024 and 2025 would be Credits validly delivered under the GEO futures contract.

This change allegedly favoured certain large financial institutions holding short positions to the detriment of long-position holders. The funds allege that CME and NYMEX acted in bad faith by adopting an irrational and arbitrary interpretation of the delivery standards of Chapter 1269 of the NYMEX Rulebook (related to GEO) and ignored the fundamental requirement that an emissions unit must be CORSIA-eligible at the time of delivery as per the criteria from ICAO. This interpretation caused significant losses for the funds, totalling $155.4m.

A specific feature of CORSIA eligibility is that it is dynamic and changes, a feature said to be reflected in Chapter 1269. The funds argue that it is agreed that the Credits to be delivered under the GEO futures contract will not just meet CORSIA eligibility at the time of entering into that contract but also at the time of delivering them. If the Credits to be used to satisfy the GEO futures contract cease to meet CORSIA eligibility requirements, the Credits delivered would need to be changed to meet CORSIA eligibility.

The CORSIA scheme consists of three phases: a pilot phase (2021-2023), a voluntary first phase (2024-2026) and a mandated second phase (2027-2035). In March 2023, the ICAO issued new CORSIA eligibility requirements specifying the types of Credits valid for the first phase of the CORSIA framework. The first phase was scheduled to commence on 1 January 2023 and run to 31 December 2026. Older Credits from the pilot phase would not be CORSIA eligible after 31 December 2023. In short, Credits that were CORSIA eligible when the GEO futures contract was entered into would not be eligible at the time of delivery under the GEO futures contract.

The funds claim that only Credits meeting the updated CORSIA eligibility requirements could be used to settle a GEO futures contract in December 2024 and 2025. However, CMEG and NYMEX interpreted Chapter 1269 differently. On 11 May 2023, CMEG and NYMEX published a statement to the market that disregarded the dynamic and evolving nature of the CORSIA eligibility framework. The statement said GEO contracts could only be settled with Credits issued between 2016 and 2020, which would not be CORSIA-eligible at the time of delivery of the December 2024 and December 2025 GEO futures contracts.

On 9 December 2024, the ICAO updated its list of eligible emissions units for both the pilot phase and the first phase. This could mean existing CORSIA credits are not compliant going forward, and there could be an additional round of issues similar to those outlined above.

Challenges and outlook

The risks that appear to have been realised in GCO’s claim against CME and NYMEX, while realised in relation to derivatives specifically, ultimately stem from the characteristics of the Credit market that underlies it. The markets for Credits are relatively new and, to a large extent, unregulated. While they are increasingly being regulated, that regulation is not yet fully or finally implemented. Therefore, the risks of participating in these markets are not always easy to spot before they are realised.

Nevertheless, these risks might include:

1. The potential for fraud or misrepresentation in both voluntary and mandatory markets

Participants in the Credit markets may misrepresent the effectiveness or authenticity of Credits or even their compliance with certain regimes. Ensuring carbon credits come from verified and established certification bodies might help mitigate against the risk of purchasing worthless Credits or, as a minimum, may improve prospects of seeking recourse if Credits purchased do prove to be worthless.

2. Failure to comply with increasing regulation on participants in high emitting industries

Where industries are mandated to meet emission reduction targets, there will always be an associated risk that parties within that industry might fail to comply with regulations properly. A party’s failure to comply with regulation might be known, or it may be the fault of a third party’s misrepresentation, fraud or other interference in a party’s ability to comply with regulation.

3. Failure to comply with regulations relating to Credits used in high emitting industries

As regimes for the use of Credits are put in place for specific industries or sectors, such as CORSIA, there will always be an associated risk that Credits within that industry or sector are not compliant with those regimes. As companies increasingly have to rely on Credits and/or become increasingly interested in investing in or trading in such Credits, this risk will carry through to those market participants. (This is the risk that appears to have been realised by GCO.)

While carbon credits offer an essential tool for fighting climate change, they also introduce a range of litigation risks that businesses, investors and regulators must navigate. The increasing scrutiny on the legitimacy and quality of carbon credits, combined with the complexity of international carbon markets, underscores the need for careful legal and operational strategies.

As the carbon market matures, stronger regulations and more transparent verification systems will likely help reduce these risks, but companies must remain vigilant to avoid potential legal pitfalls.

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