Carbon Credits — Can blockchain help fix climate change?
INTRODUCTION
To keep global warming to no more than 1.5°C — as called for in the Paris Agreement — greenhouse gas (GHG) emissions need to be reduced by 45% by 2030 and reach net zero by 2050. By 2021, 21% of the world’s 2,000 largest public companies have committed to meeting net-zero targets, and companies have turned to a financial product to offset their environmental footprints — carbon credits.
The total carbon offset market is valued at over US$262b. It consists of the mandatory and voluntary markets, which are valued at roughly US$261b and $1b, respectively, and both are projected to grow strongly. Together, they cover ~12 GtCO2e, representing more than 20% of global GHG emissions. In this article, we will try to understand what carbon credits are and assess whether blockchain-based carbon credits are an effective solution for reducing carbon footprint.
Primer on Carbon Credits & the Carbon Markets
Types of Carbon Credits
- Carbon Allowances — Carbon allowances allow holders to emit one ton of CO2. Created by governments as a way to control emissions through cap-and-trade, where emissions are capped, and credits to emit can be traded. These carbon allowances are distributed to companies for free or through an auction. Companies with lower levels of CO2 emission can then sell their carbon allowances to companies with higher emissions, incentivizing companies to reduce emissions through market incentives.
- Carbon Offset Credit — Unlike carbon allowances which allow holders to emit one ton of CO2, carbon offset credits represent one ton of CO2 removed from the atmosphere. This is done by planting trees, direct capture of emissions, etc. Many carbon offset credits are purchased by corporations or individuals to lower their carbon footprint.
Types of Carbon Market
- Regulated Carbon Market — Markets where the regulated carbon allowances are traded. Examples include the EU’s Emissions Trading Systems (EU ETS) and California’s cap-and-trade program.
- Voluntary Carbon Market — Markets that operate without government regulation. The voluntary carbon market has grown explosively in recent years as corporations and environmentally conscious individuals want to abide by ESG rules to move towards net-zero emissions.
Current Problems in the Carbon Markets
The carbon market currently faces several problems that affect the regulated carbon market and the voluntary carbon market.
Loophole in the regulated market:
- Carbon Leakage — A problem where companies will move their production from a region with a high number of carbon regulations to one with fewer regulations. This is done to exploit the regulatory arbitrage between regions and allow the companies to emit the same amount or more without having to pay or be restricted by carbon allowances.
Demand-side problem in the voluntary market:
- Carbon Market Opacity — The voluntary carbon market is very opaque as most transactions are currently done directly with brokers and intermediaries. Therefore, there is no publicly accessible index of carbon offset prices. This information asymmetry in carbon prices allows carbon offset sellers to take advantage of buyers as well as increase the barriers for participants to access the offset market.
Supply-side problem in the voluntary market:
- Carbon Accounting & Market-led Verification — It’s extremely difficult to quantify exactly how much CO2 a given project keeps out of the atmosphere. As of now, Verra and Gold Standard are the most established carbon credit registries. However, a research paper published in April 2021 found that 90% of the 100 offset providers certified by Gold Standard and Verra either failed to offset as much as they claim, are not permanent, and come with damaging side effects for local communities or ecosystems, or some combination of the above. Moreover, there has been a lot of controversy over the production of some of the carbon offsets bought by large corporations. In 2020, a Bloomberg article alleged that a carbon offset provider, the Nature Conservancy, one of the most reputable environment organizations, was creating carbon offsets credits from land with trees that didn’t need defending, and therefore the carbon credits were fraudulent.
How To Address These Problems
To address carbon leakage in the regulated market, governments across the world will have to work together and set similar standards of emission targets to reach the goals set out in the Paris agreement. This is a problem that cannot be solved by the free market, and worldwide government intervention is necessary to stop companies from playing the system.
Traditional carbon offset providers will likely need more oversight in order for the industry to gain more credibility and move past the controversies of carbon offsets from dubious sources. Although Verra has set a high standard for carbon accounting and verification, baseline accounting and double counting challenge dramatically decrease carbon credit's trustworthiness and effectiveness. For example, forest conservation is still the most common way to create carbon credits, but verifying harvest deferral claims by forest owners against the usual business baseline is difficult.
To address supply-side problems such as carbon baseline accounting, there are several Web2 deep tech companies, such as Carbon Cure, Carbon Clean, Climeworks, and 44.01, implementing carbon capture and storage (CCS) technology to precisely capture CO2 from industrial processes before it is released into the atmosphere, then either store it or utilize it into concrete or rocks.
On the other hand, the best way to address demand-side problems of the carbon offset market is to build a new marketplace that is transparent and accessible to all. This could be done in several ways, such as having carbon offsets listed on traditional exchanges or creating a new exchange in crypto where everyone has equal information and access to it. We have already seen some experimentation with carbon offsets in web3, and the infrastructure is continually being built.
Voluntary Carbon Market in Web3
Why Bring The Market On-Chain
The current voluntary carbon market is extremely intransparent and controlled by intermediaries. The carbon credit experiments in crypto so far are the first time where there are indices tracking the price of carbon offsets that is available to the public. In crypto, where all transactions are public, the opaque carbon offset industry will become more transparent, and market prices will be fairer.
Crypto will also grant all investors across the world, from retail to institutions, fair access to the carbon market. In the traditional world, it would be incredibly difficult for the normal person to purchase carbon offsets and reduce their carbon footprint as it is mostly only available to high-net-worth individuals and institutions. In web3, everyone will be able to purchase carbon offsets directly, severely reducing the barriers to the carbon market. We have already seen high retail participation in the crypto voluntary carbon market with projects such as KlimaDAO.
The KLIMA Experiment
In the midst of the Olympus Finance frenzy, a carbon-backed Ohm imitator emerged. KlimaDAO allows users to bond (transfer to KLIMA’s treasury) carbon offsets in exchange for the KLIMA token. Since its inception, KlimaDAO has built a treasury balance of over 17 million carbon credits. These 17 million carbon offset tokens are made up of 4 sources:
- C3 Universal Basic Offset
- C3 Nature-Based Offset
- MOSS Carbon Credit Token
- Toucan Base Carbon Tonne
How Carbon Offsets are Bridged On-Chain
As we can see above, KLIMA’s carbon tokens are minted by three providers: C3, Moss, and Toucan. Each provider’s process for bridging and minting carbon tokens is slightly different, but it generally follows the process below.
Carbon credits in an off-chain registry will be verified and bridged on-chain so that 1 carbon credit = 1 carbon token.
Controversy Over Carbon Tokens
Verra registry, the largest registry of off-chain carbon offsets, banned the conversion of retired Verra credits into crypto tokens in May 2022. This move was directly targeted at certain carbon token providers such as Toucan and C3. This is due to these providers bridging around millions of Verra " retired " credits, representing around 4% of all issued credits. These providers’ bridging processes are different in that they require each carbon token to be retired to avoid double-spending before it is bridged onto the blockchain, but that would also mean the tokens are backed by 1 tonne of carbon already removed from the atmosphere.
Critics say that because these credits are already retired before they are bridged onto blockchains, their economic value is diminished as investors will purchase something with no value and utility. It would be similar to trading a cash voucher that has already been redeemed. Therefore, the future of the carbon credit tokens should involve carbon offsets that are live, retain full off-chain value, and can be retired by token holders at any time.
Flowcarbon
Introduction
Flowcarbon made headlines when it raised a $70 million Series A from a16z crypto, General Catalyst, Samsung Next, Invesco Private Capital, and more. Flowcarbon wants to bring carbon credits onto the blockchain to make the carbon market more accessible and transparent.
Improving the Infrastructure
It is clear that the current infrastructure for bridging carbon credit tokens onto blockchains is not ideal. For Flowcarbon to succeed, they will have to build the core infrastructure for carbon credits themselves. From its lite paper, Flowcarbon will work directly with carbon credit suppliers to create carbon credit inventory, then use a Special Purpose Vehicle (SPV) to bridge carbon credits to and from Web3. Carbon credits are deposited into the SPV and minted into GNT with a one-to-one ratio.
This is an improvement over the previous iteration of carbon credit tokens, as GNT gives holders more utility compared to the previous generations. Holders could retire the tokens on-chain, unwrap them to represent a project's carbon credits, or redeem them off-chain to deliver the underlying carbon credit. This utility ensures that the tokens traded on-chain will have value and utility.
That said, there is limited information on which carbon offset providers Flowcarbon partners with. More transparency is needed for investors to know that the offsets they purchase are making a real-world contribution. As Flowcarbon moves closer to public launch, we believe more information about their partnerships will be released.
Conclusion
In September 2021, the UN announced that the world is off track to meeting Paris agreement targets. Although the world’s largest public companies have committed to meeting the net-zero targets, it is important that the voluntary carbon market can solve both the demand side and supply side problems by providing trustworthy high-quality carbon credits and increasing accessibility and price transparency of carbon credits.
So far, we have seen great deep tech companies implementing carbon capture and storage technology to reduce carbon emissions. However, the total CO2 captured by these companies still only represents less than 0.1% of our global CO2 emission. To further expand the capacity of carbon emission reduction by using innovative technologies will require better economic incentives for investors to fund the R&D.
From the 2022 data provided by the Paris agreement, most prices of carbon credits are below the US$40–80 per metric ton of CO2 emitted needed to keep global warming within a 2-point degree.
Fortunately, crypto has the potential to turn the opaque carbon offset industry into one that is transparent and accessible for all and eventually aligns economic incentives of carbon credits. By increasing the liquidity and accessibility of carbon credits, carbon credits will become more expensive, leading to better economic incentives to develop and implement low-carbon technologies. Also, the private sector will be less inclined to pollute as it will cost them more to offset their emissions.
Although the previous iteration of on-chain carbon credits has dubious economic value and utility, builders such as Flowcarbon are improving the infrastructure to onboard carbon offset onto blockchains. To push major adoption into blockchains, the web3 carbon credit solutions need to put more focus on solving the demand-side problems by working with high-quality carbon credit suppliers with higher transparency. That said, blockchain implementation for carbon offsets is still in its nascent stage, and we are expected to see many more challenges and innovations arise.
Disclaimer: MindWorks Capital has not invested in Flowcarbon or KLIMA. These statements are intended to disclose any conflict of interest and should not be misconstrued as a recommendation to purchase any token. This content is for informational purposes only, and you should not make decisions based solely on it. This is not investment advice.
