Carbon Markets Need Crypto and Vice-Versa

In what follows I describe how carbon markets can help pull the planet back from the brink of environmental collapse, but in their current manifestation, they’re deeply flawed. The field of crypto, taking advantage of blockchain technology, can help solve many of the Carbon markets’ most pressing problems.

By way of a disclaimer, I am new to the emerging field of regenerative finance. As I dig deeper, and as I receive feedback from people who understand the different pieces of the puzzle better than me, I’ll update this article.

By Reading On, Here’s What You’ll Learn:

• How a transparent crypto-based carbon market can work.
• The problems facing existing Carbon markets.
• The solutions Blockchain technology brings to carbon markets.
• How tokenization, smart contracts, and trustless organizations all strengthen the carbon market value proposition.

Imagine this scenario: Patriot Airlines announces that it has achieved carbon neutrality by purchasing enough offsets from sources of new carbon sequestration to cover the company’s carbon footprint. To much fanfare, the Patriot Airlines executives announce they’re the first airline to achieve this feat. While the company celebrates, others are skeptical, including activists eager to find evidence of greenwashing. To the activists’ dismay, Patriot Airlines anticipated their skepticism and made their carbon offsets completely transparent through blockchain technology.

It works like this: anyone eager to determine whether or not the airline has engaged in greenwashing is able to go to the company’s website, click on the button leading to information about their carbon offset program, and then click through to see exactly from whom the airline purchased carbon offsets.

For each carbon credit purchased, users can see the plot of land where the carbon has come from, and verify that credits from the same plot of land are not for sale on other exchanges. Users can also see who has validated the land’s carbon sequestration capacity, when they’ve done so and what methodology they’ve used.

Users can even look at historical satellite data to show the changes to the land brought about by its participation in a carbon sequestration project. Anyone can verify that the airline has “retired” the carbon credit, preventing the airline or anyone else from re-selling the same credit in the future at a higher value.

In this ideal future, sellers can offer their carbon credits on open and highly liquid marketplaces (meaning sellers can easily find buyers). Prices for carbon credits on the platform differ depending on how much data is available to verify sequestration. Premium credits are sought after, and low-quality credits are ignored.

Buyers on these marketplaces can purchase credits instantly at competitive market rates while resting assured that they’re not buying fraudulent or re-sold credits. In this transparent marketplace, middlemen are reduced to acting as advisors, consultants, and marketers, rather than value-hoarding intermediaries.

The future of carbon markets I’ve described is only really possible with the help of crypto, or more specifically Blockchain.

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The Promise of Carbon Markets

Before we get into how Blockchains are required to make carbon markets work, we have to talk about the flaws of existing carbon markets. But first, we should remind ourselves that the promise of Carbon markets is to make regenerating the planet more profitable than exploiting it.

Up until now, the earth has been subject to two different forces: destructive, exploitative forces that are leading us towards the brink of environmental collapse, and then the forces of conservation, represented by NGOs, government lobbying efforts, etc.

The fight between destruction and conservation is not a fair one: destructive practices have something that makes them more powerful than conservation-based efforts, which is cash flow. Cash flow is the tool investors use to determine what rate of return they can achieve on an investment.

We cannot underestimate the role cash flow has in determining events in our lives. As Morgan Stanley says, “whenever investors value a stake in a cash-generating asset, they should recognize that they are using a discounted cash flow (DCF) model.”

The forces of environmental destruction are able to harness inexhaustible amounts of capital by producing models that show that an investment today of X will result in Y returned to the investor in Z period of time.

With so much capital in the world looking for a home in which it can reproduce, it’s fairly easy for mining, oil & gas, the timber industry, meat production, etc., to find the capital required to extract value by destroying nature.

Of course, the cash flow models do not account for the effect their activities have on the nature, ecosystems, and communities they harm.

All of those costs, known as externalities, are essentially a free subsidy paid for by nature as well as by the health and wellbeing of those affected by these operations. Without proper accounting for externalities, we don’t know if extractive activities are creating more value than they’re destroying.

Conservation efforts and government lobbying are not able to exert the force required to prevent the destructive capacity of cash-flow-enabled organizations.

NGOs can only harness a fraction of the capital that destructive industries can harness because they provide no cash-flow models. The capital available to them is limited to the funds people are willing to give away without expecting any return.

Government lobbying, though important, is flawed as well: first, governments change. 20–30 years of a country’s proactive conservation effort can be reversed in an instant by a destruction-friendly government. For an example, see Brasil.

Second, governments represent a centralized power trying to defeat the decentralized and distributed power of destructive actors, and as the history of guerrilla warfare has shown us, it’s very difficult for centralized powers to defeat decentralized and distributed powers.

What’s more, governments, especially in the global south, often have a limited enforcement capability. Even when they’re friendly to conservation efforts, they struggle to impose their will over vast territories. As the highly resilient drug trade has shown us, so long as there is a lucrative market available, humans will take incredible risks to capitalize on financial opportunities.

Carbon markets are the first serious attempt to change the strategy in the battle to save the planet.

Rather than continuing to fight destructive activities on unequal grounds, carbon markets allow for activists to fight back using cash flow as an alley rather than an enemy. Instead of limiting themselves to demanding destructive activities stop, an entire sub-culture of carbon market builders is trying to develop a viable economic alternative to the forces of destruction. They’re trying to fight fire with fire.

After all, as mentioned in a previous post, a lot of the people destroying nature are doing so for very little pay. If we can pay them more to not destroy nature, they’ll gladly do it.

Capitalism and governments are also fairly industry agnostic so long as the money flows.

Governments want cash to pay for public works that create the illusion of progress. With the illusion of progress, politicians can win re-election and strengthen their hold on power. If it’s easier and more popular for governments to earn money not destroying nature, they’ll rip up their scripts and write new ones.

Capital, like electricity, will flow through the path of least resistance: if capital can earn a return by not destroying the earth, it’ll gladly do it.

Carbon markets make using cash flow in favor of the planet achievable through two means: voluntary markets and regulated markets.

In voluntary markets, companies driven by a marketing imperative, a need to ensure employee retention, and/or executive conviction will attempt to calculate the company’s carbon footprint and then buy credits to “offset” the footprint. Companies want to be able to say that their impact on the planet is, after carbon accounting, close to zero.

Ideally, these companies would invest in reducing their actual output; carbon offsets should be a bridge to the period in time when companies can feasibly operate without negatively affecting the planet.

In regulated environments such as cap and trade schemes that exist in places like California and the European Union, companies are forced by governments to calculate their carbon footprint and purchase offsets as a tax.

The objective of carbon markets is therefore to a.) make companies responsible for the externality of their carbon emissions b.) reduce carbon emissions by financing new sources of carbon sequestration and c.) incent companies to invest in reducing the carbon footprint of their operation in order to avoid carbon taxes.

This also sounds great. However, despite their promise, carbon markets are problematic for all kinds of reasons. I’ll run through a few.

First, sequestered Carbon is a difficult commodity to measure. Carbon is both seemingly intangible in that we can’t see it or smell it, but also highly tangible in that we know without a shadow of a doubt that the emission of carbon into the atmosphere, where it becomes poisonous Co2, is warming the planet with dramatic and disastrous consequences.

Second, to work effectively, carbon markets have to be highly transparent, otherwise, there is a high probability of fraud.

For example, imagine I take a forest that is not under threat, create a carbon credit, and sell it to a company that counts the credit towards its offset goals. The planet has experienced no net gain of carbon reduction, yet the buyer is able to brag that it has reduced its carbon output.

In order to work well, carbon credits need to be tied to under-threat sources of carbon sequestration (i.e. there is a 10% a year deforestation rate in this area and thanks to my carbon sequestration program there is a 5% regrowth rate, meaning a 15% net gain), of new sources of carbon sequestration (due to new farming techniques, tree planting, or environmental restoration, we are now sequestering carbon in an area that used to sequester none).

Second, imagine I am able to convert a piece of land into a carbon sink and I sell a carbon credit to Company A for the value of the land’s carbon sequestration potential for a year. What is there to stop me from turning around and selling the credit to Company B? How would anyone know?

Or, imagine Company A buys the credit when the price of Carbon is at $20/ton and adds the purchase to its balance sheet (basically the company’s list of things it owns). As demand for carbon increases, the price goes up to $30/ton, and Company A decides to sell its credit to Company B. Both companies claim that the same credit is helping them achieve carbon neutrality, even though carbon was only sequestered once.

Both of these problems are often referred to as double-counting and without carbon credit traceability, the status-quo will have us pushing paper around thinking we’re sequestering carbon when we’re actually re-arranging chairs on the deck of the titanic.

Assuming we solve the double-counting problem, we have another problem to contend with: who can actually certify how much carbon is sequestered in any given piece of land? Right now there are only a handful of organizations that perform the service of measuring carbon sequestration, and the more exact their work is, the more expensive it is.

For example, to truly understand a forest’s sequestration potential, someone has to undertake a tree census and measure things like the age, width, and depth of the trees. That organization has to publish its methodology, and its data, and then a third party has to verify that both are accurate. The process can take 2–3 years and cost anywhere between $100,000 and $400,000 USD.

With such a high barrier of entry, participation in carbon sequestering schemes is limited to massive landholders. Indeed, many people see the success of carbon markets as currently constrained by the supply (the number of carbon credits available) rather than demand (the # of organizations that want to buy credits).

Fortunately, right now a lot of capital is being invested in finding solutions to help drive down the cost of validating and verifying carbon credits.

Companies using satellites, sensors, drones and other technology are working to find low-cost and less labor-intensive means to accurately determine the true amount of carbon being sequestered by restorative projects, though I’d say the industry as a whole is in its infancy.

Nonetheless, increasing demand through voluntary and regulatory markets is making the entire carbon market ecosystem more lucrative. Again, capital is being deployed in expectation of future returns based on cash-flow projections. Fight fire with fire.

Carbon markets have lots of problems, but the last problem is one I am particularly concerned about, which is how carbon markets are designed and where value is accrued. When I say “where value is accrued,” I am thinking about who amongst all of the actors that exist between buyers and sellers takes the most money in the transaction.

In many markets value is accrued primarily to intermediaries, also known as middlemen and sometimes brokers.

Middlemen get a bad rap, but they perform an essential service, which is distribution.

If you’re a poor coffee farmer on the coast of Ecuador, you probably don’t have connections to anyone who works in Whole Foods’ purchasing department in Boise, Idaho (I don’t know if there are Whole Foods purchases in Boise). Getting to that purchaser requires a brand that creates trust, and for small farmers, building a brand in a commodity business is next to impossible.

Middlemen, therefore, make connections between supply and demand and are rewarded for this work.

For sellers, middlemen can provide long-term stability by committing to buy a certain volume of products at a pre-determined price.

For buyers, middlemen can act as quality guarantors.

If we look at agriculture we are immediately aware of how middlemen are able to capture much of the value the industry creates by acting as an essential link between supply and demand.

For those who have followed the cocaine trade, in the 1980s and 1990s Colombian producers were the kingpins of the industry. Today, Mexican Cartels are the distributors and main power brokers, despite producing very little of the product they sell.

Middlemen are not inherently evil, but their presence usually suggests that a market is inefficient, meaning there is an opportunity for disruption. When markets are more transparent and trust abounds, buyers and sellers can skip over middlemen.

The internet was supposed to replace middlemen, but we ultimately ended up replacing middlemen with technology companies, and in the process, we created fewer but more powerful middlemen (i.e. Google, Amazon, etc). The economy created by Web 2.0 is highly concentrated.

For carbon markets to work for people and for the planet, we need producers of carbon sequestration to take the largest piece of the value pie; otherwise, they’ll continue to turn to destructive activities to feed their families.

In other words, we need carbon markets in which small-scale landowners can easily choose to enter carbon sequestration schemes and easily get paid for restoring nature. We need to shorten the distance between buyers and sellers.

So how does crypto help carbon markets fulfill their potential?

1. Tokenization:

First, crypto, or more specifically blockchains, allows us to tokenize carbon credits, which means we can have a digital copy of a carbon credit that we can easily trade and trace.

Before RobinHood and E-Trade, for example, if you bought shares in a company you’d receive a bunch of documents you’d have to sign and keep in a safe place.

Shares in companies were eventually digitized, and now companies are able to use different platforms to organize, manage, and automate the management of their cap tables (the list of people who own shares in a company).

The aforementioned platforms are great for companies because companies have no requirement to make the entirety of their cap. tables public.

For carbon schemes, however, we want to be able to see when a carbon credit is made, and we want access to a lot of metadata, including where it was created, by whom, using what methodology, etc. We may also want to be able to independently verify land-use changes through satellites or available drone data.

That metadata is important: the more independent and verifiable data we have about a carbon credit, the less the farmer on the coast of Ecuador needs an intermediary to get his product to a purchaser.

Such an intense level of transparency allows us to quickly identify greenwashing as well as bad actors that are profiting from carbon schemes without actually creating any value for the planet.

When we tokenize carbon credits, we can do a lot of other interesting things with them.

For example, we can sell fractions of a carbon credit token, the way that you can today buy a fraction of a bitcoin.

We can create financial products using carbon credits of specific or different characteristics.

For example, someone may want to buy credits related to wetland restoration.

Maybe some organizations may be interested in buying carbon credits for cheap because they have little sequestration data available, and then adding data gathering tools or helping with land management to increase the sequestration yield, before re-selling the credits to a company that uses them towards their offsetting goals. We may see the day of carbon credit flippers in the same way some people flip houses.

When we can tokenize carbon credits, we can take advantage of a lot of sophisticated financial infrastructure that will ultimately pour more money into regenerative practices.

A number of companies are already working on tokenization, including Toucan, which you can find out about here.

2.) Blockchain as a Carbon Credit Registry

Right now numerous carbon credit registries exist but they’re not necessarily transparent or interoperable.

Registries are important because they act as a single source of truth as to who owns what, but so long as they are fragmented and walled gardens, they don’t help us solve the double-counting issues I mentioned earlier.

Crypto solves this problem because Blockchains can act as immutable (meaning unchangeable) property registries.

For example, Ethereum (ETH) is the second most well-known use of a blockchain. Every transaction ever made on Ethereum is recorded on the Blockchain, and those transactions can be scanned through platforms like Etherscan.

On EtherScan, you can see when an ETH (the token of Ethereum) was created and to whom it was first given.

Then, you can trace the history of that ETH as it moves from person to person, even as it is fractionalized (i.e. made into smaller parts). You can dip into people’s digital “wallets” and see how much they’re holding, how much they’ve transacted, and with whom.

Another way to think of this is to imagine using the serial number on your USD to trace every person that’s held that dollar since it was minted.

The difference is that with Blockchains, you can continue to trace a $50 bill as it's broken into a ten and two twenties.

For Carbon markets to work, we need a single source of truth, a single data set that allows us to trace a credit from its inception until the moment it is “retired”, meaning withdrawn from circulation. We also need to be able to quickly check that the same credit isn’t available for sale on other markets.

Finally, with carbon credits available on a single blockchain, we no longer have intermediaries hoarding credits and releasing them selectively, thus toying with the demand.

For example, OPEC is not a broker, but it’s an organization that controls supply in order to stabilize prices in a way that favors its producer members.

Similarly, a carbon credit broker might stockpile credits in order to manipulate prices. In a transparent market, such behavior would be impossible, because everyone could peak into your carbon wallet and see how much you’re holding.

3.) Crypto Offers Carbon Markets New Organizational Structures With Wild Potential

In another post on the subject of Blockchain and the environment, I wrote “the killer app of Blockchains is the ability to create trustless organizations.”

Part of what makes Blockchains so difficult to understand is that they represent a new model of organizational structure that has no executive function but can still generate a lot of trust.

Bitcoin, for example, is worth trillions of dollars yet has no executive team or steering committee, which is an idea that is difficult to wrap our heads around. The reason Bitcoin works is that its holders fundamentally trust that the underlying technology can’t be manipulated.

As a result, millions can buy, sell, mine, and build things with Bitcoin without fear that an executive decision can put their work at risk, in the way that Google can remove you from Page 1 of its search results and destroy your business. (As an Ex-Google manager, I saw that happen all the time. The founder of Ethereum claims his work came about after his favorite video game suddenly removed his most treasured weapon because it was too powerful. He cried all night, then he changed the world in revenge).

So what can you do with trustless technology?

Helium is a crypto project that seeks to decentralize telecom networks. Some people keep antennas in their homes and automatically receive payment from users who automatically pay when they use the network.

In other words, if Helium is successful, you’ll have an automated and autonomous organization without any profit motive competing with massive telecom companies. How many telecom companies could compete with a highly viral and non-profit motivated company?

A crypto use case for carbon markets might be something like drone operators.

Imagine a crypto network sends out a message that it requires drone photography of a number of properties to verify tree growth.

Drone operators participating in the network bid to take take the images. The lowest bid wins and the network sends her a map she is able to program into her drone. The images are automatically uploaded to the network and GPS confirms the exact parameters of each image. The photographer receives payment in exchange. No company was required in the creation of this exchange of value. No dividends or stock buy-backs are created in this transaction, just money flowing between buyers and sellers.

Crypto also has a feature called “smart contracts” which are basically automated contracts that have plenty of use-cases for carbon markets.

Imagine you’re a small landholder that has committed to a carbon sequestration scheme.

Your buyer requires you to accept to participate in a satellite imagery program, in which every hour images of your land are taken by a satellite.

So long as the land remains unperturbed, you receive partial payment every hour, deposited directly in your crypto account. Anyone who wants can trace the money as it moves from buyer to seller and follow whatever payment is made to the satellite company for verifying the images.

Lastly, the crypto world has given us a new vehicle for governing communities and financing initiatives called DAOs or decentralized autonomous organizations. In another post, found here, I go deep into how DAOs can be used for conservation.

Conclusion

The emergence of carbon markets and blockchain technology represent two massive, society-changing events that I suspect most people aren’t thinking about in tandem.

Once you see the parallels, however, you start to see that crypto and carbon markets need each other.

Beyond the headlines, crypto offers us a new set of tools that can vastly reshape the way the world operates. Carbon markets, as mentioned before, harness the power of cash flow to fight back against destructive forces. Carbon markets need crypto.

As a long-time resident of the global south, I am a firm believer that how we design markets leads to widely different outcomes.

Countries like Ecuador where I live have markets and regulatory systems that produce exactly what they purport to abhor: massive inequality.

If we don’t get carbon market design done right, we’ll miss our last chance to save the planet.

To work, carbon markets have to be frictionless, precise, open, transparent, and trustworthy. The task is massive; so too is the opportunity.

If you’d like to receive my weekly newsletter about crypto, climate, and carbon, please sign up to my substack here.