I’ve avoided rehashing (!) the usual debates about blockchain use in the voluntary carbon markets (essentially focussed on traceability and tradability) but I do give my takes on these, hopefully with a bit of nuance. Then I touch on a few other areas where blockchain, crypto and DeFi could add value to the carbon markets.

What I don’t do, is go into detail on how blockchains and DeFi work but I’ll link to helpful explainers throughout.

Traceability in Registry Operations.

Let’s not dwell here because it’s been well covered and it’s not particularly controversial. Yes, blockchain is great technology if you want an immutable, transparent record and for carbon credits, we absolutely do. Indeed “Transparency” is one of the core carbon principles recently published by the ICVCM. Of course, the information in the record must be meaningful so we need an agreed taxonomy, i.e. a guide to what the data actually means in the real world, but that’s true across the carbon market, irrespective of blockchain.

A better question is whether blockchain and decarbonisation are natural bedfellows.

To be both transparent and immutable, the blockchain needs to be public, but public blockchains can be energy intensive. Some are better than others; Proof of Stake is better than Proof of Work, and there are other proofs which are even more energy efficient. However, to take full advantage of the scale of decentralised finance (”DeFi”), the Ethereum blockchain is the place to be. Ethereum is (now) Proof of Stake so that’s OK, but there are still costs involved in writing to the blockchain. These can be reduced by using ‘Layer 2’ technologies or techniques like optimistic roll ups, essentially just doing some steps ‘off-chain’, but these efficiencies come at the cost of transparency and ‘trustlessness’, the idea that you don’t need to trust anyone because everything is visible on the immutable chain.

Personally, I think the trusted intermediaries in the carbon market play a vital role in ensuring the quality, integrity and impact of credits so I’m loathe to move to a trustless system with which we could throw the baby out with the bathwater.

So, there’s a trade off between cost and transparency, scalability and energy intensity.

Ultimately, whether to use the blockchain for registry operations comes down to whether the advantages are sufficient to overcome the costs and risks. I’m not convinced we’re there yet, but it’s worth keeping the dialogue going.

Tradability Through Tokenisation.

Let’s split this into a couple of areas which are often conflated:

1. trading of whole carbon credits, generally by businesses; and
2. trading of partial carbon credits (”fractionalisation”), generally to attract ordinary folk like us.

These are profoundly different things, at least they are if you agree that maintaining the quality, integrity and impact of credits is important.

The trading of whole credits on-chain is fine, and might even be a good thing as it’s just extending the traceability into the credit’s final stages. The use of smart contracts to create ‘programable credits’ can also have some advantages. For instance, it could route some portion of the profits of trading back to the originating project, it could limit trading to a select group of ‘approved’ buyers who are on decarbonisation journeys, it could auto-retire at some point, or it could be built to be included in some DeFi applications and excluded from others. Subject to all the above trade-offs, these opportunities are pretty interesting. Under this scenario, each credit is an NFT (more technically, an ERC-721 token) and everywhere it goes, its essential character, it’s quality, integrity and impact, will go with it. Great!

However, fractionalisation is a whole other matter! Tokens that can be fractionalised easily, typically ERC-20 tokens, are ‘fungible’ (the ‘NF’ in NFT stands for ‘non-fungible’ so ERC-20 tokens are the opposite of that). They can be split into any number of fractions and any fraction, indeed any token, is interchangeable with any other. Any number of fractions can reconstitute a whole, there’s no difference, there’s no nuance. They behave like money.

But in the carbon credit market, we know that any one credit, any one ton of CO2 equivalent, is absolutely not the same as any other. A nature-based credit from the preservation of a bio-diverse, tropical mangrove forest is completely different in its features from a credit generated by the use of Direct Air Capture technology. We’re not being sniffy here, it’s not a matter of better or worse, they’re both vital, they’re just different and they should appeal to different buyers who want to support different activities. Making them fungible tokens, traded in fractions on an exchange, buyable by uninformed or disinterested speculators, flattens all that nuance.

Worse still, shallow-impact, harmful or even faked credits are cheaper to produce, so if we allow the quality of the credits to become irrelevant, the market will be filled with bad credits, scandals will rightly ensue, and confidence in the entire endeavour may be undermined. This is a road we need to go down incredibly carefully, if at all.

I would also argue that it’s unnecessary, there are already ERC-20 tokens collateralised by, or indexed against, real world assets like shares or gold. If DeFi enthusiasts want to create tradable carbon credit derivatives, they should be (and are!) free to do so, but based on credits with a preserved record of their impact, integrity and quality.

We haven’t even touched on the huge topic of regulatory implications of ERC-20 tokenised carbon credits and whether they’re securities but you can bet they are somewhere (if not everywhere) and that’s a further reputational and regulatory friction the market doesn’t need.

Finally (but crucially!) does anyone actually want tokenised credits? The user experience of DeFi is still pretty obstructive to all but the most committed. Are we sure this would expand the market? I’m not convinced. (Apparently, that’s a theme, but I promise, I AM open to being convinced!)

Other DeFi in the Carbon Markets.

As mechanisms to ‘internalise the externalities’ of climate change increasingly flourish (the compliance carbon markets, disclosure regulations, carbon border adjustment mechanisms, net-zero commitments), global decarbonisation is becoming less a problem of incentives, and more a problem of coordination. And coordination is much easier among the relatively small number of corporate problem-creators, than among the 8 billion potential problem-solvers. What role can blockchain and crypto play here?

Payment.

The most obvious is payment. The established way to incentivise and reward behaviour is to pay for it, but with 1.7 billion people (one third of adults globally) having no access to the banking system, this significantly limits reach. In almost all countries, smartphone penetration exceeds banking penetration. One can therefore imagine a decentralised payment system, based on cryptocurrencies or stablecoins, which can reward significant numbers of people for making individually small, but collectively vast, contributions to the decarbonisation effort. This could be within the huge, distributed customer base of a corporation, therefore contributing to that company’s Scope 3 emission reductions and net zero commitments, or it could be among occupants of cities, countries or global regions.

Governance.

Another coordination problem for which blockchain has an answer is governance (and effective governance is another of ICVCM’s core carbon principles). Finding new ways for communities to create, coordinate and govern projects is essential to unlocking the potential for decarbonisation at a community level. While constitutions and shareholder agreements may suit some, the governance methodologies pioneered by decentralised autonomous organisations (DAOs)and other DeFi projects hold lessons from which we can learn.

Hedging Decarbonisation Risk & Global Carbon Pricing.

A final potential use for DeFi in the voluntary carbon markets brings us back to corporations which are committed to a net zero journey, hopefully through decarbonisation, not through reliance on offsetting or insetting. Decarbonisation projects can be costly and uncertain, not least because of the uncertainty inherent in the future price of carbon. This could be hedged in a company’s treasury function through investment in a stablecoin pegged (or inversely pegged) to the price of relevant carbon credits, or perhaps a basket of carbon credits which give a blended, global price. To be clear, such holdings would not in themselves contribute to a company’s net zero commitment, so they wouldn’t water down the urgency of their decarbonisation journey, but they would hedge the risk of financing decarbonisation projects.

Such a carbon-pegged stablecoin, perhaps one that algorithmically adjusts its weightings to reflect movements in the various carbon markets, might also be the route needed to create a single global price for carbon. This can either be a synthetic derivative to hedge decarbonisation risk (as above) or a fully collateralised basket of credits where the single global price can be used to incentivise activity in sectors and regions where it’s currently less economically viable.