Carbon Markets Meet the World of Crypto

Introduction

There is a growing convergence between the world of carbon markets and the world of crypto. A crypto token is a type of virtual currency that represents a tradable asset or utility that resides on its own blockchain and allows the holder to use it for either investment or economic purposes. There is a distinction between crypto tokens and cryptocurrencies which is important to highlight. Cryptocurrencies are virtual currencies that have their own dedicated blockchains and are primarily used for digital payments. Bitcoin is the most popular cryptocurrency, but there are growing number of altcoins (e.g., Ethereum, Solana, Cardano) that have uses beyond digital payments. Many of these altcoins are more token than they are currency.

Crypto tokens operate on top of a blockchain. The blockchain is the medium for the creation and execution of decentralized applications or dApps and smart contracts. Crypto tokens are used to facilitate transactions within dApps and smart contracts. One specific dApp category is decentralized finance or DeFi. DeFi is an alternative to the current financial system that allows users to borrow, save, invest, and trade through open-source applications. Decentralized applications that run on the blockchain are commonly referred to as Web3 or the decentralized web. In this new iteration of the internet, we are moving to read-only (Web1 applications like AOL online) to read/write (Web2 applications like Facebook or Twitter) to ownership in the Web3 era. For example, in the Web3 world instead of giving up your data to Facebook or Google, you could actually own your data, transport it between services, and be compensated for sharing it.

One concept that is getting an increasing amount of attention are decentralized autonomous organizations or DAOs. DAOs are member-owned communities that do not have a central form of leadership. They facilitate collaboration with like-minded people all over the world. They also serve as a way to commit funds to a specific cause (like saving the rainforest or buying the US constitution). There is one DAO in particular that sits squarely at the intersection between climate change and Web3 called Klima DAO.

What is Klima DAO?

Klima DAO has garnered significant attention since its launch in fall of 2021. In general, Klima DAO is a protocol with the stated goal of making carbon offsets (and thereby the cost of carbon emissions) more expensive. The DAO is a collective of environmentalists, software developers, and entrepreneurs. The group is aiming to pool their knowledge to make Klima DAO a “black hole for carbon”. The DOA has 30,000 members and is growing. As a DAO, the organization is decentralized in that it is governed by their own members and it is autonomous by leveraging as much code as possible to execute the processes of the organization.

Klima DAO members recognize that carbon offsets represent a permit for companies to emit. As more and more companies look to set ambitious carbon reduction targets, there will be increasing demand for carbon offsets. In 2021, the carbon market was valued at $1 billion and this is expected to increase to over $500 billion by 2050. If carbon offsets are not widely available for purchase, or if they are available but the price is high, companies will be forced to make real reductions to their operational emissions in order to meet their carbon reduction targets. In addition to forcing companies to take real climate action by making carbon offsets more expensive, the DAO also has a secondary goal, to build generational wealth for those holding the KLIMA crypto token. So far, more than 50 thousand people hold or have held the KLIMA token since its mid-October launch. Prices have been on a wide ride increase from $3600 in fall of 2021 to around $50 in the first quarter of 2022.

How does it work?

With all the buzz and volatility around KLIMA, readers may be wondering what are the mechanics behind this crypto token? The first step in creating a KLIMA token is to acquire a carbon offset from the traditional carbon market. Right now, KLIMA DAO is working with the Verra or VCS carbon offset standard, but the DAO could extend this to other voluntary offset standards like the Gold Standard, the Clean Development Mechanism (CDM), the Climate Action Reserve (CAR), or the American Carbon Registry (ACR). The DAO may even extend carbon offset tokenization to regulatory carbon markets where the “black hole” for carbon offsets would drive up regulatory compliance costs for large emitting facilities that fall under a carbon pricing system. For now, however, KLIMA DOA’s focus is on voluntary carbon markets and in particular, credits that have been registered with Verra that were generated no earlier than 2008.

The next step in creating KLIMA is to bring the Verra credits “on-chain” using the Toucan Protocol and Polygon (an execution layer built on top of the Ethereum blockchain). While voluntary offset credits vary greatly in their secondary characteristics, perceived quality, and price; once the credits are moved on-chain they become undifferentiated. This undifferentiated carbon unit is referred to as a BCT or Base Carbon Tonne. The BCT can then be locked into the Klima DAO Treasury. This effectively removes the carbon unit from the marketplace. When the BCT is remitted to the Treasury, the DAO issues its own token called KLIMA. The KLIMA token is backed by a carbon offset, so users can always sell their KLIMA token for at least one carbon offset. The market price for Verra/VCS carbon offsets is about $10 per tonne so this can be thought of as a soft floor on the price of a KLIMA token.

That all seems relatively straight forward. Here is where things get complicated. In order to accelerate the accumulation of BCT by the KLIMA DAO Treasury, there are some monetary incentives that are layered into the design of the DAO. When the total value of the KLIMA issued is higher than the value of the carbon offsets in the KLIMA DAO Treasury (i.e., as a result of price appreciation of the KLIMA token), the DAO issues a bond to market participants in exchange for BCT. These bonds can be redeemed for KLIMA at a discount to the market price of KLIMA after a vesting period has passed. This makes buying and remitting BCT to the KLIMA DAO Treasury an attractive value proposition. In essence, it allows market participants to buy KLIMA at a discount. The flywheel then kicks-in. If the value of KLIMA continues to rise, more market participants will remit BCT in order to get a discount on new KLIMA.

If carbon offset prices increase over time, the value of the KLIMA DAO Treasury should increase. The DAO introduced a profit distribution mechanism as an additional incentive to hold the KLIMA token. Users have the ability to stake their tokens. When users stake, they can earn newly issued KLIMA tokens. The returns for staking got as high as 300,000% last year. The yield is determined by a rewards rate (set by the DAO’s governance body) and by market dynamics (set by the rate new KLIMA is minted and staked).

Impact of KLIMA DAO

As of Q1 2022, the KLIMA DAO Treasury has locked away nearly 15 million tonnes of carbon offsets. That is a lot of carbon offsets. These purchases have helped to achieve the intended goal of the DAO to make carbon more expensive to emit. The price of carbon offsets has surged. At the beginning of 2021 benchmark voluntary offset credits were trading at about $1.00 per tonne of carbon dioxide equivalent (tCO2e). By the end of the year, the same benchmark price assessments were trading close to $8.00/tCO2e, with the benchmark prices for higher-quality removal-based credits trading at about $15.00/tCO2e.

This price increase is not driven entirely by KLIMA DAO. The offset market is increasing in value as more corporate purchasers enter the market and buy offsets to meet their emission reduction goals. However, market participants and offset industry veterans have said that crypto is having a material impact on market prices. The positive price impact resulting from KLIMA entering the carbon market was corroborated by offset developer South Pole as well. KLIMA DAO members believe that is this pricing pressure can be sustained, it will force companies to reduce emissions rather than just offset them. There is a flaw in this argument though. There is a price elasticity to offset supply. As prices for carbon credits increase, more offset projects will be developed to close the supply gap. Eventually the supply potential will wane, but with a large volume of potential projects that have yet to be serialized as carbon credits, it could be some time before the supply from these undeveloped projects is exhausted.

Challenges for KLIMA DAO

While the impact that KLIMA DAO is making in driving up voluntary carbon prices appears to be undeniable. There are a number of challenges ahead for the nascent organization. Members of the DAO will need to address these challenges if it is to be taken seriously as a force for good in the environmental arena. Investors will also want to see the DAO tackle these issues since the project is unlikely to be a sustainable investment unless they are addressed.

Quality

The quality of the carbon offsets that are being remitted to the KLIMA DAO Treasury are considered to have suspect validity and may not represent real emissions reductions. The DAO’s current model incentives market participants to buy the cheapest offsets and convert those to the KLIMA token. Why spend $15 per tonne on a high-quality carbon removal credit to get a KLIMA token when I can get a KLIMA token by only spending $4 per tonne on a lower-quality credit? After all, the BCTs and subsequent KLIMA tokens are commoditizes and indistinguishable, so the underlying emission reduction or removal activity does not matter.

This is a serious flaw in the design of the DAO. Not all carbon offsets are created equal. There are drastic differences in the underlying project’s claim to additionality (i.e., proof that the project would not have happen anyway in the absence of offset revenue), permanence, and secondary environmental or social benefits. The vintage year is also an indicator of quality with older vintage credits trading at a significant discount to newer credits. Older credits often present quality concerns when they have remained unsold for a long time or the credits are being sold directly by the project developer. These factors indicate that the developer did not contract with a dedicated offset credit buyer upfront and has continued to operate the offset project despite the lack of offset credit sales revenue. If you can operate the project without offset credit sales revenue, the project likely does not meet the financial additionality criterion.

As the Integrity Council for the Voluntary Carbon Market (IC-VCM), the Science-based Targets Initiative, and other organizations look to redefine offsets as removal-only (rather than reduction activity), these low-quality credits will not be recognized as valid offsets. This could put the underlying value of the KLIMA DAO Treasury at risk. The diminishing value of the Treasury will also be exacerbated by the fact that credits held on-chain (even those that are high-quality) will become less valuable over time as a result of the vintage-year becoming increasingly removed from present day.

Permanence Issues

Typically, when we discuss permanence and offsets, we are referring to the notion that some carbon removal activities (like planting trees) can be easily reversed, and the carbon released back to the atmosphere. Other removal activities (such as those that store carbon in geological formations) are not easily reversed and are considered permanent. While this issue is still relevant to the quality of credit being locked away in the Treasury, the permanence issue we are referring to here is actually a governance issue with the DAO itself.

KLIMA DAO refers to itself as the “black hole for carbon”, but the protocol that governs the project allows credits to potentially be released. When a BCT is issued, these offset credits are listed as “retired” on the Verra registry. However, the credits are not actually retired as they still exist “on-chain” and can be used by the DAO. The primary use of the BCT is that they serve as a backstop for the price of KLIMA. If the price of KLIMA is lower than the price of a BCT, holders of KLIMA can exchange the token for BCT and sell the BCT to voluntary carbon offset purchasers. If the voluntary offsets that are brought “on-chain” can be reissued and sold, this hardly represents a black hole.

Burning the BCT would be the best way to ensure that the offset credit is permanently retired, but then the value of the KLIMA DOA Treasury would be zero. While the DAO members intend for the flow into the Treasury to be one-way, they do reserve the option to reverse the flow, allowing BCTs to leave the Treasury, if they need to step in as buyer of last resort and purchase KLIMA in the event of a price collapse. Furthermore, and in addition to the “buyer-of-last-resort" reversal mechanism, BTCs can also be released from the Treasury via liquidity pool shares. Regardless of the reversal mechanism, it is clear that the KLIMA DAO Treasury is not a permanent store of carbon offsets and is anything but a “black hole”.

Breakdown of Crypto Economics

Crypto economics is an “interdisciplinary, emergent and experimental field that draws on ideas and concepts from economics, game theory and related disciplines in the design of peer-to-peer cryptographic systems.” Crypto economics can be used to describe underlying supply/demand, value creation, and price appreciation for crypto tokens. We can use these concepts to describe the economic incentives for KLIMA and to point out some potential flaws in the economic flywheel that the DAO proports.

While BCTs locked in the KLIMA DAO Treasury can be reverse and resold as emission reduction units, proponents could make the argument that this is unlikely to happen. To understand why this claim is being made, lets refer back to the underlying crypto economics. Proponents will argue that so long as the KLIMA token price is greater than the price of the underlying BCT, there is no reason to release carbon from the Treasury. As long as new capital is flowing into the space, the price of KLIMA should also remain above that of the underlying carbon offsets used to generate BCTs. Remember that if the total value of the KLIMA issued is higher than the value of the carbon offsets in the KLIMA DAO Treasury, the DAO issues a bond to market participants in exchange for BCT. These bonds can be redeemed for KLIMA at a discount to the market price making buying and remitting BCT to the KLIMA DAO Treasury an attractive value proposition. But what happens when this economic flywheel stops?

It is certainly possible that the crypto economics of the DAO could start to breakdown. If and when this happens, the project could fall apart altogether. Here is a potential scenario: Imagine that the value of outstanding KLIMA falls to a price level where it is lower, but still at a premium to the BCTs. Market participants would then have a lesser ability to purchase discounted KLIMA through the bonding mechanism. The bonding mechanism helps to bring fresh BCT in the Treasury. With less BCT coming in, the Treasury’s carbon holdings increasingly become older-vintage stale offset credits. This reduces the value of the Treasury and therefore the value of the KLIMA token that is backstopped by it. Holders of KLIMA will also have less incentive to stake their tokens. If the value of KLIMA drops further, holders may opt to exit their KLIMA position. Under this scenario, liquidity would be more valuable than any staking rewards. If this were to playout, it is possible to see how the underlying economic incentives of the DAO could quickly unravel.

Conclusion

While KLIMA DOA may have some challenges ahead with regard to the quality of credits enabling BCT issuance, protocol governance, and maintaining long-term crypto economics, it is undeniable that this novel project is having a material impact on voluntary carbon markets. With millions of offset credits being brought on chain, the DOA is actually making good on its goal of making it more expensive for companies to buy carbon offsets to meet their emission reduction goals. As the project continues to expand into other voluntary standards and regulatory markets, this is a trend that is likely to continue.

It is important that companies with voluntary carbon targets begin preparing for this new reality. Carbon market interest is increasing, prices are going up, and companies need to start thinking about locking in supply of offset credits to meet their net zero goals. Frostbyte Consulting is helping its client source high integrity offset credits that allow for removal and permanent sequestration technologies to be scaled up commercially. We are also working with carbon offset purchasers to understand the carbon footprint of their operations and supply chains.

Please Get in Touch

Frostbyte’s sustainability services are cost effective and the broadest in the industry. We’ve worked with countless businesses around the world, including those in the energy, mining, chemical, and construction sectors. Our philosophy is that environmental management is the day-to-day work, while sustainability management is the message behind the work. Ultimately, our goal is to ensure that your organization meets the latest standards in Environmental, Social & Governance ratings while also balancing the needs of people, the planet and your profits.

Contact Us Today: https://www.frostbyteconsulting.com/about/contact/