Emerging issues in Carbon Markets and Crypto

Carbon markets and the world of crypto are increasingly converging. 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. 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. Within the world of crypto, decentralized autonomous organizations or DAOs are facilitating collaboration with like-minded people all over the world. They also serve as a way to commit funds to a specific cause.

KlimaDAO is one such decentralize autonomous organization that has set out to leverage crypto economics to increase the price of voluntary carbon offsets thereby making it more expensive for companies to use offsets to meet voluntary emissions reduction targets. This will force more companies to actually reduce emissions rather than simply offset emissions. The organization has locked away nearly 15 million tonnes of carbon offsets in its Treasury. These purchases have helped drive up the price of benchmark voluntary carbon offsets from $1.00 per tonne of carbon dioxide equivalent (tCO2e) at the beginning of 2021 to $8.00/tCO2e at the end of 2021. KlimaDAO’s critics point to offset quality, permanence, and lack of economic incentives as reasons for concern about the long-term viability of the DAO.

As crypto continues to make an impact on global voluntary carbon markets, new issues are emerging. Depending on how one views these issues, they are either risks to the use of crypto in carbon market transactions or they are opportunities for future growth. In any case, we explore three issues (legal, transparency, and interactions with offset market incumbents) to provide readers a deeper understanding of how crypto is increasingly shaping carbon markets and what we can expect in the future.

Legal Issues

One of the issues that market observers have questioned is whether it is legally appropriate for DAOs to bring carbon offsets from traditional registries onto the blockchain to create crypto tokens. The world’s largest offset standard provider and registry, Verra or VCS (the Verified Carbon Standard) has disassociated itself from the activities of KlimaDAO. It is important to note that KlimaDAO is exclusively sourcing carbon offsets from VCS but has stated its intention to span out to other carbon offset registries in the future. The VCS has told market participants that the activities of KlimaDAO are not illegal but are not associated with or endorsed by the VCS. The VCS also expressed and openness to working with these types of organizations to build transparent, robust, and credible pathways for transferring their voluntary carbon offsets into crypto tokens.

The legality of such concepts that involves tokenization of carbon reduction credits has yet to be fully defined. Much of the legal precent that has been established over the years has been built through traditional market transactions and may not apply in the realm of crypto. This lack of clear legal definition creates risk for organizations using crypto tokens towards emissions reduction goals. However, good faith efforts by the VCS and other market participants could help to establish a legal framework. Once market participants have certainty and clear definition over the rights and benefits of using crypto-linked carbon offset credits, this could enable the acceleration of growth in the space.

Transparency Issues

The Toucan Protocol is the firm that is responsible for converting most voluntary carbon offsets into on-chain crypto tokens. The Toucan Protocol operates on the Polygon network which is an execution layer built on top of the Ethereum blockchain. Carbon offsets, when tokenized using the Toucan Protocol, are referred to as a BCT or Base Carbon Tonne. Recently the Toucan Protocol removed a significant quantity of nature-based BCTs in preparation of launching a separate token that will be called NCTs or Nature Carbon Tonnes. This will allow market participants to differentiate between BCTs, which is defined broadly to include all carbon reduction units, to a narrower pool of credits that includes nature-based emissions reductions only. It is expected that NCTs will trade at a premium to BCTs given their high-quality and secondary environmental benefits.

Some stakeholders saw this move as an action that lacked transparency. After all, one of the primary rationales for trading carbon on-chain is that it is more transparent than traditional offset markets. Toucan had a solid justification. They noted that the speculators would have purchased nature-based credits if such an opportunity had been communicated to the market, so they chose not to make the launch of the NCT public. They noted that speculators would have caused volatility in not just the NCT price, but also related tokens like BCT and Klima. It is not clear where and how Toucan sourced the underlying offset that will form the new NCT token and whether the initiative is related to KlimaDAO. While questions remain around the intended use of the NCT token, it appears as though Toucan is attempting to act in the best interest of market participants by preventing the release of information that could result in significant market volatility. Critics will point to this case as another instance of crypto operating in the shadows, but supporters will see this action as a responsible move to protect market integrity by preventing the release of material non-public information.

Partners

The degree to which crypto can gain legitimacy in the carbon markets may depend on the partnerships that it can form with market incumbents. As we stated above, VCS, an established offsets standard developer, has stated their openness to help make crypto-backed ventures more transparent, robust, and credible. The Gold Standard, another well-known offset standard developer, has also indicated they are happy to work with the decentralized carbon space. More recently, the industry trade organization known as IETA or the International Emissions Trading Association has launched a taskforce that will work to develop guidelines for ensuring integrity in the blockchain-based carbon market. This is a positive sign for the crypto space as it shows that traditional market participants are willing to work with nascent organizations operating at the nexus of carbon and crypto.

Not everyone is happy about the established market participants getting on board with crypto. Some are highly critical of the move given that retired voluntary carbon offsets can still be traded on chain. Normally, when an offset credit is retired it is considered to be consumed, used up, and not valid for neutralizing future carbon emissions. Once an offset credit is retired, it is typically considered to be worthless. However, in the crypto world, these credits simply take a different form. They may be retired from traditional registries but are still actively traded with the assumption that they may be used to offset future GHG emissions. Tracking the use and retirement of credits that are traded on chain will be required to ensure the environmental integrity of the emission reduction claim and to avoid double counting of any benefits. With IETA, VCS, and Gold Standard acting in good faith to improve environmental integrity of on chain carbon offsets, carbon-focused crypto organizations have the opportunity to move from niche to mainstream.

Conclusion

The impact that crypto is having on voluntary carbon markets is becoming material. With millions of offset credits being brought on chain, crypto organization are reducing market supply, increasing prices, and making it more expensive for companies to buy carbon offsets to meet their emission reduction goals. As crypto projects expand into other voluntary and regulatory markets, the prices are likely to go even higher.
It is important that companies with voluntary carbon targets begin to prepare for this new high-priced carbon reality. As carbon market interest increases, companies need to think about locking in supply now. 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.

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