Real considerations to make when tokenizing carbon credits
Note: This paper was written in October 2018, so apologies for any poorly dated references as to the state of Ethereum or the law regarding how an ERC20 token could (or could not) be regarded as a security token. The contents of this paper is not designed to provide legal or financial advice of any kind.
“We’re running the most dangerous experiment in history right now, which is to see how much carbon dioxide the atmosphere… can handle before there is an environmental catastrophe.” — Elon Musk
Tokenizing carbon credits was all the rage back in 2017 as one of the ‘first’ social impact use cases for blockchain technology. Many startups took various vantage points as to how to best develop digital carbon markets, but, up to this point, many either lack adoption, haven’t passed the development phase, pivoted, or still exist as only a white paper.
The effort is an extremely difficult one; a task that requires partnership and political alignment to ensure that existing carbon markets, many supported by the United Nations Framework Convention on Climate Change (UNFCCC), transition to a more fault-proof, digitized, and (hopefully) more liquid market mechanism. In this brief, we delve into what carbon credits (i.e. carbon permits) are, why tokenized carbon markets are necessary, and which existing (and proven) blockchain protocols can help realize a tokenized carbon market on the Ethereum blockchain.
What are Carbon Credits?
A carbon credit is a generic term for any tradable certificate or permit representing the right to emit one tonne of carbon dioxide or the mass of another greenhouse gas with a carbon dioxide equivalent (tCO2e) equivalent to one tonne of carbon dioxide.
Carbon credits and carbon markets are a component of national and international attempts to mitigate the growth in concentrations of greenhouse gases (GHGs). One carbon credit is equal to one tonne of carbon dioxide, or in some markets, carbon dioxide equivalent gases. Carbon trading is an application of an emissions trading approach. Greenhouse gas emissions are capped and then markets are used to allocate the emissions among the group of regulated sources (Carbon Credit, Wikipedia).
Typically, central authority (usually a governmental body) allocates or sells a limited number of permits to discharge specific quantities of a specific pollutant per time period. Polluters are required to hold permits in amount equal to their emissions. Polluters that want to increase their emissions must buy permits from others willing to sell them. Financial derivatives of permits can also be traded on secondary markets.
Sustainability projects (solar, wind, reforestation) also have the ability to ‘mint’ carbon credits and sell them into the market. To do so, the project implementer needs to abide by the following process:
- Project must meet standard eligibility requirements for carbon financing
- Project implementer needs to partner with a ‘Carbon Retailer,’ a type of company that helps the project implementer navigate and engage with the compliance market or the voluntary market (or both).
- Carbon Retailer will ensure that the project complies with additional requirements
- Project implementer determines whether they want to sell their credits within the voluntary market or the compliance market
- Project implementer chooses a Standards Body to work with. The Carbon Retailer will typically write and submit the Project Design Document to the chosen Standards body. The standards provide benchmarks of quality for purchases of carbon credits.
- Project implementer chooses an approved methodology for defining their baseline or submits a new methodology to their chosen Standards Body. The baseline for a methodology being chosen is that emission reductions need to be real, measurable and verifiable. This necessitates measuring the emission reductions associated with the project intervention against Business As Usual (BAU), i.e. what would have happened in the absence of the project.
- Project implementer needs to demonstrate that it is contributing to sustainable development and would not have any adverse social, environmental, or economic impact
- Project implementer will need to demonstrate that carbon emission reductions are real, that credits are not double counted, and that they contribute to sustainable development via rigorous project monitoring
Why Tokenized Carbon Markets?
Globally, carbon offset markets suffer from fragmented implementation, lack of cross-market exchange of value and quite often incorrect parameterization of the carbon ratio of given projects such that carbon credits granted and/or retired often do not actually reflect their true environmental effect, creating demand-supply imbalances (Ryan Zurrer). This has resulted in hyperinflation in carbon credits (see below diagram) therefore not incentivizing the correct behavior in emitters or propagating trust in carbon credit markets generally (Ryan Zurrer).
The current structure of how carbon credit prices and tax policy are determined is also inadequate (Carbon Token Ecosystem). Bureaucrats should never define the price of 1 ton of Co2 (or other pollutant) as there are too many variables at play to provide a wide sweeping, one-time price on all pollutions, which have different characteristics and externalities and will evolve faster than politicians can update the pricing mechanism (Carbon Token Ecosystem).
Additionally, carbon credit markets suffer from lack of consensus on how to determine the correct value of the environmental effect of a given project known as the “carbon ratio” (Carbon Token Ecosystem). How does one compare the relative environmental impact of a MWh of wind power produced in Brazil to a 30ha forest planted in Germany to a ton of Co2 sequestered in the USA to a chemical plant in China reducing operations or being taken offline? Today, the answer is that there are different results across all of these jurisdictions thus creating a lack of actual exchangeable value between different carbon credit offset markets (Carbon Token Ecosystem). Further, the relevant consultants that verify the work along the value stream often have misaligned financial incentives as they are selected and paid by the individual project that they must evaluate (Carbon Token Ecosystem).
Lastly, we lack a globally robust system of checks and balances to ensure that projects are appropriately parameterized based on an agreed upon global methodology for determining net environmental-effect, which has resulted in passive fraud in numerous instances across the industry along with too many instances of active fraud.
The fractured, non-standard, and sometimes non-transparent nature of the carbon credit market could be alleviated by leveraging a peer-to-peer carbon credit marketplace where:
- Sustainability projects are evaluated by a distributed network of ‘verifiers’ local to each project.
- Local project verifiers propose project parameters based on an assessment to the broader network of verifiers. The proposed parameters are voted on and then submitted to the market’s carbon credit minting algorithm
- The minted carbon credit tokens are sold on the market by the project implementer to consumers looking to offset their emissions.
- Consumers, having used their purchased carbon credit tokens to offset their emissions, retire those credit and the tokens are burned (destroyed).
- All parties holding Carbon Tokens could commercialize their assets on an open exchange whereby Generators and Verifiers sell the Carbon Tokens to Consumers so that emissions can be offset. Carbon Tokens would be an ERC20 compatible token and thus would also be available for exchange within the Ethereum network. This solution outline follows an open source model detailed in the Carbon Token Ecosystem.
In addition, we need to note the following for point #2:
- The market’s voted on carbon credit minting algorithm would take in parameterized inputs based on a sustainable project’s assessment and determine the projected environmental benefit (associated with USD ($) value). The projected value would determine the total number of carbon credits that will be minted by the project
- Market will have set parameters (that can be voted on by verifiers), including the algorithm used to determine projected environmental benefit by each project, the input parameters required from each project assessment to make such a projection, and the ‘carbon ratio’ used to compare impact across projects from varying regions around the world
Markets like these allow for a more inclusive price determination of carbon credits based on constantly revised project assessment practices and, most importantly, provide the public market a system in which carbon offsets are generated and subsequently retired based on a rational, verifiable formula of the actual environmental effect of respective industrial activities (Ryan Zurrer). Of course, such a global model exchanging carbon credits minted from varying sustainability projects is a tall order to develop, and will take years to manifest.
Carbon Credit Considerations
The most crucial cryptoeconomic aspect of tokenizing carbon credits is to determine a respectable and logical pricing model that resonates with the traditional, voluntary carbon market. Determining the pricing model of tokenized carbon credits will decide whether such tokens should be available on secondary cryptocurrency exchanges or only provided on a tokenized carbon credit exchange.
Fairtrade Carbon Market
Currently, the only applied pricing model in carbon markets today is the Fairtrade Carbon Market pricing model. This model calculates a minimum price that ensures the average costs of the projects will be covered. However, in the Fairtrade model a buyer also pays an additional premium on top. This “Fairtrade Premium” goes directly to the local community — smallholder farmers and producers in rural communities — to fund activities that help them adapt and become more resilient to an already changing climate (Gold Standard). Developing a ‘community fund’ of capital from the revenue generated by the sale of carbon credit tokens could easily be automated with smart contracts, particularly if buyers are paying in stablecoins. The Fairtrade minimum price for Fairtrade carbon credits is determined by the following equation:
- Fairtrade Minimum Carbon Credit Price = Investment Costs + Project Costs + Carbon Cost + Business Margin — Revenues
In Europe, the following is a standard example of Fairtrade Market minimums per carbon credit:
- Energy Efficiency — 8.20€/tCO2e + 1€ Fairtrade premium ≅ $10.78
- Renewable Energy — 8.10€/tCO2e + 1€ Fairtrade premium ≅ $10.66
- Forest Management– 13€/tCO2e + 1€ Fairtrade premium ≅ $16.40
A cost-based model is a step toward ensuring project sustainability (Gold Standard). The Fairtrade version with its premium for local communities also ensures funding is channeled directly to the most vulnerable, and it encourages producers to participate in developing the carbon projects and increase their involvement and expertise over time (Gold Standard). The Fairtrade Climate Standard also features requirements for buyers of credits to reduce their own carbon footprints (Gold Standard). Companies like DHL and Marks & Spencer have already committed to purchasing in Fairtrade Carbon Credits from Gold Standard projects (Gold Standard). However, a cost-based pricing model does not specifically account for the additional value these projects deliver in sustainable development (Gold Standard).
Given the Fairtrade Carbon Market model, and the innate need to be more transparent to potential consumers of carbon credit tokens, and there would need to be project financial statements released to the public validating the Fairtrade Minimum Carbon Credit Price utilized on the exchange. Initially, this could be done by hiring a reputable auditing firm on a quarterly basis, where statements are hashed on chain for immutable reference. Receipts should be included within these project financial statements and made public as well.
Value Based Pricing
Using a value-driven model to set a price for carbon credits can truly account for the holistic environmental, social and economic impacts of a specific project — that is, both in emissions reductions plus the additional development benefits that can transform lives (Gold Standard).
The United States Environmental Protection Agency (EPA) released an updated report in 2015 to estimate the total cost of carbon to society. For every tonne of carbon dioxide we emit into the atmosphere, we sacrifice an average of USD $36 in environmental degradation and negative social impacts. In theory, these should be accounted for in the price of a carbon credit.
Of course, the socioeconomic outcomes highly correlated to the success of the sustainable projects that would be registering the carbon permits — and this should also be taken into account on a per metric ton basis and, ideally, included within the market price of the carbon credit tokens. Prices in the voluntary carbon market do reflect some of these “economic value” principles. For example, prices for clean cookstoves projects, which often deliver life-saving health benefits to women and children, are generally higher than projects that focus more on the emissions reduction (Gold Standard). But they ultimately yield to the forces of supply and demand, without safeguards such as a minimum price. This is why there is a tremendous gap between the average historical prices for carbon credits compared to the economic value of impacts they deliver (Gold Standard). The gap is an indicator that such assets, if made more easily available, could potentially realize the demand needed to be adequately valued (and thus generate more revenue for companies taking on the sustainable projects that produce such carbon credits).
In addition, value based pricing models cater toward more transparent operating models, like the hashing of quarterly financial statements/IoT sensor data on chain, as public chain transparency proves to the public (and broader market) that the project is delivering the way it should. In a sense, public chain transparency helps validate carbon credit token price by proving the value sustainable projects are providing to their surrounding communities. With such an innovative approach, carbon credit token price could usurp the most premium carbon credit types (like carbon credits generated from reforestation projects; impact valued at $177 per metric ton of reduced CO2 emissions) because of how transparent project data is in contrast to other project deliverers.
Would a Tokenized Carbon Credit be a Security?
Tokenized carbon credits, as we’ve described thus far, as assessed by the Securities Law Framework, which was developed by Coinbase, ConsenSys, Coin Center, and Union Square Ventures in 2016, is estimated to encounter low-risk when not legally registering as a security, indicating that carbon credits, as assets, provide a different function that the SEC deems separate than that of investment utilities like stocks or profit sharing schemes. Table 2, shown below, displays how a theoretical tokenized carbon credit would score via the Framework Tool.
Leveraging Existing Tokenized Asset Protocols
Digix provides a use case for the tokenization and documentation of physical assets through its Proof of Asset (PoA) protocol. The PoA protocol utilizes Ethereum and the InterPlanetary Files System (IPFS) to track an asset through its chain of custody (Digix White Paper). This allows for the open and public verification of an asset’s existence without a centralized database (Digix White Paper). Digix also offers an API allowing other applications to be built on top of our asset tokenization service (Digix White Paper).
The tokenized carbon credit use case could leverage the DigixDao protocol in one form or another, either by leveraging the entirety of the protocol through their available API, or by recreating some of its methods in a more customized protocol for the needs of the carbon market. An important takeaway from the DigixDao protocol is how it handles the minting of asset backed, ERC20 tokens in a transparent and secure manner. The following outlines a higher level overview of the protocol’s process, as shown in Table 3:
As illustrated above, Digix’s high level architecture uses the following processes:
- Proof of Asset (PoA) Verification process which records and provides an audit trail of an asset on Ethereum to create PoA Asset Cards. The asset cards are certified using sequential digital signatures from the entities in the chain of custody, namely, the Vendor, Custodian, Auditor, which are further validated with proof of purchase and depository receipts provided and uploaded onto IPFS for permanent record
- Minter Smart Contract to create fungible DGX tokens, that accepts or holds PoA Asset Cards in exchange for DGX tokens
- Recaster Smart Contract, which is used to exchange DGX tokens back into PoA Asset cards.
- Redemption Process, for redeeming physical gold bar with PoA Asset cards
Of course, the specific context that DigixDao operates within is the increased fungibility of gold ownership and exchange. Since gold is a physical asset, it can always be proven or disproven to exist or not via physical experimentation. Carbon credits, on the other hand, are permits granted by Standards Bodies within the carbon market provided after a sustainable project has proven to create a carbon emissions offset. The DigixDao protocol would need to be adapted for the nuances of ‘minting’ carbon offset permits, using them to redeem emissions offsets, and, of course enabling sellers to prove that their carbon credits are legitimate. The following provides a rough outline of how the protocol’s process could look like if adapted to the needs of the carbon market:
- Proof of Permit (PoP) Verification — process which records and provides and assessment and evaluation trail of a carbon permit on Ethereum to create PoP Asset Cards. The asset cards are certified using authenticators leveraged by a Standards Body, a Registry, and a Carbon Retailer
- Minter Smart Contract to create fungible carbon credit tokens, that accepts or holds PoA Asset Cards in exchange for carbon credit tokens
- Recaster Smart Contract, which is used to exchange carbon credit tokens back into PoA Asset cards.
- Redemption Process, for redeeming carbon permit with PoA Asset cards
The development of this process will be one of the deliverables needed to deploy and test a proof-of concept.
Registering a Token as a Carbon Credit
Carbon permit tokens (from now on, we’ll refer to them as CPTs) will represent a portion of carbon credits, which are issued by governments under cap-and-trade programs set up over the past decade or so to limit the amount of carbon dioxide or other greenhouse gases companies emit.
In order to guarantee token consumers that their ownership of CPTs will be legally recognized by regulators as a new method to offset their emissions, CPTs will need to undergo the legal certification and registration required to represent carbon credits. The following subsections focus on how the current carbon market works and details which steps a company needs to take to ‘mint’ and trade carbon credits.
Trade and Settlement of Carbon Credits
Carbon credits can be sold privately or in the international market at the prevailing market price. These trade and settle internationally, and hence allow permits to be transferred between countries. Each international transfer is validated by the United Nations Framework Convention on Climate Change (UNFCCC). Each transfer of ownership within the European Union is additionally validated by the European Commission (Carbon Markets, Wikipedia).
Currently, there are six exchanges trading in UNFCCC related carbon credits: the Chicago Climate Exchange (until 2010), European Climate Exchange, NASDAQ OMX Commodities Europe, PowerNext, Commodity Exchange Bratislava and the European Energy Exchange.
Process of Earning (Registering) Carbon Credits
There are a few steps that must be completed to appropriately register carbon credits produced by a sustainable project:
- Define your carbon credit assessment standard (the most widely recognized standards are the Voluntary Carbon Standard or VCS, the Social Carbon Standard and the Gold Standard)
- Get your carbon credit certification (independent organizations)
- Get your carbon credits registered, a process carried out by independent organizations, called registries. These independent registration organizations handle carbon credit data in a way that is publicly available and thus open to everybody.
Note that there are many intermediaries within the carbon credit market that could be disrupted via a blockchain based, P2P carbon market. This 10 Step Guide by Mercy Corps elaborates on the requirements and considerations when earning carbon credits.
How to Sell Tokenized Carbon Credits
The point of sale for carbon credits greatly varies across social enterprises and markets. The most common approach is the online sale of carbon credits on the selling nonprofit’s website, so selling tokenized carbon credits online isn’t a far cry from the traditional point of sale. When a prospective buyer purchases carbon credits, they receive a ‘proof of purchase’ certificate by email that confirms the legitimacy of the carbon credits purchased, identifying from whom the carbon credits were purchased, to whom the carbon credits were sold, how many carbon credits were purchased, and providing a certificate serial number. This data provided in the certificate is synonymous to the data provided in a blockchain transfer transaction and, unlike an online certificate, the same blockchain transaction can never occur twice, as the problem of double counting is solved in blockchain networks like Bitcoin and Ethereum.
Here’s the proposed process to prepare to sell tokenized carbon credits:
- Choose a Standards Body to work with
- Develop a methodology including the use of blockchain technology and IoT sensors and propose it to the selected Standards Body (and have it accepted)
- Ensure coordination with financial bodies (i.e. the SEC) to make sure that the tokens are compliant with security law
- Piloted token sale of carbon credits
While developing a methodology, it may be important to ensure the following is accomplished:
- Develop a spec. on IoT Sensor to meet monitoring standards
- Develop a spec. on sale of carbon credits in the form of ERC20 tokens, where (1) Each token represents 1 metric tonne of carbon emissions removed from the atmosphere, (2) Standard Body carbon credit allocation approval on the blockchain, and (3) Tokens are minted in direct proportion to the credits allocated to the sustainable project by the Standards Body and are only minted after such allocation is provided per annum
For the piloted token sale, there are several considerations that need to be made:
- User experience and user interface of the sake of tokenized carbon credits must be seamless for mainstream users as much as possible (and attempt at replicating the traditional user experience)
- Purchasers should be able to use fiat money to purchase tokens. Fiat payments could be converted to stablecoin payments on the application’s backend if needed to have the transaction settle on-chain
Of course, the aforementioned steps are summarized in short form and will be expounded upon as the proposal matures into a more formal engagement.
How to Legally Develop a Tokenized Carbon Credit
In order to systemically validate the use of blockchain technology as part of the methodologies recognized by Standard Bodies within the carbon market, our team would need to partner with a Standard Body, develop a methodology expressing the technology’s use in explicit detail, and propose the methodology to the Standard Body. Essential details include the following:
- How is a carbon credit token minted?
- How will smart contracts ensure that there are never more tokens minted than the number of carbon credits allocated to the sustainable project?
- How do token purchasers ‘retire’ their tokens after using them to offset emissions?
- How are tokens recognized in the traditional market so that purchasers can easily validate their use to offset emissions in the first place?
By attending to these questions and expressing, in detail, how a first generation tokenized carbon market can integrate with the existing carbon market, we can collaboratively set a precedent for the minting of verified and legitimate tokenized carbon credits globally.
Legal Recognition of the Tokenized Carbon Credit
As long as the project selling tokenized carbon credits is properly registered with a given assessment Standard and has gone through the process outlined in the ‘Why Tokenized Carbon Markets?’ section, it seems that the sale is legally recognized and that the offset can be processed.
Overall, tokenized carbon credits are a difficult, but very worthy endeavor, as they are a critical piece of a number of social impact assets that can help bring synergy to the ends of commercial sector and social sector markets to help make the world a better, more sustainable place.
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I commonly write about crypto-economics and blockchain technology with a social impact focus, though I often times stray into lower-level, more technical analyses as well!