Why do we need to digitalize carbon offsets?

Blockchain, or shared, distributed ledger technology, can play a key role in boosting climate action by solving many of the underlying challenges of the voluntary carbon market (VCM).

Some of these challenges are simply due to the fact that most carbon credits are created in emerging markets, where people often face challenges verifying the ownership of assets, and the presence of intermediaries such as banks and credit card companies can be patchy to non-existent. Blockchain as a decentralized solution promises to tackle many of these problems.

Putting carbon credits on-chain can also help bring greater transparency and liquidity to the VCM, which it has historically lacked. This could transform carbon into a genuine asset class, with good risk adjusted returns, and low correlation with other asset classes, making it increasingly attractive to institutional investors who have not yet been able to get exposure to this market.

The demand is certainly growing; a fast-growing number of corporations have committed to reaching “net zero” emissions - a state in which CO2 emissions are fully balanced out by removals from the atmosphere. For the hard-to-abate parts of their business and supply chain, most of these companies are choosing to buy offsets, until appropriate technologies become available for full deep decarbonisation.

In so doing, corporations are playing a key role in preserving the earth’s natural carbon sinks, like carbon-dense rainforests which are otherwise being lost at astounding rates. Corporate offsetting via carbon credits generates a vital source of financing for projects worldwide that contribute to climate mitigation, resilience, and sustainable development goals, including large scale rainforest conservation. Projects generate carbon offsets by voluntarily either reducing emissions (e.g. preventing or slowing down deforestation) or removing carbon (e.g. planting trees).

The VCM is growing rapidly, passing the $1 billion mark for the first time last year. Issuance of carbon credits nearly doubled to 0.35 billion tonnes of CO2 equivalent (tCO2e) in 2021, while retirements, which are seen as a proxy for demand, were at 0.159 billion tCO2e in 2021, doubling compared to 2020.

Putting that into broader perspective, global CO2 emissions at over 36 billion tCO2e means the VCM covers just under 1% of the problem. But the potential of growth for the VCM is immense, by some estimates it can scale up by a factor of 15-100 by 2050, playing a key role in our low carbon future.

VCM pain points

The VCM has a multitude of stakeholders –- private project and program developers and non-government organizations (NGOs) – methodologies and project types. The buying cycle is slow, expensive, and therefore inaccessible to many who would want to participate. The vast majority of offset buying is done “over-the-counter” (i.e. bilaterally, not on an exchange), through layers of brokers. There is no centralized source of pricing or availability data. Putative buyers typically receive offerings from numerous brokers or other retailing agents, research what each offering represents at the project and issuance level, and if they decide to buy, there is a lengthy diligence and KYC process followed by negotiating an individual purchase agreement for each buy. The process can often take weeks, and requires carbon expertise, legal resources, and taking counterparty risk – creating massive barriers to entry for those who wish to purchase this asset.

Many, if not all, of these structural challenges are solved by creating asset-backed tokens representing underlying carbon credits.ringing them on chain to increase transparency and liquidity in these markets.

The VCM also mostly operates outside of regulated or mandatory carbon markets, making it a tough job for private buyers to try to navigate this complex market. Because the VCM is dominated by so many different entities involved in selling, there is a lack of transparency on pricing.

Solutions offered by blockchain

Tokens backed by carbon offsets, and built using smart contracts that are interoperable across devices and other financial systems, can be a game changer for the VCM. There is a remarkable overlap between issues identified in the VCM and the promise of blockchain technology.

First, bringing carbon credits on-chain would allow the industry to demonstrate transparent records to all stakeholders, throughout the lifecycle of each credit - generation, sale or even multiple trades, and retirement.

Second, blockchain is also a way to improve the low liquidity in the carbon market by helping to reduce entry barriers. Instead of the lengthy process required to buy a carbon credit from a registry, millions of people already using blockchain systems can participate.

Blockchain can bypass this intermediary structure, and enable much more efficient and low-cost point-to-point transactions between suppliers and buyers.

Approximately 300 million tCO2e traded in 2021 in the VCM, of which the majority was over-the-counter. Of this total, 121.5 million mtCO2e also traded on Xpansiv’s CBL exchange, almost triple the previous year.The futures market is also nascent; just 6.5 million tCO2e traded in 2021 onCME.

In contrast, on-chain volumes grew much faster last year, from nothing to nearly 17 million tCO2e in a few months. To date, these on-chain carbon credits have been mostly of low quality and/or are “non-live” credits already retired off chain, losing their value in the traditional offset market. However the surge of interest has at least shown that blockchain can bring a much broader swathe of people into the carbon market.

While financial institutions, project developers and NGOs have focused on the construction of the VCM till now, the general public is still largely unfamiliar with the concept. The application of blockchain can deepen people's personal involvement in owning and retiring carbon credits,and can encourage the whole of society to unite around climate action.

The last type of solution offered by blockchain is unlocking the forward market for carbon offsets, by matching the expertise of carbon offset project developers with capital in the Defi ecosystem.

Project developers usually face a funding deficit, as the income from carbon credits is typically received only upon delivery (sale) of carbon credits. This can be 2 to 10 years after the project start date.

Increased predictability and transparency of carbon offset purchase commitments through smart contracts provide more precise investment signals for emission reduction projects.

Why do project developers need this capital? Because they originate the carbon offsetting projects around the world using their expertise and partnerships with local communities, NGOs and other stakeholders, and bear the financial risk.

Blockchain - “like the internet in the 1990s”

The World Bank quipped that blockchain is the internet in the 1990s - weird and scary. However, the leading multilateral development bank is piloting an open-source blockchain - Climate Warehouse - that would act as a ledger for the global carbon markets under Article 6 of the Paris Agreement.

WB’s Climate Warehouse project sees the ledger as a public good, and this endorsement is a testament to the promise of blockchain in raising climate ambition.

A common criticism of blockchain technology relates to its large energy usage, which stems from the fact that older blockchains use the computationally inefficient and carbon-intensive ‘proof-of-work’ consensus mechanism.

However, a newer generation of blockchains like Polygon, built using an Ethereum smart contract, are far less computationally demanding, and so much less energy-intensive.

By using a ‘proof-of-stake’ consensus mechanism, instead of the original “Proof of Work” approach to authenticating newly mined blockchain tokens, these chains have reduced the ratio of carbon avoided per carbon emitted to 100 million to one.

By providing a new digital infrastructure for carbon offsets the VCM can be simplified, disintermediated, and modernized.

At this stage of the climate crisis, the steep rate of emissions reduction required this decade to stabilize global temperature rise within relatively safe boundaries is daunting, to say the least. Digitization of carbon offsets can be a rapidly scaling and empowering force for people, that helps us tackle the planet’s greatest challenge.

Future Thought Leaders is a democratic space presenting the thoughts and opinions of rising Energy & Sustainability writers, their opinions do not necessarily represent those of illuminem.