Programmable blockchains bring transparency and scalability to opaque voluntary carbon credit markets fraught with intermediaries. However, issues still remain on whether carbon credits are a commoditized product.

Understanding Carbon Credits

Carbon credit and offset markets are created with the idea of driving financing to environmentally critical technologies or initiatives such as renewable energy, carbon capture, or forest preservation. The concept is simple: every tonne of emissions reduced or avoided through one of these projects creates one carbon credit.

Project managers typically verify their credits through a standards body. The four most widely accepted standards bodies are Verra’s Verified Carbon Standard, Gold Standard, American Carbon Registry, and Climate Action Reserve. Each contain independent registries and methodologies. The Exhibit below from Climate Focus shows the market share for these four organizations.

In compliance markets such as the European Union Emissions Trading System, governments set a “cap” on the amount of carbon a company can emit. All tonnage above the cap must be offset through the purchase and retirement of credits - which are provided to companies under the cap participating in the scheme. In voluntary markets, there is no government set cap. Instead, companies purchase credits as part of their Environmental, Social, and Governance (ESG) objectives. 80% of these credits are purchased over-the-counter (OTC). In other words, there is no globally used spot market for carbon credits. Credit owners tend to hire experts in-house or rely on brokers to offload their credits.

Ultimately, this transaction creates a transfer of value from carbon emitters to environmentally friendly projects. However, this is a highly inefficient market. Disparate verification processes and reliance on intermediary brokers create a market that is not transparent and not scalable - but more on this later.

Growth and Impact

This section addresses why carbon markets matter and why they will likely grow over the next three decades. The graphic below states the obvious: to get to Net Zero Emissions by 2050, energy grids will have to significantly reduce their reliance on coal, oil, and natural gas while significantly increasing reliance on biofuels, renewables, and carbon capture and storage. Is this a pipe dream? Will this transition exacerbate issues of energy reliability? Potentially (and depends who you ask). But one thing is clear: energy grids in 2050 will be much greener than those of 2023, and carbon credits are critical in financing the transition.

Despite their shortcomings, carbon markets will play an integral role in this transformation. The mere existence of a voluntary carbon market points to an important truth: the free market settled on a carbon credit trading system that has flourished without a regulatory forcing function. A combined report between Shell and Boston Consulting Group showed that 2022 was a record-breaking year for compliance and voluntary carbon markets, with voluntary carbon markets expected to grow by 5x before 2030. Other reports have this market expanding 15x. Though many call for alternatives such as a carbon tax or global carbon fund, conventional offsetting has a multi-billion dollar head start. In fact, estimates point to a $10-$40 billion voluntary market by 2030. That is, assuming many of the issues plaguing current markets outlined in the next section are solved.

Problem 1: carbon markets need shared principles for verifying credits.

Carbon credits are a highly heterogenous market, not only in terms of type (reforestation, avoided deforestation, solar energy, wind energy, carbon capture and storage, direct air capture, etc.), but also in quality. MIT Technology Review highlighted that California’s forestry offset program overstated carbon savings to the tune of 20-39 million tonnes from lax issuance standards - meaning up to 39 million superfluous carbon credits in the market with no real carbon savings. Trove Research and Bloomberg draw similar conclusions, with Trove focusing specifically on the issue of decades’ old projects still obtaining credits without additional carbon savings. Carbon credits have a quality problem. Blockchain doesn’t solve that. In fact, some crypto projects have fallen into the trap of putting poor quality credits on-chain for expediency and monetary gain.

As implied above, crypto projects take different perspectives on the quality issue. Four projects in the space include Moss, Toucan Protocol, Flowcarbon, and CarbonKerma. Though first movers in the space, Moss and Toucan have summarily been dismissed by many climate experts for falling into the “subprime” carbon credit trap. A Reuters article claimed that Moss purposefully bought credits it privately stated were of low quality, while also failing to conduct any oversight on Brazilian rainforest projects whereby its credits were being generated. Toucan Protocol was also the subject of an incendiary claim by carbonplan, stating that “99.9% of BCT’s tokenized credits come from projects that are so old they are ineligible for the international aviation industry’s CORSIA program.” The act of tokenizing the cheapest credits one could buy and hoping for an on-chain scalability premium set the ReFi segment off to a poor start. In terms of providing transparency and legitimacy to voluntary carbon markets, blockchain got off to a poor start.

Flowcarbon and CarbonKerma take different approaches to establishing legitimacy in this space. Flowcarbon makes it a practice of only tokenizing high quality credits issued within the past five years. Flowcarbon is also vertically integrated, meaning it partners with project developers to assist with evaluation, project finance, and credit verification. CarbonKerma, meanwhile, takes perhaps the most robust, yet limiting approach by only tokenizing carbon sequestered through Carbon Capture Utilization & Storage (CCUS) technology. Carbon sequestered through CCUS is metered and highly regulated because it oftentimes involves permanently storing emissions in nearby geologic formations. CarbonKerma’s ledger, therefore, matches that of regulatory bodies like the Environmental Protection Agency (EPA) with meter readings to match and practically no subjectivity at issuance.

The figure below shows the tradeoffs between the multiple projects listed in this section, with Flowcarbon and CarbonKerma ultimately garnering the best total score across the characteristics of scalability and quality. However, they differ in terms of quality-assured, meaning CarbonKerma’s advantage in permanence and tonne for tonne equivalence, and diversity, meaning Flowcarbon offers credits related to forest preservation and renewable energy which are seen as more “green” initiatives.

Problem 2: trading infrastructure is required to scale

Carbon markets cannot accommodate the high trading volume required to scale to NZE levels without trading infrastructure. Siloed registries that rely on OTC trading is not a sustainable solution. Clearinghouses and meta-registries are examples of potential solutions using current infrastructure for Web2 financial products. However, the question remains: will the standards bodies agree to a third party financial infrastructure or collaborate to create their own? Perhaps in the longterm, but there does not appear to be a conceited effort to promote this. These institutions profit from a white-glove, OTC process of matching buyers and sellers, thereby preventing a liquid and transparent spot market. However, in terms of impact, collaboration may be necessary.

Carbon credit tokenization and decentralized exchanges constitute a leap frogging of sorts. Not only is a collaborative centralized exchange unlikely to occur, but programmable blockchains eliminate the need for manual operations and provide a trustless, immutable ledger to a traditionally opaque market. Carbon credit redemption is conducted through a burn function that takes tokens out of circulation. Carbon credit issuance is somewhat centralized by a warehousing solution or validation of EPA documentation. Liquid spot trading occurs in the middle. By cutting out intermediaries or introducing a warehousing solution with a decentralized exchange architecture, blockchains solve the problem of carbon market scalability and offers instant transparency.

Problem 3: we need proper demand signals with regard to commoditization.

Not all carbon credits are created equal. Some project developers are issued credits for the simple act of not deforesting the acreage they own. Carbon savings are calculated with variables like average tree height and trunk diameter. Others are issued for creating direct air capture infrastructure that sequesters, separates, compresses, permanently stores carbon directly from the atmosphere. One costs nothing. The other costs roughly $250-300 per metric ton.

Will credit tokenization projects treat these as the same? I believe this depends on whether or not consumers demand more information on carbon credit provenance. Until we have clear demand signals, crypto companies are guessing. Ultimately the market can play out in three ways: 1) commoditized credits for conveniences’ sake (i.e. every tokenized credit trades at the same price regardless of the source); 2) buckets of credits by type (DAC, CCUS, reforestation, solar, wind, etc.); 3) hyper-specific credit information.

Truthfully, high CAPEX carbon removal projects that permanently store emissions should trade at a premium. I also believe that consumers want to know what projects they are supporting when they offset emissions. Unfortunately, issuing credits as non-fungible tokens with hyper-specificity project details does not provide the liquid spot market required to scale. I believe this will be a heterogeneous market where credits are batched by type. However, only time will tell how commoditized the tokenized credit market becomes.

Conclusion

Crypto carbon projects solve the scalability and immutability problem with voluntary carbon markets. DEXs are more scalable than OTC markets for obvious reasons. This is the main role that blockchain currently plays in carbon markets: a more efficient clearinghouse substitute.

Crypto carbon projects do not solve the quality issue. In fact, projects like Toucan, KlimaDAO, and Moss exploited unwitting consumers by tokenizing poor quality credits, leaving newer entrants like Flowcarbon and CarbonKerma to attempt to clean up the mess left behind.

Until we have shared quality standards, private companies or NGOs will act as trusted credit quality arbiters in voluntary markets. This paper highlights two approaches from two reputable names in the space. Flowcarbon warehouses and tokenizes the best quality credits from the most trusted standards bodies to establish legitimacy. CarbonKerma relies on the measurability and regulation in CCUS markets to avoid subjectivity altogether. This limited scope is good in the sense that quality is undeniable, but ultimately reduces the projects’ Total Addressable Market and excludes greener projects.

The last issue is what consumers will demand of their credits in voluntary markets. If it’s convenience, commoditized credits will win. If its credit information for consumers to make the most informed quality decision, perhaps NFTs will win. Overall, fungibility is critical to scale. Due to this, I suspect we will see a less monopolistic market structure with credits aggregated by type.