As I’m looking at the #Refi space, I am trying to understand how a new system might evolve and how some players might fit into the new landscape. I invite you to challenge my assumptions and conclusion and tell me where you think I am wrong so that I can improve my thinking.

I think the #Refi space will bring about a major shift in how we design our whole economy in our natural regenerative assets are financialized and extraction is no longer baked into our monetary system. Web3 will allow us to design fundamentally new ways of coordination and collaboration.

My thesis below will focus on how #Refi will fix the broken carbon markets over the next few years since this is where most of the #Refi projects in this space are focusing on right now. I categorize stakeholders and solution into different buckets knowing that there can be an overlap between these categories.

Buyers:

• Buyers of carbon credits to offset their emissions will split into two types:

  • Type 1 buyers will focus on a portfolio of “good enough” credits to offset their emissions. Type 1 buyers will rely on brokers or marketplaces to curate the credits.

  • Type 2 buyers will buy a portfolio that consists in part of high quality credits and create stories tying the projects to their company. A bakery might buy credits from a regenerative agriculture project in their area wheres a tech startup might buy credits from new CDR technology startups that might have a significant positive impact in the future. Type 2 buyers might buy directly from projects.

  • Both types will have relatively high loyalty to their procurement channel and partner. Type 1 buyers because of their lack of sophistication and focus on the topic. Type 2 buyers because of their emotional connection to the carbon credits they buy. The friction in changing where and what to buy stems mainly from building trust in the new channel / partner

• Apart from offsetting we will see more use cases of carbon credits that will expand the market. Global decentralized autonomous organisations (DAOs) like MakerDAO or Celo will continuously expand their exposure to natural assets and carbon credits and take credits out of the market without matching them with negative externalities.

• All buyers will build portfolios of credits from different projects and also buy a premium in form of an insurance or buffer of credits to be able to compensate for projects that turn out to be less effective.

• The increase of transparency, the scrutiny of rating agencies and players like carbonplan and the resulting public discourse will increase the accountability of the market and most notable the buyers. This will lead to a price collapse of low quality credits. It will further lead to more standardization about what it means to claim carbon neutrality. Sophisticated buyers are likely to lead the pack and shape these standards.

• Furthermore these sophisticated buyers will start to bring their net zero plan on-chain by publicly tracking their current emissions, their yearly reductions and their offset portfolios. More and more carbon accounting software startups will facilitate the data bridging.

Standard bodies:

• Goodhart's law states that “when a measure becomes a target, it ceases to be a good measure”. Therefore the goalpost has to keep moving and the bar for a “good enough” credit will continuously rise just like energy effiency standards for white goods in the EU regularly rescale. This will also in part counteract the adverse selection.

• Legacy standard bodies like Verra and Gold standard have proven to be ineffective in designing good standards. Their counter statements to criticism shows their inability to reflect and adapt sufficiently and quickly enough. Their cumbersome analog processes are being recognized as a key roadblock in scaling carbon credits. That’s why their relevance will quickly fade as better standards emerge.

• Better standards will be created by new digital first entities that focus on specific project types e.g. the reduction of nitrogen in regenerative agriculture. Standards will also be co-created by highly sophisticated buyers. Stripe climate is a prime example. They allow their customers to offset through their curated carbon removal portfolio. Due to their positioning as payment infrastructure provider they’ve got a big lever to establish their standard rapidly.

• Nature based solutions will continue to be the biggest part of the supply side. Their co-benefits can create vastly higher value than their CO2 credits even at prices of 100$/tCO2e. Standards need to be highly specific to account for these and enable project to monetize their co benefits e.g. through public co-funding, collateral for green money.

• The best standards will be updated every two to five years in consideration of Goodhart’s law.

• A decentralized meta-registry will consolidate legacy and new registries and become the defacto standard.

Supplier:

• The supply side of higher quality carbon credits will not be able to meet the rapidly increasing demand. Therefore market forces are on the supply side and there are high incentives to develop more projects.

• Carbon projects will chose the channel that is economically most attractive. This goes beyond a high price for their carbon credits into the timing of the payment. Carbon purchase agreements (CPA) will become the norm since it reduces price risks and locks in partnerships over a longer time frame. Upfront financing will be another tool to attract suppliers and create projects that would not have been possible without it.

• The barriers to enter the market must be as low as possible while recognizing the quality of the project. This favours new, specialized, digital first marketplaces and MRV solutions.

• The friction of changing the sales channel stems mainly from these barriers and the CPAs that lock-in projects over several years.

• The majority of nature based projects will be onboarded by project developers rather than by the land stewards themselves, so platforms will try to focus on developers to increase their scaling capability

• Some hot suppliers might be able to continue to sell directly and own the whole value chain to the customer. Still, project by project validation will mostly be done by a third party to ensure trust.

Measurement, Reporting and Validating (MRV):

• The party doing the measurement and reporting on a project by project basis will be separate from the validating party to avoid perverse incentives

• Measurement and Reporting will be mostly done decentralized by the project owner (I do not yet have a strong conviction on this point).

• Validators will be tech companies focusing on a specific niche e.g. validating how much extra carbon has been stored due to advanced regenerative agriculture practices.

• Only a few highly specialized validators per niche will dominate the respective global market due to their tech edge.

• These tech validators will be paying local work force on the ground to do the remaining manual work e.g. taking probes, operating & maintaining drones.

Brokers and Marketplaces

• Middlemen will try to lock-in as much supply as quickly as possible since this will be their bottleneck to grow.

• Since validation will move to third parties and standards become more specialized middlemen have to move up- or downstream

• Dynamic carbon pools will allow for higher liquidity. With thousands of different methodologies third party validated comparisons can allow liquid trading of carbon credits. E.g. a carbon credit from an energy efficiency project might be valued with one token and a direct air captured (DAC), permanently stored carbon credit might be valued 100 token. With a 100 token one could then either redeem 100 carbon credits from an energy efficiency project or one DAC carbon credit.

• The winning marketplace will

  • improve MRV through separation and decentralization,

  • allow for price discovery and deep liquidity through dynamic pooling

  • increase funding opportunities for projects in terms of volume, risk, trust, duration and upfront payments

  • be linked to the leading meta registry and allow for transparency

  • have the lowest entrance barriers while ensuring quality

  • allows for a plurality of methodologies

  • allows for paying for practices instead of purely outcome based projects

  • allow for composability

  • consider additionality, permanence, risk of reversal, costs, scalability, immediacy and co-benefits for all credits

Others:

• Rating entities, scientists and scientific entities such as carbonplan could be able to monetize with a significant equity-like upside when marketplaces offer rewards for building and reviewing methodologies. These rewards could even be retroactive.

Conclusion:

Since I assume that trust will be the core value in carbon markets, web3 will dominate the market because of the inherent transparency and immutability which eliminates the dependency to trust a centralized party.

Furthermore, I think that web2 and web3 players need to be open to collaboration to deliver most value to their customers. Again, this favours web3 due to composability of programmable automatic contracts and the resulting speed of innovation. So the least a web2 company should do today is to understand their role in a web3 dominated future e.g. as an on- or offramp of data as well as customer specific interfaces and solutions. A MRV web2 company for example could participate in the open forest protocol or regen network or any superior protocol for their vertical by validating the projects on chain.

I think the highest most value can be captures by protocols, which are able to bring the different parties together (e.g. Regen) as well as in companies developing carbon removal technologies and vertically integrate as much as the market allows.

How fast we will see a shift of legacy institutions to web3 will depend on how much tangible impact the web3 native projects like Celo and MakerDAO can achieve in the short-term. But even more important is the validation by thought-leaders like Stripe and Microsoft that will bring legitimacy to this young experimental space. A country move like El Salvador for Bitcoin might further accelerate the adoption.

If you are still skeptical how fast things can go, remember how the world came to a complete halt two years ago because of a virus that ended up killing less than one per mille of the world population. We have the capability to adapt drastically and rapidly.

• The current carbon markets are inefficient because of the complex nature of carbon credits

• To evaluate carbon credits or to build in the carbon market space several aspects have to be considered: additionality, permanence, risk of reversal, costs, scalability, immediacy and co-benefits

• Solutions need to build the infrastructure for issuing and trading fungible carbon credits that allow for liquid, efficient, effective and transparent markets, to lower barriers for projects and to decentralise validation

In my first post I described why I think that climate change is a coordination problem and that crypto can be the foundational technology to solve it. Most of the current crypto projects focus on carbon credits and carbon markets. In this post I want to describe why the current carbon markets are complex and inefficient. The understanding allows us to build more efficient markets and make predictions about how the market evolves and what role crypto can play.

The current voluntary carbon market

The voluntary carbon market (VCM) for offsets is exploding and in 2021 the market grew 190% year over year to 368 Million tonnes CO2 equivalent (CO2e) issued and 161 Million tonnes retired reaching almost one Billion Dollar. The growing gap between issued carbon credits and retired carbon credits already hints at a first problem since only retired carbon actually makes a difference. The resulting average price of less than six dollar per tCO2e is worrying since the social cost of carbon are probably several magnitudes higher and are estimated between 300$ today and up to 13.000$ in 2050.

So far, this market is dominated by a few dozens to hundred project developers creating and selling cheap, low quality and mostly ineffective carbon credits due to adverse selection. Consumers, employees and shareholders demand more climate action from companies and drive them to issue net zero claims. These net zero claims do not follow any standards and oftentimes there is no concrete plan behind the claims to actually reach net-zero. Because they can’t immediately eliminate all of their emissions, companies buy carbon credits to offset their carbon balance sheet. Brokers promise to help finding high quality credits but this fragmented approach does not allow for price transparency and deep liquidity. On the issuer side, Verra is the market leader and currently 70% of all credits issued follow their standards which are often criticised for setting the bar too low albeit their process being so cumbersome that so far only 1.500 projects made it through the process. On all three sides, the supplier, the buyer and the validator side, these inefficiencies are not necessarily caused by profit-seeking intentions. The carbon market is extremely complex and big corporations set up whole teams to find high quality credits that align with their own values and develop their own criteria.

A comprehensive framework for carbon credits

The Oxford Principles for Net Zero Aligned Carbon Offsetting provide a concise and actionable framework how to approach the offsetting from a buyers standpoint differentiating between carbon removal and carbon reduction as well as if and how long carbon is stored. The guide is summarized in these four steps:

1. Prioritise reducing your own emissions first, ensure the environmental integrity of any offsets used, and disclose how offsets are used.

2. Shift offsetting towards carbon removal, where offsets directly remove carbon from the atmosphere

3. Shift offsetting towards long-lived storage, which removes carbon from the atmosphere permanently or almost permanently

4. Support for the development of a market for net zero aligned offsets.

An alternative framework created to evaluate forest carbon credit sources comes from NCX, a marketplace that pays foresters to delay their harvest by one year and issues credits accordingly.

Taken together, these two frameworks already touch on the first six dimensions of complexity namely:

1. Additionality & Verification:

   Does the issuance of the carbon credit ensure that additional carbon is stored compared to the business as usual scenario without income from the offset?

2. (Im-)permanence & time horizon:

   Does the carbon credit remove the emission permanently or is it just delayed? For non-permanent solutions time horizons and discount rates will dominate the outcome of any comparison.

3. Risk of reversal

   How big is the risk that the project fails or the effect reversed?

4. Costs

   What is the cost per ton (year)? What is the expected price decrease or increase over time?

5. Scalability

   Can this solution be scaled to a gigatonne level?

6. Immediacy

   When does the solution come into effect by reducing the anticipated level of Greenhouse gases (GHG) in the atmosphere?

Especially for nature based solutions or nascent startup solutions there is one more dimension that can have an outsized impact

7. Co-Benefits

Measuring CO2e levels in the atmosphere is a poor but relatively easy to measure proxy for planetary health. Environmental, economic and social co-benefits of carbon credits can be up to 650$ and two magnitudes higher than the price of the carbon credit. For example, protecting the biodiversity of a rainforest that is in immediate danger of deforestation can have high external benefits. However, there are also solutions like hydro power plants and dams that can reduce GHG but have negative external costs.

Helping nascent solutions like direct air capture to get to market, gain initial traction and drive down costs is further necessary. Buying expensive offsets early from these companies can therefore bring co-benefits as well.

Now, let’s go one step deeper and dig into two in more detail: additionality and permanence.

Additionality

To evaluate a carbon credit in terms of additionality a baseline has to be established, impact has to be measured, changing policies have to be accounted for, double counting has to be avoided and perverse incentives eliminated.

Business as usual (BAU) scenario

To set the baseline one has to understand the current optimal strategy of the stakeholders if no carbon credits are issued. For example how long a forester currently lets trees grow before he cuts them down and plants anew. NCX models the optimal decision for each forester individually and only issues credits for forest management strategies that let trees grow beyond their optimal age to make sure that the forester is not rewarded for their normal behaviour. Another important aspect in these cases is leakage: Does another forest cut more trees in the same year as a result? Or does a house builder use alternative materials that may even cause more emissions as a result of increasing prices for wood?

It becomes even more complex when the carbon sequestering strategy is the economically superior solution even without carbon credits but is not adopted due to ignorance, risk-averseness or lack of capital. If a farmer wants to adopt regenerative methods to reduce her dependency of nitrogen with its skyrocketing prices and thereby reduce her carbon footprint she usually has to forgo margins for a few years before earning it back. If a company wants to use LEDs or their own renewable energies it needs to invest more money upfront. The required time for a stakeholder to return the investment (ROI) is highly dependent on the business context.

It is obvious that a lot of energy efficiency measures will be implemented over the next few years no matter if there is an additional carbon credit incentive or not even without considering policies. To bring these measures forward in time is important but it is incorrect to account 100% of the benefit as additional. We should therefore look at additionality as a slider and in probabilities rather than binary. Energy efficiency measures specifically should be excluded from the voluntary carbon market just like on-grid renewable energies have been excluded in 2019 by Verra and others after becoming cheaper than fossil fuels in most applications.

Verification

Natural ecosystems are as complex as it gets. Regenerative farming is key to reducing GHG emissions in agriculture. But how much carbon is sequestered by one measure or the combinations of several measures is very hard and costly to measure and track over time accurately since scientific models are in their early stages and current methods of verification often require many manual probes from the ground.

Policies & double counting

Carbon credits must only be rewarded for projects that are not mandatory by law to be regarded as additional. Double counting does not have to be intentional but can be the result of lack of transparency and knowledge. It most often happens when a local government claims the offset that has already been claimed by an international buyer but it can also happen because several parties along the supply chain claim the same credit.

Perverse Incentives

Comparisons to the BAU scenarios require counterfactual thinking by design. But this design can lead to stakeholders emitting more carbon than they usually would just to be rewarded for decreasing their emissions back to the BAU afterwards. In these cases suppliers are being paid to net increase their emissions temporarily. Counterfactuals can lead to the loss of public trust and the decay of carbon markets and have to be avoided even if some beneficial actions can no longer be rewarded.

(Im-)permanence & time horizon

If you are reading until here, you are probably ready to fall deeper into the rabbit hole. Lucky you - it never stops.

There are several aspects that bring extra complexity when adding the time dimension: Natural absorption, the storage duration as well as the chosen time horizon and discount rate.

Natural absorption:

Greenhouse gases are naturally being absorbed by the land and the sea over decades to millennia. CO2 released in the atmosphere is being absorbed by the land and sea naturally over thousands of years while 50% is already absorbed in the first 25 years. Other greenhouse gases are not staying as long in the atmosphere. The warming effect of the much more potent GHG methane is mostly gone after a few decades. Although our planet does a great job at absorbing our excess carbon, it can not deal with the current amount of emissions hence there is a limited remaining carbon budget. A known unknown is how damaging this natural absorption is to the environment. Increasing ocean acidification is a clear symptom of the overload we put on the oceans.

Storage duration

Carbon storage can be short or long term as well as permanent. An example for short term one year carbon storage is the delay of cutting a forest like mentioned above. Longer term solutions could be regenerative farming methods that store carbon for decades in the soil before releasing it again to the atmosphere. Permanence is often considered as storing carbon for 100 years e.g. by setting up contracts not to cut down a part of the Brazilian rainforest for this time frame. Truly permanent solutions usually include new technological methods like direct air capture and the mineralization of carbon into solid objects.

Both short and long term solutions are needed to balance the carbon budget over the next decades. So it is important to build frameworks to allow a comparison between these solutions.

As shown above, CO2 stays in the atmosphere for millenia. But it is unreasonable to make contracts for millenia to store carbon since there is too much uncertainty. A family that owns a forest has a hard time to close a contract on how to manage their forest over generations to come. And since we expect and rely on technological progress, we should not limit ourselves to the known technologies and strategies of today.

Simply defining permanence as storing carbon for a fixed time like 100 years is not sufficient either. It would mean that carbon stored for 99 years does not have any value and carbon stored for 1000 years does not have more value than for 100 years.

That’s why smart people came up with the concept of ton years that allows the comparison between long and short term solutions and enables market participants to calculate the equivalence of different solutions. In this way the benefit of a larger amount of carbon stored for a shorter time can be equivalent to a smaller amount of carbon stored for a longer time. Carbonplan created a very useful calculator that visualises the influences of different assumptions well.

Discount rate

Lastly, every longer term economic decision has to account for the effect that money today is more valuable than money tomorrow by applying a discount rate. Using a discount rate in carbon storage is controversial because it values the wellbeing of future generations less. But I would argue it is useful and necessary since our progress today will help future generations to master their challenges in turn. Discount rates vary widely. In a corporate context a discount rate of 7-9% is the norm since equity is expensive and opportunity costs are high. In the context of climate change it further has to be considered that the damage over time is increasing exponentially. A peer reviewed paper therefore came to the conclusion that the “net” discount rate should be 3.3% after accounting for the increasing damage over time.

Wrap up

Because of all of these complexities carbon credits today are not fungible, markets are not transparent and illiquid, processes are heavy, hurdles are high and in some cases only 20% of the income goes to the project itself since middlemen like project developers, auditers, brokers, standardisation bodies and others take the majority of the carbon cake.

It can seem unfathomable to come up with frameworks that account for these complexities and make sure that we establish good standards for carbon credits. It is necessary though and offers great opportunities to truly have a positive impact. Fortunately, there are many brilliant people working on solutions that help to create and trade high quality offsets efficiently. In my next post I am making some predictions on how carbon markets will evolve with the help of web3.

I appreciate any feedback on parts that are not yet clear to you or missing pieces to have a more complete picture. Please get in touch with me and I’m happy to update the post.

Further resources:

VCM Primer for public stakeholders

A buyer's guide for offsets

• Money was unconsciously designed to be exploitative and the current system fails to address the global problems we face

• Web3 can be the global foundational technology to solve global coordination problems like climate change

• Current #Refi projects mostly miss the mark by being naive about the complexity

FIAT money has deterministically evolved to support the extractive economy that destroys the basis of our existence. When agriculture started and the societal caloric surplus allowed for division of labor, money was inevitable. So were the emergence of interest rates, the concentration of wealth and the exploitation of local and global public goods. The fight over resources led to an arms race and everybody had to join or was feedstock for those who did. This locked people in the zero-sum games of our nation state era. Since these nation states and their leaders follow their own short-term interests they are incapable of solving global challenges. It is the tragedy of the commons.

Web1, the early internet, built the infrastructure for tech savvy people to communicate on a global scale. Web2 enabled everyone to broadcast ideas with a click on a screen but locked people in extractive systems led by businesses that optimize for short term profit and do not act in their users’ best interest. To liberate ourselves, to coordinate and collaborate globally we were missing the glue that allows communities to become powerful enough to enact meaningful change. That glue is global, decentralized and programmable money.

Web3 and tokenomics allow us for the first time to consciously design pluralistic incentive and governance structures for global communities to align their interests and reflect their values. It allows global communication to evolve into coordination and collaboration. It allows us to assign value to our global environment and other public goods that are currently not priced into products and services. It allows for the financialization of these public goods and to leverage financial products.

Climate change and its underlying issues are first and foremost a coordination problem. On the one hand, nobody wants to live on a Dune-like planet and nobody intends to kill species at an unprecedented rate. On the other hand, everybody is doing it since our current economy and our incentive systems and currencies are based on the exploitation and destruction of our existence.

Problems are inevitable, because our knowledge will always be infinitely far from complete. Problems are soluble, and each particular evil is a problem that can be solved. David Deutsch

In the spirit of David Deutsch’s “the beginning of infinity” it is important to understand that we face this problem precisely because we have made such tremendous progress. It is inevitable that as a global economy we run into global-sized problems. Doomsayers often blame technology and advocate for de-growth. But de-growth is not an option. Instead, we have to leverage progress and technology.

To solve this coordination problem we need to create a global system that accounts for the biggest public good we share - our planet's resources and environment. In such a system everybody who is acting in his best self-interest is also acting in our best common interest. But how can you better align these interests?

By reducing market inefficiencies:

• by making the damages and benefits to our public goods transparent

• by designing money and digital assets that are aligned with our values and are in everybody’s best interest

• by punishing and rewarding corporate and state actors

• by making sure that people profit financially from making eco-conscious choices

• by showing the opportunities and economic growth that is possible

• by leveraging technology instead of focusing on sacrificing and de-growth measures

I am convinced that web3 can be used as the foundational technology to solve these problems. I am in the camp of people who think that web3 has the potential to transform our society more than the internet did over the last two decades.

Up to now decentralized finance (Defi) solutions have proven useful and shown that double digit interest rates are possible in times where institutions charge you for your deposit. And permissionless crypto currencies offer the only solution for people unwillingly dragged into financial sanctions.

Last year marked the beginning of a new movement in crypto called #Refi, short for regenerative finance. Whereas previous green crypto projects focused mainly on green (bitcoin) mining and new blockchains with low energy consumption, the Refi movement is looking at how web3 can accelerate the transition to a regenerative economy. I plan to dig deeper into specific projects over the next months. To start, I want to acknowledge that the space is in its infancy and still a niche. My first impression as a climate tech investor was that most climate related projects underestimate the complexity and their solutionism is not serving the environment and sometimes even have the potential to increase the damage. Most projects in web3 generally suffer from skeuomorphism instead of leveraging the full potential by starting with first principles. But web3 is currently attracting the most talented people worldwide with its promise of being the technological frontier and the possibility to shape the future more than most other fields, So, I am convinced this space will mature quickly and produce tangible solutions.

**

Disclaimer:

I’m like Jon Snow. I don’t know nothing. So I appreciate your thoughts and feedback. Please reach out and let me know where I am wrong and what I am missing so I can improve my understanding.