AD//HOC: Understanding the Externalities of Carbon Credit Markets, Pt. 2
Climate standards organizations need to balance any benefits of tokenization with potential credibility pollution from unsavory actors in blockchain
Verra, the dominant standards organization for carbon offsets, recently announced a consultation for third-party projects engaging with their carbon offsets. The objective was “to identify and implement anti-fraud measures relating to the potential association of VCUs with tokens.” This implores to what extent can the offset market (reliant on a few centralized organizations) harness decentralized benefits of blockchain without impacting credibility. Given how tokenization has shaken the still-fledgling offsets market, Verra faces difficult questions regarding its engagement. These questions will only grow in importance as regulators at major events such as COP27 focus on regulation in the offsets market.
The Carbon Offset Market Depends On The Credibility Of Standards Organizations
Carbon offsets allow firms’ pollutants to be negated by a project that credibly sequesters emissions. Suppose XYZ Shipping emits 100 tons of carbon-equivalent in a year, and it’s looking to become carbon neutral. A forest was determined by Verra to store 100 tons of carbon annually, based on plant species and density. The forest can sell the sequestered carbon, as offsets, to XYZ Shipping, negating their excess pollutants. This creates revenue for the forest and a cost for the shipping firm, which is now “carbon neutral”.
Offset implementation requires verification of the amount of emissions sequestered by a given project, and the status of each offset, ensuring it has only been utilized (retired) once. The offset purchaser typically does not have the means to verify and quantify offset validity, so standards organizations provide expertise and legwork that addresses both issues.
However, the credibility that voluntary offsets require is not always tethered to reality. Greenpeace has come out strongly against offsetting, stating “Offsetting allows polluters to keep emitting while masquerading as green.” With that, a publication from Yale claims “up to 80% of California [offset] credits failed additionality tests because most of the alleged additional carbon being stored was going to be stored with or without credits.”
While not immune to questions regarding their methods, Verra has maintained its status in the offset space. Their standard (VCS) is the world’s most widely utilized voluntary GHG reduction program. Verra reports that over 1,800 certified VCS projects have offset or removed more than an aggregated 984M tons of carbon-equivalent emissions from the atmosphere.
Tokenization Threatens To Pollute The Offsets Market
Proponents highlight the potential for blockchain’s immutable ledger to maintain both the reliable issuance and tracking of credits. However, for offsets to be credibly tokenized, seamless integration between registry entries and tokenized representations is required. A frequently-discussed challenge with tokenizing offsets relates to oracle problems and double-spending. Holders of tokenized carbon offsets need to be able to verify ownership of a corresponding non-retired offset in the registry, and that any token-based retirement of offsets is automatically reflected in the registry. Previous approaches, where retired offsets could be tokenized and then re-sold as “live,” or which required separate manual retirement actions for registry entries and non-fungible receipts, introduced reputational risk leading to Verra’s (and other standards organizations) retreat from tokenization.
Given that demand for offsets vastly outpaces the supply, transparent pricing can increase equilibrium prices and appropriately compensate offset projects. However, the price reflects more than the value of the underlying offsets. Consider collateral mixing– an issuer of tokenized offsets may follow the guidelines that Verra has proposed, but to collateralize their token with offsets from a number of different standards, not all of which are as credible as Verra. In this case, the price of the token reflects the market’s perceived value of the mix.
Tokenization also creates opportunities for speculation– these offsets would be subjected to the price volatility that plagues the token market. Such offsets have potential to be used as collateral in DeFi platforms, fundamentally impacting price through lending and staking. Further financialization potentially shifts the value away from the offset itself and to its potential non-fundamental value drivers. In addition, blockchain cannot prevent all malfeasance as breaches can occur through different channels, often catastrophically. Recently, Acala’s stablecoin aUSD was depegged after its value plunged 99% ($1.03 to $0.009) due to an exploit allowing hackers to mint 1B new tokens.
If tokenized offsets trade below Verra’s price-point in the primary market, this challenges what the offset price truly represents; cheaper offsets does not mean a tree is sequestering less carbon, nor that a flight becomes ecologically beneficial, but instead that the underlying technology is creating risk for buyers.
What Should Carbon Standards Do?
One advantage of blockchain is the ability to create a consensus around a set of transparent records. But the true benefit depends on the degree that required information is verifiable by market participants, and anyone else who would like to assess offset veracity. In the short term, if Verra proceeds, it should require further commitments from any tokenization partners that they will limit standards like Verra’s exposure to blockchain-specific risk.
Any tokenization project needs to build on the right protocols. Blockchains vary significantly, and standards organizations should require secure, well-developed, carbon-neutral protocols (i.e., Algorand). The less congestion and volatility, the better; a boring protocol would serve solely its core purpose.
Standards orgs should require any tokenized offsets to have minimal use in DeFi. Once the correspondence between blockchain and registry is solved, tokenized offsets will become attractive as collateral. Incorporating offsets in highly-levered protocols introduces risk that undermines the core mission of the carbon credit system. Because the market for offsets is limited, tokenization projects will want to mix different standards’ offsets with less credible counterparts to increase the size of the market. This can hurt standards like Verra; while not the only source of offsets, individual organizations should insist that mixed offsets carry similar credibility.
Standards organizations should require KYC for all users to increase security, transparency, and the cost of engaging with tokenized offsets. Given the goals of increasing liquidity in the market, this may seem counterintuitive. But increasing the cost of transacting offsets can deter speculators, to Verra’s benefit, further siphoning away activity to “unsophisticated investors”.
Competitors have stated that “[Verra’s] proposal [will] reduce or fully eliminate the added benefit of a creation of a secondary market for carbon credits.” But given the ongoing development and volatility of blockchain, caution is warranted.