A commentary on the intersection of the voluntary carbon markets & DLT

June 29, 2022
A commentary on the intersection of the voluntary carbon markets & DLT

The subject of Digital Ledger Technology (DLT), and the role it can play in addressing some of the longstanding challenges in the global Voluntary Carbon Market (VCM), has emerged as a key one in recent months, surfacing everywhere from Washington DC, to key climate policy bodies, to major investment firms and technology initiatives. Leading industry experts, such as the Taskforce on Scaling Voluntary Carbon Markets (TSVCM), have explained that “​​DLT can help increase the integrity of carbon markets, make offset markets more efficient, facilitate increased access and therefore demand, unlock supply, and clarify the relationship between voluntary and compliance carbon markets”. 1

Similarly, the International Emission Trading Association (IETA) drafted guidelines earlier this year around the use of DLT in the VCM, noting that digital innovations "could improve the performance of the carbon markets" and that "[credibly digitized credits can reduce market friction, increase access for both buyers and sellers, reduce transaction fees, and scale flows of capital to the carbon market." Across the Standards, assessments are under way to explore the benefits and proper implementation of DLT; Gold Standard, for example, is considering the “use [of] DLT to improve impact data quality, reduce time and costs in the context of MRV2” and has launched three working groups with participants from the carbon and blockchain industry to start next month.3 

As with any new technology being applied to an existing market with a multitude of stakeholders, any application of it must be preceded by deep thinking on the legal, environmental, and structural implications of a given solution. To that end, Holman Fenwick Willan (HFW), a leading global law firm with deep sector expertise in the VCM, has published a thoughtful and constructive report on the application of DLT to the VCM4, focusing in particular on the tokenization of carbon credits and how a balance can be struck between risk and reward when leveraging this new technology. In the piece, the authors, led by longtime VCM lawyer Peter Zaman, lay the foundation for much-needed legal and policy considerations for projects working to create crypto tokens backed by carbon credits from the VCM.

At Flowcarbon, we are working to unlock the considerable potential benefits of DLT for scaling the VCM while mitigating many of the legitimate risks identified in this piece. We fully endorse the diligent approach to tokenizing carbon credits espoused by HFW—indeed, we have worked directly with HFW on most of these questions—and would like to elaborate on some of the deep thinking we’ve done on the topics identified. We hope that sharing some of our conclusions will assist the broader market in establishing guardrails and best practices for utilizing DLT in carbon markets with the highest amount of integrity and accountability.

1. The importance of carbon credit quality 

The importance of carbon credit quality has been broadly debated, not simply in the context of tokenizing carbon credits, but when assessing the overall climate impact of purchasing carbon credits. These debates often center on questions of project permanence, additionality, leakage and verifiable impact. In accordance with other market participants and corporates alike, HFW concludes that issues surrounding carbon credit quality are “not points directly linked to tokenisation per se but relevant when determining normatively what types of carbon tokens should be supported by market participants.” Guidance on quality standards is needed market-wide, and is presently being developed by The Integrity Council for the Voluntary Carbon Market via their Core Carbon Principles to "set new threshold standards for high-quality carbon credits and define which carbon-crediting programs and methodology types are CCP-eligible.5

The establishment of broadly accepted guidelines setting quality principles of carbon credits is imperative and will help reduce buyer hesitancy and broaden acceptance for the voluntary carbon market. Several points need to be considered in this context specifically for DLT. Tokenized carbon credits increase access to the market by participants that traditionally lacked the means and knowledge to efficiently access the carbon markets, like individuals and small businesses. As a result, projects that tokenize credits have a responsibility to mitigate information gaps and buyer confusion by, for example, providing informational resources on the credits being tokenized, imposing their own quality and vintage criteria on the credits being tokenized, or leveraging third party rating services that assess credit quality. 

2. Legal implications and considerations when tokenizing carbon credits

Beyond normative quality considerations, HFW aptly surfaces the key legal questions that should be considered by projects seeking to tokenize caron credits.  Among the most important are those related to consumer protection, traceability and transparency, market volatility, money laundering, custodial models, and environmental concerns. These main issues are addressed below.

a. Consumer protection and auditable transparency

Creating tokens backed by carbon credits reduces most of the barriers to entry preventing individuals and small businesses from participating in the market. These include having to buy through OTC brokers, with high minimums, no transparent pricing, a lack of contract standardization and high legal costs, and most importantly, the inability of individuals to obtain the registry accounts needed to custody carbon credits. But in being the gatekeepers opening access to the market, projects tokenizing credits have a responsibility to ensure consumer protections. As described in the previous section, measures to do so include clear communication on the age, type and methodologies of credits tokenized as well as the features and rights associated with tokens. Tokens should mimic the underlying credits and their usage as closely as possible, including being unretired, with retirement controlled by the token holder.   

b. Market stability

At the heart of Flowcarbon’s tokenization process is a “two way bridge” that enables the smooth movement of carbon assets on and off chain while maintaining the legal/environmental integrity of underlying carbon credits through a robustly structured legal framework.. Flowcarbon’s tokens are direct digital representations of carbon credits, not digital receipts of retired credits. The ability to bridge assets on and off chain means that tokenized credits retain their full off-chain value and can be redeemed at any time for the underlying credits, creating a direct tie between the on-chain and off-chain markets. The free movement of carbon assets provided through the two-way bridge allows market makers and traders to arbitrage outsized price discrepancies between tokens and their underlying carbon assets, thus limiting volatility in token prices and enhancing price discovery for the entirety of the voluntary carbon market. 

c. Digital identity (KYC)

One of the key issues at the intersection of carbon markets and DLT is digital identity and questions around know-your-customer (KYC), anti-money laundering (AML), combating the financing of terrorism (CFT), and anti-bribery and corruption (ABC) checks. Stringent measures should be put in place to prevent carbon credits from being utilized by bad actors. It is worth noting that, relative to other crypto assets, tokenized carbon credits are a fundamentally poor use case for money laundering given limited liquidity, traceability and the fact that they can’t be redeemed for real assets or for fiat without extensive KYC/AML checks. Nonetheless, Flowcarbon’s has created strict processes that require KYC/AML and other identity checks any time a token owner seeks to directly interact with the real world by, for example, redeeming tokens for carbon credits; these policies have been informed not only by the policies in place at the Standards which create credits, but also by other projects tokenizing real world assets, such as Circle’s USDC. 

d. Legal connection between the token and carbon credit 

It is absolutely essential that the legal framework by which the rights associated with a carbon credit are transferred to a token holder is created with precision and deep legal analysis. If tokenization includes a custodial model whereby credits are custodied with the token project and depositors receive back a token, this construct must be architected with optimal protections in place for token-holders, including ensuring that token holders retain the rights to the underlying assets in the event of occurrences like the insolvency of the tokenization company. These rights can, and must, be clearly delineated in legal agreements, terms of service, and reflected in the overall legal architecture of the tokenization project. For example, Flowcarbon has created a bankruptcy-remote SPV to warehouse credits, which includes management by a professional third-party. Furthermore, processes can be put in place to ensure that actions taken by token-holders are indeed being undertaken; Flowcarbon does this by enlisting the services of a large US accounting firm to perform regular audits on the credits held in custody and the retirement transactions requested. 

e. Environmental considerations

Any climate project leveraging DLT must take measures to mitigate the potential climate impacts of its activities. Since the emergence of the first blockchain, widely known as the Bitcoin blockchain, there has been substantial innovation towards minimizing the energy intensiveness of blockchain technology. While the Bitcoin network and its Proof-of-Work (PoW) consensus mechanism are inherently energy-intensive, the newer Proof-of-Stake (PoS) consensus mechanism used by other blockchains is far more energy efficient. In PoS, transactions are validated and the integrity of the network is secured by network participants staking collateral and running more standard servers to do similar calculations that require little energy. By using a PoS consensus mechanism to operate the network, several chains have reduced the ratio of carbon avoided per carbon emitted to 100 million to one6. Flowcarbon will launch its token on the Celo blockchain, which not only uses a PoS consensus mechanism but is “carbon negative” in that it purchases more carbon offsets than its emissions require. 

Moving forward

The key topics surfaced by HFW and addressed above continue to be explored market-wide and will evolve over time. All are in line with the same message, as HFW puts it: It is the responsibility of all “market participants to collectively enhance understanding of this still nascent space”. Flowcarbon will continue to provide thought leadership and collaborative innovation to help leverage DLT to scale the VCM in the most compliant and transparent way.  

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1 ​​Annette L. Nazareth, The Role for Distributed Ledgers in Voluntary Carbon Markets (12 May 2021) (last accessed 23 June 2022)

2 Gold Standard, Google.org backs Gold Standard to build digital solutions to help carbon markets work for climate justice (last accessed: 27 June 2022).

3 Flowcarbon will participate in the consultation process of the WG on Digital Assets

4 HFW.  DLT AND CARBON MARKETS – CAN A BALANCE BETWEEN RISK AND OPPORTUNITY BE STRUCK? (26 June 2022) 

5 See  the work being done on the Core Carbon Principles

 6 Ethereum Foundation (2021) via https://blog.ethereum.org/2021/05/18/country-power-no-more/