Accelerating the Voluntary Carbon Markets With DLT

Accelerating the Voluntary Carbon Markets with DLT: The SIF Engages with Major Offset Registries to Set Standards for Carbon Tokenization

From November 6-18, representatives from nearly 200 nations will gather in Sharm El-Sheikh for the 27th Conference of the Parties (COP27) of the United Nations Framework Convention on Climate Change (UNFCCC). Their task has never looked more daunting. According to a grim new multi-agency report coordinated by the World Meteorological Organization (WMO), greenhouse gas (GHG) levels have continued to rise sharply following a pandemic-induced pause. The last seven years were the hottest in recorded history. Extreme storms, heatwaves, and water-related disasters are increasing in frequency and severity all over the world. We are dangerously close to a tipping point. But only about 13% of countries that pledged to increase climate mitigation at COP26 have followed through. We can no longer rely on governments alone. To avert the worst impacts of climate change, the world needs innovative new tools – and regenerative finance (ReFi) is actively building them.

Voluntary carbon markets (VCMs) may be one of the world’s best policy strategies to hasten climate change mitigation by redirecting capital flows toward rapid and efficient decarbonization activities. Until recently, however, shortcomings in transparency, credibility, liquidity, and uptake have prevented them from scaling. But now, advances in distributed ledger technology (DLT) amplified by powerful new open-source digital infrastructure tools (including digital Measurement, Reporting, and Verification systems, or dMRV) are poised to remove these blockers. To spread the word, earlier this month The HBAR Foundation (THF), through its Sustainable Impact Fund (SIF) began a program of close engagement with Verra and Gold Standard, the standard-setting NGOs that verify and register the lion’s share of the world’s voluntary carbon offsets, including carbon reduction and carbon removal credits. In two detailed policy commentaries – one of which, our submission to Verra, was joined by a broad industry coalition of 24 other climate-forward ReFi platforms – we made a strong case for enabling tokenization of carbon credits issued by and stored on the Verra (VCUs) and Gold Standard (VERs) registries.

The policy viewpoints of each coalition member differed on a range of important particulars. Crypto is a fiercely independent, decentralized community. But all companies were nevertheless firmly unified behind a shared conviction that using DLT to make and trade digital representations of Verra and Gold Standard credits, against the backdrop of robust dMRV embedded from Day One, is our best hope for healthier, more active VCMs, defined by increased liquidity, secure and transparent verified data, fair and discoverable pricing, high environmental integrity (i.e., where double counting is avoided and monitoring for reversals enhanced), robust fraud detection and deterrence, improved settlement times, lower transactions costs, and enablement of comprehensive auditability at both the asset and project levels.

Here are some of our specific recommendations for bringing this about:

• Timing of retirement. Acknowledging a risk of public confusion – if not necessarily an actual loss of environmental integrity – when credits are retired on the Verra or Gold Standard registries prior to tokenization using DLT, we supported the development of safeguards to keep such credits isolated on their respective registries until any tokens they may back are retired on ledger (i.e., burned), signaling final consumption of their environmental benefit. We further recommended that when carbon-credit tokens are burned, procedures be implemented to ensure that underlying registry-issued credits are retired. Initially, this will require communication and some division of labor between the registries and the third-party DLT platforms tokenizing their credits. Ultimately, however, given the importance of completing off-chain retirements promptly, we further signaled that building an automated system would be preferable.

• De-tokenization. We agreed that organizations creating digital tokens representing registry credits should also have a pathway to de-tokenize them. Over time, as VCMs move toward public ledgers where digital environmental assets are cryptographically linked to robust dMRV-enabled audit trails, such a two-way bridging capability may be unnecessary. At that point, registries will be able to issue credentials and attestations to actors and methodologies as assertions of quality in the form of Verifiable Credentials. Today, however, allowing tokenized credits to revert to their source registries is prudent because it ensures that, should a DLR network be disrupted, a means exists to return tokenized credits to registry custody, either permanently or temporarily. However, we advised the registries to be less solicitous where tokenized carbon credits are stolen or rendered inaccessible (e.g., due to theft via hacking or lost keys, respectively), or where de-tokenization is requested by end-users farther down the value chain (i.e., with whom they lack contractual relationships). Those situations increase the risk of double counting, and healthy, efficient VCMs do not require Verra and Gold Standard be sureties against loss.

• Fractionalization. We encouraged the registries to support the practice of fractionalizing tokenized carbon credits. This has certain policy advantages, chief among them environmental justice and inclusion, especially in the Global South. There is wide agreement: the carbon price will rise. As it does, access to climate finance in the developing world, essential for indigenous communities to invest in decarbonization locally, could fall even more. Similarly, technology-based carbon removal solutions (e.g., direct air capture projects) are currently so expensive that innovators such as Climeworks struggle to scale. Fractionalizing registry-backed credits on public ledgers stand to mitigate both challenges. Our sole caution was to avoid inadvertently decelerating progress towards integration with mandatory emissions trading schemes, which generally require compliance via the surrender of emissions allowances representing one undivided mtCO2e.

• Pooling. Here, in contrast, we advised restraint. VCMs currently are not subject to significant regulatory oversight and some uncertainty surrounds the likely future legal treatment of pooling (e.g., because pooling can be implemented in different ways, it may carry an elevated risk of securities treatment). But pooling has certain policy advantages. In the Global South, for instance, it can be used to incentivize carbon reduction and removal activities at much smaller scales than would be cost-effective otherwise, which increases capital flows to developing economies. One criticism of pooling arises due to variances in the quality – expressed in terms of the environmental attributes – of the credits to be pooled. In token issuance for those using the Guardian on Hedera, most projects use non-fungible tokens unique to the metric tonne with an auditable link to dMRV data as specified in a digitized methodology. Once issued, each could be pooled in various ways, including wrapping multiple classes of similar non-fungible tokens into a pool to increase fungibility. However, a pool could also be 1,000 unique classes of a token tied to many different methodologies as a mechanism for viewing data, not tokenization of newly created assets. Such “technical” pools could facilitate markets with distinct assets from multiple registries. This may be stifled if registries impose premature, overcautious limits on the activities. If care is taken to pool only tokens backed by credits with similar attributes – in essence, to apply minimum standards of quality and grading – we are not clear why pooling tokenized credits per se gives rise to an increased risk not carried by any effort to aggregate a commodity. Accordingly, we urged the registries to apply no restrictions on pooling at this time and revisit the question later as necessary.

• Sustainability. We expressed our view that DLT used to tokenize carbon credits and the distributed ledger networks on which those tokens are traded and ultimately burned should themselves be sustainable, defined by energy consumption and GHG emissions. But we also noted that DLT may create environmental impact in various ways, from power consumption, to e-waste, to the carbon footprint of the humans responsible for maintaining, operating, and developing applications for the networks, as well as other inputs not unique to DLT. Measuring and comparing the emissions of multiple, competing DLT networks is possible, but more complex and fact-intensive than simply whether one uses a more energetically intensive proof-of-work (PoW) protocol while others use proof-of-stake. Long term, we support creating an approved list of sustainable DLTs, but for now recommended that organizations seeking to tokenize registry credits measure their Scope 1 and Scope 2 emissions under the Greenhouse Gas Protocol and industry best practices in carbon accounting, and then commit to setting science-based targets for emissions reductions where applicable. We also suggested that a working group might be established to study this question in greater detail.

• Due Diligence. With respect to how the registries should vet their partners to avoid regulatory enforcement as well as reputational harms, we recommended that both Verra and Gold Standard apply industry-standard AML, KYC, and sanctions compliance vetting procedures tailored to the requirements of each jurisdiction in which they operate. While we are aware of no evidence that tokenization of carbon credits increases the risks of illicit finance over that seen in legacy markets, nor should web3 platforms be held to lesser standards. To ensure the credibility of VMCs as they scale on-chain, we also suggested that the registries consider seeking clarity from international accounting bodies (e.g., IFRS and GAAP) on how tokenized carbon ought to be treated on the balance sheet.

Our full comments may be viewed here.

We believe that using DLT and robust dMRV to digitize VCMs and enable auditability tokenized credits against the backdrop of these kinds of focused, narrowly tailored, pro-innovation safeguards will be an essential gateway towards realizing the SIF’s five strategic goals:

1. Making Climate Finance Auditable;
2. Digitizing Open Source Methodologies;
3. Scaling Validation & Verification;
4. Discovering a Global Carbon Price; and
5. Making ESG Reporting Credible.

We invite you to join us as we achieve them together.