The SIF Investment Thesis Part I: Making Climate Finance Auditable

Co-authored by Wes Geisenberger (VP, Sustainability & ESG), Rob Allen (SVP, Ecosystem Acceleration), Jonathan Rackoff (VP, Head of Global Policy), Paul Madsen (Head of Identity), Hania Othman (Director Sustainable Impact Europe/Africa), and Mariquita de Boissiere.

The SIF Investment Thesis:

A Five-Part Strategy to Accelerate the Formation and Expansion of Climate and Natural Asset Markets by Bringing the Balance Sheet of the Planet to the Public Ledger

In this first article of The HBAR Foundation’s new series on its Sustainable Impact Fund, we introduce our five-part investment thesis and discuss how each part maps to our integrated, five-step climate action strategy. Our ultimate goal: to fight climate change and regenerate nature by bringing the balance sheet of the planet to the public ledger. And we start by exploring how leveraging DLT to make climate finance auditable can unlock and redirect capital flows toward mitigation and adaptation, equitably include the developing world in new and expanded nature markets, and harness local and indigenous knowledge in the protection of natural capital inputs to and the development of natural assets traded on those markets.

PART I: MAKING CLIMATE FINANCE AUDITABLE

As The HBAR Foundation Sustainable Impact Fund (SIF) team reflected on COP27 and our time on the ground in Sharm El Sheikh, we were struck by the glaring contrast between dozens of government officials constantly deadlocked in negotiations while across the hall, waves of bleeding-edge climate tech innovation was announced by a web3 community undaunted by crypto winter. Now more than ever advances in distributed ledger technology (DLT) look pivotal to the near-term success of climate mitigation and adaptation. And nowhere does this seem more true than the domain of climate finance.

Increasingly, decarbonization is being seen not as a problem of collective action and weak international treaties but a distributional conflict. Yes, mobilizing capital at the scales necessary to finance the net-zero transition will be critical. The material costs of rising temperatures promise to be staggering. The passage of the Inflation Reduction Act (IRA) in the United States will help. It authorizes hundreds of billions in economic incentives that promise to drive emissions down by more than 40 percent against 2005 levels. But by some estimates, hundreds of trillions of dollars will be necessary by ~2050. Who should bear those costs, especially when historical responsibilities for greenhouse gas (GHG) emissions misalign with regional exposures to their worst impacts? That question has put the interests of developed and developing countries and private corporations in tension. COP ultimately produced a commitment to negotiate a new collective quantified goal (NCQG) for loss and damage financing, but low-cost private sector climate finance will continue to be vital. And creative new multilevel governance tools will be crucial to maximizing its impact.

At the SIF, our investment thesis begins with this challenge. By accelerating web3 projects, rethinking environmental governance to better incentivize local action and engaging indigenous knowledge and expertise, our grants will illuminate and ultimately transform the mechanics of climate finance. To drive capital to mitigation and adaptation at the necessary scale and pace, we need a far more diverse and nimble financial toolset, particularly in the developing world. Numerous bottlenecks, omissions, and incoherencies inevitably arise when standards are fragmented, methodologies are opaque, and frameworks lack interoperability, as they do today. DLT enablement promises a fix. Data transparency, accessibility, and most importantly, auditability are the key – or certainly a key – to unlocking the credibility problem that has restrained private-sector financial investment in the climate economy.

No one solution will be sufficient., But through comprehensive auditability, we achieve the level ex ante outcome transparency required to ignite public issue engagement with, and drive investor enthusiasm for, nature markets – markets that today are far too small. Auditability carries the promise of scaling these mechanisms. It enables more precise, accountable, and equitable linking of capital flows between rich nations, major corporates, and multilateral climate NGOs and local communities. That creates a positive feedback loop, where diversified participation in nature markets by those who own the natural capital inputs to, and whose labor is critical to developing the natural assets traded, incentivizes the preservation of those inputs. In turn, this leads to the creation of more assets, driving more trading, which increases prices and starts the cycle anew.

This is our starting point, the first of the SIF’s five investment priorities, and Part One of The HBAR Foundation’s integrated strategy to reverse climate change, regenerate nature, and promote sustainable development by bringing the balance sheet of the plant to the public ledger. We look forward to telling you about Parts Two through Five in subsequent articles. But first, to underscore the importance of DLT-enabled auditability to the future of climate finance, it is necessary to discuss nature markets as they exist today.

 Deeper Dive into Capital Flows

 From the catastrophic flooding that left a third of Pakistan underwater; to record-breaking temperatures gripping much of Western Europe and the biggest melting event to occur in Greenland since records began in 1979 – to name but a few of this year’s major climate phenomena – the severity of the impacts associated with crossing one degree is all too evident. To avoid surpassing 1.5 degrees of global warming, reductions in global greenhouse gas (GHG) emissions must be “rapid, deep and sustained,” reaching cuts of forty-three percent compared to a 2019 baseline by 2030. Matching this challenge requires the redirecting of trillions of dollars annually. through the harnessing of a range of financial mechanisms.

But what do we mean when we talk about climate finance and how can we ensure that it delivers an equitable climate transition? Broadly speaking, climate finance is an umbrella term that covers a range of mechanisms and instruments designed to channel funding into projects or actions that aim to mitigate the climate crisis or support adaptation efforts. As well as the public and private sectors, alternative sources for climate finance include - but are not limited to - bilateral and multilateral institutions. Blended finance, which pulls together financial flows from a combination of multilateral and private sources, is increasingly rising up the agenda as a means of adjusting risk-return profiles and stimulating climate transitions within emerging economies.

While there is consensus on the need to urgently mobilize climate finance - to the tune of at least four to six trillion dollars annually - negotiations at Sharm El-Sheikh’s COP27 revealed that inconsistencies in financial reporting and accounting methodologies are driving a persistent “diversity of definitions of climate finance” between Parties.

Though definitions of climate finance may vary, there is agreement on the need for it to architecturally uphold the principle of “common but differentiated responsibility and respective capabilities”. In light of the G20 nations’ historical contributions towards driving climate change and the differentiated adaptive capacities between Global North and South, the Paris Agreement ratifies the flow of financing “from Parties with more financial resources to those that are less endowed and more vulnerable”. It also underscores the importance that any funding unlocked through climate finance mechanisms be “consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.” 

Due partly to the rapid growth they have sustained in recent years, sustainable debt markets and the Voluntary Carbon Market (VCM) together occupy a particularly significant place within the climate finance agenda. Indeed, the inclusion of “[voluntary] internationally transferred mitigation outcomes” within Article 6 of the Paris Agreement officially recognizes the complementary role the VCM can play in global mitigation efforts within the framework of international cooperation. As such, this piece focuses on three tools that emerge from both sustainable debt markets and the VCM: green bonds, carbon forwards, and carbon credits.

Given their potential to help bridge both the financial and ambition gaps that currently have the world set on a disastrous pathway towards 2.5 degrees by the end of the century, there is a logic - and an imperative - to ensuring climate finance mechanisms serve as part of a multi-pronged solution to the climate crisis.

The Promise vs Present Reality of Climate Finance

Unquestionably, historic progress was made on climate finance at COP27. Perhaps most significant, the parties reached a breakthrough agreement to unblock loss-and-damage funding for poor countries most vulnerable to climate disasters. But we can name this historic precisely because historically so little has been accomplished relative to what is urgently needed. Even for present commitments and revenue flows to scale, numerous challenges must be overcome. They span micro- and macro-economic contexts, from insufficient supply of investment-grade projects; high upfront capital and transaction costs combined with significant risk profiles and extended time frames for projects. While addressing these concerns is beyond the scope of this piece, it is important to acknowledge the complexity of the broader, rapidly evolving, climate finance landscape in order to better understand how migrating climate instruments onto the public ledger interfaces with them. And certainly, at the HBAR Foundation, we believe that enabling full auditability of climate financial instruments represents a vital step in moving the needle on climate action overall.

Indeed, although the skepticism that has historically been leveled against carbon credits is not without validity, if long-standing issues of transparency could be resolved (spoiler alert: they can), they could play a critical role in galvanizing ambition and generating much-needed revenue streams for climate projects. The continuing reality of exponentially increasing levels of atmospheric CO₂, and the global yet disproportionate impacts already being acutely experienced across vulnerable regions of the world, urges that carbon credits be included as a mechanism to meaningfully contribute to wider mitigation and adaptation efforts.  According to the World Economic Forum, carbon credits, generated by climate projects, could contribute two billion tonnes worth of CO₂ emissions reductions towards hitting 2030’s Net-Zero targets.

Similarly, leveraging debt through green bonds and carbon forwards could play a pivotal role in generating low-cost, upfront liquidity for sustainable projects to help drive emissions reductions and shore up climate resilience. Currently, of the $119 trillion locked up in global fixed-income markets, ten percent has been channeled into early-stage funding for sustainable projects. Sustainable debt issuance more than doubled between 2020 and 2021 and exceeded a total of four trillion dollars. As global debt markets are brought into alignment with Paris Agreement pathways for 1.5 to 2 degrees, it is highly probable that total sustainable debt will eventually eclipse the value of the VCM.

With little oversight or auditability, the VCM and green bond market have historically drawn criticisms of greenwashing from major investment banks and international law firms alike. Citing a fundamental lack of transparency and accountability, analysts warn that issues such as double counting - where one set of emissions reductions are claimed by multiple parties - and even fraud, have posed systemic risks to climate finance.

Reporting by both Bloomberg and the Financial Times has pointed to the opacity within the green bond sector, raising doubts as to whether the funds currently raised through green bonds can clearly be shown to deliver emissions reductions. Some analysts, such as Group Chief Executive, Assaad W. Razzouk, go further, suggesting that green bonds are “over-hyped”, that “they are being misused and do more harm than good.”. Citing unclear definitions, weak voluntary standards and opaque accounting techniques, these reports allege systematic misappropriation of green bonds by actors with little interest in decarbonization. Elsewhere, European-based fund managers are still digesting the implications of recent updates to the EU’s Sustainable Finance Disclosure Regulation (SFDR). The changes, which aim to address greenwashing within the bond sector, have led to a number of prominent funds downgrading the sustainability status of billions of dollars worth of investments from ‘dark green’ to ‘light green’. Such regulatory uncertainty points to the deep, ongoing confusion around benchmarks and standards that play into accountability challenges.

Carbon credits also face challenges with financial auditability. According to Unearthed, Greenpeace UK’s media arm, along with SourceMaterial, carbon brokers were found making significant margins on credits sourced from small-scale projects based in the Global South. While very much in the public interest, these discoveries were not easily won and are difficult to replicate. It took a combination of on-the-ground interviews with a set of leaked emails for journalists to piece together a picture of behind-the-scenes trading. By contrast, migrating carbon credits and other climate instruments onto the public ledger would put such information where it needs to be - directly in the public domain.

Though climate finance mechanisms are witnessing a recent resurgence, it is no surprise that the lack of clarity surrounding them threatens to undermine the potential the sector has to redistribute funds urgently and meaningfully. Indeed, trust in financial products to consistently leverage positive climate outcomes has reached such low levels that carbon markets are seen as more of a problem than a solution by some environmental groups. 

Beyond Financial Transparency

From issuance to sale and secondary market trades, it is not currently possible to trace what happens - or who is involved - as a given climate asset exchanges hands. At the most basic level, making climate finance auditable implies facilitating the traceability of funds as they are transferred across actors, making it clear where funds are going and why. However, while there are a couple of notable exceptions such as Xpansiv and the Luxembourg Green Exchange, carbon credits and green bonds are typically traded through Over-the-Counter (OTC) processes. As such, the majority of information around how trades are enacted remain beyond scrutiny. While the launch of exchanges that leverage Distributed Ledger Technology (DLT) is promising from an auditability and outcomes-driven perspective, the fact that they represent a minority of actors within the space itself suggests potential systemic risk. 

To scale investment in green bonds and carbon forwards or credits, investors need visibility into three points along an asset’s lifecycle:

Use of proceeds: What kinds of projects are being funded through these instruments? In the case of green bonds and carbon forwards, is debt being leveraged towards projects that are tied to robust climate targets? Can carbon credits demonstrate that they account for additionality, permanence, and leakage? And in all cases, what percentage of the proceeds are reaching project developers on the ground? What portions of proceeds go to other roles beyond the project developer?

Trades and Secondary Market Transactions: Is it possible to trace how many times an asset has been traded? Financial auditability means having clarity on each price markup across an asset’s lifecycle. Does market activity correlate to benefit the project?

Returns on Investments: Ultimately, the risk-adjusted returns of climate finance instruments must be competitive with those currently offered within conventional settings. In the current context, there is little incentive for either issuers or investors to cover the extra costs - referred to as the ‘greemium’ - associated with bringing climate finance instruments to market.

Addressing each of these points is necessary for building confidence in sustainable debt markets and the VCM alike. Yet, if climate finance instruments are to help close the finance and ambition gaps that stand between us and a 1.5 degree pathway, auditing cannot be limited to balance sheets. Public DLT and the tooling built on top of it, such as Hedera’s Guardian, are together ushering in a new era of auditability that promises to create the conditions for the internalization of the environmental and social issues that are typically treated as ‘externalities’. 

As recognized within the Sharm El-Sheikh Implementation Plan, achieving such a drastic shift implies nothing short of a “transformation of the financial system and its structures and processes, engaging governments, central banks, commercial banks, institutional investors and other financial actors.” From an auditability perspective, an important part of this transformation will involve confronting the overlapping yet heterogeneous elements and actors within the carbon accounting ecosystem.

Decentralizing Data Flows

For the HBAR Foundation Sustainable Impact Fund, a reworking of the financial system requires a major investment in tooling that challenges how we approach data, risk and value. If the modern social contract has succeeded in providing a platform for growth by vesting trust in institutions and third parties, Web3 and DLT create a trustless basis for a new social paradigm; one that centers regenerative and just growth.

Using Web3 tooling, anyone, from anywhere, can now access data as granular as the  unique token ID for a specific credit as well as its serial number, vintage, and associated project ID. Put differently, for the first time in history, funds can be tracked and traced in real-time with precise visibility across the project chain and from one actor to another. Moreover, the very ruleset, or methodology, that a project is built upon is accessible for scrutiny - meaning that auditors can, with precision, identify whether it’s the financial process, the rule set or the data which is at fault, and propose processes to hold actors to account as well as solutions that are focused on outcomes rather than hazy corporate platitudes.

Ensuring auditability throughout value chains are the standardized workflows that, created in conjunction with the Global Blockchain Business Council as part of the Sustainability Business Working Group’s Voluntary Ecological Markets Task Force & Carbon Emissions Task Force allow for seamless comprehension and communication across diverse stakeholders - including the public. Time-stamped, automated events are linked together and validated or verified by Decentralized Identifiers (DIDs) throughout a trust chain that is searchable to the granular level. Neither DIDs nor Verified Credentials (VCs) rely upon intermediaries to function, instead drawing upon a network of individually auditable data sources. 

For a deeper look into how the tech stack comes together on Hedera to enable replicable end-to-end digitized token standards that are publicly auditable, check out this presentation on Scaling Carbon Markets with DLT.

Ultimately, it is the burgeoning network of innovative tech leaders and organizations that are picking up Hedera’s tooling and delivering solutions for real-world impact. As the work being done by Sustainable Impact Foundation grantee and Berlin-based platform, Evercity, goes to show, the impact of providing true financial auditability into carbon projects has implications both in terms of the accessibility to, and financial attractiveness of, green financial instruments. Recognizing their major contribution as engines of economic growth, Evercity focuses on making green bonds and carbon forwards accessible to SMEs - a sector that has traditionally been excluded from the market. One, particularly innovative, way that Evercity is doing this is by integrating green bond markets with carbon forward markets in ways that help small-scale project developers overcome barriers to carbon markets related to upfront costs.

With this focus on equity front and center, COP27 set the stage for Evercity to announce the launch of carbon forward tokens on Hedera and partnerships with institutions such as DNV. As well as addressing the high costs associated with submitting projects, the platform is tackling the lack of liquidity and margin-taking that have also traditionally kept SMEs from accessing carbon markets fairly or at all. Evercity co-founder and CEO, Alexey Shadrin, explained that “our platform helps to provide early-stage carbon projects with much-needed funding, democratizing the market by reducing the entry barriers”, adding “the proceeds from carbon forwards are going straight to the project owner, to the people who are actually delivering the project”. 

The accessibility and immutability of data shared on-chain make tracing each dollar invested in any given project simple. For Shadrin and Evercity these features sit at the heart of the next reiteration of climate finance; “You can see that the transaction has been made straight to the wallets of the owner of the carbon project who has been registered on our platform and verified. At the same time buyers of forwards get an opportunity to trade a liquid asset and receive carbon credits in the future at a reduced price”.  Seeing how funds end up in the wallet of the organization on the ground delivering the emissions reductions – be it a community based in India or a project developer in Uganda – creates trust and drives value for investors while distributing revenue to frontline projects in the Global South. 

Transparent peer-to-peer access to markets also solves the problem of financial speculation that can arise at the hands of intermediaries. The distributed ledger networks driving this access enable climate-related financial instruments such as green bonds and carbon forwards to offer rates of returns that are competitive with those available in the carbon intensive legacy industries that have not historically internalized the costs of their emissions.

As companies like Evercity show, much can be – and already is being – achieved by shining a light into the inner workings of climate finance projects. Transparency implies understanding the rules that define a given project methodology as well as all roles involved, the function of each one and how funds are transferred across actors.

Coming Next: Digitizing and Open Sourcing Methodologies

Throughout this five-article series, our goal will be to showcase why The HBAR Foundation believes that the balance of the planet must ultimately live on a public ledger. The SIF’s five investment priorities map to a five-part climate action strategy designed to accelerate this transition. Auditability is its foundation. In our next piece, we dive into how digitizing and open-sourcing methodologies lays the groundwork for an open ecosystem capable of driving systemic change. To become part of the global conversation on how to bring the balance sheet of the planet to the public ledger, follow @hedera @HBAR_foundation on Twitter and share your thoughts.