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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.
Next up in The HBAR Foundation’s series of articles covering the Sustainable Impact Fund’s climate action strategy, we address the fourth prong in our investment thesis: web3 innovators striving to modernize the trading infrastructure undergirding the world’s climate markets until it can support efficient discovery of a global carbon price–the hallmark of every healthy spot market. We previously demonstrated in Parts I-III that by making targeted grants to web3 innovators, the SIF can enable auditable tokenized carbon assets on chain with digitized, open-source methodologies validated and verified faster and more cost-effectively. Yet even if DLT is perfectly successful in removing those perennial frictions – and so far progress has exceeded expectations – the next logical step takes us onto the trading room floor, where an even thornier problem emerges: inefficient carbon pricing. Once again, web3 innovations by SIF grantees promise a creative fix.
Finding Where Supply and Demand Meet
For the VCMs to thrive in the long run as a mechanism of climate action, tradable assets must be accurately priced. This means that the social cost of one tCO2e must be rationally and reliably tethered to the economic value reflected by the price of the carbon credit issued to offset those emissions. But failed and fragmented climate policies (e.g., governments enacting carbon prices in the context of tax or emissions cap-and-trade schemes that inadequately internalize the true costs of climate damages) have joined with pervasive market inefficiencies (e.g., information asymmetries between buyers and sellers, low liquidity) to obscure this linkage.
Price discovery is a central function of markets, but where the attributes of individual credits are opaque, where credits are batched or layered in a manner that limits the ability of brokers trading manually under real world conditions to weigh their underlying attributes, where the lack of attribute-level transparency and auditability leads non-fungible assets to be treated as commodities – under those conditions, buyers and sellers lack the infrastructure to calculate a fair and accurate market price. Transactions may still occur, but at far higher levels of volatility and investor risk.
In contrast to making climate finance auditable (accomplished via fully auditable credits minted on Hedera) or digitizing and open-sourcing methodologies (achieved via the Hedera-based Guardian), we are aware of no silver bullet for pricing – DLT-based or otherwise. In the carbon markets, organic price discovery is enormously complex, both on the ground operationally as well as conceptually, as a matter of economic theory. But we cannot be so risk averse that only clear winners qualify for funds. Making progress towards a global carbon price is vital, even if inch-by-inch. And by supporting novel R&D into a mechanism for artificial price discovery, the SIF is leading the way (and practicing what we preach).
SIF-grantees Tolem Earth and BlockScience have developed an ARRM, or “Automated Regression Market Maker.” With this highly innovative tool, we can observe and weigh market conditions against machine learning (ML) models, leveraging granular consideration of asset-level attributes at scale to enable dynamic price discovery – we believe for the first time.
When Like is Not Like: The Semi Fungibility of Carbon Assets
From bolstering clean innovation to generating additional revenue for a climate-resilient transition, setting a clear market signal that incorporates the externalized costs of carbon is shown, time and time again, to be the most cost-effective and flexible means of driving emissions reductions.
It also sits at the heart of questions on how to scale carbon markets. Despite having quadrupled in value in 2020, the Voluntary Carbon Market (VCM) currently contributes 0.2 percent of the emissions reductions required to stay within the Paris temperature goal pathway for 1.5 degrees by 2030. Should the VCM grow by the ten to thirty times they are projected to by 2050, this figure will increase to two percent.
Central to a robust VCM, and the discovery of a global carbon price, is the issue of liquidity. The VCM, as it currently stands, has been described as a “prime example of an illiquid market”. Lack of transparency and a strong reliance upon brokers to facilitate deals has led to liquidity too often being driven through backroom handshake deals. As we have seen earlier in this series, rather than allowing efficient markets to define prices, it is a small handful of brokers who are doing so through predatory trading tactics and unjustifiable margin-taking.
High fees and prices that vary from broker to broker make it challenging to distinguish the underlying price of the assets available for trade. Ensuring liquidity in markets is one important means of helping to bring transparency to price signals. Tokenizing carbon assets that are held to publicly auditable rules by a Policy Workflow Engine (PWE) such as the Guardian, allows for new metrics to determine pricing while also enabling granular-level insight into the various characteristics or attributes behind each metric ton - vital in creating mechanisms for price discovery.
As it stands, carbon credits that are traded in the VCM are commoditized, meaning that each ton is treated as substitutable, or fungible, with any other. With the markets awash with credits that don’t account for additionality, leakage or durability - let alone more refined data such as where the emissions reductions took place or insight into the roles and actors involved in a given project - it is not surprising that appetite from investors to make serious inroads has been lacking.
Treating all assets as equal and obfuscating the context in which they are produced and traded, hurts prices because it tends towards the lowest common denominator. In Recognition of this tendency, the Rocky Mountain Institute concluded in their 2020 report, ‘The Next Frontier of Carbon Accounting’, that “until a framework of comparable methods exists, there will always be an essential conflict between financial costs and sustainable development”. From critiques to recommendations, attempts to galvanize top-down coordination across institutions and other actors within the carbon accounting ecosystem have proliferated Post-Paris Agreement as the business sector grapples with climate risk - but to little effect. Existing, institutionally-rooted, approaches and processes are no match for the highly complex, rapidly evolving, real-world problems, such as the climate crisis. While migrating processes on-chain is a necessary step towards the trustless, borderless and flexible reimagining of the financial sector, not all such solutions are built the same.
Disintermediated Open-Source Platforms for Efficient Price Discovery
Alternatives to Over-the-Counter OTC trading of digital climate assets are emerging through exchanges such as Xpansiv, the current largest spot market for environmental commodities. Although Xpansiv is playing an active role in scaling the VCM, particularly by providing much-needed liquidity, it does so as a centralized ‘trusted’ intermediary. So too does multinational tech giant, Microsoft, which launched a request for proposals (RFP) in 2020 to identify how to offset its own emissions and to create a blueprint for other businesses to follow. While helping push the conversation forward on NetZero, its multimillion dollar investment is a far cry from what could be considered replicable for many companies.
There is a growing tendency for Web 2.0 companies and other centralized platforms to add crypto rails into their verticals while bypassing open-source values and Peer-to-Peer (P2P) disintermediation. Xpansiv, Microsoft, and other corporate giants such as Salesforce – which launched its own “Net Zero marketplace” earlier this year – are incorporating the language of transparency in climate markets, yet advancing interests that remain proprietary. This reinforces the information asymmetries that continue to encumber formation of more active, liquid market dynamics.
Compared to fully auditable, well-governed DLT networks, top-down, centralized platforms risk complicating price discovery by commodifying carbon behind ‘price benchmarks’ that fail to adequately reflect the context that assets were produced in or the reputation of the actors involved. B2B gated marketplaces that serve major corporates are also likely to result in less equitable outcomes for small-scale project developers in the Global South. From forcing SMEs to maintain costly product subscriptions to keeping access to markets permissioned and continuing to prioritize corporate profits, the climate crisis cannot be leveraged as a pretext for powerful multinationals or individuals to assert their market dominance.
To discover a global climate asset and carbon price that will drive equitable climate action, markets must be able to work both efficiently and fairly, embracing decentralization and full disclosure of events across asset life cycles through public auditability.
Decentralized Trading in HD with the ARMM
Engineering, R&D and analytics firm BlockScience, in conjunction with funding and operational support from the SIF, conceived, developed, and piloted an Automated Regression Market Maker (ARMM) in less than 18 months. A novel, market-level price discovery mechanism running natively on Hedera, the ARMM is the first of its kind. It works like this:
In this way, the ARMM promises to unblock markets whose capitalization might be dramatically more valuable if not for certain, persistent inefficiencies. But we have not rushed blindly to commercialization. Instead, per The HBAR Foundation’s standard term sheet, we ask grantees to open-source their SIF-funded climate tech innovations built on Hedera as public goods. To our knowledge, no other platform – either web3 or 2 – evidences this level of commitment to scaling climate mitigation and adaptation finance. But open architecture is in Hedera’s DNA.
Importantly, the ARMM differs from the commodity-focused Automated Market Makers (AMM) in use by Decentralized Finance (DeFi) trading platforms such as Uniswap or SushiSwap. For an asset to be considered “semi-fungible,” substitutability must be determinable via a demand-side search function that evaluates assets within a high-dimensional vector space of differentiated attributes. Simply put, data-rich characteristics –including but not limited to where an asset was created, the dMRV tooling used, the identity of third-party validators associated with every aspect of a project are made visible to and evaluable by potential buyers, enabling their demand for such asset attributes to influence the asset price. Removing traditional market makers from the equation also means that asset discoverability can theoretically span disconnected markets.
To learn more, see BlockScience’s in-depth technical explanations in “Testing ARMMs in Production” as well as Blockscience (2022) Introducing Automated Regression Market Makers (ARMMs): A New Price Discovery Mechanism for Semi-Fungible Assets. Using Renewable Energy Credits (RECs) and CO2 Removal Certificates (CORCs) as illustrative examples, BlockScience diagrams how Hedera’s tech stack enables integration of these kinds of attributes – on both the supply and demand sides – to generate climate asset pricing.
Carbon Market Implications: Equity and Environmental Justice
Taken together, the ARMM coupled with the Guardian (and the other SIF-funded DLT-enabled digital infrastructure tools being developed on Hedera) have significant implications for carbon and ecological asset markets. First, having the means to guarantee specific methodological standards will enhance carbon-credit quality and exert upward pressure on price. With DLT-enabled auditability, frictions plaguing the VCMs since their inception – fraud, double-counting, etc. – can finally be mitigated.
Second, auditability helps reveal carbon credits as more than mere commodities, but rather individualized assets linked to and entangled with unique webs of localized ecosystems, globalized political agendas, and indigenous rights. Project-level attributes sourced through dMRV tooling – e.g., satellite imagery, remote sensing, IoT – can be joined with identity data for each role and actor to paint a high-resolution picture of these complex interrelationships. And as powerfully illustrated by geographer and political ecologist Dr. Sarah Milne, top-down conservation interventions in the Global South can often have violent unintended consequences; take, for example, the 2012 killing of Chut Wutty, a Cambodian environmentalist who sought to expose deforestation linked to a carbon credit-generating hydroelectric project.
Dr. Milne concludes that to avoid such heinous crimes we must “de-commodify” natural assets, but we needn’t agree or disagree. What matters is that by leveraging DLT, carbon assets quickly lose the appearance of fungibility. Their attributes visible, it becomes obvious that they count. Moreover, by enabling redirection of capital flows to local and indigenous communities engaged in the protection and development of nature, DLT empowers us to price in equity and environmental justice considerations into these – call them semi-fungible – assets from the start. More than virtue signaling, this has concrete practical utility: it drives public enthusiasm, diminishes political resistance, promotes corporate acceptance, and diversifies market participations.
In sum, DLT raises climate ambition in natural-asset markets value-chain-wide, and precisely when needed most.
Real World Impacts of Digital Exchange
Ultimately, ensuring the discoverability of a global carbon price that accounts for social and environmental rights will take nothing short of a transformation in how goods are exchanged. That is exactly what is happening on Hedera. Automated trading is bringing the efficient price matching of semi-fungible assets to a scale and pace that matches the urgency of the climate crisis.
Under this mission, Tolam Earth launched its own digital marketplace ARMM on the Hedera Hashgraph in November to help make embracing ESG goals accessible and seamless for corporations. “We are allowing companies to focus on climate outcomes rather than complex tools which we believe will build trust and transparency in the market”, explained CEO Matthew Porter. Tolam is initially using the ARMM to suggest suitable trades within its marketplace before eventually expanding into more advanced use cases and into other marketplaces. On the long-term vision for the market mechanism, Matthew Lawrenson, Tolam’s Chief Strategy Officer added, “this technology acts as a smart contract controlled by a machine learning model focused on helping discover a global carbon price across a system of agents.”
Once all actors are operating in the open; all roles, functions and transactions are immutably stored on the public ledger; and high-definition visibility into attributes is made available, a global price for carbon can finally emerge. Discovering a global carbon price is not only fundamental to scaling markets and driving emissions reductions in the face of an increasingly devastating climate crisis; indeed, research published in the journal, Nature, found that the case for establishing a global price for carbon “appears to be even stronger in a multi-boundary world than when considering climate change as an isolated problem”. At the Sustainable Impact Fund (SIF), our goal to bring the balance of the planet to the public ledger is ultimately about creating a just and regenerative future in a broad sense that encompasses the global commons and the rights of water amongst other frontiers. In our next and final piece in this series on the SIF’s five goals, we will take a look at how the Hedera Hashgraph is being leveraged to do this by making ESG reporting credible.
Next Up: Making ESG Reporting Credible
With a pathway to global carbon price discovery using the ARRM, scaled up validation and verification capabilities that avoid systematic bottlenecks, the world’s largest collection of digitized, open sourcing methodologies and tools to onboard new policy faster and less expensively than any competitor, and a DLT-enabled tech stack for minting audible climate assets to unblock sources of mitigation and adaptation finance, countries and corporations participating in the climate and natural asset markets have just one remaining obligation: reporting. ESG rules and regulations are evolving quickly, with new mandates on the horizon in a range of jurisdictions, coupled with changing industry norms that increasingly privilege voluntary disclosures, both of which are subject to rising levels of enforcement scrutiny for greenwashing. In Part V of our investment thesis series, the SIF discusses how DLT-enabled tools can help to automate, speed up, and increase the quality of climate and ESG-related reporting – ultimately enhancing ESG-related credibility of any organization that uses them.
Stay in the loop on future updates from the Hedera ecosystem and the HBAR Foundation and be part of the global conversation by following us on Twitter @hedera and @HBAR_foundation.
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