Tokenization of Carbon Credits: How tokenized Forward Credits will change the Way Carbon Projects are financed
The voluntary carbon market (VCM) is growing rapidly, passing a volume of 1 billion USD for the first time in 2021. However, the VCM still only covers about 1% of global CO2 emissions and still has plenty of challenges to scale. Key bottlenecks include verification delays, inefficiencies in the value chain caused by intermediaries and limited access to early-stage financing. There is a growing number of projects working to reduce or sequester carbon, but funding remains a key challenge for those projects. This is proving to be a major hurdle to developing innovative solutions for fighting the global climate crisis.
In the 4th part of our six part series on the different options for transferring carbon certificates on-chain, we focus on tokenized forward credits as an effective contribution to scaling the voluntary carbon market by funding projects in their early stages.
To offset their unavoidable emissions, organizations can either purchase verified carbon credits from existing avoidance and removal projects or they can invest in new projects that will generate credits over time. While most of the carbon certificates today stem from avoidance projects, it is more and more important to focus on projects that actually remove CO2 from the atmosphere. However, removal projects often require funding in early stages in return for future credits. A forward agreement reflects such a delivery of credits in the future for compensation now. But these investments pose unique risks for the investors, such as project failure, natural disasters and other factors that potentially result in a project not being able to deliver. Therefore forward agreements have additional and different challenges than other types of carbon certificates.
Another risk for removal projects with future credits, is the lack of price and volume transparency. The approaches and methodologies vary widely and by nature every individual project is different and comes with its own characteristics. Some carbon projects for instance may have additional socio-economic or biodiversity benefits, which oftentimes are being priced into the credit. This makes it difficult for projects to predict their future earnings and operate the project as a business. On the other hand it is tough to find financing without predictable outcomes. All of these factors leave even high quality removal projects in a difficult spot.
Forward credits already exist in the voluntary carbon market where well-capitalized traders make special agreements with projects in order to secure a future supply of carbon credits. However, these agreements then become illiquid assets on their balance sheets until the credits are finally delivered. Offloading credits in this phase involves manually finding buyers and signing secondary agreements to transact credits as they are delivered. The voluntary carbon market’s financial infrastructure disincentivizes these forward deals, lowering the amount of capital that actually reaches carbon projects.
Besides the enhanced transparency, the immutability of records and the lower transaction costs, providing liquidity is one of the key benefits blockchain based forward credits can provide. But before getting into the mechanisms that enhance the liquidity, let’s take a look at the overall tokenization process.
Figure 1 shows a simplified chart of the process for tokenized forward credits. The left hand side of the chart below is pretty much unchanged and identical to the other tokenization processes. (see the previous 3 articles of our six part series on tokenizing carbon credits). The project developer is providing technical assistance and support for the planning, implementation and optimization of the project concerning certification strategies, business and management plans as well as monitoring efforts. In forward projects a key task of the project developer is to seek the funding.
The token issuer plays a key role and de facto resumes most of the tasks of a broker in the traditional market. He coordinates the project funder and converts the physically signed agreement into a tokenized equivalent. These so-called forward tokens carry the promise of delivery from a specific carbon project, as well as relevant fallback scenarios in cases of non-delivery. Financial investors and corporate clients buy the tokenized forward credits to secure access to future carbon credits and lock prices since high quality carbon offsets will most likely get more expensive in the future.
Furthermore, the project developer hires a verification firm, which is verifying the project with regards to the underlying methodologies and the way the future credits have been calculated. Once approved and verified, the carbon credits issued by the project will be registered either in a traditional carbon registry such as Verra, Gold Standard or BioCarbon Registry or an on-chain registry like Toucan. The forward token will then get “burned” (this is the blockchain term for retiring the forward credit) in exchange for the actual carbon credit.
Associated New Possibilities
Several blockchain companies are designing standardized platforms that allow for specific forward agreements to be commodified into a highly-liquid form. This is done by pooling forward tokens of a specific type. By leveraging the power of decentralized finance (DeFi), like automated market-making, the liquidity of tokenized forward credits can be improved for both buyers and sellers. All of this can be facilitated while giving traders the opportunity to arbitrage the commodity layer and therefore ensure that the market can determine the value of forward credits. This way blockchain technology for forward agreements can enable a public spot price for forward assets.
Using forward credits in DeFi applications further opens the door for new kinds of previously unimaginable processes to be created around it. Loan facilities, self-repaying loans denominated in carbon, liquidity-provision-based carbon accumulation, and on-chain delivery de-risking are just a few options that will become possible.
The traditional carbon market is not just complicated and fragmented, but also fundamentally illiquid. This is especially true for removal projects that require upfront funding for the delivery of carbon credits in the future.
Tokenized forward credits can change the way new projects are funded thus making a historically illiquid asset liquid. This will be done leveraging the power of decentralized finance mechanisms, due diligence and risk assessment of projects as well as continued digital monitoring, reporting and verification. This way project developers can secure early-stage financing to realize new carbon removal projects, while companies are empowered to fulfill their Net Zero commitments by hedging their supply of carbon credits for the future.