The Crypto Dilemma of CO2 Credits

The tokens arrived with the promise of bringing more efficiency to the voluntary carbon market. Are they doing the job?

With the increase in net zero commitments by companies, the voluntary carbon credit market has exploded in recent years – which has also made its inefficiencies clear.

As the contracts for the purchase and sale of credits are bilateral, there is little price visibility, both from the buyers and sellers side, there are doubts about the technical quality of some projects, and there are fears of double counting.

Every problem is an opportunity. And, in the crypto era, blockchain came up with an almost obvious solution, which brought a new trend to this market: tokenization.

From techno-libertarians and startups to large banks, there are several initiatives to try to put credits ‘on-chain’, allowing a public record of transactions.

(SAP key: A token is the digital representation of an asset on the blockchain. Blockchain is a decentralized digital network that guarantees the registration and traceability of assets.)

In theory, the technology behind cryptocurrencies can bring more liquidity, efficiency and security to carbon markets.

Another advantage is that it allows the credits to be divided into minimum fractions, giving the chance for individuals to also offset the carbon footprint of day-to-day activities.

But if no one disagrees with the potential of these instruments to leverage climate finance, in practice, arriving at a mechanism with which all stakeholders are minimally satisfied still seems a distant goal – and with many bumps along the way.

A recent controversy over how to turn these credits into tokens is the tip of the iceberg of this debate.

How to tokenize?
In early May, Verra, the entity that certifies and holds the majority of credits traded on the voluntary market in the world, released a statement: “Verra expresses its views on crypto instruments and tokens.”

Until further notice, companies such as the Brazilian Moss and the German Toucan, among dozens of others, are prohibited from buying new Verra credits to transform them into such “crypto instruments”. (Nothing changes for stock that has already been tokenized.)

Verra’s decision was based on a technicality.

These companies bought the credits and “retired” them to turn them into digital assets, divisible into fractions and tradable on online exchanges along with other cryptocurrencies.

The problem is with retirement.

Today, credits registered with Verra can change hands without necessarily being used to offset emissions.

An investor may buy them with appreciation in mind, or a company may want to stock up on credits now to offset future issues. In this case, the credits only change account in the Verra registry.

When it reaches its final destination, that is, it is actually used to offset emissions, it is retired and goes out of circulation. In industry jargon, your “ultimate benefit,” which is to reduce greenhouse gas emissions, can only be consumed once.

Companies like Moss and Toucan found in retirement a way to get credits on the blockchain. It is a way to ensure that there is no double counting, that is, that credits are not sold again on Verra.

Moss has mechanisms within its system to take credit out of circulation when it is used. The customer can choose to ‘burn it’.

In a video interview with Reset, the startup’s CEO, Luis Adaime, demonstrated the purchase of a small fraction of a token to compensate for a flight between São Paulo and Rio de Janeiro on a hotsite available on the airline’s website.

Minutes later, it was possible to locate the transaction on the blockchain and confirm that that piece of credit had gone out of circulation.

The objective of avoiding double counting is valid, but in practice, with the use of retirement for tokenization, Verra started to lose visibility on when the credits were actually used for compensation – and are, therefore, in fact contributing to the emission reductions – and when they are only the target of speculation.

In search of the solution
If the systems of Verra or other credit “registries” were more efficient, says Adaime, it would not be necessary to create the improvisation that is now suspended.

Verra herself has already made it clear that she does not see blockchain and tokenization as a problem per se, but acknowledged that she needs better systems to make this happen without friction.

The platform is working on a new mechanism that creates a new category, allowing the ‘immobilization’ of credits placed on the blockchain. This would prevent any duplicate sales and ensure transparency for the system.

Ambify, a company of the Ambipar group launched at the end of last year also to tokenize credits, had to resort to another technical gambiarra to continue operating. As the company’s solution does not involve pre-retirement of the credits, Ambify can continue to transform Verra credits into tokens.

But João Valente, director of digital assets at Ambipar, agrees with Adaime’s assessment: “Verra’s systems are archaic”.

For Verra, it’s all about demand. “There was no demand for derivatives in the voluntary market, so there was no infrastructure. Now that the demand is there, it will be provided,” Steve Zwick, the organization’s senior media relations manager, told Reset.

Compensation or speculation?
Today, the prices of tokens based on carbon credits and traded on crypto exchanges, such as Moss’s MCO2 and Toucan’s BCT, reflect little on the market dynamics of buying and selling credits in the main market, of transactions between companies.

While, according to traders and developers, an avoided deforestation credit in the Amazon is trading at around US$15, the MCO2 is now worth around US$4.42.

That’s far lower than the high of $20.56 from early 2021 – largely reflecting the recent meltdown of everything to do with the crypto world. Toucan’s BCT is priced at $1.88.

With every new technology and new market in the making, it is natural that there is a learning curve and a lot of volatility along the way — and speculation is an important part of discovering prices.

But if, on the one hand, tokens traded on crypto exchanges have the benefit of democratizing participation in a nascent market, a good part of this price mismatch has to do with the fact that they have opened up space for speculation by traders who do not necessarily understand CO2 credits.

Carbon credits are already complex instruments: assets that represent that the emission of a ton of something you can’t see (greenhouse gases) has been avoided. Add to that the layer of complexity of cryptocurrencies and perhaps the best representation is that emoji with the exploding brain.

In carbon discussion forums, it is not uncommon to find individuals interested in investing in the market who allude to the carbon prices practiced in Europe, which is a closed regulated market, and where futures contracts already reach more than 80 euros. The problem is that there is no direct communication between the voluntary market and the European emissions trading system.

Not all CO2 is the same
Another important point is that trading CO2 from the voluntary market with a single value, as if it were a commodity, starts from the premise that every ton of CO2 avoided is equal.

But in practice, this is not so. Verification methodologies for generating carbon credits have evolved over time and today there are a number of credits on the market, especially older ones, which are considered to be of lower quality.

In the dynamics of companies that look carefully at the subject, there is a concern about the origin of the carbon credit and the externalities generated by it.

“It is up to buyers to identify the best projects and know what they are buying,” says Bruno Brazil, founder and CEO of project developer BR Carbon. “At the adults’ table, they don’t just care about carbon. They want to know about the quality of this carbon and also how the money will transform people’s lives.”

Prices vary widely, with buyers willing to pay more for projects that prove environmental or social benefits, or for credits from projects that effectively sequester carbon rather than just avoid carbon emissions.

The return of zombie credits

The wave of cryptotraders wanting to speculate with carbon credits also brought unexpected consequences, such as the resurgence of old, low quality credits that could no longer find buyers – the so-called ‘zombie credits’.

Among market experts, there is great concern about the effective climate contribution of credits called ‘old vintages’, generated many years ago, when some protocols were not yet consolidated.

One of the main arguments behind environmental cryptactivism groups is that their systems would help “sweep the floor”.

It is the thesis behind the Klima DAO, for example, which converts carbon credit tokens into a new currency, called Klima. The thesis is that, by buying the cheaper credits from the voluntary market, they would help push the price of CO2 up, which would encourage more robust projects in terms of reducing emissions.

The shot, however, backfired. The point is that, in practice, companies that want to neutralize their emissions were already avoiding part of these bad credits and the demand of cryptotraders made them come back to life.

In April, the NGO CarbonPlan analyzed the credits tokenized by Toucan, owner of the protocol to generate the most active carbon cryptocurrency, BCT.

And it found that 28% of the credits transformed through its platform were from projects that had not retired credits in the last two years or had only retired credits via Toucan.

This movement was more pronounced late last year and early this year, when arbitrage between carbon cryptocurrencies generated distortions that allowed a quick profit. For a short period of time, at the end of 2021, it was possible to buy a credit of less than US$2 and trade it for more than US$3000 on the KlimaDAO platform. (The Klimas market imploded and today it trades at around $3.)

Moss MCO2 can be exchanged for Klimas. But, in the case of the Brazilian company, CEO Luis Adaime says that there are quality standards, which include not trading assets with vintages prior to 2013, and audits of all credit projects that are sold through the platform.

Incumbents x Challengers
The dispute between the challengers of the crypto world and the incumbents reproduces, in some ways, a bigger fight between the traditional financial system and the defenders of a future of decentralized and diffuse authority.

In an interview with Time, Verra has already indicated that it tends to prefer working with Carbonplace – a project by a consortium of banks that includes Itaú, BNP Paribas, UBS and Standard Chartered.

To the magazine, Robin Rix, responsible for the legal area at Verra, said that one of the reasons for choosing an institution controlled by banks is to prevent these climate crypto assets from being part of the “anything goes” that has been seen in the markets so far.

For him, nothing prevents tokens from environmental projects from being used to launder money, for example. “Banks have sophisticated processes for getting to know customers,” he said.

Would keeping everything within the “establishment” be a way to guarantee the survival of these centralizing entities? Verra’s Zwick told Reset that the disintermediation proposed by blockchain advocates does not pose an existential threat to entities.

“It’s a challenge in the sense that we have to do things right, but blockchain is just a way to trade credits after it’s created,” he says. “The hard work is developing methodologies and managing the verification and validation process. There is no existential threat to Verra.”

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