Category: Voluntary market

Blockchain, carbon emissions and NFTs

May 16, 2022

At a recent emissions trading workshop, there was a great deal of discussion about the new kid on the block, carbon trading and non-fungible tokens (NFT). I should say up front that this is not a particular area of expertise for me, so this post represents my observations on the subject, however blockchain is becoming a tool to support the energy transition.

According to Wikipedia, an NFT is a non-interchangeable unit of data stored on a blockchain, a form of digital ledger, that can be sold and traded. The NFT can be associated with a particular digital or physical asset including but not limited to, art, songs, and sport highlights and a license to use the asset for a specified purpose. In the case of the voluntary carbon market, the NFT represents a carbon removal or carbon reduction. So it might represent the storage of carbon in a tree, or in a geological formation. NFT ledgers claim to provide a public certificate of authenticity or proof of ownership and a license to use the asset for a specified purpose. That use could be as an offset against emissions generated by the holder of the NFT.

There is no doubt that carbon markets, be they regulatory or voluntary, require a mechanism of some description to track creation, ownership and surrender of emission reduction units, credits and trading system allowances. This normally emerges as a transaction log and in the case of regulatory systems such as the EU Emissions Trading System, is centrally managed by government and also contributes to the compliance process where units must be surrendered against some obligation. Within the Kyoto Protocol architecture which spanned multiple countries and regulatory systems, an international transaction log (ITL) was created by the UNFCCC and it was used to track all cross border transfers of units available within that system (AAU, CER, ERU, RMU) and therefore effectively link the national registries. On their website the UNFCCC states that the International Transaction Log (ITL) connects registries and secretariat systems that are involved in the emissions trading mechanism defined under the Kyoto Protocol and its Doha amendment. One of the key mandates of the ITL is to ensure an accurate accounting and verification of transactions proposed by registries in order to support the review and compliance process of the Kyoto Protocol.

Within the voluntary carbon markets there is no such global registry, but rather a series of registries that align with the particular voluntary market platform used to create the credit. These are summarised here. For example, the Verra Registry was launched in April 2020 and is the cornerstone for the implementation of Verra’s standards and programs. It facilitates the transparent listing of information on certified projects, issued and retired units, and enables the trading of units. It is the central repository for all information and documentation relating to Verra projects and credits. The Verra Registry also ensures the uniqueness of projects and credits in the system.

So along comes blockchain and NFTs, which by all accounts at the workshop, can certainly do the job of tracking carbon units and ensuring integrity – but the current systems also do this and have been doing it satisfactorily for some time. It feels like the new kids on the block are a solution looking for a problem, but at least as far as unit tracking goes, there isn’t a particular problem. That isn’t to say that the current system is perfect, it isn’t, or that NFTs won’t be an improvement on the current processes, in fact they may well be more suited to the task.

But the problem that does exist is perhaps one that blockchain and its associated tools could solve, yet it is highly complex. It’s the core of the climate issue – the carbon budget. The carbon budget for a certain rise in global average surface temperature is the limit on the cumulative carbon dioxide release, less removal of carbon dioxide from the atmosphere, prior to the point of net-zero emissions. In August last year the Intergovernmental Panel on Climate Change (IPCC) informed readers of its 6th Assessment Report that the carbon budget for 1.5°C of warming was now only 500 GT, based on cumulative emissions from 1.1.2020. Today, that will have reduced to about 400 GT. For 2°C of warming it is now about 1340 GT of carbon dioxide from now.

The risk associated with carbon markets based on a variety of different baselines, credit standards, allowance allocation mechanisms and even basic structure is that they don’t add up to anything close to the carbon budget available, so we collectively overspend the budget and therefore overshoot the temperature goal, even with supposed broad use of carbon units. In an extreme hypothetical scenario, we could end up with more voluntary market carbon credits than emissions, but with atmospheric CO2 still rising. That risk doesn’t change simply by applying NFTs to the credits that are created. The risk also exists with the current Nationally Determined Contribution (NDC) process of the Paris Agreement, where each country has effectively determined their own carbon budget, their own national baseline year and their own pathway forward. The sum of the NDC carbon budgets does not currently equate to the task at hand. The Global Stocktake process that is now underway will highlight the mismatch, but the Paris process has no tools at its disposal to solve the problem other than peer pressure and diplomacy.

An alternate way for the global voluntary carbon market to evolve would be to use the tools associated with blockchain to tokenise the carbon budget, rather than tokenise the current credit system. A single global ledger would also resolve the current problem of having fragmented carbon registries. The carbon budget tokens would then act like allowances in an emissions trading system, with a surrender process linked to emissions taking them out of the market permanently. The value of a unit in a market is a function of its availability (or scarcity) and we know that the carbon budget has a defined limit in this regard. That immediately delivers scarcity and this scarcity is then enforced using blockchain which ensures that each unit of the carbon budget can only be claimed once. While the carbon budget can be expanded via removals, considerable effort is required to do this, with an associated cost. Two possibilities (and doubtless there are many others) for NFTs and carbon budgets are as follows:

  1. Target the global carbon budget, effectively turning the budget into a global cap and trade system. But this is inherently difficult as there is no current mechanism to distribute the carbon budget between nations, companies or even people. However, fractionalized ownership of carbon credits could be an enabler for bringing more liquidity into the market. The further challenge with such an approach for the global carbon budget is the initial creation and distribution of the tokens. There will be a finite number, but no one party should benefit from the creation of the tokens; after all the carbon budget is a global commons problem. Further, there can’t be an agency such as the UN or UNFCCC selling the initial tokens as that would require a transfer of funds that many governments wouldn’t tolerate or is simply not feasible constitutionally. What if the global budget was tokenised by DAOs (Decentralized Autonomous Organization) on a piecemeal basis, with NFTs existing and available to use by those who chose? The DAOs might be companies, cities, states or even whole countries on a voluntary basis, with NFTs granted in return for the entity adopting a carbon budget.
  2. Tokenise the implied carbon budget under an NDC, even though the sum of the current NDCs is leading to the global 1.5°C carbon budget being overdrawn. This approach could add considerable value to the voluntary market. A current issue in the voluntary world is the question of who owns and makes use of a carbon credit. Clearly if a project is launched in a particular country the emissions profile of that country will change, which in turn will be reflected in the reporting of its own emissions for the purposes of showing delivery of its NDC under the Paris Agreement. But if the reduction is contributing to a Paris Agreement objective, how can it also be made available to the voluntary market and in what context should the voluntary market use it? I discussed this issue in an earlier posting, but irrespective of how this matter is settled, a reduction unit is really only of value if more is known about the context of the reduction. This is why an allowance in an emissions trading systems has value – the market fully understands the context within which the unit was created and the scarcity associated with it. This is not the case with voluntary units extracted from a project that might represent a tiny part of the emissions of an economy, where information on total emissions is hard to come by. But if the project sat within an NDC and the emissions associated with the NDC sat in a clear accounting framework, then the reduction units would have context and the use of them either within the country or outside the country could be clearly understood by the market and priced accordingly.

None of the above would be simple to implement and option 1 might be impossibly difficult. But remaining within a carbon budget is entirely the purpose of emissions management and therefore the world needs some collective effort to achieve this. Management requires good accounting and transparency but today there is still very little management of carbon budgets, with systems like the EU ETS being the exception rather than the rule. While the workshop I attended was entirely about NFTs associated with voluntary reduction units, this feels like a rather simple problem for a sophisticated 21st century digital mechanism to target. The much harder application would be carbon budget management and the benefit to society would shift from modest to immense.

Double counting or dual accounting?

September 13, 2021

With growing demand from investors, customers and other stakeholders for companies to become net-zero and/or sell net-zero emission goods and services, there is increasing interest in the voluntary carbon market as a source of carbon offsets. This is because today, very few, if any, goods and services are provided without fossil fuels somewhere in their value chain. Simply storing goods in a warehouse puts fossil fuels into the value chain, because of the construction of the building. And even looking forwards, fossil fuels will remain embedded in global supply chains to some extent for several decades, if not a century.

The voluntary market has been slow to scale over the past two decades, but it is now growing rapidly. There have been ongoing concerns related to the quality of the carbon units that emerge from it. For example, do the carbon units represent real reductions? Would these reductions have happened anyway? Nevertheless, it is poised for more growth, driven by corporate commitments to achieve net-zero emission targets. This means that the voluntary market is poised to become a critical mechanism for helping deliver global emission reductions, to the extent that a special task force was created to address the concerns and put in place practices and approaches for rapid future scaling. The Taskforce was initiated by Mark Carney, UN Special Envoy for Climate Action and Finance; is chaired by Bill Winters, Group Chief Executive, Standard Chartered; and is sponsored by the Institute of International Finance (IIF). The final report was released recently and you can find it here.

One of the many discussion points within the report is how a carbon unit should be viewed with regards actions already underway or planned within the host country for the project. For example, the report discusses the need for a future voluntary market governance body to consider whether or when it may be necessary for projects to demonstrate additionality to the Host Country’s nationally determined contribution (NDC) under the Paris Agreement and the appropriate instruments to implement such a requirement (e.g. corresponding adjustments).

While the quality of carbon units is very important, some perspective on the role and shape of the voluntary market is also needed. The corresponding adjustment is a mechanism under the Paris Agreement to prevent double counting at country level and to maintain environmental integrity against the NDCs. The use of corresponding adjustments is set out clearly within Article 6 of the Paris Agreement. It is designed to work at country level where a defined NDC exists and I discussed this at some length in a 2020 post and in a 2019 post.

By contrast, the voluntary market operates at company level. The same emission activities (sinks and sources) can be viewed through two entirely different accounting approaches, one for countries and one for companies. So is the demand for Paris Agreement adjustments in the voluntary market mixing the voluntary and regulatory worlds in a way that is helpful or damaging to the voluntary market?

The voluntary market is a means of channelling capital into emission mitigation projects and it measures the results of that with the issuance of carbon credits that recipients can use as they see fit. Those carbon credits have no immediate value in a regulatory world as the recipient cannot use them to meet compliance obligations nor are they recognised by other jurisdictions. The recipient simply requires them to show that the sum total of their market and investment activities is net-zero emissions. This is a simple model, but one that has worked over time, albeit in a relatively limited way.

In the voluntary world, when a company sells a carbon neutral product in (say) the UK, there are emissions from the product in the UK and this is offset with a unit that might represent a sink from (say) forestry activity in (say) Kenya. These are combined to deliver the claim of carbon neutrality by the company in question. But that forestry activity will also lead to a larger sink in the Kenya official GHG inventory for their Paris Agreement commitments, thereby helping Kenya meet its NDC. Similarly, the emissions from the product use will likewise be counted in the UK inventory, setting back attainment of its NDC.

The two sets of accounts remain in good shape without a corresponding adjustment. Kenya measures its emissions and sinks and reports them under the Paris Agreement and the UK measures its emissions and sinks and similarly reports them. Even though the voluntary carbon neutral claim used a Kenya sink in the UK, the UK inventory doesn’t recognise it as it is counted in the Kenya inventory. Rather, the UK must report the product emissions in its NDC and take action to mitigate it such that their NDC goal is met.

Importantly, the company offering the carbon neutral product isn’t a country, it reports at a company level. The UK’s emission from the product the company is providing and Kenya’s sink from the company investment are added together by the company and reported as it’s footprint, which has nothing to do with the Paris accounting.

None of this is double counting, it’s dual accounting.

If however, the UK had used the Kenya sink and reported it under its inventory for the purposes of its NDC, then Kenya would need to do a corresponding adjustment. But this isn’t happening in the voluntary market.

Further, imagine what would be required if Kenya did need to commit to a corresponding adjustment for the use of its sink in the UK voluntary market. The company making use of the unit could ask the UK to accept the unit under Article 6 and have Kenya implement a corresponding adjustment, but the UK may not necessarily want it. So then the company would have to ask Kenya to do the corresponding adjustment anyway.

The sale in the voluntary market and the corresponding adjustment would require Kenya to find a further reduction somewhere in the economy to balance their NDC, which would create an economic cost beyond that which they had budgeted for the delivery of the NDC. While the project itself would benefit from the sale of the voluntary unit, the economy is penalised, which in turn would likely require the project developers to fund the difference. This then raises the cost of carbon units in the voluntary market and potentially diminishes investment into projects. It also means turning the voluntary market over to governments, because they will rightly seek scrutiny of local developments that result in changes to their Paris Agreement accounts.

The solution is to recognise that the voluntary market and the Paris Agreement are two distinct ways of looking at the same set of emitting activities and sinks. The voluntary market offers a mechanism for people and companies to invest in the attainment of NDCs through the purchase of carbon neutral goods and services. This is a positive development and it should be encouraged, particularly because some developing countries and most least developed economies, where many such voluntary market projects lie, are asking for help to finance their NDCs. Further, in the country where the carbon neutral goods and service are provided, the process raises emissions mitigation awareness. However, it will be essential to build understanding with voluntary market participants that the activity they are engaged in may be helping other countries attain their NDC and not necessarily the country they are living in. This can also help build wider appreciation for the role of carbon trading. But penalizing the voluntary market with requirements that stem from a completely different accounting structure may not be helpful and might have the perverse effect of slowing down emission reductions and choking off an expanding flow of climate finance into developing countries.

Eventually the voluntary market may merge into a framework regulated under Article 6, but for now these are two very different approaches to emissions management. Neither has matured yet, so an early melding of the two may not be in the best interests of overall carbon market development.