On-Chain Carbon Markets: A Primer

In certain cases, however, a company may produce emissions that are greater or less than the amount they have the credits for. This is where Voluntary Carbon Markets (VCM) come in. These are secondary markets where entities can buy and sell carbon credits between themselves. The underlying for these credits is greenhouse gasses that are removed or reduced from the atmosphere. As a result, companies have been able to build the accrual and sale of these credits into their business model - allowing some to survive that may otherwise have been financially non-viable.

These markets exist off-chain, but for reasons we’ll find out, they leave a lot to be desired.

Why are legacy carbon markets broken?

Legacy, or off-chain carbon markets are inefficient and flawed in many ways:

• Lack of price discovery. Most voluntary carbon transactions happen over the counter (OTC), which leads to poor transparency of the market. The value of carbon credits depends on multiple factors, such as project type, vintage, or country. This makes it even harder to know the real market price of a voluntary carbon credit.

• Illiquidity. As mentioned above, the voluntary carbon market is done not on exchanges but mostly OT,C which results in highly fragmented and illiquid markets. The heterogeneity of carbon credits implies that different carbon offset types trade in low volumes.

• Poor market transparency. Since the market is voluntary and not regulated by a single entity, it’s difficult if not impossible to obtain information on the owners of active carbon credits, on the project details, or on how much each owner spent.

Bringing carbon markets onto the blockchain could solve most if not all of these problems. Blockchain is a decentralized and public ledger on which no single entry can be modified, which makes on-chain carbon markets more transparent than legacy markets. Furthermore, tokenization of carbon credits adds more liquidity to the markets by introducing new users to whom the markets would otherwise be inaccessible. Transporting carbon offsets to the blockchain also results in improved price discovery, because similar carbon credits are combined in a single pool, which facilitates their comparison.

A number of protocols are already building in this space, and we’ll list a few of the notable ones below.

Toucan’s Carbon Stack contains three modules:

• Carbon Bridge
• Carbon Pools
• Toucan Meta-Registry

Anyone can bring their carbon credits from off-chain sources to on-chain through Carbon Bridge. To bring carbon credit from a legacy registry to the Toucan registry, one should retire their credits in the original source to prevent double counting. Once the bridging is complete, carbon credits can be fractionalized into tokens called TC02 - T stands for “Toucan”, “Tonne”, or “Tokenized," and C02 represents carbon dioxide.

If Toucan protocol did stop here, it would be no different from legacy carbon markets. Since there are so many carbon projects, and since carbon credits are typically project-specific, carbon markets tend to be illiquid. To aggregate carbon credits with similar features would be a natural solution to the problem, and this is what the protocol did by launching Carbon Pools.

Carbon trading is mostly done over-the-counter, not on centralized exchanges. This means that these markets are not fully transparent and lack the discovery of price. Toucan’s Carbon Pools group similar carbon offsets into pools, creating more liquid markets and a more transparent price signal for various carbon categories. Once a carbon credit is tokenized, a standardized token called a carbon reference token is created. These tokens can be traded on decentralized exchanges where liquidity is much deeper. Thus, Carbon Pools make carbon markets much more liquid, less fragmented, and more transparent.

Toucan Meta-registry is where all the fractionalized carbon credits are stored. Other details, such as project-specific information and the retirement of carbon credits are also recorded here.

One of the biggest visions of Toucan was that other projects or protocols would use their infrastructure to build on. This is what KlimaDAO did. That is a project with the goal to create a carbon-based currency. Users can exchange its coin, KLIMA, for BCT, Toucan’s native token. KLIMA token is backed by one BCT 1:1 which, in turn, is linked to carbon offsets from real projects.

When a BCT token is deposited into KlimaDAO treasury, more KLIMA is minted to the market. You can think of KlimaDAO as a blackhole for BCT – they lock away BCT and thus carbon offsets from the market, pushing the price of carbon credits higher. Reward mechanisms for investors are bonding and staking.

Bonding

Bonding simply refers to adding reserve assets, such as MC02 (see below) or BCT, to the KlimaDAO treasury in exchange for KLIMA. The important part - this allows you to get KLIMA at a discount.

Staking

Staking is another value accrual mechanism of the protocol. By staking your KLIMA tokens, you’ll get sKLIMA tokens, which have a 1:1 ratio to KLIMA. How does the protocol reward the stakers? Recall that KLIMA is backed by real carbon credits. When the treasury has more credits than it needs to back KLIMA, it will mint new tokens and distribute them to stakers. Staking is win-win both for the protocol and users. For KlimaDAO, it’s beneficial because staking tokens for some period locks up supply, thus decreasing sell pressure. Users benefit from staking through staking rewards. At the time of writing, APY is 21%.

MOSS is an environmental platform operating in Brazil, the country containing 40% of the world’s tropical forests - often considered the “Saudi Arabia of Carbon Credits”. Though the country has enormous potential, carbon credits of their environmental projects are among the cheapest in the world.

MOSS consists of two separate projects: MC02 token and Amazon NFT project. MC02 is a ERC-20 token representing one carbon credit, which is minted by MOSS based on the supply and demand of carbon credits.

An Amazon NFT represents a piece of Amazon rainforest. Proceeds from the sale of these NFTs will go to the project called Green Wall, which will combat deforestation in the region. The mission of Green Wall is to preserve the threatened borders of the rainforests. The whitepaper claims that to save the Amazon - with an area of 600 million hectares - would be much less costly than one might think. Since most of the deforestation comes not from natural disasters but from human activity, guarding the edges of the forests through building a wall does make sense both environmentally and economically. This is 600 million hectares vs 20 million hectares (the area of the forest borders)!

Flowcarbon is one of the leading projects in climate technologies, and it works as follows. First, carbon credits from multiple environmental projects are deposited into a Specific Purpose Vehicle (SPV). The next step is to tokenize these credits into GC02 tokens. But since these tokens are vintage year- and project-specific, they will be combined into a bundle with other similar carbon credits from different projects.

Finally, a GNT token will be minted from that bundle; the number of issued GNT tokens will be equal to the number of GC02 tokens in that bundle’s smart contract.

Their GNT token is backed by carbon credits from multiple “market-recognized carbon registries”. These credits have not been retired yet, so once purchased, they can always be brought off-chain and to be used by a holder.

Other than GNT, Flowcarbon also uses NFTs to bring attention to climate change problem. They launched a collection of 200 net carbon negative pieces of art called Flow3rs on November 28th. About 70% of the proceeds from NFT sales will be employed to retire carbon credits. The issuers of these credits include The Valparaiso Project, which is located in Brazil and whose mission is to preserve Amazon rainforests.

REDD+ credits refer specifically to carbon credits designed to “reduce emissions from deforestation and forest degradation in developing countries.” Universal Carbon, or UPC02 is the first tradable REDD+ carbon credit token. Developed by Universal Protocol Alliance, it is backed by voluntary REDD+ carbon credits.

KlimaDAO entered the market with an attempt at “sweeping the floor,” encouraging crypto users to buy the cheapest carbon credits in the markets. Their reasoning was that if those useless or bad credits are taken out of circulation, only the credits of the good projects will remain in the market.

The problem with this initiative was that those bad credits were associated with low-quality, dubious environmental projects. These were of such low reputation that their sale on leading carbon markets was not possible. Experienced carbon credit traders hadn’t traded those credits for years because they knew what those credits were worth. Yet these became a part of the treasury by which KLIMA was backed.

Considering this, Verra, the operator of the world’s leading carbon crediting program, the Verified Carbon Standard (VCS) Program, issued a statement on November 25, 2021. By emphasizing that it “does not administer these activities and tokens and in any event takes no responsibility for these activities and tokens,” and that the tokens “have not been licensed or otherwise authorized by Verra are not verified, endorsed, or recognized by Verra as representing or equating to VCUs or an environmental benefit associated with VCUs”, they distanced themselves from KlimaDAO and Toucan protocol.

Unsurprisingly, KLIMA and BCT (Toucan’s Base Carbon Tonnes) tokens lost a significant part of their value following the statement. This is the chart of BCT price.

And this is KLIMA price chart:

Though carbon markets have the potential to aid in the fight against climate change, they have their own flaws. They are illiquid, opaque, and not accessible to most investors. Blockchain technology can change this in many ways. First, collecting the carbon credits with similar features will improve price discovery that legacy carbon markets lack. Also, tokenization of carbon credits will result in better liquidity. All things considered, this area of the crypto space has the potential to be very disruptive and we may see it grow quite a bit in the coming years.