Key Contacts: Andrew Tzialli – Partner | Anna Hickey – Partner
In the fight against climate change, innovative technologies are emerging as powerful tools to help accelerate decarbonisation. One such technology, blockchain, is revolutionising the management and trading of carbon credits. However, the impending increase in regulation of the carbon markets, and of environmental, social, and governance (“ESG”) matters more generally, increases uncertainty for providers of technology solutions.
Certain “proof of work” blockchain protocols were once criticised as contributing to significant levels of climate damage due to the computing power needed to operate them. Nowadays, more environmentally sustainable blockchains (being those that more commonly utilise “proof of stake” methodologies) are widely used and are more suitable for carbon credits. Blockchain’s decentralised and transparent nature offers promising solutions to streamline the carbon market and help drive climate action. These include tokenisation of carbon credits and using smart contracts to execute transactions.
An overview of carbon credits
The term “carbon credit” or “offset” is commonly used to describe the commodity that is generated through voluntary carbon projects and traded in the voluntary carbon market (“VCM”). “Voluntary” is the term used in contrast with so-called “compliance” markets that are regulated by mandatory international, national or regional carbon reduction regimes (such as for example the EU Emission Trading System).
Many companies participate in the VCM as a way of contributing to climate action. Much like the application of blockchain technology, the VCM is only recently starting to come under regulatory scrutiny. While the VCM remains unregulated, legislation is emerging in jurisdictions such as the EU and California to regulate the claims that corporates may make regarding the use of carbon credits – under the broad umbrella of consumer protection and anti-greenwashing. This sits alongside a movement in the VCM towards greater integrity and transparency including through the launch of a benchmark for high quality by the Integrity Council for the Voluntary Carbon Market (“ICVCM”) of in the form of its Core Carbon Principles in 2023, which we analysed here.
Challenges in the Carbon Market
Despite their growth potential, traditional carbon markets can be difficult to access – buying and selling carbon credits often involves intermediaries, high costs and limited liquidity. This has delayed widespread participation despite decarbonisation commitments gaining momentum and increasing public support for carbon credits as a tool to accelerate climate action. For parties seeking to invest in a carbon project directly, the complexities are even greater.
Together, these challenges limit the effectiveness of the VCM in contributing to climate action. Blockchain technology has the potential to assist the VCM to overcome these challenges.
Blockchain
Blockchain technology offers a decentralised1 and tamper-resistant ledger for recording transactions in a transparent and secure manner. In creating an open distributed ledger that is accessible to all, blockchain seeks to eliminate the need for intermediaries and can enable live time tracking of carbon credits throughout their lifecycle.
Can carbon credits be tokenised?
Tokenisation involves the creation of a digital representation of real-world assets, such as carbon credits. Each token corresponds to a quantity of carbon emissions, making it easier to divide, trade, and track these assets. By digitising carbon credits, tokenisation seeks to reduce administrative burdens, increases market liquidity, and opens up new avenues for investment.
Although the tokenisation of carbon credits is meant to enhance transparency, there is a risk of that a credit could be retired on a registry but still in circulation as a token. The tokenisation of carbon credits must robustly address the risk of double counting, in particular double use, where one carbon credit is used twice (or more) to fulfil a climate action commitment.
Blockchain solutions must be careful to address this issue to ensure market confidence. One proposed solution to the double counting issue is to require linkage of the on and off chain registries to avoid multiple claims.
Consequences of tokenisation
Blockchain-based carbon credit tokenisation has received much analysis on potential benefits for market liquidity when implemented in a manner that enhances the measurement, reporting and verification processes embedded in carbon standards and registries.
For example, combining the VCM with a blockchain solution may enhance:
- Transparency and traceability: blockchain provides an unchangeable, transparent record of ownership and a transaction history, potentially reducing the risk of fraud (when aligned correctly with registries). The traceability of blockchain can enable life cycle assessment of the environmental attributes and potential impacts associated with a carbon project or credit.
- Fungibility: currently carbon credits are project specific with unique properties. Tokenisation could enhance interchangeability for market participants provided that each token represents a reduction or removal of a minimum standard.
- Fractional ownership and accessibility: tokenisation allows for the fractional ownership of carbon credits, enabling smaller investors to participate in the carbon market. This democratisation of access could promote broader participation and increase liquidity.
Any tokenisation of carbon credits would need to navigate applicable know-your-customer/anti-money laundering regulations, restrictions on financial services and products and blockchain specific laws.
Potential of Smart Contracts
Smart contracts are automatically executed contracts built on blockchains, with inbuilt pre-programmed steps. These could, if designed properly, speed up transactions and reduce costs, reducing the need for intermediaries. For example, once a certain volume of carbon dioxide (or equivalent) had been emitted, a business could automatically purchase a carbon credit to reflect a corresponding climate action.
Potential of blockchain registries
Carbon registries are electronic systems approved, authorised or recognised by various carbon standards used to transact with carbon credits. Registries are fundamental to the VCM and, like any other digital marketplace, the security and resilience of transactional data is important
Blockchain could enhance the interoperability of registries and remove single points of failure. Use of blockchains can provide a permanent record of ownership with traceable, timestamped, and indisputable transaction logs. Currently, centralised registries like any business could be compromised if their host server is hacked or destroyed and insufficient backups are kept.
Regulatory landscape
The regulation of blockchain is increasingly complex as regulators seek protect consumers.
Cryptocurrency
In the EU, the Markets in Crypto-assets Regulation (“MiCA”) has established a comprehensive framework for crypto-assets and the licensing of providers of services in relation to such crypto-assets (“CASPs”). MiCA will start coming into effect from June 2024. This legislation makes Europe one of the largest regulated areas on the planet for crypto-assets. The clarity we now have with the regulations (in particular that governing the issuance of asset referenced tokens, a category which certain tokenised carbon credits may be subject to), provides some much needed certainty to a sector that has previously be partly restrained from progress by the many legislative grey-areas surrounding the technology.
Greenwashing
As mentioned, companies are likely to be subject to various restrictions on the claims they make, to limit the risk of greenwashing. The EU has recently adopted Empowering Consumer Directive, which aims to prevent certain terminology from being used when companies make claims and label products. In addition, the long-anticipated EU Green Claims Directive has not yet been adopted but is swiftly moving through the EU institutions. Once entered into force it will require companies to substantiate their claims by supplying concrete data and scientific evidence.
ESG claims
Under the EU Green Deal, there are numerous recent regulations aiming to implement and monitor ESG reporting, in particular the Corporate Sustainability Reporting Directive, which requires certain companies to report ESG information. Carbon credits are not yet regulated but it is to be expected this will change over time, as financial instruments relating to offsets emerge.
Real-World Applications
Several initiatives and platforms are already leveraging blockchain technology for tokenisation of carbon credits. Certain standards are moving ahead with blockchain technology to expand its sales channels.
Conclusion
Blockchain technology and tokenisation offers potential for the growth of the carbon market. However, this increasing convergence between the VCM and Web3 technologies is complicated by increasing regulation, both of blockchain related technologies and the carbon markets.
Companies must ensure that they fully understand their obligations under relevant legislation and begin to prepare for future mandatory requirements.
- Note that some blockchains can be operated on a centralised basis. ↩︎
