Many carbon tokens have been announced seeking to solve the overarching problems of the current carbon markets: complexity, high administrative barriers and lack of a base price for carbon. Uniformly, these tokens look to suppliers of offset credits from emission reduction projects to supply the tons of carbon for their blockchain ledgers. These efforts to rely on pooling of offset credits to provide a base price for carbon are misplaced.
Pools of offsets are priced at the worst credit
As a pricing tool, an offset backed token reflects the value of the least desirable credit in their pool rather than the price for a ton of carbon that can commoditize carbon markets.
Repeated experience with this strategy from the ICE Futures Cerfitified Emission Reduction (CER) contract to the Chicago Climate Exchange’s Voluntary Emission Reduction (VER) contract demonstrate the inverse relationship between the utility of a basket of offsets for price discovery and the number of project types included in the pool. As the range of projects increases, buyers avoid the market because they will be forced to take delivery of the least desirable project type eligible for the pool and sellers of high quality credits do not supply the market.
While the desire to scale up voluntary markets receives prominent attention, market participants recognize that offsets are impractical for setting a base price for carbon. The Voluntary Markets Association summarizes the feedback from its members:
“Market participants are skeptical about creating an exchange-driven “core” price on carbon, driven more by a concern that overall credit quality will suffer without accurate pricing for the wide variety of additional attributes that voluntary carbon markets credits exhibit, which many buyers demand, as cheaper credits without co-benefits will have an advantage.
Tradable pools of offsets have structural limits to scale
The structural characteristics of aggregating offsets under a single price reduces supply of offsets to the pool. Owners of projects that generate credits seek to maximize value and do not want to convert carbon credits from high-quality projects into a token that is priced based on a less desired project methodology that is also included in the pool. As a result, sellers of carbon credits from a cookstove project in rural Zambia do not want to be in the same pool as carbon credit from an industrial gas facility in China because it lowers their price. Suppliers of higher quality offsets then prefer to sell over- the-counter (OTC) rather than be forced to accept the price for the lowest quality credit. As a result, supply of carbon credits to the pool is limited to credits generated by the least desireable project type.
Conversly, buyers ultimately shy away from pooled offset credits because the inability to determine what credits from the pool will be delivered to them. The experience with the forward contracts put in place in ICE futures for Certified Emission Reductions (CERs) during the Kyoto Protocol trading period is instructive. Seeking broad coverage, the forward contract permitted traders to deliver any CER certified by the UN under the Kyoto mechanisms. But there were wide range of project methodologies approved by the UN. Some had high social and environmental impacts, such as distribution of water purification in Uganda. Others offered a ton of carbon resulting from avoiding gas leaks in a pipeline in Uzbekhistan. Buyers preferred the former and would pay a premium in the OTC market. Unfortunately, traders taking delivery under the CER forward contract received almost exclusively the worst credits in the market. Accordingly the price did not reflect the blended value of the underlying pool of credits and, instead, reflected the worst available carbon credit.
Next generation of carbon-crypto needed
Existing tokens attempt to solve the consequences of the lack of fungibility of offsets in two ways, limiting the carbon offsets eligible for the pool or creating multiple tokens for different project types. Neither solution is appealing.
Limiting the emission reduction methodologies eligible for tokenization, limits the number of carbon credits available for tokenization and prevents the token from scaling. Offset credits represent less than 1% of the turnover in carbon credit market trading activity. Less than 300 million tons of offsets traded last year. But, just to satisfy existing net-zero carbon commitments by companies, projected demand for offsetting is more than 2 gigatons in 2030. The supply of high quality offsets for tokenization will never meet this demand due to the complexities, long lead times and lack of finance for projects seeking to generate offset carbon credits. Tokens employing quality criteria will be limited to increasingly small corners of this small slice of the global carbon market.
Alternately, some tokens seek to avoid this pricing conundrum by creating separate tokens for different project types. This approach is a weak solution to the problem of pricing carbon because each token will trade at a different price based on project quality and not the value of a ton of carbon. While these tokens remove some administrative barriers for purchasers they do little to address the need for a uniform price for carbon credits or to simplify the market for consumers.
The next generation of carbon tokens will have to address these structural problems with offsets carbon credits. Current, first generation carbon-crypto offerings have demonstrated the market interest in finding a solution to the limitations of current carbon credit markets. Now carbon-crypto strategies will have to find new solutions to price carbon and avoid simply transferring to the blockchain the lack of transparency, complexity and market abuse experienced in the carbon offset markets.
