A lot has been said about the potential of blockchain and other Web3 solutions to transform carbon credit markets by ushering in a new era of transparency, fraud protection and disintermediation. What hasn’t been talked about enough are the fruits of this transformation. More specifically, how can the on-chain carbon credit be used to scale the pace of climate impact?
Make no mistake, on-chain carbon credits have so much more potential than simply being a better mechanism for the “buy and retire” process we have now. For one, they can plug directly into decentralized financial services. They can also be the primary asset within the regenerative finance (ReFi) ecosystem, acting as a sort of “gold standard” for ReFi currencies and other economic activity.
For concrete examples, we can look to other on-chain real-world assets, such as real estate, bonds and art, to understand what’s possible with Web3 beyond basic transaction facilitation. Things like collateralization, cash flow financing and providing retail investment instruments are the kinds of activities that can achieve the kind of climate impact scale we need in the fight against climate change.
Access to short-term loans
One of the great hopes of a Web3-powered carbon market is a more consistent pricing framework for carbon credits. With this framework in place, along with the fact that credits hold their value for about a year, on-chain carbon credits will become an asset that can be used as collateral on decentralized finance (DeFi) protocols. This is important for projects because they can get access to short-term loans as a way of ensuring consistent cash flow while they search for a buyer or await confirmation of a sale.
Web3 carbon marketplaces could implement this feature directly as a way of building trust between lenders, projects and buyers. You can imagine a scenario in which escrow smart contracts are utilized to facilitate the sale of carbon credits and automate repayment of the loan.
Project ‘pre-financing’
One of the challenges that carbon offset project developers face is securing the financing to get their projects up and running. The lag between project initiation and the first revenue from carbon credits is the primary reason for this. It can take two to three years for actual credits to be issued, leading to significant cash flow issues.
A solution already employed by carbon offset project developers is to sell a portion of estimated carbon credits as discounted forward carbon credits. In other words, the project estimates that it will issue 10,000 credits in two years and then sells some percentage as forwards. The remaining portion helps account for delivery risk.
While this specific process can be done off-chain, issuing forward credits on-chain opens up a wealth of possibilities with respect to project pre-financing. As with the on-chain credits themselves, on-chain forwards can be used as collateral. But they can also be sold directly to buyers, who will then take ownership of the credits upon issuance and can retire or resell them as desired. Both are effective ways for carbon offset project developers to get the upfront capital they need.
Expanding investment opportunities
Carbon credits have not traditionally been seen as an investment instrument, and rightfully so. For one, they are designed to be retired immediately upon purchase so that buyers can offset their carbon emissions. Carbon credits also have the tendency to decline in value over time. A 2021 vintage issued in 2023, for example, will be most valuable in 2023 and lose value in each subsequent year. On-chain credits are unlikely to change this dynamic because we still want the buy-and-retire model to prevail.
That doesn’t mean investors will be left out of the tokenization equation, however. On the contrary, on-chain credits and forward credits will allow investors to participate to a much greater degree in pre-financing projects and providing liquidity for loans. Retail investors, in particular, can participate in decentralized autonomous organizations that pre-finance carbon offset projects and profit off the difference between the discounted forward price and the sale price of the issued credit.
Shifting incentives toward sustainability
Regenerative finance aims to engineer a shift away from our existing profit-driven financial system and toward a system that prioritizes ecological and societal regeneration. Web3 solutions and philosophies underpin these goals by making things like universal basic income, cultural preservation, and climate asset management a lot more efficient and accessible.
Part of the ReFi approach is developing financial instruments and climate assets that empower new incentive frameworks. On-chain credits have an important role to play here because they are currently the most widely recognized and accepted climate asset. They could, for example, be used as collateral for a stablecoin or even as currency in their own right. At scale, such a concept would provide the needed incentives for companies and governments to choose regeneration over-exploitation.
What we know for certain is that Web3-powered carbon credit markets are only the first step toward a larger goal. Much innovation and experimentation are needed to get where we need to be, but the initial signals are beginning to demonstrate the power of on-chain carbon credits as a means to scale climate impact. The next step is ensuring that the carbon offset projects working toward these same goals have the funding and support they need to incentivize the next generation of climate defenders.
