What exactly are carbon tokens?

In this short piece, we will examine carbon tokens: a tool of increasing relevance in the battle to address climate change.

How are carbon instruments typically structured and traded?

In the fight to address climate change, businesses and individuals have choices and tools to consider. Companies, for example, are increasingly identifying ways to reduce their carbon dioxide (CO₂) footprint. For example, this can be accomplished by adopting cleaner fuels, identifying technologies that may store or sequester CO₂ emissions and changing manufacturing processes.

Carbon trading is another tool available to businesses. The purchase and sale of carbon attributes play an important role in a diversified toolkit available to companies to address their climate change goals and obligations. Market participants use instruments, units or allowances (howsoever described) to provide a means to address climate risks and exposures that such participants face. Carbon trading is, in brief, the use of market instruments to transfer exposure to CO₂ emissions and involves the purchase and sale of certified and transferable instruments representing a reduction in greenhouse gas (GHG) emissions, such as CO₂.

Commonly traded instruments include allowances and carbon credits. Under a cap-and-trade scheme, allowances are issued by governments permitting the permit holder to emit one tonne of CO₂ (or equivalent amount of other GHGs).  If a holder of an allowance emits less than the relevant GHG emissions limit applicable to such holder’s business, the allowances can be stored for future use or traded to businesses that need to procure additional allowances to meet their compliance obligations under the regulations. On the other hand, a carbon credit is a contractual unit or certificate representing the reduction of one metric tonne of CO₂ generated by an emissions reduction project, including, for example, afforestation or solar projects. Carbon credits can, like allowances, be traded or held for future use. The ability to benefit from obtaining more allowances or credits than the holder needs in any reporting or compliance period can be monetized and provides an investment opportunity to such holder. Similarly, business owners and managers can obtain allowances and credits from other holders to address their emissions obligations.

Each party to a purchase and sale transaction of carbon attributes has completed an internal calculation based on known facts around the market for carbon instruments, the trajectory for the price of carbon and their own situation. This ‘business calculus’ conducted by business owners and managers is then multiplied many times over and the end result is a market for the purchase and sale of carbon attributes which, in aggregate, places a price on carbon and creates signals to impact business behavior.

The market for carbon and emissions trading is generally bifurcated into the compliance market – where entities required by law to do so can meet the mandated emissions limit – and voluntary market. In Canada, the compliance market is governed both federally and provincially. The voluntary market is where businesses and individuals participate to offset their CO₂ footprint on a voluntary basis. Accordingly, carbon pricing in the voluntary market is not determined by regulators, but by market forces. With growing corporate and international climate action commitments and increased governmental regulation surrounding decarbonisation, the price of carbon is increasing and attractive investment opportunities have arisen in the carbon markets.

Yet, the market for carbon attributes is often viewed as opaque. Some skeptics question the authenticity of instruments backed by carbon attributes. Is the GHG reduction underlying the traded carbon attribute real? The tokenization of CO₂, as will be discussed in the following sections, provides a means to address some of the criticism using blockchain technology.

What are carbon tokens and how do they work?

As the voluntary carbon market continues to scale rapidly, carbon credits have been tokenized to allow for their more efficient, reliable and accurate handling and tracking.

A token is a digital asset governed by a smart contract on a blockchain network. Tokens can represent shares or securities (security tokens); the right to participate in a community or to access specific goods or services (utility tokens); commodities (currencies); uniquely identifiable, authenticated assets (non-fungible tokens); and more. The creation of a token to represent one of these rights or assets is called “tokenization”.

The tokenization of carbon credits works as follows. When one tonne of CO₂ (or more precisely, the reduction in emission of one such tonne) is captured, stored and measured, and those measurements have been verified by a validating party, a corresponding token is minted on a blockchain to represent it. A carbon token could be a non-fungible token (or NFT) – if the token represents “one, unique tonne” of captured CO₂ that is associated with a particular place and time and is therefore distinguishable from other tokens – or it may be a fungible representation of “a tonne” of CO₂.

Once minted, the tokens are made available for purchase. Their value comes directly from general market forces relating to the value of carbon capture and credits. Once purchased, a carbon token may be “burned” by the owner to offset their own CO₂ emissions or transferred to a new token holder in the same way any other token is transferred. The validity of the token is tracked and verifiable on the blockchain over the course of its life and as it moves between holders.

What problems or issues does the tokenization of carbon instruments seek to address?

Together, the tokenization of carbon instruments and the implementation of blockchain in emissions trading may provide solutions to existing perceived deficiencies with carbon accounting. First, with the ability to link each carbon credit on the blockchain to metadata containing information on the credit’s origin, quality, and specific emissions reductions, blockchain will help to accurately quantify for purchasers the reductions represented by each carbon credit. Second, since a carbon token is tracked and verifiable on the blockchain over the course of its life, information on whether the token has been burned and no longer usable will not only be made transparent, but will also help prevent the double counting of emissions reductions. Third, transacting carbon credits using blockchain, a publicly available ledger, will promote and protect the unique ownership of tokens as the transfer of legal ownership of carbon credits will be made more publicly traceable and auditable.

In our view, the tokenization of carbon instruments represents the logical and much needed convergence between emerging digital technology and the fight to address climate change using market instruments.

In this introductory piece, we have shared some preliminary thoughts on the tokenization of carbon instruments. We look forward to continuing to follow this development and will share information about those developments. Stay tuned for future posts from us on the topic of carbon instruments and blockchain technology.

Learn more about our services in Structured Finance & Securitization and Blockchain, Cryptocurrency and Smart Contracts, or reach out to a member of our team if you have any questions.

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