Tokenization of carbon credits — an explainer
Tokenized carbon is the digital representation of real-world carbon credits on the blockchain. We explain how tokenization works, look at risks, benefits, and the potential of this novel technology for climate solutions
A quick summary📜
Tokenized carbon is the digital representation of real-world carbon credits on the blockchain. How exactly does tokenization work, what are the risks and benefits, and what potential does this process hold to finance better climate solutions? We'll dive in!
Read on or jump to the section you're most interested in 👇
- What exactly does "tokenization" mean?
- What happens when you tokenize carbon credits?
- How are carbon tokens different from cryptocurrencies?
- How can carbon credit tokenization help the VCM?
- Common concerns about tokenized carbon credits
- Carbon credit tokenization — introducing different models
- Which unique utility do tokenized carbon credits provide
- Conclusion
What exactly does "tokenization" mean?
Tokenization is the act of creating a digital representation of assets on the blockchain — essentially, a real-world “paper” certificate of some sort is transformed into an entry on a public and digital ledger.
To understand why this is relevant, and how blockchains can help scale our carbon markets, we need to take a step back and look at what makes this technology so special. The concept of blockchains was first introduced in 2008 by a pseudonymous entity named Satoshi Nakamoto. Nakamoto’s Bitcoin whitepaper described public ledgers that were distributed among all the participants of a network, and frequently updated based on a decentralized consensus protocol. The result: a tamper-proof, secure, and publicly verifiable database that anyone can read from or add to.
Smart contracts explained
As blockchain technology evolved, new blockchains like Ethereum were developed with additional functionality. Many of these chains support "smart contracts" which are essentially small computer programs that are stored and run on the blockchain network, drawing from the information that is stored on the blockchain. Everyone can expand on or build on top of existing smart contracts — they are like building blocks, and that's why they can unlock innovation at scale. A growing, global community of developers is working on a wide range of new blockchain applications for every industry and aspect of life, from art collection and financial systems to logistics and exclusive memberships.
Smart contracts matter for tokenization, because a blockchain-based token essentially consists of a set of smart contracts, has its functionality coded in, and can be programmed to behave in various ways.
What can be tokenized?
Many different things! Here are some common examples:
Real-world currencies
Tokenized currencies are known as stablecoins. They are backed by real money, and pegged in value to a specific currency. Popular stablecoins like USDC and DAI are programmed to be always worth 1 dollar.
Artwork
Works of art can be tokenized, and information about a pieces' characteristics and owner is stored as an entry on the blockchain. This has many advantages, for example that artists or the owners of artwork could sell directly to the public, without middlemen playing any role. One high-profile example is Picasso’s Fillette au béret, which was recently tokenized and sold for $3.68 million.
Real estate
Pilot projects that tokenized real estate spaces were tested out in the United Arab Emirates (UAE), Japan and France.
What happens when you tokenize carbon credits?
Tokenization of carbon credits means that the carbon credits’ information and functionality are moved onto a blockchain, where the carbon credit is represented as a token. Or the carbon credit can be issued natively on-chain, with all attached attributes publicly visible. One carbon credit equals one carbon token.
Background knowledge: What are carbon markets?
Carbon markets empower corporations and countries to fulfil their climate commitments based on voluntary pledges, or in line with the emission reduction targets set by the government. Market participants can purchase and retire carbon credits to compensate for unavoidable emissions, or add climate investments to their balance sheet. Individuals can choose to participate in carbon markets as well, for example by offsetting their personal emission footprint — although this process currently requires going through a third party with access to a carbon registry account.
Carbon markets exist in two different forms: Compliance markets are regulated by governments and are mainly concerned with regulating and limiting emission allowances that can be traded within the regulated market (cap'n'trade). This means that the government sets a cap or limit on how much industries and companies are allowed to pollute. If an organization exceeds their emissions' allowance, they can buy carbon credits to compensate for these additional emissions. If they are below the allowance, credits can be sold to other organizations.
The voluntary carbon market (VCM), on the other hand, targets the private sector. At the moment, it's not very regulated, and anyone can choose to participate in the VCM to fund climate solutions. Companies can purchase carbon credits to meet their sustainability goals beyond the level that's required by the government. Various registries and standards bodies issue carbon credits and govern the VCM, but it is still a fragmented and opaque space.
Overall, carbon markets play a key role in financing climate solutions, but to reach their potential, they need to become more streamlined, open, and cost-efficient.
Credits can be transferred onto the blockchain via “Carbon Bridges” which are connected to traditional registries like Verra and Gold Standard. Once bridged, carbon tokens can be sold, transferred or retired, or they can be held in safe on-chain accounts.
Who can tokenize carbon credits?
Everyone who owns credits in a registry that’s connected to a Web3 registry! All you need is an account on the carbon registry, and a wallet on the blockchain. Your carbon credits don’t change ownership when they are tokenized.
How are carbon tokens different from cryptotokens?
Cryptocurrencies and cryptotokens come in many different forms and can serve various purposes. Usually, cryptocurrencies are mainly used as a form of storing homogeneous value, denominated in a single measurement. Tokens, on the other hand, can have multiple aspects (utility, data storage, payment, etc). Carbon tokens for example represent a real-world asset, while other cryptotokens give holders utility or governance rights in a Web3 protocol; again others play a similar role to shares in Web3 companies. Cryptotokens could also grant holders access to specific platforms, or be of purely speculative nature. Even artworks that are sold as NFTs are tokens (the name “non-fungible token” indicates this).
The purpose and backing of a token can influence how much it fluctuates in price, if and where it is sold, and how it is used. Additionally, things like utility, the community of holders, monetary policy, governance rights, market capitalization, exchange liquidity, context in the crypto markets and broader economy all have an impact on token prices. For example, if a token is of more speculative nature and doesn’t have real utility, its price will likely fluctuate more than one with a clear use case. Tokens backed by real-world assets tend to swing back to roughly the price of their off-chain counterpart, if they can be efficiently de-tokenized.
Fungible and non-fungible crypto tokens
A key differentiator is if a token is fungible (there are many that are exactly the same) or non-fungible (it’s unique and can’t be replicated). Real world currencies are a good example for fungibility: One dollar equals exactly the same value and functionality as another dollar. Your plane ticket to Hawaii, on the other hand, is non-fungible: It has your name and seat number on it, and in that way, it is unique and cannot just be exchanged for the ticket of another passenger.
The question of fungibility or non-fungibility is especially interesting when we look at carbon credits, which do come from many different vintages, projects and methodologies — only credits generated from the same project and vintage are fungible, but credits issued in different years, or developed with different methodologies, are not. A good comparison to this is real estate. Houses usually have some similarities: A roof, different rooms, windows; but they also differ from each other in terms of neighborhood, square meters, overall condition, and special features like a south-facing balcony or big backyard. People will pay different prices for different houses, based on the market value, but also on their personal needs and preferences. The same is true for carbon credits: They all carry an environmental impact claim, but credit buyers will pay vastly different prices, based on a number of attributes, like country of origin, methodology, project type and year of verification. Prices per credit range anywhere from less than $1 to $1000 or more.
Exploring different types of fungible and non-fungible tokens
Fungible tokens
- Security tokens: A security in traditional finance represents proof of ownership or stake in government bonds, private companies and other legal entities in the form of stocks, bonds and debentures. Security tokens are essentially the blockchain-native version of this. They represent ownership of a stake in a Web3 organization, or in tokenized real world assets — this could be fractionalized real estate, where a property is tokenized into a large number of fungible shares.
- Transactional/payment tokens: These represent units of account which function like real-world currencies. Bitcoin and stablecoins like USDC are good examples for payment tokens.
- Utility tokens: Utility tokens help users access the services of a specific Web3 application, and serve ecosystem-specific use-cases. Binance’s BNB tokens, for example, can be used to access exclusive token sales, trades at a reduced price, and more.
- Governance tokens: Governance tokens give users the right to vote, and propose changes to the day-to-day operations of decentralized protocols, as well as larger decisions, such as capital allocation. CRV, for example, is the token that powers the Curve exchange.
Non-fungible tokens
NFTs are a category of tokens with a wide range of applications, and they often offer some form of utility. You might be familiar with NFT art collections, like Cryptopunks or Bored Apes, but a NFT can also represent ownership in physical assets like rental agreements, or be proof of participation in a certain event. The NFT holder might enjoy exclusive membership benefits or gated access to real-world experiences, like music concerts. If they choose to sell their NFT, these benefits can be reaped by the new holder, without the need to file any information or make a name change. Many applications could be tokenized using NFTs.
How can carbon credit tokenization help the VCM?
When credits are tokenized, they can be listed for sale and be bought and retired by anyone with a crypto wallet (at the moment, that’s roughly 1 billion people, but this number is rapidly increasing). This is in stark contrast to the traditional VCM set-up, where carbon credits are for the most part only accessibly to those with access to brokers or traders, and purchased by corporations. Tokenization also brings a level of efficiency and transparency to the VCM that previously didn’t exist.
Efficiency & Disintermediation
Blockchain systems shift the role of intermediaries to more specialized, value-adding services. Sellers and buyers can interact directly, which makes for faster and cheaper transactions. Fraud risk is also reduced, as it’s not needed to trust a third party. It’s important to note though that middlemen or brokers in the current VCM often play the important role of educating buyers, curating carbon credits, and retiring them on behalf of the purchaser. But they often take large fees for their services, buy credits from developing nations on the cheap and sell them at an inflated price — sometimes three times the original value, a recent report highlighted.
Healthier and more open markets
Tokenized carbon ensures more efficient markets. There is less counterparty risk. Trades are settled instantly, and everyone can purchase or sell carbon credits, without the need to first set up an account or get registered and approved. Even retirements happen in minutes instead of months.
Liquid marketplaces
Blockchains help create deep liquidity for carbon markets, which have always been very “illiquid”. Liquidity refers to how easy an asset can be traded to cash. Unique goods are usually less liquid than fungible ones — for example, it will take longer to sell a Picasso painting than a kilo of rice. With blockchain technology, we can aggregate — or pool — carbon credits with similar attributes, thus creating more liquidity and allowing the market to define a fair price for the asset.
Price discovery
Tokenized credits enable better price discovery. Instead of opaque over-the-counter (OTC) trades, all transactions and prices paid are publicly visible on a blockchain ledger. Additionally, the more liquid a good is, the better the price discovery!
Eliminate double counting
Blockchains with their public ledgers make double-counting claims easy to spot. Double-counting refers to different sustainability claims that are simultaneously levied on the same carbon credit, and it happens a lot in the VCM.
New sources of demand
Tokenized credits can be integrated into decentralized finance protocols, virtual experiences and blockchain-based games. This creates a whole host of new demand sources, and incentivizes projects on the ground to satisfy this increased demand. There are many different ways to leverage tokenized carbon credits: They could, for example, be staked for yield or used as collateral in decentralized lending and borrowing protocols. We’ll dive more into this towards the end of the piece.
How carbon credits are generated
Everyone who is taking actions that remove or avoid emissions — for example conserving a forest — can apply to get carbon credits issued. For this, they’ll need to go to a standards body like Verra or Gold Standard. They then need to develop a detailed project design document (PDD) with estimates of carbon avoidance/reduction over time, and a solid business plan. The carbon standard screens the PDD, and an approved third-party auditor checks it as well — this party is called the validation and verification body (VVB). If the PDD meets the standard’s requirements, the project is validated for a certain number of carbon credits. Project development is, by then, in full swing. Once the actual emissions reduction/avoidance has occurred, a batch of carbon credits — each with its own serial number — is issued, with regular checks (so called performance verifications) conducted by the VVBs.
The project owner can now sell their credits to a carbon broker, or they can bridge them on-chain and sell them directly to interested end-users, pool them and use them in the ever-growing ecosystem of decentralized finance.
Average time elapsed before the developer can secure funding: 1-2 years
Average time from project inception to credit issuance: 3-5 years
Average cost to get the first project certification: $50-100k
Better financing for developers
Blockchain systems can help ensure better financing for developers. As we explored earlier, sourcing credits is a lengthy, expensive and uncertain process. This makes financing really hard to come by. Developers can enter into pre-purchase agreements, where buyers agree to purchase the credits ahead of the project development. However, such contracts are not standardized and there is limited pricing data. This makes it challenging for buyers to know whether they are paying a fair price, and for the supply side to manage the risk of credits remaining unsold. Developers are often forced to offer their credits at a discount, to make up for the risks involved for the counterparty. Tokenization can help bring pre-purchase agreements onto a public ledger, and generate good pricing data and signals. This will give carbon projects more clarity on pricing.
Fractionalization
Tokenized carbon credits can be ‘fractionalized’ into units that are smaller than 1 metric tonne — like a currency. This benefits small-scale carbon projects, who could issue credits on smaller plots of land with significantly lower costs. For example, carbon credit development on a 5ha forest nets around like 30-50 tonnes of carbon credits per year, but measurements would cost around 50k USD. On the other hand, purchasing, selling and retiring carbon credits becomes more accessible. The retail and transportation industries also have a growing need for sub-tonne carbon credits, for example to offset exactly the right amount of carbon for the production of a single t-shirt or flight.
Common concerns about tokenized carbon credits
Now, let's address some of the common misconceptions about tokenization of carbon credits!
Tokenization is a passing fad and has no long-term relevance in the future of the carbon market
There is consensus among all stakeholders that tokenization will be key to the future of our carbon markets. Throughout 2022, Verra and Gold Standard held prolonged consultations on how to leverage blockchain technology in their registries. The International Emissions Trading Association (IETA) announced guiding principles on tokenization. The World Economic Forum (WEF) launched a crypto sustainability forum (Toucan is leading the working group Web3 for climate impact). And World Bank-affiliate International Financial Corp openly backed the role of blockchain-powered platforms in scaling carbon markets.
Tokenization in general has not benefitted any industry so far
Studies have shown that blockchain technology has already made a significant impact on how money flows. Tokenization is helping the financial industry unlock trillions of euros in illiquid assets, and vastly increases the volumes of carbon trades, making them more accessible to everyone.
Tokenized carbon credits are low quality
Tokenized credits can be of different qualities, just like conventional carbon credits. There will be high integrity credits, as well as credits with a lower environmental impact. But thanks to smart contracts, it is possible to block certain credits from being tokenized. How this will be implemented in the future remains to be seen, and governance and decision-making will likely be shared by experts and standards bodies. One key benefit of blockchain-based carbon ledgers is the transparency they offer: Everyone can independently verify the quality of the credits they hold.
Tokenized carbon credits invite the possibility of scams
Some stakeholders are afraid that tokenized carbon credits could be used by bad actors to trick buyers into purchasing low-integrity credits, or carbon tokens could be used to make false offsetting claims. The opposite is true: Because all information about a tokenized carbon credit can be publicly traced and verified, scams or false quality claims can be exposed by everyone — journalists, individuals, or companies. All that’s needed to check a carbon credit on the blockchain is access to the internet.
Non-additional credits get a second lease of life
Another major criticism is that tokenization gives a second lease of life to ‘non-additional’ credits which are otherwise ignored by the market. Additionality means that a carbon credit only exists because of the incentives associated with the carbon price. Otherwise, no emissions reduction would have taken place. For example, if a conservation project protects a forest which was in no danger of destruction in the first place, the credits are ‘non-additional’.
Non-additional credits are generally viewed as having low to no environmental impact. On a public ledger, non-additional credits can be identified and filtered, and tokenization can create a data trail all the way to the origin of the credit. Each carbon credit is linked to data related to its source and different characteristics, and all the data is publicly visible.
Crypto consumes a lot of energy and therefore is bad for the climate
Bitcoin is the largest blockchain network, and it is associated with a very high energy usage. This is true — its high energy consumption is part of why it is so secure. The Bitcoin network relies on a process called Proof of Work (PoW) to add blocks of data to its chain. This involves computers working in competition to solve a difficult mathematical puzzle, a process known as mining.
But on the contrary, other blockchains are extremely energy-efficient. Ethereum, for example, is the second biggest blockchain network. It recently moved to a Proof of Stake mechanism and now only consumes a small fraction of the energy of networks like Bitcoin.
Carbon credit tokenization — introducing different models
Custodial bridges
If you’d like to tokenize carbon credits via this model, you allow the tokenizer (a third-party bridge operator) to lock up your credits, so they can’t be sold or moved. They then issue digital representations of your credits on-chain. The name indicates the caveat: All carbon credits are ‘custodied’ by a centralized party while they are traded on-chain. The carbon bridge operator can be a credit registry or a third-party bridging provider.
If you want to turn carbon tokens back to conventional carbon credits, you need to require that the entity destroys the on-chain representation of your credits, and distributes the original credits back to you.
A similar thing happens if you want to retire tokenized carbon credits: You file your claim with the tokenizer, who then requests the retirement with the standards body and renders the on-chain version of the credit void.
Note that the main “source of truth” and control over the carbon credit in the custodial model remains with the carbon credit registry and the tokenizer.
A major disadvantage of this model is that it requires trust in a centralized entity — something that can create opportunities for fraud.
Another disadvantage is a waiting period while a retirement is settled on the source registry. This introduces friction & the chance of transaction reversals that is avoided if the full functionality of a credit is transferred on-chain.
Custodial models should be automated as much as possible. The more we can rely on software instead of people, the less room is there for human error. More automated models also reduce to what degree the credit holder needs to trust the bridging provider.
Non-custodial bridges
Here, the carbon credit owner moves their credits autonomously out of the source registry and into the Web3 registry. They don’t need to trust anyone to tokenize credits on their behalf, as they are using independent software infrastructure. And the complete process of credit tokenization is transparently visible to the public.
Retirements can also happen on-chain. Again, the credit holder can perform the retirement action on their own, and share the transaction details as proof with anyone they like.
This model renders trusting a third party unnecessary, and the “source of truth” of the credit is moved to the blockchain.
Native issuance
A third way to tokenize carbon credits is to issue them directly on chain (natively), instead of first giving out conventional credits that then can be tokenized. This is a clean way for a carbon credit registry to have a single source of truth for their credits directly on the blockchain, where information cannot be altered, only updated. The challenging part though is to avoid fragmentation — ideally, credits that come on-chain via carbon bridges and credits that are issued natively are interoperable and follow the same data standards.
Can carbon credit tokenization be reversed?
Yes, that is possible! It requires a ‘two-way’ bridge where credits flow freely between the blockchain and the conventional worlds. Credits which have been tokenized can be easily brought back to the registry of the standard. In order to avoid double-counting or selling credits that have been moved to an on-chain registry, they have to be marked as “blocked” in the source registry. At any given point of time, a credit can exist in a tradeable form either on paper or as a carbon token.
If the bridging process is handled programmatically — which Toucan Protocol always advocates for — both models function the same way: Credits that were immobilized for tokenization get re-mobilized. Simultaneously, the corresponding tokens get destroyed, so it's always ensured that the environmental benefit only exists in one place, on- or off-chain.
If the custodial account is operated manually (by people instead of software), the detokenization happens via a request from the token holder to the custodian who conducts the process. They make sure the corresponding tokens have been destroyed before giving back the credits in the source registry.
For non-custodial bridges, the credit holder can independently de-tokenize credits the same way they tokenized them, via the Carbon Bridge, without filing any claims or making requests.
Two-way bridges are key for efficient carbon markets.
- Credit owners feel more comfortable moving their assets on-chain, as the tokenization process is reversible.
- Tokenized carbon credits and conventional credits can trade at differing prices. In the bidirectional model, any price discrepancy can be ‘arbitraged’, and arbitraging opportunities lead to an increased trading volume, faster price discovery, and ultimately quicker mass-adoption.
Who controls which credits are bridged onto the blockchain?
Carbon bridges can run on manual or programmatic systems.
A manual system requires a human operator throughout or at certain stages of the process. It might, for example, be necessary to manually cross-check every batch of carbon credits with recordings in the source-registry, or to manually mark credits as retired.
A programmatic system, on the other hand, is powered by software. All actions are performed automatically, and no human eye or hand is needed.
ELI5 on custodial and non-custodial bridges
To make the concept of different bridging models easier to understand, let’s draw the comparison to some real-world examples.
Imagine you have $20, with which you’d like to buy fresh vegetables. There are different options. You can go to a nearby farmers market and purchase the vegetables yourself, directly from the farmer. In this case, you are personally and independently giving your $20 to the seller. The produce market is the infrastructure you’re using: They aren’t responsible for the quality of vegetables, but they are renting the space, doing the marketing, and giving slots out to interested sellers. This scenario is comparable to a non-custodial bridge: There is no middleman between you and the farmer; you are in control of your money and the vegetables, and you don’t need to trust anyone to execute any transactions for you.
Or you can hand over the $20 to a friend and ask them to purchase the vegetables for you. Here, you don’t know how much money your friend actually spent at the market, if they received any change, or if they just went and bought produce from the closest supermarket. This is the custodial bridging scenario, which requires trust in an intermediary.
Which utility do tokenized carbon credits provide?
Tokenized carbon credits can traded or utilized in decentralized finance (DeFi) applications, blockchain-based games, virtual experiences and more. Certain actions, like automatic carbon credit retirements or a stream of money back to the credit developer, could also be programmed in and executed when certain transactions happen.
Royalties for project developers
Tokenization allows us to hard-code certain conditions or actions into transactions. This opens up many new possibilities: For example, we could program royalties into each carbon credit. Whenever that credit would be traded, a portion of the value could verifiably flow back to the project originator. It’s also possible to hard-code distribution of value to many stakeholders at once.
Royalties are a very powerful tool for project financing: In the conventional carbon credit market, once a credit is sold, the developer typically won’t profit from any further trades or price appreciation. But with royalties, they could continuously receive a share of the credit value, which further incentivizes climate action. Royalties could also be embedded in bridging, redemption or retirement fees.
Forward-financed carbon tokens
It becomes a lot easier to sell tokenized future credits, as interested parties — individuals or corporations — could buy “future carbon tokens” directly from the project developer, with negligible fees. These future tokens could again have certain conditions programmed in; for example, a project developer would have to deliver in a certain amount of time, or the contract would automatically be rendered void. This process is already happening with conventional credits: Once a project is registered, developers can approach a bank to borrow money against future credits. But this is costly, slow, and not everyone is able to access financing.
Generating revenue on carbon credits
Tokenized carbon credits can flow into decentralized finance (DeFi) applications. You could, for example, earn yield (generating returns on a financial investment) on carbon, or use it as collateral to borrow against.
Carbon as a treasury asset
Protocols (those are organizations or applications that are run by computer programs instead of people) could add carbon credits to their treasury, in order to diversify their balance sheet. This could be an efficient risk-management tool, hedging against the volatility of many other cryptocurrencies which are traditionally held in protocol treasuries.
Gamifying carbon credits
Blockchain-powered games and virtual experiences could use carbon credits as green in-game assets. The market opportunity here is huge: Blockchain gaming has recently seen $6 million in daily volume. One example for green metaverse experiences is the project Atlantis World — a social metaverse where everyone can plant virtual trees by retiring real carbon credits.
Conclusion
Tokenized carbon credits can play a key role in making carbon markets more transparent, open, and efficient.
They unlock a host of new use cases, and thanks to the unbridled innovation happening in the Web3 space, new utility can be added by everyone, from anywhere in the world. Blockchain-based carbon registries provide a level of transparency that is much needed. And by opening up carbon markets to everyone with an internet connection and a crypto account, a new stream of financing is redirected to projects on the ground.
But it is obvious that a close cooperation between bridging infrastructure providers, natively issuing registries, standards bodies and existing stakeholders is needed. Only together can we scale our carbon markets in a safe way, and, by doing so, speed up mass-adoption.
It's also key to adopt and maintain an agile approach to ensure compliance and draw from the knowledge of other players in the space. With all these factors considered, we can leverage blockchains to their full potential in building the best vehicles to finance climate solutions.
Toucan is building the technology to bring the world's supply of carbon credits onto energy-efficient blockchains and turn them into tokens that anyone can use. This paves the way for a more efficient and scalable global carbon market.