Much 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 carbon credit be used across the chain to scale up 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. First, they can connect directly to decentralized financial services. They can also be the most important asset within the regenerative finance (ReFi) ecosystem, acting as a kind of “gold standard” for ReFi currencies and other economic activities.
For concrete examples, we can look at other real-world assets in the chain, such as real estate, bonds and art, to understand what is possible with Web3 beyond basic transaction facilitation. Things like collateral, cash flow financing and offering retail investment vehicles are the types of activities that can achieve the scale of climate impact we need in the fight against climate change.
Access to short-term loans
One of the big hopes of a Web3-powered carbon market is a more consistent pricing framework for carbon credits. With this framework, along with the fact that credits retain their value for about a year, on-chain carbon credits will become an asset that can be used as collateral for decentralized finance (DeFi) protocols. This is important for projects as they can access short-term loans as a way to ensure consistent cash flow while they look for a buyer or wait for confirmation of a sale.
Web3 Carbon Marketplaces could implement this feature directly as a way to build trust between lenders, projects and buyers. You can imagine a scenario where smart escrow contracts are used to facilitate the sale of carbon credits and automate loan repayment.
Project ‘pre-financing’
One of the challenges facing carbon offset project developers is securing the financing to get their projects up and running. The delay between the start of the project and the first income from carbon credits is the main reason for this. It can take two to three years for actual credits to be issued, causing significant cash flow problems.
A solution already being adopted by project developers for carbon offsets is to sell a portion of the estimated carbon credits as discounted future carbon credits. In other words, the project estimates that it will issue 10,000 credits in two years and then sell a certain percentage in the form of forwards. The remaining part takes the delivery risk into account.
While this specific process can be performed off-chain, issuing term credits on-chain opens up a wealth of possibilities regarding the pre-financing of projects. 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 take ownership of the credits upon issuance and can withdraw or resell them as desired. Both are effective ways for carbon offset project developers to obtain the necessary capital.
Expand investment opportunities
Carbon credits have not traditionally been seen as an investment tool, and rightly so. First, they are designed to be discontinued immediately after purchase, so buyers can offset their carbon emissions. Carbon credits also tend to depreciate in value over time. For example, a 2021 vintage issued in 2023 will be most valuable in 2023 and lose value in each subsequent year. On-chain lending is unlikely to change this dynamic as we still want the buy-and-retire model to prevail.
However, that doesn’t mean investors will be left out of the tokenization equation. On the contrary, on-chain credits and term credits will allow investors to participate to a much greater extent in pre-financing projects and providing liquidity for loans. Private investors in particular can participate in decentralized autonomous organizations that pre-finance carbon offset projects and benefit from the difference between the updated forward price and the sales price of the credit issued.
Incentives shift to sustainability
Regenerative finance aims to create a shift from our existing profit-oriented financial system to one that prioritizes environmental and social renewal. Web3 solutions and philosophies support these goals by making things like universal basic income, cultural conservation, and climate asset management much more efficient and accessible.
Part of the ReFi approach is developing financial instruments and climate resources that make new incentive frameworks possible. On-chain credits play an important role here, as they are currently the most widely recognized and accepted climate tool. For example, they can be used as collateral for a stablecoin or even as a means of payment in themselves. On a large scale, such a concept would provide companies and governments with the necessary incentives to choose regeneration over exploitation.
What we know for sure is that Web3-powered carbon credit markets are just the first step toward a bigger goal. It will take a lot of innovation and experimentation to get where we need to be, but early signs are starting to show the power of carbon credits across the chain as a means to increase climate impact. The next step is to ensure that carbon offset projects pursuing the same goals receive the funding and support they need to foster the next generation of climate advocates.