CryptoCarbon's Crisis: A Tale of the Catastrophic Crash of Crypto-backed Carbon
Summary of Position on Carbon Markets
As a follow on to my previous article on the complexity of the carbon markets, I wanted to elaborate on the concern I see with the trending CryptoCarbon movement.
Let’s first establish that carbon markets are complex, and cryptocurrency is complex. Meaning that CryptoCarbon is like, complex squared. Naturally, there will be huge challenges.
But if you had a scroll through my carbon article, I assume we’re on the same page that offsets are in need of a facelift. By no means do I mean to debase them as a possible climate solution, in fact, I think, if designed effectively — meaning, policed prudently or built entirely transparently — they could offer exactly the opportunity we need to redistribute capital to accelerate our climate commitments.
The challenge is, most people don’t truly understand the nuances of this controversial and complicated ecosystem, leaving them exposed to repeating history over again. Only this time, using more sophisticated technologies with far more acute pain-points.
So from what I can see, much of the crypto-community has either failed to comprehend the carbon complexity, or not bothered to care. Either way, we’ve seen a catastrophic crash in the 12 months since this movement began in earnest, and it’s not the blame of the #CryptoWinter or the crash of #Luna. It is entirely due to a misunderstanding of the intricacies of market-based mechanisms, and a failure to model appropriately for the (predictable) game theoretic consequences.
So Where are We Now?
There seems to be a never-ending stream of “green” cryptocurrency projects, all out-marketing each other at the expense of the climate.
Heralding the promises of a “trust-less” technology, blockchain has been advertised as the salvation of carbon. Public transaction records and transparent pricing would be available for the first time, and crypto would clean up a messy market. Human-proofing carbon with smart contracts executing trades and satellites proving the impact. No middlemen, no fees, no rug pulls. The seductive narrative galvanized a crusade of Web3 enthusiasts for the ‘cryptocarbon revolution’.
For those who are going gangbusters about blockchain’s promises of data integrity, transparency and decentralization, I am all for your enthusiasm. It’s a freaking historic technology and is irrefutably going to change the world. BUT, when tokenizing real-world assets, like marriage licenses, land titles, diamond certifications or…carbon offsets…blockchain’s shining features are vulnerable to the shortcomings of the underlying asset. Ever heard the term, ‘garbage in, garbage out’? In software development, it basically translates to: irrespective of how accurate a program's logic is, the results will be incorrect if the input is invalid. Infallible data on a blockchain is just as trustworthy (or untrustworthy) as data stored on any other database. Blockchain-ing something doesn’t fix qualitative problems. So, if crypto carbon protocols are simply bridging these demonstrably faulty paper credits on-chain, they are not only hamstrung by all the same design flaws as the OTC markets, but the anonymity of the chain actually exacerbates the risk of exploitation. Trading carbon credits on a blockchain does not make them any better for the climate; thus far it has been merely a greenwashing machine, repackaging poor quality credits in a crypto sheen.
So here is how it has all gone down:
The assumption was that there’s a finite pool of bad offsets, which could be bought and locked away, allowing good projects to be priced more appropriately for their impact; by removing the cheapest or lowest quality offsets from the market and becoming a “black hole for carbon”, they can sweep junk carbon off the market. Consequently, they proposed, this would inflate the price for remaining offsets, thereby simultaneously accelerating the price appreciation of carbon to reflect its ‘true’ market price, and penalizing buyers to a point where the economics incentivize real climate solutions rather than a pay-for-play, green bypassing kinda scheme. A naughty oil company would pay higher prices for offsets derived from more rigorous projects once these platforms helped clear away the worst offenders. The crypto community even came up with a term for this method: “sweeping the floor”. And in the process, climate solutions become more profitable and token holders can make a quick buck.
Theoretically, this makes sense. But the logic was flawed. Turns out, there is in fact, a robust junk market, with undesired offsets sleepily queueing for any unwitting off-taker. And crypto markets with their hysterical APYs – the Annual Percentage Yielded of returns from staking (locking up) tokens – offered just the right incentive to wake them from their slumber. These missionary cryptocarboners failed to predict / model / understand that they just created the biggest motivation to gamify the system that the carbon markets have seen in a decade. Printing money masquerading as climate-esque solutions. So while the do-gooder mission attempts to address the junk offset problem by locking them out of the market, the cryptocarbon boom is proving to actually undermine climate change efforts by impelling the bridging of even worse offsets.
So what ended up happening was a fairly predictable system hack. Scour the internet for the cheapest carbon credits available and sell at a premium. Arbitrage 101. Spiking demand for cheap credits triggered by cryptocarbon created new reasons to generate the zombie offsets. And the price was right. According to an analysis by CarbonPlan, dozens of project developers who hadn’t issued credits in years suddenly started selling again — even though they clearly didn’t need the money to keep operating, much less get off the ground. Beginning in late 2021 crypto communities motivated by unfathomable returns embarked on a shopping spree for junk credits bulk-bought by crypto traders that had previously languished for years. These projects are not only not environmentally relevant, some of them are even outright harmful.
Even more concerning, tokenizing real-world credits on a blockchain inhibits the control of the carbon standard that issued it. So not only does the tokenization of carbon draw the moths towards the light, but it also obfuscates the underlying asset so not even well-intending players can truly know what’s going on. In bridging carbon offsets on-chain, cryptocarbonites are pooling supply into a single fungible token. Buyers receive no insight into the type or quality of the underlying asset. It all looks the same on the outside, environmental integrity taking the backseat. The complexity of the infrastructure sends most people’s heads spinning so they don’t even bother to look under the hood; the must trust that cryptocarbon is doing its job, and that the ‘pool’ is good enough to justify their ESG claims. Not sure about you guys but I’m having flashbacks to 2008. Just keep rolling it up, disregarding the rating or quality. It’s like we collectively got amnesia about how markets actually work (collateralized debt instruments, anyone?). In the words of Eli Mitchell-Larson from Oxford NewZero, “all of this screams light on climate, heavy on blockchain”.
The Culprits of the CryptoCarbon 'Crisis'
To really illuminate the gory greenwashing, I want to unpack the models of some of the leading crypto carbon initiatives. And by leading I mean, the ones with the highest PR budgets. The four you are probably most familiar with are:
Toucan Protocol: Base Carbon Tonne (CCC:BCT-USD)
Klima DAO (CCC:KLIMA-USD)
Save Planet Earth (CCC:SPE-USD)
Moss Carbon Credit (CCC:MCO2-USD)
All four of the above projects rely exclusively on either Verra or Gold Standard’s carbon credits to secure their blockchain-based tokens. Users of crypto platform called Toucan now account for purchases of more than a quarter of all Verra carbon credits, the world’s largest verifier of offsets. Acting as a novel market maker for notoriously illiquid carbon offsets, Toucan devised a model it believed would transform the market.
Toucan aimed to infuse liquidity using a variation on a staple tool of decentralized finance called a “liquidity pool.” Toucan users can add their project-specific carbon-backed tokens to pools containing a mix of other carbon tokens representing similar projects. This effectively ‘locks’ their credits in the system, providing users with a new token in exchange, this one representing a slice of the whole pool rather than one specific offsetting project. This fungible, index-like token called a Base Carbon Tonne (BCT) is much easier to trade. But of course, in the process, it becomes a derivative – a securitized product, borrowing its ingenuity from the subprime mortgage crisis. Over the last six months alone, Toucan’s platform has been used to scoop up more than 21 million credits verified by Verra. That activity accounts for more than one in four credits bought over that span available via Verra. Toucan says crypto wallets on its platform hold credits worth more than $100 million, with related trading volume exceeding $2 billion. The model appeared to be working.
Spawning out as a result of this innovation, KlimaDAO, whose Mark Cuban-funded, meme-ified, “carbon black hole” rallied 40,000 “Klimates” to inject Toucan’s on-chain carbon ecosystem with real-world CO2, in the name of extraordinary returns known as ‘staking rewards’. At one point these rewards were yielding token holders APYs of 38,000%. Yes, you read that right. Now I am not trying to skewer these guys because I generally think they had a good idea, albeit, naïve, but if 38,000% APYs doesn’t sound all the alarm bells off in your head you might be drinking too much of the crypto Kool-Aid. It wreaked of a Ponzi fire and somehow people were not calling bullshit. Giving them the benefit of the doubt, they may indeed be a victim of their own success. But what really makes my head spin is that the DAO is run by the pseudonymous leaders ‘Archimedes’ and ‘Dionysus’, who claim their need to maintain secrecy “allows them to focus on delivering a good product”. While commonplace in the “meritocratic” world of decentralized autonomous organizations, the anonymity utterly contradicts its supposed goal of bringing transparency to the carbon credit market. Climate capitalism need not be clandestine. Not unless, of course, the Ponzi rocket-ship and its inevitable crash, was in fact, not a surprise. Bernie Madoff must be rolling in his grave wishing crypto had been invented a few decades earlier.
So how do the tokens actually work? KlimaDAO backs their KLIMA tokens through the purchase of carbon credits via Toucan’s BCT, again, much in the way of derivatives. Klima then incentivizes BCT holders to stake their carbon in the Klima Treasury in return for a yielding token (paid for by the next wrung of staker’s tokens, a la Madoff), so the carbon is locked, the users are rich and the offsetters pay a higher price. Mission accomplished! By accumulating all those offsets, the price of Klima rose to a record high of more than $3600 per tonne of carbon in October 2021. The real-world price of voluntary carbon offsets hovered between $2 and $9 during the same period. I do wonder if they genuinely thought they would lock up all the world’s inventory of carbon to artificially inflate the price of carbon such that it really stung offset buyers. I can get behind that mission actually. It just makes no sense from the perspective of a legacy carbon buyer – which their leadership claims to have experience in. What they failed to anticipate was the myriad of brokers and traders around the world offering the exact same (actually in many cases, much better quality), product, at a far more palatable price. So naturally, the quaint fantasy of locking up the world’s carbon was shattered when no one would buy their egregiously high-priced offsets. Predictably, the price has since slumped to around$ $20 in April 2022. I imagine a lot of swindled Klimates got burnt there, paying a steep price for ‘climate impact’.
Even more concerning than Klima’s scandalous price charts or its embracing of anonymity, is the fundamental abuse of the ‘climate’ brand as a community draw for both Toucan and consequently, Klima. Because Toucan accepts almost all Verra credits, which can sell for less than $2 each, it’s created an easy opportunity for users to make a quick buck; a user buys a $2 credit from Verra and converts it into BCT on Toucan. BCTs on Toucan currently trade at about $3 each. Those BCTs can also be used to earn KlimaDAO’s currency, which stands at $21 today. Motivation. Clear…Capiche?
The hypocrisy of this charade is that the lax inclusion criteria – BCT is a standardized contract reflecting VCS-certified credits with a 2008+ vintage – and lack of quality control means that they are purporting climate impact based on credits created up to 14 years ago. This has resulted in 28% of BCTs (about 6 million), coming from 'zombie projects', certified when standards were much lower, with almost all linked to initiatives that started before 2016. Credits qualified as so environmentally immaterial, they wouldn’t even be eligible for trading in the legitimate paper markets such as Corsia, or on regulated commodities exchanges.
Take a look at the Dayingjiang-3 hydropower dam in China’s Yunnan province. In December, the dam’s developers sold their first credit endorsed by Verra. Buyers were (naturally) anonymous entities via Toucan. Since then, more than 2 million credits from Dayingjiang-3 have been converted into BCTs, comprising more than 99% of the credits Dayingjiang-3 has ever sold. And Verra project 494, a natural gas project located in China's Jiangsu province, recorded its last retirement in April 2013, but has conveniently revived its offsetting sales by bridging more than 500,000 tonnes via Toucan. If the project was unable to offload its credits for 9 years via traditional brokers, you’d think that would reveal something of its quality. Suddenly with the advent of Toucan and Klima, an undiscerning market, scooping up these junk offsets that were left for dead, is now thriving.
Even more pernicious, these unregulated markets opens the door for absolute abuse, like in the bridging of a dangerous type of offsets called HFC-23 – a type of “super greenhouse gas”. Reviving the decade-old environmental catastrophe, companies hack the crediting system by overproducing HFC-23, to then profit from the ensuing slew of carbon credits they receive for then reducing their output to the level they would have had in the first place. Toucan unwittingly approved hundreds of thousands tonnes of the HFC-23 offset credits before the company was able to block the corresponding wallet addresses. What a train wreck.
Toucan says it’s not their responsibility to judge the quality of a carbon credit: “we’re not trying to be the standards body that’s creating the criteria by which we measure climate impact,” said John Hoopes, in charge of Toucan’s strategy. Toucan is aware of the problem of zombie projects, he added, and is working on ways to filter out older credits. Verra, meanwhile, said in a statement that it takes no responsibility for any trading that happens via Toucan or elsewhere in the crypto world and also defended its certification of old projects. Passing the buck down the road and profiting in the process. So, who exactly is responsible here?
Uniting the two unregulated markets of digital assets and carbon offsets, it’s a con man’s dream. Without creating any new carbon credits themselves, the number of projects and thus the net amount of carbon being offset is the same as it would be if the same tokens were credits on physical registers. And worse, Toucan is creating incentives to bring zombie projects to life that have no environmental integrity whatsoever, yet the whole thing is packaged in a virtue signalling veneer that is entirely smoke and mirrors.
Another spurious project, Save Planet Earth, is another of the flurry of crypto ventures to seize on surging demand for carbon offsets. They have now sold hundreds of carbon credits as NFTs, with one selling for as much as $70,000 per tonne, in order to raise money to plant 1.1bn trees in Pakistan, Sri Lanka and the Maldives. An investigation by Climate Home, however, found that while the company said it had started planting its one billion trees in Pakistan, the country’s climate minister had never even heard of the project. For Adriana Vidal, senior forest policy officer with IUCN and chair of Global Partnership on Forest and Landscape Restoration, the information provided by SPE “is not enough to ensure the environmental integrity of these projects”. “If you want to sell carbon credits you have to make sure that they are grounded in reality, which requires clear agreements with stakeholders, land owners and authorities. It’s not really serious if you don’t have this information in place.”
When Climate Home suggested to SPE’S CEO that they were misleading investors, he replied that SPE was “in its early stages and that the pandemic had made the work really difficult”. It was “a huge undertaking” but he insisted SPE “will achieve everything that we said we want to achieve” and “is being regarded as a serious environmental outfit” by those it has struck agreements with.
Lastly, MOSS, an broker of REDD+ offsets, aims at saving the South American rainforest. Through purchases of the tokens, the network claims to have sent $10 million in funding to Amazon rainforest conservation efforts. But per the chapter on forest-backed carbon above, a thorough investigation is recommended to all buyers.
Ok, so Now What?
The carbon offset market is broken. But the founding principles of capital redistribution from polluting enterprises and activist individuals to worthy climate causes, still makes a lot of sense. It just needs to be grounded in integrity and easy to police. What we need is a mechanism to democratize access on the both the demand and supply sides while accelerating meaningful climate action that people actually trust.
But if this is so easy, why hasn’t it already been done? Sometimes it’s most difficult to change a system from within. Too many vested interests and stakeholders standing to profit from the dysfunction.
So our proposal takes aim at a parallel market, one that remains untarnished by the chaos of carbon, yet operates in a strikingly similar fashion. Referring to the latest series of IPCC reports, renewable energy is one of the most crucial levers we can pull to avert climate crisis. Deployment is still far short of its economic potential and the levels required — 80% by 2030 — to meet agreed greenhouse gas emission reduction targets, are far from materializing into reality. So rather than building a whole house of cards on top of carbon, why don’t we use the same instruments, the same burgeoning technologies, to direct that capital into something real? Something that establishes a market that aligns market needs with market interests.
Renewable Energy Certificates (RECs) can help. Acting as bridge finance to new renewable developments or direct subsidies to capitalize existing operations, RECs are tools to help in the transition to net neutral. By providing a secure revenue stream for project developers, they not only enable the bankability of project development but also send an attractive price signal to capital markets that fuels further investment into these regions.
Due to the systemic reduction in renewable energy technology, many governments are lifting their Feed-in-Tariff programs to support renewable producers, leaving them to fend for themselves while competing against the highly subsidized fossil fuel incumbents. It is simply not financially viable, particularly in emerging markets where capital is skittish. A buoyant REC market can unleash the potential of emerging markets, prioritizing certification of RECs for renewable energy projects there in order to reach into underserved markets, sometimes for the first time.
RECs are a reliable source of immediate income which the renewable energy company can reinvest directly into expanding their portfolio, allowing them to establish cost-competitiveness in an ever-saturated market, and overcome the hurdle of upfront financing. Purchasing RECs helps develop the renewable energy supply by subsidizing the cost of renewable energy. With enough renewable energy certificates driving more finance to renewable energy, fossil fuel plants will eventually close; expensive, polluting and no longer needed.
We need to set a new standard for environmental commodities, to become the best in class for trust, integrity, transparency and impact. And RECs are the ideal place to start. Even a prudent carbon market will still face the dilemma that is particularly hard to solve with blockchain technology: carbon credits will always require trust in someone. Their calculation and monitoring is complex. But renewable energy credits are much easier to validate. Being public utilities, governed by public private partnerships, whose output is un-tamperable, and whose production capacity is predictable, RECs are the low-hanging fruit of the crypto climate revolution.
We need verifiers and traders working one-to-one with the climate project owners (or in the case of RECs, directly with the renewable producers) eliminating the multiple layers of intermediaries that obfuscate offsets. No more ‘trusted’ third-parties; only layers of code and transparent ledgers that don’t promise integrity, but actually show it. We need to leverage the unique features of the blockchain to allow for publicly verifiable projects, with transaction history, environmental impact, ongoing maintenance and ownership rights, all being fully visible on the public ledger. No more obfuscating or securitizing. Buyers see exactly what they get; data room and all.
In order to legitimize this crypto-climate movement, we need to evolve towards projects working with environmental projects versus environmental instruments. We need a re-conception of value, the return to first principles, that begets the triumph of crypto climate.