By Mary Grady, Lisa DeMarco, Rick Saines, Enric Arderiu Serra and Jonathan Shopley – the IETA Council Task Group on Digital Climate Markets
Since 2017, the International Emissions Trading Association (IETA) has tracked digital innovations that could improve the performance of carbon markets.
These cover the entire value chain from new digital approaches to monitoring, reporting and verification (“digital MRV”), “smart” contracts, data repositories and meta-registries, to distributed ledger technologies for registry services.
Such innovations can expand market access in developing countries, facilitate green investment, and accelerate market linkages and growth if done with security, integrity and transparency. However, done poorly, they could erode public confidence in carbon markets – threatening their ability to help deliver the ambitions of the Paris Agreement.
In recent months, the market has witnessed the rapid emergence of digital carbon assets. Millions of carbon credits are now virtually tied to newly minted digital tokens. These new products have created demand for older vintages of carbon credits from a new category of buyers, and triggered a temporary surge in the price of legacy carbon credits issued by independent standards.
Carbon credits tied to digital tokens represented a significant traded volume in the voluntary carbon market (VCM) last year, and the market for such tokens witnessed strong price action, resembling the volatility of other digital currency markets.
In the context of a voluntary carbon market which is growing rapidly, and in the face of some criticism over the lack of integrity, the proliferation of digital carbon tokens has raised concerns from established participants about the reputational risks these new instruments pose to the market.
Against this backdrop, IETA’s governing Council convened a Task Group of Council members earlier this year to study this trend and the use of digital tools in carbon markets more broadly.
Over the past several weeks, the Task Group heard from data providers, exchanges, independent standards, project developers, and digital innovators on the use of digital tools in the carbon market.
Our main conclusion is that digital innovation can improve the performance of carbon markets across the value chain, but such innovation comes with significant risks across the three main use cases, which need to be carefully identified and managed.
Digital MRV: The deployment of digital technologies in monitoring, reporting and verification (MRV) can create efficiency, accuracy, and transparency but these advances need guardrails in order to ensure the technologies enhance robustness and accuracy and do not undermine integrity in exchange for efficiency.
Data Repositories: Distributed ledger technology can enable data repositories such as the World Bank’s proposed Climate Warehouse, which aspires to link all carbon credit issuing authorities and registries under one platform.
Such innovations can provide much needed transparency in a highly fragmented and dispersed market on the status and location of all carbon credits as well as help avoid double registration and double counting.
As with digital MRV, these technologies should be supported by data standardisation and minimum system requirements to reach their full potential.
Credit Tokenisation: Credibly digitised credits can reduce market friction, increase access for both buyers and sellers, reduce transaction fees, and scale flows of capital to the carbon market.
However, digital climate assets raise many concerns including the seemingly speculative nature of tokenisation schemes, the loss of environmental integrity from tokenising retired carbon credits, the lack of transparency in the governance of Decentralised Autonomous Organisations (DAOs) and lastly the uncertain regulatory treatment of tokenised carbon. All of these risks need to be carefully thought through and managed to protect the integrity of the market.
Initial Recommendations for Guiding Principles
Based on these initial findings, the Task Group has begun to develop an initial set of recommendations for guiding principles for the application for digital innovation to the carbon market that ensure overall market integrity.
Credible Standards: Where carbon credits are being used to issue digital tokens, these credits should come from projects that are validated, verified and registered under endorsed and conditionally endorsed standards by ICROA or government-approved carbon crediting schemes (the “Standards”).
Registry Control: The authority to decide whether or not to allow market participants to tokenise carbon credits and retire them should reside solely with the Standards. The Standards should have the infrastructure to record and track carbon credits that are being tokenised before allowing market participants to tokenise them.
Tokens: Tokens should be minted only for issued, ex-post verified carbon credits, not cancelled or retired credits. The Standards should not allow token issuers to use expected forward streams of un-verified or un-issued emissions reductions and removals from projects.
Consumer Protection / Transparency / Know Your Customer (KYC) / Anti-Money Laundering (AML): Token issuers should be subject to KYC and AML checks by the Standards. Customers should look for full transparency around KYC/AML in digital carbon trading markets. The infrastructure to manage the KYC/AML of the users should be explored.
Investor Safeguards: Where tokenisation involves no direct nexus to the underlying carbon asset the risk of confusion among end users is high, and so token issuers and DAOs in particular should ensure that digital climate assets are suitable for customer’s goals, needs and risk tolerance and appropriate for their knowledge and experience, particularly when assets are marketed to retail investors.
Sustainability: Any digital technology deployed must be truly sustainable. This means it must be inclusive, open, resilient and secure as well as have a low carbon footprint.
IT Security: Digital technology should be deployed safely using proven methods of protection against cyber-attacks.
Public Record of Tokens: Tokenised carbon credits should be issued (not retired or cancelled) and recorded or held in escrow in a publicly accessible registry linked to the Standard, and shall be reflected in the relevant data repositories to avoid double selling, duplicate claims and non-authorised tokens.
Claims: Where tokens are digital twins of issued carbon credits, claims relating to carbon neutrality, offsetting, and/or compensation of emissions shall only be made after the token is permanently removed from circulation (by “burning” it on the blockchain) and the underlying carbon credits are been retired.
No valid compensation claims should be made in relation to only holding, but not retiring, credits. Further, the above claims should not be made for tokens trading in markets that are not directly and immutably linked to the underlying carbon assets.
Digital MRV Integrity: The deployment of digital MRV tools needs to draw upon best practices to ensure integrity and that proper standards are followed. The increased use of digital MRV should be coupled with a rigorous and transparent process to control data and claims integrity, eliminate bad actors, and ensure auditability and data accuracy to appropriate levels of confidence for intended use.
IETA is setting up a Task Force on Digital Climate Assets for IETA members to build on the work started by the IETA Council and further develop and refine the initial set of guiding principles outlined above.
The Task Force will be able to invite external experts from outside the IETA Membership to inform its efforts. The Task Force will assist in conducting public forums for dialogue with the broader stakeholder community on the opportunities, risks and solutions for the use of digital tools in the carbon market.
We look forward to continuing the learning on this important topic.