Tokenisation refers to the representation of a real-world asset on a blockchain. Anything from real estate and bonds to accounts receivable invoices and art can be tokenised, but carbon credits have garnered by far the most interest. The voluntary carbon market, in particular, is infamous for being opaque and controlled by rent-seeking intermediaries, so the push for tokenised carbon credits came as no surprise.

What follows is an overview of tokenised carbon credits, how they work, and what it means for the industry.

Bridged vs. native

The most important distinction to make when looking at tokenised carbon credits is bridged vs. native.

Bridged credits are issued off-chain, by standards such as Verra and The Gold Standard, and then tokenised on-chain via a bridge. Initially, these bridges were only one-way, meaning that only changes to a credit's off-chain status could be reflected on-chain, not the other way around. Two-way bridges are now the norm. A credit purchased and retired on-chain, for example, is now reflected in its respective off-chain registry.

Native credits are those issued only on-chain with no off-chain equivalent. The credits would be "stored" in a blockchain-based registry which would keep track of their status and prevent fraud. The current challenge with native on-chain credits is putting a verification layer in place to ensure that a thorough verification process is completed according to globally accepted standards.

Blockchain-based registries are probably the future, but without movement towards this end by the big standards, we will continue to have issues with verification. Because, as we know, blockchain as a data repository is only as good as they data that goes into it. Transparency and immutability amount to nothing if the issued credits don't represent actual carbon sequestration.

Metadata

Another key feature of tokenisation is the ability to attach metadata to a token. We saw this used effectively with digital art NFTs, where traits, media links, and other details were hardcoded into the token. For carbon credits, metadata is most useful for establishing provenance.

Provenance refers to everything about the origin of the carbon credit. The plot of land it came from, the year (vintage), the project, country, and so on. Metadata enables highly granular data about even a single credit to be attached to the token at the time of issuance. The transparent and digital nature of tokenised credits means that the sky is the limit for the type of data that can be stored. Something as granular as specific geocoordinates for a credit or satellite imagery proving carbon capture.

Buyers are the ultimate beneficiaries of this metadata. It allows them to find the exact credits they need to best offset their carbon emissions. For example, a company with a factory in Sumatra, Indonesia could buy credits geolocated as close to the factory as possible. This is currently difficult using legacy marketplaces.

A new asset class

Regardless of whether a credit is bridged or native, tokenisation makes carbon credits into a legitimate asset class that can realise the benefits enjoyed by other asset classes.

  • Leverage - Carbon credits have value, so their tokenised version can be used as collateral on DeFi protocols to borrow other assets. And while this may not be a good long-term strategy due to the fact that a carbon credit's value declines over time, it does offer up some great short-term leverage opportunities against a relatively stable asset.
  • Derivatives - Investment vehicles can be created by bundling tokenised carbon credits together, providing exposure to specific regions or credit types. Tokenisation also unlocks a host of other financial machinations that would need another article to properly articulate.
  • Medium of exchange - Project developers can use tokenised carbon credits as a means to repay investors.

Some have expressed concern at the idea that a tool meant to regenerate the environment would be used as a financial instrument. The argument goes that credits would be hoarded, not retired, and certain parties would go to great lengths to try to manipulate the market in their favour.

This is surely a valid concern, at least to some extent, but it tends to ignore the potential of forward carbon credits in the effort to scale the pace of reforestation and regeneration.

Forward credits

Forward carbon credits represent perhaps the most interesting use case for tokenisation. Similar to accounts receivable, forward credits represent future revenue. The idea is that project developers can "pre-finance" their projects by selling the rights to future carbon credits. Even without tokenisation, this is an attractive prospect for two reasons: 1) it can take anywhere from 2-5 years from project inception to carbon credit revenue, and 2) projects are expensive to set up and maintain until that revenue is realised.

There are two other key points worth noting. The first is that only a percentage of the estimated (ex-ante) credits can be issued as forwards, while the buyer is ultimately entitled to all of the actual (ex-post) credits issued. The second is that forward carbon credits are sold at a discount. Both help account for delivery risk in the case where the project is unable to deliver the estimated number of ex-ante credits.

As an example, consider a project developer who estimates that 1 million credits will be generated by its project. It may decide to issue 800,000 of those ex-ante credits as forwards and sell them at a 20% discount. Then, let's say that 950,000 ex-post credits were issued once verification is completed. The buyer takes ownership of these 950,000 credits and can retire or resell them.

The case for forward credit tokenisation is quite simple: access to larger and more diversified pools of liquidity for project pre-financing and scaling reforestation. This, in effect, lowers the barriers to project development, especially for smaller scale projects developers without access to institutional capital. Impact investors can pool their liquidity, accept verified forward credits as collateral (or simply buy them with the intention to sell the ex-post credits upon issuance), and effectively lend capital to project developers.

Final word

Tokenised carbon credits are undoubtedly a net positive for the industry. Whether bridged or native, they introduce a level of transparency and disintermediation that the voluntary carbon market sorely needs. More importantly, especially as far as the climate is concerned, tokenisation opens up new avenues for project financing that were previously inaccessible. Project developers can take advantage of tokenised forward credits to both pre-finance and scale their projects. Investors, in turn, can generate a return simply for helping projects plant more trees.

What remains to be seen is whether fully native credits will become the norm and replace most off-chain issuance. Getting there is going to be an uphill battle. Verification is difficult and requires significant planning, development, and testing in order to ensure that carbon credits are legitimate. As a result, it may materialise that the big standards like Verra will have an advantage if they were to make the switch to blockchain-based registries.