The Tokenization of Carbon Assets

Carbon Assets Tokenization

Tokenization is the process of utilizing blockchain technology throughout an asset’s lifecycle.

July 2023

Barbara Widholm
Digital Product Development,
State Street Digital®

Ekaterina Stolyarova
Digital Product Manager,
State Street Digital

It can make the process more effective and efficient for both the fund issuer and the end investors by allowing shares of a fund to be freely traded on a digital ledger. The recent crypto downturn has revealed some “elasticity in demand” among institutional investors who understand blockchain is here to stay, and are enthusiastic about the wider opportunities that tokenization can offer.

The advantages of tokenization
Tokenization can increase accessibility to markets, create liquidity in historically illiquid markets, and generate efficiencies and cost savings. Like markets for real estate, infrastructure and private equity, carbon assets are less efficient, more customized, have different operating models and requirements, and require a human settlement process.

Promoting greater accessibility
Market participation and capital inflow are constrained by limited access points or complicated restrictions of some investment instruments, such as carbon credits. The barrier of entrance into a market can be decreased, and access points to tokenized assets can be standardized with blockchain technology.

Enhancing liquidity
Tokenized assets increase transaction flow competition, which benefits issuers and leads to better pricing and more secondary market liquidity. Assets that have been tokenized can be immediately exchanged on-chain or across-chain.

Generating efficiencies
In certain markets, inefficient transfer of ownership leads to a loss of alpha. Tokenization allows the settlement process to become almost instantaneous, while the transfer of value and the validation of ownership are simultaneous.

Processing of complicated events, such as corporate actions, can be expedited. Additionally, some blockchains integrate smart contracts, self-executing programs with rules established in code. Smart contracts allow automated transactions by defining a set of parameters that, if met, execute automatically.

For instance, smart contracts can start making payments at predetermined benchmarks or on specified dates. As a result, tokenized platforms may one day enable investors to purchase, sell and swap tokens in accordance with predetermined guidelines – and with little assistance from outside brokers.

The tokenization opportunity for carbon assets
Over the past 10 years, investments in climate technology have grown at a rate five times1 that of global startups, helping with efforts to achieve decarbonization goals and to create regulations for emissions disclosure.

One of the key drivers of growth in carbon credits has been the ongoing efforts to reach net-zero emissions goals. However, the market is divided in terms of value and structure due to the vast range of standards being released, as well as the lack of transparency in the data on underlying carbon intensity. Since the majority of agreements are over-the-counter and carbon credits are distributed through a number of registries, market efficiency and transparency are necessary for scalability.

Blockchain technology can help overcome some of these key challenges. Its effective real-time settlement can promote greater volumes and liquidity by making carbon credits more composable.

A carbon credit needs an audit trail of the components contributing to its carbon intensity, and open blockchain could produce useful price data to encourage asset comparability.

Tokenized carbon credits can be representations of off-chain Verified Carbon Units (VCU) or natively digital carbon credits – distinguished by traceability across the underlying carbon offsetting chain – to enable the scalability of the carbon credits market.

Events affecting carbon intensity would be recorded on a distributed ledger, and traceability would ensure a carbon credit’s value on the market by creating inherent quality. Therefore, a VCU’s value would be more accurate and not dependent on a manual, non-standardized audit evaluation of the underlying project. As a result of incorporating the Internet of Things and blockchain, a credit’s underlying data would be programmable, comparable and produce price signals.

In digital asset markets, the ability of an asset to interact with other assets in the market, or interoperability, defines an asset’s worth. Creating a worldwide data infrastructure that is constantly updated (e.g., using oracles to feed data to an asset, which cascades to other assets in the chain) makes sure that businesses cannot double spend by offsetting the same credit again. With smart contracts, the programmable capability of a token and underlying traceable data may be used to design the workflow, integrate regulatory requirements and add business logic across the whole lifecycle of a carbon asset. As a result, a carbon credit token is composable and opens up new types of trading and capital development.

A carbon credit’s success, even when tokenized, depends on the way it was created and how well a smart contract was written. Understanding the foundations of a successful carbon credit token is crucial.

Fundamentals for tokenized carbon credits
When working to build a composable structure for carbon credits, the fundamentals of decentralized finance must be considered. These fundamentals, often called primitives,2 are the essential building blocks of technology that can be combined and leveraged in a variety of ways. Oracles, blockchain protocols, smart contracts and token standards are all key primitives to consider when issuing a carbon credit token. Indeed, a blockchain can be chosen over another for its characteristics, including the number of users, number of smart contracts available, activity and rules.

For example, Ethereum is open source, which means that smart contracts are public, and any logic worked out once is available for reuse by the entire ecosystem (syntactic composability). The multitude of smart contracts are as much reliable code already tested by the protocol to which projects can integrate the carbon credit specific components.

The smart contract is as good as the rules it is governed by and a blockchain protocol is as composable as the data available in it. Therefore, a carbon credit quality is influenced by the blockchain it is issued, as well as the smart contract governing it.

Ethereum facilitates composability by its architecture, but that does not guarantee that tokens’ morphology is comparable by nature. For this purpose, a number of standards have been agreed to, and are known as Ethereum Requests for Comment (ERC). The famous ERC20 and ERC721 define characteristics of fungible and non-fungible tokens (NFTs). They define the parameters for a token interaction with other elements in the protocol and increase their comparability.

On one hand, ERC721 has been utilized by carbon offsetting projects for its non-divisibility. Certain carbon credit tokens may represent a collection of multiple projects or activities contributing to creating a single carbon offset unit. Therefore, an NFT provides the exclusivity and unity required for a carbon offset to faithfully reflect real world activity.

On the other hand, ERC20 are interchangeable and can be divided. Used by the majority of existing tokens, the standard is, therefore, more interoperable and unlocks new opportunities for targeted investments, portfolio diversification, and greater capital flows to facilitate the transition to net-zero emissions.

Unlocking the opportunity for institutional investors
When considering tokenization opportunities, institutional investors must take into account the technology and tangible assets as investments vehicles, but also the technology applications in improving processes and products offered today.

Investor interest in an asset class is driven by tokenization’s ability to diversify investable assets, creating an ability for new investment strategies and allowing investors to move assets more seamlessly. Today, investors in tokenized securities are mainly wealthy individual (accredited) investors, and the market is challenged by a lack of participation from high-quality institutional investors. Creating an effective marketplace to support institutional participation will drive overall issuance. Additionally, exploration of smart contracts and distributed ledger technology to automate certain processes, such as tokenization of trade collateralization, can help enhance servicing of these assets and reduce risk.



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