Regenerative Finance (ReFi): Tokenizing Carbon Offsets and Incentives

Regenerative Finance (ReFi): Tokenizing Carbon Offsets and Incentives
By: James R. Holbein, Braumiller Law Group PLLC, Justin Holbein, Web3 Consulting LLC[1]

Introduction to ReFi. Regenerative Finance (ReFi) is a growing Web3 field that offers an opportunity to rethink how we approach finance, investing, and sustainable economic development. ReFi takes a holistic approach to finance and development, considering the environmental, social, and economic impacts of financial decisions, and aims to create a regenerative economic ecosystem rather than following a primarily extractive approach. ReFi builds upon earlier advances made in Decentralized Finance (DeFi), a field based on blockchain technology that seeks to create a more equitable financial system by removing intermediaries, automating transactions via smart contracts, and having fully open and transparent transactions. The growth of ReFi is driven by trends in understanding economic interdependence with nature, the fragility of extractive economic systems and supply chains, and using blockchain technology to enable natural regeneration for climate causes at scale. To understand a practical implementation of ReFi, we will explore the implementation of tokenized carbon credits, what problems these tokenized credits solve, and common-sense approaches to regulation.

DeFi Characteristics. A good starting point when thinking about ReFi is to consider existing DeFi implementations that share many of the same technologies and philosophies. Decentralized blockchain technology, permissionless execution of smart contracts, the ability to tokenize digital or real-world assets, and disintermediated incentives are shared by both fields. DeFi has the potential to revolutionize how we conduct finance and transact with one another, primarily due to removing third parties from having to mediate transactions, automating transactions and agreements with smart contracts, and largely removing costs and barriers for market participants. DeFi is still in the early stages of development as a field, and still needs a common-sense legal framework to allow the field to grow in healthy ways and protect users.

ReFi Goals. ReFi aims to correct many of the excesses of globalization we have seen over the past 40 years. ReFi is an integral part of the solution, as the technology allows entrepreneurs and communities to define their own incentive structures for priorities that are defined by the community itself, and not a far-flung corporation with little awareness about the reality on the ground in local situations. ReFi projects and proponents want to return the focus back to more local communities, build resilient supply chains, and create economic systems that do not prioritize shareholder growth over these ReFi goals. Economic systems based solely on increasing shareholder value can often have negative effects on the people, communities, and the environment. In our interconnected world, businesses and organizations who don’t take a holistic view of the larger system they comprise can be more fragile due to compounding, and unforeseen shocks. These shocks often come from the neglected parts of the system each entity comprises. ReFi aims to use web3 technology and decentralized coordination to help solve these issues and build new incentive structures.

Decentralization. Decentralization is key to the value ReFi protocols, decentralized autonomous organizations (DAOs), and regenerative projects seek to articulate. In our current economic system, corporations and larger banks are often intermediaries between market participants, and these intermediaries often have their own goals and interests. The goals of market intermediates can run counter to the goals of market participants and be outright adversarial in some cases. Financial gain for shareholders can take the form of using customers and users as resources to be exploited. Adam Smith’s invisible hand has become a silent partner to all transactions. Blockchain technology offers a way out of this coordination trap, with smart contract enabled programs enabling value exchanges occurring peer-to-peer, without an unseen counterparty either weighing the game in its own benefit, using capital as a lever to manipulate the outcomes, or gaming a system of interaction that is not in the best interest of the market participants. Smart contracts are immutable pieces of code running on a decentralized blockchain and cannot be interfered with or stopped once deployed. This allows communities, businesses, and individuals to create businesses, organizations, and systems on the blockchain that they design, without unseen counterparties unfairly weighing the game. Smart contracts lead us directly into another key pillar of ReFi: Tokenization.

Tokenization of Real-World Assets. ReFi extends the DeFi model beyond traditional financial markets and introduces ways to tokenize different asset types. Smart contracts allow digital and real-world assets to be tokenized and represented on the blockchain. Each token is a symbol for an underlying real-world or digital asset and is cryptographically secured from interference and control from a third-party. Tokens enable liquidity of formerly static and illiquid assets, while also enabling independent verification and real time auditing on the blockchain ReFi utilizes web3 technology for public goods and regenerative projects, and it is important to understand the values and context underlying the efforts to build with the technology.

Carbon Offsets. Carbon Offsets are defined as anything that captures carbon and takes it out of the atmosphere, and a carbon credit is a representation of said offset. The carbon market’s main lifeblood may well be the carbon credit, as this represents offsets, and companies want to procure as many offsets as they can. Offsetting and carbon credits is one approach countries are using to achieve carbon neutral status and meet climate goals. Everyone, individuals and companies, has a carbon footprint. A carbon footprint is any activity that releases carbon into the atmosphere. Nearly everything you do has a carbon footprint, eating food that isn’t locally sourced, using electricity, using gasoline in our vehicles, charging our electric vehicles, and even taking a shower lead to release of carbon into the atmosphere. Offsets are often thought about more as compensation to an environmentally conscious organization or individual rather than as digital assets that could be traded on the carbon credit market.

Carbon Credits. A single carbon credit is equal to one ton of carbon released into the atmosphere. Carbon credits issued to a company represent their “cap” in cap and trade, or the limit or carbon that they can emit. The idea then is that if the company is below their cap, then they can trade their surplus credits at a profit, typically to those companies who exceeded their cap, and now have to buy credits to make up the difference for what they emitted. Offsets can be used by anyone, however, in states with cap-and-trade laws, carbon credits can be purchased. Carbon credits are derived from offsets but are only applicable with cap-and-trade laws, whereas offsets apply anywhere and can be done by anyone, individual or corporation. There are a variety of carbon reduction programs, with considerable variation among them. Offsetting and carbon credits is not without criticism, some claiming that these measures are merely lip service and do little to actually help the problem. It is estimated that 85% of carbon reduction projects have low likelihood that they actually reduce emissions to the extent claimed. (SEE: https://www.weforum.org/agenda/2019/06/what-is-carbon-offsetting/ and https://corporatefinanceinstitute.com/resources/esg/carbon-credit/).

Types of Credits. There are two main types of carbon credits, and these are nature based, and technology based. Some examples of nature-based projects include reforestation, regenerative farming, and grassland projects. The other type is technology based and generally refers to any tech-based solution that captures carbon or transforms it into something else from the atmosphere. Other types of credits refer to how credits accomplish carbon removal. These can be described as avoidance or removal credits. Removal credits are projects with the goal of removing carbon from the atmosphere directly. Avoidance credits are projects which goal is to avoid producing any carbon in the first place. (SEE: https://plannetzero.org/differentiating-the-types-of-carbon-credits/).

Carbon Markets. Carbon markets, or greenhouse gas trading systems, are markets that trade in credits representing carbon reduction. Environmental markets have been shown to work. In the 1990s, acid rain was a large problem, mostly because of sulfuric acid production, also related to carbon production as well, and credits for sulfuric acid were introduced. After this initiative, acid rain went down a great deal in the US by the late 2000s. Ever since the Kyoto Protocol, there has been the ability to trade offsets. Compensation can range from $8-$125 per ton. Carbon credits are a more recent development but could expand the carbon market quite a bit. (SEE: https://extension.psu.edu/carbon-markets-101). “There are now 30 ‘compliance’ carbon markets operating around the world, in which entities must purchase or trade allowances for the emissions they produce. Together, these markets reached a value of more than $850 billion in 2021 and cover close to a fifth of global greenhouse gas emissions.” (https://about.bnef.com/blog/the-untapped-power-of-carbon-markets-in-five-charts/). An example is RGGI. “The Regional Greenhouse Gas Initiative (RGGI) is a cooperative, market-based effort among the states of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, and Virginia to cap and reduce CO2 emissions from the power sector. It represents the first cap-and-invest regional initiative implemented in the United States.” https://www.rggi.org/.

Problems. Companies around the world are now turning to the voluntary carbon market (VCM) for their carbon concerns. Unfortunately, the voluntary carbon market suffers from lack of oversight. Many claims for carbon reduction are hearsay, disingenuous, inflated, or otherwise spurious. Voluntary carbon markets are growing, which could be a problem, with many projects offering emissions reduction that are speculative or lack real data to support the credits. A criticism of the VCM is that they will use many terms to mislead the public like “carbon neutral”, “science based”, and “Paris aligned” which are ultimately buzzwords and allow deception. Carbon credits can cover the purported carbon reduction, however, getting legitimate agencies to verify the actual reductions and to hold them accountable is a challenge. Fossil and biological carbon are not interchangeable, and this causes many of the problems with carbon credits. Companies are incentivized to choose voluntarily to participate in these markets, not necessarily out of altruism, but because it helps their bottom line and profits. Governments must take greater measures if they truly want to decarbonize our current economy meaningfully. (SEE: https://www.globalwitness.org/en/campaigns/greenwashing/carbon-trading-continues-whats-wrong-with-the-voluntary-market/).

Web3 Carbon Credits. In ReFi, carbon credits have been a candidate for tokenization, as current markets are burdened by inefficiencies, illiquidity, and even outright fraud. A recent report found that as many as 90% of rainforest offset tokens from leading carbon standard Verra do not represent genuine carbon reductions.[2] Tokenized carbon credits, proof-of-impact certificates, and community-based tokens are several types of assets being explored in the ReFi space to drive regenerative, positive-sum action. Tokenized carbon credits can be integrated into a variety of businesses and organizations using permissionless smart contracts, in-building a regenerative component to make all types of business carbon neutral and carbon positive. Impact certificates are NFT-based certificates issued to verify impact on a variety of causes, chosen by the community or organization issuing them. Finally, community-based tokens can have rewards for people that patronize certain small businesses and return automated royalties to a shared community treasury for public goods projects.

Tokenization Protocols. Tokenized carbon credits offer a path forward, improving liquidity of carbon credit markets by offering transparent market transactions for all participants, creating more efficiencies by standardizing how carbon credits are produced and creating independently verifiable audit abilities, and removing fraud by providing cryptographic verification that makes duplication of carbon credits impossible. Protocols like Toucan, Flowcarbon and Nori are working to build the Web3 carbon market, each with slightly different approaches. What they share in common are providing openly verifiable, transparent, and liquid carbon credits that resolve the inefficiencies in today’s markets, potentially incentivizing tokenized carbon credits in many different contexts. At a time when companies and individuals are highly motivated to take action to combat climate change, the opacity of current carbon markets reduces the tangible action companies can take to offset their carbon emissions. Tokenization of carbon offsets provides a solution to a centralized “source of truth” on the accuracy of carbon credits. Tokenized carbon credits offer interesting applications beyond simply improving illiquid carbon credit markets. Being smart contracts, carbon credits can be automatically built into a variety of different formats, including blockchain games, virtual metaverse experiences, DeFi applications, trading platforms, and more. This could open an entirely new avenue of possibilities that incentivize taking positive climate action.

Toucan Case Study. To understand a ReFi use case in action, let’s take a deeper look at Toucan. Toucan aims to be the “catalytic infrastructure that (em)powers a vibrant on-chain carbon market with the sole purpose of addressing climate change.”[3] Toucan offers the infrastructure behind Base Carbon Ton (BCT), a carbon reference token other companies and protocols can use to build applications. Toucan offers a process that allows bridging of verified carbon credits onto the blockchain. “Once tokenized, the bridged carbon credits are assets that can be pooled, traded, and integrated”[4] with other web3 projects. Since launching in 2021, Toucan has created over 4 billion in carbon trading value and tokenized over 50 climate projects. Importantly, Toucan provides the infrastructure any web3 protocol or app can use to integrate carbon offsets into their project to make it carbon neutral, while simultaneously improving the illiquid and un-verifiable aspects of current non-tokenized carbon markets.

Regulation for Carbon Tokens and Markets. We have written about the need for regulation, oversight and guidance from the government that is necessary for the digital assets sector to grow and develop in a way that protects consumers, businesses, and investors while increasing trust and security for all participants in the sector (SEE: https://www.braumillerlaw.com/author/james-holbein/). For carbon credit tokens to be actively traded and broadly accepted, a number of important regulatory and market conditions should be established. In particular, either regional or international standards must be agreed upon for creating both carbon offsets and the carbon credits that derive from them. Establishing such standards takes years and even decades, so that aspects of normalizing markets, pricing, and valuation of carbon credits will not be an immediate outcome of movements to create viable carbon markets.

At a minimum, the quality of the carbon offsets and credits must be verifiable through standardized criteria and proof of genuine carbon offsetting through removal or avoidance. Standardization will enable tokenization of these digital assets on a standard basis that will enable price visibility, common for meeting ESG goals, and ease of use for trading and monetizing credits. Smart contracts can be standardized for these purposes based on meeting core carbon standards and enabling quantification and fractionalization of credits for ease of trading. Once used, the credits embedded as smart contracts can ensure that the credit is only used for the purposes intended and not reused multiple times, artificially inflating the numbers of credits in the market. One suggestion that can be implemented by the protocols analyzed above is to establish “a digital process by which projects are registered and credits are verified and issued. Verification entities should be able to track a project’s impact at regular intervals, not just at the end. A digital process could lower issuance costs, shorten payment terms, accelerate credit issuance and cash flow for project developers, allow credits to be traced, and improve the credibility of corporate claims related to the use of offsets.”[5]

As regulators and legislatures apply anti-money-laundering and know-your-customer guidelines to stop fraud in the trading of cryptocurrencies, they can also create basic regulatory guidelines for creating governance mechanisms for qualifying carbon offsets and credits, supervising markets and overseeing carbon markets that are modeled on existing regulations but take into account the digital nature of tokens and the advantages provided by these digital assets. Such regulations could improve the functioning of VCMs by addressing participant eligibility, participant oversight, and market functioning.

It would also be helpful if legislators and regulators do not overregulate the types of entities that can participate in such markets. There is no reason that existing governmental entities, corporations, non-profit organizations, cooperatives and decentralized autonomous organizations cannot participate in such markets through wallets that are linked to the organizations, at least for reporting to essential regulators. Tracking of token trading into wallets on transparent blockchains will provide far more insight into trading than is currently available through banks. Trading can be conducted on permissioned blockchains so that confidentiality of market participants can be maintained but remain accessible to regulators if probable cause for investigations arise.

Conclusion. As blockchain technology continues to proliferate and change how industries conduct business, relate to consumers, and deliver value, ReFi imagines a path forward that acknowledges the entire ecosystem involved in economic transactions. ReFi is being used right now to re-imagine and provide value to the carbon credits space, providing verifiable, dis-intermediated, and liquid carbon credits that can be verified for accuracy independently and used as building blocks to improve the climate impact of nearly any business. Beyond carbon credits, ReFi seeks to re-imagine how value is delivered and who decides what is valued in communities by giving them tools to tokenize, customize, and design crypto-economic incentives where their community needs the most impact. While still a relatively new and emerging field, regulation is needed to help these markets proliferate in a positive-sum way, and encourage entrepreneurs to develop ideas utilizing these technologies. ReFi has real potential for increasing public good and the development of clear guidelines can help builders understand how to create the most impact and lead to some truly innovative ideas that can help society solve complex carbon reduction problems.