The Amsterdam Law & Technology Institute’s team is inviting scholars to publish guest articles in the ALTI Forum.
Here is the latest contribution authored by David Rossati (Vrije Universiteit Amsterdam)
The Intergovernmental Panel on Climate Change, an international organization that offers the most comprehensive periodic assessment of climate-related science, has recently stated in its latest report that “[t]racked financial flows fall short of the levels needed to achieve mitigation goals across all sectors and regions.”1P.R. Shukla et al (eds), Climate Change 2022 Mitigation of Climate Change: Working Group III Contribution to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change – Summary for Policy Makers (Intergovernmental Panel on Climate Change 2022) 62, https://report.ipcc.ch/ar6wg3/pdf/IPCC_AR6_WGIII_SummaryForPolicymakers.pdf In sum, in the context of a capital-led transition, more resources need to be raised and channelled towards the many activities that will help reduce or avoid greenhouse gas (GHGs) emissions.
At first glance, blockchains offer all sorts of possibilities for decentralised forms of action, including ways to source new and accessible finance that could ‘do good’ about the climate while allowing trading in profitable digital assets. And in fact, blockchains are already a reality for innovative small-scale initiatives on clean energy production. To name a couple, a neighborhood in New York has created a local solar energy market place, where solar panel owners (‘prosumers’) can sell their excess renewable energy to local peers via an app: all the transactions take place on a blockchain. In South Africa an investment initiative crowdsources finance to pay and lease solar panels for entities that could not otherwise afford them. Energy users pay investees and their fees directly via Bitcoin, thus facilitating international liquidity transfers.
Aside from these small-scale examples, other early initiatives are trying to deploy blockchain technologies on the global scale. If successful, they could work as bedrock infrastructures for how emission reductions will be sold, transferred, and accounted for. In contribution, I focus on one of these initiatives spearheaded the World Bank and linked to the implementation of the new market-based mechanisms for global emissions reductions under the Paris Agreement. These mechanisms –which are still in an early phase of implementation– are supposed to buttress and revamp the global carbon market. A market estimated to have grown by 161% in 2021 alone from the previous year up to a trading value of $851 billion.
In this short piece, I focus on the type and nature of the data, which at the moment populate the prototype ledger developed by the World Bank’s initiative. The absence of some key information related to the carbon units traded is a missed opportunity to further promote transparency and environmental integrity in the future carbon market. In the end, I also reflect on what this deployment of prototypes can entail in terms of future governance. Before that, however, the readership of the ALTI Forum might want to know more about the global carbon market and the market-based mechanisms of the Paris Agreement.
The upcoming state-backed infrastructure for a revamped global carbon market
The nuts and bolts of market-based mechanisms for climate mitigation
To reach a ‘net-zero’ society by 2050, a global policy goal indirectly set by the Paris Agreement, it does not matter where the reduction or avoidance of emissions that causes climate change takes place. For some entities—be them states or polluting companies—it might cheaper to reduce emissions somewhere else and by someone else than facing more costly actions on their own and where they are: this is the basic rationale for the adoption of ‘market-based mechanisms’ under the Paris Agreement. These mechanisms should promote the recognition and transfer of ‘climate mitigation efforts’ among countries and eligible private entities, with the end result that the overall costs for reducing emissions will be lower than the more traditional environmental policies.
There are two types of market-based mechanisms: cap-and-trade and baseline-and-credit (or offsetting). Under the first, a public authority sets an overall emission reduction goal across selected sectors of the economy, it then either auctions allowances to emit or assigns for free a corresponding number of allowances to the level of the emissions cap. Polluters have to periodically prove compliance by returning as many allowances as the actual emissions released with the following catch: the scarcity of allowances will bring virtuous companies to sell the allowances that they might own in surplus to their actual emissions, while high polluters will have to source and buy the needed allowance in the market.
Baseline-and-credit mechanisms are more known in our everyday life since many ‘green pledges’ of corporates around the globe are increasingly relying on the offsets that these projects generate to claim the carbon neutrality of their products, services, or operations. In essence, offsets are credits representing an amount of avoided or reduced emissions that have occurred from projects that reduce GHGs from a business-as-usual scenario. An authority, or a private company in the case of the voluntary offset schemes, will certify these reductions by releasing credits that can be used to claim mitigation efforts or even compliance with cap-and-trade schemes, as it was the case for the EU Emissions Trading Scheme for a while.
Bridging market-based mechanisms with the blockchain
The link between the functioning of these mechanisms and blockchain technologies is the commodity that is actually created and traded: the unit of accounting (unit). Indeed, to run these mechanisms, there must be ‘something’ that is generated, allocated, and then transferred. Otherwise, there would not be an objective system of recognition and transfer of these mitigation efforts and of measurement of how much a state or a company has actually reduced emissions.
This is why market-based mechanisms rely on units, each one measuring one metric tonne of CO2 equivalent (1Mt CO2eq) and representing an asset or a currency that users can exchange and trade to claim their ‘climate mitigation efforts,’ i.e. emissions reductions that are either promoted by law or entirely voluntary under private schemes. Since 2008, the Kyoto Protocol has experimented with these mechanisms with mixed results, while the Paris Agreement is expected to reignite the forces of the market with a new set of mechanisms explained below.
The two market-based mechanisms of the Paris Agreement
The Paris Agreement set up two market-based mechanisms, both obscurely named and still on the way to being implemented. Yet they promise to work as the backbone of a revamped global and integrated market of allowances and offsets. The first, called ‘Internationally Transferred Mitigation Outcomes’ (ITMOs) sets up a scheme for states to voluntarily recognize and transfer the mitigation efforts that took place from another state. Such mutual recognition is thought to allow the efficient ‘transfer of mitigation outcomes’ in ways that a state, or companies within that state, if allowed, can acquire emission reductions from more virtuous entities in other states and thus reduce the costs of reducing emissions. It is not yet clear exactly how, but ITMOs (at least most of them) are expected to be accounted for in units, thus enabling international carbon market exchanges. The matter with ITMOs gets more complicated because these transfers are expected to be linked with already existing national and sub-national cap-and-trade mechanisms, such as the EU Emissions Trading Scheme. Another complication for ITMOs is that the Paris Agreement does not set a centralised institution and a registry that will account for all the transactions between states and, possibly, companies of these units. It only comes with an open-ended process of transparent communication by states of these transactions and mitigation efforts.
But it is in carbon offsets that, at the moment, much of the hype on blockchain, NFTs, and Decentralised Autonomous Organizations is going. As seen, offset schemes can be of public and of private nature and the Paris Agreement has also opened up the gates for a centralised carbon offset scheme under international law as its second market-based mechanism. This is poised to generate offset credits from projects that reduce emissions in any state party that wishes to participate. The scheme, which comes with the odd name of ‘Article 6.4 Mechanism’, builds up from the previous Kyoto Protocol’s Clean Development Mechanism (CDM), but its latest regulatory guidelines give more consideration to environmental integrity and avoidance of double counting. Behind this development is the reality that virtually all offset mechanisms are fraught with the problem of demonstrating that a given project will actually reduce emissions from a putative baseline and in a specific geographical location. In fact, many credits released under the CDM have not proved ‘additional’ because either the baseline was miscalculated or the emissions ‘leaked’ (i.e., took place) somewhere else, even within the territory of the same state. 2Junjie Zhang and Can Wang, ‘Co-Benefits and Additionality of the Clean Development Mechanism: An Empirical Analysis’ (2011) 62 Journal of Environmental Economics and Management 140.Forest-based projects are an example of what can ‘lie behind’ an offset credit: not only these can be affected by mistaken estimates as to the actual level of CO2 eventually stored in a preserved or regenerated forest biomass,3Clemens Kaupa, ‘Scrutinizing Net-Zero: The Legal Problems of Counting GHG emissions, Removals and Offsets Together’ (2022) Review of European, Comparative & International Environmental Law (forthcoming). but some of these projects also came with bad designs and implementation, so to result into negative impacts on communities depending on targeted forests, land tenure issues, and other unsustainable practices.4Julia Dehm, ‘Indigenous Peoples and REDD+ Safeguards: Rights as Resistance or as Disciplinary Inclusion in the Green Economy’ (2016) 7 Journal of Human Rights and the Environment 170.
The problem with offset credits is that they are not only linked to the quantitative aspect of representing emissions reductions but also to the more complex realities of what has been done to reduce such emissions. This leads to the notion that credits from ‘bad projects’ cannot value the same as ‘good ones’ both in their emission reduction value and claim to environmental and social integrity, the latter now being a requirement under the Paris Agreement.
Overall, it is the Paris Agreement’s new mechanisms and the increasing pressure on corporations to demonstrate their contribution to climate mitigation that are setting the basis for a global market of digital commodities to be created, registered, verified, valued, traded, and used to claim compliance and positive efforts. With such a complex and fragmented landscape of units that could be traded, an open decentralised ledger could work as the ideal infrastructure to register all units, their related data, and transactions.
A blockchain initiative for the Paris Agreement’s mechanisms: the World Bank’s Climate Warehouse
The potentially enormous number of units, the decentralised structure that the mechanisms entail, and the need for a robust system of transparent transfers of units across countries and between private actors make fertile ground for deploying blockchain technologies. Given the fast pace of how blockchains and related apps are developing, there are already early entrants in this arena.
I focus here on an initiative of the World Bank. Its Climate Warehouse aims to come up with a prototype infrastructure. This will be based on an “an opensource, interoperable and permissionless public blockchain platform” that will enable, verify and transparently show all transactions done under the Paris Agreement’s mechanisms. Some positive potential features that a decentralised ledger of this kind will offer are, . This should be realised in practice through a ‘Chia DataLayer’ on the blockchain, which will show information on the units circulating in the form of NFT-like coins, named ‘singletons’. It will be states through their own national registries of units, or other delegated entities, that will upload information on a Chia DataLayer and will generate related ‘singletons’. In this way, the ‘meta-registry’ so created on the blockchain will be accessible to queries and data analysis from the public, including the related transactions.
Second, the problem of double counting or use of units, which is something that has troubled these mechanisms, will become difficult, if not impossible, given the distributed system of verification based on the blockchain’s protocol. Finally, the alleged functionality of the blockchain is supposed to considerably reduce the transaction costs that market participants face when trading on the carbon market. The Climate Warehouse prototype simulation is currently running on Chia, a blockchain envisioned by the creator of BitTorrent and by a ‘Network,’ which is aiming to become a public traded company in the US. While the Chia Network cannot change what is contained in the blockchain, as this would depend on the agreement among the majority of the 300,000 nodes currently supporting it, it will still be at the centre of developments of its protocol and architecture, which, according to the World Bank, is ideal for running ITMO transfers under the Paris Agreement.
Aiming at ‘good quality’ units on the blockchain…
As to the specific content that will be stored in the blocks and related to the units of accounting, the Climate Warehouse’s demo shows how the prototype gives the opportunity to the public and market actors to see what units are circulating in the market and what are some of their specific characteristics. But there is also another potential reason for relying on blockchains to run transactions in the global carbon market. As seen, what happens on the ground for offset projects and allowances is increasingly becoming a factor appreciated by market actors and the general public. To put it more concretely, the value of an offset credit from a project involving the construction of a medium-sized dam, which overhauls local ecosystems and requires human resettlements, is likely to be lower than the one of a similar credit originating from a small solar panel, off-grid, farm that delivers clean energy to remote villages and generates local employment. Similarly, an ‘ITMO’ unit from a country with an unambitious mitigation goal, or a country that overestimates its business-as-usual emissions, would be valued less than one from a country that has rigorous accounting and an ambitious emission reductions plan under the Paris Agreement. This is because it is more likely that the transfer of the former will not represent a valuable reduction of emissions in line with the collective efforts needed by all states under the treaty.
A blockchain of this kind seems to allow for a transparent input of these ancillary data so that users can get a better understanding of the quality of the unit or the offset. However, at the moment, the taxonomy of data used for this ledger only gives partial consideration to these important qualitative aspects. There is the possibility to include data on the ratings given to a certain offset project. Simple ratings, however, do not give a detailed outline of what is exactly affecting the quality of an offset credit. Also, ITMO units are excluded from this rating data type, which is something undesirable given that also ITMO units will differ in their own quality.
One might justify this exclusion on the basis that it would be difficult and cumbersome to input such data on blocks because this would require another layer of third-party verification, ensuring that the unit circulating is backed by a positive project or an ambitious goal. However, looking at the White Paper for the prototype, there are possibilities for changes to the data layer, and these could be easily attributed to trusted third-party verifiers, such as accredited NGOs, research institutes, etc.
… but risking a bad mix?
The risk of poisoning the well of the global carbon market with ‘bad units’ is made even more complicated by the strong push of market actors to usher in offset credits generated by private entities into ITMOs. For now, this has not happened yet in regulatory market-based mechanisms. Such a push comes despite the fact that the rules under the Paris Agreement do not explicitly allow for that. Private offset credits come from the so-called Voluntary Carbon Market, which has been growing considerably in demand in the last couple of years as more corporations are relying on these offsets to somehow prove their efforts towards carbon neutrality.
The issue with voluntary credits is that these commodities are not created under public regulation but by entirely private standards and processes, which leads again to the question of good quality offset creation and circulation. For how transparent and rigorous these VC standards appear to be, the question of ensuring their accountability and responsibility in the case of a global public platform for transfer and recognition of offsets will always stand until a robust and public verification, and redress mechanisms will be in place. To be sure, in order to include these credits as valid units to be transferred under ITMOs, there will be need for specific regulations and agreements between participating states, and this might offer the opportunity to set some conditions as to what VC standards and credits will be allowed in the transfers. However, the Climate Warehouse prototype appears to already allow for a mix of public- and private-based intangible claims of emission permits or reductions without clear safeguards that could be embedded in the blockchain. These could consist of ex-post recognition via database and block changes that units released from a project did not actually reduce emissions as claimed or caused local harm to people and the environment. The prototype seems instead to leave this important filtering function to domestic jurisdictions, while there could also be more transparent processes on the blockchain to contest specific offsets or allowances and ask for their cancellation or reduction in value. The open and transparent character of the blockchain chosen could be used for promoting global participation in enhancing the quality of the units that will be transferred and used.
When implemented, the market-based mechanisms of the Paris Agreement will encase a revamped global carbon market of potentially enormous proportions, where public and private efforts at generating and transferring emissions reductions will be recognised and traded. In this piece, I explored a prototype that seeks to demonstrate how blockchains could support the transparency and efficiency in this market to come.
Yet, as Fleur Johns has shown, governance is increasingly embracing new models of authority and the deployment of prototypes, particularly by powerful actors, has its own normative properties. In this light, I drew some early criticisms on the prototype promoted by the World Bank, which seeks to set up a permissionless and open-source blockchain to buttress all future transactions of the global carbon market to come. While this prototype has indeed the potential to increase clarity and transparency in the market, it already excludes the possibility of linking crucial qualitative data to each unit transacted under the two market-based mechanisms of the Paris Agreement and the voluntary carbon market. But the absence of these data has been a central critique of those suspicious of any market-based mechanism for climate mitigation. And the fact that no feature is offered in the prototype for the inclusion of this information on what is traded raises the concerns that, in the long run, the amount of the GHG reductions that are accounted for and transferred under the blockchain will not reflect the number of particles that will actually be the atmosphere.
To be sure, the prototype could be improved and, if so, its normativity might be even more convincing to those states who will adopt it as their key technology to enable a transparent transfer of units. Still, such a path dependency for a prototype is not a necessary outcome: as other initiatives to run the market-based mechanisms on a blockchain are emerging, another possibility is of a competing field of prototypes and early initiatives and, thus, of competition among different infrastructures with different ambitions, blockchain designs, and governance models. In this scenario, the goal of a unified global infrastructure will become a mirage, and so the running of a global carbon market based on high transparency and efficiency.
Citation: David Rossati, Blockchain prototypes for the new carbon market under the Paris Agreement, ALTI Forum, July 12, 2022
Invited by Thibault Schrepel