Can carbon credit alone turn deals green? | ISDA White Paper | Dawn of carbon negative cryptocurrencies

Introduction

In March 2021, Tesla announced its plan to accept Bitcoin for purchase of Tesla. However, within just two months of the forward looking announcement, Tesla took a reversal from their great leap forward, citing environmental impact concerns over energy usage associated with Bitcoin. That having been said, Elon Musk did add in his announcement that Tesla would consider accepting Bitcoin again if issues of environmental concerns could be addressed.

“Hong Kong must put words into action in addressing the crisis of extreme weather brought by global climate change.”

– Hong Kong’s Chief Executive Carrie Lam, 2021 Policy Address

At the same time across the pond, the Government of Hong Kong has also adopted the stance that the objective of addressing the crisis of climate change is to take centre stage in Hong Kong’s policy. All in all, little doubt can be had that the policy of going green is here to stay and such policy will inevitably be reflected in regulations and laws (both in Hong Kong and across the Globe).

Dawn of green finance | ISDA Whitepaper

Green finance, which strives towards environmental benefits and managing environmental and social risks, is gaining momentum in present financial markets. In respect of the reduction of carbon footprint of human activities through natural hazard mitigation measures, carbon financing is utilized to place financial value on carbon emissions and thus broaden the source of funding for sustainable projects that emit less carbon into the atmosphere.

Recently, the International Swaps and Derivatives Association (ISDA), which is the trade association representing leading participants in the international privately negotiated (over-the-counter, or OTC) derivatives markets, has published a white paper to discuss the legal issues in relation to the carbon credits and provide recommendations for achieving greater legal certainty in the trading of carbon credits.

One question which remains unanswered is whether the carbon credit alone is truly effective when underlying transactions ultimately remain rooted in traditional finance. At the same time, it is pivoted that the recent introduction of innovative carbon negative cryptocurrency may be a significant game changer which may ultimately fill the missing parts of the puzzle.

Voluntary market for carbon credits trading

Two major positions conceded by ISDA are that, in their view, (i) carbon emissions are unavoidable and (ii) the implementation of emission reduction strategy takes time. As such, the concept of “carbon credits trading” or “emission credits trading” was created and first formalized in the Kyoto Protocol back in 1997. Countries that have emission units to spare, i.e. emissions permitted to them but not “used”, can sell this excess capacity to countries that are over their targets. Suffice it to say, much of the world has changed since 1997 (with new technologies and economies in today’s reality). A voluntary carbon market, which distinguishes from mandatory markets created and regulated by governmental authority, is now playing an important role in global efforts in transition to a low carbon economy. Projects that reduce or remove carbon emissions can “earn” carbon credits upon assessment and sell the carbon credits for funding.

The value of the global voluntary carbon market skyrocketed from around US$750 million in August 2021 to around US$1 billion by the end of 2021, with an increase of nearly one third in just a quarter of a year. Heartening as it seems, one must not lose sight that the notable increase in transaction volume of the market means more frequent use of traditional transaction tools i.e. fiat currency, which may incur even more carbon footprint than those saved by voluntary carbon credits.

The maintenance of the fiat money system is no less energy consuming than the notorious mining process of some cryptocurrencies, such as Bitcoin and Ethereum. There are sources of carbon footprint which are always neglected by the public, including the infrastructures for sustaining fiat money and the cost of renewing the currencies. According to one study, the annual carbon dioxide emission for maintaining the fiat money system is estimated to be 4 times of that of mining Bitcoin.

Possible alternatives to traditional transaction tools are crypto-based systems and cryptocurrencies for tracking and trading carbon credits, which can, not only make the market less opaque and more liquid, but also alleviate the negative environmental impact by the above mentioned traditional transaction tools.

Carbon negative cryptocurrency as alternative transaction tools

Bitcoin and Ethereum have been the most well-known and sought-after cryptocurrencies globally, but they may not be the most ideal alternatives to traditional transaction tools. To achieve decentralization, cryptocurrency employs various protocols to secure their networks, the most common of which are Proof of Work (“PoW”) or Proof of Stake (“PoS”). These protocols and algorithms require a considerable amount of electricity for network maintenance, validation of transactions and creating new coins (i.e. cryptocurrency), which is also known as the mining process. Mining is the process where specialized hardware is employed to solve extremely complex mathematical problems, and the computation effort of the first miner solving the problems will be rewarded with coins. It is estimated that Bitcoin mining and transactions now consume 0.1% of electricity supply globally, which is higher than that of Argentina.

“Tesla has suspended vehicle purchases using Bitcoin. We are concerned about rapidly increasing use of fossil fuels for Bitcoin mining and transactions, especially coal, which has the worst emissions of any fuel…”

– Elon Musk

Amidst the cry for an environmentally friendly substitutes to cryptocurrencies using PoW or PoS algorithms, carbon negative cryptocurrencies were created to combat the climatic changes. Carbon negative cryptocurrencies, such as ALGO from Algorand (“ALGO”) or DOT Coin from Polkadot (“DOT”), employ a consensus algorithm known as Pure Proof of Stake, which does not involve the expensive and wasteful mining process.

Every user can participate in creating the blockchain network by being selected to propose blocks and vote on block proposals. Without the need to race against other users in the mining process, energy would not be wasted and the development of blockchain can be sustainable.

Besides the environmental benefits, ALGO can be utilized as transaction tools to support various types of smart contracts, including:-

1.Stateless Smart Contract, with purpose to authorize transactions by validating transactions between parties (like an escrow);

2.Stateful Smart Contract, which operates via logical programs designed to store data on the blockchain; and

3.Algogeneous Smart Contract, which integrates both stateless and stateful smart contract functionality and are written in a programming language called Transaction Execution Approval Language. With such contracts, the underlying transactions can be in the form of indivisible and irreducible series of database operations such that either all occurs, or nothing occurs.

Parties participating in the trading of carbon credits can make use of the smart contracts available for adopting ALGO as a transaction tool to improve the trading efficiency and further reduce the carbon footprint of the transactions.

Connecting carbon credits and cryptocurrency can also stabilize the price of carbon credits and ensure that the investment was made to fund environmental projects instead of being pocketed. With the use of blockchain, a promising ledger technology, liquidity of the carbon credit market can be sustained and the trace of the fund can be effectively monitored, so that the trading scheme will not be mere public relations tools in disguise. Currently there have been initiatives to staple cryptocurrency and carbon credits, such as Climatecoin which is based on Ethereum. It is expected that similar moves can be seen in the future which affix carbon negative cryptocurrency with carbon credits, so that the voluntary carbon credit can truly go green.

Key takeaways

There has been a notable change in the way people invest and the sole financial benefits no longer top the list of investors. Green finance is gaining prevalence and more and more financial products, including cryptocurrencies such as ALGO and DOT Coins, are created as substitutes of traditional products (e.g., Fiat Currency and BTC) or to accomplish sustainable development initiatives. While the voluntary carbon credit system strives to reduce carbon emission, its underlying linkage with traditional finance per se is going contrary to its aspiration. However, initiatives to connect voluntary carbon credit and carbon negative cryptocurrency may turn a new leaf of the carbon credit market and allow businesses to truly go green.

Still, the legal nature of combining cryptocurrency and voluntary carbon credit remains uncertain and still calls for regulations on details of transactions. If companies are minded to use cryptocurrencies as transaction tools, they should seek legal opinions and take extra caution on drafting agreements to better secure their interests.