Executive Summary
At KlimaDAO, we believe that public blockchain technology is uniquely well-suited to host environmental assets like verified carbon credits.
KlimaDAO launched on October 18th, 2021, with a vision to scale the impact and efficiency of climate finance globally through building transparent, neutral, and public infrastructure for the carbon market. It achieves this through the development of a Web3-enabled tech stack that can improve the performance of the carbon markets.
KlimaDAO has continued to develop a strong, value-aligned community, and the DAO has participated in consultations and engagements with the wider carbon market and policy arena. These include the consultation processes undertaken by major VCM registries and the community voting in favor of removing the problematic HFC-23 credits from the BCT pool and properly disposing of them. The DAO has also begun to develop partnerships and engagement with the market’s supply side, and is now playing a large role in defining how new tokenized carbon can be onboarded within the ecosystem. Examples include the C3 Forum post on introducing EEMIP credits and the KlimaDAO Forum proposal to explore investment into supply-side innovations.
KlimaDAO asserts that tokenized carbon credits should be as transparent and widely accessible as possible, while mitigating risks such as money laundering and fraud by monitoring the entry and exit points of the on-chain ecosystem. This is in line with other tokenization schemes such as asset-backed stablecoin issuers like Circle, the issuer of USDC. Most importantly, tokenized carbon credits should not be subject to even more stringent requirements than the status quo for off-chain credits. In the off-chain market, retailers routinely carry out batched retirements on behalf of small-dollar retail customers based on just a credit card - not full KYC.
It’s also possible for Verra account holders to retire on behalf of another party with a blank beneficiary text, preventing the public from knowing which entity consumed those credits, as well as introducing the risk of double counting if the same blank-beneficiary retirement certificate is provided to two different clients by an unscrupulous Verra account holder.
The tokenized carbon ecosystem should offer options to those entities who have policy or regulatory requirements to KYC their counterparties, or who wish to publicly attest to their retirement activity, but should minimize the requirement of KYC to ensure broad access and minimize friction. Meanwhile, Verra should develop a system to allow public attestations of beneficiaries based on Decentralized Identifiers (DIDs) or Verifiable Credentials (VCs).
Given the urgency of the climate crisis, Verra must do all it can to enable and support innovations across the Web3 space which help accelerate the delivery of capital to carbon project developers. To enable this, we recommend a phased approach for tokenization (outlined in response to question 2 below) that mitigates risks while allowing innovation to continue.
We are grateful to Verra for opening this consultation process on tokenization and carefully considering the input of all stakeholders.
Definition of Terms
Tokenizer: A Verra-authorized legal entity who provides the service of tokenizing assets found in the Verra registry.
Asset: Within this document, Asset refers to any certified units which Verra provides as well as any derivative of those assets, including PCUs, which Verra is expected to launch at the end of the year.
Contract: Within this document, a Contract refers to a set of instructions that can exist (and can be interacted with) on a blockchain, such as Ethereum or Polygon.
Customer: A legal entity that uses the tokenization services provided by the Tokenizer.
Consultation Questions
1. Regarding the creation, transfer, and use of VCU-backed crypto instruments and tokens, what safeguards should be implemented by Verra to ensure environmental integrity, particularly to prevent double-issuance and double-use? Verra should publish clear guidelines for appropriate tokenization of VCUs, ideally in line with the tokenization framework being developed by IETA. Under the IETA framework, guidelines for both “Direct” (a.k.a. one-way) and “Secured” (a.k.a. two-way) tokenization should be published. Direct tokenization is much simpler to implement and technically represents a lower risk of failure than Secured tokenization. Direct Tokenization should permanently immobilize the credit, and all structured attributes of the credit available in the Verra public registry’s serial number (methodology, vintage, location, CCBs, etc.) should be recorded onto the blockchain and associated with the tokenized credit during the tokenization process. Secured tokenization holds an inventory of credits in a dedicated Verra registry account, with credits immobilized during tokenization and remobilized upon detokenization, based on Customer activity. This requires more complex infrastructure than Direct Tokenization, but also offers the opportunity for credits to flow both into and out of public blockchain ecosystems. Allowing for “remobilization” of credits avoids lock-in of credits within a given system. Regardless of which tokenization scheme is utilized, as the tokenized credit represents an immobilized VCU on-chain, with metadata tying it the tokenized representation to the token for that specific project/vintage in the Verra database, such retirements must require that the underlying token is destroyed (preventing double-counting of the tokenized credit). For Secured Tokenization, when a retirement is issued on-chain, Verra should require that the underlying immobilized credit is retired in the Verra registry within a reasonable period of time. 2. What infrastructure and processes do entities participating in the immobilization approach need from Verra? The implementation of an immobilized state for carbon credits that have been bridged onto the blockchain will enable data flow between on-chain and off-chain systems, increasing understanding of the rate of retirements on-chain, and delivering clarity to the market in terms of at what point the environmental benefit of tokenized carbon credits are claimed. KlimaDAO proposes a phased approach to implementing infrastructure that immobilizes carbon credits that have been tokenized. This approach can enable continued development of the blockchain-based carbon credit ecosystem without introducing risks to the integrity of the market while more sophisticated solutions are being implemented. Phase 1 The implementation of an immobilized state that allows tokenization to continue using existing Direct bridges such as Toucan, C3, and Moss. In this initial phase, credits can be immobilized but cannot be “remobilized”. This would be achieved by introducing a new Boolean (true/false) field into the Verra Registry which dictates whether a credit is immobilized, and a text input field for “immobilization message” or “immobilization hash”. This field is referenced by the Tokenizers as cryptographic proof of ownership, and for associating the immobilized Verra assets with their tokenized counterparts. Per IETA’s guidance on Tokenization, this first phase would only support Direct Tokenization, wherein the environmental attributes of the credit are irreversibly transferred to the tokenized carbon credit. Phase 2 Tokenizers will provide a system to ‘detokenize’ already tokenized carbon credits, that avoids risk of double-counting and/or fraud. To enable this, Verra would provide a mechanism for approved Tokenizers (i.e. those that hold a Verra account) to “remobilize” credits in their Verra accounts (including credits they did not originally immobilize by bringing on chain. The responsibility will be on the Tokenizer to ensure integrity by e.g. batching retirements, providing a publicly auditable inventory of immobilized credits, and undergoing necessary KYC checks from the Verra Registry. While Direct Tokenization results in a verifiable trace from the Verra registry to the resulting on-chain credit, auditing a Secured Tokenizer requires knowing the holdings of the corresponding Verra registry account; to facilitate this, Verra should provide a simple, standardized mechanism for Secured Tokenizers to publish their inventory of immobilized credits. Phase 3 Finally, to add greater robustness and security, we propose the introduction of an event-driven architecture where a listener process is deployed in the Verra Registry system that responds to blockchain events involving tokenized credits.
A detailed guide for implementation of this final phase:
The “detokenization” process should take the form of an open-source Smart Contract that allows a user to permanently destroy their unretired tokenized carbon credits.
Whenever a token is destroyed in this manner, the blockchain would record this event as an immutable and public record.
These events would contain all relevant data such as the target registry, target registry account, offset vintage, project data, token origin, token quantity and more.
These events would be emitted in real-time and would signal to the Verra registry system that compliant assets can safely be remobilized in the Verra system, without risk of double-counting or tampering.
This solution would ensure that Verra can apply its own respective Terms of Service to the process. For example, Verra would retain the power to implement restrictions on wallets and recipient accounts, offset credit criteria, quantities, fees, and more.
This same smart contract could also serve as a trusted and transparent way to transfer qualified credits from other registries directly into the Verra system.
In addition to the approach outlined above, a grandfather mechanism should be introduced for tokenized credits associated with good-faith Tokenizers created prior to Verra’s prohibition to become properly immobilized credits (permanently immobilized in the case of Direct tokenization like Toucan or C3). 3. Is there a market need to provide for the reactivation of immobilized VCUs, as long as any related crypto instruments or tokens were not used for any other purpose and are destroyed as part of this reactivation? Reactivation for unretired tokenized credits provides an avenue for the movement of VCUs both on and off the blockchain, allowing for migration between different Tokenizers and mobility between different market arenas. This minimizes lock-in associated with Direct Tokenization, though as outlined above Secured Tokenizers should have more sophisticated compliance and technical guidelines than Direct Tokenizers because of the risks associated with reversible tokenization which we outline and address above. We align with IETA guidance that redemption of immobilized VCUs should only be possible for a minimum unit of one tonne. 4. What are the legal and operational implications of a crypto instrument or token being fractionalized? KlimaDAO welcomes collaboration with key stakeholders in the VCM, including Verra to continue exploring regulatory questions in regard to tokenized carbon. Since February, KlimaDAO representatives have met with state governors and Members of Congress from both political parties on the Senate and House side to educate them on KlimaDAO's offerings and policy priorities. In addition to a number of productive meetings, KlimaDAO has played a direct role in providing feedback and expertise on Senator Cynthia Lummis' (R-WY) and Senator Kirsten Gillibrand's (D-NY) groundbreaking Responsible Financial Innovation Act to ensure that the crypto-focused bill encourages the growth and maturation of the industry while protecting consumers; this will provide new clear regulations that can make the market more accessible to newcomers. KlimaDAO has developed meaningful relationships with members of key committees including the House Financial Services Committee, Congressional Blockchain Caucus, Senate Commerce Committee, Senate Financial Services Committee, and Senate Agriculture Committee. In addition to federal legislators, KlimaDAO has met with state governors and other officials to advocate for smart regulatory frameworks for the ReFi industry at every level of government. Some general legal considerations associated with tokenized carbon credits include:
AML regulation of tokenized VCUs should be proportional and in line with FATF’s Standards on VAs and VASPs, due to new techniques in blockchain;
Vlinder Austria GmbH, a partner of KlimaDAO, has a legal opinion from law firm in Liechtenstein that 2-way tokenized VCUs and PCUs are utility tokens (not securities) in EU/MiFID II
KlimaDAO’s legal team engaged a big 4 US law firm that confirmed that “In the case of the Token, assuming arguendo that it entailed a contract, it is clear that its underlying asset (be it the tokenized carbon credit, or the carbon credit itself) is not a security.” for United States laws;
The legal team at C3 has a legal opinion from different law firms that confirms that 1 and 2 way tokenized VCUs are utility tokens under EU/MiFID II, British Virgin Islands and Cayman Island law;
KlimaDAO is specifically concerned about the status of over 20 million VCUs tokenized via 1-way bridges; we have a strong opinion that the burning of Directly Tokenized carbon credits via the Contract’s “retire” function is a correct claim of the respective environmental benefit - regardless of whether the retirement is fractional or whole-tonne. To support this claim, independent auditing can be conducted on public digital records, tying back from the retirement transaction that burns the tokenized credit, to the fractionalization transaction, to the original bridging event, and finally to the corresponding Verra registry serial number. Tokenized carbon markets should be open by design and permissionless by default, regulated at the edges. We do not believe fractionalization specifically introduces unique legal considerations, though operationally fractionalized retirement of credits tokenized by a Secured Tokenizer may require a mechanism for “batching” fractional retirements of a given project/vintage combination given the technical constraints of Verra’s whole-tonne registry system. 5. What KYC checks (and in relation to which jurisdictions) should Verra apply to platforms before authorizing them to issue, market, and/or transact in crypto instruments or tokens that are backed by VCUs?
Verra’s existing KYC checks should be applied to Tokenizers of VCUs, since any entity directly interacting with the Verra Registry via a registry account must pass Verra’s KYC checks. However, in line with the “monitor the edges” approach recommended above, such requirements should not necessarily apply to platforms which simply build on top of already-tokenized VCUs. Correspondingly, third-party issuers of tokens that are built on top of tokenized VCUs should not require KYC checks so long as they are only operating within the monitored boundaries of the tokenized credit ecosystem. Considerations around organizational structure should be more flexible as Web3 organizations may not be structured as a LLC or Limited Company, but rather as individuals who are able to KYC and are accountable to the organization as well as to Verra. In addition, the business models implemented by Web3 organizations may diverge from traditional retailer, brokerage, or investment fund activities. Due consideration of novel business models should be given – with the burden on the organization applying for the account to communicate the business model with Verra. In any case, rather than obliging an organization to incorporate in a state which can be far away (for instance, obliging an organization to incorporate in US while it’s EU based, or vice-versa), it would be advisable for Verra to issue guidelines that can be inspired from a jurisdiction that has the KYC controls that Verra thinks are suitable for accessing the market, keeping in mind the characteristics of permissionless protocols. 6. Should platforms be required to apply KYC checks on all entities that hold crypto instruments or tokens, or just on the entities that receive, use, or are the beneficiaries of such instruments? In general, KlimaDAO advocates for a tiered and proportional KYC environment, in which KYC is optional for activities that do not represent substantial risk to the integrity of the ecosystem while it may be required for other activities. Some KYC processes can be implemented by the entities participating in the on-chain market, as opposed to Verra having to be responsible for actually doing the KYC. Tiered approach:
Tokenization (and de-tokenization) should always require KYC, and implicitly does even without explicit checks by the bridge provider because first-party bridging requires a registry account (which requires KYC to open).
For transactions, users should have the option of whether they are comfortable (or permitted) to transact with other parties who are not KYC’d via a permissionless pool. This is the approach taken by major lending protocols such as Aave to provide institutional-grade pools for trading.
For users who have requirements to only interact with known entities, a KYC-required permissioned pool along the lines outlined above for BCT.safe can be offered:
A solution is being developed in conjuction with IdentDeFi, whereby: “A Proof of Concept will demonstrate the technical feasibility of the solution with a single KYC provider. A KYC-wrapped version of BCT (BCT.safe) will be created, which will automatically check for a valid KYC identifier in both the sender and receiver wallets prior to any transfer that is made with the BCT.safe token."
This means that users who wish to hold or trade the BCT.safe directly will need to undergo a KYC process with a supported KYC provider (see illustrative example in diagram below)
Retirement should never require KYC, but functionality should be built into the tokenized credits to provide the option for retirements to be tied to a specific KYC’d entity rather than simply a wallet address
Requiring KYC for all retirements would represent a double standard given the existing practice of off-chain retailers reselling Verra credits without requiring KYC (simply a credit card number).
Thus, if Verra believes that KYC should be a requirement for retirements, a reasonable maximum retirement size should be provided, below which entities are not required to KYC.
KYC-optional retirements paired with KYC-required bridging (and transactions) would be analogous to the blank retirements already possible today in the Verra registry
SushiSwap's integration of automated offsetting demonstrates how latent demand can be unlocked by non-KYC-enforced small transactions. Our early projections suggest that over 1 million tCO2e could be offset by small transactions and Web3-native retirements over the next few years.
Reactivation of credits would always require KYC as the receiving party requires a registry account
7. What, if any, information on crypto instrument or token holders should be made publicly available? All data for crypto instruments and token holders on public blockchains is made publicly available by virtue of it being a publicly held database (that is, the blockchain itself).
The level of detail and tracking of interactions with on-chain carbon are far superior using public blockchains thanks to solutions such as KlimaDAO's Carbon Dashboard (see below) which currently tracks all tokenized carbon credit activity on Polygon and Chainalysis (see below) which allows analysis beyond what is currently possible in the traditional VCM, which is typified by opaque OTC trading.
Data for who is tokenizing on the Verra Registry should be treated as the rest of the market is – i.e. that account holder information can be made private subject to Verra’s agreement. Holding of Secured Tokenizer’s dedicated accounts should be required to be public, and Verra should provide a standard view for accessing a Tokenizer’s immobilized inventory to ensure auditability of tokenization/detokenization activities by that Tokenizer.
About KlimaDAO
KlimaDAO’s mission is to accelerate the delivery of climate finance to high-impact sustainability projects globally. Pursuant to this mission, we build infrastructure rails for both market access and analytics, including a carbon offset retirement aggregator and APIs for programmatic offsetting applications. Thus far, nearly 500,000 tonnes of tokenized carbon have been retired, and over 25 million bridged onto the Polygon blockchain.
The DAO has over 60,000 members, hundreds of which actively contribute to the development of the organization and our products and services. Our structure as a decentralized autonomous organization is, in our view, critical for two major reasons:
Decentralization serves to create credible fairness: applications where DAOs are taking on functions like basic infrastructure provision are applicable when traits like predictability, robustness and neutrality are valued above efficiency (where a more hierarchical company structure may be advantageous).
Decentralization is better at making effective decisions in concave environments, where pluralism and even naive forms of compromise are on average likely to outperform the kinds of coherency and focus that come from centralization. As stated by Vitalik Buterin, “When decisions are concave, relying on the wisdom of the crowds can give better answers. In these cases, DAO-like structures with large amounts of diverse input going into decision-making can make a lot of sense. And indeed, people who see the world as a more concave place in general are more likely to see a need for decentralization in a wider variety of contexts.”
KlimaDAO views the complexity of the carbon market and the challenge of climate change as exemplifying such a concave environment. We thus view our organizational structure as appropriate to developing fair and neutral carbon market infrastructure via the coordinated input of stakeholders from around the world. We welcome Verra and other traditional market participants to observe our governance process in action on our public forum and to participate in that process as appropriate; in the future we plan to propose additional structures that give greater voice to recognized VCM experts in our evolving DAO governance system.
Notes
Link to consultation document: https://verra.org/wp-content/uploads/2022/08/Verra-Public-Consultation-on-Crypto-Instruments-and-Tokens.pdf
KlimaDAO governance forum discussion: https://forum.klimadao.finance/d/94-verra-public-consultation
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