Unlocking Environmental Asset Liquidity: Biochar Pools

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In our first piece on “Unlocking Environmental Asset Liquidity,” we explored the role that traditional commodity contracts and on-chain liquidity pools can play in enhancing market liquidity and trade. These mechanisms aggregate the diverse array of environmental assets, such as carbon credits and RECs, into more tradable, standardized units. This approach enhances market liquidity and fosters transparency and efficiency, addressing the fragmentation issues highlighted by McKinsey's 2021 report “Blueprint for Scaling Voluntary Carbon Markets to Meet the Climate Challenge.” 

The rise of CDR pathways

Carbon Dioxide Removal (CDR) pathways are a fast-growing and yet highly fragmented segment of the market, making them an ideal candidate for new liquidity instruments. From January ‘23 to January ‘24, sales of CDR credits increased more than 600% from 750k to 5.5M. This surge resulted in a transaction volume of $2.1B, up from less than $300M the previous year. Across the same period, deliveries of these credits doubled from 100k to more than 210k. Notably, however, only around 4% of transacted removals have been delivered to date, indicating an impending wave of issuance and increased spot liquidity as these transactions start delivering. Most of these transactions and deliveries have been for biochar projects, a segment of carbon markets that is expected to grow significantly in 2024. 

Even with the expectation of significant deliveries, there are still no standardized liquidity instruments for biochar credits. This is partially due to the segment’s nascency, but also a result of the failures of previous standardized trading instruments to sustain traction and improve market efficiency. 

When Neutral first thought through building an exchange, we had to decide between adopting traditional commodity contract structures or pools for our liquidity instruments. We chose the latter due to a general thesis that financial markets will move on-chain, a more specific thesis on why carbon markets can benefit from moving on-chain, and the richness of features that can be built using smart contracts. One of the most notable benefits of pools is their ability to publicly record credits deposited into them and allow for selective redemption, or the selection of a specific project from the pool during settlement/redemption. This allows for increasing liquidity while maintaining specificity, a key combination for environmental asset markets as buyers maintain preferences for specific projects. 

Neutral started working with Toucan, a pioneer in on-chain carbon markets, to develop the next generation of liquidity instruments for on-chain users and the Neutral exchange. When working with Toucan on their new biochar pool, we realized that product design updates would be needed to make the liquidity instrument successful. Biochar prices generally range from $100 to $300, with a Nasdaq index price of around $130. Aggregating assets across such a wide range of prices would require differentiating between the credits across that spectrum; otherwise, only a small subset of projects would use the pool. This was seen with the first generation of liquidity instruments that served other carbon market segments. 

Consolidating heterogeneous assets through discriminatory logic

In the first article, we discussed the importance of employing discriminatory logic when creating standardized trading instruments for heterogeneous assets. Discriminatory logic means adjusting the conversion of a specific credit into a liquidity instrument and vice versa, what we call “pooling” and “redeeming” in the context of pools. In the absence of discriminatory logic, standardized trading units will allow for arbitrage opportunities that result in a drag to the bottom of their acceptance criteria. This problem exists for both traditional commodity contracts and pools.

We generally think through two different types of discrimination – ex-ante and ex-post. Ex-ante discrimination means discriminating before a credit’s conversion into a liquidity instrument, whereas ex-post discrimination adjusts discrimination based on a specific project’s interaction or composition within a pool. I.e. with ex-ante discrimination, we have to ask, “What are the characteristics of a project, how does it translate to a project’s value, and how should we adjust the deposit and redemption rates to reflect those characteristics/value.” With ex-post discrimination, we say, “Let's not worry about the characteristics of a given project; how can we infer a project's value given its interaction and composition within a pool?”

Ex-ante discrimination requires assumptions about a project or credit’s relative value based on external data. If those assumptions are well-informed, they remove arbitrage opportunities before they can be executed. Ex-ante discrimination requires a large amount of data and can always lead to miscalculations given the “animal nature” of certain asset pricing. With ex-post discrimination, we can outline the arbitrage opportunities that lead to pool degradation and create intervention mechanisms to mitigate them instead of removing them completely. Ex-post discrimination also doesn't require any presuppositions on a credit's relative value, doesn’t require extensive data, and allows pricing to be driven by the general market rather than a few participants.  

Marginal deposit/redemption fee functions

To mitigate arbitrage opportunities, we first have to identify how they manifest. Pool degrading arbitrage trades occur when traders deposit lower-priced credits, redeem or buy higher-priced ones, and realize the difference as profit in an OTC market. This activity results in lower-priced projects having a high allocation in a pool and higher-priced projects having a low allocation or being removed completely. We can then think of a project’s allocation within a pool as inversely proportional to its value. 

As a result, we design marginal deposit and redemption fees that are a function of a project’s allocation within a pool—and by proxy its value. Practically, this means that the more credits from a specific project someone deposits into the pool, the more expensive it will become to deposit that project’s credits. Similarly, the more credits of a specific project an actor redeems from the pool, the more expensive it will become to redeem an additional credit of that same project from the pool. If someone tries to execute the aforementioned deposit-redemption arbitrage trade, each marginal execution of that arbitrage will increase fees in both directions and reduce the size of the arbitrage opportunity. 

The difficulty in such a system is designing fee functions that maintain the pool’s usability while mitigating the aforementioned arbitrages. One can imagine having deposit and redemption fees so high that they eliminate all pool-degrading arbitrage opportunities but make the pool unusable. To maintain usability, we designed the fee functions so that they gradually increase for target allocation ranges but become more and more aggressive outside of that range, eventually becoming asymptotic.

These marginal fee functions can be adjusted over time to account for the number of projects entering the pool and the size of the market, among other characteristics. One can imagine that the max deposit allocation for a pool consisting of only a few projects should be relatively high, whereas it should be reduced as the number of projects comprising a pool increases in order to maintain pool diversity reflective of the number of available projects.  

The future of environmental asset liquidity

Two key themes guide our work on liquidity instruments. The first is the belief that increasing liquidity does not have to mean commoditization of an asset. The fact that standardized commodity contracts are being used as liquidity instruments in carbon markets is a result of missing creativity, not because they are the instruments best suited for the job. The second is that to be successful, we have to rethink the features and functions of both the liquidity instruments and their associated exchange infrastructure to fit the market that they serve. Simply adopting approaches from other markets because they are familiar or comfortable will not produce market infrastructure that will allow carbon markets to scale at the pace they need to. 

Those two themes were the inspirations for the launch of the biochar pool and to the products we’ll be launching in the future. This liquidity instrument and its ex-post discrimination is the first of many products we are developing alongside partners to improve the liquidity for environmental assets. Another benefit of on-chain infrastructure is that functions can be modularized and updated, resulting in better trading instruments over time. Project due diligence and whitelisting with ex-post discrimination will set a strong foundation for biochar markets that we can improve on over time. 

In the future, we imagine the incorporation of project level data and external quality assurance into the pool acceptance criteria as they become available. Liquidity instruments can also be bolstered by insurance products that provide additional assurances. Regardless of the specific mechanism adopted, the necessity to experiment and build liquidity instruments using a first-principles approach is clearer than ever. This will result in trading products and features tailored for the specific qualities of this unique market.