Unlocking Environmental Asset Liquidity: Contracts and Pools

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Environmental asset markets need to be highly liquid to provide transparent pricing and efficient trade, but the heterogeneity of these assets has long been a drag on their growth. In its 2021 Blueprint for Scaling Voluntary Carbon Markets to Meet the Climate Challenge report, McKinsey lamented how “the heterogeneity of carbon credits means that credits of particular types are being traded in volumes too small to generate reliable daily price signals.” The absence of reliable price signals results in an inefficient, opaque market that is difficult to scale. This can be seen in carbon markets, which despite being the oldest environmental asset market—with the Kyoto Protocol laying the groundwork for greenhouse gas emissions trading in 1997—have until recently remained highly fragmented and illiquid. The same is also true of other, newer environmental asset markets such as Renewable Energy Credits (RECs).

Off-chain contracts and liquidity pools on blockchains (on-chain) have emerged as instruments for consolidating liquidity in environmental asset markets to generate reliable pricing and create a transparent, efficient market. Both contracts and pools are aggregation mechanisms that allow for the creation of standardized units representing an array of assets. These units can be easily traded, unlocking liquidity by bringing the trading of these assets into line with more established, liquid markets. This post explores these two approaches to consolidating environmental asset liquidity, setting out how off-chain reference contracts and DeFi-style pools work and how both act as benchmarks in price discovery, as well as exploring some of their advantages and drawbacks.

Standardized contracts

Standardized contracts are a recent innovation in off-chain environmental asset markets and represent a basket of environmental assets eligible for delivery once a standardized contract is settled. Eligibility for delivery into the contract is determined based on qualities of interest to traders such as project type (nature based, blue carbon, etc.), issuing registry, and vintage, among other criteria.

The contract structure screens carbon projects to ensure all individual units delivered meet a uniform threshold of eligibility. When an organization makes a purchase under one of these contracts, they are buying and will receive a project’s credits but they are not responsible for choosing a particular project individually. This enables buyers to purchase credits without the need for time-consuming project-by-project due diligence, which is required when purchasing them directly. Different contracts can be created to cover different categories of interest. For example, contracts can be created for nature-based credits or for technology-based credits to cater for the specific needs of traders and the different price points of the assets being combined. In this way, off-chain contracts provide a streamlined and standardized way to trade environmental assets—one that has vastly improved liquidity in the off-chain market.

Another advantage over the previous market structure is the facilitation of price discovery based on market participants’ assessments of contract standards. Once a price benchmark for a category of credits is established over time, it acts as a reference price for over-the-counter (OTC) deals. Credits that remain outside the contract as a result of not meeting the contract’s eligibility criteria can be benchmarked against the standardized contract pricing, either at a discount or at a premium.

Global Emissions Offset (GEO) and Nature Based Global Emissions Offset (N-GEO) are popular standardized contracts launched by Xpansiv company CBL Markets. The former represents projects that meet the ICAO-CORSIA criteria and the latter Agriculture, Forestry, and Other Land Use (AFOLU) projects that meet Verra’s Climate, Community, and Biodiversity (CCB) criteria. Both of these spot contracts trade on the CBL Exchange and were explicitly designed to improve carbon market liquidity, enable transparent price discovery, and provide a reliable benchmark for the wider Voluntary Carbon Market (VCM). They achieved early success in 2021/22, with the then-buoyant carbon market valuing their reliable daily settlement price and ease of access.

Liquidity pools

On-chain liquidity pools are another method for enhancing environmental asset liquidity. Pools are a blockchain-enabled solution that involve carbon credits first being tokenized and then subsequently pooled using specific gating criteria. In the first stage, individual environmental assets such as carbon credits or RECs (both of which are, in essence, semi-fungible in nature) are mirrored on-chain via the issuance of a token that retains all of the project-specific attributes, such as the project's methodology, issuing registry, vintage, etc. These on-chain or tokenized mirrors reflect exactly the information contained in the off-chain environmental asset. At this stage, the specific tokenized assets are not fungible but can now interact with on-chain smart contracts.

The specific tokenized credits become fungible in the second stage when they are grouped together according to set criteria, similar to those found in standardized contracts, in order to produce pool tokens that are entirely fungible. Pools are fungible representations of the credits backing them with every pool token backed by an environmental asset that must have the attributes gating that pool. For example, a pool might group together nature-based carbon credits from 2016 or later in order to create a fungible pool token for such a grouping. Pool token holders can use their pool token to redeem the credits backing the pool and have a smart-contract-enforced guarantee that only certain types of credit can be deposited into the pool. This kind of pooling can be done for carbon credits, RECs, and more sophisticated underlying assets such as carbon forwards. 

A key differentiator between standardized contracts and liquidity pools is how the fungible contract or pool token translates into a specific environmental credit or underlying asset. A purchaser of a standardized contract receives delivery of a credit fitting the contract’s eligibility after a certain period of time, whereas pool tokens can be held for an indefinite period and can be used to selectively redeem a project-specific token at the pool token holder’s discretion. This process of selective redemption results in the dissolution of the pool token and delivery of the project-specific credit to the user. As a result, traders can take advantage of the increased liquidity of the pool token while being able to choose a specific project within a pool to redeem or retire.

The logic for redeeming an asset within a pool can also be adjusted to increase the potential for liquidity consolidation. A pool can have redemption logic that has a variable deposit or redemption rate dependent on the characteristics of the assets being deposited or redeemed. For example, a pool consisting of forward contracts can vary the redemption rate based on the time-to-maturity of the underlying forward contracts backing the pool. This discretionary logic can help consolidate credits with wider characteristics and price points into a pool without the perverse incentives discussed in the next section.

Toucan Protocol was the first to launch pools for nature-based assets in-chain: the Base Carbon Tonne (BCT) pool in 2021 and later the Nature Carbon Tonne (NCT) pool. Recently, Toucan and Neutral jointly launched a pool for Puro Earth biochar credits, called CHAR. CHAR provides transparent market pricing and enables instant purchases and sales of biochar credits. It is also the first instrument to introduce an incentive mechanism to maintain the diversity of the underlying assets. Similarly, Jasmine Energy has launched pools for North American renewable energy credits (RECs) and recently launched pools for REC forwards.

The challenges of liquidity consolidation

Standardized contracts and liquidity pools are both powerful tools for increasing liquidity and efficiency in environmental asset markets, but they have to be designed correctly in order to act as effective instruments. While these tools increase liquidity and efficiency, they can result in reduced specificity. This means that, on the sell side, traders sell at the contract or pool price even when that credit would sell at a premium—or a discount—in OTC markets. This is because existing contracts or pools don’t have discriminatory logic that differentiates between assets being sold into the contract or pool. For example, if a contract or pool allows for reforestation carbon credits from 2016–2023 to be deposited, a highly rated 2022 credit would sell at the same price into the contract or pool as a poorly rated 2016 credit. Not discriminating between different credits sold into the pool means sellers are incentivized to sell credits that fit the eligibility of the contract or pool but that would have taken a discount to the pool price in OTC markets, while they are not incentivized to sell credits that they could sell at a premium in OTC markets.

On the buy side, the lack of specificity affects contracts and pools differently due to the latter’s capacity for selective redemption. In contracts, delivery of a credit or asset that fits the contract’s eligibility criteria means there may be hesitancy to use the contract to acquire credits if a buyer wants a credit more specific or strict than the contract’s general criteria. This is because a buyer doesn’t know what credit they’ll receive across the range of eligibility criteria when the contract settles. On the other hand, selective redemption in pools—in the absence of discriminatory logic for redeeming—means that buyers are incentivized to redeem the highest-quality credits from the pool as they are paying the same price to access all the underlying credits. 

These perverse incentives can lead to low adoption of contracts or to a quality-degradative arbitrage opportunity for pools. For pools, that arbitrage opportunity means that traders can deposit low-quality credits, redeem or buy higher-quality ones, and realize the difference as profit in an OTC market. These incentives and resulting low adoption or pool arbitrating can lead to a deterioration in the quality of the assets being traded within a contract or in the underlying assets available in a pool and, as a consequence, a decline in the contract or pool’s price. When the price of any standardized instrument—whether contract or pool—becomes too low then it no longer makes sense for projects that can be sold above the price in OTC markets to be sold via a contract or enter a pool, solidifying the quality level and associated downward price movement.

This results in a race to the bottom in terms of the quality of credits being sold in a contract or the underlying credits backing a pool. The challenges of liquidity consolidation and its associated asset and price degradation mean that a significant portion of environmental asset markets still do not use liquid assets to conduct their trade, perpetuating market inefficiencies and stunting growth. 

It is important to note that these perverse incentives and their associated effects are not inherent to liquid trading instruments and can be mitigated with intelligent trading infrastructure and instrument design. At Neutral we are working to address the challenges of liquidity consolidation in order to provide environmental asset markets with liquid, high-quality assets and trade. This means building trading infrastructure that caters to the unique characteristics of environmental asset markets and working with partners on developing the next generation of liquid instruments. We’re excited at the growth this will unlock and the resulting impact it will have on natural ecosystems and clean energy production.