A New Model for Carbon Pricing Using Blockchain Technology

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As the 2015 Paris Climate Summit approaches it appears that some positive steps will be taken in the fight against climate change, but one of the most important steps will again fail to be realized. Voices from governments, industry, academia, and activism have called for a price on carbon to help drive deep cuts in carbon dioxide emissions, but it is likely that no new frameworks for pricing carbon will come out of the Paris talks. The policy tools available today for carbon pricing: carbon taxes and emissions trading systems, have been ineffective so far in driving deep emissions cuts and face many years of challenging political negotiations before they offer any chance of success.

An alternative carbon pricing instrument could be developed in the financial markets that is simple and fair, and designed to be transparent and traded internationally. A carbon deposit and redemption system could be built using new internet based financial accounting technology called blockchains or distributed ledgers, best known as the foundation for Bitcoin digital currency. In this system a deposit would be paid for every ton of fossil CO2 created and the deposit recorded in a blockchain digital asset, call it a carboncoin. The deposit funds would be held in escrow until they are redeemed by a party anywhere in the world who successfully sequesters a ton of CO2 underground through either reforestation or industrial CCS (carbon capture and sequestration). In this system every ton of CO2 is individually accounted for and financial incentives are created to sequester the CO2 in a safe manner. When all the accounts are balanced then zero net emissions of CO2 will have been achieved.

Carbon sequestration is the lowest cost method for achieving large scale cuts in CO2 emissions. Both industrial and biological pathways are proven and there is ample storage capacity, but both methods have had trouble gaining traction because of challenging economics. Energy efficiency, renewable energy and nuclear power are all valuable tools in reducing the amount of fossil fuels used to drive the global economy, but they cannot replace fossil fuels in broad swathes of industry, heavy transportation and large heating applications. Fossil fuels will remain the backbone of industrial civilization for a long time to come and it is crucial that CO2 emissions be directly sequestered in the earth rather than allowing excessive CO2 to continue to accumulate in the atmosphere and driving climate change.

Industrial CCS is the only viable pathway to reduce carbon emissions from a wide variety of heavy industries such as the manufacturing of steel, cement and petrochemicals that intrinsically require the use of fossil fuels in large quantities. Likewise, coal remains a critical resource used throughout the world to fuel industry and electric power and CCS is key to making coal environmentally sustainable. Billions of dollars have been spent in recent years developing CCS technologies and there have been enough successful pilot projects to know that the technology works. Captured CO2 is useful, particularly in the oil and gas industry where CO2 is an effective production fluid used to produce oil and natural gas. But in a world with a glut of oil and gas and low prices for both it is unlikely that industry will invest large sums of money in CCS and CO2 utilization without some form of financial incentives.

Deforestation and land degradation continues to expand globally, by some estimates we are losing 25 million acres of forest a year, undermining the ecosystem’s ability to hold water, cycle nutrients and clean the air. Land use changes are the second biggest source of greenhouse gas emissions after fossil fuel combustion. According to a recent report by the Economics of Land Degradation Initiative more than half of the world’s arable land is moderately or severely degraded. Land degradation ultimately leads to desertification, and the loss of healthy lands forces people to migrate promoting political instability. As much as 2 billion hectares of degraded lands could be rehabilitated for use in agricultural production if financial incentives were in place. Offering precise definitions of biological CO2 sequestration per acre is a complex undertaking beyond the scope of this article, but there is science on the subject and it is well understood that reversing deforestation and regreening the earth will have a tremendous impact in pulling billions of tons of CO2 out of the atmosphere while simultaneously improving air, soil and water quality to the benefit of all humans and wildlife alike.

Over 1000 companies and investors publicly expressed support for carbon pricing at the New York Climate Summit in 2014. An oil and gas industry coalition led by Shell, BP, Statoil, Total, Eni, and BG Group recently signed a letter pledging their commitment to doing their part to reduce carbon emissions and called for a carbon pricing framework. The oil majors argue that a price on carbon is a key element for driving investments towards low carbon options such as CCS and they ask that carbon pricing systems be expanded to regions where they do not exist today with clear linkages between nations.

The systems for pricing carbon today are carbon taxes and emissions trading systems. These systems have merits but both systems have critical faults that point towards continued difficulties in achieving the goal of a stable global carbon price that can be a reliable variable in long term investment decisions. Currently only 12% of the world’s CO2 emissions come under any kind of carbon pricing regime, and most of the prices are far too low to be effective.

Emissions trading systems (ETS), also known as cap-and-trade, work by having political authorities setting caps on total allowed CO2 emissions and creating permits for those emissions. The permits are distributed to industry and can be traded between low-emitting and high-emitting parties. A price for carbon is established by the market price for the permits being traded. Over time the cap is supposed to be lowered which should drive up the price for the permits. In theory ETS should have many advantages, this system specifies the amounts of CO2 that can be legally emitted which should reduce emissions to acceptable levels. This system should also facilitate the international trade in permits and the creation of linkages between the systems of different countries.

The flaw in emissions trading systems is largely a function of the political nature of the process, because the caps are set by politicians and the permits distributed by them as well, there is an endless campaign to influence the political process to keep the caps high and the corresponding carbon price low. To date, none of the world’s existing ETS have managed to get the carbon price above $10/ton when most analysts believe the carbon price needs to be in the range of $25-$50 per ton to change fuel usage behaviors. Most of the revenues earned in ETS are intended to be spent on clean energy projects, but it is not required and local political authorities ultimately have discretion over how the money is spent.

Existing ETS have not been uniformly applied to all fossil fuel emissions, with most systems narrowly focused on coal fired electric power. Carbon offset projects are also used to generate tradeable permits but there is little consistency to the definition or valuation of those offsets which has led to examples of fraud in some instances. The complex political process coupled with imprecise definitions of carbon emissions and carbon offsets and the need to negotiate international linkages points towards continued difficulties in ETS markets for many years to come.

Carbon taxes have the advantage over ETS of being conceptually simple and relatively easy to implement. Carbon taxes set a consistent price within a given jurisdiction, but do not place hard limits on the quantity of emissions. British Columbia has a carbon tax of $25/ton ($30 CAN) and it has been successful in reducing emissions to some extent in sectors where fossil fuels are used inefficiently, but it does not drive deep emissions cuts in heavy industry. The critical challenge in carbon taxes is that they only apply to the state or country that implements them which can create difficulties in cross-border competitiveness. The cement industry in BC has suffered from the carbon tax because imports of cement from the US and China are not subject to the tax and therefore advantaged. It is extremely difficult to harmonize tax regimes internationally and using tariffs, subsidies, or import controls to offset tax regime discrepancies is a messy process that runs counter to longstanding free-trade efforts to reduce tariffs and encourage the free flow of goods.

Carbon taxes also suffer from political inconsistencies that undermine their effectiveness as a price signal. Australia implemented a carbon tax in July 2012, only to have it rescinded by the next political administration in July 2014. For carbon pricing to be effective it needs to be consistent over time so that it can be a reliable variable in investment decisions.

Revenues earned from carbon taxes are also subject to the political winds. It has become vogue in politics for carbon tax proposals to be ‘revenue neutral’, meaning that the revenues earned need to be offset by spending elsewhere. For liberals, leading proposals for revenue neutral carbon taxes have taken the form of ‘fee and dividend’ models where the revenues earned are distributed back to citizens. For conservatives, most proposals have suggested offsetting the carbon tax with tax cuts to businesses. The problems with both of these proposals is that the revenues earned are not used to fund solutions to the carbon dioxide problem which is expensive to solve. Instead, most carbon taxes rely solely on the price signal to drive behavior even though it is established that price signals alone are insufficient to drive deep emissions cuts.

Aside from carbon pricing there is another critical financial challenge that continues to vex international climate talks and that is the need for funds to flow from rich developed world countries to poor developing world countries to finance mitigation efforts and investments in clean energy. Despite a lot of rhetoric over the years, nothing close to the $100 billion dollars annually identified for the UN’s Green Climate Fund has been raised. Expectations are low that significant progress will be achieved at the Paris summit in raising these funds.

A carbon deposit and redemption system is an admittedly radical and outside the box proposal that borrows the strengths of carbon tax and ETS models while striving to mitigate their weaknesses by narrowing the scope of efforts and applying precise definitions to behaviors. Advanced financial accounting technology, the blockchain, offers the capacity to integrate auditing into the system in a manner that is transparent to all parties and dramatically reduces the capacity for fraud. Additionally, by starting with a financial instrument that is intended to be traded globally, the international flow of funds will be facilitated. This model is intentionally conceived as a financial instrument in order to deemphasize the need for political negotiations.

In the carbon deposit and redemption system one ton of CO2 is equal to one ton of CO2 anywhere in the world. This precise and narrow definition is meant to bypass the existing ad-hoc carbon accounting methods and carbon offset definitions used today in emissions trading systems that have made it so challenging to create linkages between countries and their national policies.

In the carbon deposit system any country would be eligible to participate. Participants would pay a deposit on every ton of CO2 they produce from all fossil fuel sources. These funds would be placed in an escrow account and recorded in a blockchain. The funds would remain available until they are redeemed by a participant who successfully sequesters one ton of CO2 through any approved method. Funds would accumulate in the early years and would act as an enormous prize for anyone who is able to claim them. This large fund could finance reforestation and carbon management projects all over the world. Presumably there would be a net flow of funds from developed world countries that have large emissions into poorer countries that would be incentivized to do forest restoration projects. Industry would also be incentivized to invest in CCS and recapture some of the funds.

In aggregate, countries would be competing for the funds and striving to innovate and find the most cost effective and fastest methods to sequester CO2. It is entirely possible that large industrial countries like the USA, Canada, Russia and China that have significant sequestration capacities could redeem an equal amount of funds as they deposit. Smaller industrial countries in Europe and Asia would presumably pay more deposits than they redeem while developing countries could redeem more than they deposit. In this way funds would flow internationally in the spirit of existing agreements and in a manner that is completely fair to all participants, competition for the funds encourages fast action.

The use of blockchain technology is primarily intended to integrate transparency and auditing into the system. A deposit and redemption system could be built with conventional accounting, but the human element slows the system down and increases the likelihood of fraud. A human based accounting system would share most of the challenges with today’s ETS and there is little reason to repeat the experience. One of the primary reasons to embrace the new technology is to bypass the administrative pitfalls that have plagued current emissions trading systems.

Blockchain technology is best known as the foundation for the digital currency Bitcoin, but blockchains have many applications and can be used to track any asset. Blockchains are not a single technology, nor a single software product, they are a family of technologies based on decades of computer science. A whole new industry is emerging with many vendors offering products with varying capabilities. It should be noted that Bitcoins require outrageous amounts of electricity and computational overhead but this can be avoided in other blockchain architectures. Bitcoin is built on a no-trust open network that requires the solving of complex math equations to validate the integrity of the blockchain causing high electricity usage, but blockchains built on trusted networks do not require the computational overhead and electricity drain of Bitcoin.

The heart of the blockchain is the distributed ledger which is a truly disruptive innovation that has the potential to forever change financial accounting the same way that other internet technologies have radically changed the world we live in. In a distributed ledger the entire financial history of an asset, its’ chain of custody, is embedded in the asset in a cryptographically secure manner that is unchangeable yet visible to all parties. In traditional accounting the sale of an asset is recorded in ledgers that are kept independently by each party to the sale. Accountants maintain their own private sets of ledgers which must be laboriously reconciled and are occasionally audited by authorities to make sure they are correct. Blockchain technology turns this system inside out by recording ownership in the asset itself. Instead of each party maintaining their own accounting ledger independently (which may contain errors or frauds), the ledger is distributed to all parties who read the exact same information.

Blockchains could be used to record the ownership history of any type of asset. For instance, in the diamond trade there is real concern that diamonds are sourced from legitimate and legal mines and are not ‘blood diamonds’, blockchains could be used to ensure the diamonds have passed through legitimate channels on their way to market. Likewise for automobiles, blockchains could validate ownership history so that used cars buyers can be sure of what they are getting. Blockchains are a powerful tool to combat fraud and the illicit exchange of goods.

Blockchains have other attributes, contract terms can be embedded in the asset enabling smart contracts where terms are automatically executed when specified conditions are met. Blockchains are being examined closely by the financial industry where it is believed they could facilitate transactions of complex financial instruments that currently can take weeks to clear.

In a carbon deposit and redemption system deposits would be paid on every ton of fossil CO2 that is created and the dposit recorded in a blockchain. The system would behave just like a carbon tax on the upstream side. A fixed value for a ton of CO2 would have to be chosen, say $25 per ton for this example. The $25 carbon price would drive fuel efficiency and fuel substitution efforts and begin reducing emissions just like a tax. Unlike a tax though, the funds would be deposited in escrow accounts where they would be remain available until they are claimed. Obviously a great deal of funds would accumulate initially, perhaps for years.

Total CO2 emissions in 2014 were 32 billion tons, assuming global participation in the system the fund would accumulate $800 billion a year (at $25 per ton). Countries would then compete to redeem those funds by successfully sequestering the CO2 using approved methods. The blockchain would include provisions where auditors sign off at specified points in the life cycle to ensure that processes are followed correctly. When auditors validate that the CO2 has been appropriately sequestered then the funds would be released. Monitoring, reporting, and verification methods and registries would need to be established by accepted international authorities. Since the signatures of auditors and methods of sequestration would be visible within the blockchain it is possible for third parties to validate the work. By design these funds could flow internationally to any country that participates in the system. Since the system is based on a strict one ton equals one ton model it is straightforward to create the linkages between countries.

Among the advantages of this system is that all of the money raised is used strictly to solve carbon emissions problems, unlike today’s carbon tax proposals where the money raised is used to fund alternative political agendas that may not have anything to do with climate change. Another implication of the system is that the money raised would be used strictly for carbon sequestration activities, not for energy efficiency investments, nor for renewable energy, or other mitigation efforts. This is necessary to maintain a global scientific definition where one ton equals one ton. If the funds were to be used for other efforts, no matter how worthy those efforts may be, then we would be in the same position we are in today with ETS where definitions of carbon credits are not consistent across carbon markets. A strict definition that one ton of CO2 deposited pays for one ton of CO2 sequestered provides a clear and unambiguous target for mitigating all CO2 emissions.

The carbon deposit and redemption system shares the simplicity of a carbon tax with the internationally traded credits of an ETS and is built on new technology that enables auditing and transparency by design. The system would fund massive reforestation efforts with benefits to all as well as upgrades to industry. If the system were to be implemented globally and all the accounts balanced to zero then it would achieve a complete solution to mitigating fossil fuel carbon dioxide emissions that are contributing to climate change.