Zou Chuanwei: Exploring the Application of Blockchain Technology in Carbon Emission Trading Market

Outside of institutions, how can individuals participate in the carbon trading market? One approach worth trying is blockchain-based carbon credits.

Zou Chuanwei: Exploring the Application of Blockchain Technology in Carbon Emission Trading Market

In September 2020, President Xi Jinping clearly put forward the “30-60” target at the United Nations General Assembly, and achieving low-carbon development was elevated to a national strategy. Of all the ways to reduce carbon emissions, carbon trading is the most effective market-based approach, and fiscal measures such as carbon taxes and subsidies work on the premise that market-based trading forms a reasonable price for carbon credits as a reference. The price of carbon credits will also effectively guide R&D and medium- and long-term investments related to carbon peaking and carbon neutrality.

China has been piloting carbon trading in Beijing, Shanghai, Tianjin, Chongqing, Guangdong, Hubei and Shenzhen since 2011, but the pilots have experienced inconsistent market rules, varying levels of government intervention, and large differences in carbon allowance prices.The national carbon trading market will be launched in Shanghai at the end of June 2021. The national carbon trading registration system (CCRS) in Hubei has already opened accounts for the first 2,225 compliance enterprises, all of which are key emission units in the power generation industry.

At this stage, the trading products of the national carbon emission trading market are mainly carbon emission credits allocated to key emission units within a specified period of time. The Ministry of Ecology and Environment develops the total number of allowances and the allocation scheme according to the total national greenhouse gas emission control and the phase target. Initially, free allocation will be the main focus, and paid allocation will be introduced in due course according to national requirements. Under carbon emission allowances, enterprises can adopt more advanced low-emissions equipment, make low-emissions modifications to existing equipment, or purchase carbon emission allowances from enterprises with a surplus of carbon emission allowances.

As a kind of right certificate of greenhouse gas emission, carbon emission right is a new asset type created by human society based on economic theory according to the needs of economic and ecological development, which is of epoch-making significance in financial development. This asset has distinctive financial attributes, including homogeneity, divisibility, registrable custody, and the possibility of spot and futures trading. Theoretically, the impact of equivalent GHG emissions on atmospheric temperature is the same in different countries and regions, and the carbon emission rights created in different countries and regions should be equivalent to each other.

Similar to the logic of China’s move from multiple local pilot carbon trading markets to a national carbon trading market, if the carbon trading markets of different countries and regions move toward interconnection, the resulting global unified carbon trading market will be more efficient and better priced, and will lead to a convergence of carbon emission allowance prices in different countries and regions. In this scenario, regions with higher carbon emission allowance prices are equivalent to giving financial support to regions with lower carbon emission allowance prices. However, how do different countries and regions move toward interconnectedness when their carbon emissions trading markets vary greatly in design? For example, the European Emissions Trading System (EU-ETS) has been operating since 2008, while the U.S. does not have a carbon emissions trading market at the federal level to date, with the Regional Greenhouse Gas Trading Initiative (RGGI) covering ten northeastern states and the California carbon cap-and-trade system having the most scale and influence.

Another important issue in the carbon trading market is the participating parties. Theoretically, in addition to key emitters, institutional and individual investors could be included. They may see the investment value of preserving and increasing the value of carbon assets, or they may be motivated by the sense of responsibility to serve green transformation and development. The diversity of participants can help improve the price discovery efficiency of the carbon emission trading market, which is good for the healthy development of the market. In addition, there are a large number of institutions and individuals who, although they will not directly participate in the carbon emissions trading market, are willing to contribute to the green transformation and development. How to design incentive mechanisms for these institutions and individuals so that the carbon emission trading market can play a more socially effective role?

Blockchain-based interoperability mechanism for carbon emission trading market
There are two main types of participants in the interconnection mechanism
First, in different countries and regions, corresponding to the carbon emission trading market, there is a carbon emission registry system, which undertakes the functions of carbon emission rights registration, trade settlement and allocation compliance, equivalent to the central securities depository (CSD) and securities settlement system (SSS) in the securities market. On the one hand, the CRS interfaces with the emission reporting system to obtain emission and verification data of enterprises in the jurisdiction and provide support for carbon quota allocation and compliance; on the other hand, it interfaces with the carbon emission trading system and clearing banks to provide trading change confirmation of carbon assets and clearing and settlement services of funds.

Second, in different countries and regions, a certain number of important participants (such as key emission units) in the carbon emission trading market are selected and allowed to buy and sell carbon emission allowances with overseas counterparties. Such participants are equivalent to importers and exporters of carbon emission rights.

Interconnection Network
The core of the interconnection mechanism is a federated chain called the “interconnection network”. The federated chain nodes are operated by the carbon credit registry systems participating in the Interconnection Mechanism.

Carbon credits are embodied as digital vouchers on the Interconnection Network. In each country and region participating in the Interconnection Mechanism, if a participating institution in that country applies to its own carbon credit registry, the carbon credit registry generates one unit of digital voucher on the Alliance Chain for each unit of carbon credits destroyed by the carbon credit registry (digital voucher issuance); conversely, if a participating institution in that country destroys one unit of digital voucher on the Alliance Chain, the carbon credit registry generates one unit of carbon credits (digital credit redemption). This is to maintain the discipline and integrity of the carbon emissions trading market and to eliminate the creation of false carbon emission rights or digital certificates.

The carbon credits created in different countries and regions are equivalent to each other, and the digital certificates generated by different carbon credit registries are also equivalent to each other and should have the same price at the same time. This provides a basis for cross-border trading of digital certificates.

Participants from different countries and regions can agree their own settlement currencies for trading digital certificates on the interconnection network. Settlement would be more efficient if a compliant stable currency is introduced, allowing for silver goods against (DvP) through smart contracts.

Assuming that a participant obtains a certain number of digital certificates through buying and selling on net, and applies for redemption to the carbon credits registry in the country where it is located, the carbon credits registry will generate an equal number of carbon credits and grant them to the participant. These carbon credits can then be circulated in the country’s carbon trading market and sold to other institutions in the country.

In addition to facilitating cross-border trading of carbon credits, the Interconnection Network also enhances mutual trust between carbon credit registries in different countries and regions through the credit enhancement function of the Alliance Chain, and is compatible with differences in carbon credit trading markets in different countries and regions (e.g. different systems used, different trading hours, and different price marking methods, etc.).

Interconnection limits
If there is no limit to the number of digital carbon credits that can be generated and traded on the interconnection network, the price of carbon credits in different countries and regions will converge, driven by arbitrage mechanisms. However, in the early stage of the development of the interconnection mechanism, in order to avoid a large impact on the carbon emission trading markets of countries and regions (especially when the carbon emission trading markets of many countries are immature), the number of digital carbon emission certificates generated and traded on the interconnection network should be limited. The general principle is that developing countries should be allowed a certain number of negative carbon allowances per year to be sold to developed countries through the interconnection mechanism in order to promote the green transition and development of developing countries.

The interconnection limit could be dynamically adjusted as needed, and the Alliance Chain and smart contracts would facilitate such adjustments. The higher the limit, the more obvious the effect of the interconnection mechanism to “level out” the price of carbon credits in different countries and regions.

Blockchain-based carbon credit mechanism
How can institutions and individuals in general participate in the carbon credit market? If they are allowed to trade directly, three issues need to be considered. First, carbon credit pricing requires a high level of expertise, and general institutions and individuals without the relevant knowledge may encourage market speculation. Second, in the early stage of the development of the carbon emission trading market, the price of carbon emission rights will not be very high, and small transactions may not be economical in terms of fees. Third, it will make the carbon emission trading market more difficult to manage.

Drawing on the practice of China’s A-share market, the carbon emission trading market should adopt a membership system, mainly for institutional participants, but the group of participants should be diversified from the current one, such as absorbing financial institutions like banks, securities companies and insurance companies, so that the carbon emission trading market can become an organic part of the financial market. General institutions and individuals can open accounts in their real names in the national carbon trading registration system through some special members of the carbon emissions trading market (they are equivalent to the securities companies of the carbon emissions trading market) and place orders for trading through these special members. In other words, the carbon emission trading market adopts a direct holding model. The carbon emission rights held by general institutions and individuals are held by these special members on behalf of their clients, and the carbon emission rights held by the special members themselves and on behalf of their clients are recorded in the National Carbon Registry.

Under this system, carbon credits will truly become a mainstream asset type that can be owned by the general public. In the future, everyone’s financial APP will not only show how many deposits, stocks, funds and financial products they have, but also how many carbon emission rights they have.

In addition to purchasing carbon credits as investment products, institutions and individuals can also make their own contribution to carbon peaking and carbon neutrality by purchasing negative carbon credits. This is related to the national Certified Voluntary Emission Reductions (CCERs). There are already many APPs that help organizations and individuals in general to assess their carbon footprint. For example, how much carbon emissions will be generated from a single domestic trip, and individuals can purchase negative carbon allowances as a hedge through a special member of the carbon emissions trading market based on the assessment. As society as a whole becomes more aware of green transformation and development, there will be an increasing number of application scenarios for this type of application.

In order to better utilize the “gather less to make more” effect of carbon emission reduction efforts of general institutions and individuals, and make carbon emission reduction penetrate into all aspects of social life, a practice worth trying is the blockchain-based carbon credit, with the following mechanism design.

The carbon credit alliance consists of a number of organizations that play an important role in social life, such as power grids, gas networks, public transportation networks, home appliance companies, car companies, shopping malls, restaurants and other consumption places.

The member organizations of the alliance run the alliance chain, where they generate and issue carbon credits to their own users. Carbon credits have no use other than to be exchanged for carbon credits, especially they cannot be bought and sold directly with legal tender.

Based on the behavior of their own users in the relevant scenarios and with reference to the carbon footprint assessment results, the alliance member institutions award carbon credits to their users reflecting their carbon reduction efforts. Carbon credits issued by the same institution are common, but not between carbon credits issued by different institutions. Through smart contracts, a user can easily manage the carbon credits he or she holds from multiple organizations. Some application scenarios may involve multiple alliance member organizations, which can issue their carbon credits to users without conflict with each other with the help of smart contracts.

The carbon credits issued to users by each Alliance member organization are accumulated to reflect the strength of the organization’s carbon reduction efforts in its own application ecosystem, and can be quantified and verified to be linked to the CCER mechanism. Alliance member organizations can thus obtain carbon quotas.

Based on the carbon credits held by the users, the member institutions of the Alliance will redeem and reward the users with a certain percentage of the carbon quotas obtained. The rules of redemption are set by the member organizations of the alliance. By pooling carbon credits from different organizations (carbon credits are universal), users can achieve the effect of “making more out of less”, which gives them more incentive to participate in carbon reduction. Don’t do anything for a good cause” needs to be supported by financial incentives.

In the blockchain-based carbon credits, the blockchain plays a role in establishing mutual trust among different coalition member organizations. Smart contracts help different organizations to run their carbon credit systems in parallel, and help users to better manage their diverse carbon credit assets.

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