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

This article is from ChainNews, original title: "Zou Chuanwei: The Application of Blockchain in the Carbon Emission Trading Market" Author: Zou Chuanwei.

In September 2020, President Xi Jinping clearly proposed the "30·60" target at the United Nations General Assembly, elevating low-carbon development to a national strategy. Among all methods to reduce carbon emissions, carbon emission trading is the most effective market-based approach, while measures such as carbon taxes and subsidies rely on the formation of a reasonable carbon emission rights price through market transactions as a reference. The price of carbon emission rights will also effectively guide research and development and medium- to long-term investments related to carbon peaking and carbon neutrality.

Since 2011, China has piloted carbon emission trading in places such as Beijing, Shanghai, Tianjin, Chongqing, Guangdong, Hubei, and Shenzhen. However, issues such as inconsistent market rules, varying degrees of government intervention, and significant differences in carbon quota prices have emerged during the pilot phase. By the end of June 2021, the national carbon emission trading market will be launched in Shanghai. The national carbon trading registration system (China Carbon Registration) located in Hubei has already opened accounts for the first batch of 2,225 compliance enterprises, all of which are key emission units in the power generation industry.

At this stage, the trading products in the national carbon emission trading market mainly consist of carbon emission quotas allocated to key emission units within a specified time. The Ministry of Ecology and Environment formulates the total quota and allocation plan based on the national greenhouse gas emission control and phased targets. Initially, free allocation will be the main method, and paid allocation will be introduced as needed according to national requirements. Under the carbon emission quota, enterprises can adopt more advanced low-emission equipment, retrofit existing equipment for low emissions, or purchase carbon emission quotas from enterprises with surplus quotas.

Carbon emission rights, as a certificate of the right to emit greenhouse gases, represent a new type of asset created by human society based on economic development needs and economic theory, which is of epoch-making significance in financial development. This type of asset has distinct financial attributes, including homogeneity, divisibility, registrability, and the ability to conduct spot and futures trading. Theoretically, the impact of equivalent greenhouse gas emissions on atmospheric temperature is the same across different countries and regions, and the carbon emission rights created by different countries and regions should also be mutually equivalent.

Similar to China's transition from multiple local carbon emission trading pilot markets to a national carbon emission trading market, if the carbon emission trading markets of different countries and regions move towards interconnectivity, the resulting globally unified carbon emission trading market will be more efficient, better at reasonable pricing, and will lead to a convergence of carbon emission rights prices across different countries and regions. In this scenario, regions with higher carbon emission quota prices effectively provide financial support to regions with lower carbon emission quota prices. However, the design of carbon emission trading markets in different countries and regions varies greatly; how can we achieve interconnectivity? For example, the European Union Emission Trading System (EU-ETS) has been operational since 2008, while the United States still lacks a federal-level carbon emission trading market, with the Regional Greenhouse Gas Initiative (RGGI) covering ten northeastern states and California's cap-and-trade system being the most extensive and influential.

Another important issue in the carbon emission trading market is the participants. Theoretically, in addition to key emission units, institutional and individual investors can also participate. They may be attracted by the investment value of carbon assets or motivated by a sense of responsibility to support green transformation and development. The diversification of participants helps improve the price discovery efficiency of the carbon emission trading market, which is beneficial for the healthy development of the market. Additionally, there are many institutions and individuals who, although they do not directly participate in the carbon emission trading market, are willing to contribute to green transformation and development. How can we design incentive mechanisms for these institutions and individuals to enable the carbon emission trading market to exert greater social effectiveness?

Blockchain-Based Interconnectivity Mechanism for Carbon Emission Trading Market

Two Main Participants in the Interconnectivity Mechanism

First, in different countries and regions, there is a carbon emission rights registration system corresponding to the carbon emission trading market, responsible for the confirmation registration, trading settlement, and allocation compliance of carbon emission rights, equivalent to the central securities depository (CSD) and securities settlement system (SSS) in the securities market. The carbon emission rights registration system connects with the emission reporting system to obtain emission and verification data from enterprises within its jurisdiction, supporting carbon quota allocation and compliance; it also connects with the carbon emission trading system and clearing banks to provide trading change confirmation and fund settlement services for carbon assets.

Second, in different countries and regions, a certain number of important participants (such as key emission units) in the carbon emission trading market are allowed to buy and sell carbon emission quotas with foreign trading counterparts. These participants act as importers and exporters of carbon emission rights.

Interconnectivity Network

The core of the interconnectivity mechanism is an alliance chain, referred to as the "Interconnectivity Network." The nodes of the alliance chain are operated by the carbon emission rights registration systems participating in the interconnectivity mechanism.

Carbon emission rights are represented as digital certificates on the interconnectivity network. In each participating country and region, if a participating institution applies to its national carbon emission rights registration system, for every unit of carbon emission rights destroyed by the registration system, a unit of digital certificate (digital certificate issuance) is generated on the alliance chain; conversely, if a participating institution destroys a unit of digital certificate on the alliance chain, the carbon emission rights registration system generates a unit of carbon emission rights (digital certificate redemption). This is to maintain the discipline and integrity of the carbon emission trading market and to prevent the inflation of carbon emission rights or digital certificates.

Carbon emission rights created by different countries and regions are mutually equivalent, and the digital certificates generated by different carbon emission rights registration systems are also mutually equivalent, meaning they should have the same price at the same time. This provides a foundation for cross-border trading of digital certificates.

Participants from different countries and regions can agree on the settlement currency for digital certificate transactions on the interconnectivity network. If compliant stablecoins are introduced, settlement efficiency will be higher, and delivery versus payment (DvP) can be achieved through smart contracts.

Assuming a participant gains a certain number of digital certificates through buying and selling, and applies for redemption from their country's carbon emission rights registration system, the registration system will generate an equivalent number of carbon emission rights and grant them to the participant. These carbon emission rights can then circulate in the country's carbon emission trading market and be sold to other domestic institutions.

In addition to facilitating cross-border trading of carbon emission rights, the "Interconnectivity Network" also enhances mutual trust between carbon emission rights registration systems in different countries and regions through the credibility function of the alliance chain, and can accommodate the differences in carbon emission trading markets across different countries and regions (such as different systems used, trading times, and pricing methods).

Interconnectivity Quota

If there are no limits on the number of carbon emission rights digital certificates that can be generated and traded on the interconnectivity network, then driven by arbitrage mechanisms, the carbon emission rights prices in different countries and regions will converge. However, in the early development of the interconnectivity mechanism, to avoid significant impacts on the carbon emission trading markets of various countries and regions (especially in cases where many countries' carbon emission trading markets are underdeveloped), the number of carbon emission rights digital certificates generated and traded on the interconnectivity network should be limited. The general principle is that developing countries should be allowed to sell a certain number of negative carbon quotas to developed countries each year through the interconnectivity mechanism to promote green transformation and development in developing countries.

The interconnectivity quota can be dynamically adjusted as needed, with the alliance chain and smart contracts facilitating such adjustments. The higher the quota, the more pronounced the interconnectivity mechanism's role in "leveling" the carbon emission rights prices across different countries and regions.

Blockchain-Based Carbon Credit Mechanism

How can general institutions and individuals participate in the carbon emission trading market? If they are allowed to trade directly, three issues need to be considered. First, pricing carbon emission rights requires a high level of expertise; general institutions and individuals lacking relevant knowledge may contribute to market speculation. Second, in the early development of the carbon emission trading market, carbon emission rights prices may not be very high, making small transactions economically unfeasible due to transaction fees. Third, this would increase the management difficulty of the carbon emission trading market.

Drawing on the practices of China's A-share market, the carbon emission trading market adopts a membership system, primarily targeting institutional participants, but the participant group should diversify from the current base, such as incorporating financial institutions like banks, securities companies, and insurance companies, making the carbon emission trading market an organic part of the financial market. General institutions and individuals can open real-name accounts in the national carbon trading registration system through special members of the carbon emission trading market (equivalent to securities companies in the carbon emission trading market) and place orders 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 entrusted to these special members for custody, and the carbon emission rights held by the special members themselves and on behalf of clients are recorded in the national carbon trading registration system.

Under this institutional arrangement, carbon emission rights will truly become a mainstream asset type that can be owned by the public. In the future, in everyone's financial APP, in addition to showing how much savings, stocks, funds, and financial products they have, it will also show how many carbon emission rights they possess.

In addition to purchasing carbon emission rights as investment products, general institutions and individuals can also contribute to carbon peaking and carbon neutrality by purchasing negative carbon quotas. This is related to the national certified voluntary emission reductions (CCER). Currently, many apps help general institutions and individuals assess their carbon footprints. For example, how much carbon emissions are generated from a domestic trip, and individuals can purchase negative carbon quotas through special members of the carbon emission trading market as a hedge based on the assessment results. As awareness of green transformation and development grows across society, such applications will have increasingly larger application scenarios.

To better leverage the "small contributions add up" effect of general institutions and individuals' carbon reduction efforts and to integrate carbon reduction into various aspects of social life, a blockchain-based carbon credit mechanism worth trying is designed as follows:

The carbon credit alliance consists of institutions that play important roles in social life, such as power grids, gas networks, public transportation networks, home appliance companies, automobile companies, shopping malls, restaurants, and other consumption venues.

Alliance member institutions operate the alliance chain, generating and issuing carbon credits to their users on the alliance chain. Carbon credits have no other use besides being exchanged for carbon emission rights, particularly cannot be directly bought and sold with legal tender.

Alliance member institutions grant users carbon credits reflecting their carbon reduction efforts based on their behavior in relevant scenarios, referencing carbon footprint assessment results. Carbon credits issued by the same institution are interchangeable, but carbon credits issued by different institutions are not. Through smart contracts, a user can conveniently manage their carbon credits from multiple institutions. Some application scenarios may involve multiple alliance member institutions, which, with the assistance of smart contracts, can issue their carbon credits to users without conflict.

Each alliance member institution accumulates the carbon credits issued to users, reflecting the institution's efforts in promoting carbon reduction within its application ecosystem. After quantification and verification, this can be linked to the CCER mechanism. Alliance member institutions can then obtain carbon quotas.

Based on the carbon credits held by users, alliance member institutions will exchange a certain proportion of the carbon quotas obtained and reward them to users. The exchange rules are determined by the alliance member institutions themselves. Users can gather carbon quotas obtained from different institutions (carbon quotas are interchangeable), achieving the "small contributions add up" effect and motivating users to participate in carbon reduction. "Do not neglect small acts of kindness" needs economic incentives as support.

In the blockchain-based carbon credit mechanism, blockchain plays a role in establishing mutual trust among different alliance member institutions. Smart contracts help different institutions operate their carbon credit systems in parallel without conflict, while also assisting users in better managing their diverse carbon credit assets.