How the decentralization of finance (DeFi) can drive the energy transition

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Intro

In the history of the world, the narrative of climate change will take a central role in the 21st century. There are many different measures and approaches, communications and escalations. The transformation of society — as in the area of energy supply — will be unprecedented. The question is how such a gigantic transformation can be accomplished. In addition to the pure execution in the real world (e.g. more photovoltaics, battery storage, etc.) by craftsmen, the right incentive structures and possibilities for financing and inclusion are needed above all. My petition: The decentralization of the financial sector (DeFi) is the missing piece of the puzzle to establish the economic stimulus program on a broad social basis that is really needed for the transformation. This is not just about scalability on a global scale, but about entirely new ways and opportunities to foster societal interactions in a new sustainable framework.

The COVID-19 pandemic has disrupted every aspect of our daily lives and exposed several flaws in the current global economic and social systems. It has highlighted the growing need for solutions that can bring about positive change. In the context of the 17 goals drafted by the UN and ratified by many of its member states, the pandemic seems to have once again reinforced the need for decisive action at the global level. Social injustice or climate change are difficult to address in national solo efforts. Of course, these 17 goals are not just lofty aspirations, but they are concretely linked to a massive transformation of society and all its corresponding systems. The energy turnaround is a big part of this — and this energy turnaround is also inextricably linked to the topic of ESG. ESG (“Environmental”, “Social” and “Governance”) is used as a broad term for CSR (Corporate Social Responsibility) and is today an elementary component in the corporate context — especially in the question of financing on the capital market. In the context of the transformation of society, companies naturally play a crucial role. Accordingly, a key question is how to steer global money flows in the right direction — ESG helps here and provides a consistent and comparable framework.

The pandemic has raised awareness of ESG investing and retail investors also want and should have an incentive to participate in the transformation of society. The opportunity to participate is also a fundamental component of the 17 goals, creating a common ground globally for an overarching goal. Given the rapidly growing demand for ESG products, companies are therefore seeking to comply in order to meet financial needs and gain competitive advantage on its basis. From an investor perspective, while many ESG products (e.g., ETFs) already exist, basic numbers (e.g., “how ESG compliant a company is”) are often based on estimates and weak data. This is often not due to the companies, but to the prevailing analogous way of our economic activity. To ensure that the figures can still be used for the ESG framework, companies make use of third-party verification and auditors. Many investors are therefore forced to invest a large amount of trust in the ESG system — and ultimately in the traditional financial industry.

The ESG theme combines three core elements, with the “E” undoubtedly appearing as a weighty part. Review: In 2021, 120 world leaders attended the UN Climate Change Conference in Glasgow (COP26). Mitigating the effects of global warming and reducing greenhouse gas emissions were among the key issues discussed. Less than a year later, the Intergovernmental Panel on Climate Change (IPCC) reported that the world would reach the 1.5-degree mark within the next two decades. The report emphasized that only a drastic reduction in carbon emissions could prevent environmental catastrophe.The ESG theme combines three core elements, with the “E” undoubtedly appearing as a weighty part. Review: In 2021, 120 world leaders attended the UN Climate Change Conference in Glasgow (COP26). Mitigating the effects of global warming and reducing greenhouse gas emissions were among the key issues discussed. Less than a year later, the Intergovernmental Panel on Climate Change (IPCC) reported that the world would reach the 1.5-degree mark within the next two decades. The report emphasized that only a drastic reduction in carbon emissions could prevent an environmental catastrophe.

Climate change activists question whether blockchain is not only an energy-intensive technology, but also offers ways to support and address the climate crisis.

ESG, Blockchain and the fight against climate change through measures like decarbonization belong together at the end of the day — and DeFi (Decentralized Finance) could become a crucial catalyst in this regard. DeFi can be the new link to address the problems in ESG reporting and mitigate the overall trust issue through trustless methods (as in blockchain). However, before we get to this possible solution, we should understand one more detail a bit more. In general, carbon reduction (decarbonization) is considered a cornerstone in the global ESG strategy. To this end, the Kyoto Protocol was drawn up back in 1997 as part of the UN Framework Convention on Climate Change. An important component: reduction of global carbon emissions. As a result, a global carbon market was created, now commonly known as the Voluntary Carbon Market (VCM). It allowed carbon credits to be purchased outside of formal national or international regulations through over-the-counter exchanges. Despite the VCM’s goal of using market mechanisms, the incentives for companies, governments, and individuals to participate have not been aligned with economic realities. This is due in large part to a clear market failure associated with costly and opaque administrative requirements. Today’s carbon credit market is widely regarded as fragmented and complex. There are questionable practices in the sale of carbon credits and limited data on pricing that make it difficult for buyers to know if they are paying a fair price and for suppliers to manage the risk they are taking.

Bottom line

• There is a worldwide awareness of climate change and of the need to restructure society (e.g. energy transition).
• Despite various global efforts and conferences for more climate protection, national and economic interests seem to have been greater incentives so far.
• Participation in the transformation of society must be accessible to all citizens and institutions of society in order to create sustainable acceptance.
• With ESG, there is a global regulatory and steering framework so that funds can flow for investments in projects that conform to the transformation.
• Existing (additional) incentive systems such as CO2 trading are considered to be systemically vulnerable, as the data basis as well as the market mechanisms are intransparent and outdated.

What if …

• there would be a digital, global architecture that
• could solve the general problem of trust and data, and
• unleash new financing opportunities for the transformation, and
• at the same time would be fully consistent with many of the 17 goals?

From big investors to everyman participation: The financing of large infrastructure projects — such as we will see in the coming years for the energy transition — traditionally involves debt and equity. Corporations or, optionally, joint ventures accumulate investments and form the general contractual bracket for those projects. Equity is provided by institutional funds, while debt is secured by major banks. The ESG framework described would at least favor those good measures. In practice, however, large institutions here have significant financial advantages from these projects — compared to the small investor. The problem is compounded by government infrastructure programs and the so-called Cantillion effect, which naturally favors certain market participants. Accordingly, new money is not automatically distributed equally to all sectors of an economy, but in stages, with some sectors (especially the banking sector, other government-related firms, the entrepreneurial sector and politically favored groups) benefiting first, while the rest of the economy follows later or does not benefit at all from money creation. For example, the U.S. plans to invest around $550 billion (476 billion euros) in new infrastructure over the next few years.

This market distortion could become a real social problem. The sheer magnitude of the rebuild needs broad general approval and a way to participate. Hence, an alternative to the traditional ways: Decentralized Financing (DeFi) of blockchain technology. DeFi is changing the paradigm of traditional financial models. DeFi is a seamless flow of financial transactions and users can interact between each other (peer-to-peer), allowing smaller investors to provide their funds for these projects. DeFi is reshaping finance for millions of people. Using smart contracts and Automated Market Makers (AMMs), DeFi has created new ways to trade assets. Web3 technology is enabling the transformation of organizational structures and creating new opportunities. P2P lending and tokenization are aspects that can be maximized by DeFi to provide the needed incentives for climate goals.

CO2 reduction with DeFi

Let’s start with decarbonization and remember the low-function VCM mechanisms. Blockchain can bring needed disintermediation and transparency to the carbon credit market. The transition from the traditional market to blockchain is achieved by bridging verified and robust carbon credits. This process integrates carbon credits into the blockchain and opens up new opportunities for them to be traded. Here, they can be more easily tracked or exchanged.

Beispiel C3 Carbon Bridge

A concrete example is the C3 Carbon Bridge, launched in March 2022. This web3 app, for example, uses mechanisms developed by Curve.finance to bring carbon credits to market and can provide a range of new incentives. By embedding carbon credits into blockchain-based tokens, carbon credits inherit the functionality of other decentralized financial tokens (DeFi). This enables the creation of novel financial products that can interact with other innovations developed in this space.

Example Tokenomics from OlympusDAO

However, the power of DeFi arises when users suddenly have different ways to use their assets — such as CO2 tokens. For example, the bonding and staking systems developed by OlympusDAO offer opportunities to apply the architecture to on-chain carbon markets. For example, users of tokenized carbon credits can earn rewards for locking and permanently removing their carbon from the market. Once a carbon credit is linked to the blockchain, it can be exchanged or burned by participants and completely removed from the market without the risk of double counting. Market operations are permission-free and data is traceable, opening the market to greater participation and scrutiny.

Example Automated Market Makers (AMMs)

Another important issue: the creation of highly liquid pools that enable the transparent and efficient exchange of assets on established decentralized exchanges such as Uniswap and SushiSwap. This overcomes a key barrier to VCM associated with over-the-counter trading and illiquid markets. In theory, VCM can be moved to a blockchain, and the metadata for each credit that proves its quality and origin can be publicly available. Companies can gain access to this transparent and liquid compensation market in a way that does not exist today. DeFi and DAO (Decentralized Automone Organizations) communities are location-independent, forming a network of individual contributors working toward common goals. Decentralization allows them to penetrate even the most remote areas.

Example Toucan

As a final example, the Toucan Protocol, launched in October 2021. It aims to improve the infrastructure for environmental goods on Web3 and bring carbon markets to DeFi marketplaces. The so-called ClimateDAO was the first platform built on Toucan’s Web3 carbon market technology. It works to redesign economic incentives in the voluntary carbon market (VCM). For example, Toucan issues credits in the form of non-fungible tokens (NFT). This NFT contains data on the specific offset project it represents and can be broken down into Tokenised CO2 (TCO2) tokens. These can then be traded on a decentralized exchange (DEX) like any other cryptocurrency. However, the full power of DeFi is revealed in the fact that apart from pure trading, the following options exist with the tokens:

• CO2 as collateral: adds tokenized carbon credits as diversified collateral in decentralized finance.
• Interest on CO2: Accesses new ways to turn carbon credits into productive, return-generating assets.
• CO2 as a digital asset: diversify a portfolio with real carbon credits that are tokenized.

Conclusion

While ESG investments are becoming more popular because they have a positive impact on society and the environment, DeFi is gaining traction because it eliminates the need for intermediaries in financial transactions. Thanks to trusted smart contracts, DeFi protocols establish direct contact between transaction participants and drastically reduce the exorbitant fees charged by traditional financial service providers. Initially, the mechanisms and methods from DeFi were closely tied to the traditional financial market, however they can be extended to specific areas (see VCMs). This opens up new opportunities for companies that have to operate in an ESG context. On the other hand, new opportunities also arise on the financing side, with both large and smaller investors gaining access to ESG-compliant projects. Tokenization allows the social disruption of large structures and can generate the necessary acceptance and thrust in the course of a major upheaval of current systems. Decentralized financing models like crowdfunding can play an important role in the energy transition, energy accessibility, and the global fight against climate change.