One day, not so long ago, carbon markets and crypto decided to have a baby and called it Klima DAO.
If you are unfamiliar with Klima DAO, first go read about it here.
Klima DAO ELI5?
Klima DAO is the best cross pollination of carbon and crypto we have today. Think about it as a digital carbon capture machine, which absorbs voluntary carbon credits from the market and stores them in its treasury as collateral, similar to how a carbon capture installation sucks in CO2 from the air, solidifies it and it can be buried or used for other productive purposes. Klima DAO’s current capture cost is ~8 usd/tn (the price of BCT tokens).
The climate / carbon rabbit hole is the new crypto rabbit hole. Exciting times.
You can read all about the voluntary carbon markets here.
Carbon 101. There are three types of carbon assets:
Compliance market: must have
Allowances, meaning companies pay to pollute with a higher price costing them more and theoretically driving investments to reduce emissions. The EU ETS is the main market for those with the Government ITMOs coming up next. These are not yet in Klima DAO.
Voluntary market: nice to have
- Offsets: project that prevent emissions, i.e. build solar plant instead of a coal plant or protect a forest from being cut. CO2 does not increase, but does not decrease either. The large majority of issued credits to date.
- Removals: actively reduce CO2 via carbon capture, ie planting new trees, absorbing from the air etc. These are the best type of projects as they actively reduce emissions with trees being the only available “tech” at scale at the moment, but many new crazy things being developed (just scroll through BEV and Lowercarbon’s portfolios).
But before we get to the details, a step back. How is a carbon credit created. Below is an ugly schematic with the simplified steps.
The carbon brokers and exchanges are the old intermediaries. The new ones, the climate fintechs are tech enablers, i.e. for B2C, they offer footprint calculator apps and a marketplace, apps based on open banking etc. For B2B, they offer footprint calculation dashboards and tools plus a marketplace, they source the projects and do everything around offsetting and burning. All of this with great UI/UX. These startups do the sales and marketing so they create the demand instead of waiting for the end customers to figure out what to do, when and how. There are many startups in this space, but to name a few: Ecologi, Yayzy, Plan A, Chooose etc. They own the distribution part of the value chain.
Until Toucan happened.
Toucan is a blockchain protocol which enables the tokenization of carbon credits. They started with those issued on the Verra registry and were the enablers of Klima DAO. It is very early days, literally months and the major functionality, currently missing in Toucan, is the ability to burn tokens, which is just a matter of time. When it does, it will allow companies to replicate on-chain the “offline” value added by the fintechs. New on-chain services will surely arrive to participate in the massively growing market. But it would also enable the off-chain fintechs to integrate and use Toucan and Klima DAO, which is even more powerful.
Let’s explore how Toucan is disrupting the age old voluntary carbon industry.
First, it allows people who own carbon credits on Verra to burn them and revive them on-chain. It’s a bit like Schrödinger’s carbon credit, they are both burned and alive on-chain at the same time. That is absolutely necessary to avoid double spending / burning / counting.
One aspect to note: unless it is the project owner directly, any intermediary would have already paid for the VERs (Verified Emission Reductions = carbon credits) so, in the traditional sense, the job is done — a carbon credit has been issued, paid for and used.
So why bother? By tokenizing these credits, the owner can make money by arbing the price or earn more money by staking on Klima DAO, defi lending etc. until someone finally burns these credits on-chain. In this sense, it is a prolongation of the lifecycle of these credits.
How does the tokenization happen?
First a batch NFT (ERC-721) is created for the whole burned amount. This NFT can be traded on NFT marketplaces. It is for a specific project, a specific vintage and specific amount of VERs.
Next step is to mint TCO2 (ERC-20) tokens, which makes the batch NFT fungible and fractionalizes it into tokens equaling 1 ton (1 TCO2 token = 1 CO2e VER) in order to be comparable with the carbon market metric system. The issue is that these are still project and vintage specific so there is little to no liquidity.
This is why Toucan decided to create a carbon pool, which has a certain inclusion logic and aims to combine different projects and vintages in order to commoditize them based on common features.
The BCT (Base Carbon Tonne) pool was created and is the first accepted by and used by Klima DAO.
Why is the tokenization needed? It solved the problem of illiquidity on voluntary markets, which has plagued them pretty much since they’ve existed. Everyone wants a liquid market with increased prices and high volume. Toucan enabled it and Klima DAO made it a reality.
This new model allows market participants and end customers to postpone the offsetting decision by holding BCTs and later decide which specific project tokens they want to burn. As a result, it will kind of replicate the compliance market where companies hoard carbon allowances at lower prices because they know roughly what they will need to use (“burn”) in the future. This wasn’t the case in voluntary markets up to now because older vintages quickly became “obsolete” in terms of desirability even if they represent exactly the same 1 ton emission reductions as a newer vintage.
The BCT tokens have now become a crypto-carbon primitive allowing people to use them in DeFi for liquidity mining, lending, lock them into NFTs, use them as collateral (like in Klima DAO, but also in stablecoins) etc.
Back to Klima DAO.
History / Launch highlights
Klima did an IDO (Initial Discord Offering) with ca 500 people who could buy Klima DAO tokens (KLIMA) worth 500 or 1,000 DAI, meaning the first pricing was set at $10 (DAI) per KLIMA. The end result — 57k KLIMA sold.
Step 2 was to broaden the community via a Liquidity Building Pool on Balancer where the tokens are distributed and price is dynamically adjusted to match demand. The LBP average price was $323 / KLIMA with 113.8k tokens sold (out of 120k). Total auction volume was $33.9m and the DAO raised $17.5m. This was the first real price discovery. Proceeds from the IDO and LBP were used to provide liquidity for the USDC/BCT and BCT/KLIMA pools on Sushi Swap. For early community members and holders at launch, the BCT required to back the KLIMA tokens will was automatically delivered to the treasury on their behalf, this is why you can see a large amount of BCT in the treasury on Launch Day, October 18, 2021.
The people behind Klima DAO are pseudonymous. Many of them came from Olympus DAO of which Klima is a fork and where they were early contributors. Some of them also have background in carbon markets and from what I have heard at the Office Hours calls, they do seem to know what they are talking about. To at least hear their voices, watch this episode of Bankless.
Cumulatively, all of the stakeholder groups can never own more than 15.8% of total KLIMA supply.
- Team: 330m pKLIMA, and 7.8% supply share
- Project Stakeholders: 70m pKLIMA, and 3.5% supply share
- Advisors: 50m pKLIMA, and 1% supply share
- OlympusDAO: 70m pKLIMA, and 3.5% supply share
- Klima DAO community: 480m pKLIMA (no supply share)
They can only redeem their tokens by injecting BCT themselves at the prevailing rate when vested. That means that at 1mn Klima outstanding, should the team, advisers and stakeholders decide to sell, they would need to secure 158k BCT (this looks like an ESOP with options priced in BCT).
At a very high level, people buy KLIMA and the DAO keeps the money in its treasury in the form of BCT and liquidity pool tokens on Sushi Swap. This is why KLIMA is a carbon credit backed algorithmic “currency” and this gives it value. It is literally backed by “dirty air”, pun intended.
Why would anyone buy KLIMA instead of BCT?
Staking. The DAO incentivizes people to lock up their BCT in exchange for KLIMA, which they can stake in order to receive more KLIMA.
Which comes from…?
Thin air? No, actually, these staking rewards come from the money printing function of the DAO. However, the newly minted KLIMA are backed by BCT, which sits in the treasury. Technically, these rewards are possible because the market price of Klima is higher than the market price of BCT. We will come to that in a second.
A staking analogy: the idea should not be foreign to non-crypto people, who follow financial markets. The US Federal Reserve increases the supply of US Dollars at increasing rates post 2008. The increase in the quantum of USD out there turned out to be very close to the price increase of the S&P500. In effect, you stay on par with money inflation if you stake every investment dollar you have (ex money for consumption) in the S&P 500. You then own a giant revenue generating, asset owning corporation. If you did not “stake” and kept the USD in your bank account, you’d have a lot lower purchasing power today (ca 15% lower every year). With Klima DAO, when you stake, you keep your purchasing power in this revenue generating, asset owning organization.
What happens under the hood.
There are two ways to get KLIMA — buy directly and bond. Here is what happens.
The DAO’s revenue comes from two sources: the difference in market price between KLIMA and BCT (in the example above, someone buys 1 Klima for $1,500, which equals ca 200 BCT. Since from Klima’s perspective 1 KLIMA = 1 BCT, the rest is considered revenue.
Part of the revenue is then used to mint new Klima in order to pay stakers (inflation or you can view it as the “cost of business”). The rest stays in the treasury which increases the BCT backing of every Klima outstanding (currently 5 BCT per Klima). This is only possible if the BCT that comes in is more than the BCT that needs to go out to stakers based on the current APY (more on that later).
When the price of 1 Klima < 1 BCT, DAO buys back KLIMA and burns it, recording the difference as revenue. The book value of all assets is the level, below which it makes sense for the DAO to do this.
The other way to buy KLIMA is to bond BCT.
The DAO receives less “revenue” via bonding, because it needs to incentivize people to sell their liquidity tokens.
Bonding is a concept where the DAO sells KLIMA at a discount to anyone willing to lock BCT or Liquidity Pool Tokens for the KLIMA / BCT and BCT / USDC pools on Sushi Swap. The catch is that you get your KLIMA over 5 days according to a vesting schedule. The discount is the illiquidity premium for 5 days, much like a loyalty test.
Bonding is an automated mechanism which operates within some capacity constraints. Why? Because if bonding capacity increases, this could decrease the stakers’ share in the issuance since bonds are sold at a discount to the market price, hence there is a dilution for stakers.
This is an important trade off at the DAO level — offer incentives to people to give up the ownership of liquidity pools, but at the same time don’t dilute stakers too much.
The second revenue stream for the DAO comes from the LP pool fees as it owns the liquidity. These fees accrue in the pools and ultimately increase the book and market value of the treasury.
Protocol owning its own liquidity turns out to be better than renting liquidity where the DAO would get others to provide it and incentivize them with Klima, but anyone can run away at any time. However, if someone bonded, they will get Klima, they can stake and unstake, sell Klima for BCT, but can’t get back their LP tokens.
Let’s talk about the APY and seemingly absurd 40,000%.
When you see a figure like 40,000%, this is the first thing that comes to mind.
But before you do that, let’s spend 3 minutes to understand what it actually means. This is a measure of the inflation / printing of KLIMA and has nothing to do with the price KLIMA.
When you go to Klima’s app page, you see a 5-day ROI of 8.5%. ROI sounds misleading as it relates just to your Klima amount and not the dollar value of your holdings. This confuses people, I understand — confused me as well initially. It shows how fast the amount of KLIMA you own increases, but no one knows what the $ price of KLIMA will be.
So, having clarified this…
The APY, which is how people compare DeFi protocols, is derived from the reward rate, which is the rate at which rewards (KLIMA) are distributed to all stakers. It is set by the protocol governance (i.e. the policy team at Klima). Reward Yield (and APY) are functions. Here is how they are calculated:
- KLIMA distributed = KLIMA totalSupply * rewardRate
- rewardYield = KLIMA distributed / KLIMA staked
- APY = [(1+rewardYield)¹⁰⁹⁵] — 1
It is impossible to target a precise reward yield and APY because they rely on factors like % of total KLIMA staked — which is a decision made by the market participants, rather than the protocol. The reality shows (as expected) that when people unstake and sell, the APY increases.
The reward rate (and hence APY) was initially set high: 1/ to attract the community and 2/ based on the initial traction (pre-sales in IDO and liquidity building) and BCT supply. A lot of work has been done for this to work well so it didn’t just happen randomly.
There is more to the APY than meets the eye.
- The higher the APY, a higher % of the revenues are paid out as staking rewards.
- The APY is monitored by the policy team at Klima DAO and changes have now been proposed and voted for (KIP-3) to reduce it in order to make it more sustainable.
- The APY floats within a range. As staking increases, the APY tends to decrease in order for the DAO to be able to support more stakers and not blow up. If people unstake and sell, the APY increases as there are less people to claim the staking rewards.
- Higher APY keeps people staked, which removes Klima from the market and some of the price volatility as people may not sell too much.
- Lower APY on the other hand pushes the nominal Klima price up as the inflation rate decreases and also shows a more stable protocol, which helps to provide confidence with external parties.
Ok, now that we know how Klima DAO works, let’s open door number 3 and explore the treasures it hoards.
This is a snapshot of the composition of the market price of KLIMA thanks to the really helpful Dune dashboard.
The majority of the price is not backed by assets, rather market forces and other factors, which I’ve attempted to list above. Reducing the APY after KIP-3 will certainly help with the increase in intrinsic value as the amount of BCT per Klima will increase.
Let’s delve into the fundamentals of BCT and what is in it. Kudos to Rez for doing the grunt work and compiling all the data for Verra here.
As we know, BCT is a pool of different projects. I took the project with the largest amount of tokenized credits — the Vishnuprayag Hydro-electric Project (VHEP) by Jaiprakash Power Ventures Ltd.(JPVL) in India.
This is the issuance and retirement history. The project has a history of retiring credits on behalf of various companies and individuals. Till 2013, they regularly issued and retired credits and then the music stopped. Not sure what happened, but my guess is the large hydro VER prices and especially for older vintages dropped to levels which did not make sense to issue (verification and issuance are actually quite expensive).
Fast forward to 2021 and you can see the massive issuance in 2021 so far — 4.6m VERs of which 1.4m have been retired and of those, 1.1m have been tokenized and added to BCT. Just this project has the potential to tokenize further 8m–10m credits from older vintages. I also checked the second and third largest projects in BCT and they all reveal the same picture.
Take the whole market (Verra, GS, CAR, ACR), it will take a while for Klima DAO to absorb it as 97% is still not tokenized = 500m tons. Verra is ca 80–85% of the total market.
However, this does not account for unissued credits, so this number could easily double. In theory, if Klima absorbs 50% of Verra issued credits, it would have ~ 500m tons in the treasury at a conservative book value of say $5, i.e. $2.5bn. $5 is probably realistic because ca 45% of Verra VERs are energy (trading between $0.8-$3) and another 45% is forestry and agriculture, which have traded between $4.5-$11.
Unsurprisingly, the majority of the volume has come from Asia (accounting for 2/3rd of global VER supply).
Impact on the intrinsic value of BCT and the Treasury
Based on the one project in India, which is 8% of Toucan’s current tokenized credits and the fact that almost half of the credits are large hydro, we can conservatively assume that the book value of BCT as a pool is probably close to $2/token max, so 25% of the current price of ~8 usd.
Because if Klima stopped and wanted to sell everything, this is where the market would be for those credits at the moment I think. I don’t think we’ll get there, but good to have a downside view.
What does that mean?
Applying the 25% discount to the book value would give us a written down conservative value of $60/KLIMA. Consider this as “Margin of Safety”.
Positive factors for the price of BCT
- The current BCT price, which is like a market index is officially the highest in history.
- The addition of a Gold Standard pool, for example can easily 2x-3x average prices, however the total issuance volume is much lower than Verra. A GS pool can likely add another 5–10mn tons.
- One thing that will help keep the BCT price up is when Toucan and Klima enable burning of TCO2/BCT for offsetting purposes, because then other end user services like Ecologi, Yayzy, PlanA and many others can connect their demand. In addition, there will be on-chain versions of these companies, which will do the same in various creative ways.
- The other factor is that as the BCT increases towards the $8-$10-$12, it starts to become interesting for higher quality projects which currently sell at higher prices elsewhere. There is plenty of room as the current BCT price is currently only sucking up the bottom part of the range (see below).
Negative factors for the price of BCT
- In supply terms, I believe the BCT price can see more selling pressure when more and more projects realize how Toucan / Klima work and be able to sell credits at scale. Historically, the price difference for a 5k and a 100k VCU transaction has been almost 2x as the market lacked depth in demand.
- I don’t think many project developers will use their converted BCTs to buy KLIMA, although I think this would make sense in the future as KLIMA stabilizes. So far, the external dollar demand for BCT has been higher than the supply as evidenced by the price increase from $5 to $8 in a month or so.
We are currently in a game of chicken where we need to turn a blind eye to the current value in BCT and hodl till the relative value increases over time. I hope that Klima will carefully monitor this and not allow a flooding of the cheapest VERs even if I understand that this is a necessary evil.
An investment example: buy 1 KLIMA risk / reward analysis.
I have assumed an average APY of 10,000% as it is clear that the current 40,000% will drop over time. For the runaway, I’ve assumed that the APY has already decreased to ca. 20,000%. In both cases, I’ve used the full and discounted book value from the previous calculations in order to show what happens if the market price converges to the current (as of 29.11.2021) book values of $242 for the total treasury and $40 for the RFV. So no market premium at all. The risk / reward looks about right for startup investing.
Now, let’s take off the rosy glasses and sober up about the issues. Let’s try to kill Klima DAO:
- Rug pull by team, because to the outside world, they are basically random anonymous people.
- Hack or other code issue because they are not audited or something else.
Market / Price risks
- Early Klima holders dump before sustainable new demand has really kick in.
- Ponzi game (not Ponzi scheme): there is an element of Who will sell first given the market value premium, but this is compensated for by the staking rewards and book value.
- People withdraw better TCO2s from BCT and leave low quality (cheaper) credits in. The risk with this is that currently you can take out TCO2 which are different than the ones you put in the BCT. That means that you can tokenize 100 tons of large hydro you bought for $1 and then take out 100 tons of some better forrestry project, which you can potentially sell for $5. Now, you can’t go back from TCO2 to Verra as the tokenization is a one way bridge, but once burning is enabled, there is a risk of this happening and the BCT pool to be drained of the better TCO2s, thus drivig its value and likely its price down.
- Carbon market participants flood the BCT pool with credits and push the price down
- Klima will need to absorb between 500m-1bn older vintage credits from Verra only before the supply glut has been cleared — will there be enough demand onchain?
- There has always been an issue on the voluntary market, where projects with questionable additionality and/or logic have issued huge amounts of credits, then other truly additional projects had trouble selling their credits because of the lower average market prices due to lacking exchange infrastructure and subdued demand. As a result, many projects stopped verifying and issuing credits (it is also not very cheap to verify/issue).
- Carbon projects need a higher price, but couldn’t get it because of old issuance overhang. All that changed in 2021 when the market ticked up due to many climate fintechs in B2C and B2B that started bundling and selling projects at higher prices to end customers. These companies have the incentive to get cheap VCUs in the mix to make more money, but there is a trade off with transparency, because forced to choose, people would prefer the higher quality projects. Klima is trying to force the higher BCT price on everyone as a pool.
- Nobody knows what is inside the BCTs, but people don’t care. It created the incentive for old project devs to issue and revive projects — I view this as a necessary evil to kickstart the market, but we should also be honest with ourselves about what is inside at least in the short term. The saving grace may be when burning becomes possible and people burn BCT as a pool. But for now, God bless the APY.
- New DAOs replicate Klima and community flocks there, thus reducing demand for Klima, leading to drop in long-term APY.
- A completely new / different carbon finance mechanism replaces the voluntary market as a way to fight climate change — like a global carbon tax directly at a country level.
- Carbon removal projects with innovative tech reduce emissions based on a different business model without using carbon credits, i.e. some methane burning tech for power plants makes money off of hardware sales instead of credits or some digestion pills for cattle that reduce methane are sold to farmers and don’t use credits as additional revenue.
A closer look into one particular risk: a Bank run
The treasury holding should protect the DAO from a bank run below a certain Klima price. Assuming it is currently $242, this would in theory mean that below this price, the DAO will start selling assets to buy up Klima and burn it. However, given that the treasury assets are not in stable coins, but rather in BCT, the BCT selling pressure could in theory be so high that it causes it to fall in a vicious cycle until it finds its buyers at a higher APY level.
You can compare this to an attack on the currency of a country like Hong Kong which has a currency board pegged to the USD. The central bank has reserves and in the event of an attack (a bank run), it starts to use its USD to buy HKD. It also raises the interest rates in HKD to entice people to bring in their USD. However, if the central bank runs out of USD, then the value of HKD vs USD will fall.
Klima has a similar potential issue and I hope this does not happen soon (or ever), at least before BCT has stabilized its intrinsic value and has found external demand from people who want to offset on-chain (so far, Klima DAO represents nearly all the demand for BCT).
Ok, rosy glasses back on. Future of the DAO.
- The obvious one — burning tokens for offsetting, which will reduce BCT and KLIMA, which will help the price.
- Other building blocks around Klima — lending already started.
- New pools: new projects from different standards, which are more expensive and would push the treasury assets up. Potentially compliance credits?
- Focus on removal credits and direct links to project developers, which will create a whole new financing ecosystem.
- Verification: current standards are too slow, bad UX, expensive. Klima could share fees with other on-chain services
- The DAO becomes the de-facto carbon exchange (the off-chain exchanges are pretty much non-existent).
- Automatic greening of other crypto tokens by integrating BCT, which would increase demand. Such tokens could be accepted into the treasury (listen to the Klima team office hours from 25.11). Klima DAO can only accept something with a carbon offset in it.
- For carbon project developers, this new infrastructure opens up a plethora of new opportunities to sell and monetize their credits, which, in turn, would enable new project development models.
- Upcoming from Toucan: NBCT pool — nature-based pool with forestry and agriculture
Competitive moat of Klima
This Twitter thread describes three main moats for web3 projects:
- Liquidity: Klima owning all of its liquidity is a crucial benefit and they will continue to do so with any next pool.
- Community: Klima has amassed >50,000 strong community in just a few months, which is a huge advantage that will be very hard to replicate. The first mover advantage is really strong as all the PR and attention goes to them for free since they are the first to do this.
- Composability: Klima itself is building on top of Toucan and a lending market has already been created so the tools stack up as legos. Klima is really well suited here.
Klima DAO storing all the carbon credits to prop up the price looks a lot like how state subsidies for renewable energy used to work 10 years ago. A country would set very high purchase prices for electricity generated from solar, wind, biomass in order to stimulate investments in these technologies.
They needed to do this as the manufacturing capacity was still small and expensive. The goal was that over time, the economies of scale will kick in and building a solar or wind part will be cheap and enable them to sell power at the normal prices. This is what happened in the end and renewable power prices are currently pretty much on par with coal or gas.
Who paid the bill? The government and ultimately, the end customers. With Klima DAO, the end customers are the companies, governments and all of us who will pay for the price of carbon credits, directly or indirectly.
Klima will hopefully enable the carbon industry to dramatically increase in size and new effective tech to be developed and financed more easily.