Exploiting polymorphism in carbon to manufacture its investability

Graphite and diamond are both forms of pure elemental carbon. The first is the soft grey core of a pencil, while diamond is the hardest natural material known, and one of mankind's oldest stores of economic value. What makes them different is how their carbon atoms are bonded to one another, which is dictated by the physical conditions they form under. The same element, subjected to different amounts of heat, pressure, and time, can form a variety of different chemical structures, each with unique properties. Chemists call this property polymorphism.

A carbon credit, even though it is entirely man-made and intangible, is polymorphic too.

Its core element is a unit of account: one tCO2e (a tonne of carbon dioxide equivalent). On its own that is only a measurement. In order to convert it into something that can be owned and traded at scale, it must be bonded to four other elements: a sovereign authority that stands behind it, a framework that creates and accounts for it, a regime that regulates the market in it, and a cap that limits how many can exist.

For physical polymorphs (like our graphite / diamond example), nature sets the conditions that form those bonds. For intangible inventions (like carbon credits and carbon markets), humans do. No chemist discovered the rules that bond the pieces of a carbon credit together. Legislators and standard setters wrote them, and anything written can be rewritten.

The form a carbon credit takes, and the characteristics it expresses, are not intrinsic properties of carbon. They are choices, made by people, about what the carbon is bonded to, and those bonds either give a credit financial utility or take it away.

Today's voluntary carbon credit is akin to the graphite form of carbon, because three of the four bonds required to make it institutionally investable are empty. A private standard body issues it, and no sovereign stands behind it. It is not regulated as a financial instrument, and nothing caps its supply. What remains is a registry record, bought to be used up.

The voluntary carbon credit does half the job it was built for. It works as an emissions offset (the "environmental benefit" in the carbon world). But its structure, which people designed, actively undermines the formation of the global market needed to supply credits at the volume net zero requires. Punitive accounting rules mandate carrying credits at cost and never let their value rise, and open questions of legal form mean lenders do not accept them as collateral. If a credit's environmental benefit is reversed, each buyer deals with the consequences alone. These "features", and the consequences which stem from them, make it impossible to hold a sizable inventory of voluntary carbon credits for resale, and without sufficient inventory there are no market makers. So the production of almost every credit is financed by the buyer who intends to use it for offsetting. That is not a capital market. It is a pre-paid supply chain sourcing a product with almost zero fungibility.

When the European Union launched its Emissions Trading System in 2005, it deliberately chose to bond the core tCO2e to a different set of elements than the voluntary credit, because its explicit aim was to cut emissions through a market in carbon allowances. An allowance is a permission to emit, issued by the EU before the fact, limited in total number by a cap, and tied to the legal obligation that every covered emitter must surrender one allowance for each tCO2e it emits. The EU stands behind it, EU law creates it, MiFID II (the EU's financial markets law) regulates the market in it, and the cap limits it. All four bonds are filled.

The market developed as a direct consequence of those bonds. Exchanges listed the allowance and banks financed it, and the EU system has been for most of its life the largest carbon market in the world by value.

Figure 1. One element, four bonds. A table comparing the voluntary carbon credit, the EU allowance and the investable Article 6 unit across sovereign authority, governing framework, market regulation and supply cap. The voluntary credit has three of the four bonds empty; the other two forms have all four filled.

But every one of the allowance's bonds only applies in a single jurisdiction. An EU allowance satisfies an EU obligation only, likewise with China, California, the United Kingdom and others; with few exceptions those markets are not connected. This market balkanization creates massive economic inefficiencies, as each region pays its own price for its own last reduction, while the same magnitude of reduction is available outside the region for a fraction of the cost. In the end, this dynamic makes regional allowances a partial solution to a global problem. They are also inequitable, because most of the world's population lives in countries with no way to sell verified high-quality tCO2e into any of these systems.

Comparing the cost of mitigating one tCO2e in the EU with what Singapore pays for a foreign sourced tCO2e unit illustrates the scale of the inefficiency. Germany subsidizes a household heat pump by up to €21,000. Spread across the emissions it avoids over its working life, that is several hundred euros of public money per tCO2e. In contrast, when Singapore's government invited offers of authorized reductions from other countries, most came in at US$22 to 30 per tCO2e. The same outcome, one tCO2e kept out of the atmosphere, is priced an order of magnitude apart, and the gap persists because nothing bonds the two markets together. That pricing gap is where a scaled global market in carbon would route capital, trading away the price arbitrage as volumes grew and unleashing a torrent of mitigation and adaptation finance.

Why doesn't this market exist? Because we have been focusing our efforts on the wrong task: we have been busy trying to make a new carbon market rather than a new carbon product for an existing market. The first task is nearly impossible, the second needs no new parts.

So, rather than attempt to compel a global market in carbon, we should focus our efforts on the four bonds required to create a form of carbon that is akin to a diamond: a store of financial value that can be traded across borders and regulatory regimes. Let's look to the foreign exchange markets for inspiration. No government compels dealers to make that market, and yet it turns over $9.6 trillion a day. Dealers make it because they can finance and hold what they trade.

We can exploit carbon polymorphism to manufacture the "diamond" form of carbon credit. Since the 1950s, people have turned graphite into diamond in a press, by applying heat and pressure deliberately rather than waiting for nature to run its course. The same is possible with carbon credits: apply the proper intellectual heat and pressure to the voluntary credit, and we transform it into diamond form.

Figure 2. The conditions are rules we write. The voluntary carbon credit, in graphite form, becomes the investable Article 6 unit, in diamond form, under two conditions applied together: sovereign authority as heat, which creates three of the four bonds, and investable form as pressure, which creates the fourth.

The intellectual heat we have to add is sovereign authority. Under Article 6 of theParis Agreement, a host country can authorize a carbon credit (called an "Internationally Transferred Mitigation Outcome or ITMO" in this context) for use abroad and make a corresponding adjustment to its national account, so the same reduction is never counted twice. That creates two of our four bonds at once: a sovereign now stands behind the unit, and Article 6 is the framework that creates and accounts for it. It creates the third bond as well, the supply cap. Every unit a country authorizes is one it gives up counting toward its own target, so overall supply in the market is limited by countries' Nationally Determined Contributions.

The intellectual pressure we need to add is investable form. By placing the authorized unit inside a recognizable financial instrument, issued under the securities law of a regulated venue, we create the fourth bond, because then the market is supervised and an investor's interest is governed by settled law. This action also delivers the accounting, custody, financing and permanence arrangements an institution requires to establish an investment position in an asset, such as being carried at fair value and pledgable as collateral.

Neither intellectual heat nor intellectual pressure alone is sufficient to create the diamond form. Authorization without investable form produces a carbon credit a government stands behind but that no institution can hold. Investable form without authorization produces an asset with no buyer who must offset, and so no reason to hold it. Apply both at the same time, however, and the same carbon takes a new form: the credit a company buys in order to use up becomes a financial asset an institution buys in order to hold.

None of the ingredients is new. Each has been used in other financial instruments, most of them for decades. What is new is the recipe.

Investability is not a property carbon has or lacks. It is manufactured, by writing the rules that decide its form. Europe proved that with the allowance and built a regional market. AeonLoop has defined the investable polymorph of carbon, the one a global market needs, and designs the instruments that give it form.