This article is part of KlimaDAO's Contributor series, where DAO contributors involved in any capacity independently pen articles to be shared via the KlimaDAO platform.
About the author
Andrew Bonneau is the Managing Director at Carbonmark, a fintech platform facilitating the trade of environmental commodities. He’s also a core contributor at KlimaDAO, a decentralized protocol serving as a market maker and capital allocator for carbon credits. Prior to contributing to KlimaDAO, Andrew co-founded Offsetra, an environmental company providing bespoke consulting services for carbon accounting and carbon project financing. Connect with Andrew on X and LinkedIn.
Introduction
While the blockchain industry may be at a turning point, there’s no denying that the user experience of interacting with decentralized finance (DeFi) continues to be a struggle. The myriad technical hurdles that must be overcome for one to experience the ‘Aha!’ moment of understanding why one would want to build with this technology at all raises the fundamental question – why?
For an organization working in the environmental commodity space, doing so over the last three years via the usage of blockchain technology has been akin to playing on hard mode. Client accounts powered by Web3 (the suite of technologies leveraging blockchain tech)? Good luck. Seamless interoperability with the wider financial system for on-ramping and off-ramping capital? Well, how many businesses do you know that have Circle accounts? In short, it’s still quite difficult to actually move money between our financial system’s traditional infrastructure rails and those being built atop blockchain technology.
And yet, there is something magical, as with all great technology, when you start to dig into the possibilities that this new medium of exchange offers the world – and certainly environmental commodity markets.
We stand at a chasm between the old world of fragmented, siloed market systems and a new world, where the interoperable nature of blockchain technologies allows for network effects to take hold and propel innovation and collaborative potential to previously unseen heights. When diving headfirst into the world of DeFi, one cannot help but marvel at the possibilities that this new market substrate provides.
But why is blockchain and the DeFi landscape such a wellspring for innovation? It starts with the network.
The power of networks
Network platforms gain from external innovation through a process known as "network effects", a fundamental concept in economics and business strategy that is particularly relevant in our digital age.
Network effects occur when the value of a product or service increases for its users as more people use it. This phenomenon is a powerful driver of growth for network platforms, which range from social media networks like Facebook to marketplaces like eBay, and also include software platforms like Windows or iOS.
The theory behind network effects and external innovation is grounded in the work of economists like Joseph Schumpeter—who emphasized the role of innovation in economic development—and Robert Metcalfe, who formulated the idea that the value of a telecommunications network is proportional to the square of the number of connected users of the system.
This concept is crucial for understanding the dynamics of modern digital and technology-driven markets. There are two key theoretical aspects and principles that underpin the concept of network effects:
Metcalfe's Law
Metcalfe's Law is often cited as the formal articulation of network effects. Named after Robert Metcalfe, one of the inventors of the Ethernet protocol, it proposes that the value of a network is proportional to the square of the number of its users. The formula can be expressed as
V=n2, where V is the value of the network, and n is the number of users.
The implication of this law is that, as a network grows, its value doesn't just increase linearly but rather exponentially, due to the increasing number of possible connections and interactions among users.
Reed's Law
Expanding on Metcalfe, Reed's Law takes the concept further by suggesting that the utility of large networks, especially those that form social groups, can scale exponentially with the network size. Reed's Law posits that the value of a network can scale even more dramatically than Metcalfe's Law suggests due to the formation of subsets within the network (e.g. groups or communities).
The value of a network can grow as 2n, reflecting the power of network formation beyond simple pairwise connections. Critically, for networks to reach their full potential and value, the agents within their systems must be able to interact effectively. This brings us to the next critical factor: interoperability.
Networks and interoperability
Interoperability is a critical part of the blockchain network effect story. Without interoperability, a blockchain’s network could never realize its full potential value.
Interoperability in networks refers to the ability of different systems, platforms, or products to work together seamlessly, without the need for special effort from the user. It's a crucial factor across the digital economy, enhancing the utility and value of technology through the facilitation of communication and data exchange across diverse systems. Interoperability is fundamental to maximizing network effects, fostering innovation, and ensuring competitive markets.
The importance of interoperability
Enhanced network effects: Interoperability magnifies network effects by allowing a broader user base to interact or transact across platforms. This cross-platform interaction increases the value of each network, as it can reach and serve more users.
Facilitation of innovation: By allowing new technologies to connect with existing ones, interoperability lowers barriers to entry for innovators, enabling them to build upon existing platforms rather than starting from scratch. This can accelerate the pace of technological advancement and the introduction of new services.
Consumer choice and flexibility: Interoperable systems offer consumers more choices, enabling them to mix and match products and services from different providers. This flexibility can lead to better user experiences and greater satisfaction.
Efficiency and cost reduction: Interoperability can lead to significant efficiencies and cost reductions by avoiding the need for duplicate systems or complex integration efforts. This is particularly important in industries where information sharing is critical, such as healthcare and finance.
Theoretical foundation
Taking a step back, there are a few important theoretical underpinnings that we’re already beginning to see play out in the blockchain-enabled carbon market. The first is in relation to Transaction Cost Economics, a theoretical framework that suggests interoperability can reduce the transaction costs associated with finding information, negotiating agreements, and enforcing contracts across disparate systems.
Simply viewing Carbonmark’s marketplace page can help one understand how transaction costs can be reduced when directly linking end-buyers to those with supply (especially carbon project developers themselves). In contrast to today’s market, where a sourcing agent must reach out to multiple brokers and traders, wait potentially days to weeks for updated inventory information, and then enter into a written contract to ensure both parties receive what’s due in a commercial transaction, the on-chain approach of Carbonmark provides a sourcing and acquisition experience that can take as little as 30 seconds. Lower costs mean that a greater share of the capital in this market goes to the project developers themselves, helping scale carbon mitigation and removal activities, while significantly reducing the transaction costs associated with sourcing for buyers. Lower transaction costs ultimately lead to improved market efficiency and increased market velocity.
It is the interoperability of disparate DeFi components that makes this sourcing experience via Carbonmark possible. Indeed, the functionality of the platform is enhanced through the integration of DeFi-derived interoperable technology and market components (e.g. decentralized exchange liquidity pools). Asset and platform programmability via smart contracts allows the entire sourcing and asset utilization experience to become automated, which adds a layer of functionality to the carbon market that thus far has not been feasible. Enhancing this further is the fact that other DeFi protocols building on blockchain technology are able to quite easily integrate functionality built by Carbonmark, and vice versa, enabling novel uses of environmental assets and derivatives, as well as support for additional environmental commodities, such as energy attribute certificates. Innovation Diffusion Theory is an interesting framework that helps elucidate how interoperability facilitates the spread of innovations. Core to this is ensuring that new technologies are compatible with existing systems, accelerating their diffusion across markets. That brings us to our next point.
From theory to practice
Achieving interoperability in this space hasn’t been smooth sailing. Indeed, one of the biggest challenges is simply interfacing with the traditional carbon registries themselves, which run on legacy systems (often private SQL databases that aren’t designed to communicate with some sort of cohesive infrastructure such as that provided by blockchains). The so-called ‘bridges’ that provide tokenization pathways for environmental commodities have an important role to play in bringing these assets onto public blockchains, where the aforementioned benefits can be realized across an underlying connective infrastructure.
That said, we have yet to achieve a common standard across the carbon bridges themselves in terms of how market processes like carbon credit retirement should be carried out. Working groups like the one organized by the Blockchain x Climate Leadership Network are a stepping stone to achieving a shared understanding by market participants on developing best practices for on-chain market processes.
Increasing the interoperability between and within off-chain and on-chain market systems will enhance the value of their respective networks, encouraging innovation, providing consumer benefits, and improving efficiency. By ensuring that diverse systems and platforms can work together seamlessly, interoperability lays the foundation for a more connected, innovative, and user-friendly digital ecosystem. As we’ve seen in the wider world of DeFi, on-chain market systems—by the nature of their design—often hold greater interoperable potential than their siloed and fragmented off-chain counterparts. Take for example the myriad connections possible between assets being traded on a decentralized exchange and other DeFi platforms like Aave, or cross-chain bridges that allow these assets to be moved across different blockchain networks for utilization on their own native applications.
The value of interoperability holds especially true in the environmental commodity space given its currently fragmented status and potential for integration across other fintech applications, thus driving our efforts toward moving an increasing share of market activity onto blockchain networks.
External innovation
External innovation refers to the contributions made by users, developers, or third-party businesses that add value to the platform. This can include the development of new applications, tools, or content that enhance the platform's utility and attract more users.
How network platforms gain from external innovation
Increased platform value: External innovations contribute additional features or services that make the platform more valuable to its current and potential users.
Enhanced network effects: As the platform becomes more valuable through external innovations, it attracts more users, which in turn increases its value even further, creating a virtuous cycle.
Diversification of services: External innovation allows a platform to offer a wider range of services or products without bearing the full cost of development, thereby attracting a broader user base.
Feedback loops: External innovators often provide valuable feedback that can inform future development of platforms and base-layer infrastructure.
DeFi is an excellent example of a sector that benefits significantly from external innovation. As discussed previously in regard to network effects and interoperability, the interconnections that are possible across DeFi provide low-friction opportunities for builders to connect new products and services in innovative ways.
KlimaDAO and the environmental commodity markets of tomorrow
KlimaDAO sits within the broader network of inter-chain activity secured by Ethereum mainnet. Within this realm, a plethora of decentralized applications has been built that add to the overall network’s value, while concurrently increasing the value of these individual applications via their interoperability with Ethereum-compatible chains and the protocols built on top of them.
By shifting an increasing share of environmental commodity market activity—and key components of the value chain itself—to blockchain infrastructure, we begin to expose these markets to the benefits and value of their networks. Increased interoperability and interconnection allows transfers of assets and value to become more seamless, while the programmability of blockchain-native assets affords increased process automation. Moreover, and perhaps most critically in realizing the raison d'être of these markets, the velocity of capital flowing through them increases – thus scaling up carbon mitigation and removal activities worldwide.
Our traction
One of our first publications after KlimaDAO’s launch touched on the themes presented in the present article – namely that blockchain technology provides a catalyst for innovation within the voluntary carbon market (VCM). Specific examples were utilized in the 2022 article to showcase analogues and alterations to existing market infrastructure and how their on-chain equivalents would lead to market benefits. In this piece, I want to take a step back and lift the veil on the big picture of why these positive effects are manifested in the first place.
The past three years have made it very clear that KlimaDAO’s launch represented a step-change in the thinking around how environmental commodity markets can be facilitated and operated. Critically, we should not forget that KlimaDAO’s launch provided the catalyst for nearly every major carbon registry to hold working groups on ‘digital carbon’ and the role that blockchain technology can play in facilitating the carbon markets of tomorrow. That work provided a basis for realizing the potential of platforms like Carbonmark, where I now sit as Director, in gaining advantage through external innovation and enhanced network effects from other builders in our space.
Furthermore, KlimaDAO’s market-making activities and the growing standardization across different tokenized carbon assets on chain have provided the foundation from which multiple protocols and businesses are now growing. Over 20 million tonnes of carbon have been tokenized thus far, with over 550,000 tonnes retired using on-chain tooling. To put things into perspective, the carbon liquidity on chain is equivalent to 38,000,000 round trip flights between New York City and London. Considering the current carbon market landscape, this still represents a drop in the ocean compared to what will come. We now have connections in place via Toucan Protocol with Puro.Earth, an innovative carbon registry focused on carbon-removal credits, as well as full interoperability with International Carbon Registry, a new player focused on ISO certification leveraging the expertise of veteran players in the carbon market space who are building on the Polygon blockchain itself. The pieces are falling in place to expand on-chain carbon liquidity far beyond 50 million credits in the months to come.
The interplay between network effects and external innovation is a critical factor in the rapid growth and evolution of digital platforms and decentralized financial systems. Our primary task has been, and always will be, to accelerate the flow of capital to high-impact sustainability projects that mitigate and remove greenhouse gasses from the atmosphere. While we have experienced challenges in leveraging blockchain technology to achieve this, including the accessibility of the tooling itself, I believe we’re now at the cusp of accelerated, positive change. We can increase the velocity of these critical markets and gain collective leverage in the fight against climate change.
The work continues.