„Show me the incentive and I`ll show you the outcome” – Charlie Munger
This issue is based on KlimaDAO, which we discussed last week in connection to Game Theory. In case you missed it, you can find it here, as this essay will not explain that part in depth.
KlimaDAO is an autonomous decentralized organization, a phenomenon popular in crypto in which all the members of an organization control it, or so the idea goes. KlimaDAO, as previously discussed, had the purpose of helping to save the environment, by creating a sophisticated market for carbon offsets and driving up the price and quality of those, by buying and locking away cheap, low-quality offsets. The way it set out to do this is by, issuing cryptocurrency and attracting participants through complicated rewards systems, which are not the focus of this piece, but for those interested are explained by the website itself here.
The issue that I want to highlight in this piece is the second purpose of KlimaDAO, which was to purchase cheap carbon offsets and put them into its treasury, out of reach for corporations who would otherwise buy them to achieve their emission targets. To understand why this did not work out as well as intended, we need to first look at India.
In the times of the colonisation, the British government took issues with the number of cobras in Delhi, and accordingly, offered a payment for every dead cobra to citizens. A straightforward seemingly good idea, this strategy succeeded initially. But after a while enterprising people began breeding cobras to later kill them and collect their payment from the government. Once the government itself became aware of this trend, it stopped paying for dead cobras altogether. Cobra breeders, now without use for their hordes of snakes, promptly released them all, resulting in an even higher number of wild cobras than before the whole spectacle. This later became known as the cobra effect, coined by economist Horst Siebert, and is an example of a perverse incentive: an incentive that has an unintended consequence contrary to the original intention.
Now there are a variety of instances in which such an incentive was devised, implemented and ultimately led to a worse outcome. The giant American bank Wells Fargo comes to mind during the last decade, managing to make this mistake twice. First, the executives set extremely high sales targets for new account openings. Salespeople, eager for bonuses and not losing their jobs, retorted to opening the accounts themselves, without customers knowledge and most certainly against their wishes. Those executives probably regret setting this incentive, seeing as they all got severely punished for it. Later, hoping to diversify its workforce among the upper levels of the company, whenever a new position opened, the hiring manager would need to interview at least one “diverse” person, meaning a woman or a person of colour. In practice, such diverse candidates would often get interviewed after a candidate for a position was already determined. Finally, a former executive got fired for bringing this issue up with his bosses and it quickly became a PR crisis with huge backlash to Wells Fargo. These instances illustrate how the intentions of the incentives, to increase sales or diversity, are the direct opposite of outcome, an account scandal and a diversity scandal.
With this in mind, we can turn towards KlimaDAO. One of their goals, was to drive up the price and quality of carbon offsets available in the market. To achieve this, it would buy the cheap offsets, locking them away from other market participants. [i]
This brought about two issues: some of the cheap offsets bought by KlimaDAO initially were already largely known to be worth less by existing market participants. They were trading so cheaply, or barely trading at all, because people knew that they were at best dubious. In effect, the interest by KlimaDAO created value for these largely worthless offsets.
But even more interesting is the second issue. Attentive readers will see clear similarities to the Cobras. By buying the cheap, poor quality carbon offsets KlimaDAO signalled demand to the market for exactly these kinds of projects. Soon enough, enterprising people realised this opportunity and started poor quality projects themselves, where they could then sell the cheap carbon offsets to KlimaDAO. Instead of eliminating the cheap offsets, KlimaDAO caused the emergence of more of them than before, directly opposed to its goal.
This is a textbook example of perverse incentives, where the original idea, erasing low quality offsets, is directly opposed to the actual outcome, which incentivized new low-quality offsets and even created additional value for old ones.
Ultimately, Verra, the leading verifier of carbon offsetting projects, banned the tokenization of retired offsets and is leaning towards collaboration with banks, through a project called Carbonplace. While some Verra offsets can still be tokenized and used by KlimaDAO, interest in the project has strongly declined, and so has the potential impact on the carbon offset market and thus the planet in general.
The lesson to take away here is that designing incentives are hard and unforeseen consequences can turn a well-intended idea to a terribly opposing outcome. Second order effects and actual incentives need to be carefully considered and evaluated to make sure the implementation of an incentive leads to the desired effect. In this specific instance, the best hope is for a mature market to emerge, through crypto or traditional banking systems, where transparency and standardisation allow for participants to easily distinguish between projects with actual value and those without.
[i] The actual complexity of these transactions is higher than implied here: Carbon Offset Projects were verified by different institutions, the most important one being Verra, and certified with Carbon Offsets. Toucan, another Crypto startup, would buy those carbon offsets, issue a token on the blockchain representing it and then retire the original. KlimaDAO would issue the KLIMA token to then buy the Toucan tokens called BCT - Base Carbon Tonnes. Ultimately, there is just another layer of intermediaries in between the offsets and KlimaDAO.