Cryptocurrency and ESG – heading for a collision course?
This article was co-authored by Isaac Chulu Chinn, Trainee Solicitor, London.
To borrow a phrase from Zoolander’s Mugatu, cryptocurrency (crypto) is so hot right now.
In recent days, the utility of crypto has been thrust onto the world stage in what The Washington Post has dubbed “the first crypto war”, with the Ukrainian Government officially appealing for donations in crypto in light of the Russia/Ukraine conflict.
This comes off the back of a manic 2021 in the crypto world where Bitcoin reached an all-time high of US$69,000 in November (though it has dipped to around US$44,000 at the time of writing). The first crypto-linked Exchange Traded Fund debuted on the New York Stock Exchange in October 2021, becoming the fastest ever fund to reach US$1 billion in assets, and the surge in popularity of NFTs (non-fungible tokens) led to Ethereum’s price increasing by over a 1000%, creating many millionaires in the process.
Crypto no longer represents a murky sector of investing but is now a legitimate asset class. Indeed, Goldman Sachs recently indicated that mainstream investors are increasingly including crypto in portfolios as an inflation hedge alongside traditional assets, such as gold.
While crypto has been catapulted into the mainstream in the last couple of years or so, ESG – incorporating Environmental, Social, and Governance measures into running a business - has been a topic of discussion since the seminal 2004 UN report ‘Who Cares Wins’.
ESG has slowly grown in popularity since and climate change and sustainability have become major societal issues – as reflected by the recent United Nations Climate Change Conference (COP26). A company’s ESG credibility and reputation are now key considerations as to whether it is a viable investment.
Consequently, a growing amount of companies now require environmental clauses to be embedded into their contracts. Legislators around the world are taking note, and are beginning to legislate the implementation of ESG related disclosures by companies such as the EU Taxonomy Regulation. With the UK Government’s public commitment to ‘carbon net zero’ by 2050, a uniform, ESG specific legislative regime is expected shortly.
Acutely aware of these two trends, asset managers, hedge funds and institutional investors are pouring money into the crypto industry whilst simultaneously touting their ESG credentials. BlackRock, the biggest asset manager in the world, for example, has been trading in Bitcoin derivatives while their CEO Larry Fink has been leading the charge for an industry wide transition to sustainable investing.
Is crypto ESG friendly?
However, many point to the paradox in adopting these two strategies. Firstly, the negative environmental impact of crypto, especially Bitcoin, cannot be understated. As per research conducted by the University of Cambridge, Bitcoin alone is responsible for around 0.4% of the world’s total energy consumption, consuming more electricity than countries such as United Arab Emirates and the Netherlands.
Bitcoin is so energy intensive because new coins are created through a procedure calling ‘mining’, which is essentially the act of solving highly complex puzzles using super computers, via a process known as ‘proof of work’ (PoW). This mechanism is inherent to Bitcoin as it verifies transactions without the need for a centralised institution such as a bank. Unfortunately, because of the complexity of the puzzle, these computers require a large amount of electricity. As more Bitcoin gets mined, the more complex the puzzle becomes, resulting in more electricity used.
However, much of this electricity comes from fossil fuel sources, resulting in large amounts of carbon emissions directly from the mining of Bitcoin. Currently, it is estimated that mining one bitcoin using non-renewable energy sources consumes a larger carbon footprint than nearly two billion Visa transactions.
Crypto also raises major red flags in the social aspect of ESG, namely the social pillars of financial product safety and responsible investment. For example, prices of smaller alt coins are often manipulated by nefarious actors in what are known as ‘pump and dump’ schemes.
These are where conspirators use misleading and fraudulent information to raise the price of a coin, after which they sell it at a profit, sending the price crashing down, resulting in huge losses for other investors.
Similarly, Decentralised Finance, an offshoot of crypto which allows peer-to-peer lending free from centralised banks and exchanges, are particularly susceptible to hacks.
In 2020, as per cyber-security firm CipherTrace’s Cryptocurrency Crime and Anti-Money Laundering Report, major crypto thefts, hacks, and frauds totalled US$1.9 billion. Due to crypto’s decentralised nature, those responsible are rarely held accountable.
Significantly, crypto is the preferred method of payment for cyber criminals. The hackers who shut down the Colonial Pipeline in May 2021, causing an official state of emergency in Georgia, USA, were paid their ransom in Bitcoin, while North Korea has been accused of financing its ballistic missile program through stolen crypto, raising an estimated US$400 million in 2021, according to Chainalysis, a blockchain analysis firm.
Crypto can also be used to evade sanctions and hide wealth. For example, it has very recently been identified as a potential way that those linked to the Russian state can circumvent the recent global economic sanctions imposed on Russia resulting from the Russia/Ukraine conflict.
Hope for the future?
The crypto community is acutely aware of its carbon emissions problem after an onslaught of negative publicity and steps are being made to address it. In 2021, we saw the creation of the Bitcoin Mining Council (BMC) whose goal is to improve Bitcoin’s sustainability. ‘Green’ mining is possible via renewable energy sources. Also, since China banned Bitcoin mining in May 2021, 57% of all Bitcoin is now mined using renewable sources of energy.
It is important to also consider that Bitcoin is not the only crypto. Wary of the criticism levelled at Bitcoin, many major alt coins (any crypto apart from Bitcoin) such as Cardano and Polkadot employ a ‘proof of stake’ (PoS) protocol - as opposed to Bitcoin’s PoW.
PoS allows owners of a particular crypto to use their own coins to verify transactions on the blockchain in order to receive brand new ‘forged’ coins as a reward. This uses a fraction of the energy required for PoW.
The EU Commission, cognizant of the environmental issues linked to PoW, has been officially encouraging the industry to migrate applications from PoW to PoS. Notably, Ethereum, which is the second largest cryptocurrency, plans to shift to PoS by the end of 2022.
Regulators are also attempting to tackle the social aspects of crypto. For example, proposed changes to EU law will require companies transferring crypto-assets to collect details of both recipient and sender. According to the EU Commission, this could reduce terror financing, money laundering, and cyber-crime.
As things stand, crypto probably does not belong in an ESG compatible portfolio. Until Bitcoin cleans up its act, or less energy intensive coins become more mainstream, a company or investor engaging in crypto-related activities risks damaging their ESG credibility and reputation.
Although steps are being made in the right direction, ESG driven winds of change are moving at such a pace that stringent ESG legalisation such as the Economic Crime Bill and the UK Sustainable Disclosure Requirement (expected in 2022, and 2023 respectively) will likely arrive before the crypto industry manages to clean up its act.
Read other items in the Commercial Brief - May 2022