Is There A Future for Cryptocurrency Beyond its ESG Shortcomings?Article
Cryptocurrency, in particular Bitcoin, has been the subject of much debate when it comes to topics like ESG criteria and impact investing. However, this discussion became more prominent and mainstream when Elon Musk publicly backtracked on his decision to accept Bitcoin as a method of payment for Tesla, citing environmental concerns.
What are ESG criteria?
The ESG criteria are a set of standards designed to assess the environmental, social, and governmental dimensions of companies’ operations. These standards are used by investors to anticipate negative impact on stakeholders due to shortcomings in these three areas.
Bitcoin: What is cryptocurrency?
Cryptocurrency is a digital or virtual currency that is secured through cryptography. This makes it highly secure and difficult to counterfeit. Usually, cryptocurrency uses a decentralized system based on blockchain technology, in which transactions are verified and recorded. The decentralized system replaces a centralized authority, such as our traditional banking system.
Crypto & ESG: Environment
The boom in cryptocurrencies and other digital finance innovations is increasingly viewed from a more scrutinizing perspective. In particular, investors and critics are highlighting ESG concerns for crypto investments. Its increasingly damaged reputation is making some question whether cryptocurrency is meeting environmental, social, and governance standards. Often the discussion relates to ESG’s first pillar: the environment. However, the other two pillars, namely ‘social’ and ‘governance’, also play a significant role, particularly the social dimension. We will focus mostly on Bitcoin to evaluate the environmental pillar of the ESG standards.
Current data from the Cambridge Bitcoin Electricity Consumption Index suggests that Bitcoin uses an estimated 97.7 TWh of electricity per year, which is about 0.44% of all energy consumption globally. That last percentage may sound small, but it is a percentage that exceeds the energy use of quite a few entire countries. Due to its rather large energy consumption, Bitcoin is mostly ‘mined’ in countries where the cost of electricity is lower. However, in these countries, there are very few renewable energy sources. Most energy originates from coal-powered plants.
- Proof of Work vs. Proof of Stake
Bitcoin is ‘mined’ meaning that miners compete by solving certain cryptographic puzzles. The first to find the solution to the puzzle will receive Bitcoin. The puzzles are solved using highly specialized computers which use a massive amount of energy. This form of mining cryptocurrency is known as a proof-of-work model, whereby the ‘work’ is the solving of the puzzle(s).
Alternatively, cryptocurrencies may use a proof-of-stake model. Another well-known cryptocurrency, Ethereum, is currently transitioning to the proof-of-stake model. Whereas formerly, Ethereum used proof-of-work as well, similar to Bitcoin, this is set to be completely phased out by early 2022. This transition will result in a 99.95% drop in energy use by the Ethereum cryptocurrency. As opposed to the proof-of-work model, the proof-of-stake model relies on hard drive storage rather than computer power. Those who are already in possession of coins are able to mine more coins.
- Current initiatives to make cryptocurrency more sustainable
Cryptocurrencies, particularly those using the proof-of-work model, obviously have a significant environmental impact. Yet, there is also an upside: there are many sustainable initiatives underway. To name a few:
1. The Crypto Climate Accord: This initiative is headed by Energy Web, RMI, and the Alliance for Innovative Regulation. The Accord includes calls to decarbonize the cryptocurrency industry by 2030. More than 45 companies in the crypto-, finance-, technology-, and energy industries have already signed onto the Accord.
2. Energy Web launched a platform situated on the blockchain which is to be used to verify renewable energy certificates. Miners and companies can use these certificates to prove that they are committed to the environment.
3. The Universal Protocol Alliance launched a tradeable token that will offset carbon footprints.
Crypto & ESG: Social
As opposed to the environmental dimension, is cryptocurrency generally positively regarded when it comes to the social pillar. The social pillar is one that is difficult to quantify, but it carries a lot of risk. We maintain that there are both positive and negative aspects to the social dimension of cryptocurrency. These aspects are summarized in the below image.
- Benefits: Decentralization & financial inclusion
Bitcoin’s whole premise is that it decentralizes currency. The middleman, such as banks and other institutions, are removed from the transaction, without compromising on security and trust. As a result, bitcoin/cryptocurrency is perceived as a democratic currency as financial inclusion is accelerated. Moreover, the amount of Bitcoin out there is finite, meaning that it is protected from devaluation. Financial inclusion is even further enabled through increased portability of the currency by digital wallets and the elimination of exchange rates between different countries. Finally, another major social benefit of cryptocurrencies is that they provide a level of privacy for people doing transactions. This is particularly beneficial to those under oppressive regimes.
- Downsides: Anonymity, volatility, and human rights concerns
While the privacy offered by the use of cryptocurrency is beneficial to certain groups, it also poses a threat due to an increase in illicit operations and money laundering. Bitcoin, for example, was used by the dark web marketplace Silk Road, where users could purchase and sell illegal goods and services without being traced. This, paired with the decentralized nature, means that there is also limited protection for owners or transactors in the crypto industry.
Furthermore, cryptocurrencies are a trendy investment, even for unsophisticated investors. Many investors do not realize or sufficiently consider the fact that they may lose a lot of their investment due to the volatility of cryptocurrency. This volatility is in part spurred by the lack of regulation in the industry. Moreover, there are currently many influencer scams, whereby influencers and social media celebrities encourage their followers to invest in crypto, often resulting in the influencer making a lot of fast money and the young, inexperienced investors losing their investment.
Perhaps most importantly, there are also human rights concerns with cryptocurrency. According to the Cambridge Bitcoin Electricity Consumption Index, the most recent numbers (April 2021) indicate that 46.04% of Bitcoin mining takes place in China. Of that number, 54.37% takes place in the disreputable province of Xinjiang. The province has come under international scrutiny due to alleged forced labour and alleged violations of human rights. As previously mentioned, the main source of energy used for the mining of Bitcoin is coal. Although it is not entirely conclusive whether forced labour is used in the Xinjiang coal mines, it is already grave that so much of this financial product is created in a province that is accompanied by severe ethical and regulatory risks.
Crypto & ESG: Governance
Whereas from its inception, Bitcoin (and cryptocurrency in general), has been a highly speculative asset, multiple jurisdictions are now implementing a regulatory framework which would provide more stability. Such regulation could include an auditing structure, reporting and compliance mechanisms, and capital reserve requirements to ensure that cryptocurrencies are used legitimately.
There are however persisting diversity concerns in the cryptocurrency sector. In 2019, the US-based non-profit ‘Diversity in Blockchain’ published a report which indicated a severe lack of diversity. The report highlights how only 4-6% of the workforce is female. Further, there is a lack of information and data regarding racial and ethnic diversity.
A rigorous regulatory framework could benefit the crypto industry and its ESG profile by providing more guidance, safety, and stability. Although in the EU, the Sustainable Finance Disclosure Regulation was passed, which requires funds to report on the ESG standards of their products, cryptocurrency is not covered under the regulation. However, the EU is currently working on a regulatory framework termed ‘Markets in Crypto-Assets Regulations’, which will likely be passed in 2024.
We maintain that taken overall, Bitcoin and proof-of-work cryptocurrencies do not pass an ESG assessment. However, given the novelty of the industry and its flexibility, this is likely to change in the future. The proof-of-work and proof-of-stake models both have their own benefits and shortcomings. Yet, we think that the proof-of-work model is most suitable for positive change, since the environmental shortcomings can be resolved, whereas it is more difficult to resolve the social shortcomings of the proof-of-stake model.