Technological developments have allowed us to be more connected than ever before with information flowing relatively freely whether or not news channels report it or authorities disclose it. Because of this, companies and those in power are held to higher accountability and forced to be more transparent about their actions.
The environmental, social, and governance metric (ESG) was born from society’s demand for greater transparency of all the negative externalities and intangibles associated with corporate operations. ESG acts as an investment framework that enables investors to find companies in line with “public good” and shift resources to support them.
Purpose Investments was one of the first investment firms in the world to embed ESG across our entire process, but ESG continues to grow in popularity, which is highlighted by its 30% yearly growth over the past five years. ESG funds are on track to surpass $37.8 trillion assets under management (AUM) by the end of the year and $53 trillion by 2025, almost a third of global AUM [1].
Over a similar timeframe, the same need for transparency and accountability has fueled cryptocurrencies that promise an immutable, censorship-resistant, and decentralized financial system. Their market cap has surpassed $2 trillion with the top two, Bitcoin and Ether, having more than $1.6 trillion in market cap [2]. While their growth has attracted investors into the crypto space, it also put them in the limelight when it comes to their ESG qualities.
Here we talk about what ESG is and whether it is on a collision path with cryptocurrencies as both movements gain momentum.
What Is ESG?
ESG is essentially a scoring system that enables investors to get a sense of companies’ environmental, social and governance policies. Let’s dive into each area in more detail.
Environmental
The environmental assessment focuses on a company’s compliance with government environmental regulations and may consider a firm’s energy usage, waste, or pollution levels, among other factors. However, as some countries have lax environmental laws, compliance with government regulations is not always sufficient for a good score.
Social
The social assessment analyzing a company’s business relationships, supply chains, and corporate practices to ensure it makes ethical decisions, supports diversity, and has policies in place to protect employees, among others.
Governance
The governance assessment takes into account whether a company has the checks and balances in place to prevent fraud, promote transparency, and allow stakeholders to voice their opinion on important issues.
For quite some time, ESG investing was seen as a tradeoff between socially responsible investing and performance. However, once we started to include these negative externalities into the business equation, it revealed a potential to limit regulatory and operational risks in the long term.
Now that we’re a little more comfortable with what ESG is, let’s see how cryptos fare in this area.
How Cryptocurrency Scores on ESG
The ESG features of cryptocurrencies are more difficult to analyze than corporations because of the non-standard ways they report their data. Our best option to get a useful understanding of how cryptocurrencies perform within these metrics is by using third-party analysis. Bitcoin is perhaps the one that has the most information out there, so we took advantage of that for some of the comparisons.
Cryptocurrency’s Environmental Impact
The biggest issue on the environmental side for Bitcoin is the energy consumption and the associated carbon emissions. Although these concerns are for cryptos in general, it is the Proof-of-Work consensus mechanism that is the main culprit behind these concerns because of the nature of Bitcoin mining as opposed to staking. Not sure of the difference? Check our Crypto 101 whitepaper.
The main argument is that Bitcoin uses too much energy, roughly 170 TWh, as of September 2021, putting it in 25thplace when compared with entire countries [3]. There are additional reports showing that a single transaction of Bitcoin uses considerably more energy than 100,000 Visa transactions [4]. These numbers look even worse when we consider the ambiguity around the energy source miners use, which tends to be the cheapest available, whether coal or renewable.
While these arguments aren’t baseless, they do not tell the full story. There are additional reports showing that the conventional banking system and gold use more energy than Bitcoin [5]. Additional reports from Bitcoin Mining Council put the share of renewables in Bitcoin to around 56% [6]. Furthermore, not all cryptocurrencies use the energy-demanding Proof-of-Work mechanism. This is one of the reasons behind Ethereum’s plan to transition into Proof of Stake, which they expect will reduce the energy consumption by 99% [7].
Although we can agree that this is an area where cryptos – in general – need to improve, the adaptability of the technology makes it promising.
How Cryptocurrency Fares on Social Factors
On the social side, Bitcoin, and cryptocurrencies in general, enable individuals to have censorship free access to financial resources. While this doesn’t sound so impressive in relatively democratic and free countries, it is a form of liberation for those in more authoritarian regimes where simply being against the government could put you on a blacklist and have all your financial assets frozen. In these scenarios, cryptocurrencies enable individuals to transfer money in a borderless fashion, across continents and into countries that they would normally not be able to do so without the permission or control of the central authority.
The same argument that makes cryptocurrencies “liberators” can unfortunately enable criminals evade government oversight. We have seen examples of this where ransomware hackers demanded payment in crypto or in other instances where illegal trades made easy within the medium cryptocurrencies provide [8]. However, in some of these instances the authorities were able to recover stolen funds.
This creates an interesting dilemma and reminds us of the “Blackstone’s Ratio.” How do we measure the net outcome of this situation? Is it better for 10 guilty people to escape than one innocent to suffer? Cryptocurrencies enable individuals breathing room in a time where governments’ digital grasp is getting stronger, and it is ultimately up to the public to determine whether this is more important than catching criminals.
Cryptocurrency and Governance Factors
This is where cryptocurrencies are the strongest. When it comes to the representation of stakeholders’ and a decision-making process that is transparent and free, cryptocurrencies are perhaps the best example. Both Proof-of-Work and Proof-of-Stake mechanisms make it very difficult for a single player to dominate and override the consensus mechanism for their own interest. This ensures that the network behaves in the best interest of the majority of stakeholders. In addition, having more people join the network makes a hostile takeover even more unlikely. This is perhaps one of the main reasons why decentralized finance is seen as an alternative and not a complementary system to conventional financial systems.
Moving Forward
While the current narrative places cryptos and ESG on a collision path, the reality is that cryptocurrencies have unique features that score highly on the governance side and arguably on the social side as well. The biggest issue seen by many is the environmental impact, perhaps highlighted even more because of our heightened awareness on climate issues. However, the energy consumption discussion is not a clear cut one, especially when we consider the inconsistent nature of reporting standards. Furthermore, consensus mechanisms like Proof of Stake can allow cryptocurrencies to turn one of their biggest perceived weaknesses into a strength.
While cryptocurrencies do not pass the ESG criteria with flying colours, the nature of blockchain and cryptocurrencies make them highly adaptable. As a result, we may eventually see one of them differentiate themselves from the rest of the pack and become the posterchild for ESG.
This information has been compiled by representatives for Purpose Investments Inc., an investment fund management firm. The information contained in this document was obtained from sources believed to be reliable; however, Purpose cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.
Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.
[1] https://www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum/
[2] https://www.coingecko.com/en (Retrieved on October 19th, 2021)
[3] https://digiconomist.net/bitcoin-energy-consumption (Retrieved on September 22, 2021)
[4] https://www.statista.com/statistics/881541/bitcoin-energy-consumption-transaction-comparison-visa/ (retrieved on October 19th, 2021)
[5] https://cointelegraph.com/news/banking-system-consumes-two-times-more-energy-than-bitcoin-research
[6] https://cointelegraph.com/news/bitcoin-mining-council-survey-estimates-a-56-sustainable-power-mix-in-q2
[7] https://blog.ethereum.org/2021/05/18/country-power-no-more/
[8] https://www.reuters.com/business/energy/us-announce-recovery-millions-colonial-pipeline-ransomware-attack-2021-06-07/