For market participants pivoting toward ESG and digital assets, weighing the issues at the crossroads of these two megatrends is critical.
By Paul A. Davies, Stuart Davis, Simon Hawkins, Nicola Higgs, Yvette D. Valdez, Thomas Vogel, Stephen P. Wink, and Deric Behar
The huge rise in popularity of Bitcoin — and the growing interest by mainstream financial institutions in virtual assets as an investable and tradable asset class — has shone a light on the cryptocurrency industry’s environmental, social, and governance (ESG) performance.
The vast majority of the world’s financial institutions manage climate risk and other ESG risks in their own portfolios. As a result, many financial institutions perform related diligence on corporates they look to service, whether by traditional lending, capital markets underwriting, or direct investment. While the focus has primarily been on the ESG performance of cryptocurrency miners (given their role in the creation of cryptocurrencies and the energy requirements associated with that process), the ESG performance of the broader cryptocurrency industry will increasingly need to be considered, particularly as institutional investment in this space is accelerating. Accordingly, investors in cryptocurrency miners, in cryptoasset service providers, and even in companies that put cryptoassets on their balance sheets must now weigh the potential for increased returns against the possible negative impact on their ESG credentials.
While much has been written about the sustainability challenges related to cryptocurrency mining, ESG represents a broad range of considerations. This post explores the ESG-related challenges that cryptocurrency market participants are facing and practical steps to meet them.
Environmental concerns have circulated in popular media relating to the amount of energy expended in mining cryptocurrencies, particularly those that rely on a proof of work consensus model (such as Bitcoin and Ether) rather than proof of stake or proof of authority consensus models. Such emissions, it has been argued, have the potential to significantly contribute to the acceleration of global warming.
According to research by the University of Cambridge, the majority of Bitcoin miners are based in China, a country heavily reliant on coal for energy. Until recently, a large amount of cryptocurrency mining was conducted in Inner Mongolia, an autonomous province in northern China, where coal-burning power plants provided the electricity for mining operations. However, in March 2021 the provincial government of Inner Mongolia announced that it would ban all cryptocurrency mining operations in a bid to achieve carbon-reduction targets set by the central government. In addition, a significant portion of cryptocurrency mining occurs in Sichuan province, the most hydroelectric-rich region in the country. With China publicly stating that it is targeting carbon neutrality by 2060, further policy decisions and initiatives to shift from fossil fuels to clean energy sources may reduce the cryptocurrency mining carbon footprint.
Furthermore, a growing range of blockchain protocols supporting the issuance of cryptoassets that do not rely on energy-intensive consensus models are coming into the market, including permissioned networks, which the financial industry is increasingly adopting. Even so, the continued success of Bitcoin as an asset and its broader importance to the cryptocurrency market means that environmental questions continue to be extremely relevant.
Where and how cryptocurrency is mined is a growing area of focus for investors who do not want to buy cryptocurrency that is created in a way that causes excessive energy waste or environmental damage. Anecdotes have circulated about investors seeking sustainably mined “virgin” bitcoins at a premium, as these bitcoins are less likely to be associated with problematic activities, and therefore less likely to raise ESG or reputational risks. Some institutions even want to mine their own supply to be able to prove their coins’ provenance to clients.
Today nearly 40% of cryptocurrency mining relies on renewable energy sources, as an increasing number of miners aim to reduce carbon emissions and meet investors’ demands. Miners can differentiate their ESG credentials by switching to or emphasizing their use of sustainable energy sources, and other cryptocurrency market participants can consider taking steps to encourage the use of renewable energy in bitcoin mining.
Climate Focus: The Impact of the Paris Agreement
The Paris Agreement is a legally binding international treaty on climate change, adopted by 196 countries at the United Nations Climate Change Conference in Paris on 12 December 2015. Its goal is to limit global warming to below 2°C, compared to pre-industrial levels. Those 196 countries are now looking to build their own legislative frameworks to ensure that they can achieve the carbon reduction goal set out in the Paris Agreement. They will achieve these goals by imposing carbon reduction requirements on companies operating in those jurisdictions. In practice, for the vast majority of companies, this requirement will likely involve aligning with the Task Force on Climate-related Financial Disclosures (TCFD), a private sector task force whose recommendations are widely recognised as authoritative guidance on the reporting of financially material, climate-related information. A number of governments and financial regulators around the world have expressed support for the TCFD recommendations and are integrating them into their guidance and policy frameworks. Examples include the UK, Australia, New Zealand, Canada, Hong Kong, Japan, Singapore, and South Africa, as well as some EU Member States.
The TCFD recommendations and supporting disclosures include the following:
- Governance: Disclose the organisation’s governance around climate-related risks and opportunities.
- Strategy: Disclose the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning where such information is material.
- Risk management: Disclose how the organisation identifies, assesses, and manages climate-related risks.
- Metrics and targets: Disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.
For the reasons highlighted above, many cryptocurrency miners and firms may find having to disclose their GHG emissions publicly as a highly sensitive exercise. And careful consideration should be given both to the data integrity to support the accuracy of those disclosures and to the plans to transition to more sustainable business models over time.
Cryptocurrency firms may also be interested in exploring carbon offset and energy efficiency/sustainability programmes. For example, the Energy Web Chain is an Ethereum-like base layer network protocol for the purpose of building renewable energy applications on the blockchain. Unlike the Ethereum or Bitcoin protocols, Energy Web Chain uses a proof of authority consensus model, which Energy Web Chain argues is more energy efficient due to its permissioned, proof-of-authority consensus. These types of blockchain consensus models have been gaining prominence as a result of energy efficiency concerns, and may become an increasingly important factor in the success of these platforms. Energy Web has also recently partnered in the launch of the Crypto Climate Accord (CCA), a private sector-led initiative inspired by the Paris Agreement. The CCA focus its efforts on decarbonizing the cryptocurrency industry, aiming for all blockchains to be powered by 100% renewable energy sources by 2025, as well as net-zero emissions for the entire crypto industry by 2040. Separately, the power industry is being pushed to innovate and find ways to create micro grids and other energy-saving programmes that empower the consumer to participate in the supply and demand of energy.
Treasury Focus: Putting Bitcoin on the Balance Sheet
Aside from volatility and accounting issues, corporate treasuries are also acutely impacted by the tension between the ESG agenda and the environmental concerns of digital assets noted above. Most listed corporates now have an ESG policy in place and, at one level or another, are looking to finance themselves by relying on ESG-linked products (sustainability-linked bonds or loans, ESG swaps, etc.). Concurrently, many corporate treasuries (especially in the US, but trending in Europe as well) are looking to invest a portion of their balance sheet assets in digital assets (Bitcoin in particular). This is because, in the face of impending inflationary concerns, corporate treasuries are increasingly looking for uncorrelated hedges in the form of cryptocurrencies to invest some of their liquid assets. For public companies looking to issue ESG products and also allocate a portion of their balance sheet to digital assets, the contradiction is acute. The decision to move forward may require a reckoning with this specific contradiction.
Social impacts have moved to the forefront of our collective attention during the COVID-19 pandemic. Bitcoin and other cryptocurrencies have notable stories to tell on the subject of social benefits. Namely, the opportunity for greater financial inclusion and the protections afforded to society as a result of censorship-resistant transactions. Cryptocurrencies aim to allow users to seamlessly transfer value in all parts of the world via a monetary network that is robust, free of censorship, and resistant to intervention by state actors and geopolitical conflicts. The only barrier to entry for aspiring market participants is an internet connection.
Many cryptoasset service providers have taken significant steps to implement compliance safeguards such as anti-money laundering (AML) and combating the financing of terrorism (CFT) frameworks even in advance of formal regulatory requirements being imposed on them, though this is not universally the case. For example, the increasing use of decentralised finance (DeFi) platforms in order to trade cryptoassets or provide/take liquidity through lending or market-making platforms raises concerns as to whether these unregulated platforms may be used to sidestep the compliance safeguards of regulated platforms. DeFi platforms do not tend to impose AML “know your customer” (KYC) standards on their users, and governments and regulators have raised concerns as to whether the anonymity associated with these platforms could lead to undetected market manipulation or financial crime.
On the other hand, a benefit of cryptocurrency transactions is that they are largely transparent and traceable (with the exception of privacy coins). The blockchain analytics firm Chainalysis estimates that criminal activity represented only 0.34% of cryptocurrency transactions in 2020, down from 2.1% in 2019. Blockchain analysis has been recognised as an important tool for cryptoasset service providers to consider when dealing with assets that have originated from anonymous or private sources. Still, important questions remain as to how AML/KYC requirements should be adjusted to take into account the traceable nature of the blockchain (e.g., how many “hops” should a cryptoasset service provider analyse to be comfortable with the source of the asset?). However, as the industry matures, and as regulators and international bodies such as the Financial Action Task Force continue to work with the sector, market standards in this space should continue to emerge.
In light of the above concerns, market participants in the cryptocurrency industry can use their social impacts as a method of competitive advantage, particularly by contrasting their activities with any perception that cryptocurrency is an avoidance mechanism for taxation and other regulatory regimes, or a driver for criminal activity. But to do this, they must also be able to demonstrate meaningful social contribution by understanding the metrics customarily used to measure social impacts. Opting in to transparent regulatory regimes that are built with social protection measures in mind will become a distinguishing feature of cryptocurrency miners and other market participants in the future.
Another important area is how firms deal with the inherent cross-border nature of cryptoassets and the significant fragmentation of regulatory standards globally that has emerged in this space. Due to the extraterritorial approach taken by many regulators with respect to cryptoassets, firms must fully consider the regulatory requirements that apply both in the jurisdiction in which they are incorporated as well as the jurisdiction in which their customers are based. However, different regulatory standards can lead to firms being subject to inconsistent regulatory requirements that are designed to deal with the same regulatory risk, and regulators need to be mindful of the significant burden that these requirements can place on firms.
Governance, and in particular the transparency of a cryptocurrency market participant’s governance framework, forms a key driver of opportunity or exposure. Considerations include:
- Does the management body take into account sustainability issues in the course of business?
- Is the operation structured to align with the long-term ideal of being sustainable by maintaining a diverse management team?
- Does the firm operate with tax transparency?
- Is financial crime, bribery, and corruption risk adequately managed?
- Does the operation have systems in place to protect against cyberattacks that could result in losses for investors and breaches of privacy?
- Is executive pay linked to sustainability targets?
Some of these questions may challenge high-growth companies that often operate under regimes that have not adapted to their model, particularly in the case of financial crime legislation. Over time, governance will organically improve as digital asset businesses become more mainstream and list on public exchanges (whether through IPOs, direct listings, SPACs, or otherwise), as they will be forced to adhere to formalised governance and disclosure models as would any other publicly traded company.
The ESG agenda includes both investment risks and opportunities. Some jurisdictions, such as the EU, require financial institutions to look beyond climate risk to other environmental factors, in addition to social and governance concerns. And because many financial institutions view ESG performance as directly linked to financial performance, they elect to diligence such matters regardless of the regulatory frameworks they are subject to. For these reasons, it is advisable for any cryptocurrency firm looking to access finance from financial institutions to holistically review its ESG credentials and narrative and consider how it would like to publicly present its performance against traditional ESG metrics. For ESG-conscious financial institutions looking to trade, invest, or custody digital assets, it will be critical to review the cryptocurrency firms’ ESG credentials and narratives to ensure that they are in line with their own ESG objectives, as well as client expectations. And for corporate treasuries exploring the possibility of adding cryptocurrency hedges to their balance sheet, a well-devised strategy and execution is imperative to ensure consistency with internal ESG policies.
 “Proof of work” is a method of deciding who is allowed to publish blocks to a blockchain by requiring a certain amount of resources to be expended. It is the mechanism used by Bitcoin to validate transactions and determine which miners are rewarded. “Proof of stake” is a method that allows users to mine blocks according to the stake they hold (i.e., the more coins a user holds, the more mining power a user has). “Proof of authority” is a consensus model, similar to proof of stake, that leverages identity (in the form of set, pre-approved authorities, called validators) as the form of stake rather than actually staking tokens. Each network implements a system to authorize and identify validators, who will then validate transactions and Blocks within the respective network. This allows proof of authority networks to use less computational power and does not require communication between nodes to reach consensus. See the Latham and Watkins Book of Jargon – Cryptocurrency & Blockchain Technology at https://www.lw.com/bookofjargon-apps/boj-CryptocurrencyandBlockchain?documentid=13328
 The US withdrew from the Paris Agreement on November 4, 2020, but officially rejoined on February 19, 2021, by Executive Order of US President Biden.
 Privacy coins are coins that provides its user community with a higher level of anonymity than is typical for cryptocurrency. Privacy-related features may include encryption, the bundling of transactions (so that individual users cannot be linked to individual transactions), and stealth addresses. See the Latham and Watkins Book of Jargon – Cryptocurrency & Blockchain Technology at https://www.lw.com/bookofjargon-apps/boj-CryptocurrencyandBlockchain?documentid=13328
 See the Chainalysis 2021 Crypto Crime Report, available at https://blog.chainalysis.com/reports/2021-crypto-crime-report-intro-ransomware-scams-darknet-markets.
 See the Joint Money Laundering Steering Group’s Sectoral Guidance on Cryptoasset Exchange Providers and custodian wallet providers.
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