Crypto and ESG (Environmental, Social and Corporate Governance) probably made more headlines this year than anything else in the global investment space. Due to their popularity with investors, a strong overlap between the two is set to arise. As the use of crypto becomes ever more prevalent, so does demand from investors for ESG-compliant investment products: they want to know the ESG credentials of what they are investing in. So how might crypto’s carbon footprint be minimised, enabling it to become a more sustainable and ESG-focused investment, and what regulations can be anticipated to achieve that?
This question is tackled by partner Gelu Maravela and managing associate, Daniel Alexie, at MPR Partners:
At present, cryptocurrencies are not considered to be sustainable from an ESG perspective, particularly when it comes to environmental matters: crypto mining invariably relies on fossil-fuel based energy sources creating high levels of energy consumption. According to the University of Cambridge Bitcoin Electricity Consumption Index, the global bitcoin network alone (thus excluding other types of crypto) currently consumes about 80 terawatt-hours of electricity annually. That is estimated to be equivalent to the annual output of 23 coal-fired power plants, or the total annual energy consumption of Finland.
This high energy usage occurs because crypto mining is a resource-intensive process, making it very lucrative for some companies in the field. Globally, a vast number of dedicated energy-hungry machines work around the clock to produce crypto coins. Some may argue that cryptocurrencies are still more sustainable than traditional payment mechanisms and are likely to become even more so in the future. Several players are already taking steps on crypto sustainability. Cryptocurrencies that claim to encourage eco-friendliness include:
- Solarcoin, which distributes its coins to solar energy producers that file a request and provide proof of their activity (creating 1 Solarcoin for every Megawatt hour generated from solar technology); and
- Cardano, which claims to have created the world’s first peer-reviewed blockchain, which consumes much less energy than other crypto.
Although such ‘sustainable’ coins may appeal to ESG enthusiasts, their relatively low market value could make them unappealing to many profit-seeking investors. Critically, the big players need to make their cryptocurrencies more ESG compliant by implementing eco-friendly solutions, such as developing better and more efficient mining and validation algorithms.
By adopting different systems to validate transactions, some players are moving from the traditional Proof of Work blockchain transaction verification, validating every block and generating enormous energy consumption to a Proof of Stake validation system. The latter depends on random verification of the nodes participating in the blockchain, which is claimed to require significantly less energy than the proof of work system.
Meanwhile, cryptocurrencies miners, who play an enormous role in the crypto market, can make a significant ESG contribution by moving to alternative energy means for mining: solar, wind or hydro-power. Likewise, hardware developers can aim to develop more energy-efficient crypto-mining machines.
Regulators also have an enormous potential role in shaping crypto’s future, including potentially, from an ESG perspective. Primarily, they are concerned about the inherent volatility of cryptocurrencies. Over the past year, warnings about the potential dangers and risks for investors have been highlighted by regulators worldwide: they point to a regulatory void in the crypto marketplace.
Sir Jon Cunliffe, Deputy Governor of the Bank of England, recently warned of “a plausible scenario” in which “a massive collapse in the price of unbacked cryptoassets” could occur and that there are “justifiable and growing concerns around investor protection, law enforcement and market integrity.”
The problems of regulating crypto are significant, not least because there are so many definitions and getting consensus on a single legal definition agreed by multiple jurisdictions will be very hard. Despite the political rhetoric, specific crypto regulation is not anticipated for several years, whether that be in the UK, US or EU.
As the most important crypto market, the US matters most. After much talk of the need for regulation in the US, The House Financial Services Committee recently began hosting a wide-ranging hearing on digital assets and stablecoins, questioning senior crypto executives. It is anticipated that a House bill that might follow would direct the SEC (Securities and Exchange Commission) and the CFTC (Commodity Futures Trading Commission) to set up a working group to help determine the shape of US regulation.
But the two agencies have very different approaches and there may be a turf war between them over who gains the regulatory upper hand: the SEC’s chair Gary Gensler, who is a promoter of regulating crypto, has said that many crypto ventures meet the definition of securities and would therefore fall under SEC rules, while the CFTC has a more welcoming attitude towards crypto, outlining that regulators should issue clear guidance before punishing crypto companies.
ESG is in an equally difficult place. Without a single standard definition, ESG has instead become an umbrella term to define a broad range of standards. For ESG to have real substance over time in changing corporate behaviour, including the crypto industry, regulation will be essential. But the regulatory process will inevitably be slow. The recent COP26 summit in Glasgow showed just how hard it is to get consensus between multiple countries on complex issues.
This decade will likely see significant regulatory progress on both crypto and ESG. But different jurisdictions – the US, UK and the EU – may well choose to take their own distinct approach which will result in them not being fully aligned with each other. Meanwhile, the technology underpinning crypto and the issues underpinning ESG know no borders: the space is global by nature. For regulators, investors and markets, that will present yet another challenge.