This post is the start of a crossover series looking at Environmental, Social and Governance issues (ESG) in the context of fintech. We’ve got plans for more posts on ESG x Fintech and maybe even a podcast, so watch this space…
It ain’t easy being green
Although bitcoin’s value is notoriously volatile, what has consistently increased over time is scrutiny of its environmental impact. Working out the energy usage of bitcoin is difficult, but some estimates (including by a member of the executive board of the ECB) put the electricity usage of bitcoin alone as being higher than that of the Netherlands.
As the most well-known cryptocurrency, bitcoin has received the most attention. However, other systems also use “proof of work” (more on this below) so other cryptocurrencies, such as ether and dogecoin, and non-fungible tokens transferred using Ethereum, also raise similar environmental concerns.
Why are cryptocurrencies so bad for the environment?
Transactions in certain cryptocurrencies are verified essentially by people competing to solve calculations – the first to solve the relevant calculation is rewarded with a number of bitcoin or ether or similar. The solution to the relevant calculation is difficult to determine (numbers which are close together can produce wildly different answers) but easy to verify once the solution is found. This sort of system is known as “proof of work” (PoW) and effectively a verification system like this is needed to ensure that the same token or coin cannot be spent twice.
Over time, the calculations have become more difficult and mining has become very energy-intensive as it requires ever more computing power (and indirectly, more energy to cool down over-heating computers). In theory, miners could use electricity from renewable sources but these are typically more expensive than non-renewable sources and in practice, it is hard to tell what type of energy was used to mine a particular coin or verify a particular transaction. And some would argue that we should be using the energy created by renewable sources for other more useful things.
Why do we care?
In a world where ESG is increasingly on the agenda at board level, any company looking at using cryptocurrencies or providing DLT solutions needs to consider the potential impact on its own sustainability. A fairly straightforward example is whether a company that is accepting bitcoin as payment or using Ethereum to provide services can really claim to be sustainable. Premium listed companies in the UK are required to at least consider climate-related disclosures in line with the Taskforce on Climate-Related Financial Disclosures (TCFD) recommendations and recommended disclosures (see the FCA’s requirements for premium listed companies at LR 9.8.6 and the FCA’s primary market technical note on disclosures in relation to ESG matters including climate change, for example) and the FCA is consulting on whether to extend climate-related disclosure requirements to issuers with standard listings. Query how the use of cryptoassets could affect disclosures, such as targets around greenhouse gas emissions. We’ll be considering ESG disclosures for listed companies in more detail in another post in this series.
Also of relevance for EU entities, the EU’s Taxonomy Regulation requires corporates of a certain size to include in their non-financial statements information on how and to what extent their activities are associated with environmentally sustainable economic activities. The European Commission has recently published a draft of a delegated regulation which sets out the content and presentation of information to be disclosed by non-financial undertakings, asset managers, credit institutions, investment firms, and insurance and reinsurance undertakings.
Where institutions such as fund managers, financial advisors and pension funds aim (and claim) to invest sustainably, such institutions will need to consider whether they are able to invest in cryptocurrencies or in companies providing services using PoW systems. Certain EU financial institutions will be subject to the EU’s Sustainable Finance Disclosure Regulation (SFDR), which includes requirements to disclose whether, and to what extent, their products and services are sustainable.
Such disclosures will likely need to take into account investments in cryptocurrencies or companies using DLT (see our briefing for further information on Hot Topics in ESG for financial services firms). UK financial institutions are unlikely to escape the need for sustainability disclosures, with the UK Chancellor indicating in a recent speech that the UK Government will work with the Financial Conduct Authority to create a new sustainable investment label so that consumers can clearly compare the impacts and sustainability of their investments.
Financial institutions also need to be aware of their own position given the environmental impact of PoW systems, which are increasingly being explored for internal use cases. Many institutions are exploring cryptoasset services, such as custody, which could involve transacting in cryptocurrencies that rely on PoW systems. Some financial services groups may also be considering making minority investments in, or acquisitions of, companies that are using DLT or investing in cryptoassets. Financial institutions’ sustainability disclosures will be complicated as a result of such activities, even if an institution never invests in bitcoin for itself.
Regulators are increasingly requiring that sustainability considerations are integrated into the governance and risk management practices of financial institutions and disclosure of organisations' governance around climate-related risks and opportunities is one of the recommendations in the TCFD report. The direction of travel is certainly towards linking remuneration and ESG factors – the EU SFDR for example will require certain institutions to disclose how sustainability risks are managed and the link between remuneration and sustainability risk management.
Even if those regulatory expectations were not in place, investors are increasingly focussed on the environmental and sustainable impacts of the businesses they invest in – ESG shareholder activism is on the rise and financial institutions will not be immune. Institutions may also wish to take into account whether their activities might contribute to them being excluded from certain climate benchmarks – for example, EU benchmark administrators are subject to more prescriptive requirements for the methodology of climate benchmarks (in part to reduce the risk of greenwashing).
Balancing regulator and investor expectations regarding sustainability, customer demand for cryptoasset solutions and the need for innovation (and not forgetting financial returns) is likely to result in some difficult conversations in the boardroom. Depending on how environmental factors are linked to executive pay, this may well disincentivise financial institutions from developing or exploring cryptoasset services or DLT technology solutions – at least, using PoW systems.
What are the alternatives?
The increasing focus on the environmental impact of PoW systems has led to industry reaction. There is, for example, one group (backed by Ripple and ConsenSys, among others) setting out a “Crypto Climate Accord”, which is targeting 2040 for the entire crypto industry to reach net zero emissions, and another, the Climate Chain Coalition, which is backed by the UN Climate Change secretariat and seeks to align with the long-term goals of the Paris Agreement.
The Ethereum Foundation intends to transition Ethereum, eventually, to a new consensus mechanism - proof of stake, which is one of a number of newer consensus mechanisms, using less energy but which still allow for secure transfers on permissionless systems.
- Proof of stake (PoS) – generally, PoS systems rely on persons (“validators”) contributing (or “staking”) tokens that they own in order to participate in the validation process. Staking often involves a minimum size of stake held for a lockup period. Depending on the system, rewards in the form of more cryptoassets are given out to validators – often based on size of stake and length of time the stake has been held. PoS does not rely on miners competing to solve the same puzzle, so should allow the network to operate with lower energy usage and thus avoid the same environmental impact of PoW systems, but there are other issues that arise with a proof of stake model (e.g., the risk of a 51% attack is more likely in a PoS system).
- Proof of authority (PoA) – PoA typically relies on designating a small number of persons to validate transactions within a network. This clearly relies on some form of trust among the relevant authenticators and is a move away from permissionless systems such as the bitcoin blockchain. However, it is only likely to be an appropriate solution for institutions where the need to know the counterparty is considerably higher or for institutions considering internal use cases.
Ironically enough, the reason for needing any sort of proof in order to avoid the double-spend problem is because there isn’t a trusted intermediary involved in the transaction. That problem should be resolved where there is a trusted intermediary – such as a central bank, in the case of a central bank digital currency (CBDC) - which doesn’t need to expend so much energy verifying transactions. CBDC papers have not focussed extensively on the verification methods, noting at most that any CBDC would need to take into account energy usage. However, at least part of the reason for the birth and subsequent success of bitcoin was reluctance to trust central authorities, so it is unclear whether there will be a significant move towards a centralised cryptocurrency.
Conclusion
Exploring the dichotomy between demand for cryptocurrency products and blockchain-based solutions on the one hand and the expectations of investors and regulators on the other is likely to be the focus of many financial institutions in the near future. Whilst the concerns over bitcoin not being green have been highly publicised, the implications for proof of work systems more broadly have not. Financial institutions will need to balance sustainability concerns with consumer demands for innovative products and services very carefully.
