Commentary

Four Ways Blockchain is Restructuring ESG

Alisa DiCaprio, Chief Economist at R3, explains how blockchain applications are already supporting improvements in transparency, efficiency and governance.

ESG policies have gained increasing attention by many industries and businesses over the past few decades. At the same time, blockchain’s integration into the global financial system has been advancing ESG credibility.

Often ESG discussions around blockchain centre around the environmental problems associated with mining. However, the original use of blockchain was intended to democratise social policy and financial governance. As such, it’s unsurprising that blockchain applications are already demonstrating their ability to help companies and investors manage ESG risks and opportunities.

Improving market efficiencies

Market structure is an ongoing problem within the ESG space, even where products are standardised. The carbon market provides a clear example of this where we have seen overwhelming demand for voluntary carbon offsets. It’s predicted to rise from $1bn in 2021 to a colossal $50bn by 2030.

Markets are struggling to handle this demand. As a result, offsets are often misused, misreported, and undervalued. Carbon credits are also not comparable across markets, presenting another roadblock.

However, the integration of blockchain into carbon markets has led to significant improvements. Over time, decentralisation has reduced the complexity of how carbon credits are registered, traded and managed, leading to an increase in quota utilisation. Blockchain also addresses market opacity by making existing markets more reliable and open. All of this has led to a positive impact on problems such as lost quotas, illegal trading activity, fraud, and repeated transactions.

Safer analytics for social policies

The ‘S’ in ESG relates to the social dimension of corporate policies, but social policy efforts are often obstructed by data measurement problems, particularly where highly sensitive cases are involved. This makes effective data analysis difficult since any leaks in the original data could expose sensitive information around those who provide it.

One solution has been to apply the use of blockchain alongside confidential computing to allow firms to create aggregated analytics without exposing the underlying data. This has proved successful at tackling the historically underemphasised problem of sharing data about sensitive topics such as geopolitical risk, safety risk and use of forced labour.

The application of blockchain has therefore provided governments and socially responsible businesses with an unparalleled ability to leverage their own data, with potentially transformative results for global inequality.

Diversifying good governance

The ‘G’ in ESG is arguably the most difficult of the three components to get right. Significant governance failures can have a severe impact, particularly on corporate profits. For example, in 2021, inadequate governance resulted in the default of Archegos Capital Management with over $10 billion of reported losses across multiple companies.

What blockchain brings to governance is new methods. By making voting more accessible to a wider range of stakeholders, blockchain can bring more inclusive means of control and oversight.

One example of this is the use of on-chain governance through the creation of governance tokens. On-chain governance refers to a built-in smart contract that enables stakeholders to vote for protocol changes directly on the blockchain through governance tokens.

This model contrasts off-chain governance (Bitcoin and Ethereum) processes where proposals are mainly made by core developers and a few influential stakeholders have decision-making powers.

Creating new investable asset types

Although things like organic cosmetics or shoes made from plastic bottles are popular among consumers, lack of standards creates incentives to cut corners and occasionally exposes overblown claims. Blockchain enables the asset in question to verify its own ESG claims,  due to the fact that information around identity and credentials is auditable, tamper-proof and traceable on the ledger. This has diversified assets in two ways:

  1. Bringing tradability to previously illiquid assets by verifying governance claims. This means that blockchain can support the issuance of green bonds or new instrument classes where ESG provenance is an essential characteristic.
  2. Bringing previously syndicated assets – such as infrastructure – to a broader market. This makes legacy asset types more accessible via enhanced liquidity discovery and tokenization. Since the provenance of digital assets is easily traceable, this increases trust among all market participants.

These activities are expanding the variety of assets in the market to include those whose value depends on ESG criteria. But by putting these assets on ledger, their issuance, asset servicing and market discoverability allows them to expand.

Conclusion

Blockchain’s ESG credentials have faced scrutiny due to the high energy consumption of the proof-of-work (PoW) consensus mechanism. However, not all blockchains are the same. Private blockchains – whose peer-to-peer architecture does not use PoW – are emerging as a key driving force behind greater sustainability efforts, with DeFi instruments being increasingly used to shift the ground on which ESG claims are rooted.

There is still work to be done. The technology sector must work in tandem with businesses and governments to realise these benefits on a larger scale before today’s ESG challenges outstrip the impact of the solutions we are implementing.

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