Daniel Liebau, Founding Director of Lightbulb Capital, outlines the importance of investors measuring the ESG risks and opportunities of digital assets.
Digital assets and ESG principles are two of the defining asset allocation trends of our times, but the two are often seen as incompatible: Elon Musk famously changed his mind about accepting Bitcoin as payment for Tesla cars because of the cryptocurrency’s high energy use.
Sustainable investment and digital assets don’t have to be in conflict. Investors need to start working out how they are going to invest in the future of commerce and the future of the planet at the same time. That’s why I am developing propositions on the interaction between ESG and smart contract blockchain ecosystems, which will be documented soon in a working paper.
Most importantly, in the world of blockchains, we need to think of ESG assessment in terms of technology, mechanism design and community, rather than trying to assess a corporation’s management team and their sustainability-related decisions. And we need to focus on today’s impact rather than what may be possible in the distant future.
Not created equal
Digital assets and the ecosystems they power are going mainstream fast – think decentralised finance (DeFi) or non-fungible-tokens (NFTs). The market capitalisation of all tokens is already above US$2 trillion. A survey released in July by Fidelity Digital Assets found that 71% of institutional investors said they will invest in digital assets, while more than half already do.
The adoption of digital assets will be limited, though, until investors’ concerns about their sustainability are addressed.
These concerns are justified. A number of blockchain platforms currently consume much more electricity than the value they add to humankind can justify. According to the Cambridge Centre for Alternative Finance, Bitcoin’s annual electricity consumption alone is estimated at 144.28 TWh – roughly equal to a country the size of the Philippines.
While the egalitarian potential of a more decentralised and digital economy is clear, inequality plagues digital assets. Some 1,000 ‘whales’ are reported to control about 40% of all Bitcoins, for example.
There are problems with governance, too. Fraud is increasing, issuer disclosures are inconsistent and processes can be improved, as the recent voting debacle at decentralised finance platform Uniswap proved.
Not all digital assets are created equal. With the right analysis, investors can – and should – measure the ESG characteristics of their crypto holdings.
Any ESG analysis of digital assets must focus on technology and community, not company management. Ideally, this asset class is governed by a source code that follows protocol, not by the subjective, human decisions made by a few powerful board directors or chief executives.
Making it happen
So how could we assess the more material ESG characteristics of smart contract platforms?
In environmental terms, the carbon footprint of platforms differ dramatically depending on the underlying technology.
Blockchains where the addition of new data to the ledger is ‘validated’ by token holders through a ‘proof-of-stake’ protocol are becoming more popular while remaining secure. These consume a tiny fraction of the energy used by a proof-of-work consensus, which relies on a network of computers solving complex cryptographic puzzles.
To show the difference: Ethereum is estimated to consume an average of 70 kWh of energy to process a single transaction using its proof-of-work protocol. At the other end of the scale, proof-of-stake-based Algorand is estimated to consume only 0.000008 kWh – making it more than eight million times more energy efficient. In an ESG-aligned portfolio, it is clear that less energy-hungry smart contract blockchain platforms should be preferred to more carbon-intensive ones.
In the social dimension, there is wealth inequality to consider. This is a major problem for most societies, restricting opportunity and impacting quality of life – and its impact is being felt in the digital realm, too.
Tokens with more evenly-distributed ownership may be a better choice for an ESG-conscious investor. These should also perform better because wider ‘wealth distribution’ tends to lead to greater development activity, creating value for the ecosystem as a whole.
Intuitively, governance risks should be less of a worry with a blockchain ecosystem as the integrity of the distributed ledger is key to its value proposition. However, just as traditional investors worry about bad actors, a possible governance analysis for digital assets must consider the risk of collusion among the ‘nodes’ that serve as auditors of transactions on the ledger.
I have developed four propositions for assessing the risk of systematic collusion in this process. The number of validating ‘nodes’ (more is better); the time it takes the blockchain to update with finality (less is better); the ability of nodes to influence the order of transactions in a new ‘block’ (the less they can do this, the better); and the nodes’ ability to inject own transactions into a new block they are validating (again, the less this is possible, the better).
My three ideas for E, S and G analysis are a starting point for a serious discussion about how investors can assess the sustainability of digital assets that power smart contract platforms. Integrating the two megatrends of blockchain and ESG will not happen overnight. But it will be a critical process if digital assets are going to make up a meaningful proportion of the US$53 trillion of assets Bloomberg expects to be managed in accordance with ESG principles by 2025.