Environmental, Social & Governance: The state of ESG in the digital asset space

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The scandals and collapses of 2022 in the digital asset space came in a year of energy crisis and further damning evidence of climate change around the globe, further emphasizing the importance of ethical and responsible investing. With this in mind, where does the industry currently stand in terms of its moral and ethical claims, and how does it relate to ever more important ESG standards?

Environmental, Social, and Governance, commonly known as ESG, is the acronym de jour and the standard that any asset, digital or otherwise, must increasingly aspire to make itself an attractive investment—the peacock feathers of the investment world, if you will.

The digital asset space is not immune to the trend toward ethical portfolios, and increasingly, investors are viewing assets through the ESG lens. This includes a digital asset’s environmental impact and carbon footprint; its potential and actual social harm or benefit; its internal governance, management structure, employee relations, and everything related to running and maintaining the asset.

The importance of ESG to investment is tangible, as shown by a review of over 200 sources on ESG performance by Oxford University and Arabesque that found that for the 88% of companies that focused on sustainability, operational performance improved, and higher cash flows followed.

According to Bank of England Governor Mark Carney, we’ll soon be in a situation where investors will tailor their investments and fulfill their duties to clients and trustees through “better quality and more widely available data on sustainability and performance, and more informed judgments of strategic resilience.”

This suggests that companies’ and entities’ performance in ESG standards may eventually be almost as important as their financial performance, especially since the latter is often more reliable if the former comes with it.

But are these standards and criteria that make up ESG just preferable characteristics for the ethical and forward-thinking investor, or are they actually written into law and regulation as well, enforceable by authorities?

Rules or suggestions?

“Currently, the status quo is that most of these so-called obligations are soft law standard, which means that such obligations are not compulsory,” explains Dr. Lerong Lu, senior lecturer in Law at King’s College London, speaking with CoinGeek.

“They are not made by our lawmaker or legislature, or parliament, but are mostly advocated by some business associations which do not have enforcement power,” says Dr. Lu, who suggests that currently, by and large, ESG compliance relies on the voluntary will of companies to adhere to a “higher standard.”

While some of the individual aspects of ESG, such as environmental impact or connection to illegal activity, are covered by a range of existing laws and regulations across the globe, as Lu points out, ESG as a whole is not written into law or regulated. It is simply a way for investors to judge a sustainable, socially conscious, and well-organized asset and a method for assets to advertise themselves as such.

Currently, existing ESG regulations vary across countries, with most common law jurisdictions’ legal traditions being pro-business, which means they allow companies and businesses to pursue goals free of excessive oversight. Lu suggests this is, to a large extent, the best approach.

“They should be allowed to maximize their profit, and that’s what a business is supposed to do. It would be quite difficult to make obligations under ESG or even CSR (corporate social responsibility) standard into the law that we force businesses to consider the interests of a wider community.”

However, this pro-business’ ‘softly-softly’ approach, reliant on the voluntary will of companies and influenced by investor sentiment, could be about to change with the introduction of several new bills, notably the snappily named EU Corporate Sustainability Due Diligence and Reporting Directives (CSDDD) and the U.S. SEC Climate Change Disclosure Rules, both of which extend their reach into the digital asset space.

However, before looking at incoming regulation, it’s worth considering the current state of play in the digital asset industry and how the key players are, or are not, interacting with ESG trends.

Exchanges

When examining ESG credentials, the digital asset industry can be broadly broken down into exchanges, such as Binance and the mid-bankruptcy FTX, and assets, such as BTC, Ethereum, or Bitcoin (BSV).

The situation is somewhat complicated by Decentralized Autonomous Organizations (DAOs), which function more like businesses (or business ventures) and aim to follow some of the decentralized and egalitarian governance ideals behind blockchain assets, but when considering ESG in the space exchanges and digital assets are the key players.

“When it comes to exchanges, I think it is more reasonable to ask or expect them to commit to the ESG standards because they can brand themselves as an ESG compliant platforms and make it a selling point to investors to attract more customers,” explains Lu.

Digital asset exchanges have more ‘traditional’ business structures and, as such, can be assessed by much of the same criteria as any incorporated entity, they are also—despite claims to be non-domiciled—centralized entities.

They should, therefore, be under much the same regulatory scrutiny as other businesses, such as those involved in the finance sector.

However, as Lu points out, this is largely not the case: “Crypto trading platforms are doing business similar to traditional financial services, but in a way that they are not being regulated as traditional service provider.”

You need to look no further than the catastrophic mismanagement and misappropriation of customer funds that led to the FTX collapse for evidence of this lack of stringent oversight.

Venturing beyond exchanges to the digital assets they deal in, the question of fitting them into ESG categories becomes an even more complicated one.

Ethical Assets?

Their non-traditional organizational structure—based on decentralized finance (DeFi), and a less clearly defined set of regulatory frameworks governing the industry—means that digital assets require a different approach when assessing their ESG credentials, one primarily focused on mining and transactional processes, social implications, accessibility, and network management.

Key ESG issues in the digital asset industry revolve around the prevalence of theft through hacks, the relative merits or drawbacks of decentralized governance, and the social ‘mission’ of digital assets.

If an asset is easily or frequently hacked or stolen, this reduces its security and value to the consumer, or investor, damaging its social responsibility; a decentralized governance structure, if implemented correctly, could promote equality in leadership, accountability, and fair work-reward distribution; and assets claiming a grand social ‘mission,’ such as improved global access to the economy, could potentially be seen as ethical investments for the socially conscious.

All these factors come into the discussion. However, the most hotly debated aspect is the energy use and carbon footprint involved in the mining and proof-of-work process.

The digital asset space has been much maligned for the notoriously high levels of energy required in the mining process, with a September 2022 study by Earthjustice suggesting the electricity consumption of cryptocurrency mining in the United States “was responsible for an excess 27.4 million tons of carbon dioxide (CO2) between mid-2021 and 2022—or three times as much as emitted by the largest coal plant in the U.S. in 2021.”

This energy use is largely attributed to the computing power required for the ‘proof-of-work’ process, and thus something unique to the digital asset industry.

“In the public mind, at least in Europe, crypto is mostly viewed from an electricity usage and CO2 emission perspective,” says Isabel Gehrer, President of Green Crypto Research, a nonprofit specializing in evaluating the sustainability of digital assets and developed an ESG rating to assess them.

Gehrer admits that there is much work to be done to improve the energy efficiency and green credentials of digital assets, but suggests that some of the commonly touted statistics might be of the straw man variety: “If you take Bitcoin (BTC), there’s a lot of talk around CO2 and you can compare its energy usage to a country like Portugal, that’s one way you can look it, but you can also compare with industries and see that Bitcoin mining takes about the same amount of energy as gold mining.”

This might well be true, but you don’t need to go to other industries or sectors to find a preferable comparison to the example of BTC’s energy usage. The BSV ‘big block’ approach, in contrast to BTC’s ‘small blocks,’ is capable of many magnitudes more financial transactions due to more being included in every block, meaning the energy cost of mining per transaction declines concerning the increased throughput.

This was backed up by a November 2021 study from MNP, the fifth-largest professional accountancy and business consulting firm in Canada, that investigated the energy efficiency of Bitcoin-based blockchain technology, finding BSV blockchain is more energy-efficient than the other two blockchain protocols included in the comparison – BTC and BCH.

Moving to the other letters in the ESG equation, Gehrer suggests there can be an overall advantage for a lot of big digital asset projects, giving an example that “coins such as Bitcoin have a strong social mission to empower emerging markets.”

The good social aspect of digital assets is yet another contested point and taking Gehrer’s example, BTC’s partnership with El Salvador’s crypto-dictator Nayib Bukele is one damning mark against its ‘social’ credentials.

When the country became the first state to accept BTC as legal tender, back in June last year, the International Monetary Fund (IMF) warned against hailing this as the beginning of a new era, stating at the time: “This is not something the World Bank can support given the environmental and transparency shortcomings.” The organization then duly pulled out of a much-needed loan that would have helped El Salvador deal with its substantial national debt – the social good appears hard to find here.

Dr. Lu agrees that there are significant blind spots for digital assets when it comes to the social dimension of ESG, highlighting how digital assets are used for illegal purposes, such as money laundering and tax evasion: “If we have such a regulatory loophole, allowing people whether they’re investors, speculators or just criminals, to use such platforms to transfer their money to launder their criminal profits, they would not be able to do this in a traditional banking and payment sector which are heavily regulated by authorities in most countries.”

Arguably the global ‘traditional banking’ sector has been, and is, used for money laundering and tax evasion as well, but it’s true that it’s under a more extensive regulatory regime which makes these illicit activities more difficult and riskier.

The regulatory loopholes that currently exist in the digital asset space are a source of debate for authorities across the globe, particularly in the wake of FTX, but they might not be open for too much longer. Increasingly, lawmakers’ goal appears to be bringing the industry more in line with the well-regulated financial sector and closing some of these avenues for criminal and fraudulent activity.

Incoming changes

In relation to ESG criteria, as Gehrer suggests, “we don’t have a clear regulatory framework as we do with other assets or companies that are incorporated in a country with a clear legal framework.”

She goes on to explain how the focus at the moment revolves around investor protection, with network security, monitoring of security, and the distribution of miners or validators also being key talking points.

An emphasis on consumer protection and governance is clearly important, but as has been proved by numerous cases of fraud and mismanagement, there’s still plenty of room for development. It’s also no excuse to let standards drop in the environmental and social spheres.

Fortunately, developments are ongoing across jurisdictions for those favoring a more active approach to encouraging ESG standards. In October, the Markets in Cryptoassets Regulation (MiCA) was approved in the EU, and as part of these new measures, the European Securities and Markets Authority (ESMA) has been tasked with developing draft regulatory technical standards on the content, methodologies, and presentation of information related to ESG.

In addition, earlier in the year, the European Commission adopted its proposal for the Corporate Sustainability Due Diligence Directive (CSDDD) as part of its European Green Deal and its commitment to a broader human rights strategy.

The CSDDD, once adopted, will oblige certain large businesses to:

• Carry out due diligence to identify and address human rights and adverse environmental impacts.
• Produce climate plans.
• Introduce specific duties for directors regarding sustainability and their company’s environmental and human rights impacts.
• Impose sanctions on companies for failure to comply and civil liability for violations of the due diligence obligations.

The directive will apply to companies with over 500 employees and more than €150 million ($163.1 million) global turnover, and—crucially for the digital asset space—companies in third countries with more than €150 million turnover in the EU.

This latter category is important as it leaves room for certain non-domiciled digital assets with large turnovers in the EU to be subject to the directive, and the CSDDD’s definition of ‘company’ includes corporates, banks, asset managers, funds, and partnerships—a definition loose enough to see digital asset exchanges, as well as potentially some digital assets, fall with its purview.

Across the Atlantic, the U.S. Securities and Exchange Commission (SEC) has proposed climate disclosure rules with a similar mandate to the CSDDD, but with an increased focus on the environmental side and less on human rights disclosure obligations. Public companies, including foreign private issuers, will be subject to SEC oversight, including listed digital asset players such as Coinbase and Riot.

The SEC proposal is long-awaited but comes amidst deep disagreement on the role of the SEC in this area.

While the EU’s CSDDD will come into force in 2024, the SEC proposal is likely to be delayed due to legal challenges to the EPA’s authority to demand climate disclosures without clear congressional authorization.

Within or without

Despite lawmakers’ recent push to regulate ESG standards, there’s no universal agreement that more laws and tighter controls are the solutions to enforcing what is essentially a set of criteria derived from ethical investment strategies in the digital asset space or any other industry.

“ESG is a good thing, but it will be too onerous to make law with all these compulsory obligations for companies to follow because a lot of these concepts are very abstract and quite hard to put into concrete wording,” says Dr. Lu, who maintains that investor influence is the favorable route.

Lu suggests the push from the institutional investor might be a more effective way to promote ESG in the sector because they are under commercial pressure to include compliant assets in their portfolios, so if digital asset companies want to attract investor money, “they have to actively embrace ESG” off their own backs.

It might be, then, that outside of some overlap with current trends in digital asset industry regulation, the impetus to change and implement practices that comply with improved environmental, social, and governance standards comes from the industry itself and that the fastest way to ESG compliance is from within.

With this in mind, if and when some ESG standards do eventually make their way into law, it will be a significant test of the ESG claims and credentials of digital asset industry entities that, thanks to recent events, will no doubt be under increased scrutiny going forward.

Watch: ESG Compliance & Blockchain