Do cryptocurrencies have a place in ESG-focused portfolios?

More and more investors are considering the environmental, social and governance (“ESG”) impacts of their portfolios, as they face increasing pressure to integrate sustainability into their investment strategies. The severe environmental impacts relating to cryptocurrency mining means investors therefore need to tread carefully if they do wish to invest responsibly.

The environmental impact of cryptocurrencies

The major criticism that has triggered the global dialogue around how sustainable cryptocurrencies are, is the demand for energy to mine and transact the digital coins. In the case of Bitcoin, transaction verifications and mining are performed by high-power computers that solve complex computational problems, based on a protocol referred to as proof-of-work (PoW).

This process is essential for Bitcoin’s operation, as the time and computational power required for each transaction ensures their validity and veracity, and protects the network from frauds. The amount of energy required however, generates a huge carbon footprint that has recently received significant attention from academics, the media and the wider public. Emerging studies estimate the carbon impact of most cryptocurrencies, such as Bitcoin, Ethereum, Litecoin and Monero to be tens of millions of tons of CO₂e.

The carbon intensity of digital coin transactions differs from country to country and depends on the energy generation mix within each country. Unfortunately, many mining centres are based in regions of the world that have a high reliance on coal or other carbon-intensive sources. The very volatile nature of cryptocurrencies forces miners to resort to these kinds of polluting but cheap energy sources, as they try to keep their operational costs to a minimum.

The drive to maximise profits leads to an additional environmental concern, that of hardware waste. A huge number of powerful computer servers with fast processors are run continuously at high speeds to mine cryptocurrencies 24/7, and once their purpose is served and they have reached their end-of-life, they are disposed of.

The issue with these processors is that they quickly become outdated and less cost-efficient for miners, leading to the generation of thousands of tons of e-waste and are consequently responsible for vast upstream and downstream (end-of-life disposal) emissions.

Overall, cryptocurrency emissions, and specifically Bitcoin, could push global warming above 2°c and it is difficult to see how, with the currently available technologies and regulatory framework, they could be part of a low carbon economy transition.

Social and Governance Concerns

Environmental issues might be the centre of criticism, but they are not the only issues when it comes to cryptocurrencies. Some social concerns arise from the fact that they require an internet connection, capital and computer literate people with specialist knowledge in order to use them safely. Lack of access to these prerequisites might exclude people of certain age groups or parts of the world from using them. Moreover, while the use of decentralised ledger systems promotes anonymity and security of transactions, they also serve as a perfect medium to facilitate criminal transactions, money laundering, hackers and ransomware attackers.

Is there a way to tackle these ESG threats?

On the other side of the coin, cryptocurrencies are based on a revolutionary idea that can offer social advantages. Their very decentralized nature means that there is no need for intermediaries, while financial markets can become more accessible and democratised with blockchain technology. However, this surely cannot come at such a huge environmental cost.

Some recent developments in certain cryptocurrencies propose to move away from PoW and towards a different protocol, called Proof-of-stake (PoS). In theory, this new model promises to be a lot more energy efficient and sustainable than its predecessor by spreading the responsibility for transaction verification across the entire network.

Ethereum has announced that it’s looking to implement this new protocol in the next few months and should it be applied in practice, new solutions may arise to mitigate the carbon footprint of cryptocurrency mining. A ban on PoW coins, commitments to use energy exclusively from renewable energy sources, regulating mining emissions or using voluntary carbon offsets are some of the improvements that we could potentially see in the near future.

To conclude. As the rate of adoption of cryptocurrencies increases, so do the concerns about their environmental and social impacts, which makes it  hard to look at them from a positive ESG standpoint. While the blockchain technology and ideas behind them could offer certain ESG advantages, digital currencies need to go a long way to overcome their current sustainability issues.

Investors and institutions looking to meet high ESG standards, and assume full responsibility for their activities, need to be very meticulous and thorough when reporting datapoints that will be used to calculate their portfolio’s carbon intensity. This level of attention to detail is particularly important when measuring the environmental impacts of portfolios with exposure to cryptocurrencies.

Bear in mind that assuming environmental responsibility and driving positive change is not just a matter of adjusting portfolio allocations to meet ESG KPIs. Redirecting investment towards more sustainable blockchain technologies, such as the adoption of PoS, can also have a significant positive environmental impact.

To find out more about how Apex Group’s ESG Ratings & Advisory services can help you plan and track your ESG strategies, contact our team.