Can Crypto Fit into an ESG Portfolio?

Can Crypto Fit into an ESG Portfolio

The two don’t have to be mutually exclusive.

Environmental, social and corporate governance (ESG) criteria are increasingly being used to screen investments. Nowadays, with greater environmental and social awareness, more and more fund managers and investors are prioritizing non-financial metrics, such as environmental impacts, inclusivity and diversity, to determine where to place their money. In fact, a survey of 600 people in the fund management industry found that a staggering 96% expected firms to increase their prioritization of ESG during the upcoming year.

Coinciding with the rise of ESG is the increased recognition of Bitcoin and other cryptocurrencies as viable investment assets. It begs the question: do cryptocurrencies fit into an ESG-friendly investing portfolio? As Bitcoin often gets a bad reputation for its negative environmental impact, you may think that cryptocurrency and ESG investing are mutually exclusive. But this is not necessarily the case. 

Crypto’s Place in an ESG Portfolio

Most critics of cryptocurrency as an ESG-friendly investment point to the high processing power and energy required to mine or complete transactions with cryptocurrencies. For those who aren’t familiar, Bitcoin and other cryptocurrencies are decentralized, meaning they are not overseen by traditional governments. Thus, in order to prevent theft and fraud, every computer in the Bitcoin network has a complete list of Bitcoin transactions (called a blockchain). Each time someone sends or uses a Bitcoin, most of the computers on the network must also verify the transaction in order to prevent others from spending coins they don’t own. Since mathematical problems required to verify Bitcoin transactions can only be solved through trial and error, and answers are one in trillions, powerful computers must run constantly to have the best chance of finding the key and be rewarded with Bitcoin. This requires copious amounts of energy.

Most cryptocurrencies use the method mentioned above, which is called Proof of Work (PoW), to mine and verify transactions, which critics argue creates excessive carbon emissions that endanger the planet. However, there is also a different method of mining and verifying transactions that alternative cryptocurrencies, like Cardano and Polkadot, have employed Proof of Stake (PoS) consensus mechanism. PoS allows owners of particular cryptos to use their own coins to verify transactions, which results in PoS using a fraction of the energy required for PoW. 

Aware of the Bitcoin energy criticism, many organizations in the crypto industry have encouraged migration towards PoS from PoW. For example, the EU commission has been officially encouraging crypto to migrate from PoW applications to PoS. Also, Ethereum, the second largest cryptocurrency, plans to shift to PoS by the end of 2022, which would increase crypto’s suitability in an ESG portfolio.

Environmental Factors

With regard to environmental friendliness, it is also important to compare crypto to other forms of money and to be wary of holding it to a higher standard than fiat money. For one, fiat money production requires energy, water, wood pulp, cotton, metals, linen and other resources, and its lifespan is not as long as cryptocurrencies or other digital currencies. Moreover, unlike Bitcoin miners, banks cannot relocate to where sustainable energy is cheap or available. However, regardless of these comparisons, it is impossible to outrun the fact that digital currencies and monetary transactions, through methods like bank-to-bank, credit cards or newer FinTech, are still the most efficient and environmentally friendly by miles.

Ever since the initial onslaught of negative publicity, the crypto community has been very aware of its carbon footprint, and steps have been taken to address the issue. In 2021, the Bitcoin Mining Council (BMC) was created to improve Bitcoin sustainability. Ever since China banned Bitcoin mining in May 2021, 57% of Bitcoin has been mined using renewable energy sources. Another analysis by Coinshares in 2019 suggested that 74.1% of the electricity used by Bitcoin came from renewable sources, which would enlarge the desirability of cryptocurrency in an ESG portfolio. 

Social Factors

Socially, ESG tends to focus on diversity, human rights, consumer protection and financial inclusion. Regarding cryptocurrencies, there are also two sides to the debate on societal benefits. On one hand, some investors believe that crypto promotes financial inclusion by enabling anyone with internet access to own crypto. Proponents of crypto as a component of the ESG portfolio also argue that the anonymous nature of most cryptocurrencies protects variable actors in oppressive regimes from censorship. 

However, these arguments are not without nuances. First, although anyone with internet access can own crypto, the necessity of owning a smartphone and having an internet connection does nothing to help the world’s poorest inhabitants and does not elevate them to a new level of financial wellbeing. Even for those who can afford to access crypto, crypto’s very nature of severe price volatility and high conversion costs means that it is simply not a suitable investment for the majority of investors, and it merely benefits the rich. Second, in countries with a rule of law, the anonymity of crypto transactions facilitates criminal activity, including tax evasion and the evasion of exchange controls. 

Governance Factors

Finally, there’s the governance aspect. It’s extremely difficult to apply the concepts of corporate governance to cryptocurrencies since the entire industry is full of coins without visible leadership. Although leaders and makers of crypto are rarely visible, many cryptos are surreptitiously centralized, having a single organization that acts as their creator and maintainer and primarily benefits from their sales. Bitcoin itself has a high power concentration over the mining process, sales process and code maintenance. The difference between the illusion (that it is decentralized) that Bitcoin promoters sell and the reality of crypto control is one of the most worrying aspects of crypto from a governance perspective. 

So what’s the verdict?

All in all, while crypto has seen many improvements recently in terms of its impact on the environment, it still may not be 100% suitable for an ESG portfolio due to some of its governance and social issues. However, it is invigorating to witness the industry’s changes in response to the awareness of ESG issues and to anticipate the improvements in the crypto industry as a whole.

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