Thursday, 22 September, 2022
ESG Environment, Social and Governance
These three components form ESG – Environmental, Social (inclusion), and Governance. ESG investing has gained traction in the last few years, and the question of whether cryptocurrency is compatible with it has been raised many times. In this edition of The Bridge, we address this topic. We conclude that many cryptocurrencies are aligned with the ESG standards and can be included in a well-diversified portfolio.
Proof-of-Work and Bitcoin’s energy problem
The first issue with cryptocurrencies is often related to energy consumption. As Bitcoin is the most famous cryptocurrency of all, it is often believed that what is true with bitcoin is valid for all cryptocurrencies. This is a huge misconception.
According to BloombergBloomberglink1, Bitcoin’s energy consumption is estimated to have increased from 6.6 terawatt-hours in 2017 to 138 terawatt-hours in early 2022. Its annual power consumption is greater than that of the whole country of Norway. Bitcoin’s carbon footprint is around 114 million tons of carbon dioxide of annualized emissions. (Comparable to that of Belgium.)
Figure 1: Total Bitcoin Electricity Consumption
Source : SEBA, University of Cambridge
Bitcoin intensive energy use comes directly from the consensus mechanism and the way blocks are produced. Bitcoin uses a Proof-of-WorkProof-of-Worklink1 (PoW) mechanism. This mechanism is designed in a way that miners compete to mine the next block and get the rewards paid in bitcoin. As the fastest miners get the rewards, mining has become an industry where thousands of mining racks run parallel to solve the cryptographic puzzle that unlocks the reward.
Notice that the energy spent is used to secure the bitcoin network and create a decentralized, open network that everyone can use worldwide. The energy is thus not wasted.
The source of energy used to mine bitcoin has changed over time. According to the consulting firm Roland Berger, 57%57%link1 of mining comes from renewable energy. In another report from another consultant, PWCPWClink1 states that “the bitcoin network can serve as a flexible energy buyer of last resort to balance fluctuations in renewable energy power generation and demand”, participating in the energy revolution.
The crypto community is aware of the energy issue. It has come out with its solution, called the Crypto Climate Accord.
Crypto Climate Accord
The Crypto Climate AccordCrypto Climate Accordlink1 (CCA) is a private sector-led initiative for the entire crypto community focused on decarbonizing the cryptocurrency industry. A consortium of private players announced it in April 2021. It wants to transition all blockchains to renewable energy by 2030 and reach net-zero greenhouse gas emissions by 2040. The initiative is led by three non-profit companies — the Rocky Mountain InstituteRocky Mountain Institutelink1, the Energy Web FoundationEnergy Web Foundationlink1, and the Alliance for Innovative RegulationAlliance for Innovative Regulationlink1. The first two are non-profits focused on sustainability and transition to low-carbon footprints. At the same time, the Alliance for Innovative Regulation is an international advocacy group that speaks for implementing fair financial systems.
The accord currently has two objectives:
There is an alternative to PoW, which is the Proof-of-StakeProof-of-Stakelink1 (PoS) consensus mechanism. Networks functioning on this mechanism are increasingly being used. At the time of writing, only two of the top 20 coins run on a PoW consensus, namely Bitcoin and Dogecoin. All others use consensus mechanisms related to PoS.
To appreciate the energy efficiency potential of PoS compared to the PoW mechanism, note that the Ethereum network’s transition from PoW to PoS, called The Merge, reduced energy consumption by a staggering 99.95%99.95%link1.
The reason behind PoS efficiency comes from the incentives to secure the network. Contrary to PoW, where miners compete to mine the next block, PoS validators are randomly chosen to validate the next block. As a result, PoS validators don’t need fast computers to get higher rewards; they need to lock more coins in the network to increase their chance of being selected in the next validating round.
In addition to energy efficiency, PoS allows anyone to contribute to network security via delegation and earn rewards. It is worth noting, however, that the PoW chains are considered more secure against a 51% attack than the PoS chains.
Blockchain protocols are software, and those who can change the software code have the power to make and break the network. Governance plays a vital role as a small group of developers often have the right to change the code. As they say, with great power comes great responsibility.
Protocol changes are not decided by a single party or a fixed group of “shareholders”, as with traditional companies. There is greater fluidity regarding protocol management, as everyone has the right to make proposals. This approach’s benefit is broadening the decision base to include more stakeholders. There is greater fluidity regarding protocol management, as everyone has the right to make proposals. This approach’s benefit is broadening the decision base to include more stakeholders. However, the difficulty is ensuring that decisions taken ensure the longevity and prosperity of the protocol.
As far as protocol management is concerned, governance is either off-chain or on-chain. The old blockchains, such as Bitcoin and Ethereum, have off-chain governance. It means it is unnecessary to hold the protocol coin to have the right to change it. You can imagine it as a company where non-shareholders have the right to participate in the general assembly and to make proposals.
In the case of Ethereum, the various entities involved in Ethereum governance are:
To propose a protocol change called EIP for Ethereum Improvement Proposals, there are clear rules. More importantly, all the EIPs are listed publiclyEIPs are listed publiclylink1 and reviewed by all the participants wanting to have their say.
The way it works is as follows. A member usually proposes an EIP on the governance forum. It includes an in-depth description of the technological changes being proposed and the reasoning behind the proposal. The community then provides feedback, which is shared with the core developers, usually over the “AllCoreDevs call”. It is then decided whether to go ahead with it, shelf it for the time being, or reject it. Suppose it passes this stage and is considered. In that case, the EIP is iterated towards a final proposal incorporating the feedback gathered from the relevant members. It is then tested on test nets before it is scheduled for deployment on the Ethereum Mainnet.
In the Bitcoin Network’s case, proposals are referred to as Bitcoin Improvement Proposals (BIPs). BIPs are informal proposals and ideas usually generated in community chats or through social media engagement. Before becoming a “BIP”, the recommendation is shared via email or other communication channels where the community provides initial feedback. Once the proposal receives significant support, the author can progress it to the next stage and turn it into a BIP. Once a BIP is submitted as a draft to the BIP GitHub, the proposal is reviewed and worked on transparently by the developer community so everyone can view its progress and consequent testing outcomes. As the Bitcoin blockchain is based on code, protocol changes will immediately reflect. Because of the severe implications, some changes might inflict a cost to miners. Hence, a change in the code requires the acceptance of around 95% of miners unless the author gives a reasonable motive for a lower threshold.
The process is similar for Dapps (decentralized applications) built on top of these base layers, except that the network’s core developers are not involved in that process. Almost all Dapps have a governance token for this process (usually either airdropped to the app’s early users or can also be bought off exchanges at market price). There is an on-chain voting process generally using a tool like snapshot.orgsnapshot.orglink1. The weighted average of the votes (weighted corresponding to each voter’s respective holding of the governance token) decides what happens to the proposed implementation for the Dapp.
A form of on-chain governance is through DAOs (Decentralized Autonomous Organizations). Voting in DAOs is like on-chain voting for protocols. Here, the token holders need to “stake” their tokens to be able to participate in governance. The greater the number of tokens the voter holds, the higher the weightage given to the vote. These tokens will remain staked until voting closes. For more on DAOs, read our previous article hereherelink1.
While transparency is welcome, not all governance is perfect. Protocol governance is often obscure and not always as transparent as presented above. One primary concern is that because of the anonymous identities of many market participants, we cannot know whether governance is truly decentralized, or most of the votes are from just a few whales owning protocol tokens being held across multiple wallets. In this context, the initial distribution of coins is a vital variable in analyzing the governance as knowing who owns what help to understand the short and long-term incentives of the token holders.
The more transparent the process and the more participants participate in decision-making, the slower the governance is. In case of emergencies (for instance, a bug), an elaborate proposal and voting procedure must be done appropriately.
Cryptocurrency exchange Gemini's 2021 reportGemini's 2021 reportlink1 said that women represent only 26% of investors in the crypto space, showing low gender diversity. This result is not surprising as blockchain and cryptocurrencies are an amalgam of finance and technology, two male-dominated sectors. A 2021 McKinsey studyMcKinsey studylink1 showed that 64% of financial services executives are white men, and 23% are white women. The gap is significant in tech sector as well, with data showing that women hold only 24% of computing jobs.
Multiple women-led groups tackle this problem in the web 3 space. Below are a few.
In this publication, we have covered some aspects of ESG investing. We have focused on climate change and carbon emissions, financial and social inclusions, illicit activities, and governance. The ESG standards have broader coverage than the one we discussed here. A list of the ESG factors can be found on the CFA websiteCFA websitelink1.
We have focused on a few factors as they are the ones that repeatedly come up in our discussions with clients, and we realized that there were some misconceptions in the market.
Whether cryptocurrencies are aligned with ESG standards cannot be answered definitively in this publication. In our view, many of them are, and the general trend is towards more ESG-friendly protocols.
With the notable exception of Bitcoin, energy-intensive PoW protocols are slowly losing traction. Energy-efficient PoS protocols are replacing them. Regarding Bitcoin, the energy mix has improved, as 57% of it is renewable.
Cryptocurrencies alone cannot solve poverty. However, data suggests that cryptocurrencies are broadly used in developing countries where the financial infrastructure is not as developed as in the Western world, leading to some financial inclusion.
The share of illicit activities is declining as the cryptoverse is preparing for coming regulation. Diversity is still low, but groups are working on it. Finally, innovation in governance is taking place and offers a level of transparency rarely seen in the traditional world.
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