How can we make cryptocurrencies more ESG-friendly?

Cryptocurrencies get a bad rap from environmentalists – and with good reason. Bitcoin consumes more electricity in a year than Sweden, Norway, or the United Arab Emirates. So does that mean the environmental case against cryptocurrencies is closed, or are there ways to reduce crypto’s carbon footprint? And what about other environmental, social and governance (ESG) priorities that investors might have?

To understand crypto’s environmental impact, first you have to understand the relationship between virtual currency and the physical infrastructure and operating inputs it requires. As a digital representation of value, cryptocurrencies use distributed systems to store and transfer ownership securely through a cryptographic process based on complex computations.

There are many different methodologies to control how the network agrees to update to a blockchain ledger. Bitcoin, for example, adopted the so-called proof of work methodology (PoW). Anonymous miners, who could be in any geography, compete to add a set of proposed transactions as a new block to the network by solving a mathematical challenge whose complexity is adjusted with respect to the computational power available.

The PoW model consumes increasingly large amounts of energy, especially if the cost of energy is lower than the profits made from mining. Bitcoin’s energy consumption is estimated based on a further estimation of the computer power being used by the network (see figure below).

Other cryptocurrencies have adopted a different approach: proof of stake (PoS). PoS means that the network choses a participant to make the next update based on the amount of the respective cryptocurrency that participant holds, and how long they have held it, as well as an element of randomness.

While arguably less secure, PoS methodology is significantly more energy efficient and also offers higher transaction throughput and thereby operational efficiency.

A campaign to switch bitcoin mining from PoW to PoS called Change the Code Not the Climate estimates the move could reduce bitcoin’s carbon footprint by 99%. In the case of Ethereum, another popular cryptocurrency, efforts have been underway for six years to move from PoW to PoS.

There is also a push to make mining more sustainable by using more renewable energy. However, current estimates of the share of renewable energy used to power bitcoin mining vary widely, making it hard to pin down. For example, CoinShares found that as of December 2021, renewables contributed less than 30% of bitcoin mining, while the Bitcoin Mining Council puts that figure closer to 60%.

Recent research has found that the share of renewable energy powering bitcoin decreased from 41.6% to 25.1% after China’s crackdown on crypto operations. Miners in China had access to renewable energy sources, but this was lost when mining was forced to move to countries such as the US and Kazakhstan.

When it comes to social impact, the case for crypto is more positive. Cryptocurrencies can promote financial inclusion by driving innovation in financial services, like peer-to-peer micropayments, potentially providing accessibility to anyone with an internet connection and reducing costs by automating financial services at scale.

The World Bank estimates that 1.7 billion people in the world today, or about a third of all adults, are unbanked. In some developing economies, that figure is as high as 61%.

The benefits of promoting financial inclusion are well known. The McKinsey Global Institute calculated that widespread use of digital finance could boost annual GDP of all emerging economies by $3.7 trillion by 2025, a 6% increase versus a business-as-usual scenario, and create an addition 95 million jobs across all sectors.

Cryptocurrencies could also facilitate low-cost cross-border transfers for small amounts, as they do not require currency conversions. Companies like Bitpay are already multiplying in this space. A report by Oliver Wyman and J.P Morgan found that digital currencies could save global corporations $120 billion a year in transaction costs when it comes to cross-border payments.

The developing use of digital currencies including crypto seems set to offer a naturally competitive way of reducing some of the negative aspects of the financial system for the poorest in society.

By design, cryptocurrencies are decentralized. For many proponents, that is indeed the beauty of such systems, but this beauty might come at a wider cost. Cryptocurrencies can add risk to the financial system, including by facilitating criminality and due to a lack of education, transparency and regulation.

While crypto has a reputation for providing cover for illegal activity, so far those who have tried to measure the extent of illicit activity find that it may only make up a relatively small portion of total activity. According to Chainalysis, between 2017-2020 illicit activity accounted for less than 1% of total crypto activity.

Whether those figures are correct remains subject to debate. Even if they are, cryptocurrencies will retain their attraction for criminals and others wishing to hide their tracks. That means introducing better know-your-customer (KYC) regulations, periodic reporting and potentially a framework which includes penalties for violation of disclosure requirements. In the end, finding the right balance between the attractions of anonymity and increasing trust in cryptocurrencies through disclosures will be key and a delicate balancing act.

As things stand today, an ESG investor would have a tough time making the case for investing in cryptocurrencies. Both the negative environmental and governance impacts go a long way towards cancelling out any potential positives for increasing financial inclusion.

However, that may not always be the case. The industry recognizes it has an environmental problem and has options for reducing its carbon footprint. At the same time, governments are accelerating efforts to provide regulatory and oversight frameworks. Over the longer term, widespread adoption of cryptocurrencies will very likely depend on how well ESG considerations are addressed.