Clifford Chance

Environmental, Social and Governance (ESG) priorities are increasingly shaping the development and use of new technologies.  Some technological developments, such as carbon-capture technology and other GreenTech, were driven by ESG imperatives. In other cases, technologies have been commandeered to assist in achieving ESG goals.  In addition, ESG concerns are evident in many of the regulatory and supervisory frameworks that seek to guide and control the evolution of emerging technologies.

However, the varied and ubiquitous nature of ESG considerations can make them difficult to appropriately navigate when developing and using certain technologies.  The current state of distributed ledger technology (DLT) is an example of how layers of ESG considerations have created ambiguity about how a technology should be viewed from an ESG perspective and how perception of the technology may help shape its future development, use and regulation.

DLT as an ESG enabler

Emerging DLTs, such as blockchain, are increasingly being used to enable the delivery of sustainable infrastructure for a low carbon future. Across the energy sector, developers seek to leverage DLT technology to help decentralise energy distribution, control energy networks through smart contracts and provide demand response services linked to electricity usage and supply forecasting.

Crypto assets generated through blockchain also have the potential to enable greater access to the financial system for people who cannot access the traditional financial system due to economic, social or geographical conditions that prevent them from opening traditional banking and other financial accounts.  Progress in this area may be accelerated by the advent of stablecoins and government-issued virtual currencies, which could result in cost-effective distribution of funds in the context of social programs.

ESG-related concerns

At the same time, there is an increasing focus on ESG concerns regarding DLT.  For example, if not appropriately regulated, crypto assets could be used to facilitate crime, such as ransomware attacks, and to support new methods for laundering illicit funds – due in large part to the open nature of DLT-based platforms, which require little to no customer identification to use.  Indeed, these concerns are among various issues that appear to have slowed the expansion of DLT-based technologies globally as regulators try to curb illicit uses and impose customer protection regimes.

Blockchain validation processes may also give rise to environmental concerns due to excessive energy consumption and electronic hazardous waste. Although certain studies indicate that bitcoin network energy consumption is significantly lower than that of the traditional financial economy, bitcoin does not operate at the same scale as traditional financial institutions, and concerns remain about the huge amount of energy needed to add new blocks to "proof-of-work" blockchain protocols like Bitcoin and Ethereum. To stay competitive and increase energy efficiency, companies may invest in upgraded hardware for blockchain processes, but this comes at an environmental cost as the hardware is not necessarily easy to repurpose or recycle, and recent reports have found that redundant units create approximately 24.28kt of hazardous electronic waste each year.

Tackling ESG concerns

One way to reduce the energy consumption of a blockchain protocol is to transition it from a "proof-of-work" to a "proof-of-stake" model. "Proof-of-work" protocols require miners to solve complex mathematical equations generated by the protocol, with the first miner to solve an equation and present proof to other miners being able to add a new block to the blockchain and receive a financial reward. Miners attempt to gain a computational edge over others by using energy intensive mining machines that excel at rapid computations. In contrast, "proof-of-stake" blockchains often use a network consisting of a set number of "validators" that contribute their own crypto in exchange for a chance to validate a new transaction, update the blockchain, and earn a reward.  "Proof-of-stake" blockchains may have as few as 11 validators vs. the hundreds of thousands if not millions of miners on the Bitcoin blockchain.  Reducing the number of miners/validators leads to a corresponding reduction in the computing power necessary to update a "proof-of-stake" blockchain and can thus result in a blockchain achieving significantly higher transactional efficiency and lower energy consumption.

Further ESG complexity

However, adopting a more environmentally friendly "proof-of-stake" blockchain model can be complicated by regulatory frameworks designed to ensure consumer protection.  For example, the US Securities and Exchange Commission (SEC) and other global regulators believe that many crypto assets used on blockchains have characteristics indicative of a "security" that falls under their regulatory authority, a designation which can have an existential impact. One factor the SEC weighs heavily in favour of a crypto asset being a "security" is the existence of a defined group of persons responsible for managing a blockchain or blockchain-related project that asset purchasers reasonably expect to rely on to realize future profits.  This is due, in part, to concern that a small group of managers with power over a blockchain or access to its software can lead to informational asymmetries that managers can exploit to take advantage of unsophisticated investors.  "Proof-of-stake" blockchains with centralized governance including, blockchains with too small a validator pool, run the risk of creating the kinds of control and informational asymmetry issues that may cause global regulators to step in.

Another avenue explored by some companies seeking to position bitcoin mining as 'sustainable' is to procure energy from renewable energy sources or to enter into corporate power purchase agreements. However, companies must consider the reputational risks associated with 'green washing' and the focus by stakeholders on verification and reporting (which may necessitate steps such as embedding audit rights in the underlying power purchase agreements).

Conclusion

We may be at a pivotal moment in relation to the impact of ESG on the development of potentially transformative technologies. Ethereum, the second largest blockchain protocol in the world, is currently in the midst of a complicated transition from a "proof-of-work" to a "proof-of-stake" model. Many attribute this shift, in part, to public concern about energy consumption. Examples like these suggest that DLT, which remains in its relative infancy, may be much more heavily influenced by ESG-related concerns than prior technologies with the same transformative potential. 

This article forms part of GDF's Report: Digital Assets: Laying ESG Foundations