Cover story: Thorny issues for cryptocurrencies

Cover Story: Thorny issues for cryptocurrencies

The biggest conundrum that ESG investors may face when it comes to cryptocurrencies is the high energy consumption when mining them. The mining process requires high-performance computers to verify transactions made on the blockchain. If the energy is generated by fossil fuels, this results in high carbon emissions.

The Cambridge Center for Alternative Finance estimates that Bitcoin mining consumes 125 TWh of electricity per year (as of February 17), which equals or exceeds the electricity used by entire countries, according to various reports. This could add pressure on power grids.

But Aaron Tang, country director at digital asset exchange Luno, points to a voluntary Bitcoin Mining Council (BMC) survey late last year that suggests 59% of Bitcoin miners use renewable energy. The BMC is a voluntary global forum of some of the biggest Bitcoin mining companies in the industry, according to its press release.

There have also been innovative miners using wasted or stranded energy to power their operations, he says.

The problem is that investors would not know if the cryptocurrency they buy is powered by renewable energy, given the lack of information. According to reports, miners have moved to places where energy is cheapest, which are mostly countries still dependent on fossil fuels.

“I guess something investors can do is look at crypto mining organizations that have a good mix of renewables or consider that a lot of bitcoin mining today already uses renewable energy,” says Tang.

Another important point is that not all cryptocurrencies are the same. Some cryptocurrencies use the proof-of-stake (POS) model, which uses less power, instead of the proof-of-work (POW) model to verify transactions.

POW, which is used by many cryptocurrencies including Bitcoin, uses a consensus mechanism that requires computers to solve complex mathematical problems. Miners compete with each other to solve the same problems, which encourages more energy to be spent on computing power.

In the POS model, validators “bet” their own cryptocurrencies for a chance to validate new transactions. The network rewards the most committed validators, and other validators must verify that it is accurate. Unlike the POW model, validators are not pressured to invest in powerful and energy-consuming IT equipment just to be competitive.

Last year, Ethereum announced plans to move to a point-of-sale model. The Ethereum Foundation estimates that this can reduce its power consumption by up to 99.95%, according to a research paper by law firm Katten Muchin Rosenman. Other cryptocurrencies that use the POS model include Cadano and Solana.

On a more fundamental level, many people may find the environmental footprint of cryptocurrencies unacceptable because they don’t see the value in this digital asset, Tang suggests. It could be different if you think that cryptocurrencies are very beneficial in providing a faster and safer way of transactions.

“For example, if you compare Bitcoin mining to people watching YouTube, it’s possible that people consume more energy watching YouTube than mining Bitcoin. But most people understand the value of watching YouTube, whether for education or entertainment,” he says.

However, the Cambridge Center has estimated that a single Bitcoin transaction could have the same carbon footprint as 680,000 Visa transactions or 51,210 hours of YouTube viewing, according to The Guardian.

Meanwhile, non-fungible tokens (NFTs), which took off last year, are mostly bought and sold on the Ethereum blockchain. According to a report by The Verge, the energy used to produce an NFT is equivalent to two months of electricity consumed by an EU resident.

But it’s important to note that the Ethereum network is still likely to work whether or not NFTs are issued, Tang observes.

The “S” and “G” Problems

Regarding concerns about the use of cryptocurrencies for illegal activities, Tang points to a recent report by blockchain monitoring firm Chainalysis which shows that illicit cryptocurrency use was only 0.15 % of total transaction volume in 2021.

This is against the backdrop of an increasing use of cryptocurrencies for ransomware payments over the past year. The Colonial Pipeline in the United States, for example, paid out US$4.3 million in cryptocurrency to hackers due to a ransomware attack. Fortunately, the US Department of Justice was able to seize Bitcoin worth approximately US$2.3 million from the perpetrators.

According to research by Katten Muchin Rosenman, the total damage caused by ransomware was estimated at US$20 billion in 2020. However, crypto-ransomware only accounted for around 2% of the total amount.

“Every bitcoin transaction is recorded on the blockchain. People have tried to cloud the money trail, but with the coming regulations, players like us must also adhere to know-your-customer and anti-money laundering procedures. So, it becomes more and more difficult for people to use Bitcoin to do bad things,” says Tang.

The decentralized nature of cryptocurrencies, meanwhile, is something ESG investors might need to understand. There is no central decision-making body for cryptocurrencies. Instead, it’s backed by communities of miners, software developers and other players, according to a report from MSCI, which recommends investors get involved in the development of cryptocurrency protocols or s Engage with other players to understand this asset class.

Investors can also read the cryptocurrency whitepaper to understand their governance structure, Tang suggests.

There are, however, governance mechanisms built into cryptocurrency networks. Whenever a change is suggested for a cryptocurrency, it must be approved by the miners in the network.

“Basically, all computers on the Bitcoin network have a certain time limit to indicate whether they support or reject the proposal. It can affect tens of thousands of people. No one is forced to adopt or reject a change. For example, in the past, when two factions disagreed on a change, they forged cryptocurrency, which resulted in Bitcoin Cash,” Tang explains.

So what should ESG investors do? Opting for the better-known coins such as Bitcoin and Ethereum is a good bet, he says, because of all the studies that have been done on cryptocurrencies. Their backgrounds are also public information.

Ultimately, cryptocurrencies are still a new asset class. More transparency and disclosure would be useful for ESG investors. Tang expects this to come from individuals or cryptocurrency companies as regulators continue to monitor these digital currencies.

ESG via ETFs – easier but not without challenges

The major global providers of exchange-traded funds (ETFs) already offer a diverse range of ESG ETFs for investors. Given that ETFs generally involve lower fees and are easily accessible through robo-advisors, would it be fair to say that investors who want a diversified ESG portfolio should opt for this method of investing instead?

According to Wong Wai Ken, country manager of StashAway Malaysia, these vendors also have their own challenges.

In Malaysia, two digital investment managers or robo-advisors have rolled out ETF portfolios in recent months. MYTHEO’s Global ESG Portfolio, which invests in 11 ESG ETFs offered by BlackRock and US asset manager Nuveen, was launched last October. ETFs primarily track indices of companies in developed markets and the United States, including small, mid and large capitalization stocks. He owns an ETF that tracks large and mid-cap emerging markets.

StashAway launched its responsible investment portfolio and environmental and cleantech thematic portfolio in January. The ETFs in these portfolios are issued by companies such as BlackRock, Amundi and VanEck. The responsible investment portfolio covers developed and emerging market equities as well as conventional and green bonds, while the thematic portfolio focuses on themes such as clean energy and waste management.

Neither portfolio has ETFs that specifically cover Malaysia.

“The [ESG] the selection was made by the ETF issuers, which makes our job a little easier. The next challenge is to match these ETFs to conventional ETFs. Finding an ESG alternative to an S&P 500 ETF is relatively easy. But once we get down into certain geographies or sectors, it becomes difficult,” Wong says.

For example, to hedge inflation, one could look to sectors such as commodities and energy that could do well, he says. The Australian market is a good indicator of the former, but ESG ETFs tracking this market are rare. “So for that we have to rely on the underlying Australian ETF which already has high MSCI (ESG) ratings.”

Opting for a clean energy ETF could circumvent the ESG concerns that come with a conventional energy ETF, but their risk-return profiles are very different, he adds. The technology sector is also outperforming at the moment. However, ESG alternatives for some technology funds like the KraneShares CSI China Internet ETF are hard to come by.

“The matching process isn’t the easiest, and it’s only for stocks at the best of times,” Wong says.

It is even more limited in the fixed income space. StashAway invests in a global green bond ETF, but is unable to represent the entire bond space.

Due to these challenges, StashAway’s responsible investment portfolio is not a full ESG replica of its general investment portfolio. Some of the ETFs it invests in are not strictly marked as ESG, but have high ESG ratings by MSCI.

But according to the company’s back-test results, the returns are about the same, Wong says. “When we isolate the ESG factor, there is a 2% outperformance compared to the benchmark index [conventional portfolio].”

StashAway chose to rely on MSCI’s ESG ratings because the service provider is well known in the credit scoring space and is widely used, he says. There have been criticisms of the subjectivity of ESG assessments by different service providers, with a Bloomberg article pointing the finger at MSCI for being too lax with its ratings.

But Wong thinks MSCI is on the right track as it encourages companies to consider ESG as a risk management issue.

“I think if you’re talking about risk management, companies are more likely to report [on ESG issues], especially if it’s to avoid fines, debarments, boycotts or PR nightmares. I think asset managers will also see that companies that avoid controversy perform better,” he says.