Digital Assets and ESG
Digital assets are not a common stop for investors who have ESG as a top priority. On the surface, it’s not hard to surmise why that might be the case – the significant energy requirement for mining new tokens on proof-of-work (POW) based blockchains, such as Bitcoin, has been well-publicized. For example, the New York Times stated that the annual energy required to create new Bitcoin in 2021 was around 91 terawatt-hours of electricity, more than was used by Finland. More recently, a University of Cambridge study showed that Bitcoin’s electricity usage in 2022 totaled 107 terawatt-hours (TWh), equivalent to that of Ukraine.
Source: University of Cambridge
Should that stop investors who have a sustainability goal from considering the digital assets space altogether? A recent 2022 survey by iConnections indicated that although ESG concerns may not be a showstopper for a digital assets allocation within a portfolio, it remains a significant consideration.
Perhaps framing the question differently may yield different insights into the issue.
To start off, digital assets present investors with a once-in-a-generation opportunity to participate in the emergence of a new risk premium. Long-horizon investors with a diversified portfolio should probably be considering an allocation in line with the size of the digital assets market relative to other asset classes but ESG concerns, primarily related to energy use may be giving them pause.
Most approaches to ESG-aware investing require the investor to use their judgement to determine how much of the less attractive characteristic is acceptable in any investment. After all, no company uses zero resources, and firms like Tesla may score very high on E but low(er) on S. If any investor has a non-ESG benchmark, there is a potential trade-off between tracking error and improved ESG score (relative to benchmark) that will vary by investor.
Taking a step back, there are a number of approaches that issue-focused investors can utilize in order to have their investment choices best reflect their beliefs:
Portfolio weighting – underweight names with less attractive ESG characteristics relative to a benchmark and overweight substitutes
Negative screening (aka exclusion) – removal of names from the portfolio due to certain criteria
Positive screening (aka best-in-class) – inclusion and/or overweighting of names that have superior ESG metrics
The above examples are assuming a typical long-only portfolio with a specific diversified benchmark. An investor can also develop a custom benchmark that has any of the above techniques applied to it and then track or manage against that benchmark. Note that the approaches described above can also be combined.
We can ask, “Can we get exposure to this asset class with a lower energy footprint than the default market weighting?” The answer is “Yes!”, and all of the above approaches can be utilized, based on investor preferences.
We will lay out two very simple examples, not as fully conceptualized investment strategies, but rather as a building block upon which to build further thinking.
The digital assets market is dominated by BTC, which makes up about 44% of the total market cap of all cryptoassets. We have to accept that the full crypto market – many thousands of instruments - includes many tokens with little liquidity, so let’s consider a more liquid proxy for the digital assets market. Looking at the top 50 tokens, we see that BTC makes up 55% of the total market cap.
We’ll take a slight detour here to touch on an important point regarding the energy usage of digital assets. BTC uses proof-of-work (POW) as its consensus mechanism and POW uses a significant amount of energy. The University of Cambridge estimates that Bitcoin mining’s electricity usage currently tops 135 TWh per year, slightly more than that of gold mining. An alternate consensus mechanism is proof-of-stake (POS), which uses far less energy. In a highly publicized and well-planned move, ETH recently switched its consensus mechanism from POW to POS and reduced its energy usage by 99.99% as a result.
To the extent that ETH is the second-largest digital asset by market cap, making up 24% of the top 50 tokens, the first very simple example of an ESG-aware digital assets fund would be simply holding ETH. The correlation of ETH to the broader digital assets market is approximately 50%, albeit with a lot of variability. This strategy has a strong benefit of simplicity, offset somewhat by lack of diversification and correlation. These latter two elements are subjective, and each investor will weigh them differently. What is important to take away is that you have gained exposure to the digital assets risk premium reasonably accurately and with a far better ESG exposure. Again, this is not an actual investment strategy, but a conceptual building block.
There is a fairly straightforward second step we can take to build a portfolio with a bit more diversification and improved tracking error relative to the broader market. That step is to introduce BTC to the portfolio and keep its weight below that of the market, thus acknowledging ESG-aware weighting. As mentioned earlier, each investor will need to determine the appropriate trade-off between tracking error and improved ESG score.
With these two sample strategies described, the foundation is laid for something perhaps more realistic. That would be building a portfolio with a diversification consistent with investor preferences and upweighting scores (all other factors being considered) for weighting POS tokens as compared to POW tokens. As with other ESG-aware investment strategies, the ESG score becomes part of the asset analysis, selection and weighting process.
We’d be remiss if we didn’t include, as a final example, something that excites us at Firinne – the idea of tokens that have verifiably been mined using renewable energy sources. We think this is a promising avenue for improving the energy usage and carbon impact of digital assets. Sustainable Bitcoin Protocol is one example of a firm focused on creating “clean” digital assets, in this case bitcoin.
This note has focused on the “E” part of ESG as energy use of digital assets has received a lot of airtime. At Firinne Capital, we consider the “E” as well as the “S” and “G” in token research. Digital assets hold the promise of social benefits such as improved inclusivity in the financial system. Governance is a key consideration of nearly all digital asset investing, including considerations of decentralization.
With the above discussion, it is our hope that investors who think that digital assets ought to have an allocation in their overall strategic asset allocation but have been put off by the negative ESG aspect of the energy consumption have a path to follow to both gain that exposure and remain consistent with their ESG aims.