As investors’ interest in the Bitcoin market grows, Professor Annalise Vendramini, FGV-EAESP Center for Sustainability, reflects on an ESG (environmental, social and governance) analysis of this new market.

Bitcoin and ESG Analysis. By Annalise Vendramini with kind acknowledgements to Adrian Zicari.

The Bitcoin. What is it?

In 2008, a programmer known by the pseudonym Satoshi Nakamoto, who was dissatisfied with the conventional financial system, published a White Paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System”. At that time, with the subprime crisis unfolding, there was an increasing public criticism of the conventional financial system.

In that White Paper, Nakamoto proposed a digital currency and a peer-to-peer payment system with no a financial institution as an intermediary. That electronic payment system, based on cryptographic proof instead of trust, would allow willing parties to transact directly without the need for a trusted third party.1 In order to ensure validity and no record duplication, Bitcoin uses an encryption system called Blockchain. This system, with a public key and a public registry of operations, all transactions in its network2.

In 2009, Bitcoin was launched based on the ideas in Nakamoto’s paper. A new currency and a new decentralized payment system was born. Despite the concept of Bitcoin being relatively easy to understand, the underlying technology is sophisticated and the result of decades of research, generally unknown to Bitcoin enthusiasts3. Note that the technology associated with the Bitcoin “ecosystem”, such as mining and its public ledger, has advanced over the last decades and several resources and characteristics are still in development.

Since Bitcoin was launched in 2009, several other cryptocurrencies have appeared, such as Ethereum, Tether and Bitcoin Cash. Nevertheless, Bitcoin continues to be the cryptocurrency with the largest market share (about 50%4). Furthermore, this growing interest from investors in Bitcoin and other cryptocurrencies, lead us to consider this new market from an ESG viewpoint. This article consequently presents few reflections on the relationship between these two worlds, Bitcoin and ESG. 

What is the purpose of an ESG analysis?

ESG considerations recognize that social, environmental and governance questions can impact the risk, volatility and long-term return of securities and markets. Thus, investments can have a positive or negative impact on society and on the environment.5 To this day, the scope of ESG analysis has been companies, their projects and also sovereign bonds. However, ESG analysis for currencies (the dollar, the euro) or payment systems has been rare.  

There can be several focuses for ESG analysis. For instance – reducing portfolio risk, avoiding controversial or morally questionable businesses and so on. There is no standard ESG analysis, as several ESG strategies are possible, depending on a variety of investment objectives and investor profiles.

One of the reasons for ESG analysis is the potential to influence managers of a business to reduce environmental and social impacts. This approach is known as the ESG engagement strategy. To what extent can an ESG investor contribute to improving these aspects of Bitcoin, for example? From this perspective, performing an ESG analysis of Bitcoin might have several practical effects. 

Another ESG strategy is the negative filter, or in other words the exclusion of certain sectors from all possible investments due to their ESG impacts. From this point of view, some reflections on the ESG aspects of Bitcoin are also worthwhile.

As such, this article intends to highlight possible issues regarding environmental, social and governance aspects that might be of interest to investors, depending on their investment objectives and the ESG analysis.

The environmental aspect of Bitcoin: Power consumption and recycling of materials 

Environmental aspects reflect the relationship of the business with the natural world, such as the use of renewable and non-renewable resources. 6 From an environmental point of view, the large amount of energy required for Bitcoin mining is well documented.

According to a report by the Cambridge Centre for Alternative Finance, the main operational cost of the mining process is electricity. Despite more than 70% of mining companies seeking to include renewable energy in their power mix, the total consumption of renewable energy still represents only 39% of total consumption. Undoubtedly, issues associated with greenhouse gas emissions might be relevant in an ESG analysis of Bitcoin.

China, for example, has placed severe restrictions on mining operations and it is speculated that the reason for this, at least in part, is its plan to achieve carbon neutrality by 2060.

Another factor that must be taken into consideration is the use of materials and manufacturing of hardware for mining. This activity requires highly efficient equipment. Despite using ASIC (Application-Specific Integrated Circuit), to achieve more efficient hardware efficiency with a lower obsolescence rate, hardware still becomes obsolete every three to five years.

However, given the need to be ever more efficient, mining firms tend to switch to new equipment before the end of the useful life of the older equipment. This, without a doubt, raises questions regarding the use of new materials and recycling of obsolete equipment.

Bitcoin and ESG Analysis: Three social and governance aspects

In an ESG analysis, social aspects are those that affect human life, such as human resources management and relationships with communities and clients. Governance aspects involve issues inherent to the business model, in addition to the interests of interested parties.7 In the case of Bitcoin, as it is a currency and payment system, social and governance aspects are intertwined.

• Illegality:

The fundamental characteristic of Bitcoin is the decentralization of operations and their anonymity. Bitcoin allows fund transfers without identification, without intermediaries, worldwide. However, this same characteristic — which is very appealing to many investors because the currency is not controlled by a government and, therefore, provides a defense against inflationary effects — makes Bitcoin also susceptible to misuse (e.g. money laundering, corruption and terrorism).

The same happens with cash transactions, but international regulations on capital controls, currency movement and Know Your Customer (KYC) rules, make it difficult to use the conventional financial system for illegal activities, both for individuals and legal entities.

With regard to this aspect, Bitcoin users tend to prioritize privacy over safety while users of the conventional financial system prefer safety to privacy. Privacy and the founding principles of Bitcoin ensure protection against government control, but the same principles can open the door to fund transfers for illegal or harmful activities, and/or those with serious negative externalities, such as ecological crimes or activities that violate human rights, all very dear to the ESG agenda. 

In the conventional Brazilian financial system, banking activities are governed by a set of laws and the regulations of the Brazilian Central Bank (BCB), which are designed to manage social and environmental risks. Deposits in a financial institution monitored by the BCB are used to provide loans and financing to legal entities based on applicable social and environmental risk laws and regulations. Operations carried out in the Bitcoin environment do not undergo the same scrutiny.

As the saying says, “put your money where your mouth is“. Investors concerned about ESG should keep in mind that using Bitcoin — even for transactions that do not have serious externalities — represents support (“putting your money”) for the maintenance or expansion of a system that can facilitate controversial activities. On the other hand, there are positive social and environmental externalities related to blockchain technology, such as an increase in trust and transparency in activities, health records, food security, and votes, etc., but this is independent of its use for cryptocurrencies.

• Security:

Another important point is the security of the Bitcoin investor. In recent years, several cryptocurrency trading platforms and portfolio providers have been hacked, leading to billions of dollars in losses for investors.8 A recent case in Turkey, in which a platform went off line and disappearing with over $2 billion in digital assets, has increased concerns about the cryptocurrency environment. In South Africa, a Bitcoin investment platform scam led to losses of about $4 billion.

On the other hand, advances in the regulation and monitoring of platforms and custodians have significantly improved investor security. The creation of the Nasdaq Crypto (NCI) index and HASH11, the first cryptocurrency ETF in the Brazilian financial market, with the NCI as a benchmark, are important examples of advances in this direction.

• Suitability:

Suitability refers to the appropriateness of investment products, services and operations for the investor’s profile. Cryptocurrencies are highly volatile and appropriate for a more risk-tolerant investor. It is important that investors be aware of the risk profile associated with Bitcoin and ensure that it is aligned with their investment strategy.

Nevertheless, the hype surrounding Bitcoin and the lack of regulation has led investors with a wide variety of profiles to engage in purely speculative activities. There is no shortage of criticism regarding Bitcoin’s economic basis; quite a few people believe that Bitcoin is a Ponzi Scheme. Charlie Munger called Bitcoin a “noxious poison.” In a blunt critique, Nassim Taleb stated that Bitcoin has failed to live up to its claim of being a “currency without a government,” it is neither a short-term nor a long-term value reserve and it cannot function as reliable insurance against inflation“. Regardless of whether it is a good or poor investment, it is important to keep in mind that suitability is a key feature in the investment world and that there are imprudent investors in all asset classes. This point is not exclusive to Bitcoin. 

*** 
An ESG analytical framework can indeed be applied to Bitcoin, both as a currency and as a payment system. The conclusions of this analysis cast light on the environmental, social and governance impacts of this promising – while intriguing and ambiguous – new tool.

Useful links:  

• Follow Prof. Annelise Vendraminin on Twitter @VendraminiAnne
• See Prof. Annalise Vendramini’s academic profile at FGV-EAESP (Portuguese and English)
• Further reading: The Bitcoin & Social Innovation and The Future of Blockchain
• Discover the GVces Sustainability Studies Center website, articles and downloads
• Apply for the international OneMBA or Professional Master’s in International Management (MPGI) at FGV-EAESP.

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