Blockchain is restructuring ESG

R3 Sep 09 2022 By: Alisa DiCaprio
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Blockchain is restructuring ESG
Alisa DiCaprio
Alisa DiCaprio Senior Business Economist
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Blockchain has advanced the markets for environmental, social, and governance (ESG) policies in a unique way—by diversifying the set of credible assets.

This claim may come as a surprise. Most discussions of blockchain focus on the environmental problems associated with mining. But one overlooked fact is that the original blockchain use case was intended to democratize social policy and financial governance.

Looking more closely into blockchain’s role in ESG, we can see that there are 4 ways that it has already changed how ESG markets work.

1. Improving market efficiencies

Market structure is a nagging problem, even where ESG products are standardized. Carbon markets provide a particularly clear example. Rebalance Earth’s Walid Al Saqqaf points out that an African forest elephant is worth $40,000 for its ivory, though alive, it provides $1.75 million worth of carbon sequestration services. Inefficiencies such as these have generated consumer cynicism about what could become a powerful tool for sustainable finance.

One cause of market friction is simply overwhelming demand. Corporate net zero commitments means that global demand for voluntary carbon offsets is predicted to rise from US $1 billion in 2021 to up to $50 billion by 2030.

Yet markets cannot reliably handle even today’s throughput. As a result of market structure, offsets are often misused, misreported, and undervalued. This is compounded by the fact that carbon credits are not comparable across markets.

The incorporation of blockchain into carbon markets has made three operational improvements.

The first improvement is that decentralization reduces the complexity of registering, trading and managing carbon credits. One example is the ESG1 platform, which generates public chain offsets directly from energy measurement software. Built by GuildOne Inc, it uses the Corda network and smart contracts to create an automated credit validation ecosystem.

Simplifying markets in this way has been shown to increase quota utilization. One example is AirCarbon in Abu Dhabi which is building the first fully regulated carbon trading and clearing house in the world—a major development in a previously stagnant global market.

Another improvement is that the transparency that a shared ledger offers makes existing markets more reliable and open. This addresses market opacity, which has been the direct cause of “typical” problems such as lost quotas, illegal trading activity, fraud, and repeated transactions.

2. Safer analytics for social policies

The “S” of ESG covers the social dimension of corporate policies. Social policy efforts are often beset by data measurement problems. Specifically, collecting data can be dangerous to those it is meant to help.

An example of both the problem and the solution is the Hope for Justice charity, which collects data on human trafficking. Companies like R3 support efforts like this as a way to provide transparency into a global problem. But their data gathering is based on highly sensitive, individual cases. This has historically meant that analysis is impossible because any leaks in the original data could threaten the precarious position of those who provide it.

One solution has been to apply blockchain along with confidential computing. This allows the charity to create aggregated analytics about human trafficking trends without exposing the underlying data. This has already shown success in one particular country by pinpointing a 35-mile radius from which 95% of all human trafficking reports originated. This information provided authorities with the intelligence they needed to locate and stop the traffickers.

The difficulty of sharing data about sensitive topics like exposure to geopolitical risk, use of forced labor and safety risks has meant that this component of ESG is historically underemphasized in company policies.

The application of blockchain underscores that governments and socially responsible businesses have an existing and unparalleled ability to leverage their own data, with potentially transformative results for global inequality.

3. Diversifying good governance

The “G of ESG is perhaps the most difficult of the three components to get right. And yet, significant governance failures are a common way in which corporate profits are lost. In 2021, inadequate governance resulted in the default of Archegos Capital Management with over $10 billion of reported losses across multiple companies.

What blockchain brings to governance is new methods. By making voting more accessible to broader types of stakeholders, blockchain brings more inclusive means of control and oversight. Decentralized Finance (DeFi) in particular has popularized on-chain governance through the creation of governance tokens.

On-chain governance is a concept that is used in the decentralized exchanges (DEXs) that govern liquidity pools. It refers to a built-in smart contract that empowers stakeholders, who receive governance tokens for their stakes to vote for protocol changes directly on the blockchain. It allows all stakeholders to have a role in governance. This model is in contrast to the off-chain governance (Bitcoin and Ethereum) processes where proposals are mainly made by core developers and a few influential stakeholders have decision powers.

Another venue in which on-chain governance is used is decentralized autonomous organizations (DAOs). A DAO is built with no central leadership, and decisions are determined by community votes by its collective membership. Crypto exchange ShapeShift recently issued governance tokens during their 2021 transition into a decentralized autonomous organization.

To understand how governance tokens are used, we can look at Constitution DAO, in which a consortium of crypto investors raised $47 million worth of Ether to bid on a first edition copy of the US constitution. Each investor received governance tokens which would be used to vote on where the Constitution should be custodied if they won. They did not, so the governance tokens were used to decide what should be done with the funds that had been raised (the decision was to wind down the investment).

Of course, on-chain governance introduces some challenges as well, including the plutocracy of supply, where users with more tokens may control the voting process. Thus, even as blockchain broadens what good governance means, whether it provides better governance remains under debate.

4. Creating new investable asset types

A fourth way that blockchain has streamlined ESG programs is by creating new investable asset types.

Multinational corporations as diverse as Ikea, Keurig and H&M have struggled to monetize positive ESG characteristics in goods. Things like “green” cosmetics or shoes made from plastic bottles are popular among consumers. But the lack of standards creates incentives to cut corners and occasionally exposes overblown claims.

What if the asset could verify its own ESG claims? This is already happening in finance and has diversified tradable assets in three ways. The first is by bringing tradability to previously illiquid assets by verifying provenance claims. This means that it can support the issuance of green bonds or new instrument classes where ESG provenance is an essential characteristic. RABC group and Banyan both leverage the Corda network to provide sustainable finance to broader markets and consumers.

Second is that it brings previously syndicated assets—such as infrastructure—to a broader market. This makes legacy asset types more accessible via enhanced liquidity discovery and tokenization. Since the provenance of digital assets is easily traceable, this increases trust among all market participants.

A third example is the growing investor and consumer preference for sustainable fuel, including renewables and certified low-emissions natural gas and hydrogen. Blockchain traceability and emissions accounting contribute to the global shift to cleaner fuel and investable products, such as through ESG1’s low-carbon natural gas certification project on Corda, launching in Q3 2022 with two Canadian energy partners.

All three of these activities expand the variety of assets in the market to include those whose value depends on ESG criteria. This can include the sustainability of the materials used or the types of businesses in the network. But by putting these assets on ledger, their issuance, asset servicing and market discoverability allows them to expand.

Conclusion

We can’t end this blog without acknowledging the ever-increasing energy requirements that underpins proof-of-work based blockchains. But not all blockchains are built the same. Increasingly, blockchains like Corda and Algorand are addressing the importance of sustainability of the platform itself.

The technologies of decentralization and smart contracts are being used to shift the ground on which ESG claims are rooted. Truly transformative projects using blockchain are driving efficiencies within businesses and communities while simultaneously cutting emissions, reducing inequality, and saving lives.

As the world continues to tackle these massive challenges the industry must work with businesses and governments to realize these benefits at scale, recognizing that, as of today, societal and environmental problems are growing faster than the solutions we are implementing.

Alisa DiCaprio
Alisa DiCaprio Alisa DiCaprio is the Chief Economist at blockchain technology firm, R3, based in New York City. In this role she oversees R3’s research and market intelligence functions. This includes providing economic advice on developments in blockchain, digital assets, Central Bank Digital Currencies (CBDC), trade and payments as well as contributing to R3 interactions with the public sector.

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