Author: Ben Ashby, CFA, Derek Usher and Gerard Fox
Ben Ashby from the CFA UK Future of Money Working Group, and co-authors Derek Usher and Gerard Fox look at whether ESG considerations will turn Bitcoin into a digital ‘stranded asset’ or monetary MySpace
We have many economic reasons for believing that ‘first generation’ crypto assets will fail to displace either ‘conventional’ money or traditional safe assets in the long run, but it is in the area of ESG where we believe that the case against these products and their related infrastructure is most compelling. Efforts to bring into the mainstream or ‘regularise’ first generation crypto currencies in their current form, as investor safe assets, sharply conflicts with policy initiative to address the energy transition. Indeed, there is a not immaterial risk that they may become digital ‘stranded assets’ as environmentally conscious societies seek to either ban, regulate or simply tax them out of existence.
We at Good Governance Capital (GGC) are enormously enthusiastic and supportive of innovation & competition in finance. As former mainstream bankers ourselves we see many opportunities for fintech to creatively disrupt. We are very sympathetic to - some - of the motivations of those looking to alternative assets to protect their privacy or wealth in the face of substantial post GFC fiscal and monetary intervention. Indeed, Bitcoin’s creator Satoshi Nakamoto highlighted the breach of trust caused by Central Banks debasing currencies. However, we are very sceptical that crypto currencies, in their current form, present an immediate solution to this investor dilemma.
We believe that the recent mania to bring into the mainstream or ‘regularise’ first generation crypto currencies reveals substantial gaps in ESG approaches to tech in general and to the fintech sector’s grasp of the operation of the global financial system in particular; hence the high failure rate. We see Bitcoin and Ethereum as probable casualties of these failings. Despite announcements by Tesla and BNY Mellon, we have difficulty seeing any mainstream future for such early generation products.
First, we believe it is highly unlikely that any cryptocurrency would be allowed to become a true parallel currency in any advanced country and thereby threaten the state’s monopoly over money[i]. Second, we see the energy intensity of crypto currency mining as a substantial ESG red flag which conflicts directly with climate policy and commitments signed up by most advanced countries. Third, increasingly there are less energy-intensive digital currency substitutes beginning to emerge, such as EOS. Finally, we are unconvinced that the use of Bitcoin for illicit purposes can be easily solved through regulation.
A short history of crypto
The emergence of Bitcoin and other first generation crypto currencies over the last decade has ridden a wave of global financial angst motivated by a number of drivers such as a desire for greater sovereignty from the state or a fear for the consequences of quantitative easing and debt monetisation. There is also a desire - among some - to replace the hegemony of the US Dollar or to evade increasingly intrusive initiative around money laundering. It has also resonated with a growing fascination with tech and disruptive fintech. Yet, coincident with this, another wave of rising global angst and policy commitment has arisen to address the collective action challenge that is Climate Change.
Crypto currencies have grown exponentially since the launch of Bitcoin in 2008. Its market capitalisation alone passed the $10bn mark in Q4 2016[ii], growing to over $1trillion in February 2021. Such exponential growth saw the value of an individual bitcoin rise from $600 in Q4 2016 to $39,000 in early February 2021, peaking at over $61,000 on 14th March; a growth in value of 100 times.
This growth has increased the profit motive to compete for Bitcoin transactions and mine new coins and has been accompanied by calls for cryptos to be included in mainstream asset allocation and considered a standard part of investors’ portfolios and cash management.
Tesla’s recent controversial decision to buy $1.5billion of Bitcoin to put on its balance sheet has added fuel to the fire. In addition to the highly questionable value of Bitcoin as a store of working capital, the fact that Tesla is a company that burnishes its ESG credentials, renders the decision somewhat incredulous.
Energy intensity & Bitcoin
The energy intensity of Bitcoin related activities is not disputed by its advocates, but we believe that the magnitude and nature of energy use is poorly understood by the investor community. Its green credentials are highly questionable and ultimately un-auditable compared to other safe assets or mediums of exchange.
A recent study by Cambridge University Judge Business School[iii] [iv]estimated that Bitcoin related activity uses anything between 38 TWh and 259 TWh of electricity annually, depending upon the estimation methodology used, with a mid-case of 109 TWh. To put this in context, this compares with UK annual electricity consumption of approximately 300 TWh. If we take the mid-range estimate, Bitcoin mining equates to that of the 15th largest country in the world in terms of electricity use.
This huge energy use intensity currently supports annual global Bitcoin transactions whose volume is 190 times less than UK Non-Mainstream Financial Institutions (MFIs) transactions, which include debit card and credit cards, direct debits and cheques.[v]
Whichever of the energy use estimates is accurate, it is surely questionable for a global activity that arguably produces no tangible value and is dwarfed by financial transactions in the UK alone to be allowed to continue to operate in environmentally conscious society.
It has been argued by some that since Bitcoin mining is so energy intensive it is forced to chase cheap electricity, utilising curtailed variable renewables (VRE) or low carbon “stranded” electricity sources, incentivising it to locate itself in renewables generating intensive regions or countries like Iceland. Estimates of this renewable electricity component range from 30% to 70%.
However, claims towards the upper end of this range just do not stand up to scrutiny. First, Bitcoin mining does not largely occur in countries with a high proportion of renewable energy generation. Second, despite 36.7% of global electricity coming from low carbon sources (Nuclear, Hydro, Wind, Solar, Geothermal), only around 10% comes from Variable Renewables (VRE, i.e., Wind/Solar) suggesting a limit to the capacity of miners to access cheap curtailed VRE sources and high odds that more emissions intensive electricity dominate.[vi] Third, the mission to electrify most things over the next 30 years, and to bring nearly a billion people currently off the grid on to it, will require a massive increase in global electricity generation capacity – a doubling in the UK alone; there are clearly more pressing useful demands on the generation system than Bitcoin mining.
Finally, even where utilising renewable electricity, through demand displacement the energy requirements of Bitcoin has the potential to adversely impact on the quantity of “dirty” energy produced globally, as less profitable activities have to use alternative sources. Thereby slowing the pace of CO2 emissions abatement.
Taking these arguments in the round, claims around any alleged greenness of Bitcoin mining will likely have overrepresented the importance of renewable energy sources in its creation. On a global basis it seems more probable that utilisation of renewable electricity in its creation approaches the lower bound of claims; a recent estimate suggesting that only 29%[i] of Bitcoin energy consumption is from renewable sources. Regardless, given its energy intensity, the burden of evidence falls on Bitcoin miners to demonstrate its green credentials. It is our belief that in its current architecture it is not possible to reliably audit Bitcoin from a carbon footprint perspective.
The reason that Bitcoin and its sister currency Ethereum are so power hungry is that they use an underlying technology called PoW (Proof of Work), which requires highly complex computations to be undertaken in order to complete a transaction and businesses across the world compete to conclude those computations first. For many Bitcoin enthusiasts this vast energy usage represents a “feature not a bug” as that is how Bitcoin derives its “value”. However, this again demonstrates the knowledge gap as it appears to be an example of the “sunk cost fallacy” in its most basic form.
However, new technologies have been developed such as PoS (Proof of Stake) and DPoS (Distributed Proof of Stake), which move away from the high computational effort approach of the early blockchain products. For instance, EOS[vii], which is based on DPoS technology claims to be 66,454 times more energy efficient than Bitcoin. So, for the equivalent of the Bitcoin transaction volume this would equate to 1.6Gwh per annum this would mean that it had a substantially smaller electrical usage than any of the 219 countries registered on the Wikipedia list of countries by electricity usage.[viii] However, if this is scaled up just to UK non-MFI transactions it still requires 311 GWh, which is still the same size as some small island states like the Faroe Islands, just to process the transactions of 1% of the world population, so whilst it may be a big step in the right direction, its power usage is still enormous if it were to scale and replace existing global transaction flows.[ix]
Another defence of Bitcoin’s energy usage is to compare it against traditional mining activities, especially precious metals. Firstly, our point here is not to make the case for precious metals but to highlight this is fairly obviously false equivalence. Promoters of Bitcoin may wish it to be compared to gold or other precious metals but wishing for something doesn’t make it so. Precious metals are not just ‘stores of value’ they also have some industrial value adding usages as well as the obvious jewellery demand whilst there is no obvious reason for these crypto activities to exist. Finally, precious metals are not sunk costs after their creation as they can be reclaimed or melted down and reused.
Given its limited use as ‘money’ if Bitcoin and its peers should be compared to anything at all then possibly gaming software is more appropriate.
The Social & Governance case against Bitcoin
The Social & Governance argument against cryptocurrencies relates to what the ECB’s President Christine Lagarde called “funny business” or Treasury Secretary Yellen more specifically called “illicit financing”.
Naturally the scale of these activities is harder to quantify. Crypto based company Chainanalysis published a report [x] that claimed criminal activity accounted for just 2.1% of all transactions, or $21.4bn USD in 2019. They believe this fell to just $10bn in 2020 despite a large increase in overall transactions. This needs to be contrasted against illicit financing in ‘traditional’ forms of money where the UN calculates between 2-5% of global GDP ($1.6trn – $4trn USD). So, nothing to see here surely? It would be odd for the authorities to be concerned about cryptos given such estimates of the relative and absolute scale of criminal activities?
Yet, even if we assume that Chainanalysis’s calculations are accurate, which we have doubts about, it misses the issue. This issue begins to touch on the governance and purpose of the monetary system within a legitimate, democratic society. These societies have made democratic decisions as to levels of taxes or what actions and activities should be illegal. Whilst we appreciate the desire for privacy it should not be at the expense of undermining society. As such, we have seen a constant increase in AML and KYC regulation over the past few years in traditional finance. This is not a trend that is going to reverse. We have seen major Central Banks even going to the lengths of outlawing high denomination traditional bank notes. So, it seems very unlikely that alternative payments systems will be overlooked where anonymity and the lack of central control are key features.
Further some of the major Bitcoin mining centres are in China, Russia, Kazakhstan and Iran. These are all countries with serious human rights questions hanging over them as well as, in many cases, sanctions. Other than the obvious ethics questions of doing business with miners located in these regimes, there are the obvious environmental standards linked to how the energy is produced, an issue we covered earlier. It is inevitable that where there are sanctions around traditional financial channels that sanctions around alternative ones will be introduced.
On these grounds alone, we cannot see how any mainstream financial institution committed to ESG – or indeed KYC and AML - can justify having connections with systems having deep roots in these parts of the world.
Finally, we ask the question again: Why would fiat currency issuers in a heavily indebted world, permit or empower a competitor digital currency, over which they have no control, to become dominant? Why would they also let an effectively unregulated system become systemically important where it could form a systemic risk to financial stability?
Bitcoin, Tesla & the problems with ‘traditional’ approaches to ESG
The whole Bitcoin & Tesla ‘affair’ highlights several issues inherent with traditional ESG that we at GGC continue to see. The recent success of ESG investment management has in many cases relied on the operational performance & share price rises of technologically advanced companies. Yet both the environmental issues, related to the actual operations of these businesses, as well as the wider social & governance issues have largely been overlooked. The traditional scoring approach used by industry incumbents often fails to capture the inherent complexities of the issues. But it also highlights the issues of how, in a world of rapid technological advancement, the wider implications of these innovations get overlooked.
What the entire cryptocurrencies debate does highlight is the knowledge gap between the various parties involved in understanding of each other’s world. Many of those with technological backgrounds don’t seem to understand the vast complexity of the financial system and its long organic development. Whilst those with more traditional finance backgrounds (along with parts of the ESG community) often seem to overlook the engineering & societal ‘side effects’ from all the innovation that is going on.
This shouldn’t be seen as a criticism, rather just pointing to the realities of trying to make sense of a vast, complex and evolving system. One of the surprises we had during the global financial crisis was how little understanding many professional bankers had of the architecture and plumbing of the world’s financial system. When you are at the intersection of such two large and evolving fields then these knowledge gaps should be perhaps no surprise.
Given the large gaps still inherent in ‘conventional’ ESG evaluation it should be perhaps no surprise that investors are even less able to appreciate the inherent issues with new technologies and only later come to the realisation of what they have effectively financed in. In the race to embrace the ‘new’ investors have employed an old, limited lens with which to view new issues.
Given one of the key claims of the crypto community is that it is ‘forward looking’ and this represents the future of money, it is somewhat ironic that they don’t seem to have grasped that the future entails a serious effort against climate change. This has serious implications with regards to many countries’ emissions targets. This alone makes it highly unlikely that any early cryptocurrency based on the most common forms of blockchain are likely to be allowed to continue to persist in their current forms. The question is more ‘when’ rather than ‘if’ and what form will it take? Will it be an outright ban such as India has proposed[xi] or the imposition of a tax that perhaps combines both features of a Tobin and a carbon tax?
Another irony is that one of the problems with cryptocurrency as an illicit form of financing is the fact it doesn’t work very well as money at present. It is volatile, relatively illiquid and not easy to convert into real assets. All of which limits its attractions to those engaged in criminal activity or indeed nearly any legitimate commercial activity! Further, despite the claims of anonymity due to the nature of Blockchain, there is a record of usage. Yet if these problems are overcome and that is a very big ‘if’, then ironically the more likely it seems to us that crypto will either be significantly curtailed or co-opted by the authorities in many countries.
To be clear, this is not to say there isn’t a niche opportunity for some future money architecture or an opportunity for future crypto ‘assets’ as opposed to a ‘currency’ as an alternative investment vehicle, but we are deeply sceptical that first generation is crypto is the finished article. Rather it has a high probability of a monetary MySpace or Betamax as the technology improves and regulations change.
At Good Governance Capital, we believe that the new – private sector – crypto champion hasn’t yet emerged and is more likely to be a fusion of StableCoin and ETFs - but that is a discussion for another time. In any event, given the prospect of Central Bank Digital Currency could render the whole debate redundant. This highlights a key point that is often overlooked, the whole area of crypto assets is still, to all intents and purposes, an infant technology and might yet to prove to be a technological dead end. Yet proponents of Bitcoin and its ilk would like to believe that they have perfected it first time and it is ‘future proofed’. We believe this is highly improbable.
Despite the recent frenzy in Bitcoin activity these inherent and huge ESG hurdles seem very unlikely to be either overcome or accepted by most countries. So perhaps this is the final irony; those that claim to be forward looking technologists and claim crypto forms part of a future financial system, cannot see that it may well be a digital stranded asset and is already a relic of the past.
[iv] Cambridge University Judge Business School - 2021-ccaf-3rd-global-cryptoasset-benchmarking-study.pdf (cam.ac.uk)
Ben Ashby is a Partner at Good Governance Capital. Previously Ben was a Managing Director in JPMorgan’s Chief Investment Office & Treasury. Ben@GoodGovCap.com
Derek Usher is a Consultant at Good Governance Capital. Previously Derek was Manging Director of Cabot Credit Management. Derek@GoodGovCap.com
Gerard Fox is a Consultant at Good Governance Capital. He is a Director of the Regulatory Policy Institute. He Chairs the East Sussex Pension Fund Committee and has steered major changes to the Fund seeking to better align it with the challenges and opportunities associated with the Energy Transition. A member of the Corporate Programme Advisory Group for the Institutional Investors Group on Climate Change (IIGCC), he is a Chapter Zero member. He is a former Managing Director of Credit Suisse. Gerard@GoodGovCap.com