Cover Story: Thorny issues for cryptocurrencies

This article first appeared in Wealth, The Edge Malaysia Weekly, on February 28, 2022 - March 06, 2022.
Cover Story: Thorny issues for cryptocurrencies
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The biggest conundrum that ESG investors may face when it comes to cryptocurrencies is the high energy use in 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 Centre for Alternative Finance estimates that Bitcoin mining consumes 125twh of electricity annually (as at Feb 17), which is equivalent or exceeds the electricity used by entire countries, according to various reports. This could add pressure to the electricity grids. 

But Aaron Tang, country manager of digital asset exchange Luno, points to a voluntary survey by the Bitcoin Mining Council (BMC) late last year that suggests that 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 who use wasted or stranded energy to power their operations, he says. 

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

“I guess something investors can do is look at crypto mining organisations that have a good mix of renewable energy 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 energy, 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 to solve the same problems, which incentivises more energy use on computing power.

In the POS model, validators “stake” their own cryptocurrencies to get a chance to validate new transactions. The network rewards validators who are most invested, and other validators have to verify that it is accurate. Unlike in the POW model, validators are not pushed to invest in powerful computing equipment that are energy-intensive just to compete. 

Last year, Ethereum announced its intention to shift to a POS model. The Ethereum Foundation estimates that this can reduce its energy use by up to 99.95%, according to a research article 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 do not see the value of this digital asset, Tang suggests. It could be different if one believes that cryptocurrencies are very beneficial in offering a faster and more secure way of transactions.

“For instance, if you compare Bitcoin mining to people watching YouTube, it could be possible that people are consuming more energy watching YouTube than by mining Bitcoin. But most people understand the value that comes from watching YouTube, whether it is for education or entertainment,” he says.

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

Meanwhile, non-fungible tokens (NFTs), which have taken off in the past 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’ worth of electricity used by an EU resident.

But it is important to note that the Ethereum network is still likely to be running whether or not NFTs are minted, observes Tang. 

The ‘S’ and ‘G’ problems

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

This is against the backdrop of a growing use of cryptocurrencies for ransomware payments in the past year. The Colonial Pipeline in the US, for instance, paid US$4.3 million in cryptocurrency to hackers due to a ransomware attack. Fortunately, the US Department of Justice was able to seize Bitcoin valued about US$2.3 million from the perpetrators. 

According to research done by Katten Muchin Rosenman, the total damages caused by ransomware were estimated to be US$20 billion in 2020. However, crypto ransomware only accounted for about 2% of the total amount. 

“Every transaction of Bitcoin is recorded on the blockchain. People have tried to obfuscate the money trail, but with regulations coming up, players like us also have to do Know Your Customer and anti-money laundering procedures. So, it is becoming increasingly difficult for people to use Bitcoin to do bad stuff,” says Tang. 

The decentralised nature of cryptocurrencies, meanwhile, is something that ESG investors may have to wrap their heads around. There is no central decision-making body for cryptocurrencies. Instead, it is supported by communities of miners, software developers and other actors, according to a report by MSCI, which recommends that investors get involved in the development of cryptocurrency protocols or engage with other actors to understand this asset class. 

Investors can also read the white paper of the cryptocurrencies to understand their governance structure, Tang suggests. 

There are, however, some inbuilt governance mechanisms in cryptocurrency networks. Whenever a change is suggested for a cryptocurrency, it needs to be approved by the miners of the network. 

“Basically, all the computers on the Bitcoin network have a certain period of time to show whether they support or reject the proposal. It can go into tens of thousands of people. There is no forcing of anyone to adopt or reject a change. For instance, in the past, when two factions did not agree on a change, they forked the cryptocurrency, which resulted in Bitcoin Cash,” says Tang.

So, what should ESG investors do? Going for the most widely known coins such as Bitcoin and Ethereum is a good bet, he says, due to all the studies that have been done on the cryptocurrencies. Their track record is also public information. 

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

 

ESG through ETFs — easier but not without challenges

The big global exchange-traded fund (ETF) providers already have a diverse suite of ESG ETFs for investors. Since ETFs generally involve lower fees and are easily accessible via robo-advisors, would it be fair to say that investors who want a diversified ESG portfolio should opt for this investing method instead? 

According to Wong Wai Ken, country manager for StashAway Malaysia, these providers have challenges of their own as well.

In Malaysia, two digital investment managers or robo-advisors have rolled out ETF portfolios in the past few months. MYTHEO’s Global ESG portfolio, which invests in 11 ESG ETFs offered by BlackRock and US-based asset manager Nuveen, was launched last October. The ETFs mainly track indexes of developed-market and US companies, comprising small, mid and large-cap stocks. It has one ETF tracking large and mid-cap companies in emerging markets. 

StashAway launched its responsible investing portfolio and environment and cleantech thematic portfolio in January. The ETFs in these portfolios are issued by the likes of BlackRock, Amundi and VanEck. The responsible investing 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] screening has been done by the ETF issuers, so that makes our job one degree easier. The next challenge is to match those ETFs to conventional ones. It is relatively easy to find an ESG alternative to an S&P 500 ETF. But once we go down to certain geographies or sectors, it becomes difficult,” says Wong. 

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

Opting for a clean energy ETF could sidestep 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 an outperformer at this time. However, ESG alternatives for certain tech funds like the KraneShares CSI China Internet ETF are tough to find.

“The matching process is not the easiest, and this is just in equities in the best-case scenario,” says Wong. 

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

Because of these challenges, StashAway’s responsible investing portfolio is not a complete ESG replica of its general investing portfolio. Some of the ETFs that it invests in are not strictly branded as ESG but have high ESG ratings by MSCI.

But according to the firm’s back-testing results, the returns are roughly the same, says Wong. “When we isolate the ESG factor, there is an outperformance of 2% from the benchmark [conventional portfolio].”

StashAway chose to rely on the ESG ratings by MSCI because the service provider is well known in the credit rating space and is widely used, he says. There have been criticisms on the subjectivity of ESG evaluations by different service providers, with an article by Bloomberg singling out MSCI for being too lax with its ratings.

But Wong believes that MSCI is on the right path as it encourages businesses to think of ESG as a risk management issue. 

“I think if you talk about risk management, businesses are more inclined to report [on ESG issues], especially if it is to avoid fines, write-offs, boycotts or public relations nightmares. I think asset managers will also see that businesses that avoid controversies are better performers,” he says.