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Blockchain and its underlying technologies have been around since the late 1970s and were brought to life from the introduction of Bitcoin in 2008. The general public might associate blockchain technology with just cryptocurrency, but the application of blockchain technology goes beyond that. As people see that blockchain is a valuable technology due to its nature of transparency and traceability, automation (from smart contracts) and decentralization, the technology has been evolving tremendously over the past years to include new use cases in several sectors such as banking, supply chain, healthcare, etc. The technology is considered to be on the path to mainstream adoption in coming years.
On the other hand, the topic of Environmental, Social and Governance (ESG) has been a growing topic of interest and businesses have to fine-tune their operations to raise the standards and accountability to comply with the current and upcoming regulations. Blockchain offers a great fit for organizations that have a desire to initiate and/or incorporate ESG initiatives to their existing operations and manage relevant reporting requirements.
In this article, we will discuss the current use cases of blockchain in Environmental, Social and Governance aspects, current and foreseeable challenges from leveraging blockchain to tackle the ESG issues and implications to financial institutions (FIs).
When Blockchain Collides with ESG
Conceptually, the key strengths of blockchain of traceability, automation, and decentralization could be translated to an increase in transparency, efficiency and accountability across Environmental, Social and Governance elements in several meaningful ways.
Nevertheless, the intersection of how blockchain and ESG could work together is only at the beginning of formation, as blockchain is still considered as an emerging technology and the ESG impact measurement and reporting practices are still under development. Due to the urgency of the problem and suitability of using blockchain technology, there are a number of use cases on the Environmental aspect, compared to Social and Governance elements that are still in the exploration phase.
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Environmental x Blockchain
There are growing use cases in the Environmental aspect by utilizing blockchain technology particularly the infrastructure levels to promote transparency and efficiency such as energy management, deployment of renewable energy, recycling etc. Nevertheless, there are three main use cases of blockchain technology consisting of tracking, trading and compliance, which are currently implemented across different industries.
The immutable ledger of blockchain enables a better transparency to the supply chain. The companies can track the movement of materials from the point of origination to the destination, leading to the opportunity to pinpoint the area of inefficiencies, energy usage, and carbon emission. The traceability allows the companies to better reduce waste and carbon footprint, control that the production is operated in a sustainable manner and promote economic circularity from recycling materials and transparency to consumers. For example, Food Trax is a farm-to-fork traceability solution provider enabled by blockchain technology to eliminate food waste from storage and improper operations and offers better visibility of consumers. The company is developing a solution to collect and monitor various data points leveraging RFID, variable data printing, scanners, mobile computing platforms, and et cetera to cover all steps in the supply chain. The transparency yields an increase in revenue and higher brand loyalty from clients.
One of the main advantages of blockchain is its ability to provide a more effective and efficient settlement process as the nodes/validators certify the transaction and all members in the network have the same record, reducing the need for reconciliation. Blockchain could be the backend technology for the trading of sustainable financial products such as green bonds and renewable energy credits including renewable energy certificates (RECs). Additionally, tokenization of real-world assets such as carbon credits can enable more efficient trading by reducing the investment ticket size from fractionalization, increasing price discovery and liquidity to the market and performing almost real time settlement. Consequently, businesses and individuals can participate and promote the growth of renewable energy and sustainable production. For instance, Toucan Protocol is developing technology to bring carbon credits to an open blockchain, allowing everyone to have an access to the carbon markets. The protocol has built Carbon Bridge to tokenize the carbon credits by transferring certified carbon credits onto Toucan’s system and mint TC02 carbon tokens. TC02 carbon tokens can be staked into Toucan’s carbon pools with each pool linked to credits with similar characteristics and receive carbon pool tokens, a fungible token backed by one tokenized carbon credit. This mechanism allows carbon pool tokens to be traded in decentralized exchanges and used as collateral in the lending markets, paving the green building block in Web3.
The transparent nature of blockchain as well as smart contracts, a self-executing program that automatically executes the required actions if the conditions are met, could help companies to comply with the ESG standards. As the companies are able to trace its supply chain, they could report the emission and trading of carbon offset in a more accurate manner. Furthermore, smart contracts could help automate the enforcement of sustainability and ethical practices. This could help smaller companies with limited time and resources in their ESG monitoring and reporting endeavors. One of the companies helping companies to comply with ESG reporting using blockchain technology is Diginex. Its DiginexClimate integrates climate-related data to the existing ESG reports that companies have to do and comply with the company’s reporting requirements covering different frameworks such as GRI, SASB and TCFD. The solution could greatly save time and cost for businesses following the ESG standards.
Social x Blockchain
It is undeniable that the general media usually ties cryptocurrencies with criminal activities. However, according to Chainanalysis, in 2022, only 0.24% of all cryptocurrency transaction volume is associated with illicit activity. In contrast, cryptocurrency and blockchain could bring the ‘good’ to society by providing solutions to promote financial inclusion and facilitate humanitarian causes. The most developed use case is payment for cross-border payments, domestic transactions and payment for humanitarian causes.
Due to Blockchain’s decentralized nature and the ability to transact without intermediaries, crypto transactions could be faster, cheaper, inclusive and censorship-free. This means that cross-border transfers can be made with smaller amounts at a much lower cost than the traditional money transfer. A report by Oliver Wyman and J.P Morgan found that digital currencies could save global corporations $120 billion a year in transaction costs for cross-border payments. They are arguably a better alternative than cash in countries with volatile and/or depreciating local currencies.
Nations are separated into two schools of thoughts regarding regulations of crypto as means of payment. Thailand and China as examples of viewing crypto as means of payment on a stricter side. While Thailand has regulations supporting digital asset businesses, the country banned cryptocurrencies as a method of payment. The Thai Securities and Exchange Commission (Thai SEC) stated that digital assets do not provide improved efficiency to the payment market because of their volatility and high transaction fees. China wiped out trading and cryptocurrency mining.
El Salvador and Ukraine, on the other hand, legalized crypto transactions. El Salador has made bitcoin a legal currency and aimed to become a hub for crypto activity. Additionally, in 2022, Ukraine passed a law that creates a legal framework for the cryptocurrency industry in the country. The first use case was accepting donations toward its military defense against Russia via bitcoin and ether.
Payment for Humanitarian Causes
Apart from the commercial use case of payment, cryptocurrency could also support humanitarian causes. One of the prime examples is a project by the United Nations High Commissioner for Refugees (UNHCR) and the Stellar Development Foundation, a nonprofit that supports the growth of the Stellar blockchain network. UNHCR realized that some refugees do not have a bank account and cash is difficult to move around. The two organizations are working alongside MoneyGram, a money transfer company, and Circle Internet Financial, an issuer of the USDC stablecoin, to deploy an alternative system to send aid directly to Ukrainian refugees using cryptocurrencies. The UNHCR delivers USDC through the Stellar network to a refugees’ digital wallet installed in their smartphones. The refugees then exchange USDC for local currency at the MoneyGram facilities.
Governance x Blockchain
Blockchain advocates argue that decentralization promotes good governance from the absence of a single point of failure. No single entity has control over the network. Nevertheless, to fully and properly govern the networks, it will take time for stakeholders to participate, design and enforce rules to ensure stability, and penalize bad actors. There are two emerging use cases for the Governance aspect that blockchain could provide value-adds on the transparency consisting of measuring and assessing ESG milestones and blockchain voting.
Measurement and Assessment of ESG Milestones
Blockchain networks with decentralized databases could help entities measure and prove ESG milestones. Participants in the network may include vendors, suppliers, internal business divisions to share information such as product tracking, carbon emissions and labor conditions. Smart contracts embedded in the blockchain networks can be applied to automatically disclose the data, all without the need for human intervention. The regulators or a credible third party could securely access the collected data and verify whether the organizations are meeting standards as claimed. Blockchain could act as a tool to boost transparency.
Blockchain voting has been in discussion globally. This use case is still in its early stages, and there are many challenges to be addressed through several pilot testing before implementing nationwide. However, several countries have put efforts and endorse blockchain voting. In October 2022, Cointelegraph reported that Greenland was exploring an online voting platform, which may be based on blockchain. In November 2022, South Korea became the first country to set up an online voting system based on blockchain making sure each vote is secured and cannot be manipulated. In India, blockchain-based voting has been tested for Telagana’s municipal election in 2021. The pilot showed positive signs; however, more pilots are needed to fully implement the system.
Challenges of Utilizing Blockchain in the ESG Space
Despite a lot of benefits that blockchain technology could bring to support ESG initiatives, there are a few points that also need to be considered as blockchain is not problem-free. The current challenges of using blockchain can be seen from both the technology layer and its applications across Environmental, Social and Governance aspects.
Technology Layer of Blockchain
Blockchain is mainly a backend enabler
Blockchain technology does not help businesses determine what kind of data to collect, measure or verify but it is rather an enabler to make the process more efficient. It is important to determine which types of data, verified or unverified, to be uploaded to a distributed ledger or set rules on how to differentiate them as the uploaded data cannot be changed and can affect business’s data usage and compliance with the ESG standards.
Blockchain technology is still in its early days
Blockchain technology is considered as an emerging technology. The infrastructure is yet to be fully developed despite its proposed potential to disrupt several industries. Additionally, companies across verticals are still at the beginning stage to integrate blockchain to their current operations. Therefore, the technology is still evolving and it has to be developed in parallel with the initiatives in the ESG space through trial and error.
Applications of Blockchain Across ESG Aspects
(E) Utilizing energy-inefficient blockchain create environmental impact
By using blockchain with Proof of Work (POW) consensus like Bitcoin, it is very energy-inefficient as the miners who compete among themselves need to use a lot of electricity to tackle computational problems to get a chance to validate the transaction and receive reward. It creates more problems than trying to solve the environmental impact. Therefore, it is crucial to use energy-efficient blockchain, which can be Proof of Stake (POS) consensus, to decrease carbon emission or use POW blockchain that uses electricity from renewable energy sources.
(S) Crypto space has been plagued with fraud and cybercrime
Given the nature of blockchain, it attracts fraudsters to continue to exploit user’s funds as crypto transactions could not be reversed and no personal data is required to receive cryptocurrencies for the non-custodial wallet. The safety of user’s funds is often compromised and causes tremendous loss to the users. It is very important for both centralized and decentralized platforms to step up in the game to enhance their technology stacks/codes to increase platform securities, improve ID-proofing without increasing onboarding friction and/or utilize data enrichment tools to get to know more about the users. These solutions could help prevent scammers from participating in crypto activities.
(G) Blockchain also subjects to risks of bias and conflict of interest
Despite blockchain’s benefits of transparency and automation, the design of the blockchain that involves human decision-making can be flawed with human biases. Conflict of interest also arises when people behind the code design do not put the users at heart. Certain groups of users, especially minorities or marginalized populations, might be treated differently and not have the access to a particular product/service or users’ data might not be properly managed. Ethical code of conduct and regulations could potentially solve the issues and govern blockchain technology. There is no bullet-proof solution at the moment and awareness on these risks is needed to be able to utilize the technology in a fair and appropriate manner.
How the Concept can be Applied to Financial Institutions
Apart from using blockchain as a backend technology for financial institutions (FIs), the institutional adoption of Web 3.0 is becoming an increasingly popular topic as digital assets are seen as a portfolio diversifier and can create more yields in a portfolio and treasury account. A relatively new concept such as Regenerative Finance (ReFi) is also being discussed on how Web 3.0 and FIs could play in the space such as responsible lending by taking into account environmental and social factors.
While Web 3.0 gives people sole control over data and assets, it comes with complexity. Unclear regulations, complicated user experience and limited scalability and interoperability hinder the growth of institutional adoption in the space. Web 2.5 may help solve the issue. Web 2.5 is used to describe blockchain businesses that operate in between Web 2.0 and Web 3.0. “The idea behind Web 2.5 is that consumers want the advantages of a blockchain-based platform. However, they don’t want the complexities and friction that often come with blockchain-based systems.”, DropChain explained.
Web 2.5 takes advantage of both worlds by prioritizing privacy and decentralized nature while maintaining the ease and accessibility. Blockchain technology is used at the infrastructure level and appropriate Know Your Customer (KYC) measures take place to mitigate the risks for sensitive financial data.
With the concept of Web 2.5, blockchain could help solve the challenge of FIs and their customers across ESG aspects.
- Improve Internal Infrastructure
Financial Institutions could build and/or integrate blockchain-based Infrastructure for collecting, tracking and tracing data for ESG-linked bonds, green loan origination and credit rating embedded with ESG factors. As multiple parties are involved in ESG measurement from data collection to validation, Web 2.5 could bridge the gap by providing a secure and transparent platform with ease of use to all parties.
- Collaborate with External Parties
Financial Institutions can collaborate with external parties by leveraging their solid compliance capabilities or partnering with blockchain companies to expand reach of existing businesses or build new products/services. FIs could provide modular services such as KYC services to partners and clients to reduce risks and comply with current regulation and ESG standards. FIs could also partner with trusted blockchain companies to support open finance initiatives and improve financial inclusion such as providing access to low-cost cross-border payment for foreign workers or unsecured personal loan.
Although blockchain proposes a lot of potentials to support the growth of sustainability going forward, the technology is not a panacea for tackling all the sustainability issues and there are a number of challenges that blockchain has to overcome to maximize its capabilities. The organizations including financial institutions need to define their sustainability goal then initiate strategies which involve the identification of which tools, technologies and partners would work best for them to accomplish impactful outcomes for the organizations and the society.
Editor: Woraphot Kingkawkantong (Ping)