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11/08/20
Blockchain And The Future Of Sustainable Investing
Throughout our history, humans have leveraged technology to bring about a more sustainable future. As early as the third century BCE, the Indian emperor Ashoka issued edicts on topics including animal welfare and the importance of environmental stewardship on stone pillars erected throughout his country—the ancient equivalent of an email blast to a nation of subjects—while renewable energy reliant upon wind, water, and biomass fuelled the development of human civilisation up until the mid-19th century.
It's no surprise, then, that many have seen the relatively recent financialisation of our world as not only an opportunity to profit, but yet another chance to create new processes and tools to build a better future. One of those processes, the concept of sustainable investing, or the idea that an investment strategy can generate both attractive financial returns and positive social or environmental change, is rapidly growing in popularity. According to Morningstar, the market research firm, net investment flows into open-ended and exchange‑traded sustainable funds available to US investors totalled almost US$21 billion in 2019, about four times the amount in 2018.[i]
At the same time, the use of blockchain has exploded onto the world stage. By one estimate, the market for this exciting new technology will grow at a staggering CAGR of 67.3 per cent over the next five years, from US$3 billion in 2020 to US$39.7 billion by 2025.[ii] The convergence of these two powerful trends has already resulted in the creation of new tools for creating a better world: sustainable financial products built on blockchain technology with the potential to bring unprecedented changes to global business and corresponding new investment opportunities. Ultimately, these developments present new opportunities for investors and wealth managers to consider as they approach this next phase of our collective journey toward sustainability.
Blockchain Explained
To date, the public's attention to blockchain has largely focused on its application to tradeable cryptocurrencies like Bitcoin and Ethereum. The underlying technology, however, has implications far beyond digital currencies. At its most basic, a blockchain is a ledger of records (called "blocks") linked together using a system of cryptographic codes. Each block contains (1) data (for example, transaction information) converted into code using a cryptographic function; (2) a timestamp for when the block was entered into the blockchain; and (3) a cryptographic code corresponding to the block that precedes it. Before a block of information is entered into the blockchain, other users in the network must verify that the information is accurate. To facilitate the verification process, the complete ledger is shared among a network of users (which may be a private group or the general public) so that all entities within the network have access to the same information.
Blockchain proponents often cite three principal benefits:
- Information stored on the blockchain is immutable. As all blocks are tied together with a system of cryptographic codes that build upon each other, even slight changes to the data stored in an existing block (for example, capitalising a letter originally input in lowercase font) would noticeably change the entire blockchain;
- Blockchain brings complete transparency to the data that it stores. Anyone with access to the relevant network can review a blockchain in its complete form, including all of the information ever recorded on it, at any time; and
- The system is decentralised, meaning that network participants need not trust one central authority to verify the information recorded on the blockchain. Decentralisation makes the information verification process more efficient and resilient.
The result is a digital ledger that is immutable, transparent, reliable and, with the appropriate amount of computing power, more time and cost efficient than traditional information sharing processes.
The Future of Data
At some point in the distant future, it's possible that all sustainable investments (and, indeed, all transactions) will be made entirely in cryptocurrencies reliant upon blockchain technology. In the near term, however, blockchain could impact the sustainable investing space most significantly through its application to data collection, analysis, and verification.
According to the UN's Principles for Responsible Investment (UNPRI), sustainability data "needs to be consistent, comparable, reliable, clear and efficient" to provide useful information to investors.[iii] Blockchain technology provides a unique platform that can be used to meet these goals and may create new opportunities for investors, data providers, and data users. As the generation of sustainability data increases and the applications for the analysis and use of that data grow, investors will increasingly demand greater quantities of reliable information. In response, data providers and users may charge enhanced premiums for access to high-quality, blockchain-enabled sustainability data. These and other opportunities have led entrepreneurs around the world to develop innovative blockchain solutions that could significantly improve the ability of investors to assess existing or prospective sustainable investments.
Blockchain, IoT And The Environment
In the environmental space, the combination of blockchain with Internet-of-Things (IoT) technology is particularly encouraging for investors. IoT refers to a system of connected "smart" computing devices and machines with the ability to automatically record data and transfer it over a network. IoT devices relevant in the context of environmental concerns include electrical meters and carbon emissions monitors which can operate without human supervision to provide a continuous record of an asset's environmental impact. In the case of renewable power, for example, an IoT-enabled electrical meter can record a power plant's output in real time. That data could then be verified by participants in a public or private network (which may consist of sustainable investors, authorities, regulators, and others) and uploaded into its blockchain, at which point it becomes an immutable and reliable statement of the asset's environmental performance.
This process has significant implications for both an investor's ability to evaluate a prospective investment and a company's ability to report on its ongoing performance. Importantly for debt investors, these benefits implicate two of the four "core components" of the Green Bond Principles ( GBP), a leading set of voluntary standards for issuing environmentally‑sustainable bonds used in over 435 transactions to date, according to data from the International Capital Markets Association (ICMA).[iv] The GBP encourage issuers to maintain a "high level of transparency" and "clearly communicate" environmental sustainability objectives and information to prospective investors.[v] Specific quantitative performance measures, such as electricity generated or greenhouse gas emissions reduced, are particularly valuable data points.
In short, the blockchain can be tailor-made to collect and report such information in a secure, transparent, and verifiable manner. Within the GBP framework, issuers can point to their historical environmental data on a blockchain as reliable evidence of sustainability when seeking new investments. As studies suggest that sustainable investments are less volatile,[vi] this information could lead to lower interest rates for issuers while allowing investors to make better decisions based on more robust data. Further, scrupulous investors can require issuers to adhere to blockchain-enabled monitoring schemes as a condition to investment, enhancing their ability to assess compliance with quantitative standards set out in the investment documentation (e.g. the issuer's production of a certain amount of renewable energy). The market for this innovative application of the blockchain to sustainable finance kicked off at the end of 2019 with the launch of "Green Assets Wallet", promoted as the "first blockchain platform for validating green bonds and reporting on green impact".[vii]
Digital Environmental Assets
In addition to improving existing environmental financial products like green bonds and emission reduction certificates, the combination of blockchain and IoT technology could create entirely new asset classes. For example, the information in a company's environmental performance record can be converted into tradeable digital instruments, such as digital renewable energy certificates (dRECs). These digital instruments represent the positive environmental attributes associated with an asset, which may include kilowatt-hours of renewable power generated or reductions in greenhouse gas emissions. Market participants can invest in and trade the instruments on a sustainable investing network, with the proceeds of investment driving the reduction of critical greenhouse gas emissions. An exchange facilitating the transfer of these instruments can further leverage the blockchain's ability to provide transparent purchase and sale transaction records to create new, efficient markets for these "green credits".
One such platform, Allinfra Climate, is already leveraging blockchain technology in an integrated platform to create, track and trade environmental products.[viii] It seems the marriage of blockchain, IoT and environmental markets is already underway, while preserving critical aspects of existing initiatives, such as the UN's Paris Climate Agreement and The Climate Group's RE100, is important. Bill Kentrup, co-founder of Allinfra Climate and long-time climate markets investor, says: “Our approach has not been to integrate blockchain wherever possible, but rather use blockchain in highly targeted ways that reduce risk for market participants and unlock climate finance at a scale that was previously impossible. This platform not only applies to renewable energy assets, but to nearly any asset where climate-relevant data is reliably collected, with the resulting dRECs recorded, minted, traded and retired on the blockchain and leaving a traceable, permanent and immutable record of climate action.”
Blockchain For Global Supply Chains
In a broader operational context, blockchain's key business application may come in the form of supply chain "traceability". The global nature of supply chains means that raw materials often travel thousands of miles and may be processed in numerous countries until they finally meet the end user. This complex logistical network makes it difficult for customers and investors to obtain reliable, transparent, and timely information about a product and its origins, potentially obscuring health and environmental risks, as well as human rights and labour violations throughout the supply chain.[ix]
Blockchain technology can reduce these investment risks in a unique way. A company's suppliers (or even automated IoT technology) can record information about the company's raw materials or retail goods as they move across the world. That information can include data about a product's origins, its current location and quality, and even the working conditions in which it is processed. When a company verifies and uploads this data into a private or public blockchain, the relevant network of users can look to that ledger for reliable evidence of a specific product's history and, in general, the sustainability of that company's supply chain.
A Public Supply Chain Ledger
As the use cases are clear and the benefits potentially significant, the incorporation of blockchain technology into the supply chain is already moving at a rapid pace. According to the World Economic Forum (WEF), many companies are already utilising private blockchain networks to track their own raw materials throughout the supply chain, and some are even making parts of that data public. The WEF notes, however, that "about 90% of customers want big brands to help them be environmentally friendly and ethical", but there are few, if any, completely public blockchains for supply chain data that they can turn to.[x]
Accordingly, the WEF recently launched a pilot programme to develop a free, public blockchain traceability platform that will allow customers to view supply chain data from all of its contributing companies on demand.[xi] A company's participation in a public blockchain of this type could have a twofold impact for investors:
- Investors themselves can analyse the reliable, transparent information on the blockchain to assess the sustainability of a company's supply chain; and
- A public and verifiable commitment to supply chain sustainability may improve a company's brand, expand its market to include more of the world's increasingly sustainability-minded consumer base, and, overall, improve business performance.
Blockchain And Risk Reduction
In addition to the potential to grow profits and increase investment returns, a blockchain-enabled supply chain can reduce a company's downside risk, which may be just as attractive to certain investors. For example, certain retail companies now require fresh produce suppliers to contribute product-tracking information to private blockchain databases. In the event of an outbreak of a disease like E. coli, these companies can rapidly identify the source of contamination and the specific affected products on their shelves. This process limits the amount of inventory that must be destroyed and helps establish trust among customers and the broader market that these companies can take swift action to protect public health in an emergency.
Risk reduction benefits can also extend into the social realm. A blockchain-enabled record of a product's origins can help end users avoid raw materials and products from untrustworthy suppliers, or from areas where violations of human rights and fair labour practices are common. In industries where these risks are prevalent (e.g. garments, palm oil, manufacturing, diamonds), companies must take great care to ensure their supply chains are safe. Here, the incorporation of blockchain can not only help combat unfair practices in the first instance but may also provide a helpful defence to the reputational risk that would almost certainly arise if they are uncovered in the future. The blockchain could reveal to customers, suppliers, and the market almost everything that a company knows about its product origins and, hopefully, the measures that it takes to prevent bad behaviour. Accordingly, investors considering an investment in any company with potential health or reputational risks tied to product origin will, increasingly, demand the implementation of traceability systems built on the blockchain.
The Path Forward
Investors and wealth managers are participating in a truly unique market, in which unprecedented investor interest in sustainability concepts and the development of a technology that could help shape human development in the 21st century are converging. As we assess the dynamic, emerging developments in the application of blockchain to sustainable investing, the future will be difficult to predict. If history is any indication, however, we can be certain of one thing: our ability to harness new technologies to contribute to a brighter, more sustainable future will only grow with time.
Footnotes:
[i] J. Hale, Ph.D., CFA, Morningstar, "Sustainable Fund Flows in 2019 Smash Previous Records" (10 January 2020), available at: https://www.morningstar.com/articles/961765/sustainable-fund-flows-in-2019-smash-previous-records
[ii] PR Newswire, Yahoo Finance, "The global blockchain market size is expected to grow from USD 3.0 billion in 2020 to USD 39.7 billion by 2025, at a Compound Annual Growth Rate (CAGR) or 67.3%" (13 May 2020), available at: https://finance.yahoo.com/news/global-blockchain-market-size-expected-140000250.html
[iii] UNPRI, "Investor Priorities for the EU Green Deal" (April 2020), p. 20, available at: https://www.unpri.org/download?ac=10494
[iv] ICMA, "Green, Social and Sustainability bonds database", available at: https://www.icmagroup.org/green-social-and-sustainability-bonds/green-social-and-sustainability-bonds-database
[v] ICMA, "Green Bond Principles" (June 2018), available at: https://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/June-2018/Green-Bond-Principles---June-2018-140618-WEB.pdf
[vi] New Amsterdam Partners, UNPRI, "Linking ESG ratings to returns and volatility", available at: https://www.unpri.org/listed-equity/linking-esg-ratings-to-returns-and-volatility/164.article
[vii] Green Assets Wallet, Press Release, "Launch of the Green Assets Wallet" (12 December 2019), available at: https://greenassetswallet.org/news/2019/12/12/launch-of-the-green-assets-wallet
[viii] Allinfra Climate, additional information available at: https://climate.allinfra.com/
[ix] M. Uhrynuk and A. Burdulia, "Understanding the "S" in ESG: Guidance for Asset Managers and Investors in a COVID-19 Paradigm and Beyond" (1 April 2020), available at: https://www.mayerbrown.com/en/perspectives-events/publications/2020/04/understanding-the-s-in-esg-guidance-for-asset-managers-and-investors-in-a-covid-19-paradigm-and-beyond
[x] Ledger Insights, "WEF launches blockchain traceability platform for sustainability" (January 2020), available at: https://www.ledgerinsights.com/wef-blockchain-traceability-sustainability/
[xi] WEF, "An Open Platform for Traceability: Accelerating Transparency and Sustainability Across Manufacturing Ecosystems" (January 2020), available at: http://www3.weforum.org/docs/WEF_Accelerating_Digital_Traceability_for_Sustainable_Production_2019.pdf
Mark Uhrynuk
Mark Uhrynuk is a partner of Mayer Brown resident in the Hong Kong office. Mark represents assets managers, family offices and other investor groups, corporations, and financial institutions in a variety of transactional matters. His wide-ranging experience includes private equity and venture capital investment and related financings; cross-border mergers, acquisitions, divestitures, joint ventures and strategic alliances; investment fund matters, including the formation of private equity, infrastructure and real estate funds; and international equity and debt capital markets transactions.
Mark is a key contact point for the ESG Initiative within the Mayer Brown network and is a founding member of the Firm’s ESG Steering Committee. Mark also co-leads the Firm’s Family Office Initiative in the region. An active thought leader in these fields, Mark has been widely quoted by the leading media and has authored a number of articles and legal updates on these and related topics.
Mark is qualified as a lawyer and has practiced law in Hong Kong, New York and England. According to IFLR1000 (2021), clients say “Mark has deep experience in the field. He knows how to get deals done and has years of global practice experience to draw on to ensure we are able to see issues from all sides and pick the best path forward." Mark has been nominated as highly regarded Hong Kong lawyer by IFLR1000 for and Private Equity (2018-2021) and Mergers and Acquisitions (2018-2021).
Alexander Burdulia
Alexander Burdulia is an Associate Sustainability Director at Sedgwick Richardson in Hong Kong, where he focuses on sustainability and ESG projects for multinationals in Asia. His experience covers strategy development, materiality assessment, rating requirements, stakeholder engagement, governance, policies, benchmarking and reporting in multiple sectors including financial services and real estate. A former private equity lawyer, he helped develop Mayer Brown's ESG product group and was a member of the firm's global ESG Steering Committee. He also served as the Head of APAC Public Policy at Credit Suisse, where he covered sustainable finance and other financial services regulatory and policy matters across Asia. Alex holds a JD from the University of Pennsylvania, a BA from Rutgers University and a Certificate in Management from the Wharton School of the University of Pennsylvania.
