This crypto rally can be different.
Crypto’s rise, then fall, then recent rise again, presents an opportunity for venture capitalists to invest more responsibly this time. FTX, which collapsed earlier this year, was deemed ‘a case study in bad governance’. Its downfall prompted the US Securities and Exchange Commission to take more aggressive action over the last 12 months targeting the likes of Coinbase, Kraken, and more recently, Binance.
While consideration of environmental, social and governance factors has penetrated other financial and investment sectors, crypto investors have largely failed to consider ESG factors. Ignorance of such risks increases the likelihood of bad behavior and ultimately failure.
Signs of a shift are emerging in public markets. Jacobi Asset Management this year received an European Union-compliant ESG label for the continent’s first Bitcoin exchange traded-fund.
New guidance from VentureESG, based on dozens of interviews with ecosystem participants, can help crypto investors in private markets address ESG concerns up front, and allow the technology to deliver on its promise of a more sustainable and socially responsible financial ecosystem.
Ups, downs, and up again
Recent events have brought the intersection of cryptocurrencies and ESG into sharp focus. A tumultuous year for crypto with a variety of explosions and collapses, with the FTX saga only being the tip of the iceberg, crypto’s ESG problem had become very obvious.
Now, the UK’s Financial Conduct Authority (FCA) outlined its 2023 priorities, which include ESG, crypto assets and AI, and in the same week the EU’s first Bitcoin exchange traded-fund (ETF) received the ESG label. The tensions are evident.
Zooming into the ETF, some surprising facts spring up: there had been no previous instance of a cryptocurrency being positioned as an ESG-compliant fund based on EU guidelines. Now, Jacobi Asset Management joins a diverse portfolio of Article 8 financial products with the fund’s ESG status anchored in its investment in renewable energy certificates (RECs). Jacobi has conveyed to investors that the Bitcoin ETF aims for full decarbonization.
The launch of the ETF is a great start but how far are other parts of the – mostly private – crypto and web3 industry dealing with ESG and responsible investing?
While ESG principles have been considered integral to traditional finance and investing for years – only further manifested by the EU’s SFDR rules which started to also impact the VC ecosystem this year – crypto and web3 have been (mostly) unregulated and unaffected by ESG. This needs to change, far beyond a single ETF, to turn crypto and web3’s promise of an alternative digital ecosystem into a reality.
More G is needed, but E is in focus
For many, the core of ESG is ‘G,’ governance. There is an obvious case for more focus on the G in crypto following the FTX failure. As the primary regulator of America’s capital markets, the SEC has long since expressed concerns about the compliance of large crypto exchanges with existing regulations.
First FTX, now Binance. Based on fraudulent activities related to customer funds, anti-money laundering, unlicensed money transmitting, and sanctions violations, the recent fine of $4.3B against Binance and its former-CEO Changpeng Zhao personally paying $50M has been described by prosecutors as “one of the largest corporate penalties in U.S. history.”
These moves reflect broader discourses within the industry regarding the classification of cryptocurrencies and which market they should operate in – especially since court decisions have recently largely swayed towards the crypto industry securing early victories in legal battles with regulators.
But right now, our conversations within crypto communities confirm that out of E, S and G, the environmental E is where insiders focus their action. Central to Jacobi’s strategic investment, for instance, are ways to invest directly in renewable-energy projects in return for digital renewable-energy certificates (REC), which offset carbon emissions from Bitcoin mining.
This approach aims to create a cleaner, more eco-friendly cryptocurrency landscape. It echoes similar eco-conscious developments in crypto such as the Sustainable Bitcoin Protocol, which financially incentivises Bitcoin miners to use verified clean energy – and for the first time ever, allows investors to sustainably own Bitcoin.
The Toucan Protocol’s transparency and accessibility also address E-concerns by ensuring credibility, combating greenwashing, and opening carbon trading to a broader range of participants while simplifying the complex carbon trading market. Toucan enables tokenized trading of carbon credits from the Voluntary Carbon Market (VCM) on a blockchain platform, facilitating the transfer of carbon credits onto the blockchain as crypto tokens, which can be purchased and retired by emitters to offset their environmental impact.
What is holding the crypto people back?
Skeptics are raising questions about the unconventional fusion of crypto and ESG. They doubt whether a Bitcoin-focused fund can genuinely meet ESG standards, given the energy-intensive nature of crypto mining, which consumes energy equivalent to entire countries. Judging from the enormous governance issues that are built into the value-system of the ecosystem – decentralization being the strongest one of those – a turn-around on that front seems highly unlikely.
In a research project developed by VentureESG and the Minderoo Centre for Technology and Democracy, University of Cambridge, VentureESG researchers have delved deep into the convergence of crypto and ESG, uncovering insights that shed light on the complex relationship between these historically mostly disparate realms.’We want to share three findings from the research, offering a glimpse into why crypto needs ESG:
- ESG terminology gap prevents engagement: The fundamental ethos of Web3, aimed at reshaping societal and economic norms, often diverges from traditional corporate practices which is what ESG is (still) mostly associated with. However, we found that this didn’t mean that crypto and Web3 participants were not having discussions around environmental, social, and governance principles; they are.
Some of the foundational use cases of Web3 are rooted in social empowerment and technologically-enabled democratization. Many Web3 participants, however, demand a new, crypto-specific language to address ESG concerns. We are unsure whether that is in fact the right way forward but see similar critiques of terminology also in the mainstream ESG ecosystem.
While we strongly suggest sticking to the widespread concept of ESG, the application of its principles are more important than the nomenclature. An alternative could be ‘responsible investing’ which has become more popular, e.g., among LPs in VC more generally. - Lack of incentive mechanisms can only be cured ‘from the top’: The absence of incentive mechanisms for ESG integration among venture capital investors reflects the practical challenges in incorporating ESG considerations into the crypto and Web3 ecosystem. This finding underscores the financial incentives and competitive landscape that currently deter VCs from prioritizing ESG within their investment processes and as part of their policy for portfolio companies.
Addressing this challenge from the top, i.e. through asset owners and limited partner (LP) pressure, is in everyone’s (financial) interest. Top-down requirements are essential for fostering responsible investment practices in the crypto sector. - Lack of formalised or structured tools: VCs and investors in the crypto and Web3 space often lack formal tools and structured processes for integrating ESG in investment decision making and due diligence; instead, as much of VC more generally, investors rely on personal judgments, (university) network, and strong emotions (such as the ‘fear of missing out’ currently driving the AI craze).
While the absence of concrete data, especially during early-stage evaluations, limits the applicability of standardized questionnaires, due diligence around ESG issues should not follow intuition alone. Overcoming the push-back from investors in particular depends on providing them with the right tools to integrate fit-for-purpose ESG into their investment decision.
These findings illuminate the need for tailored ESG approaches and frameworks within the crypto and web3 ecosystem, underscoring the evolving dynamics in this nascent but growing industry. This is where VentureESG saw value in developing a practical ESG framework tailored for VCs, focused on crypto and Web3 startups and projects.
ESG-crypto framework
The ESG-crypto framework (see the end of our report here) resulting from our interviews with over two dozen ecosystem participants aims to provide venture capitalists with essential guidance on ESG principles specific to the sector. This addresses a prior lack of consideration of these factors and unique material issues in due diligence processes and the ecosystem overall.
Our research highlights gaps in ESG recognition within the crypto space, as well as certain crypto-specific ESG issues such as NFTs, pseudo-anonymous communities, decentralized finance (DeFi) and tokenomics, and on/off-chain data.
The framework offers VCs a practical tool to enhance their due diligence process for crypto and Web3 investments, and can be used as an addendum to pre-existing investment processes VCs may already be using.
The guidance, for example, prompts investors to begin by questioning the need for blockchain technology in startup projects in due diligence while scrutinizing environmental impact, societal, and governance implications. It also helps them navigate industry-specific ESG concerns and promote responsible and sustainable practices in the crypto world.
As the crypto and Web3 space continue to evolve, it is clear that addressing ESG concerns is not only part of a responsible investment approach but also strategically and financially advantageous. FTX not only failed to yield any financial returns, but due to its governance failures, it also caused significant reputational trouble for its investors.
Crypto is an industry that clearly needs an ESG framework to start thinking more responsibly as legal ramifications continue to evolve. By embracing responsible investing principles, cryptocurrencies and blockchain technologies can not only mitigate their environmental impact but also enhance their credibility socially, attract a broader investor base, and contribute to the creation of a more sustainable and socially responsible financial ecosystem. The crypto world is at a pivotal juncture, and integrating ESG is not just a choice but a necessity for its longevity and hyped success.
Cessiah Lopez is a crypto research fellow at VentureESG.
Johannes Lenhard is co-director of VentureESG and researcher affiliate at the Minderoo Centre for Technology and Democracy at the University of Cambridge.
