Bitcoin: the ESG conundrum

Two of the major investment stories in early 2021 have been the sharp rise in the value of Bitcoin, and the continued investor demand for products that prioritise the fight against climate change. As major stories, the two are odd bedfellows.

An unusual “asset”

Regular readers of our articles will know we are sceptical about the economic case for investing in Bitcoin. This is an “asset” with no backing, no income stream to support it and no issuer behind it. There is no transparency or investor protection, and both it and the exchanges it is held on and transacted on are totally unregulated – the exchanges regularly “lose” coins or “suffer fraud”, both probably euphemisms for theft by the exchange operators. Above all, it is a rigged market, the ultimate “insider job”:  95% of all bitcoins are held by just 2% of holders.

There is no pricing model which can price such an asset. It is literally without a rational value, and while we ought to note in parentheses that the fact that one cannot price Bitcoin using normal pricing models means that no single figure is any less likely to be a fair value of the coin than any other (the case for a price of $500,000 is as strong and valid as the case for a price of $5,000 … or indeed zero), it is hard to avoid the conclusion that the entire market is based on The Bigger Fool theory, ie “I cannot justify paying this for it, but I hope someone will pay me more than I paid to buy it”.

Be that as it may, Bitcoin continues to attract interest. Corporations are looking at Bitcoin as a home for spare corporate cash, the most high-profile being Tesla, who bought $1.5 billion of Bitcoins last month – though this has produced a backlash against their CEO Elon Musk as several prominent shareholders of Tesla are known to be unhappy at the idea of their company taking huge bets in such a volatile asset, with the company making (and then losing) more money in a week on their holding in Bitcoin than the profit from a year of making and selling cars.

Even more surprisingly to our mind, Bitcoin is also starting to attract investment from serious institutional fund managers. Though quite how the management of institutional asset managers assess the risks in Bitcoin and deem them suitable for any other than their raciest of clients, and quite how they will explain their positions to those clients if they go wrong, will be interesting to see – and they may have some explaining to do to their regulators and shareholders too about the exercise of their fiduciary trust.

All of this has led to a rally in the price of Bitcoin (it passed $57,000 a week ago, before a correction) and has prompted a flurry of speculation over what the upside potential might be. One forecast suggested that the price could hit $300,000 before the end of 2021, helped by the knowledge that supply will be capped at 21 million coins and the fact that over 18 million have already been mined.

An ESG Conundrum

And this is where the ESG conundrum comes in. Tesla’s recent Bitcoin purchase, which was described as “environmental idiocy” by the Financial Times, has helped to highlight the asset’s poor green credentials. All cryptocurrencies are intensive users of energy, and as Bitcoin is the largest cryptocurrency, it has the poorest green credentials. A huge amount of energy is required to create (or “mine”) the coin. More energy is required to maintain the blockchain (a version of distributed ledger technology) on which it exists. A recent report from Cambridge University revealed the startling news that Bitcoin now consumes as much energy in a year as Argentina – a country with a population of 45 million.

The energy consumption problem will probably get worse as Bitcoin issuance creeps toward the 21 million cap. The incentive to “mine” Bitcoin will increase as the dollar value of Bitcoin rises, because successful miners are paid with the coin. On top of this, the mathematical formula behind Bitcoin is designed to ensure that additional Bitcoins become gradually more difficult (and therefore time and energy consuming) to mine.

The criticism of Bitcoin’s ESG position has begun to prompt a public relations fightback. Not, so far, from those institutional asset managers who have bought into the story (we wait to see how they explain to their investors and shareholders how Bitcoin sits with their ESG commitments), but from more long-term Bitcoin fans.

The Bitcoin fight back

The riposte is based on three arguments. The first is that our conventional diet of fiat (or paper) currency also has a green cost, secondly that renewable energy is a key electricity provider in regions where Bitcoin mining is common, and finally that the energy footprint of Bitcoin is better than that of gold. A varied set of arguments that deserve analysis.

The argument that fiat money has an energy cost that is overlooked begins with the observation that bank branches (traditionally important in the distribution of fiat money) have a large lighting and heating need. It continues with the argument that notes and coins also have forestry, mining, and even a fuel distribution cost. It has even been suggested that the new polymer bank notes can’t easily be recycled (which we think is the reason for their invention … but let’s allow that one to pass), and hence score poorly compared to digital money.

These arguments have holes in them. As bank branches are being closed down, and the use of notes and coins in the economy shrinks, then the green footprint of old-fashioned currency is improving day by day (the opposite trend to Bitcoin). Secondly, the current fiat system already operates on the digital money created by commercial banks. This type of digital money has a much lower energy need than Bitcoin because it is created by a “stroke of the pen”, and does not need to be mined, or maintained using distributed ledger technology (DLT). Finally, we must recognise that bank branches offer other banking services apart from the storage and distribution of cash, making the comparison imperfect.

The point on renewable energy is based on the argument that although most Bitcoin mining is undertaken in China, where coal is a key source of electricity, many miners work in areas where hydroelectric power is a contributor to the grid. This may be true (we don’t know for sure where Bitcoin mining is undertaken), but hydroelectric power has mixed green credentials, courtesy of the cement required in construction, and the biodiversity loss associated with dam creation. For balance, we should point out that high-street bank branches might also operate on renewable energy.

The comparison with gold is interesting because both gold and Bitcoin should probably be classified as asset classes rather than currencies (they are a store of value, but not a very efficient medium of exchange). Mineral mining is a dirty and energy demanding business and the mining of gold is no exception. Crypto fans argue that the energy footprint of Bitcoin is only 40% that of producing gold. We don’t have evidence to dispute this, but instead would highlight that gold does have multiple uses, and the majority of gold that is mined each year is used in industry and jewellery, and not shaped into the gold bars (for storage) that would make this argument more relevant.

What about Central Bank Digital Currencies?

It has been suggested that the development of Central Bank Digital Currencies (CBDCs) will undermine the green credentials of central banks, because of the demands that CBDCs might place on energy supply. However, in contrast to Bitcoin, CBDCs are unlikely to require DLT, and instead they will probably operate on existing financial payments infrastructure. The Chinese pilot CBDC project supports this view.

However, even if CBDCs were to eventually operate on a DLT system in the future, an important difference would be that CBDC would not be mined, but simply created by the central bank at the flick of a switch. Bitcoin miners by contrast need to demonstrate “proof of work” to earn their Bitcoin rewards. Even if DLT was used, the difference in complexity between the technological framework required for CBDC and Bitcoin would be significant.

Layered on top of this is the fact that CBDC will be centralised (unsurprisingly, at the local central bank) rather than decentralised. This will allow simpler consensus algorithms to confirm wallet content. By contrast, Bitcoin is a system that is specifically designed to operate without the need to place trust in a central authority. Quite apart from this being an anathema to the Chinese authorities – for whom the central control and oversight is one of CBDC’s attractions – a decentralised ledger (where everybody can see everything) is by definition massive, and its enormous computing and electrical power requirement alone make it unsuitable for a nationwide CBDC.

In conclusion

We don’t know where the price of Bitcoin is going – there is no rational pricing model that can price the irrationality of investors – but despite the efforts of Bitcoin aficionados, it will continue to travel with poor ESG credentials, thanks to a high and growing energy footprint. This image problem for Bitcoin will not be solved by the introduction of CBDCs because they will not close the relative energy usage credibility gap to Bitcoin in a meaningful way.

We do know that the ESG investment revolution is real, that it is still gathering momentum, and for many investors is becoming the centrepiece of their core investment holdings.

Putting these two together, Green investment funds, and the major benchmark providers, are unlikely to be impressed with the poor credentials of cryptocurrencies such as Bitcoin that utilise blockchain or other distributed ledger technology. Despite the attempt at a spirited fightback, Bitcoin still has an unshakeable energy monkey on its back. These two headline‑making investment themes of 2021 are uncomfortable bedfellows, and there is little chance of that changing.