Apr 8, 2021
Blockchain — a new technology to manage ESG issues reliably?
Both, the term ESG (Environmental, Social and Governance) and the term blockchain are currently experiencing and unprecedented demand and are on everybody’s mind. The amount invested in ESG related investments has more than doubled from approx. USD 21 billion in 2019 to approx. USD 51.1 billion in 2020, there is an increasing number on indices focusing on ESG matters and the companies’ ESG strategies are becoming more advanced and sophisticated. The blockchain technology, that was only associated with the crypto currency Bitcoin in the past decade, has now got much more traction. The amount spent on blockchain has increased from approx. USD 1 billion in 2017 to USD 4.1 billion in 2020 and is expected to reach approx. USD 17.9 billion in 2024. At the same time, more and more organizations are currently analyzing use cases for a broader set of applications. This includes, inter alia, whether the blockchain technology will be a reliable solution to many of the ESG issues that companies face every day.
What is blockchain technology?
The blockchain technology has undergone significant development since it was first mentioned in 2008 as part of Bitcoin by Satoshi Nakamoto — not only from a technology perspective but also from the variety of its use cases: finance, supply chain and healthcare, to mention some examples. Blockchain is designed to record specific transactions and events that are shared across a network of parties where transparency and collaboration is required.
The central element of blockchain technology is information being stored and shared between different parties. Blockchain falls into the category of distributed ledger technology (“DLT”). The key fact is, that the ledger containing all the records of information is shared between a network of peers rather than being stored in a central location and administered with a single authority. All users of the decentralized ledger maintain their own copy of the ledger, where they validate new entries to the chain through the use of a consensus protocol (see Fig. 1).
The distributed ledger is characterized by a continuously growing list of records, that are linked together in a sequence to create a ledger and where the blockchain technology comes into play:
The blockchain technology consists of the following elements: (i) a set of (transaction) data — a block, (ii) hashes, (iii) nodes and (iv) proof-of-work. Each block is linked to the previous one and thereby forming a chain. The linkage is made by using a cryptography so that it is virtually impossible to decode the block (see Fig. 2).
The advantage over a centralized ledger technology is that every block contains a complete history of everything that has ever happened in the chain before it. Each block is identified with a hash, an alphanumeric value. If someone wishes to create a new block (e.g. as a new entry shall be made or new transaction data to be added) this request will be evaluated by the network users, the nodes. The evaluation will be based on a complex algorithm to check it if it is valid against pre-set criteria. This process is called proof-of-work. This proof-of-work is necessary, as everybody can add information to the blockchain and therefore all new information must be reviewed and confirmed before being accepted. Only if the majority of the users individually conclude that the transaction is valid against pre-set criteria the new block will be added to the blockchain, time-stamped and given a unique identifier. In a last step, the members of the network will be provided with an updated version of the ledger.
What are the advantages of blockchain technology?
Even though blockchain technology was primarily developed for cryptocurrencies, its potential scope of application goes far beyond it what already can be seen in certain sectors/industries. The advantages of the blockchain technology are:
Ø Collaboration
No central “authority” is required. Even two or more parties not knowing each other can work confidentially together without the need for intermediaries. Inefficiencies and transaction costs can be avoided.
Ø Transparency
Each transaction is copied to the computers in the network. The detailed list of every transaction or record of information is accessible by every participant (or selected participants in a private network).
Ø Security
The high security of the blockchain technology is achieved as the identity of the individual entering the network is linked to his account. Additionally, there is a reliable chain of cryptographic hashes, which includes the previous hash value once a new block is created. Last but not least, the ledger is not stored in one location, but rather duplicated across the entire network — meaning the ledger cannot be manipulated, stolen or corrupted from a single location.
Ø Accuracy
Blockchain is construed by the consensus of the network; each new block will be automatically checked before it is added, which results in an accurate record of information.
Ø Consistency
Users on the network have identical copies of the ledger as opposed to there being multiple individual copies that are stored locally and can become unsynchronized.
Ø Timing
Normally, a transaction takes time. The blockchain updates at set intervals, with the ledger held by each individual user being updated near-instantly.
Which ESG issues can be resolved by the use of blockchain?
Monitoring and being compliant with ESG standards can be a challenge for the company for several reasons, such as unreliable information. The blockchain technology addresses precisely this problem and has to be considered as suitable solution to resolve certain ESG issues, such as the following:
Ø Supply Chain
Supply chains have become more and more complex throughout the years. Before the product reaches the end-customer, it is common that several suppliers are involved and that the products pass multiple parties. The four “pain points” of a supply chain, namely: traceability, flexibility, stakeholder management and in particular, compliance, will be a challenge for the companies regarding monitoring and managing. The blockchain technology provides a full audit trail, as all suppliers alongside the supply chain are invited to the network. Every time a product changes hands within the supply chain, its precise location and time-stamp is documented by creating a new block. Once a product is sold, the ledger contains the history of the respective product from the manufacturing to its sale. This mechanism gives the business increased confidence in the authenticity and quality of goods, impacting sourcing decisions and the compliance with (certain) ESG factors.
As regards to the environmental sustainability, the blockchain technology can enhance for example (i) environmental emission, as it allows participants to track amount of emissions, (ii) resource management, as origin of raw materials can be monitored and (iii) waste management, as companies can track their waste, making it possible to recycle, reuse or properly take care of those wastes. Social sustainability can be achieved by building a transparent procedure with the help of blockchain technology. Supplier’s operations can be verified and potential unethical sourcing issues (e.g. child labor and human trafficking) can be prevented.
Last but not least, governance (or economic) sustainability requires a robust management structure to ensure transparency, traceability and accountability to strengthen relations with stakeholders. Both, the access to accurate and reliable information and the solution to asymmetric information issue can be achieved by the implementation and use of blockchain technology.
Ø Anti-Money Laundering (“AML”)
The amount of the money laundered globally is estimated to be 2–5% of the global GDP, or approx. USD 800 billion to USD 2 trillion. To prevent money laundering, financial institutions/funds have established and developed processes (so called Know Your Customer (“KYC”) or Customer Due Diligences (“CDD”)) and frameworks that increase compliance and introduce greater levels of regulations in the system to comply with KYC and new AML guidelines as the old ones have been criticized to be ineffective. Currently, background checks can take days or weeks to satisfy the increasing demand of regulators.
Most AML efforts that are currently implemented are highly individualistic, with each financial institution deploying its own solution and every country having its own laws to prevent money laundering. There is also not enough standardization and the lack of collaboration makes money laundering more challenging to detect and act against.
The implementation of blockchain for KYC/CDD processes would have a positive effect on their efficiency. The shared nature of the ledger allows to make all client activity and background information available to those on the network, with updates to a client’s status or fraudulent transactions. Those updates will be communicated in near real-time.
Ø Proxy Voting
The voting right is one of the most important right a shareholder has. In the past, the voting rights have only been exercised in a physical shareholder’s meeting either by the shareholders themselves or by authorized persons. However, proxies often have voting discretion and thereby use votes to fulfill their personal agendas which are not always aligned with shareholders’ interests. In addition to that, there is a danger of misuse of voting rights.
Lately, proxy voting — the process of voting remotely — has become more important, in particular since COVID-19 regulations have prohibited companies from summoning and holding physical shareholders’ meetings.
The current proxy voting systems have been proved to be cumbersome and inefficient, as voting instructions have been transmitted through a series of disconnected intermediaries. The fact that the various participants in the proxy voting process/instruction chain (e.g. sub-custodians, custodians and company registrars) have separate record-keeping systems will not easily allow for auditing and reconciliation of votes.
The above disadvantages can be eliminated by the use of blockchain technology. As an example, a voting system based on blockchain could be designed as follows: A ledger contains information on shareholder title, making it easy to determine who has voting rights. When it comes to exercising the voting rights, a shareholder receives a token and has the right to cast the vote. With this mechanism, the number of votes will correspond with (or be less than) the number of shares outstanding. Such design does not prevent the shareholders to use a proxy, as the token can be transferred to the proxy’s ledger. Therewith, transparency and trust in each proxy’s number of votes will be maintained. It is nearly impossible for proxies to cast votes beyond their authority, as those without proper tokens cannot be added to the ledger — there is only one token per share.
What risks does blockchain technology entail?
Like any technology, blockchain has more than just advantages — namely also disadvantages. The disadvantages mainly arouse of the circumstances, that this technology is rather new and is currently finding its way into the daily business.
Ø Compliance with data protection laws
Blockchain will face difficulties, when it comes to the compliance with data protection laws, in particular, with the EU’s General Data Protection Regulation (“GDPR”). The aim of the GDPR is to protect individuals’ rights for privacy by bringing the individual in control of their own data. It seems as if the GDPR was developed to target traditional database systems rather than being focused on “new” technologies such as blockchain. In particular, blockchain’s concept of immutability is contradictory to art. 17 of the GDPR, which sets forth the right to be forgotten. It has to be seen, how this contradiction will be resolved in the future.
Ø Regulation
Until today, the blockchain technology is hardly regulated. Consequently, investments in this technology are riskier as there could be sunk costs if today’s architecture of blockchain technology systems is not compliant with tomorrow’s regulatory landscape.
Ø No internationally recognized standard
Although the overall concept of blockchain is quite fixed and clear, the exact design and mechanism of network can vary. This missing internationally recognized standard can increase the costs and risk of investments.
Ø Energy consumption
As each user of the network is required to process cryptographic calculations and requirement for mining to power its operation, the processing power of a blockchain network is substantial. The estimates of energy consumption vary between 60 and 125 TWh per year for Bitcoin, which is in the range of the annual energy consumption of Austria or Norway.
Outlook
The blockchain technology becomes more and more accessible to a wide mass, including companies, which start to take this new technology seriously by integrating it into its business ecosystems. The fact of blockchain being a still quite young technology might require some research, development and co-operation in advance of the implementation of the specific use case. The users must be aware that this process might be costly and takes time. However, there are already proven use cases, also when it comes to address ESG matters (e.g: Walmart: tracking meat sold in its outlets, Maersk: shipping platform, Nestle: supply chain management).
The range of applications for and the companies that implement blockchain technology increases on a daily basis, what makes clear that this technology will not only be a short-term thing but is here to stay. It might not be so prominent in the headlines as the respective cryptocurrencies but in the “back-office” there is a high probability that the blockchain technology will start its triumphant march and become a disruptive technology given the exciting opportunities it provides to companies to tackle not only sustainability issues.
