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Blockchain’s Potential to Enhance Transparency and Efficiency for Responsible Investments

Opinion

Blockchain’s Potential to Enhance Transparency and Efficiency for Responsible Investments

Millennials Favor Socially Responsible Investing—Are They Getting What They Paid For?

Demand for new ways to invest reflects an erosion of trust with the financial services industry after the Great Recession, during which the average American lost $70,000. Today, only 2% of Americans trust the industry to do what is in their best interest, which is a problem for financial institutions seeking to attract new customers like millennials. However, millennials’ entrance into the workforce and accumulation of wealth is spawning a new species of clients for financial institutions: young investors who are tech savvy, demanding of transparency, and not only concerned with returns when they invest.

Environmental, Social, and Corporate Governance (ESG) principles are driving the decisions of young investors, who seek to invest in socially responsible and sustainable companies: those with solid track records integrating ethics into their business models by embracing social impact issues and adopting environmental sustainability initiatives. Financial institutions are meeting this demand by developing “ESG” funds, unsurprising given that millennials will inherit approximately $30 trillion from baby boomers by 2050. Everyday investors would be surprised to learn, however, that many ESG funds are tied to companies like Philip Morris and ExxonMobil (Exxon), firms with dubious claims for ESG stamps-of-approval. This mislabeling is attributable to a lack of transparency into financial institutions, which have considerable discretion in how they market novel investment products, such as high-fee ESG funds.

The Problem: A Lack of ESG Standards

A lack of objective standards guiding the articulation of ESG-criteria has led financial institutions to develop disparate ESG classification methodologies. There is little agreement on what constitutes an ESG investment, causing companies to be assessed under different standards by different institutions, raising doubt over ESG funds’ legitimacy. For example, Daimler is included in some ESG funds simply because the Mercedez-Benz manufacturer issued a statement about the risks and opportunities posed by climate change, despite standing accused of participation in the Volkswagen emission scandal. Exxon, an oil production company known for downplaying its environmental impact despite mounting evidence to the contrary, is also included in several ESG funds. Exxon and other major oil producers make the cut for ESG compliance because a robust corporate governance model (the Gin ESG) boosts a company’s overall ESG score. In sum, receiving the ESG designation diminishes public perceptions that these companies are contributing heavily to climate change (the Ein ESG) while enabling financial institutions to claim they invest only in companies with the “best in class” ESG practices.

Tracing Your ESG Investment

Market observers suggest young investors might be better served with blockchain technology, which operates on a distributed ledger and can screen investments that claim to be socially and environmentally sustainable against an ESG-compliant framework. As a result, socially responsible investors could know from the outset of their investments whether an ESG fund will invest in companies they aim to support. Because a distributed ledger gives rights to every participant in its value chain, the technology democratizes access to relevant information for everyday investors seeking to invest responsibly. Given millennials’ rising demand for a more honest understanding of how their money is managed, a blockchain would serve to meet these customers’ needs because of its capacity to track and trace information. Specifically, blockchain would allow millennials with different ESG motivations (e.g., Environmental vs. Social vs. Corporate Governance) to track how their funds are invested. For example, an investor seeking to invest in environmentally sustainable companies could track whether his or her ESG fund is backing companies with low carbon footprints, or companies like ExxonMobil. Using blockchain, investors could also receive real-time notifications about changes to their ESG funds, such as the addition of unsustainable investments, which would allow them to quickly divest of these investments rather than having to verify dispersed information with several independent third-parties.

Transparency & Trust

By providing pre-established rules (a protocol) stipulating what types of investments qualify for an ESG fund (on the basis of individual investors’ preferences) blockchain standardizes the process for verifying if a purported ESG-friendly company is, in fact, behaving responsibly. Everyday investors putting their money into these funds can rest assured that an agreed-upon automated process would uphold the integrity of their investments. Unilateral statements by companies like Daimler would no longer be sufficient to raise their overall ESG scores. Instead, the blockchain measuring a company’s ESG performance could mandate that actual steps be taken for an ESG-promoting input to take effect on the blockchain, which would raise the company’s overall ESG score whenever a block is added. These digital blocks would reflect corporate actions that objectively demonstrate ESG compliance, such as an automobile manufacturer’s new policy to reduce waste at different points in its supply chain. Because a blockchain requires approval from verified participants for new blocks to be added, companies purporting to be ESG-friendly would need the community’s approval before claiming credit for responsible conduct. Because a blockchain is immutable and not managed by a centralized authority, there would be little opportunity to tamper with a company’s ESG score as blocks would only be approved by a distributed, while trustworthy, network of customers, employees, regulators, and suppliers.

Conclusion

Financial institutions will continue reaping the benefits of ESG funds, because a lack of standards defining what constitutes a “responsible investment” permits firms to set ESG criteria on a discretionary basis. In addition, everyday investors have limited visibility into the financial institutions that manage their funds, an issue given that these firms are touting investments as ESG-compliant in a largely unregulated environment. These issues could be mitigated, however, by a blockchain’s ability to trace information. For example, an investor could track whether their money in a purported ESG fund is actually being invested in ESG-friendly companies. In addition, a blockchain’s standardized protocol would reduce subjectivity in the ESG fund management process, reducing costs for individual ESG investors. Taking comfort in bona-fide metrics that have been approved by a network of impartial stakeholders, investors will also know what they are getting when investing in ESG funds: an investment supporting companies with robust ethics across corporate operations.

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Andrés Franco is currently a JD/MBA candidate in the Class of 2020 at American University. Since graduating from Davidson College with a BA in History in 2015, Andrés’ graduate studies have focused on capital markets, the energy industry, regulatory policy, and emerging technologies. In 2017, Andrés was selected for the U.S. Securities and Exchange Commission (SEC)'s Student Honors Program, where he gained experience in the Division of Enforcement and the Division of Corporation Finance. In 2018, Andrés and his colleagues at the Washington College of Law founded the Blockchain & Cryptocurrency Law Society, a student-managed organization that seeks to generate interest in topics relating to distributed ledger technologies.

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