The potential benefits of distributed ledger technology (DLT) are manifold, and may be exactly what the ESG bond market needs to reach the maturity levels required for such a large asset class.
Applied properly, DLT could mitigate the risks of greenwashing, facilitate transparency in use of proceeds reporting and bolster accountability.
Transparency is the key word. As the supply of green bonds grows, so too do investor demands that bonds act as labelled and contain no surprises. There is an overall rise in awareness of the risks of greenwashing in the sector as investors become more savvy to potential scams.
As such, the permanent, unalterable nature of digital ledger technology means that blockchain-based bonds are being touted as the potential solution. An ipso facto, inherent inability to lack transparency means blockchain can be a beam of trust and accountability for the industry.
And the hurdles for green bond issuers are only getting higher. As the years go by — and as more and more ESG-related bond supply is injected into the market — investors are only going to become more demanding about how issuers plans to meet sustainability goals, making transparency even more important.
By luck or coincidence, or maybe even design, the definitive transparency, structured data and analytical opportunities offered by DLT exactly align with the exact demands of the green bond market.
The use of proceeds for ESG assets is one way that digital tracing can come into play. A traceable on-chain bond lifecycle would allow intended use of proceeds to become programmable, and to directly link with the real-life features of the underlying asset.
Speaking during last week’s fintech and digitalisation Icma forum, Josselin Hebert, senior digital innovation officer at the European Stability Mechanism, said that because of their ability to allow investors to monitor data at any point along the process, private permission DLT networks can greatly enhance investors ability to invest in green bonds.
For example, the data that a particular bond receives from a green asset — say, a solar farm — is immense. The blockchain can record the gigawatts of electricity it produces, the costs of the solar panels, how many solar panels fail etc.
That data is essentially credit information that feeds into the smart contract automatically, and automatically alters the bond itself via its use of proceed clauses. This is an “incorruptible interpretation environment” for that green asset, coined a digital fintech founder.
Once the market infrastructure is up and running in order to support this automated smart-contract-executed process, issuers and investors will be able to manage an entirely different level of complexity of data input into the bond.
Beauty behind the madness
The elegance of the blockchain is that it is incorruptible, and the data it houses unmanipulatable. Harnessing this to find true transparency is the only way to fully extract the potential of the ESG bond market.
Doing so will remove the need for eagle-eyed monitoring from both investors and issuers, allowing them to trust that the automated data will reveal any discrepancies for them. This will in turn effectively remove the interpretation ambiguity that can surround ESG bonds over the course of their lifetimes, therefore increasing their validity.
This also removes issuers’ ability to be fluffy about data points, and ultimately, keeps everyone involved accountable. The question of whether a green bond is on its way to achieving sustainability goals becomes binary.
However while the transparency offered by blockchain technology has the potential to address the complexity of ESG bond verification, it is unlikely that smart contracts will ever replace the need for a strong regulatory framework. Smart contracts can provide an immutable ledger of activity, but regulation and standards will still be necessary to define what can be considered green, and what can not.
Moreover, the energy-intensive nature of the largest public ‘proof of work’ blockchains —like Ethereum — mean that digitally-native ESG bonds will have to include some kind of sustainable compensation to make up for the computing power required to validate the transaction in the first place. Maybe a transition to ‘proof of stake’ blockchains — a model that requires considerably less computational power — is only natural for ESG-based bonds if they are to be taken seriously.
A digital economy that produces a lot of data is close. And in a digital and data-producing economy, this means having instruments that are able to consume that data in a structured and sophisticated way.
But the smart contracts that currently govern our digital instruments are just about powerful enough to embed a PDF file. There is certainly a long way to go, but it is clear that the potential to revolutionise the ESG bond market is getting closer.