Digital assets, their environmental impact, and litigation risk

An ever-growing body of English case law recognises cryptocurrency and non-fungible tokens (NFTs) as transferable property. Following our recent Business Guide to Climate Disputes, in this article we examine some of the issues around the environmental impact of digital assets and the associated business and environmental risks.

The price of bitcoin and other major cryptocurrencies has recently plummeted. In June 2022, the value of bitcoin dipped below USD20,000 for the first time since November 2020, two cryptocurrencies (the apparent "stablecoin" terra and its sister currency luna) collapsed, and a number of leading crypto lending platforms blocked customer withdrawals.

The recent cryptocurrency crash comes as the price of nearly everything else – not least energy – is rising. This cocktail of falling crypto prices and rising electricity prices has proven unpalatable for cryptocurrency miners. Many are switching off or repurposing their operations because of their newfound lack of profitability.

On the surface, this can seem like good news from an ESG perspective. The amount of electricity consumed by the largest cryptocurrency networks has fallen by up to 50%.

But this should not be mistaken for an improvement in the underlying environmental credentials of the cryptocurrency industry. Fundamental issues remain. We urge our ESG-conscious clients to remain aware of the environmental risks of digital assets such as cryptocurrencies and NFTs. 

Digital assets and the environment

One of the key differences between digital currencies and traditional currencies is the decentralised structure that digital currencies are based on. Rather than a bank or other financial institution acting as the record keeper of transactions, cryptocurrencies and NFTs exist on a blockchain – a decentralised record or ledger of ownership.

Responsibility for updating the ledger is shared. Taking bitcoin as an example, users of the blockchain compete for the right to add a new block of transactions to the chain and thus update the ledger. These new updates are then verified by other blockchain users, and the updating user is rewarded with bitcoin. This process of updating the ledger is known as blockchain mining.

Traditionally, and as is currently the case for the world’s largest cryptocurrencies, a user must be the first to solve a computer-generated puzzle to win the responsibility to update the communal ledger. In simplified terms, this puzzle involves correctly calculating a 64-digit hexadecimal number. This process of winning the right to update the ledger by solving the puzzle is known as a proof of work system.

The issue with proof of work systems is that they’ve given rise to computational arms races, as users seek to have the most powerful systems so they can be the first to solve the puzzles. Blockchain users have even joined together to form mining farms: facilities comprising of rows and rows of computers working together to solve the puzzles.

Mining farms and the general computational infrastructure needed to sustain a blockchain and the digital assets on it use an enormous quantity of power. Bitcoin, which has an approximate 40% stake in the digital currency market, is currently responsible for more electricity consumption annually than Argentina, producing 65 megatons of carbon dioxide, and is responsible for more than 0.5% of global electricity consumption. Moreover, the closer bitcoin gets to its supply limit of 21,000,000 bitcoins, the computing power, and therefore energy needed to mine, increases.

Litigation risk

For businesses looking to either align their operations with, or invest in or acquire, cryptoassets, the ESG impact such assets have on the environment creates a potential litigation risk. This can be from disgruntled shareholders, environmental groups or others. Greenwashing, or the making of misleading environmental claims, for example, can cause huge reputational damage, and result in significant legal liability.

Climate change litigation has grown dramatically in recent years, and is an increasingly prominent feature of the international disputes landscape. In a growing number of markets, cases have been brought seeking to compel governments and businesses to act on climate change. That trend is accelerating. By 2006, only around 20 cases relating to climate change had been brought in courts globally. By 2007, that number had quadrupled. By the end of 2020, well over 1,700 climate-related court cases had been decided worldwide.¹

In our recent publication Tortious claims and climate change: Where are we now? we explored the boundaries of tort law in the context of recent attempts by claimant lawyers to bring claims in respect of a novel tortious duty to "cease contributing to damage to the climate system."² This area of law is quickly evolving, as advocates focus more closely on environmental wrongs.

Recent UK Supreme Court decisions will also encourage claimants and funders to direct their attention toward parent companies in the event of environmental wrongdoing on behalf of subsidiaries or other entities in the supply chain.³

The key international framework for climate-related financial disclosure was developed by the Task Force on Climate-related Financial Disclosures (TCFD). Its 2017 report and recommendations have become the reference point for both international and national standards, being adopted into mandatory regulatory reporting requirements in several jurisdictions.

The global shift towards mandatory climate-related financial disclosure by companies will allow for more comparable data scrutiny and accountability for climate action, which can itself increase exposure to climate-related claims. Businesses that invest in cryptoassets and claim such to be environmentally friendly or beneficial might well face closer scrutiny of the 1 impact such digital assets have on the environment, and civil claims if those claims turn out to be 0.

Businesses and consumers increasingly expect their partners and suppliers to demonstrate their ESG credentials, so the high energy cost of digital assets can have an adverse effect on a company's green credentials. Consumer pressure is also being felt. For example, in September 2021, chat service Discord publicly backtracked on its stated intention to integrate cryptocurrency and NFT features into its application. This decision followed users threatening to cancel their subscriptions and boycott the chat service due to the environmental impact of crypto and NFTs.

Change the Code Not the Climate, a recent campaign run by Greenpeace and Environmental Working Group, calls for bitcoin to change its code to alter its proof of work system and reduce its environmental impact. The campaign manifesto is expressly addressed to industry leaders and key players in the market.

A separate campaign, the Crypto Climate Accord, pledges to achieve net-zero emissions from electricity consumption by 2030 and accelerate the adoption of 100% renewable-powered blockchains by 2025. It has been signed by more than 200 companies and individuals across relevant sectors.

Limiting the environmental impact of digital assets

There are broadly three main ways that the blockchain community has sought to combat the environmental impact caused by digital assets:

1. proof of stake systems (to replace proof of work)
2. renewable energy sources
3. carbon offsetting

First, some cryptoasset providers and cryptocurrencies use proof of stake as opposed to proof of work systems. TOKO, an award-winning enterprise grade tokenisation and digital assets platform delivered in collaboration with DLA Piper, uses Hedera, one of the most-used enterprise-grade public networks by total transaction count.

Hedera is a public, open source network using proof-of-stake, rather than proof of work. When the network's native cryptocurrency, HBAR, is staked to nodes by retail and institutional participants, they have a weighted influence on consensus for validating transactions. Weighted voting makes it difficult and expensive for a bad actor to maliciously affect consensus. Other proof of stake systems involve, for example, randomly selecting from prospective "validators" to add new blocks to the blockchain. These validators stake digital currency as collateral that can be destroyed if the validators behave dishonestly or lazily, by not updating the blockchain properly or on time.

The proof of stake system is more energy efficient, because it doesn't put users in competition with one another for the right to update the blockchain. These computational arms races are replaced with a randomised selection system, which avoids incentivising users to invest in more powerful computers that use more energy to win additional cryptocurrency.

But proof of stake systems are not yet widespread. The six most widely used digital currencies, which together represent approximately 75% of the market, all currently use proof of work systems. Though ethereum, the world’s second largest cryptocurrency, is planning to make the transition to proof of stake.

The relatively unproven nature of proof of stake systems also brings operational risk. Indeed, the founder of ethereum, Vitalik Buterin, has stated "[we thought] it would take one year to [implement] proof of stake…but it actually [has] taken around six years." The change in operating model for some of the world's largest and most established cryptocurrencies is far from straightforward.

Second, the environmental impact of cryptocurrency mining operations depends on where these operations take place and the use of renewable energy sources in these regions.

Historically, the vast majority of bitcoin mining operations took place on mainland China – over 75% in September 2019. But China has since introduced a blanket ban on these operations, prompting miners to relocate.

Today, operations are spread across the US (43%), Kazakhstan (22%), Russia (14%) Canada (11.5%), Ireland (6%) and Malaysia (6%), among other countries. But in Kazakhstan, for example, only around 2% of energy consumption comes from renewable sources, indicating that the availability of renewable energy for mining operations is not a key concern for many miners.

Third, public distributed ledgers, digital currency and NFT providers are looking at carbon offsetting to counter the environmental impact of their actions. For example, Hedera, one of the greenest proof of stake networks, has committed to continuously remain a carbon negative network by purchasing carbon offsets quarterly. Super Rare, a popular NFT trading platform, recently committed to using carbon offsets, while Beeple, a digital artist who last year sold an NFT for USD69m at a Christie’s auction, has committed to ensuring his future work is carbon negative.

Key takeaways

Environmental due diligence on digital currencies and assets should remain a key consideration for those looking to move into the market or make any investments. ESG-conscious businesses should be particularly diligent in assessing the ESG risks when investing in digital assets or evaluating proposed investments in digital assets. They should vigilantly monitor the environmental credentials of existing investments over time.

In spite of the well-documented volatility and recent fall in value of cryptocurrencies, these emerging digital assets may nonetheless remain attractive as part of a modern-day investment portfolio with an eye to the future.

But we advocate a pause-for-thought approach for our ESG-conscious clients. For now, these digital assets have at their core an operating model that brings huge negative environmental impact. If bitcoin changed its code to become proof of stake, its energy use could reportedly be reduced by 99.9%.

Whether bitcoin and the other large cryptocurrencies will drastically alter their code and way of working remains to be seen. Only when cryptoassets overcome these environmental obstacles can they be viewed as viable investments for ESG-conscious investors.