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How DeFi Can Help Make Climate Change an Investable Asset

source-logo  coindesk.com 13 September 2021 15:57, UTC

Fixing our planet is going to cost a lot of money. It’s not hard to find projections of those costs that run into the trillions of dollars. A quick literature survey turned up estimates of $4.5 trillion to decarbonize the U.S. electric grid, another $3 trillion for climate change mitigation, just in the U.S. over the next decade, and about $4 trillion needed to redress systematic inequalities in our education system. That is starting to sound like a lot of money, even for the $23 trillion U.S. economy, although the amount is still less than the cost of replacing our planet or moving to a new one.

Historically, the U.S. invests about 17% to 20% of its gross domestic product, which amounts today to around $5 trillion annually. Addressing some of the world’s biggest environmental and social challenges over the next decade would require the U.S. to increase that investment closer to 22% to 24%, adding another $1 trillion annually. While very recent history suggests a renewed appetite for investment in the U.S., especially led by the government, another $10 trillion might be too large for most politicians and voters to embrace.

Paul Brody is EY’s global blockchain leader and a CoinDesk columnist. Join me and CoinDesk’s Michael Casey on September 14 online and live in New York for a discussion about the future of DeFi and ESG.

The good news is that there is no shortage of capital. In the U.S., the widest measure of money velocity (MZM), published by the Federal Reserve, shows that money is changing hands at the slowest rate since records have been kept. Money is moving slowly partly due to concerns about the economy but also because of a sense that asset prices are high and there is a lack of good investment opportunities. The cyclically adjusted price/earnings ratio for the S&P 500, a good measure of how richly valued assets are, is currently higher than at any time in recorded history except for the third quarter of 1999. As a result, lots of capital is sitting on the sidelines looking for sustainable returns.

In theory, there should be a good match between the $10 trillion in investment needed to transform our society and all that idle capital. In practice, there’s disagreement about the potential for return on investment and the opportunity to capture it. If you listen to the optimists, the ROI on social and ecological transformation is actually pretty good – with typical internal rates of return (IRR) of 6% on college educations, between 4% to 7% on utility-scale solar investments and between 7%to 10% on climate change adaptations.

In practice, the obstacles to capturing those returns are high. Adaptation to climate change is a good example. Investments in prevention or mitigation might lead to much reduced damage from climate change, but who benefits? Without a mechanism to identify the opportunity or capture it, the opportunity for return doesn’t really exist. There are similar challenges for educational investments or renewable energy.

Investments in renewable energy are gathering pace, and they show both the potential and the pitfalls of investing in social good. One bottleneck is the ability to spot good investment opportunities for utility-scale solar or wind investments, to align with local governments on incentives and regulatory challenges, and then to find patient investors with a tolerance for some risk.

All of these different investing strategies are possible and are occurring with increasing frequency, but there are multiple bottlenecks along the way. The biggest gap is the expertise required to identify opportunities that fit with regulatory compliance issues and patient investors. This is a highly specialized and localized skill that takes years to develop. Even then, once an opportunity is developed and matched, it can take years to complete and exit before freeing up capital for new opportunities.

Legacy industries such as oil and gas, traditional college loans or disaster insurance, have a century or more of maturing behind them. They have mountains of data to compare risks and how to mitigate them. Even if the returns are weak, the friction involved in getting them to market is low and there is a large pool of experienced investors who are comfortable with and understand the risks.

Three ways

Across the board, this same infrastructure is missing or underdeveloped for many critical social investments. Blockchain technology offers some hope for accelerating this path forward in three different ways.

The first is around new methods for tracking, managing and capturing returns. The logic in smart contracts allows companies to do things that were not easy to do at scale in the past – such as tracking carbon emissions from a single enterprise and matching those with offset activities and verifying that there’s no double-counting.

Using blockchain technology and smart contracts, complete with oracles and external auditors, makes it possible to look at the total life cycle of a product, to attach carbon outputs to asset tokens along the process and bring products to market that have a verifiable net-zero carbon footprint. Hundreds of companies have pledged a path to net-zero carbon emissions and this will offer them a provable mechanism for getting there.

Second, blockchains allow us to segment assets in ways that were not possible or simple in the past. Mortgage-backed securities allowed investors to buy slices of risk in a pool of securities, but in practice, the assessment of risk was subjective. With a blockchain-based smart contract, you can separately tokenize a renewable energy investment as a vanilla energy-producing asset and a carbon-offset investment, offering one to a low-risk utility investor and the other to a company that has pledged 100% carbon offsets, with data flows and smart contracts verifying outputs and distributing returns. Unlike past securitization efforts, this one can be underpinned with real-time systems data and transparent business logic on-chain.

Third, blockchain investors have something else corporations need to fund the path to a better world: a high tolerance for risk. Bloomberg estimates that $500 billion was poured into renewables in 2020. Not only is that not enough, but it also didn’t get that big overnight. It took years to build the skills and investment opportunities to attract that much capital. The early days were much riskier. If we want to accelerate the path forward on education opportunities or climate change, we need more risk-tolerant investors putting capital into the hands of portfolio managers who will need to learn and get better at spotting investments.

The early days will be rough as the ecosystem works through challenges from investment skills to external data validation, to the right way to construct smart contracts and how to package all the pieces to suit investors. The faster we get risk-tolerant capital into the mix, the faster we start flattening that learning curve.

I count myself among the optimists who believe there is enormous ROI to be had in making our world a more sustainable, fairer place. It’s not a question of if or why, just a question of how soon, and will that be soon enough.

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.