Data privacy, security, human capital present material ESG risks for blockchain funds

DATA privacy and security, human capital, and business ethics are among the material ESG (environmental, social and governance) risks that investors should watch out for in the growing blockchain ETF (exchange-traded fund) market, Morningstar Sustainalytics said in a recent report, which also highlighted financial and technology sectors as "highly exposed" to these issues.

Nearly half, or 22 of the 46 companies in the financial sector analysed have relatively high unmanaged risk scores in relation to product governance and business ethics, reflecting potential gaps in their preparedness to deal with risks related to blockchain and crypto, the report said. 41 per cent of the financial companies studied have also experienced significant to severe business ethics controversies, while a third have faced significant product quality and safety events.

While the distributed nature of blockchain systems will benefit the financial sector in various ways, Sustainalytics urged companies adopting the nascent technology ought to make appropriate disclosures on product features and risks to ensure client awareness and protection.

"Non-uniform and dynamic regulatory environments can expose firms in this sector to compliance and ethical risks, especially for those with crypto offerings. Managing these risks is important because the safety nets that govern traditional banking and investment service providers do not typically apply to cryptos," wrote Sustainalytics' researchers Shiva Mitra and Martin Vezer.

They cited Singapore's DBS and China-based insurer Ping An as firms that demonstrate a superior management of product governance and business ethics risks, compared to their peers. The researchers noted that they have not found evidence of these companies being "directly involved in significant controversies" relating to business ethics or product quality and safety.

Companies in the tech and software industry face material data security risks, Vezer pointed out. Even though the transmission of information through distributed, immutable ledgers can improve data privacy and security, blockchain has unique vulnerabilities that have been exploited by hackers. Such hackers stole nearly US$3.78 billion in 2020, according to estimates by digital security company Atlas VPN.

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Attracting and retaining developers is another concern for firms in this sector, he wrote, noting that the US's tech sector saw a 4.5 per cent increase in employee turnover last year. The challenge is enhanced amid strong competition for crypto and blockchain tech talent.

Despite the highlighted risks, Sustainalytics' analysis suggests that investors in the blockchain market face slightly less overall ESG risk than those in the broader global equities market.

It came up with this assessment by pooling the investments of 10 blockchain-themed ETFs. This "model fund of funds" has an overall weighted ESG risk score of 19.9, compared to 21.6 for its global equities index, the Morningstar Global Markets Large-Mid index.

However, the firm noted that this lower score is largely the result of sector allocation and stock selection effects. For instance, the "model blockchain fund" has largely overweighted the information technology sector, even though the sector is also the largest component of the equity index.

Information technology represents 59 per cent of the fund, compared to 29 per cent of the equity index. Financials, which is the second-largest component of both indices, represented 31 per cent of the model fund, compared to 14 per cent of the equity index.

That said, the weighted average risk scores of the model fund are 71 per cent higher on data privacy and security, and 17 per cent higher on human capital.

The total value of Sustainalytics' study sample grew from US$1.7 billion in January 2021 to US$3.7 billion in mid-November, demonstrating growing interest in blockchain-themed investing.

Apart from highlighting material ESG risks in blockchain, Sustainalytics looked at how companies in resource-intensive industries like utilities and mining have been developing blockchain applications to address environmental risks.

For instance, Norway's Norsk Hydro, a primary aluminium and renewable energy company, is using the technology to measure and report its use of post-consumer aluminium scrap - referring to previously used aluminium, for which the carbon footprint is zero. Some companies in the sector are also using blockchain to track carbon emissions more precisely and consistently.

In the consumer goods sector, early blockchain adopters are also integrating blockchain into their data systems to improve supply chain transparency and traceability for selected food products.

It cited French supermarket chain Carrefour as an example. The company is using blockchain technology to improve product traceability by allowing customers access to product information such as harvest and packing dates and transport duration, all by scanning a QR code.