The Necessity of Ambition: DLT and the Growth of Sustainable Finance

By Todd McDonald, Co-Founder & Chief Product Officer at R3

As summer in the northern hemisphere nears its end, many are assessing the impact of climate change on a season that brought extreme heat and devastating weather events across the world. With extreme weather becoming all too commonplace, public concern, government action, and private enterprise are converging to produce a surge of interest in sustainable finance.

Funding a more sustainable future will require herculean effort in relatively short order. A joint report from Boston Consulting Group (BCG) and the Global Financial Markets Authority (GFMA) in 2020 estimated that $100-150 trillion of investment will be required globally to transition to a low carbon economy. Hoping to boost this effort, in July, the European Union (EU) finalized ambitious action plans to reduce barriers to funding climate goals which they estimate will require over €300 billion annually, or 2.3% of GDP.

Financing of this level, and for an issue this important, will require concerted effort from all stakeholders, public and private. The digital financial industry can play a crucial role in supporting the growth of sustainable finance by reducing barriers and injecting pace into an asset class that must scale quickly to meet public and climate needs. As demand grows, so will the need for digitization, and our industry can help ensure sustainable finance is transparent, efficient, and effective in supporting the global effort to meet ambitious sustainability targets.

Growth of green

The BCG/GFMA report further estimated that around 21% of the overall financing needed globally would come in the form of bonds, commonly referred to as “green” or “KPI-linked” bonds. Generally speaking, green bonds are defined as such if they support a broad range of sustainable investment. On the other hand, KPI-linked bonds are tied directly to performance metrics (for example, emissions reduction in a “transitioning” industry like energy production). Both green and KPI-linked bonds are well suited for digital financial innovation as their issuance, maintenance, and redemption can be digitized in order to link them more effectively to their sustainability aims or performance metrics.

Demand for green and KPI-linked bonds has grown significantly in recent years, although still only representing around 0.4% of the global bond market and only 4% of overall corporate bond issuance in the EU. (Despite disruption in the market due to COVID-19, global green bond issuance still grew, albeit at a slower rate, and this rate is expected to tick up again as recovery progresses.) This is still far short of the financing needed to wholly fund sustainable development.

Moreover, growth in the green bond market has been accompanied with caution amid concerns about greenwashing, a term that reflects the lack of standardized taxonomy to ensure funds are directed precisely toward their stated aim. Currently, there are no global standards as to what constitutes a green bond or any appropriate metrics. This certainly invites risks that some bond issuers will want to capitalize on an additional avenue to raise cash, with little oversight or accountability to deliver on investor expectations.

Another challenge for the ability of the green bond market to scale at pace is reliance on burdensome administration. Most bond markets, not just the green ones, depend on manual processes at some point during the asset life cycle. Paper-based or non- automated systems are a well-known barrier in the industry and, for green and KPI-linked bonds especially, they hamper not only scalability, but also the reporting of results, an essential feature of green and KPI-linked bonds.

This has created legitimate concern amongst investors as to assurance that funding will produce the marketed sustainable outcomes. In fact, this is what the EU seeks to address in their recent publication of green bond standards. Digital financial services would increase accountability and reduce barriers over the lifecycle of a green bond, making them more attractive as investments and spurring the gargantuan demand growth needed to support sustainability imperatives.

Digital finance for sustainable finance

Within digital finance, distributed ledger products offer many potential efficiencies for the bond market, which the World Economic Forum highlighted includes establishing a single source of truth for bond terms, automating settlement, as well as coupon and repayment instructions. From R3’s perspective, much of this potential is beginning to come to life as our industry matures. From our involvement in a wide range of digital assets projects, including SIX’s Digital Exchange we’ve seen how offering atomic settlement and scalability that meets the standards of regulated financial industries can unlock tremendous value in the digital financial ecosystem. In debt markets, we’re excited about the potential for partners like Agora to automate the asset lifecycle for corporate bonds.

The unique benefits of distributed ledgers converge neatly with the opportunities and challenges of green and KPI-linked bonds and make some blockchains well suited to mitigate concerns about greenwashing. Specifically, distributed ledger-backed green or KPI-linked bonds can provide transparency and accountability by enabling automated and immutable KPI progress tracking that in turn provides assurance that funds are being used for their stated purpose. Confidence in this asset class and its attractiveness could be even further advanced through the application of interest rate penalties when benchmarks are not met, a unique opportunity offered by green or KPI-linked bond issuance on a distributed ledger.

A distributed ledger also offers potential upside to reducing administrative costs, which would further bolster the market. However, analysis of the suitability of distributed ledgers should not stop at the financial products themselves. Rather, it must extend to the underlying technology, as well. To ensure distributed ledger solutions are not undermining the aim of a sustainable financial product, digital financial solutions should not rely on energy-intensive data processing and storage methods and must also provide sufficient scalability for the potential size of the market. Investors should seek assurance of these aspects to reduce the potential for greenwashing all the way down the stack.

At R3, we’ve seen how innovation in the bond market can unlock hoped-for efficiencies utilizing peer-to-peer data processing that provides appropriate scalability and does not impede the sustainability commitments of firms. Solutions that rely on proof of work consensus mechanisms, and therefore outsized energy consumption due to mining requirements may not be aligned with the intention of sustainable investors. For this reason, solution providers should be forthcoming about disclosing their energy footprint as it relates to all aspects of the asset lifecycle.

It is important to note the technological benefits of digital finance and distributed ledgers should not be viewed as a panacea to challenges in sustainable finance, which faces other political and economic headwinds. However, sustainable finance has the potential to be a truly digitally native industry and is a crucial way our industry can contribute to the global imperative of transitioning to a carbon-neutral future. Leveraging distributed ledgers to make the green bond market more transparent, efficient, and accountable will only increase investor confidence, hastening the ability of the market to scale in accordance with the needs of corporations and governments to meet their climate goals.

Read more from the report, Digital Assets: Laying ESG Foundations