A growing number of forward-looking investors seek to generate social and environmental impact as well as financial returns. According to the 2018 Impact Investment Survey by the Global Impact Investing Network, respondents invested $35.5 billion into 11,136 deals during 2017.
We believe that the growth of impact investing is stifled by:
• The lack and/or high cost of trustworthy data on the social or environmental results of an investment, making credible accounting of impacts difficult
• Challenges around the “attribution” of impact – meaning the allocation of an impact-related claim to an investor, often risking the “double-counting” of claims
• Roadblocks in monetizing impacts – i.e. illiquid impact markets, uncertain returns, high transaction costs
Could blockchain-based solutions solve these problems?
Blockchain technology currently revolutionizes the storing, management and transfer of value between digital identities in many economic sectors. Blockchain-based tokens are used to crowdfund new business ideas, enhance transaction-based business processes and serve more generally as stores of value.
Blockchain has recently made its way into the impact investment community, and a broad range of use cases are being developed to take advantage of its features, giving rise to a new category of application referred to as “impact tokens”. These tokens represent a UN Sustainable Development Goal-related impact, usually in the form of a quantified, unit-based measurement metric, which is linked to its origin (the activity that created it, which also represents its identity). These tokens can be used to make performance-based payments, track impacts through supply chains or substantiate claims on supporting SDGs.
The case for blockchains in impact investing
The management of assets on a blockchain have a number of advantages, from which impact investing could potentially benefit: greater transparency, enhanced security, improved traceability, increased efficiency and speed of transactions, and reduced costs. These features add real value within the context of impact investing:
1. Trust: Many impact investments take place in developing countries with low institutional capacity and low-trust environments. The use of blockchains mitigates the need for trust due to its built-in trust-generating features, thus reducing reputational risk exposure from unverifiable claims. Blockchains can also help automate and accelerate impact measurement and verification which, using current models and processes, remains slow and expensive. At a higher speed and reliability, impact creation can be used as a parameter in performance-driven dashboards for managing impact investments.
2. Attribution: Impact tokens can be used to track the impact of an investment (i.e. in sustainable production) through a supply chain. They can be passed along – i.e. to the purchasers of a product that has been made sustainably – and help impact investors to derive financial value from impact creation.
3. Impact monetization: The monetization of impacts can be accelerated and transaction costs removed. High-trust impact tokens, especially those measured on a unit basis, lend themselves as key metric for the design of results-based finance schemes. Monetization of such tokens can also become rapid or even instant, creating strong behavioural incentives on the implementation level: immediate rewards are much more effective for influencing behavior. These lower transaction costs also make it possible to facilitate transfers to individuals, reducing the need for middlemen.
It is therefore no surprise that a substantial number of impact tokens have entered the market within the last year. While these tokens differ in purpose and design, most of them claim to represent a quantified unit of impact related to one (or more) SDGs. Some of these tokens have been made available to the interested public through Initial Coin Offerings (ICOs) as a means to fund a) the activities that originate the claimed impact, and b) the team that drives the development of the blockchain platform that manages the token.
A need for due diligence
The recent hype around new tokens and ICOs as a means to raise funds for blockchain projects brought charlatans with fraudulent intentions onto the scene and, as a result, increased the scrutiny and criticism of blockchain-based solutions.
This need for more scrutiny also applies to impact tokens. We believe that it is important to establish and apply criteria that allow impact investors to assess the integrity of an impact token and its ability to channel funds to enable desired impact outcomes.
Here are five criteria to assess the quality of an impact token:
1. It adds real value to how the impact is accounted for
A key feature of blockchain technology is that it automates the creation and management of verified data using a decentralized approach. A well-designed impact token would be based on models for data acquisition and verification that are free from human intervention or judgment.
This feature could also make a substantial contribution to the design and operation of measurement, reporting and verification systems for greenhouse gas (GHG) management under the Paris Agreement, as well as the implementation of market-based approaches, which is already being explored by UN organizations. In 2017, to support these efforts, a number of bodies, including the UNFCCC Secretariat, formed the ClimateChainCoalition.
For example, SolarCoin (SLR), one of the earliest impact tokens (one SLR is awarded for the verified production of 1MWh of solar power) has used a manual “proof of impact” verification procedure, but is currently in the process of upgrading this procedure to a fully automated process in cooperation with inverter manufacturers.
IXO Foundation places the implementation of automated verification procedures at the heart of its proof of impact protocol, while the GainForest project explores the conversion of high-resolution satellite data into carbon stock data and impact tokens. South Pole, IXO and the Gold Standard have just launched a blockchain-powered pilot that captures data from greenhouse gas emission reduction projects. The pilot’s long-term aim is to auto-verify data, and make the resulting positive impact tangible at the moment it is physically achieved.
2. It increases trust between users and stakeholders
Successful blockchain projects inspire trust because they have been designed as collaborative projects with high levels of transparency and decentralized consensus-making processes. They provide rewards to those who contribute to the project’s evolution and the protection of its integrity. They are successful because of the broad buy-in and support of a community of users and stakeholders.
A well-designed impact token will need to be developed on the basis of these principles. The ClimateChainCoalition and the Natural Capital Finance Alliance are among the first communities with a commitment to collaboration. However, as of today, there is no impact token that has been designed on the basis of these principles.
3. It accelerates the flow of impact investments
Current impact-related financial instruments, such as development impact bonds, are hard to scale, mostly because of the difficulty of tracking progress and verifying that milestones have been met. The UN’s Principles for Responsible Investment initiative has listed a variety of areas, including energy trading systems, secure recording of educational certificates for local schools and storing and access to medical data, where blockchain could accelerate financial flows by simplifying systems, while noting that many of these areas are not widely penetrated yet.
Probably the most famous application of “blockchain for good” is the use of the Building Blocks platform by the World Food Programme to make payments to refugees, which has already resulted in millions of dollars in savings. Blockchain technology is used to provide a unique digital identity to eligible beneficiaries – using a retina scan or fingerprint to access an identity – and to make regular cash transfers with no transaction costs.
The Sun Exchange provides another good operating example for the use of impact tokens to fund new solar projects in Africa. Most impressive here is the scalability of fundraising efforts: thanks to low transaction costs, impact investors can invest as little as $1 to fund impact.
Finally, well-designed impact tokens will bring cost savings by curtailing the role of financial middlemen.
4. It is transparent and open-source
The impact investment community exists within the context of a broad stakeholder base. It needs to be accessible to all and responsive to the public interest. As a result, any blockchain used for the management of impact tokens must be based on freely accessible open-source code.
5. It keeps its energy consumption in check
Last but not least, the environmental effects of creating and managing an impact token needs to be addressed in the design process. There are now a number of studies and websites that show just how much energy is used and GHG emissions released by the operation of bitcoin and ethereum, the two leading cryptocurrencies. A new study published in Joule magazine – the first on the subject to undergo the rigours of peer review – argues that, globally, bitcoin mining consumes at least as much electricity in a year as the whole of Ireland (about 24 TWh). Worse still, it contends that the energy use is doubling every six months and could reach the annual consumption of the Czech Republic (about 67 TWh) before the end of 2018, which would be about 0.3% of the world’s electricity consumption.
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Where do we go from here?
As shown, blockchain is a game-changing technology that can contribute to scale impact investment by providing trust, transparency and low transaction costs. However, it is early days for impact tokens, and the impact investment community needs to be prepared for a trial and error approach. As demonstrated by the complex establishment of the carbon market – arguably the world’s first large-scale payment-for-impact schemes – the first priority must be in developing trust, and thus to build consensus around processes and procedures in the community. Only by broad cooperation within the interested community, and the willingness to commit to common standards, can impact tokens reap the potential advantages provided by blockchain technology, and ultimately lead to unlocking of finance at scale to achieve the Sustainable Development Goals.