ECB: Crypto driving ‘elevated climate transition risk’, regulations likely

Investors in cryptocurrency do not seem to have considered the impact of regulations and climate risk, the ECB warns.

Rising financial institution exposures to energy-intensive crypto assets “are contributing to elevated climate transition risk for the financial system” and will likely prompt increased regulatory scrutiny, the European Central Bank (ECB) has said in its biannual macroprudential analysis.

The ECB has confirmed that banks, which it directly supervises in the EU, will need to incorporate the climate-related financial risks of crypto-assets into their climate and risk strategy under new prudential guidelines issued by the Basel Committee. On the other hand, investors must assess whether cryptocurrencies are “in line with their ESG objectives”, it said.

The ECB commentary comes as a growing number of institutional asset owners, predominantly US-based, eye investments in cryptocurrencies or crypto-related activities. A study last year by US-based Fidelity Investments showed that seven in 10 institutional investors expected to buy or invest in digital assets.

According to research quoted by the ECB, the joint carbon footprint of bitcoin and ether – two of the most popular cryptocurrencies – would cancel out previous greenhouse gas emission savings recorded by most eurozone countries, and are equivalent to the energy consumption of mid-sized countries such as Spain, the Netherlands and Austria.

This means that a hands-off approach to regulating the sector is “highly unlikely”, said the ECB. Possible policy measures set out in the analysis include the imposition of additional capital banking requirements through risk-sensitive add-ons or – more punitively – capital deductions “for all new exposures to crypto-assets with a significant carbon footprint”. Banks would have to set aside larger amounts of capital to cover potential losses arising from crypto exposures as a result, leaving less capital to generate returns.

This is not expected to have any immediate impact on broader lending, as crypto does not yet make up a significant amount of bank balance sheets, but “will disincentivise investing in such assets from the outset and prevent the build-up of transition risk”, said the ECB.

Using renewable energy to generate cryptocurrency may not be enough to evade regulation either. According to the ECB, green crypto mining would crowd out “likely more productive uses of renewable energy” which directly contribute toward meeting climate targets and could result in policymakers moving to “privilege” these activities over cryptocurrency mining.

The ECB also said it was unlikely that bitcoin investors “have currently priced in the negative ecological externalities and authorities’ possible policy measures”.

DWS and UK-based Fidelity International, both of which have launched crypto-focused funds, have been approached for comment.

Regulators could also enact measures to incentivise the cryptocurrency market to move from the more energy-intensive proof-of-work (PoW) protocol, currently used by around 80 percent of the crypto market, to the alternative proof-of-stake (PoS) protocol. According to the ECB, estimates show that moving the ether blockchain to PoS would reduce energy consumption by 99.95 percent while ensuring the same functionality.

But a lack of community consensus over the security and decentralisation merits of PoS means that many stakeholders are “unlikely (to) initiate the adoption of PoS in the near future”.

Last year, the Swedish environment and securities regulators called for an EU-wide ban on mining PoW-based cryptocurrencies due to their energy-intensive production and has said that it will introduce domestic measures to halt these activities. Separately, the European Commission has been asked to assess the treatment of crypto-asset mining activities under the bloc’s green taxonomy.

Responsible Investor has requested details of any upcoming ECB supervisory initiatives to manage the climate risks of crypto-assets but has not received a response as of press time.