Smart contracts are a new vehicle for innovation in finance. We have seen the application of smart contracts in Decentralised Finance (DeFi) including collateralisation, lending and borrowing, and through the introduction of governance contracts.
The ability to programme financial instruments has big implications on existing instruments, and specifically the addition of further dimensions which are dynamic.
How can we construct an ESG bond using smart contracts?
Let’s take an imaginary car manufacturer who, sensing the demand for electric cars decides to borrow €500 million for 10 years to retool the factory line to build the cars. The coupon is set to 0.875% and is paid bi-annually.
To write a smart contract with the coupon schedule and the redemption mechanism is straight forward as all the terms are known and the lifecycle management is programmed to run automatically.
There are some further dimensions which are added to bring in social and environmental considerations.
We take a scenario where the car manufacturer is committed to selling 150,000 units to car-sharing clubs. The sale volumes are published and verified and can be read by the smart contract through an oracle. There are several options which could be considered, say, for every 50,000 units sold there are 100 units of a social credit token or reward issued. The social token represents social good, as it reduces the number of cars needed in the towns and cities thus making life more pleasant.
We know that electric engines are quieter than the internal combustion and electric cars will contribute to the reduction of noise pollution. We can see a scenario where a number of units, say, 10,000 results in the issuance of social credits for the reduction of noise in towns and cities.
As there is an environmental element to the production of electric cars, there is a mechanism to link the production and sales to environmental rewards. We could consider a scenario of 100 units of an environmental credit token issued for every 10,000 units of vehicles produced.
There are also the incentives to use recycled materials, and in the retooling of the factory and production of the electric cars there are metrics set to measure the percentage of recycled materials used. On achieving the targets set there are environmental credit tokens issued.
Let’s say that in retooling the factory lines the car manufacturer was able to combine it with the production or sourcing of sustainable electricity through hydroelectric, solar or wind power, there will be further environmental credit tokens available.
Finally, the disclosure of the key data used in the issuance of environmental and social credits would also generate a governance credit.
What do we do with social and environmental credits?
Environmental, Social, and Governance (ESG) investors are defined as those people that consider the environmental, social, and governance criteria into account when they’re considering investing in an asset.
ESG investment or impact investment is a fast-growing sector. Between 2013 and 2019, the impact investing market has grown at 27% CAGR from $25.4 billion to $715 billion. There is a generational shift in assets and millennials, who are driving the demand for ESG assets, are set to inherit the family wealth. 95% of millennials are interested in sustainable investments.
The robust processes in place to link metrics to social and environmental benefits and the generation of the social and environmental credits opens up some interesting opportunities.
We can see a scenario where a bond issued, generates a significant amounts of social and environmental tokens, and thus makes it an attractive instrument for ESG investors and ESG fund managers. This incentive is of benefit not only to the ESG funds that can demonstrate clear goals and that the companies are achieving their objectives, it also benefits the issuer by increasing demand for its debt.
There are some open questions when it comes to what is possible with the ESG credits. Should they be fungible? If they are fungible then can they be traded so that companies needing to buy ESG tokens to off-set their social and environmental adverse activities can do at the prevailing market price? If they are non-fungible do these tokens accrue towards an ESG score of a company, as an equivalent to a credit rating?
What does all this mean?
In exploring what is possible, we have seen how taking an existing financial product and adding a programmable element we can add further dimensions based on lifecycle events through the lifetime of an instrument.
There is a strong case for developing measurable ESG goals, verifiable outcomes that feed into a financial instrument. It not only counters the claims about companies “greenwashing” by providing clear metrics, but has the building blocks for further innovation and new market places for the generated tokens.
We can observe that there is a broader application in writing smart contracts to create programmable financial instruments that can have multiple dimensions and that is a first step towards Peer to Peer exchanges of value, where value is not a nebulous term but something tangible.