ESG, Crypto, and What Has the IRS Got to Do with It?

Despite their volatility and the many regulatory challenges that cryptoassets present, they continue to be adopted by institutions and individuals alike, with some of the world’s largest organizations, ranging from Wall Street banks to UN institutions, allocating resources to the space. As exciting as crypto assets may be, however, no singular technology or financial instrument exists in a vacuum; cryptos are no exception. Alongside the increasing adoption and understanding of crypto asset applications and use cases, two other trends are set to fundamentally impact how crypto space develops. First, the long-awaited pivot away from Proof-of-Work (PoW) to Proof-of-Stake (PoS) as the dominant form of consensus mechanism seems to be approaching and has already materialized in the case of Ethereum, with significant implications for the development of future blockchain-based applications. These might include spurring more staking activity, and making the blockchain space more eco-friendly. Second, outside of the crypto sphere, growing interest in environmental, social, and governance (ESG) factors continues to pressure investors across asset classes. Despite the recent crypto winter, marked by a substantial fall in cryptoasset prices, the continuing evolution of the sector, including the growing institutional investment, provides a unique opportunity for policymakers to reassess current regulatory treatment related to the aforementioned trends. Specifically, the industry’s current downturn provides an opportunity to refocus on the underlying fundamentals and use cases of the technology, versus focusing on price volatility and potentially fraudulent activities. In a new article, we focus on these issues and several specific policy implications that should interest academics, regulators, and practitioners alike.

First, the continued adoption of blockchain technology, beyond bitcoin trading and investment, has generated an incentive for regulators to take a more nuanced approach to the rulemaking process. Given that in the United States much of the rulemaking has taken place via regulation by enforcement, there has been some uncertainty as to who should supervise cryptoassets and how. That uncertainty has not been ideal for consumers and market participants. Moreover, several regulators are seeking to carve out certain pieces of the crypto landscape for the purpose of regulatory oversight. With a looming crackdown and important cases, including the high-profile crypto tax case of Jarrett in connection with the IRS’ decision regarding staking rewards, the ongoing debate around how crypto-industry participants should be taxed and regulated is certainly something that lawmakers should be more aware of and focused on. This is all the more likely that last week, the Tennessee district court  dismissed the case without the court addressing the underlying issue.

Second, the pressure and scrutiny brought to bear on financial markets by ESG considerations—supported by regulators, policymakers, and some of the largest financial institutions in the world—continues to highlight an ongoing issue with crypto assets. Indeed, one of the primary reasons why PoW is set to be superseded by PoS is the ongoing debate around the environmental impact of blockchain and crypto assets. Specifically, the power necessary to mine, process, and validate transactions under PoW has been widely documented and debated at the state, national and international levels. The pressure to find an alternative consensus is another major narrative in the crypto space, on top of the growing expectation that all industry groups will operate in a manner consistent with environmental conservationism. Following the Ethereum merge, leading to a forecasted drop in energy consumption of up to 99% for the second largest blockchain in the world, the opportunity for policymakers to integrate tax, crypto, and ESG policies successfully has never been more important.

Lastly, regulators can help advance desired agendas by developing an innovative and well-thought-out tax policies. In our article, we argue that the current tax framework is less suitable for further investment and development of crypto, particularly because (i) current tax treatment creates burdensome compliance and reporting structures for anyone looking to use crypto as a medium of exchange; (ii) classifying crypto as property, without exception, stymies the utilization of crypto for use cases besides speculative investment and trading; and (iii) policymakers can leverage the growing interest and investment in crypto to positively drive pro-ESG policies.

Tax policy can create a more hospitable environment for continued crypto development and encourage ESG-friendly policies. Consider the following: first, certain crypto assets should be treated differently depending on the holding period, use case, and composition of those specific crypto assets. Second, ESG-friendly crypto projects and tokens should receive tax incentives and breaks, much like other projects bolstered via financial regulation designed to nudge persons and businesses in a desired direction, such as, for example, increasing pension savings by changing default rules from opt-in to opt-out. Finally, as crypto assets become more closely affiliated with the PoS consensus model, these digital assets might become closer to securities than ever before. Classifying crypto assets as securities will create more complications but also provide regulators and practitioners with an opportunity to reframe the policy debate around how crypto will fit into the broader financial asset landscape. This also creates an opportunity for individual and institutional investors to use the increased interest in ESG and other environmentally focused projects to elevate the funding and buy-in certain crypto initiatives receive. This opens a window for a win-win outcome of clearer policy, more sustainable crypto-based products and services, and, last but not least, more environmentally focused projects receiving the funding they require. Implementation of these suggestions will allow for the development of more crypto products, better transparency of said products, and can assist with aligning the goals of ESG investors, crypto investors, and financial regulators.

Nizan Geslevich Packin is a Professor at the City University of New York’s Baruch College, Zicklin School of Business, and a Senior Lecturer at the Faculty of Law at the University of Haifa.

 Sean Stein Smith is a Professor at the City University of New York’s Lehman College.