Cryptos and Energy Consumption; Here We Go Again

KEY TAKEAWAYS

• The energy debate is not new and is brought up in every crypto market cycle.

• Cryptos can help alleviate the intermittency problem of renewable energy sources.

• Proof of Stake consensus algorithms might be one of the solutions to reduce energy consumption.

HOW DO CRYPTOS USE ENERGY?

Cryptocurrencies are subject to what is known as the Scalability Trilemma. This means that a given crypto can only optimize for two out of the three variables below.

The more decentralized and secure a network is, the less scalable it becomes. The more secure and scalable a network is, the less decentralized it becomes. You get the idea.

What the protocol of a given cryptocurrency optimizes for is at the heart of that cryptocurrency’s use case – store of value, improve transactions efficiency, enable smart contracts, etc. – and one of the externalities of these optimization decisions tends to be the amount of energy consumption needed for the network to function properly. We would intuitively say that protocols that focus on security and decentralization tend to be more energy-dense, but let us know if you think otherwise.

Energy specifically matters in cryptocurrencies because of its underlying technology – the blockchain – which, in very simple terms, uses computing power as the one input to ensure the well-functioning of its network. Consider this:

• The blockchain enables decentralized and yet trusted authority thanks to its transparent Proof-of-Work consensus mechanism, in which miners (i.e. computers in the network) attempt to solve complex math equations (each attempt is called a hash) in order to solve a block of transactions and get rewarded in crypto coins for the work.

• These complex math equations are cryptographic hash functions that can only be solved by trying to “guess” a solution – i.e. there is no evident logic to it, and it simply is a matter of trial and error.

• This means that miners are incentivized to maximize the number of guesses they submit to every block, in order to increase their probability of solving the block and, thus, receiving the crypto reward.

• Every guess, successful or not, uses computational power which, in turn, is fueled by electricity.

• As a cryptocurrency gains traction, and its value increases, more miners are incentivized to submit attempts, as the reward becomes gradually more valuable.

• As competition increases for the “guesswork” around the blocks, so does the hash rate (total number of guesses to solve the cryptographic hash function), which implies higher and higher energy consumption (remember, every guess is simply a result of random computational power work that is fueled by electricity).

Frequently, the more computing power one blockchain uses, the more mature the network it supports should be, meaning that more mature cryptos imply higher energy consumption (in fact, BTC and ETH account for the majority of energy consumed by crypto).

On the positive side, optimization in the code or hardware (i.e. mining equipment) might change this. Case in point:

• According to the IEA, the latest generation of mining equipment is c. 50 million times faster and a million times more energy-efficient than the central processing units (CPUs) that were used to mine in 2009. That said, hardware efficiency gains are already slowing down, meaning innovation on the code side rather than the hardware is likely to matter more for future efficiency gains.

• Proof-of-stake (as opposed to the standard proof-of-work) consensus algorithms are expected to significantly reduce energy consumption (more on this below).

Beyond fueling computing power, cryptocurrencies’ energy consumption also includes what is consumed by non-IT infrastructure, such as the cooling systems in order for mining equipment not to overheat.

This makes the energy consumption analysis slightly less straightforward.

BITCOIN’S ENERGY CONSUMPTION

Bitcoin is the most dominant cryptocurrency out there, and the majority of the computing power that supports its blockchain is located in China.

China is known to have a relatively dirty mix for energy sources, which implies that, if Bitcoin mainly relies on computing power located in China, and if that computing power uses energy sources that have a dirty (i.e. polluting) mix, then Bitcoin must have a negative environmental impact.

There are two main points that need to be made on the energy discussion before we give you the stat dropdown:

• Opinions on Bitcoin’s energy consumption will vary greatly depending on one’s opinion on the utility and importance of BTC as a positive or negative asset. The higher your opinion of cryptocurrencies is, the more willing you are to accept a higher energy consumption, and vice-versa.

• It is more important to look at the sources of energy used in the Bitcoin network rather than at the overall energy used, as it gives us a much more accurate view of the environmental impact of its ecosystem.

With that, the energy discussion is, really, less about numbers and statistics and more about ideology, something that we’ve become accustomed to in the world of cryptocurrency.

Here are some stats:

• According to the Cambridge Centre for Alternative Finance (we hope not to lose Oxford Alumni here), Bitcoin consumes 0.46% of total electricity production and 0.53% of total electricity consumed around the world. Is that too much? That depends on your view of the utility of Bitcoin.

• Digiconomist estimates that the carbon footprint to mine one single BTC is 176 tonnes of CO2. At the current new supply per day rate of c. 900 BTC (based on 6.25 BTC per block reward), this implies almost 58 million tonnes of CO2 emissions per year, which is 0.16% of the world’s CO2 emissions from the burning of fossil fuels. But that is probably an overstated calculation as it isolates single transactions, which is not an adequate metric for the efficiency of Bitcoin’s Proof-of-Work.

• As we’ve mentioned, the energy mix is very important. Surprisingly, CCAF estimates that 39% of total energy consumed by miners comes from renewable energy. This compares with the total world’s renewable share of 11% in 2019, according to Our World in Data. This would imply that Bitcoin has a cleaner mix than the average energy consumption profile in the world.

• A 2018 Nature paper highlighted how Bitcoin needed, at that point in time, 17 Megajoules (MJ) to generate one US Dollar, whilst gold needed 5 MJ. This might have changed in recent years given the exponential rise of BTC prices (which have been partially offset by the increase in the hashrate of the BTC blockchain), but it gives a frame of reference of how BTC’s energy consumption, in dollar terms, is not necessarily significantly more competitive than current alternatives to store value (also, take a look at last months Charts of the Month to see how BTC production stacks up in oil terms to the rest of US consumption).

SOLVING FOR INTERMITTENCY

In our view, the most important thing to highlight about Bitcoin miners is the uniqueness of their profile as energy buyers. Quoting Square’s recent Whitepaper:

“Bitcoin miners are unique energy buyers in that they offer highly flexible and easily interruptible load, provide payout in a globally liquid cryptocurrency, and are completely location agnostic, requiring only an internet connection. These combined qualities constitute an extraordinary asset, an energy buyer of last resort that can be turned on or off at a moment’s notice anywhere in the world.”

With solar and wind energy already at a lower deployment cost than coal or natural gas, its largest headwind is no longer price, but the lack of consistency of its energy production (i.e. intermittency) – the sun isn’t always shining and the wind isn’t always blowing – which, paired with peak energy demand in the morning and the evening, creates a supply and demand power imbalance and grid bottlenecks (think demand peaks around 6pm, when there is less sun shining).

Whilst improved energy transmission and storage will eventually solve this, Bitcoin mining’s unique profile can efficiently complement renewable energy’s operations by:

• Being a buyer of the renewable energy produced that is not met with appropriate demand, and would otherwise go to waste.

• Giving renewable energy projects incremental buyers, thus increasing the revenue profile of renewables products and allowing for more projects to become financially viable.

• Having the energy producers themselves open mining operations and allocating excess power to mining and “storing” the energy in Bitcoin (this is more of a stretch, we know).

This would obviously be severely impacted by the headline price of Bitcoin, which makes all of the above possible (or not). But one thing is reasonable to assume: Bitcoin mining presents a new source of flexible demand for constrained renewable energy producers across the world.

THE PROOF OF STAKE SOLUTION

Proof of Work (PoW) consensus has been the standard blockchain algorithm of choice for the most important cryptocurrencies out there, with more than $1 trillion in market cap using that consensus algorithm in their protocol.

PoW requires significant computing resources and, thus, energy consumption in order to ensure the network’s security, which is one of the reasons why Proof of Stake consensus algorithm has been pointed to as one potential solution for the energy consumption debate (follow this link in case you need a refresh on how Proof of Work… works.)

There are more than 300 coins based on Proof of Stake consensus algorithms and more than $100 billion of market cap associated with it.

PoS’ basic idea is that letting everyone compete against each other in the mining process to validate transactions is simply wasteful. Instead of having miners compete against each other, PoS algorithms randomly (with a few caveats) select one node to approve the block (PoS doesn’t have miners, only validators), and lets that node run the computation.

These potential validators must deposit a certain number of coins in the network (similarly to a security deposit when you rent a car) before they can be considered to be selected for the validation of a block. The larger the node’s deposit, the more likely it’ll be selected as the validator.

Once the validator validates the transactions, it is rewarded with the transaction fees associated with the block. As long as these transaction fees are smaller than the number of coins staked, the network can expect the validators not to approve fraudulent transactions (or else, they would lose their deposit and incur a loss).

Ethereum, which currently uses PoW, has always had the goal of transitioning to PoS, and with it, to bring its energy consumption down by 99%.

Make no mistake: the energy consumption argument has surfaced on every crypto market cycle, and it will likely continue to be the case going forward. But we find that the crypto community is not ignoring these issues, with multiple solutions popping up every day. We have learned not to be bearish human ingenuity, and we think that this is yet another example of that.