Ever since its inception, from its origins as a hobby to the development of so-called dark web currencies up to more complex uses such as ICOs and DeFi, the topic of cryptocurrencies has gathered the regulators’ attention, mainly due to its criminal and financial concerns. Even if it became evident from a very early stage that regulation was necessary, very few could predict that calls for legal action would have soon stemmed from discussions on energy consumption and the environment. Inflamed by the news that the Bitcoin network consumed a nation-sized amount of energy, the spotlight recently moved to the environmental effects of cryptocurrencies. The timing could not have been worse for the blockchain industry: in 2021, several instances of energy shortages across the globe, some carrying devastating results, further increased the attention devoted to this phenomenon.
The technology: Consensus mechanisms
In order to understand the energy problem underlying cryptocurrencies, one must first understand some key aspects of the blockchain technology and, in particular, of consensus mechanisms, i.e. the way through which blockchain technology decides which information is true and can be added to its “chains”.
As it was explained in a previous Insight, blockchain is a way of storing data in a sequential and decentralized manner. Blocks of data are created in chronological order. When a block reaches its size limit, a new block is created, with each new block being connected to the previous one. In order for a new block to be created, its data must in compliance with data in the previous block. This verification is done by “miners” (anyone who, using computers or specialized machines, decides to participate in the network validating transactions) using consensus mechanisms, which are nothing more than the rules by which the miners decide what block can be considered reliable and, hence, can be added to the chain.
The two most common consensus mechanisms are the Proof of Work (PoW) and the Proof of Stake (PoS). In a PoW system, miners validate new blocks by guessing the answer to a complex mathematical puzzle – a process which requires a lot of computational power and, inherently, large amounts of energy – in exchange for a reward.
In a PoS system, users can become validators by staking a set amount of currency, which acts as a collateral both to ensure that the blocks they add contain only true information and to calculate their chance at verifying a block – eventually earning its reward.
Note that in both systems validators need to have some investments: In a PoW model, the miners are essentially betting that their block will be added to the blockchain in exchange for a reward; whereas, in PoS models, the stake acts as collateral for backing the right block.
Both systems of “validation” of the information added to the blockchain have advantages and disadvantages. PoS promises higher efficiency and scalability, while drastically reducing energy consumption. Conversely, PoW boasts higher security, which, as demonstrated by a decade of experience and testing by the Bitcoin network, leads to virtually impeccable results. However, this added security of larger and energy-hungry networks is inevitably tightly connected with the core point raised by this contribution: the environmental problem.
The future: How can the industry adapt?
Faced with increased scrutiny, some industry players have decided to abandon the PoW consensus mechanism altogether. Ethereum, the second largest PoW chain and the standard model for any blockchain application (be it DeFi, NFTs, Smart Contracts or others) has been slowly losing dominance to the benefit of its faster and cheaper PoS competitors. Until January 2021, 95% of all DeFi assets were in the Ethereum network. In just one year, that figure has plummeted to 58%. It can be hard to pinpoint exactly what caused this phenomenon, but speed and cost of transactions are certainly among the main reasons behind this shift: indeed, Ethereum’s PoS competitors are able to offer much faster and cheaper transactions. In light of these developments, the Ethereum foundation has announced that it will shift to a PoS model in 2022.
From an environmental point of view, this is a meaningful example of self-regulation and evolving industrial policy in action: While aiming for faster, cheaper, and more competitive networks, industry players are also steering cryptocurrencies into greener practices.
However, even though some blockchains are moving away from PoW, it is unlikely that the Bitcoin network, by far the largest energy consumer, will make this jump. Acknowledging and expecting a certain degree of reluctancy, what is important to highlight is the evolving process of awareness and intentional reduction of environmental costs by some – even if not all – industry players.
Ways to minimize the impact of PoW
There are two important dimension that are worth considering separately: industry and public policy.
Embracing the point of view of the industry players, one proposed solution is shifting from fossil fuels to renewable energy in order to power the networks. However, even this seemingly innocent solution has been met with some resistance. Erik Thedéen, vice-chair of ESMA, has recently accused Bitcoin of consuming too large of a share of the renewable energy currently produced, suggesting that the EU regulator should ban PoW mining as a whole.
Another issue with this “green” solution is that distorted competition for clean energy from other industries is a highly likely scenario. The clearest example of this situation is Electric Vehicles (EVs), which are also straining energy grids. However, whereas EVs use renewable energy to replace fossil fuels, the same cannot be said about PoW cryptocurrencies. In the fight for energy between these two significant industries, EVs are more likely to prevail.
From an industrial point of view, there are other ways through which Bitcoin mining can coexist with a greener future. Once again, we need to look at renewable sources of energy, such as solar, wind, and hydro power. In some instances, energy production by way of these systems exceeds demand, resulting in a surplus of energy that goes unused. The storage of this energy is a big hurdle that needs to be overcome in order to promote a larger adoption of renewables. Bitcoin mining could provide a convenient way to turn clean energy that would otherwise be wasted into a valuable asset that is easily stored and transferred. While not as useful as an actual battery, it can at least store the energies’ value. The timing of the mining operations could be managed by utility companies or by reaching an agreement with existing miners.
Looking at the regulators’ perspective, there are two viable options worth assessing: taxing mining or, more radically, banning it.
Taxing market players that cause negative externalities is nothing new in the context of environmental public policy. Tried-and-true examples include taxes on plastic bags and carbon taxes, which dissuade environmentally harmful practices. A tax on cryptocurrency miners that use non-renewable energy to power their operations could incentivize them to switch to cleaner energy sources and develop more efficient mining equipment or, at the very least, provide resources to reduce the impact of the emissions resulting from this activity. Paired with an increase in the availability green (renewable) or green-ish (nuclear) energy, these measures could drastically reduce the negative impact of cryptocurrency mining.
However, some countries are considering of taking one step further into banning any and all mining activity. The efficacy of these measures is highly questionable. If countries where the shift to renewable energy is more advanced were to ban mining, it could be expected that these activities would move towards more favorable jurisdictions, where energy is still derived from less environmentally friendly sources. This would have an overall negative impact on the environment. In other words, the “out of sight, out of mind” approach does not promise to be the most effective answer to a global problem. Even in light of a hypothetical global attempt to ban mining, one might expect energy-rich and developing countries to hardly contrast the multiple incentives in refusing to align their legislations in favor of easy mining and related profits.
While cryptocurrencies could have a place in a greener future, the current state of the art from an industrial and regulatory point of view is far from being compatible with the environmental goals we are currently attempting to pursue, among which carbon neutrality. Achieving meaningful change willrequire a joint effort from industry agents and regulators and, although a one-size-fits-all solution can hardly be expected, several promising avenues and developments should be taken into account and serve as guiding lines for a more structured policy action.