As cryptocurrencies and NFT trading continue to shift towards the mainstream, a considerable push is emerging to regulate the sky-high energy use of the underlying blockchain infrastructure.
In February last year, the digital artist Beeple sold an NFT (non-fungible token) for around $US6.6 million.
For many, it was an astonishing result, but the artist followed that up just a month later with a record-setting $US69 million NFT sale that placed him among the world’s top three most valuable living artists, according to auction house Christie’s.
Those sky-high sales prices illustrated just how popular these assets are becoming among a new class of collectors who value novelty and see big money-making potential.
One of the advantages of blockchain is its immutability, which means once a transaction is made, it can’t be reversed. Anyone can scour the blockchain and see the ownership trail, making it perfect for artistic provenance.
The other common use of blockchain technologies is for cryptocurrency, of which Bitcoin is the best-known. There are dozens, if not hundreds of blockchain protocols, including Ethereum, which is where most NFTs are “minted,” Solana, Tezos, Polkadot and many more.
Since the first bitcoins were created as an alternative to centralised currencies by the mysterious Satoshi Nakamoto in the wake of 2008’s Global Financial Crisis, cryptocurrency trading has steadily increased in popularity to become a genuine asset class.
In November 2021, the global market capitalisation of cryptocurrencies hit an all-time high of around $US3.1 trillion, according to data from CoinGecko.
And while that market cap has plummeted in recent months down to around $US1.7 trillion, there are now more than 12,000 cryptocurrencies being actively traded across 560 exchanges.
The elephant in the room, however, is the energy consumption used by many blockchains to mine coins, mint NFTs and verify transactions.
Cambridge University’s Bitcoin Energy Consumption Index estimates 137.78 Terawatt hours of electricity are consumed by miners annually, with that energy use estimated to rise to 206TWh if the price of a single bitcoin rises to $US47,000.
NFTs are digital representations of an artwork stored on a blockchain, which is a distributed ledger held across thousands of computers.
By comparison, a study published in the scientific journal Joule in 2021 estimated all of the electric vehicles on the road in 2020 consumed 79TWh, while 131TWh is also much higher than the energy used annually in many developed countries around the world.
Exacerbating the issue is the power used by blockchains often comes from non-renewable sources.
Cryptocurrency’s reliance on electricity produced from fossil fuels, however, could already be changing, according to Todd Olson, Director, Digital Assets, Baker Tilly.
“The industry is taking giant steps towards using more efficient energy sources,” Mr Olson said.
“Society may conclude that bitcoin, as an example, is misaligned with the large component of the world trying to move towards improving our environmental impact.”
Until it cracked down on crypto in 2021, China was a Bitcoin mining powerhouse, with miners often located near cheap energy sources.
But when the rug was pulled out from under mining by the Chinese government, miners looked to other places where power was inexpensive.
“Many relocated to Texas, where they have been harnessing natural gas being flared into the atmosphere,” Mr Olson said.
“They were able to capture some of that usage, making it more efficient.”
Scrutiny on the energy consumption and efficiency of the ‘consensus mechanisms’ that blockchains use to verify transactions or mine coins is also on the rise in Europe.
One of the EU’s top financial regulators recently called for a ban on the main form of Bitcoin mining, ‘proof of work’, with the industry urged to shift towards the less energy intensive ‘proof of stake’.
Consensus mechanisms: a comparison
With proof of work (often shorted to PoW), powerful computers solve complex mathematical problems to arrive at a consensus. With Bitcoin, the miner that solves the problem first is rewarded with additional bitcoins.
“As long as the cost of mining a coin is cheaper [than the energy cost] of minting it, people will continue to mine,” Mr Olson said.
“You solve the transaction and get six Bitcoin, and it’s currently profitable to mine at the existing energy costs.”
The problem with proof of work is it consumes huge amounts of electricity and if the power used isn’t renewable, then there’s a climate issue.
A 2019 study found Bitcoin production was estimated to generate between 22 million and 22.9 million metric tonnes of carbon dioxide emissions a year, equating to a level sitting between that produced in Jordan and Sri Lanka.
The two largest blockchains by trading volume, bitcoin and Ethereum, both rely on the proof of work model, which requires all participants on the blockchain ledger to verify transactions.
Baker Tilly Cayman Senior Audit Manager and Digital Assets Practice Leader Julian van Zyl said the rising popularity, and in turn energy use, of proof of work cryptocurrencies was counter-intuitive to the global movement towards energy conservation.
“The world is trying to conserve resources in an effort to curb global warming on the one hand, and on the other we have proof of work blockchain technology that is undermining these incremental improvements at an alarming rate,” Mr van Zyl said.
“I believe that society may conclude that bitcoin, as an example, is misaligned with the large component of the world trying to move towards improving our environmental impact for the long term.
“Bitcoin could one day have no value – its inherent value is what society values it at, and I’m very surprised that it is still the number one blockchain given more efficient alternatives exist.
“Ultimately the total market capitalisation of energy-wasteful chains could decrease due to change in sentiment, and with that, the electricity use will go down because there is less incentive to mine and there will be fewer transactions on the network.”
Proof of stake (PoS) is the other most common consensus mechanism, relying on people who validate the transactions on the blockchain to “stake” some of their holdings.
Generally, the more a validator stakes, the more likely they are to be chosen to create the next block on the chain, and in doing so receive rewards like coins or tokens.
Ethereum is currently undergoing a challenging upgrade to shift it from being a proof of work chain to one using proof of stake, reducing its energy consumption and making it more attractive to corporate users.
“Most companies are starting to think about ESG, and they want to be aware of the energy they use in transactions,” Mr Olson said.
“Going forward, it’s going to be important for [any company choosing a blockchain] to be associated with one which is energy efficient.”
A recent report from the EU Blockchain Forum, Energy Efficiency of Blockchain Technologies, notes blockchain solutions based on proof of work should be avoided due to their significantly higher energy consumption compared to other consensus protocols.
But proof of stake blockchains don’t get off lightly. All those computers competing to be the validator of the next block in the chain consume power both when they are idle, as well as when they are vying to be the next validator.
This additional energy use is not often taken into consideration when the overall power consumption of a proof of stake chain is examined.
The report also noted that renewable energy must be used to the maximum possible extent, regardless of the consensus mechanism under consideration to eliminate the climate toll blockchain takes on the environment.
Where to from here?
It’s worth noting, Mr Olson said, that Bitcoin is a value store, while other blockchains are used to mint NFTs and write smart contracts.
It’s not an apples-to-apples comparison. And there are only a finite number of bitcoins that can ever be mined, so despite recent value fluctuations, the long-term prospects for Bitcoin as a value store are bullish.
“Bitcoin is not going to move to PoS,” he said.
“But miners will look to solve the energy problem and computers will become more efficient.
“Other protocols, however, are even more energy efficient with PoS being around 99.9 per cent more efficient.”
Mr Olson believes blockchain technologies and Bitcoin is here to stay.
“Going forward, it’s going to be important for [any company choosing a blockchain] to be associated with one which is energy efficient.”
“Blockchain is what my kids will use, and distributed ledgers reduce transaction costs, so I believe the technology is going to be very valuable in the future,” he said.
One area where Mr Olson said blockchain tech has the potential to have a massive impact is in the financial services industry, where many middlemen stand to lose market share.
This is because blockchain is immutable, verifiable and allows people to undertake direct transactions with one another without having to rely on someone else to process the deal.
“Banks want to become more digital and FinTechs want to become more like banks, but as far as the technology goes, it is here to stay,” Mr Olson said.
But without an emphasis on greater computational efficiency, as well as shifting power use from fossil fuels to renewable energy, blockchain’s environmental footprint is going to remain the elephant in the room, regardless of how promising this technology is and how much (hypothetical) wealth there is to be made from exploiting it.
Baker Tilly Cayman’s Mr van Zyl, however, doesn’t entirely share Mr Olson’s optimism about Bitcoin.
He believes coins and tokens produced using proof of stake are more innovative and useful than those created using proof of work, which are designed to be wasteful as a security feature, being that the energy use required to corrupt or hijack the chain would be more expensive than the reward for doing so.
“I was speaking with clients of mine who are involved in investing in new blockchains and new crypto technologies and they said to me ‘Bitcoin is a dinosaur. We played with dinosaurs when we were kids, but it’s time to grow up now’,” Mr van Zyl said.
“It was necessary for the first implementation of blockchain technology to use proof of work because initially there were too few users holding the currency for proof of stake to work – proof of stake needs the cryptocurrency holdings to be widely distributed to ensure security.
“Satoshi Nakamoto and other major holders had most of the coins, so they would have had too much power over the blockchain’s transaction. This would negate the security.
“Now that we have got a booming crypto market, there are few reasons, in my opinion, that blockchains need to be proof of work.
“Proof of stake offers many solutions, and it is being developed constantly.
“It is a more versatile starting point to work from on a chain, to improve and to address certain disadvantages.”
“Whereas proof of work is proof of work. You can build scaling solutions on top of it, but your core layer will always be extremely wasteful for it to work. The more valuable it becomes, the more wasteful it needs to be.”
However, Mr van Zyl acknowledged there would need to be a fundamental shift in the way institutional investors approach cryptocurrencies before there would be any meaningful change in energy consumption.
He said most hedge funds that invest in crypto were non-directional, with their use of algorithms ensuring their investments were profitable when the market goes up or down, therefore they were agnostic as to which coins they invest in.
“Most of them are trading on technical analysis, so when the market goes up it goes up a lot because everyone is pumping money in, then the algorithms change, and everyone is selling,” Mr van Zyl said.
“Everyone is just working with the cycles, because it is an easy way to make a good return.”
“I think if there was sufficient fundamental analysis investing out there, people would assess the pros and cons of different tokens against each other and many would look at Bitcoin and say that it is not a future-proof algorithm and that it will soon start to be rejected by society.”
“Therefore, people would be sceptical of investing in Bitcoin. I’m not a crypto investor, but if I was, I would not invest in Bitcoin because I believe it has such a negative impact on the environment.”
“I would rather invest in alternatives like Ethereum and other proof of stake algorithms.”
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