Decoding the environmental impacts of cryptocurrencies and the potential solutions


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In Brief

The rise of cryptocurrency and the blockchain technology that underpins it has a potentially transformative effect on international commerce. Despite the vast potential of the technology, there are problems. Bitcoin, the first modern cryptocurrency, relies on vast amounts of computational power (and therefore, electricity) to operate – bitcoin consumes as much electricity as some countries. An estimated 85% of cryptocurrency mining occurs in China, where electricity is cheap and largely sourced from environmentally unsustainable sources like coal-powered plants. As the cryptocurrency industry grows, and the adoption of blockchain technology increases, it is increasingly important for cryptocurrencies’ blockchain technology to be more environmentally conscious. As cryptocurrency moves into its third generation, new methods of carrying out computational work have been proposed. By prioritizing efficiency, these new cryptocurrencies also reduce their environmental impact. In doing so, the industry neatly exemplifies how improving the environmental output of an industry can be linked to enhanced productivity and effectiveness. This solution could be buttressed by other environmental solutions – like environmental taxes or incentive schemes – though the practical challenges of alternative approaches should not be underestimated.


 
Introduction: Bitcoin and ‘Proof of Work’ Blockchain Systems

Cryptocurrency and the blockchain technology that underpins it have the potential to transform global commerce.1 Bitcoin and its rival cryptocurrencies provide a decentralized means of fast, cross-border payment for a much wider range of digital activities than was previously possible. Blockchain technology has created a new way for users to transact, store data, and carry out a range of functions more efficiently, without reliance on a trusted ‘third party’ intermediary. Initially, the small size of the cryptocurrency industry and its nascent development meant its potential environmental impacts remained relatively unexplored. The rapid growth of the industry through 2016-2017, and the significant range of future applications of the technology, makes examination of cryptocurrency and blockchain’s environmental impacts increasingly important. For instance, bitcoin now consumes as much electricity as some small countries, and is estimated to account for 0.5% of the world’s energy consumption by late 2018.2

The rise of cryptocurrency is widely attributed to the creation of the bitcoin blockchain, as articulated in a paper entitled ‘Bitcoin- A Peer to Peer Electronic Cash System’, published online under the pseudonym Satoshi Nakamoto in 2009. The bitcoin blockchain system Mr Nakamoto created governs the generation of new bitcoins, and also verifies the transactions using existing.3 This is done through the peer-to-peer network of computers that are all connected to one another via the internet.3 Each bitcoin transaction needs to be verified and then added to the ledger of past transactions known as the blockchain.3

The process of verifying a transaction is known as ‘mining’. Mining involves each user’s computer solving complex algorithms to verify the validity of bitcoin ‘keys’, and thereby verify bitcoin ownership and transaction validity through a process known as ‘proof of work’ (PoW).4 Under the PoW model, bitcoin miners’ computers compete to be the first to verify transactions. The first miner to do so is paid in bitcoin. This verification process has become more complex over time as the blockchain ledger grows, and as more transactions are carried out and more bitcoins are created. High bitcoin values have seen miners compete to be first to verify transactions, seeing computing power (and electricity consumption) dedicated to bitcoin mining increase dramatically.4 This technological ‘arms race’ has seen competitive bitcoin miners devote substantial banks of computer processors and infrastructure to bitcoin mining, having a substantial impact on electricity consumption. Given the underlying commercial objectives of miners, there is an obvious incentive towards bitcoin mining being undertaken in jurisdictions where electricity costs are lowest (which is often associated with energy from unsustainable sources like coal).4

 
The Problem: The Environmental Costs of Bitcoin Mining

The underlying problem is that the process of bitcoin mining requires significant power, and miners are incentivized towards using cheap, often unsustainable energy. This underlying problem is not uncommon. It has been widely acknowledged that free market processes are often inefficient at capturing the environmental costs of certain activities.8 In the case of bitcoin mining, the market does not have a direct mechanism to account for the environmental damage associated with the consumption unsustainable electricity, nor to differentiate between bitcoin mining from sustainable versus unsustainable sources.
 
Market failures
Market failure is the inefficient allocation of goods and services on the free market.5 This results in externalities (such as the cost of social or environmental damage) not being reflected in the cost of that good or service on the market.5 This energy consumption of bitcoin mining has become an externality in the market that is not presently reflected in the price of bitcoin, or addressed by regulations. The environmentally problematic nature of bitcoin (and more specifically the PoW model) can therefore be attributed to both market failures and a lack of government regulation within the cryptocurrency sector.

A degree of market failure is inherent in the underlying bitcoin blockchain technology, in that the premise behind bitcoin mining fundamentally promotes in inefficient use of computational power. Under the bitcoin blockchain’s PoW model, any number of individuals on any number of computers can all be working on verifying the same block at the same time; that is, they are all in competition with each other to verify that particular transaction first.3 This results in large amounts of computational power going to waste in an effort to verify a particular transaction.3
 
Distributional nature of bitcoin mines
The market economics behind bitcoin mining are inherently cost driven, and the unencumbered nature of the bitcoin mining process allows mines to be transported or established with relative ease all around the world, and bitcoin mines have gravitated towards countries where electricity is cheaper.4 This is often correlated with jurisdictions where electricity is created through unsustainable means. For instance, in China, coal plays a significant role in quickly and cheaply meeting the country’s energy demands, and accounted for around 80% of electricity production in 2015.6 This has resulted in China emerging as a hotspot for bitcoin mining.7 Vranken (2017) found that “the five largest miners, which are mostly based in China, mined over 85% of the [transactions] in 2016”.
 
Environmental Impacts
The rise in cryptocurrency mining can therefore be seen as environmentally damaging in two ways. Firstly, the mining of cryptocurrency requires substantial volumes of electricity. Secondly, cryptocurrency mines are distributed in a way that enables them to take advantage of cheap electricity in countries that utilize power generation from non-renewable resources such as coal6, effectively giving the industry a commercial preference towards unsustainable energy (at least to the extent that unsustainable energy remains a cheap source of energy).

Additionally, bitcoin mining falls outside conventional environmental regulatory frameworks designed to address traditional mining. For example, bitcoin mining is not addressed Environmental Impact Assessments or Cap and Trade energy use policies. While the physical damage on-site remains minimal, the indirect environmental damage these mines produce as a result of their electricity consumption remains unchecked. Similarly, bitcoin miners are not required to offset or mitigate their electricity consumption as other forms of mining or even industrial operations may be required to do. Consequently, not only do bitcoin mines use vast amounts of electricity, they are not held to any form of environmental standard for either where they source their electricity, nor are they required to mitigate the environmental damage they cause.

 
Potential Solutions
There are two potential approaches to reducing the environmental impacts of bitcoin mining. The first solution is passive – it appears that the cryptocurrency industry is already beginning to address this problem without external input.8 The second solution involves the introduction of new environmental regulatory frameworks for cryptocurrency mining operations.
 
‘Let the market solve it’
The free market approach to solving environmental issues is based on the premise that over time individuals and companies will acquire information about the externalities produced by the market on a voluntary basis.9 Moreover, not only will they voluntarily seek out these externalities, they will work to organically internalise them without government involvement.9 Environmental outcomes are often aligned with other cost-driven market outcomes and, where this is the case, it is beneficial for producers to act on inefficiencies in order to enhance their net gain.9 As a result it is often seen that markets become more efficient over time as they will correct market failures (including environmental damage) without government intervention.9

A core issue with the bitcoin platform as it was originally devised is its inefficiency: in its most basic form, bitcoin’s blockchain system involves multiple miners competing to be first to successfully undertake verification work, with only the first successful miners’ work being ‘used’ by the platform. This has led to significant delays in transaction processing times and costs. To address this, bitcoin miners have contributed to the innovation of more efficient computer processing hardware with which to conduct mining.4 However, this does not fundamentally change the unnecessary duplication of effort; nor the commercial impetus for bitcoin mining to be based in jurisdictions with low-cost, unsustainably created electricity sources.4 Hardware improvements alone are unlikely to be an adequate solution.

The cryptocurrency industry evolves extremely quickly. New cryptocurrencies and new blockchain platforms are developed regularly, and a more promising solution lies in the transformation of the fundamental way in which cryptocurrencies’ blockchain platforms operate. ‘Third generation’ cryptocurrencies’ blockchain platforms are inherently more efficient in their productive processes than their first generation counterparts. For example, Cardano, a third generation cryptocurrency, sought to increase its efficiency generally, to improve processing times and transaction costs. To do so, Cardano adopted a new ‘proof of stake’ model to maintain its blockchain ledger.10 Unlike bitcoin’s PoW model, Cardano selects miners on an individual basis to verify each transaction. By reducing unnecessary duplication and competition, Cardano is more efficient, requires significantly less computational power, and therefore requires significantly less electricity consumption.4,10 Cardano (amongst several other new cryptocurrencies) therefore provides a clear example of how the coalescence between market efficiency can organically lead to more efficient, effective environmental outcomes, as environmental externalities are internalised by the market. In short, the cryptocurrency market may have already found a solution to its environmental problems.

However this passive approach remains problematic as it relies on the market naturally identifying cost driven solutions that are also environmentally beneficial. As outlined, this can work, but the most cost-effective solution will not always be an environmentally beneficial one; for example, the cost-driven approach in the past has been for mining to occur in low cost jurisdictions like China, where the (externalised) environmental costs of bitcoin mining are more pronounced. If markets identified more commercially effective means of improving efficiency this may see progress towards more environmentally efficient outcomes stall. This suggest that, whilst the approach has significant short term potential, it may need to be supplemented by other, more active solutions.
 
Government regulation
The underlying issue with relying solely on the market, is that this passive solution works only to the extent that commercial and economic objectives (like cost and expediency) align with environmental objectives.9 Regulatory frameworks can help to internalise environmental costs, so that commercial-effective solutions directly take into account, are more closely aligned with, environmentally-effective ones.11 To do so, regulatory frameworks can introduce rules and requirements which have the effect of better controlling or mitigating the environmental impacts of bitcoin. Such frameworks could include conventional ‘Cap and Trade’ schemes designed specifically for the cryptocurrency industry, to control the amount of electricity used by bitcoin mines. Alternatively (or additionally), incentivising the use of clean energy sources in bitcoin mining, or the more efficient ‘proof of stake’ model, could be alternative avenues for environmental regulatory bodies to encourage more environmentally conscious developments in the industry.

An inherent issue with any of these approaches is that the global, flexible nature of cryptocurrency businesses (and markets) means that they can easily relocate to the most favourable jurisdiction – unlikely conventional mining. If one country introduces onerous regulations to improve the environmental impacts of cryptocurrencies, and this comes at a commercial cost, cryptocurrency miners may move offshore to a country that does not enforce or have such regulations in place (broadly like miners did to utilise low cost electricity in China). Regulations must therefore take into account the unconventional nature of bitcoin mines and their ability to easily relocate if regulations are unfavourable.12 Globally co-ordinated efforts to regulate cryptocurrency’s environmental impacts may mitigate this outcome, though present regulatory agreement and diverse policy approaches make this unlikely in the short term.12

To address this, it is likely that regulatory efforts may be better designed around incentive mechanisms which encourage positive activities like ‘proof of stake’ an using sustainable energy in mining. Some countries are actively trying to promote the development of the cryptocurrency and blockchain industry (like Dubai, Singapore and the Isle of Man), and are doing so through the introduction of more favourable regulatory regimes in particular legal contexts: for example, anti-money laundering, and corporations/securities law.12 In the current uncertain regulatory climate, cryptocurrency businesses are likely to be attracted to such jurisdictions, which potentially gives regulators some leverage.12 Consequently, one practical solution to this may be for governments to introduce environmental requirements (like using ‘proof of stake’, sustainable energy sources, or taking other measures to mitigate a cryptocurrency’s environmental impacts) as a condition of receiving concessional treatment in the context of other regulatory frameworks. Whilst this may be a difficult approach to co-ordinate between government departments, it may offer a viable medium-term solution to complement the passive approach explore above, and soften cryptocurrency’s environmental impact.

 
Conclusion
The rise of cryptocurrency globally has resulted in concerns about the environmental impact that this platform will have in future years. The computational power required to sustain these cryptocurrencies is central to these concerns. Moreover bitcoin miners utilise cheap electricity from countries such as China where coal combustion is a major source of electricity to power their mines, further compounding the problem. As cryptocurrency moves into its third generation a new model for the way in which computational work is carried out may offer a solution to the energy consumption problem currently facing these platforms. Governmental regulation could also offer another avenue for mitigating the environmental concerns surrounding cryptocurrency but the unique nature of this industry makes it easy for miners to relocate to more favourable jurisdictions.

 
References

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