The Proof-of-Work ESG Debate

It is almost impossible to have a reasoned debate about digital assets and ESG. The argument is rife with fear, uncertainty and doubt; red herrings; sophistry; greenwashing; opinions charged by ideological positions and polarization; category errors and oversimplifications. The few times I have done so myself I probably did no better. So for this week’s essay we are going to take a different angle on it, and break down the arguments both sides and try and put some structure around the debate. This is not an advocacy piece, though you will find in here links to passionate arguments both sides. But whatever you believe, I hope you walk away with a better understanding of the nuances, and get an appreciation that this is not a black-and-white issue, but rather a matter of trade-offs to which reasonable people can assign different weights, and thus reach different conclusions.

There is, however, one overarching assumption where I will take a position: the importance of blockchain technology and tokenization via digital assets as a disruptive force in society. This is why this debate matters: the blockchain is not going away, and it is going to become pervasive in society and the economy. To overemphasize this issue in hopes digital assets will just go away like an awkward mania, a passing fad, is to miss the bigger story. To ignore this issue or dismiss as some kind of establishment trick to cheat people out of their chance to live in a Utopian crypto city future is to bypass addressing a potential obstacle to the technology’s widespread adoption. The argument will not go away and needs to be confronted head-on.

Why ESG Matters in the Market

Taking one class of institutional investor as an example, the 5,000–10,000 family offices worldwide control more than $4T in assets (The Economist, 2018). In their 2021 survey, more than half of Goldman’s family office clients indicated plans to invest in digital assets, but equally 60% had already implemented sustainability screening in their portfolios; in Europe, where this is a particular focus, 80% identified it as a significant concern (Goldman Sachs Family Office Investment Insights, 2021). If ESG is truly a problem for digital assets, how will this sizable pool of capital square its desire to invest more in them with their sustainability criteria? Taking another example, Tesla’s announcement that it would not accept Bitcoin for payments any longer due to concerns about a conflict between its green image and this ESG issue caused the market to swoon until Elon Musk walked it back. And one key driver in China’s accelerating crackdown on cryptocurrencies and Bitcoin mining in particular is environmental concerns. Whether you agree that this is an issue or not, there are market participants who believe this is an issue and make decisions accordingly: the market can remain irrational longer than you can remain solvent.

So This is All About Bitcoin?

No. This is one of the oversimplifications. Because Bitcoin was the first cryptocurrency and has so much mindshare worldwide, and because it is far and away the largest proof-of-work based network, this debate is sometimes framed as Bitcoin’s ESG problem, which among other problems give a pass to a number of Bitcoin derivatives and most importantly Ethereum, all of which also use proof-of-work today. Although Ethereum is moving toward proof-of-stake in part due to these concerns, it is not there yet, and so for now at least it’s part of this debate.

The issue is better framed as the proof-of-work ESG debate. Since Satoshi Nakamoto’s whitepaper, there have been numerous attempts to find other mechanisms to establish trustless decentralized networks similar to Bitcoin, using everything from disk space to whitelisted authorities to bonded holdings (staking) to incentivize network participants to do the right thing or to make it prohibitively expensive to do the wrong thing, or both. A detailed exploration of PoW, PoS, PoA and all the rest is well beyond the scope of this essay, but the first thing to understand is that PoW, by requiring progressively more difficult computations to mine blocks, is energy-intensive. Initially PoW was feasible with standard CPU’s, but over time it gravitated to GPU and then specialized ASIC chips, to perform these calculations faster and faster.

When this happened, it introduced a second issue: the specialized hardware required becomes obsolete quickly and has no other utility, and so the electricity use is paired with electronic waste generation as each generation of ASIC miners gets retired. These two factors, electricity use and e-waste, are at the heart of the “E” argument, which we will go through below. That said, the numbers for Bitcoin’s networks are biggest, and so it’s not unreasonable to shorthand this debate as being primarily about Bitcoin. Unfortunately, once you do that, the argument can be taken as an attack on Bitcoin, and there is a very passionate community of believers in Bitcoin who feel compelled to respond to this questioning of the technology and Bitcoin’s value.

What do the numbers look like? As of September 2021 Digiconomist estimated the electricity usage as around 200 TWh, up from 77 TWh at the start of the year, and the e-waste as around 27 kilotons; note Digiconomist did a similar estimate for Ethereum, acknowledging that this is not just a Bitcoin issue, though there is a big difference in scale. How does that compare to the total, and how does the rate of change compare?

In 2019, global electricity production was around 27,000 TWh (IEA, Key World Energy Statistics 2021). In 2021, worldwide energy use increased about 1000 TWh as economies started to recover from the pandemic (IEA, World Energy Outlook 2021) — and demand is growing faster than renewables (IEA, article, July 2021), so electricity use went up and got dirtier in 2021; as just one data point, China is opening a new coal plant almost every week in 2021, and added 100 GW of coal plants just in the first half of the year (Reuters). So PoW electricity consumption grew substantially faster than the total, but is still a relatively small fraction of the electricity consumption worldwide. How small, and whether that is too much, and where that electricity comes from, is where the debate gets interesting, and we’ll explore that more in a bit.

Source: https://digiconomist.net/bitcoin-energy-consumption/

A Short Primer on Electricity Mixes

One key dimension to understand before we go into the details of the environmental concerns is a bit about how electricity generation works. Broadly speaking electricity producers can be broken into baseload and peak load providers. Baseload provides steady power generation; peak load offers additional power when there are sudden increases in demand. One of the challenges with the growth in renewables is wind, solar and other green electricity sources are not suitable for baseload yet, unlike fossil fuels and nuclear power. Grid-scale batteries and other means of smoothing out power — storing energy while the sun is shining and releasing it later — can help here, but is still at very early stages. So if a lot of your electricity is coming from renewables you are more likely to need to turn on “peaker” generation plants, which are generally gas-fired or coal-fired plants depending on the country. Taking a concrete example, if the wind stops blowing in Texas and everyone turns on their air conditioners in Houston due to a heat wave at the same time, the electricity mix will become dirtier for that period of time. While this dynamic is well-understood and modeled in G20 countries, elsewhere in the world the data on peak power providers is not as good: so we can get a good grasp of what it means for Texas, but perhaps not as good an understanding for, say, Kazakhstan. This matters because some of the “pro” Bitcoin arguments we will look at next talk about how Bitcoin mining uses green power, incentivizes its growth, and balances or unbalances the grid depending on who you ask.

The key takeaway here is that it’s not quite as simple as saying Bitcoin mining uses a lot of green power, because understanding the full impact requires accurately modeling what happens when the demand is greater than the supply and peaker plants switch on. As grids shift power around, looking at any one miner or aluminum smelter or what have you in isolation does not make sense. In fact, arguably even if every Bitcoin miner in Texas used 100% green power, when the air conditioners turn on in Houston and the peaker plants fire up this does have an environmental impact because that power is going to be dirtier than average. The load has just moved.

E: Environmental Concerns

Almost all of the ESG debate around proof-of-work focuses on the E, or Environmental part of the triad. This in itself is a problem, which we’ll explore below, because it conflates carbon intensity with ESG, ignoring the social and governance dimensions where blockchain technology has a number of strong arguments in its favor. But climate risk is a major issue and so the environmental implications of proof-of-work’s rising electricity are worth addressing. Bloomberg took on the “con” side here back in October 2021, arguing that although it represents only 0.5% of global electricity usage, mining can distort local electricity markets and harm the grid. Bitcoin Magazine, which has done a number of pieces on this issue, looked at the other side of the coin, talking about how the fact that Bitcoin miners can provide responsive demand — demand that quickly scales up or down — actually could make the grid more resilient, not less. But the usual argument deployed here in favor is that mining drives clean energy, and that one is a bit more problematic.

When Musk went back-and-forth on his views about Bitcoin mining this spring, one of the arguments that came out was that a significant portion of Bitcoin mining uses hydropower, wind and other green sources. There is logic to this: one of the reasons one might locate an energy-intensive plant like an aluminum smelter in, say, Iceland, is the potential to tap into the very low-cost, clean geothermal power available there. Bitcoin miners face the same incentives: with the plunging costs of green power compared to fossil fuels, they will tend to gravitate toward the least expensive, cleaner sources. By so doing, they create more demand for green power and thus encourage green power development. This argument is not very well supported, though. I’ve seen data all over the map on the electricity mix cited by both sides: for example, GDF quoted a renewable power use range from 30% to 70% in Digital Assets: Laying ESG Foundations.

The argument is also not a slam-dunk because if demand for green power from miners causes other consumers to require more power from peakers, it’s not a great outcome. And if you look at the numbers above on growing electricity demand — that 1000 TWh increase, with a bias toward dirtier sources — anything that diverts clean power from other uses should at least be questioned. We will look at this most fundamental question, one of value, at the very end.

Coin Center has a very nice and detailed point-by-point response to the environmental concerns which is worth reading to see how the pro argument with regard to electricity usage is usually structured.

S: Social Concerns

Out of the three dimensions of ESG, I think the social one is the strongest for blockchain and decentralized ledger technologies more generally. Although a lot of the social value is still in the future, reducing the cost of payments around the world and increasing access to credit for people traditionally frozen out of the traditional financial system are forces for good. Growing concerns around money laundering, terrorism financing and other counterparty risks have in recent years caused corespondent banks to withdraw from emerging and frontier economies. Though well-intended, this has had knock-on effects by making it more difficult to move cash across borders. For migrant workers from the world’s poorest countries, this burden has fallen on their shoulders. Taking the Philippines as an example, remittances constitute nearly 10% of GDP in 2020 (Statista, a significant contributor to the economy. In a recent BIS report on the potential and risks with blockchain and CBDC, they estimated that to send home $200 the average migrant from an EMDE (Emerging Markets & Developing Economy) nation spends $14. This is an extraordinary burden on workers least able to support it. Given blockchain-based mechanisms could drive these transaction costs to a fraction and the amount transferred every year — $551B in 2019 according to that same BIS report — to dismiss blockchain adoption as without value, especially when the hammer being wielded is ESG, forgets that the “S” is about the social implications of the investment.

G: Governance Concerns

With the rise of Decentralized Autonomous Organizations (DAO’s) there is a governance angle to blockchain technologies that deserves a look too. By distributing ownership to a DeFi protocol’s many stakeholders, this opens up the possibility of allowing for greater involvement by everyone who has a stake in the success of the protocol. There are even companies that are taking this a step further and fully automating this process (Aave is a good example) so proposals for changes can be submitted, reviewed, voted on and automatically applied to the protocol via smart contracts. Typically this is done through a separate governance token which is often distributed to users of the protocol as a reward for early engagement. This kind of democratization of governance, though not perfect, is certainly a very interesting aspect coming out of decentralized technologies.

However, it is worth pointing out that incorporating governance into the blockchain is not without a cost. At least under U.S. regulations and legal precedent, what makes an asset a security is not the venue where it trades or the nature of the company, but rather the properties of the asset. The precedents like the Howey Test are principles-based and thus very flexible: things that act like securities are generally deemed securities rather than, say, defining a security as a stock that trades on NYSE. If it were the latter, the novelty of digital assets might mean that there’s some ambiguity about whether they are securities, but it’s the other way around: because a particular asset is a security, it is subject to certain rules, and what makes a share of that stock a security is more about its properties than the details of how you trade it.

Though it’s somewhat more complicated, the two most critical elements are control and economics. If an asset gives you control over an organization and participation in its economics, e.g. you get a share in its cashflows or benefit from its appreciation, that asset could well be deemed a security. Because governance tokens give you votes in the DAO, there is a chance this could be considered a form of control. Because airdropped tokens are sometimes promoted with language that could set some expectation of appreciation, and some give you shares in the protocol’s performance, e.g. a slice of transaction fees, there is also potentially an economic element as well. So streamlined blockchain governance is a potential good point for ESG, but where it implies control over the protocol it could be a double-edged sword.

Is There No Alternative?

This final aspect of the debate is where the rubber hits the road. If you believe that blockchain has no value or that there are reasonable alternatives which work just as well that use a fraction of the electricity, almost any degree of doubt about proof-of-work and ESG is damning: why burn all that electricity for no good reason? And I think this element powers a lot of the passion on both sides in the debate. When talking about Bitcoin mining and ESG, there is a value judgement under the covers: opponents are not just saying Bitcoin mining is dirty, but that it’s pointless and dirty. This is where comparisons to Visa’s electricity use per transaction comes in; this is where proof-of-stake blockchains pitching themselves as sustainable alternatives to Bitcoin make their case, pointing out that PoS can do the same job as PoW but use 1000x less electricity with far less e-waste (given PoS can use conventional hardware). Equally, for people who believe PoW is essential to protect trillions of dollars of wealth on the blockchain, that only the extreme security assured by the eye-watering cost of a 51% attack on the Bitcoin blockchain is enough to keep the network safe, the ESG argument feels like it’s missing the point. This is where, for instance, comparisons between Bitcoin mining and various other uses come in: I have seen not only comparisons to power wasted by always-on devices, but even one comparing it to the military-industrial complex’s carbon footprint. You can always find someone people do not like wasting more power than Bitcoin mining.

On the blockchain security question, personally I think the burden of proof is on the alternatives to proof-of-work: after 13 years and no successful attempts to crack Bitcoin’s security, it has a far longer record of successfully defending the blockchain than proof-of-stake. And I think given the importance of blockchain for the future of finance and the economy and the relative strength of the social & governance dimensions, there is a good argument to be had that the trade-off for the electricity usage is defensible especially as the power mix gets greener, especially if there is merit to the argument that Bitcoin mining’s ability to scale up and down quickly can help make the grid more resilient, though this is not a slam-dunk due to the complexity of how this plays out in the real world. My advice: if you find yourself getting into an argument with someone about PoW mining being wasteful and worthless, don’t just say it’s actually better for the environment and dismiss the other person’s concerns: likely those concerns are rooted in doubts about the social utility of blockchain, and so approaching the debate from why it’s useful rather than why it’s clean may be more productive.