Does Ethereum's Merge point to a greener future for crypto assets?
The unabated fascination with cryptocurrencies and other digital assets as an attractive, albeit speculative, asset class has coincided with growing research, and, consequently awareness, into the environmental impact they have on the planet. Global organisations advocating to reduce their carbon impact face a unique dilemma when they are also engaging in the crypto space, due to the energy consumed in some blockchain networks.
In this article we explore some of the key sustainability issues that global organisations need to be aware of based on our conversation with Alex de Vries, the founder of cryptocurrency index Digiconomist and academic researcher at Vrije University and offer our own perspectives on what this means for regulation of crypto assets.
Decentralised Blockchain networks and the rise of DeFi
A key goal of decentralised systems that has spurred the popularity in decentralised finance (or DeFi) applications is the individual sovereignty it affords its users to transfer stores of value immune from any control from a central authority, such as a bank. Public blockchain systems such as Bitcoin and Ethereum – the two largest ecosystems - are, by definition, open networks, where there is no central authority in control of the network. Theoretically, anyone can join and participate in maintaining the underlying system and add new blocks for the blockchain. Participants are incentivised to participate because they are paid a reward in cryptocurrency. This feature of validating transactions and adding blocks to the blockchain is a key component in maintaining the integrity of the underlying system.
Proof of work in the dock
Not all blockchain networks use the same method to validate transactions. The “proof of work” method of validating transactions (also called mining) used in the Bitcoin, and, up until very recently the Ethereum network, has been heavily criticised for the energy required to run the validation mechanism. Proof of work mining involves network participants (or miners) using computing power to attempt to be the first to correctly guess the solution to a mathematical puzzle, that serves to validate the block and add it to the blockchain network. Currently, in the Bitcoin network, by being the first to solve the hash puzzle, the miner receives a reward of 6.25 BTC. The value in fiat currency of the amount earned depends on the value of the cryptocurrency. The higher the value of Bitcoin the more BTC the miner will earn by correctly solving the hash puzzle. In Bitcoin, there are approximately 200 quintillion (200 with 18 zeros) guesses to solve the hash puzzle every second of every day, with only one correct guess approximately every 10 minutes.
Specialist computer hardware connected to a significant power source is a key requirement in proof of work mining. This is because the greater the computational power that can be deployed, the greater the chance of a miner successfully solving the hash puzzle. Miners are therefore incentivised to use energy to win. It is estimated that Bitcoin alone currently consumes approximately 150 terawatt-hours of electricity annually, surpassing the entire country of Argentina. Another often cited statistic is the power consumed by Bitcoin is more than half of all the power consumed by all data centres globally. It is estimated that a single Bitcoin transaction represents 0.012% of what the traditional financial industry is handling of more than 700 billion digital payments every year; and that a single Bitcoin transaction has the same carbon footprint as taking a flight from London to New York. Whilst one might argue these comparisons are comparing apples with oranges, they are helpful in underscoring the importance of the environmental impact of proof of work mining.
The security and stability of blockchain networks that run on proof of work systems has often been cited as a necessary trade-off for its high energy consumption. Private sector initiatives, such as the Crypto Climate Accord (CCA), seek to create more transparency on using more sustainable energy sources for proof of work systems, with the longer-term aim to achieve net zero carbon emissions. Some critics point to the lack of enforcement of these private sector initiatives if targets are not reached absent any formal regulatory measures.
Critics also point to the inherent wastefulness of proof of work mining given that the majority of the output of the 200 quintillion guesses to solve the hash puzzle is discarded and has no useful purpose. There is also a lot of clustering in mining because electricity is the most vital component. This has led to massive shortages of supply in areas such as Kazakhstan – a key area of concentration for many miners. Other criticisms are that there are more appropriate uses of the world’s energy sources, such as using available renewable energy to power schools and hospitals and other more useful purposes.
The environmental impact of cryptocurrencies is also at the top of minds of regulators and policymakers. The World Bank criticised the environmental impact of Bitcoin in the spring of 2021. Earlier this year the European Parliament narrowly voted to remove controversial provisions that would effectively ban proof of work systems under the proposed Markets in Crypto Assets Regulation (MiCA). Sweden has also been very vocal in advocating against proof of work mining when the increasing use of renewable energy sources by miners is at the expense of climate neutrality goals in other sectors such as in hospitals, as mentioned above.
Is The Merge by Ethereum the answer to the sustainability problem?
The Merge refers to the merge in the Ethereum blockchain network of the Ethereum Mainnet (the execution layer which gives the power to conduct transactions) with a separate blockchain called the Beacon Chain (the consensus layer in the system dealing with validation of transactions which “want” to occur in the execution layer). The completion of the Merge last month was a key milestone for Ethereum. The major outcome of the new consensus layer being merged is that Ethereum has stopped using proof of work mining and moved to a new system called "proof of stake" validation. This is a notable change and one which was hotly anticipated, with the planned go live date having been delayed many times. As Ethereum is a public blockchain it also required the approval of the Ethereum community to make the upgrade.
The Merge is significant from an environmental perspective because proof of stake validation dramatically reduces the energy profile of validating transactions to the Ethereum network. It is estimated that proof of stake validation uses approximately 99.9% less energy than proof of work mining. The main reason for the significant drop in the energy usage is the design of the validation mechanism. Unlike proof of work which relies on vast computational power (and therefore vast supplies of energy) to solve a mathematical puzzle to mine a block of transactions, validation is instead achieved through a staking process. Participants who wish to validate the next block each stake a minimum amount of cryptocurrency (for Ethereum it is 32 ETH) to qualify as one of multiple other participants all of whom want to be selected to validate the next block to the Ethereum blockchain. As with proof of work there is still a reward for correctly adding the block to the blockchain but the computer hardware and computational power (and therefore energy consumption involved) has no bearing on whether a participant will be selected or not. The winning participant is randomly selected by an algorithm with the reward paid being proportionate to the amount staked. Improperly validating incorrect or fraudulent data results in the loss of some or all a participant’s stake as punishment.
Flow on effects
Initial reactions to the changes made by Ethereum to the blockchain network have been mixed. Despite the positive predictions regarding The Merge, investors woke up to an immediate 20% drop in Ether value post merge. This has been cited as being due to Ethereum focussing on the change to proof of stake (and focussing on solving the environmental issue) and not solving several other challenges, such as Ethereum’s high fees and scalability issues. It is also likely other market forces played a role, such as the impact of the US Federal Reserve's interest rate hikes to combat inflation, which can dissuade consumers pursuing returns in alternative assets classes when the interest earned on savings held with banks improves.
As with any major software upgrade the longer term effects are also still to be understood and worked through. There is some concern cited of a creep towards centralisation over the longer term because of the effects of staking pools such as the big exchanges that control most of the resources required to secure the network. This will need to be understood.
An additional impact is the regulatory environment in relation to proof of stake networks. In recent years, we have seen increasing focus from regulatory authorities on the functionality of staking and the potential that it involves features and structures which are more aligned with what one would expect from securities, investment contracts or other forms of regulated investments (such as pooling of assets and returns, absence of control of the investment property on a day-to-day basis, expectation of profit etc.). This is particularly true of exchanges and other market operators who often provide staking services as part of the package of services made available to users, whereby tokens held in custody are deployed for staking on the relevant underlying blockchain by the operator or a third-party, with a portion of that return then shared with those users.
The Commissioner of the U.S Securities and Exchange Commission, speaking shortly after The Merge, but not necessarily about The Merge, said that staked tokens may well be subject to federal securities regulation because of their investment contract-like features.
We have seen first-hand in a number of jurisdictions some of the regulatory challenges that arise from the provision of staking services and we expect that the transition of the world’s second largest crypto asset by market capitalisation to a proof of stake model is only likely to increase regulatory focus in this area in the coming months and years.
Whilst these issues are complex what is evident is that Bitcoin is now the only major ecosystem left operating on proof of work mining and that, for now at least, Ethereum appears to have shown that a greener future is possible for crypto assets.
The authors would like to thank Jonny Marshall for his assistance in preparing this article.