Beyond price volatility, here in Neuberger Berman’s Option Team we think the threat of regulation is probably the next biggest source of risk for Bitcoin and other digital assets.
The U.S. has been relatively slow in formulating its plans with respect to the regulation of digital assets, although it has now ruled that some stablecoins, which are cryptocurrencies backed by reserve assets, are simply swap contracts; the Commodity Futures Trading Commission (CFTC) has categorized Bitcoin as a commodity; and the Securities and Exchange Commission (SEC) approved the first U.S. crypto Exchanged Trade Fund (ETF) in November. In contrast, Europe and Canada have decided to be relatively accommodative. China has been the most vocal and taken direct action against miners, forcing them to move offshore despite the relatively low energy cost available from China’s clean energy investments and widespread coal plants (more on this in a bit).
Regulation May Be a True Revelation
More regulation is certainly on the horizon. Admittedly, we have little visibility into what forms of regulation will ultimately pass, but the slow pace of development outside of China is encouraging. Cryptocurrency price volatility has slowed adoption by investors, buying time for authorities to watch from the sidelines and avoid rash overreactions.
We believe the utility of open digital securities is too high to be blocked from free markets. In our view, attempting to quell the revolution is likely only to reinforce the belief that digital assets are needed as protection from regulators. The global economy can most certainly handle a large-scale “nondenominational” digital asset base without it destabilizing the global monetary system. And, ultimately, we see too many benefits: facilitating global money transfers (think Fed wire transfers); making resource allocation more transparent; providing a benchmark for digital asset pricing (yes, even those coins your kids buy in video games); providing shelter from hyper-inflation and fiat currency devaluation (which tends to ravage poorer communities with static wages and little to no access to financial products); and lowering dependence on gold, potentially reducing the environmental impact of gold mining.
That’s why we think the probability of an extinction level event is next to zero, and that asserting that digital currencies issued by central banks will eventually negate Bitcoin is like claiming that Netflix would kill the movie producers. On the contrary, we think the outcome with the highest probability is that Bitcoin will enjoy some benefit as the first, least complicated and most widely understood digital security, and that regulation will strengthen the cryptocurrency ecosystem and winnow the field of lower quality, more speculative competitors.
In our view, as the authorities validate Bitcoin’s existence, the cryptocurrency race will become a race for second place.
A Waste of Energy?
One of the biggest criticisms of Bitcoin is the energy consumption required to add new blocks to its public, decentralized blockchain and validate transactions within those blocks. As we mentioned in Part 1 of our series of Bitcoin blogs, mining profits are a function of mining fees minus energy costs. Hence, Bitcoin miners around the world have sought low-cost energy supplies, including clean alternatives and cheap coal in China.
Let’s start by putting the energy demands of Bitcoin into context and perspective. Estimates vary wildly, but some of the more reasonable assumptions around mining equipment efficiency and energy usage mix suggest that the Bitcoin network consumes somewhere between 0.1% and 0.3% of the world’s annual energy production, with a significant portion sourced from alternative energy sources like hydro, solar and wind. To put that in perspective, one estimate we have seen has it on par with the global annual production of zinc and about one half the energy used to mine gold.
It’s also important not to simply extrapolate the current growth in Bitcoin’s energy consumption into the future. There are two elements to this: technological advance and the overall trajectory of the energy demand for Bitcoin mining.
Historically, we tend to underestimate the pace of technological advancement. In simple terms, new advances generally push forward the ability to develop “next-level” advancements, which further accelerates advancement potential, in a virtuous cycle. Moore’s Law, which correctly predicted, back in 1965, that the number of transistors in integrated circuits would double roughly every two years, is a good example of this: at the time, most people considered that pace of exponential advancement to be unattainable. Bitcoin stands to benefit from continued advancements in technology, given that its profitability is directly related to computing speed and efficiency: indeed, new mining machines, or “rigs,” are many multiples faster than those available just five years ago. Most recently, IBM announced an unprecedented two nanometer semiconductor design and process, which it claims can increase chip performance by 45% and reduce energy consumption by 75%, versus comparable, seven nanometer chips.1 This could have a huge positive impact on data centers and mining operations related to Bitcoin.
Technological advance is not the only reason why predicting the trajectory of Bitcoin mining’s energy use is complex. Over the past few years, mining new Bitcoin blocks has been very profitable which, in turn, attracts new miners and increases the overall energy consumption of the network. By design, as the number of Bitcoin miners increases, so too does the difficulty of the cryptographic equations you need to solve to do the mining. And ultimately, perhaps around the year 2140, the last Bitcoin will be mined and the network will switch exclusively to the less energy-intensive process of transaction processing. The net result is that the Bitcoin network’s energy usage is dynamic and fluctuating and, in the end, likely to diminish substantially.
Monetizing Surplus Energy
In the meantime, Bitcoin miners are getting creative in order to mitigate their energy-related impact (and costs). Many have chosen locations where the supply of renewable and low-emission energy is abundant, or where cold climates naturally cool their computer equipment, for example.
Some are entering into contracts with nuclear and renewable energy providers to utilize the surplus power they generate when the sun or wind is strong or hydro reservoirs are full, or when demand falls off. This could help improve the financial sustainability of renewables. Because these are long-term, high-capex partnerships between miners and energy providers, the miners will often agree to turn off their operations if demand spikes. Overall, this creates more normalized demand for renewable energy providers, and prevents them from having to sell energy at a loss, without compromising their core obligation to customers. Some energy industry commentators and consultants suggest that energy providers could even start monetizing surplus energy by Bitcoin mining themselves.2
We have also seen reports of companies in the oil and gas industry using flared waste gas to power on-site Bitcoin mining operations via mini mobile generators. This industry burns off immense amounts of harmful gases, especially methane, that are created in the manufacture of fuels, plastics and industrial chemicals. This flaring mitigates the gases’ environmental impact, but it also generates wasted heat energy that could, and reportedly is, being used to generate power. We have seen estimates that the energy lost to gas flaring globally could power a significant portion of the existing Bitcoin network. This activity not only monetizes the conversion of harmful to less harmful emissions, it could also reduce the emission of greenhouse gases caused by incomplete combustion in the flaring process.3
With global adoption of grid-based storage solutions likely decades away, Bitcoin mining can offer energy producers additional pathways for many forms of “wasted” or mismatched energy that don’t just dead-end into the environment without monetization. A market-capitalist solution for monetizing otherwise wasted energy resources is arguably comparable to “negative” carbon credits. Many environmental, social and governance (ESG) advocates might argue Bitcoin mining profits should be re-invested in emission reduction, efficiency gains and the development of battery storage technology at the underlying energy production facility—which sounds like a reasonable argument to us. In a similar vein, some have suggested that the adoption of Bitcoin and other digital assets could materially reduce the energy consumed by the global banking system’s physical branches and countless automated teller machines (ATMs), in the pursuit of reduced costs and higher profits.
In short, our view is that assessing current and future environmental footprint of Bitcoin mining is much more nuanced than the headlines might suggest.
What Happened in China?
One reason that China became a miners' haven was that it generated significant levels of excess energy from alternative sources. That changed with China’s recent restriction on Bitcoin mining. Why the turnaround?
Over the past decade, China invested heavily in cleaner energy sources, but they are located thousands of kilometers from the cities along its coast where energy demand is highest. Without connectivity, these energy sources generated enormous amounts of surplus energy, creating ideal circumstances for localized, low-cost Bitcoin mining operations.
Well, China eventually connected these cleaner energy sources with urban coastal load centers via a huge, new, high voltage power transfer network. This reduced the surplus energy available at the energy sources, leaving Bitcoin miners to compete for resources—thereby driving up the overall cost of energy for all consumers. The Chinese government restricted mining in order to control and stabilize the price of power over its new network.
The relocation of these mining operations appears to have had little impact on the stability of the overall Bitcoin network. Bitcoin miners continue to search the world for other means of surplus or non-rival energy, because this tends to impose the lowest costs and therefore results in the most profitable implementation of their business. Indeed, Bitcoin miners would welcome a circumstance like the one that occurred in China, as other countries around the world make substantial investments in alternative energy sources that can make mining more environmentally sustainable.
Positive Incentives
That is, in our view here in the Option Team, the most important point to make when it comes to thinking about Bitcoin’s energy and wider environmental footprint. Miners are already strongly incentivized to seek out low-cost energy, and in many cases that means surplus renewable and alternative energy, or wasted energy, such as that from gas flaring, whose utilization has environmental benefits. Should digital asset prices decline due to environmental concerns, that only increases the incentive to find environmentally beneficial sources of energy and deploy more efficient technology—and any resulting decline in profit would represent the cost of environmental compliance that traditional companies face.
Ethereum and other digital coins also stand to benefit from these efficiency gains, but we anticipate that the overall impact on Bitcoin would be greater, given that energy demand is one of the primary criticisms of its mining operations.
Boldly, one might assert that Satoshi Nakamoto, the originator of Bitcoin, in choosing not to limit Bitcoin’s rather onerous cryptography algorithm and blockchain methodology, which leverages it specifically to advancements in processing efficiency, had the foresight to anticipate that those advancements would play their role in consolidating Bitcoin’s value over the long term.
