Blockchain Security, Energy Use, and Consensus Mechanisms

Fundamental truths

October 11, 2021Michael Nadeau
Blockchain Security, Energy Use, and Consensus Mechanisms

Hello readers,

To evaluate the long-term viability of various blockchains, we need to deeply understand security, energy use, and how each consensus mechanism works. This isn’t as fun as analyzing price charts and adoption curves, but it is incredibly important nonetheless.

In today’s report, we’ll take a first-principles look at these areas through Bitcoin and Ethereum. Topics covered:

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Let’s go.

Proof of Work

When I first started studying Bitcoin, I had my first big “aha” moment when I took a deep dive into Bitcoin mining and the consensus mechanism of Proof of Work.

Proof of work is at the absolute core of the Bitcoin blockchain. To understand how it works, we must go all the way to the base layer regarding how a bitcoin comes into existence.

When we get all the way down to the sand, we can see that an entrepreneur must invest land, labor, and capital into the following: location (real estate), mining equipment (ASIC hashing machine), and energy (electricity).

It goes like this. Capital is exchanged for an ASIC mining machine. These machines are composed of various commodities and computer chips. They connect to the internet and use computing power (electricity) to solve complex math problems. By solving these math problems, miners are validating the transactions on the network. It is estimated that there are over 1 million individual Bitcoin miners throughout the world today.

When a miner solves the math problem, they are minting (verifying) a block of transactions. Each block appends to the prior block as the blockchain expands.

Bitcoin Nodes

Bitcoin nodes are just computers scattered throughout the world running Bitcoin software (Bitcoin Core). That is, they store the entire ledger of transactions on the network. When folks say that Bitcoin introduced “triple entry accounting” this is what they are referring to. Each transaction has a debit and a credit (double-entry accounting), but with Bitcoin (and other blockchains), we also blast out each transaction to every single computer in the world running Bitcoin Core (or other nodes for various blockchains). This is the “3rd entry.” All nodes are connected to each other, forming a network of communication based on decentralized consensus and shared data. 

Centralized banks record and verify most of the debits and credits today. We believe this will happen on Bitcoin and other decentralized open data blockchains in the future. 

When a Bitcoin miner solves the math problem (verifying transactions), a signal is sent to the network of decentralized nodes that they have done so. The nodes then agree or disagree with these facts based on the consensus rules of Bitcoin Core. When the nodes agree, the miner is rewarded with a bitcoin subsidy (currently 6.25 BTC per block) and potentially some transaction fees. This happens like clockwork every 10 minutes on the Bitcoin network. And it never stops running - open 365, 24/7.

So what is the “consensus?”

The consensus of the nodes is simply stating that they all agree that the miner committed land, labor, and capital in verifying the transaction. They did the work. And they proved it to the nodes. Therefore they receive a reward. The reward that they receive (Bitcoin) is used to store the energy (value) of the inputs required to create it.

The nodes use consensus to determine that each wallet involved in a transaction has the bitcoin they say they do. They are ensuring that bitcoin is not being double-spent on the network. Bitcoin has been around for 12 years and we have not had any bitcoin double-spent. This thing works.

What I just described to you is a breakthrough in computer science that was decades in the making prior to the advent of Bitcoin and blockchain in 2008.

Similar to gold, there is real consideration behind each bitcoin that comes into existence. We can observe fundamental economics and a commitment of land, labor, and capital in the mining process. When we contrast this with how a dollar comes into existence we observe a centralized organization of unelected officials pushing buttons on computers.

Proof of Stake

Ethereum’s consensus mechanism today is proof of work, but the network is moving to Proof of Stake next year. Proof of stake is similar to proof of work, with one big difference regarding what is “staked.”

With Bitcoin, energy is staked. This is what backs Bitcoin. It is what secures the network. Energy has had value since the beginning of time.

When Ethereum transitions to ETH 2.0, the native token of the network, Ether, will be staked. Ether has had value for about 6 years.

This is the big difference between these consensus mechanisms. 

Holders of Ether today can stake their assets into pools on the beacon chain. By doing so, one is sacrificing their assets for the promise of receiving additional Ether via transaction fees. Holders of Ether secure the network and validate the transactions by staking their assets. They are incented to do so with transaction fees.

Similar to Bitcoin, Ethereum has its own network of nodes. These nodes are confirming that a staker has submitted Ether assets (their consideration) and therefore earned the right to validate transactions in a block and receive the fee subsidy.

The key here is that there is legitimate consideration in both consensus mechanisms. Because of this consideration (investment) made upfront by miners and stakers, economic incentives are aligned for them to act in accordance with the consensus rules of the network to receive their fees/subsidy.

Important takeaway: If you cannot find proper incentives that promote security as well as reasons for supply/demand organically forming in a blockchain economy, you are likely looking at a Ponzi scheme.

Energy Use

If you are reading this, you have probably seen headlines about Bitcoin’s energy use. It’s one of the ways that incumbents seek to distract the general public from the benefits of Bitcoin, of which there are many. Here is one of my favorites from Newsweek:

Here’s the reality in 2021:

The dates on headlines like this are always pretty interesting as well. This one came during the peak of the bull run back in 2017. We’ve seen the same FUD (fear, uncertainty, doubt) propagated around energy use in this bull run.  When I see stuff like this, I always first try to understand the incentives behind why an article like this would be written.

Bitcoin and other blockchains are extremely disruptive. There are thousands of reasons that a banker, economist, policymaker, journalist, etc would want to slow it’s progress or discourage the general public from engaging with it. When an incredibly powerful industry is incented to slow innovation, we need to take their opinions on said innovation with a bit of a grain of salt. If I told you I could create technology that would put you out of a job, I would not expect you to take kindly to that. It would be nearly impossible for you to see or acknowledge any benefits of my technology. We need to have clear eyes about this.

Every major innovation throughout history has seen similar misinformation campaigns from incumbent industries.

Moving on.

Bitcoin is complex. Energy is complex. Let’s try to unpack what is actually going on here rather than get distracted by sensational clickbait headlines.

It’s true that the Bitcoin network uses as much energy as a small country. Let’s put that into relevant context to better understand what it means.

Today, Bitcoin mining uses about .117% of the world’s total energy. That’s about one-tenth of 1%.

Additionally, Bitcoin mining is estimated to use 56% renewable energy. Why? Renewable energy is the cheapest form of energy. Energy is about 90% of the operating costs for Bitcoin miners. Simply put, miners are incentivized to find the cheapest forms of energy. Which just happen to be renewables.

Incentives flat out matter when mapping out outcomes. In particular, economic incentives.

You might be thinking: “that's all well and good, Mike, but what would the energy use become if Bitcoin were wildly successful?”

Let’s discuss.

Plenty of ink has been spilled on this topic. I won’t bore you with the technical details. I’ll simply cover the big picture and link to more technical pieces if you are interested in exploring more.

The key concept to think about here is that Bitcoin’s monetary issuance is on a set, disinflationary schedule. Less and less over time. The block subsidy paid to miners (currently 6.25 BTC/block) is where the vast majority of the energy consumption comes from. And the block subsidy is cut in half every 4 years. In the spring of 2024, the subsidy will be reduced to 3.125 BTC/block.

We can see this in the data below. Annual security spend is the total miner revenue, including block subsidies and transaction fees. We can see that more is spent on security each year, but as a % of the market cap, the ratio declines each year. This is due to free-market forces (individual decisions by miners, the value of the network, and how the algorithm works) and not any decision by a central party.

*Security spend is actually less than noted above. This is because the miner subsidy and transaction fees are the metric above for security spend. In reality, most miners are making a profit so the security cost (energy cost) is lower.*

Furthermore, there is no “cost per transaction” as critics like to point to. The problem with this reasoning is that Bitcoin uses energy whether or not transactions are occurring. A large portion of the energy used in securing Bitcoin is for its purpose as a store of value. One block might have 2,000 transactions during morning hours. Later in the day, we might have a block with 3,000 transactions. Meanwhile, the same # of miners were hooked into the network, verifying blocks, and paying for electricity. Whether blocks are full or not, they’re using roughly the same amount of energy.

We can think of this as running a dishwasher or a dryer. Whether or not it is full, it is still using the same amount of electricity. Another analogy would be keeping your computer running all day and sending 20 emails or 100 emails. The marginal amount of “energy per email” is irrelevant because your computer is going to use the same base level of energy anyways. Here is some further context:

I think we get the point.

Bitcoin energy consumption does not scale 1:1 based on transactions. And the bitcoin subsidy paid to miners is on a disinflationary schedule. With this understanding, we can project out what Bitcoin’s energy consumption might look like in the future as the network scales out. Lyn Alden has done some fantastic deep work on this topic. Her analysis suggests that if Bitcoin were to become systemically important and a $5-$10 trillion dollar asset, we should expect energy consumption to increase 2x - 3x from what we see today. This would represent about .3% of global energy usage. And if Bitcoin were to reach an outragiously high price of one million dollars per coin, we should expect its energy consumption to increase 6x from today, or about .6% of global energy usage.

This seems appropriate for a global monetary network with many use cases while offering access to the financial system for 2 billion unbanked individuals worldwide.

Little Known Facts About Bitcoin Mining

Bitcoin miners are mobile. 

Energy is not. Energy can travel about 500 miles at most. This is why we see the big substations typically right outside cities and towns. We do not move energy across the country. This is the reason that Bitcoin mining was largely concentrated in China (about 60-65%) up until last spring. Why? The Chinese government overbuilt hydroelectric power dams in rural regions of the country. And because population centers had not yet converged on these areas, energy was being wasted. This energy cannot be moved to Hong Kong and Beijing where there is consumer demand. Therefore, Bitcoin miners simply tapped into this cheap source of renewable energy for their mining operations. Again, miners are economically incented to find the cheapest forms of energy, which is renewables.

Curtailed Energy

Curtailed energy is wasted energy. About 1/3 of all energy produced worldwide is wasted each year. Why? Situations like I explained above in China. Additionally, energy infrastructure must be set up in a way that we can meet extreme demand. If you live in the US you may remember the polar vortex a few years back or the ice storms in Texas last winter. The grid must be set up to handle extremes. But extremes are few and far between. Which means we waste energy. We always need to maintain more supply than demand.

This wasted energy has a cost. Energy providers must pass this cost back to the communities they operate in. But Bitcoin miners are mobile. Therefore they can seek out areas where there are high volumes of curtailed energy. They can be a buyer of this wasted energy. This ultimately reduces the cost passed back to communities. To you and I. We call this a win/win situation.

Bitcoin Miners are helping Oil Producers Reduce Flared Gas Emissions

When oil companies drill oil, they often hit natural gas too. Yet most drillers lack the infrastructure to sell the gas and so instead they burn it off in a process called flaring. These are fossil fuels released into the atmosphere. Most states have regulations on the amount that can be flared. So, in some cases, oil producers must pay to have this excess material moved off-site. A sunk cost for these companies.

But again, Bitcoin miners are mobile.

So they show up, install a piping system to divert the natural gas away from the flares and into generators. The generators convert the natural gas energy into electricity which is hooked into Bitcoin mining machines and used to mine bitcoin. These miners are paying the oil producer for the natural gas used to power the generators. This provides them with an additional revenue stream. They were getting nothing for this excess natural gas or paying for its removal previously. And we also reduce fossil fuel emissions as a result of running the gas through a generator and converting it to electricity rather than flaring it into the atmosphere.

Companies like Crusoe Energy, Great American Mining, EZ Blockchain, and Upstream Data continue to grow and create win/win situations with energy producers while reducing fossil fuel emissions.

Driving Demand for Renewable Energies

As I mentioned, Bitcoin miners are economically incented to seek out the cheapest forms of energy. These just happen to be renewables. Therefore, Bitcoin miners compete against each other primarily on energy costs. It’s a race to the bottom. And they can locate anywhere in the world that has cheap renewable energy. Per Wrights Law, demand for renewable Solar and Wind energies should ultimately reduce the cost to produce these energies. This should drive further demand and allow other industries to move away from other forms of non-renewable energy.

Bitcoin Mining and the Production Equation

The production equation is fundamental to economics and measures how Technology interacts with Land, Labor, and Capital to create production.

It’s something I often think about as I map out the exponential growth in information technology we see today. Technology creates abundance. It makes things more efficient. It removes middlemen and friction. It reduces costs.

The technology we see today does all of these things.

The technology we saw in the past (automobiles, railroads, assembly lines, etc) did the same. However, the major innovations in the 1800s and early 1900s created demand for other parts of the production equation. For example, with the invention of the automobile, we created demand for commodities such as steel and oil. Railroads did the same. When electricity was invented we had to leverage energy sources to use it. So, while we made things more efficient, we also created more jobs outside of just the companies producing the cars/railroads/electric power lines, etc. We created demand in other parts of the production equation. We increased productivity and created jobs.

We don’t see this with information technology today. We mostly see things becoming more efficient with jobs leaving the system or moving abroad. For example, Zoom video conferencing makes it such that many companies do not need offices today. And business travel is less necessary. This means less is spent on commercial real estate, flights, car rentals, hotels, restaurants, etc. This is deflationary and reduces the velocity of money in an economy. Innovations like video conferencing are not driving significant demand in other areas of the economy/production equation.

But Bitcoin mining can drive demand for the adoption of renewable energies. Similar to how automobiles and railroads drove demand for oil and other commodities or energy sources last century. Bitcoin is one of the few innovations today that could drive demand for other parts of the production equation.

This is something to keep an eye on and potentially a really, really big piece of the Bitcoin story that very few people are talking about today.

Ethereum’s Energy Use

I’ve mostly focused on Bitcoin here so let’s wrap this up with a note about Ethereum, which recently moved its consensus mechanism to proof of stake. This move was made to reduce Ethereum’s carbon footprint. They estimate that energy consumption will drop 90% as a result of moving to proof of stake. This is a significant move and one that should absolutely be applauded.

However, it is my opinion that this does not fundamentally make Ethereum more ESG friendly than Bitcoin for the reasons mentioned above.

Finally, energy use and security go hand in hand. Because Ethereum is backed by the native token of the network, Ether, anyone that acquires enough Ether to control more than half of the market cap could theoretically take control of the consensus of the blockchain. This does not mean Ethereum lacks security, but the difference is worth noting here.

Can Blockchains be Hacked?

Technically, yes. 51% of a network’s mining/staking would have to be controlled for this to happen. It has an incredibly low probability. And it is also important to understand that if this did happen, it would only impact transactions from the time of hack forward. Prior transactions would not be impacted. And the network would immediately catch this and redirect new, valid blocks to the old chain.

But what prevents this hack from happening? 

It’s the cost to secure the network. Bitcoin’s energy use and the cost of the electricity to run the network is what secures it. So, for someone to take control of 51% of the network, they would have to control 51% of all of the mining equipment, real estate, and energy to do so.

So, when we think about energy consumption, we need to consider security on the same hand.

There is a cost to securing a global monetary system.

And there is no free lunch in this world.

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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general investment information only, is not individualized, and as such does not constitute investment advice.

Sources:

https://www.lynalden.com/bitcoin-energy/

https://bitcoinminingcouncil.com/

https://panteracapital.com/blockchain-letter/esg-is-the-little-bighorn-of-bitcoin-skeptics/

https://hbr.org/2021/05/how-much-energy-does-bitcoin-actually-consume

https://www.coindesk.com/business/2021/03/05/the-frustrating-maddening-all-consuming-bitcoin-energy-debate/

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