The Green Bitcoin Theory: How are Bitcoin, Electricity Consumption and Green Energy Related?
With this article, we explain that the architecture of Bitcoin is only beneficial for mining companies that have access to low-cost electricity and efficient mining hardware. We argue that companies with access to low cost electricity will drive companies operating at much higher costs out of business. In order to be cost efficient, mining companies will demand more efficient hardware and more efficient electricity-producing solutions that allows them to stay competitive or even ahead of the curve. This also includes engineering companies manufacturing this equipment. These companies should also increase their R&D spendings in the mid-term. We also expect that more electricity resources will be made accessible such as hydro power in remote areas. Based on these arguments, we present the theory that Bitcoin might contribute to higher R&D investments in renewables in 3–5 years. We acknowledge that these considerations are counter-intuitive and might represent a minority opinion at this point in time. We therefore develop our arguments in a step-by-step manner that ultimately allows us to present said conclusion. — Authors: Philipp Sandner, Daniel Wingen, Stefanie von Jan, Andreas Straub
Remark: Save time and skip the introduction? The astute reader knowledgeable about Bitcoin mining can easily jump to the chapter “Which mining companies will leave the network when the Bitcoin price decreases?”
Development of the Bitcoin price and its volatility
Bitcoin is the first digital bearer asset drafted by the pseudonym Satoshi Nakamoto in 2008. For several years, the price of one Bitcoin remained below $10 and was driven by a small tech-savvy community. During the first relevant hype in 2013, Bitcoin spiked to above 1000$. Thereafter Bitcoin fluctuated around $400 for a few years. In 2017, Bitcoin saw an amazing year with an all-time-high of close to $19,000. At that time the massively overhyped market led to a market capitalization of $300B. The market consolidation known as the “crypto winter” followed and Bitcoin dropped below $4,000. In early 2020, at the time of writing, Bitcoin has recovered to $8,770 at a market capitalization of approximately $159B. The Bitcoin network is operated and secured by more than 10,000 public nodes and computes 116 quintillions of hashes per second (i.e. 116 mio. TH/s equalling 116 EH/s). These computations consume significant volumes of electricity. At this point the electricity consumption is approximately as high as the one of Austria or Venezuela.
We saw and will continue to see a very high degree of volatility which is driven by strongly varying market expectations of a phenomenon not easy to understand. There are “experts” who argue that Bitcoin will soon fade away and will be hampered by regulation. This would result in a price of close to $0. Other “experts” set out future price expectations of $100k, $200k or even more. This would result in a market capitalization of $1,800B or $3,600B, respectively. Gold has reached a bandwidth for its market capitalization between $7,500B and $9,000B. As a result, expectations for Bitcoin’s market capitalization as a share of gold’s market capitalization range from 0% to 40%. At the upper bound, these would be very high values but the expectations vary significantly.
Governments are regulating crypto assets
In recent years, startups, companies, governments and academics have been inspired by the underlying blockchain technology. Not only are they interested in decentralized crypto assets but also entreprise-oriented distributed ledger technology (DLT) systems. Ultimately the value of the technology will become clearer as time passes. Therefore, startups and companies called for regulatory efforts — and governments are delivering: Switzerland is proposing new rules to accommodate both crypto assets and DLT in their legislation. Germany has introduced a “crypto license” as of January 1, 2020. Liechtenstein and Malta created sound legal frameworks. China heavily drives blockchain technology but is skeptical concerning initial coin offerings and several crypto assets (but not all). Despite its scattered legal system, the USA is also pushing in this direction. Depending on the country, regulation is in place or will be in place to integrate crypto assets in a countries’ legal framework and, with it, increase investors’ protection. This might also attract institutional investors to invest in crypto assets.
To wrap up: Crypto enthusiasts and startups have driven crypto assets. They called for clear rules and governments replied with regulatory efforts. With the technology working and the proper legislation in place, companies are now able to actually apply the technology and/or invest in it. In all, the technical and legal base for adoption in the upcoming years has been or is being built. Therefore, it is reasonable to argue that blockchain technology diffuses and with it, the Bitcoin price might rise.
Architecture of Bitcoin and the importance of mining
The architecture of the Bitcoin system — in particular the mining process — resembles physical gold: Workers at gold mining companies are digging for gold. Bitcoin mining companies are “digging” for Bitcoins. They do this by purchasing and running specific mining hardware. This costs electricity and requires buildings and human resources (HR) for setting up the IT infrastructure. All these mechanisms are rooted in the proof-of-Work (PoW) consensus mechanism that has been described extensively elsewhere.
To be precise, one significant difference exists between the Bitcoin network and gold: If the gold price increases, gold mines will increase their efforts to dig for gold. This can result in an increased supply. With Bitcoin, the supply is entirely inelastic such that the supply of new Bitcoins cannot increase subsequently to higher resources invested. If a single mining company enlarges its mining operations with new hardware and new electricity sources, it will increase its share of newly mined Bitcoins. Yet, the network-wide sum of newly mined Bitcoins will not change.
The Bitcoins generated follow a predefined schedule such that the supply of new Bitcoins can be determined ex-ante. This schedule is effectively impossible to change with Bitcoin. Yes, new Bitcoin variants can be launched which then can inflate the number of different assets. But such new variants cannot alter the supply schedule of the existing Bitcoin network. Recently, the stock-to-flow model gained popularity when investigating the scarcity of Bitcoin. Researchers have found a highly significant correlation between the stock-to-flow value of Bitcoin as a proxy for scarcity and its market capitalization.
The following important mechanisms apply: If the Bitcoin price rises, new mining companies launch their operations, ceteris paribus. Conversely, if the Bitcoin price decreases, some mining companies stop their operations. This was observed multiple times in the past due to Bitcoin’s high volatility in price. However, the Bitcoin price is of course not the only factor that influences mining activity. The following three factors matter in particular: First, the price of the mining hardware and its efficiency. Second, operating expenditures such as cooling equipment, buildings, IT staff, legal. Third and most important, the price for electricity. This article focuses on the relevance of the latter as the mechanisms of the Bitcoin network imply demand for green electricity. Other articles have also explained these mechanisms in great detail, especially regarding the input factors for Bitcoin mining.
Which mining companies will leave the network when the Bitcoin price decreases?
For the remainder of this article, the following question is very important: Which mining companies are leaving the network when the Bitcoin price decreases. Here, we can assume that the population of mining companies is very diverse. There are mining companies located close to Chinese coal-based power plants. Other mining companies are located in Northern Europe or in Canada (cold climate improves cooling of the hardware). These mining companies have different mining hardware (from different manufacturers, supplied in different generations), have to pay different electricity costs ($/kWh) and have varying HR expenses. This results in a wide distribution of the efficiency of various mining companies with efficiency simply being measured by revenues from selling Bitcoins versus expenses for electricity, hardware, buildings and HR. This distribution reflects the costs of production for one Bitcoin. As with gold, the cost to produce one Bitcoin is not the same for the entire population of mining companies (see Figure 1). The bell-shaped curve in Figure 1 is only for illustration; the true distribution cannot be empirically observed at this point in time. For simplicity, we assume that efficiency is very strongly correlated with profitability.
So, in case the Bitcoin price decreases, which mining companies are stopping its mining operations? It will be those that are the least profitable ones in the entire distribution. It will be those that produce Bitcoins at costs that exceed the market price. These mining companies would sell the freshly generated Bitcoin at a loss (see Figure 2). Recall that the decreasing Bitcoin price reduces revenues and profitability such that — based on the distribution of efficiency — the mining companies at the low-efficiency end of the distribution stop operating. The highly efficient mining operations continue mining. These companies ensure that the Bitcoin network “survives”, even at a lower hash rate.
Mining companies with access to low-cost electricity join the Bitcoin network
A smart entrepreneur would join the Bitcoin network and start or enlarge its mining operations in case he or she makes a profit. This requires access to low electricity prices and purchasing mining equipment of the most recent product generation. In case many of these highly efficient mining operations join the Bitcoin network, they will drive low-efficient mining operations out of business: Such inefficient companies are those that e.g. pay high electricity prices, run older hardware equipment or operate in environmentally/regulatory unfriendly regions. We assume that all Bitcoin mining companies seek to use state-of-the-art hardware. Then, it is reasonable to argue that, ceteris paribus, Bitcoin has a tendency to consume the lowest-cost electricity available.
Which energy sources provide the lowest-cost electricity?
Now, the next relevant question is which energy sources are providing the lowest-cost electricity available? According to experts from utilities companies producing electricity, such energy sources are primarily hydro power but also — to a lesser degree — solar and wind energy (e.g. Philippe Bekhazi, CEO at Stablehouse). This can be explained as follows:
Coal- and gas-based power plants require resources (i.e., oil, gas) that have to be purchased in order to burn them. Such procurement costs are not existing with renewable energy sources based on water, wind or sunlight. The sun shines for free; wind blows; and water flows through power plants automatically based on earth’s gravitation. In addition to that, coal- and gas-based power plants have higher maintenance costs. With renewables, only an electricity generator and mechanical parts need to be maintained. With coal and gas, in addition, far more mechanical parts are needed (e.g., boiler, heater, condenser, cooling tower) that have to be maintained. Furthermore, with coal and gas, filtering exhaust gases is costly. We acknowledge that not all energy production facilities have such equipment.
For the remainder of this article, it is important to highlight the fact that renewable energies (i.e., water, wind, solar) on average have lower marginal costs compared to conventional energy sources (i.e., coal, gas). Let’s present some numbers to be very clear: According to an expert working at a utilities company we interviewed, coal- and gas-based power plants, for example, produce electricity at 3–8 euro-cent per kWh, whereas hydro power facilities and windmills produce electricity at 2–4 euro-cent per kWh.
Besides this general fact, there are additional benefits for the Bitcoin network: Fluctuations in renewables (i.e., long vs. short phases of wind or sun, rainy seasons) with an inflexible demand profile (i.e., day-night-cycle) lead to excess energy such that utilities companies have to burn electricity to not overload electricity networks. Excess electricity that is not needed by the grid and that cannot be stored needs to be grounded and wasted. This is the cheapest form of electricity for the Bitcoin network.
In the past, such excess electricity that was consumed by the Bitcoin network was predominantly provided by coal- and gas-based power plants in Mongolia whose capacity exceeded the local demand. The same holds true in the USA where energy-intensive industrial sites have been abandoned but the power plants are still there. In case such power plants have been fully depreciated, the procurement costs for oil and gas are offset such that these conventional power plants have been (and still are, but to a lesser extent) formidable electricity sources for mining companies. Such power plants have a long lifecycle and can potentially operate for multiple decades.
There is also a tendency to access entirely new renewable energy sources as is the case with some hydro power plants in Canada that are used for Bitcoin mining and hardly anything else. Bitcoin might therefore locally lead to “isolated” special electricity networks (like islands!) where dedicated electricity production equipment supplies mining companies only.
In line with the facts presented above, recent studies have revealed that the share of renewable energy sources that supply the Bitcoin network is above 50%. As shown in Figure 3, a share of 73% renewables for the Bitcoin network was recently estimated. We argue that this share should increase: Recall that mining companies having access to low-cost electricity drive others that only have access to high-cost electricity out of business. As electricity is cheaper when produced by selected types renewable energies (in particular water and wind, not necessarily sun) in comparison to conventional energies, it will be the “renewables-based” mining companies that drive the “fossil-fuel-based” mining companies out of business. This logic could increase the share of renewables energies of the total energy the Bitcoin network consumes.
Will the need for low-cost electricity sources drive R&D in efficient electricity provision?
As this shift towards lowest-cost electricity already happened in this highly competitive market environment (and still happens), adequate equipment will be required that utilizes (i) the cheapest energy possible (ii) in the most efficient way and converts it into electricity. As outlined above, the percentage of electricity supplied through hydro, solar and wind energy for the Bitcoin network should steadily increase.
Besides powerful mining hardware, mining companies mainly demand low-cost energy. This in turn requires energy suppliers and engineering companies to invent and deploy highly efficient electricity-supplying facilities. The mechanism at work is known as “merit order”, a way of ranking energy sources based on ascending marginal costs. Therefore both, engineering companies and energy producers, should have an incentive to invest in research and development (R&D) to improve these facilities and related equipment. The reason is simple: Investments upstream with engineering companies and energy suppliers should increase energy efficiency and utilization in order to allow mining companies to operate profitably downstream. This relationship is illustrated in Figure 4.
Increased R&D investments should lead to the following: Engineering companies and energy suppliers will hire engineers capable of improving the electricity-generating facilities. Therefore in the mid-term, these R&D investments might even contribute to increasing the efficiency of electricity production in general. Potentially, R&D outcomes might possibly spill-over to the engineering of electricity-producing equipment unrelated to Bitcoin.
By the way, the same holds true for mining hardware manufacturers and cooling equipment. It is a fact that, already now, new cooling systems have been developed (e.g. air flow optimizations) to cool down the mining hardware with the effect of lowering electricity consumption to some degree.
It is a fact that the Bitcoin network consumes a lot of electricity. Yet, the important question is what types of energy sources are used to maintain the Bitcoin network (i.e., fossil fuel vs. renewables). With this article, we have explained that the reward scheme of Bitcoin is beneficial for mining companies that have access to low-cost electricity. Recent studies have revealed that the share of renewable energy sources that supply the Bitcoin network is above 50% at this point in time.
We argue that highly efficient mining companies will drive companies operating with low efficiency out of business. The highly efficient mining companies will therefore demand energy-producing equipment that allows them to achieve this high efficiency — to remain profitable and to continue their operations. This pushes engineering companies and energy suppliers to improve equipment and to invest in R&D to improve the electricity-producing facilities and related equipment.
If the Bitcoin price increases substantially, these mechanisms will be stronger: Demand to access renewable energy and to access excess energy will be higher such that R&D in these facilities and equipment should even increase. We have presented two reasons for this: First, electricity from renewables — in particular hydro power plants — can be produced cheaper than electricity from fossil fuels. Second, excess electricity from renewables, which is not needed and cannot be stored, can be used for mining.
With this we have provided arguments for the following hypothesis: Bitcoin can play a role in making electricity production more efficient in the mid term. Even though Bitcoin consumes a very high degree of electricity, we also argue that Bitcoin can contribute to higher R&D investments in utilizing and harvesting renewable energies.
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Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2021, he was ranked among the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. He has been a member of the FinTech Council and the Digital Finance Forum of the Federal Ministry of Finance in Germany. He is also on the Board of Directors of FiveT Fintech Fund, 21e6 Capital and Blockchain Founders Group — companies active in venture capital financing for blockchain startups and crypto asset investment management. The expertise of Prof. Sandner includes crypto assets such as Bitcoin and Ethereum, decentralized finance (DeFi), the digital euro, tokenization of assets, and digital identity. You can contact him via mail (email@example.com) via LinkedIn or follow him on Twitter (@philippsandner).
Daniel Wingen is the general manager of DW Innovate, a digital asset consulting company. He has been doing Bitcoin research in depth for 4 years with the focus on the economical underlyings of the Bitcoin network with a highly sceptical basic attitude. In order to bring researchers and experts in this field together, he also initiated the Value of Bitcoin Conference in partnership with the BayernLB. You can contact him via email (firstname.lastname@example.org), via LinkedIn (https://www.linkedin.com/in/danielwingen/) or follow him on Twitter (@danielwingen).
Stefanie von Jan is an economist and blockchain researcher at DW Innovate. Her focus lies in Token Engineering, the practice of designing decentralized digital marketplaces with sound economic incentive mechanism that correctly incentivize participants and eliminate fraud. Inspired by Austrian economics and her research into Bitcoin, she applies the concepts of sound money theory in the design of new blockchain based tokens. You can contact her via email (email@example.com), via LinkedIn (https://www.linkedin.com/in/stefanie-von-jan-3b518067/) or follow her on Twitter (@stefanievjan).
Andreas Straub is an electrical engineer and works for the German energy company EnBW AG. His focus is on the area of digital transformation in the energy sector,and he also lies on blockchain technology and crypto assets for years. With this experience in the construction and operation of energy networks,he has the technological background to assess energy sources and map it to the architecture of the networks of crypto assets. You can reach him via eMail (firstname.lastname@example.org) or via LinkedIn (https://www.linkedin.com/in/andreas-straub-3129b6127/?originalSubdomain=de).