Kitefin Capital backs Australia’s Greenest Bitcoin Mining Project

Kitefin Capital is proud to announce our recent investment in Tasmanian Data Infrastructure (TDI)’s $3.5m (AUD) seed round.

The decision to invest was made leveraging our team’s combined 90+ years of experience in the power markets, asset management and blockchain infrastructure sectors. Below we provide a glimpse into our evaluation of this opportunity. We also outline our approach to formulating a portfolio that inspires and complements in-house initiatives developed by our partner project, Kitefin Labs.

A Clean, Green Infrastructure Vision

Tasmanian Data Infrastructure is a company name that disguises the ambitious plans of the founders and financial backers to build a sizable Bitcoin mining farm in one of the southernmost lands on the planet — Tasmania, Australia.

Tasmania is a state and small island south of continental Australia. It is rugged, often cold, beautifully lush, windswept and rain-soaked; not very far from Antarctica. Its dense green forests and snow-capped mountains stand in stark contrast to the sun-baked desert terrain that is typically associated with Australia. Here lies one of its great natural assets — mountains and lots of rain- ideal for hydropower generation. It also has wind generation, but hydro is the dominant power source for the island. It is often referred to as a ‘battery of the nation’, exporting clean green power to the mainland. This is only set to grow, with the Tasmanian government targeting hydro generation to reach 200% of Tasmania’s electricity demand by 2040*.

This natural resource also gives away one of the competitive advantages of establishing a Bitcoin mining farm in Tasmania — abundant, near limitless, reliable supply of well-established (i.e., sunk cost) electricity generation.

It’s worth noting at this point that while Tasmania is an amazing green source of power, not all of the electricity that the bitcoin mining farm will consume will be renewable. That is because Tasmania connects to the Eastern Australian national power grid by a cable that runs along the seafloor to the mainland. Electricity is pooled across five states, mixing renewable and fossil fuel power sources. Since Tasmania is electrically connected, there are times when the Government-owned hydro operator chooses to reduce water flow. At those times, a mix of non-renewable and renewable electricity may flow back into Tasmania.

The following chart shows a typical mix of energy sources generated in Tasmania:

• 84% hydro
• 16% wind
• <1% thermal

Tasmanian electricity mix by fuel source

TDI plans to build up to 35MW of Bitcoin mining farms, with the first 10MW scheduled to begin in early 2023. The site has expansion capacity up to 100MW subject to infrastructure upgrades.

Kitefin Capital’s Investment Process

Opportunity Pipeline

Kitefin has an experienced team across four countries who have long histories in commodities, derivatives, power markets, traditional finance, decentralised finance, tech infrastructure, venture capital, funds management, and deal-making. This investment opportunity was through a connection forged by Kitefin Capital founding member Joel Cann, who has an extensive network built on 30+ years of experience in traditional finance and asset management.

The reputation of our team is directly relevant to our investments because we provide more than capital and more than generic support to our portfolio companies. We hold licences for dealing in financial products and are adept at hedging market risk and bridging liquidity between disconnected markets. Additionally, our long and broad collective experience in funding and supporting high-growth companies across the infrastructure landscape enables us to contribute sector specific insights and risk management strategies that are directly relevant to our investees’ pain points.

Beyond this, and rather rare in the venture space, our team also gets their hands dirty by building, solving and piloting so that we can offer tangible support that extends beyond capital.

Evaluation Process

One of the most important steps for each investment is to articulate the criteria against which we will evaluate the opportunity. While some criteria is generic across all deals, crystallising the specific assumptions for success is not always trivial.

For the TDI investment, the value proposition distilled down to these deceptively simple questions:

• Does this investment align with our vision?
• Are we prepared to take a leveraged long position on Bitcoin while accepting the risks of entering that position through this project? (more on the risks later)
• Is this leveraged investment preferable to just buying Bitcoin?
• What unique capabilities can Kitefin add to this project to add value and reduce risk?
• Do we think the return will meet our target return multiple for this type of investment?

This deal contains many factors to review, including a suite of fairly complex, interconnected risks and opportunities to mitigate them (see below).

Before we commence a deep dive into our assessment of the financial value and why Kitefin can invest in TDI at a far lower risk than anyone else, I’ll first briefly explain why this opportunity aligns with our vision, values and mandate.

Alignment to vision

The invention of the bitcoin protocol in 2009 was a major leap forward in monetary system design, unleashing an “internet of money”, where value can be instantly transferred in the form of data. Kitefin is committed to supporting the Bitcoin network and ecosystem, due to its unrivalled adoption, security record and active developer community.

We acknowledge that the electricity consumption and therefore carbon footprint of Bitcoin is significant and the evaluation of this is a complex and controversial topic. Having worked in power markets for many years, we are no strangers to the broad environmental cost of economic activities. While we do not shy away from discussing this transparently, a deep dive is beyond the scope of this article. However, broadly speaking our current belief is that the benefits of disintermediation and automation have the potential to vastly improve wealth and environmental management by introducing unprecedented accountability, transparency and access. Rather than inhibit this innovation we are focussed on supporting greener approaches, such as in the case of TDIs bitcoin mining project.

Bitcoin — a power station in reverse

Building a traditional power station

In the mid-2000s, I created a business case for purchasing land to build a 400MW combined cycle gas (CCGT) fired power station at Tallawarra in New South Wales. A proposal like this is usually started with an assessment using a standard financial model with discounted cash flows to determine whether it meets a required rate of return hurdle.

On the one hand, you have relatively predictable costs:

• These include the land acquisition costs, turbine and infrastructure costs, electrical and gas connection costs, labour, permits, and so on. These costs can be estimated within known parameters and don’t pose a significant risk to the project.
• Gas input fuel costs, which are pretty easy to calculate when you have an extensive national gas portfolio to leverage, can be unknown in the longer term but should also fall within predictable ranges over a shorter period.

The most unpredictable part of the valuation for a power station is the future power price; that is, for how much can we sell the output? We needed to answer what we expected the electricity price to do over the next 5–10 years (the period over which the IRR mattered) and also consider the size and plausibility of pricing scenarios that would turn the project into a lemon.

Get this right, and the project would be highly profitable, but get it wrong, and it would be a white elephant asset you wouldn’t want on your résumé.

The proposition became whether or not to take a leveraged long position on the future electricity price, given the risks. Did it meet the required hurdles, and did it fit strategically into the portfolio? And also, if we were wrong in our forecasts, what would uniquely give our team a competitive advantage to withstand a poor market environment better than others?

And much like comparing bitcoin mining to just buying bitcoin, were we better off just buying long term forward energy contracts as opposed to building a power station?

Returning to the forecast electricity price, the spot (real-time) electricity price in Australia is (like Bitcoin) extremely volatile. It ranges from -$1000 /MWh to $15,500 /MWh (1 July 2022). If you consume 35MW, your cost could vary between -$140k to $2.3m for just 4 hours per day**.

Consider this chart of quarterly historical electricity prices in Tasmania:

Buying from the spot market can seem extremely attractive when prices are low for long periods, but as many have discovered (cue 2022 winter prices), low rates don’t last forever, and a window of extreme prices can be a black swan event to your business. Consider the above chart where spot prices in some quarters have been upto 9x the prices in others. That is quite a risk if you are running an energy intensive business.

A lower risk approach would be to hedge the future price received for every unit of generator output. To hedge means to lock in a fee for a fixed period to remove unpredictable volatility risk, but this comes at a cost because you are paying for someone else to take that risk (much like an insurance premium pays someone else to take your risk of loss).

Think fixed versus variable mortgage rates but in reverse as it is a revenue item, not a cost.

Bitcoin’s link to power generation

The reason I went into a lengthy explanation about power stations is because assessing a potential investment in a Bitcoin mining farm is a lot like assessing a greenfield power station investment.

Many establishment costs and risks are similar and should be manageable by competent operators, who must be good at tasks like:

• Good planning.
• Keeping development and maintenance costs within acceptable tolerances.
• Working with regulators and government, and
• Overcoming potential delays to deliver on time and budget.

Ultimately the Bitcoin mining investment proposition comes down to taking a leveraged long position on the bitcoin price relative to the most considerable input cost — electricity, and having sound plans to mitigate the risks to achieving our target IRR for this type of investment.

The Opportunity Space

Tasmania is highly attractive for BTC Mining.

Some critical benefits to BTC mining in Tasmania set it apart from other locations.

1. Sovereign risk has been particularly on the radar over the last 12 months. First, the industry had China ban bitcoin mining, and then in 2022, the Russia-Ukraine conflict brought a huge sovereign risk of investing in operations in Russia. With the energy crisis and flip-flopping attitude towards crypto, the USA and Canada may not be safe long-term either. But Australia is one country that is (so far) welcoming of crypto innovation, has a robust regulatory framework and is not a current risk to crypto mining. Australia is undoubtedly attractive to investors, considering there is the real risk of total asset loss in other countries.
2. An abundance of hydro generation. While the electricity spot price will be volatile, there is a considerable excess supply to demand for electricity in Tasmania. Even though there is only one actual seller, the supply/demand dynamics still put the advantage in the buyer’s court in the long term.
3. The people and the rule of law. Tasmania and Australia generally have an abundance of highly skilled people and a legal system almost free of corruption when trying to develop projects. Like the low sovereign risk, Tasmania is a great location to do business.

Risk evaluation and mitigation

There are many risks inherent in a project of this scale, however for brevity below is a summary of the key ones we considered.

Mining vs. buying BTC

Given that bitcoin mining is taking a leveraged long position, we must ask whether the investment is worth the additional risks compared to just buying bitcoin and ‘hodling’? One way to consider this is to look at the return with no change in BTC price.

I’ll illustrate this using Braiins’ excellent Bitcoin valuation tool.

Braiins: Cost of mining one Bitcoin

Note: this chart shows the BTC metrics at the time of the investment.

Using inputs for electricity similar to the average in Tasmania and current BTC prices, we can see that a medium-level miner of 90 TH/s at 3050Watts will cost $13.4k to mine one Bitcoin. This price is less than a third of the BTC price at the time of the investment and provides a lot of wiggle room should BTC move lower in the short term. More broadly, in terms of satoshi-hashing, a single unit should mine around 0.00035 BTCs per day (all other things being equal), which extrapolates to ~0.1 BTCs in year 1.

Assuming the BTC price doesn’t die, the mining hardware cost can be recovered in around 12–18 months, less if BTC moves back up to all-time-highs.

Delivery Risk

This is a critical risk for obvious reasons. Regardless of how good the opportunity seems, the delivery of infrastructure is prone to all manner of challenges.****

Naturally, an investor wants to know whether the management team is likely to deliver on the plans they outline in their pitch. We assessed this by considering the team’s previous track record of delivery, exploring evidence where they had

• Have they previously shown they can recover from significant setbacks?
• Do they have the experience and connections to get through red tape?
• How secure is their finance and ability to raise?
• Do they have the capacity to move a project from concept to operating asset ?
• How cohesive is their team?

Furthermore, networks are invaluable, not just to access deals but to know the decision makers well enough that you understand their character, how they respond to adversity, and whether they are genuine. TDI’s executive team has an impressive history of project delivery, including at Genex Power, Cobre, OzAurum Resources and Lithium Power International.

Financial Risks

Is it robust to significant financial threats?

We must understand the size of the risks of the key variables that could hurt our IRR and then ask ourselves how are we placed to mitigate those risks. How controllable are they, and which ones are just a ‘kick and hope’?

For this investment, the key variables are:

• Capex. Because the IRR heavily favours money in hand today versus in 5 years, the capital expenditure is significant to the overall return. However, like the power station example, this variable can be reasonably predicted within known ranges. So then it comes down to our confidence in whether the management team can do the job within budget, and monitoring their progress against stated goals.
• Uptime. The high capex cost of Bitcoin mining means that the uptime of the Bitcoin machines is crucial to the IRR of the investment. Normally this works against the intermittent nature of renewable energy sources, but the grid-connected hydro of Tasmania ensures electricity is always available — albeit may not always be 100% renewably sourced. The table below from a very good Braiins blog post shows just how important the utilisation percentage is; yes, more important even than the electricity price.

In addition to the capex and utilisation risks, next come the risks that impact the marginal cost of Bitcoin products. Top of this list is the electricity price, but it is not the only one:

The following factors can significantly impact the marginal cost…

1. Electricity price. After the capex (assuming a new build with new ASIC miners), the highest cost will be electricity. Fortunately, this is the Kitefin team’s bread and butter because over our 60+ combined years in power markets. Our experience means that we can accept and/or reduce risk when others can’t, and provide TDI with a competitive advantage over any other Australian BTC mining operation.
2. Carbon emission costs. There is ongoing uncertainty on what future carbon obligations business like TDI could face in Australia; direct or indirectly embedded into power prices or levies. The Kitefin team has experience in, and is licenced to trade carbon credits across the regulated and voluntary sectors. We also have trading relationships with entities who will pay a premium for Bitcoin that is “fresh” (purchased directly from miner) and clean (“created from renewable sources”), which can help to offset the cost of purchasing additional offset credits should the need arise.
3. Weather. The electricity price in Australia (and Tasmania included) correlates with the temperature. have used weather derivatives to hedge electricity price risk at cheaper rates than what the electricity market can achieve itself. Traditionally this is very challenging, with very few insurance providers offering weather derivatives at competitive prices. DeFi has the potential to increase access to and the range of weather products that can be used to hedge electricity price.
4. Ability to dynamically load shed. We mentioned earlier that the price paid for electricity can increase by over 400x in just 5 minutes. Over a week, that really hurts. There are some software tools that automatically shed load when electricity prices exceed a given threshold, but the optimization tends to be quite simplistic. We believe that there are a lot of improvements that can be made here and TDI are working in-house on tools to do that.
5. Terms in power purchase agreements. Signing a power purchase agreement can be a huge win and a colossal regret if signed incorrectly. To understand it, think about it a bit like taking out a fixed rate mortgage rather than sitting on the floating rate. Our power market experience means we have a proven ability to decide when to PPA and when to run the variable rate, saving millions.
6. Miners as batteries. I hinted earlier that bitcoin miners can act a bit like batteries. There is a time to add electricity to the mine and a time to draw down. But determining the optimal time for each is a stochastic optimisation problem, not unlike managing a hydro-dam or large bank of batteries. The mining operation is both a reservoir of electricity and a quasi-supplier. To get the most from the procedure, this needs understanding, accurate modelling, and the ability to utilise financial instruments in TradFi and DeFi to execute the plan.

Last but not least (in fact, this is likely to be the most important factor)

• The future Bitcoin price. We are directional investors who fundamentally believe in the long term value that bitcoin provides society. However, navigating the volatility in the short term isn’t trivial. Our experience with derivatives enables us to hedge our portfolio from large negative impacts.

Sovereign Risk

Australia is slowly moving forward to become an attractive destination for digital asset businesses. While resource and labour costs are higher than many other countries, Australia is a top tier country in terms of low sovereign risk. This includes:

• Australia’s rule of law is very strong for protecting assets and deterring fraud
• Mining operations in Australia are unlikely to be placed on an OFAC sanctions list
• Australia is moving towards licensing crypto and creating a predictable regulatory environment for crypto and digital finance
• Stable politically — so it is unlikely private assets will be nationalised or face other black-swan political risks
• Australia has a mature and robust electricity market and financial markets, and
• There is a low risk of public rioting directed at infrastructure assets.

It is difficult to quantify the value of these, but they do provide investors with significant comfort when comparing options between Tasmania, Australia and choices in other countries.

Kitefin <> TDI Advantage

It’s critically important to us that we only undertake investments that provide a measurable, mutually beneficial risk-return advantage for us and our partner projects. This means investing in projects where we deeply understand the domain and can provide an expertise that they are able to utilise when the time is right.

Martin Holland, CEO of TDI summarised their reasoning for inviting us to their round.

“We consider Kitefin Capital a strategic partner as their team offers a breadth of expertise that spans power and crypto markets, asset management and infrastructure development. It’s helpful that their presence extends beyond Oceania, allowing us to leverage their trading partnerships globally.”

Put simply, our attention, network and expertise is available to help our portfolio companies with their challenges, as and when they need.

What sets us further apart, however, is that we are also designing and building (software) infrastructure through Kitefin Labs. The investments that we make tangibly inspire and influence what we build. For example, one of our current projects is developing onchain hedging solutions for miners that can integrate automatically with their optimisation control software.

Kitefin Bio

Kitefin is a decentralised finance project formed by a complementary group of traditional finance (TradFi) professionals turned Decentralised Finance (DeFi) natives, comprising Kitefin Capital, an early-stage principle investment and trading group, and Kitefin Labs, established to build market infrastructure solutions.

The Kitefin team has spent 80+ combined years navigating the inefficiencies of analogue finance (gated by central banks, brokers, reconciliation agents) and 10+ combined years designing and helping operate open financial systems using blockchain and decentralised protocols.

Kitefin’s core belief is that wealth is unlocked by openness. As more opportunities become available to previously excluded communities, the total pie grows; this is not a zero sum game.

Currently the team is focussed on supporting the infrastructure layers of the technology stack with recent investments in a decentralised account protocol for Ethereum and in a renewable energy blockchain mining operation. Alongside investment, Kitefin Labs is designing and building complementary Web3 protocols for institutional-grade risk management and trading.

Further Information

You can read more about TDI at https://tasdata.com.au/

Kitefin can be reached at https://www.kitefin.xyz/ and we are on Twitter and Github.

Co-authored by Guy Mullon and Tamlyn Rudolph

Footnotes:

* https://www.weforum.org/agenda/2020/12/tasmania-renewable-energy-sustainable-hydropower

** Yes, you are reading this correctly. When prices are negative, you can actually get paid to use electricity. In practice, negative prices are rare and short-lived.

***In May 2022, Swiss-based Bitriver BTC mining operation with facilities in Russia, was hit by US sanctions. This resulted in an immediate loss of access to privately-owned ASIC miners from all around the world (not just the US citizens) who at the time of writing have not been unable to recover, sell or relocate their miners.

****Infrastructure challenges can be entirely unexpected. Take for example the iceberg lettuce shortage in the Australian winter of 2022, which caused the price of a vegetable that is quick and easy to grow to increase from $1.5 to $12 in some shops. This forced KFC to replace lettuce in their burgers with cabbage.