Tokenization of Energy: Crypto Mining, Proof of Work and the Reinvention of Energy Financial Markets
Blockchain-based innovations are as much about new technology as they are about new concepts of governance. In particular, the continued proliferation of Proof of Work (PoW) consensus has the potential to fundamentally change the structure and incentives of the energy markets. By translating physically trapped energy into global and digitally mobile value, the energy economics of production and distribution may change.
One of the most common misconceptions about the Blockchain and Digital Assets space is that we’re witnessing “a technology-driven” revolution. While the technology paradigm of distributed ledgers (“DLTs”) certainly brings incremental innovations to the table — mainly increased standardization and electronification — arguably, the bigger transformational innovation comes from new forms of distributed governance and incentive mechanisms.
It is perhaps not surprising that those who follow this space, spend a significant amount of their time on governance and durability of incentives. A decade-in since the launch of the Bitcoin network, and the introduction of Proof of Work (PoW) consensus, numerous arguments have been made and fiercely debated. At it’s core, Proof of Work (PoW) is an incentive mechanism designed around the consumption of energy in exchange for a reward from securing a global distributed data ledger. So long as securing this ledger (the blockchain) rewards someone with economic value that is worth more than what they put in, the incentive works.
A wise person once said: “Show Me The Incentive, I’ll Show You The Outcome”
This deceivingly simple incentive has birthed new industries (e.g. Crypto mining) and has the potential to trigger knock-on effects for global energy systems and markets. As Proof of Work consensus mechanisms mature, traditional paradigms advocated in energy systems engineering, energy economics, and energy financial markets (e.g. power trading, project financing, green finance, purchase power agreements) could fundamentally change.
This article explores some of the context and significance for these changes— split across 3 sections:
- Section 1: Understanding The (very) Basics of Proof of Work (PoW) and Mining
- Section 2: PoW and Energy Systems Engineering and Energy Economics
- Section 3: Implications for Energy Markets
Understanding the (very) Basics of Proof of Work and Mining
To set the appropriate context for the rest of the article, it is important to understand the very high-level basics of Proof of Work (PoW) and Crypto Mining. The basics of the Proof of Work process, is to convert energy (something which is globally distributed and available in various formats / quantities) into a digital, liquid, and mobile form of economic value (represented in the form of a cryptocurrency / token).
Institutions that participate in the Proof of Work process are called “miners”. Miners run specialized hardware / equipment to solve a cryptographic puzzle (e.g. SHA 256 in the Bitcoin network). Those that can configure their mining operation to solve the puzzles in the fastest time, while incurring the least amount of costs, will have profitable businesses. This is not dissimilar to other types of energy manufacturing (e.g. in the Oil & Gas industry) — except that the final economic good being manufactured is digital.
Therefore, so long as people ascribe a non-zero value to the tokens being mined (e.g. Bitcoin), there is an economic incentive to mine. (Refer to an earlier article on non-sovereign assets for why tokens may have non-zero value). Miners do not necessarily need to believe in the principles of the blockchains they are helping to secure through mining. In fact, they can be 100% agnostic, and mine the blockchains that the market deems to be most valuable (e.g. the mined tokens that the market will pay them the most for). In many ways, this is the beauty and elegance of Proof of Work.
This property and incentive could have profound implications for those who study and work in the energy sector— all the way from exploration & production, refining & distribution to energy financial markets & policy.
PoW and Energy Systems Engineering and Energy Economics
Back in university, I majored in Chemical Engineering. In my final year, I took a course called Energy Systems engineering — which would proceed to have a major impact on my life. The point of the course was to design and analyze energy systems that could technologically supply sufficient energy to meet the round-the-clock demands of customers of a given market, while also being economically and financially viable.
Matching supply and demand
In a nutshell, the key to understanding the complexity of energy systems revolves around matching the profile of energy supply (“how much energy can be produced in a given physical location, at a given point in time?”) vs. the profile of energy demand (“how much energy does a community need, in that same location, at a given point in time?”).
The energy mix, based on what technologies and methods are available, reflect a complex optimization exercise. In addition to supply and demand, other real-world constraints can be overlaid including, but not limited to things like:
- Environmental factors (e.g. Burning coal releases more CO2 vs burning natural gas vs running a wind farm)
- Build / decomissioning factors (e.g. Building a nuclear powerplant requires building 100-year financial reserves for future tear-down)
- Lifecycle operation factors (e.g. Different types of ongoing servicing / maintenance required for upkeep of different technologies)
From carbon-based, to carbon-free
One of the main focuses of many energy systems engineering exercises today is to try and maximize the use of renewable (carbon-free) sources. Political developments like the UN’s Sustainable Development Goals / SDGs, and the Paris Climate Agreement have further supported this.
However, the challenge with achieving this often boils down to the inherent economics arising from renewable energy production. The challenges most commonly cited are two fold: (1) most renewable energies either are too intermittent and/or (2) too geographically limiting. As a result, the economics alone may not always incentivize development (depending on where you live in the world).
To solve this problem, a number of solutions have been proposed — from government subsidies and purchase power agreements, to technology R&D to develop better energy storage. Each have their own pros and cons.
The common thread across these solutions is that none can immediately address the issues we face, at the scale needed (at least not yet). Further complicating the matter is the high degree of global political co-ordination required to even take baby steps forward. Given the urgency (as estimated by some) to change our energy system, there is a risk in relying on global political consensus to drive progress.
Proof of Work as a potential market-driven bridge solution?
A potential bridge mechanism to kickstart the longer-term solutions could be to leverage Proof of Work-based mining mechanisms. Proof of Work presents new potential pathways for the energy sector to monetize energy production and unlock it from its historical physical constraints. In particular, carbon-free / renewable energy producers may see Proof of Work mining as a means to create new cashflows that can reduce the volatility of the energy economics that have plagued their business models.
Implications for Energy Financial Markets
While it is beyond this article to make recommendations around the specific configurations, locations and contexts to best deploy Proof of Work mining, this high-level thought exercise, at a minimum, should present some interesting considerations for classic Techno-Economic Analysis.
Before going further, it is critically important to note that Proof of Work consensus and the proliferation of blockchain networks / infrastructure has no moral or political biases. Like any other tool or technology, “the way it’s used, determines whether it is good or bad”. With that in mind, there are some general hypotheses that can be drawn from a world where public blockchain networks supply the world with global censorship resistant settlement infrastructure, powered by Proof of Work:
- Energy production and distribution: From carbon-based to non-carbon based producers, there is now an avenue to monetize trapped capacity through mining. This changes the economics of traditional energy production and distribution. In the past, it was always assumed that energy (fuel) could be transported from point A to point B to be monetized (e.g. using a variety of physical infrastructure like pipelines, ship tankers and rail). More localized / renewable production methods did not have the means to be transported, and thus excess capacity had minimal economic value. In this new world, trapped capacity can be monetized locally (e.g. using a mining rig), creating an alternative business model to physical distribution. Intuitively, renewable producers should benefit the most from this, as their marginal cost of production is basically ~0 (not to mention minimized environmental risk).
- Energy financial markets: To the extent that the cost of production and distribution fundamentally change, the shape and size of the energy financial markets (e.g. power contracts, power futures, and other forms of energy derivatives) will change. Carry costs (in terms of storage and insurance) and risk management may also shift from their traditional conventions. Furthermore, recognizing the presence of new cashflows should also spur those who deal in project financing to consider how to incorporate these new innovations into their financing structures. This should provide new levers to de-risk the financing of energy production methods that are highly intermittent and historically rely on government subsidy (e.g. renewables).
- Energy policy: Finally, even with a market-driven mechanism to drive new economics, it still is worth nothing that policy still plays a role in the speed of change in our energy system(e.g. Deciding on whether or not to put a price / tax on carbon will materially affect the pace of de-carbonization). Inching the world towards the long term solution of cheap and efficient energy storage should still be an imminent priority — as this is one of the few sustainable solutions to future global energy security. As crypto mining becomes increasingly commoditized , there should be increased incentives towards pricing negative externalities and advancing energy storage technology— something that producers need to recognize. Innovative policy makers could view this as an opportunity in the meantime to prudently kick-start development in these areas and direct the much needed resources (e.g. Like the space programs in the 1960s/70s).
Those in the field of energy systems and energy financial markets may benefit from taking a look at blockchain-based governance incentive mechanisms. In particular, the proliferation and persistence of Proof of Work has the potential to fundamentally reshape the energy market, and introduce new market-driven incentives. If utilized creatively, these innovations may potentially help to propel us forward in building a more resilient and secure energy future that many of us — especially the younger generations — will eventually inherit and live in.
For those interested in more content that takes a macro-strategic view of the digital asset ecosystem, please follow the publication: “Macro Narratives in Blockchain”. Have a question you’d like answered? Comment in the article below!
The views and opinions expressed in this article are those of the authors. and do not necessarily reflect the official policy or position of any other institution or entity.
Thanks to @chris.sjang for helping to read drafts / edit this.