Understanding the Bitcoin Network and its Energy Consumption

Introduction

In recent times, Bitcoin (BTC) has been making headlines that may make digital assets investors a bit queasy. Since the all-time high of US$ 64,863.10 on April 14, 2021, the price of Bitcoin has fallen over 45% in about two months. There could be a plethora of reasons for such a price downturn in the short run – like an overheated market needing a consolidation phase, the influence of large investors affecting market sentiment, regulatory crackdowns on digital assets, and so on – which might be too difficult to precisely factor in (read our newsletter for more information on this). However, unlike the price, the technology behind the Bitcoin network is absolute and is based on algorithms and governing principles that are indifferent to all externalities. 

In this article, we talk about 

  • the Proof-of-Work (PoW) consensus algorithm that powers the Bitcoin network,
  • how a Bitcoin transaction flow looks like,
  • what are the various on-chain metrics associated with Bitcoin, and
  • lastly, the energy consumption conversation around the Bitcoin network.

Bitcoin’s Proof-of-Work (PoW)

The ultimate utility of the Bitcoin network is its ability to coordinate trust and facilitate the transfer and storage of value without any centralized authority. The mechanism of this coordination comes from Bitcoin’s PoW consensus algorithm.

In a nutshell, PoW works on the principle of competition, where “miners” (analogous to “validators” in Proof-of-Stake networks) compete for block rewards by performing computationally intensive puzzles that require electricity. Hence, PoW incentivizes the expenditure of computational efforts and requires energy to run the machines that “mine” the PoW algorithm. The result of employing such a mechanism is a decentralized network, where anyone can add to the mining power with no upper limit. Due to this distribution, the network becomes highly secure unless an attacker can take control of more than 51% of the network’s computational puzzle-solving power. With more than 51% of the network’s hashing power, the attacker can publish fraudulent transactions on the Bitcoin blockchain and exploit the network. 

To further elaborate, the network is designed to listen for the “longest” chain (the blockchain with the most blocks). This means a fraud miner will have to consistently win against the block lottery in order to ensure that his/her version of the blockchain grows faster than the honest miners’ blockchain. Due to the probabilistic determination of block miners, this becomes impossible without the majority of network computation under control of the fraud miner. This also means Bitcoin transactions are irreversible because in order for someone to change the transactions in older blocks, he/she would have to recompute the hash for that block and all the subsequent blocks, at a faster rate than the growth of the current longest chain. Reverting transactions becomes more and more computationally infeasible with the age of the block on the chain.

However, critics of PoW deem the mechanism as inefficient and unscalable due to the never-ending energy demands of the network, whereas Bitcoin proponents see this as a fundamental feature that gives Bitcoin its value. Supporters argue that it is a necessary trade-off to secure trillions of dollars of value stored on the network.

Bitcoin Transactions

After a primer on Bitcoin’s PoW, let us look at how a Bitcoin transaction looks like. The infographic below illustrates a Bitcoin transaction from Bob to Alice:

Source: Medium

Definitions and Network Parameters

Here is a glossary that will help explain things in greater detail –

  1. A Bitcoin address is represented by a string of letters and numbers (e.g. – 1DTmlcZo3MNH9MscHizTLjrUwsfpvSLdf7) to which a certain balance of Bitcoin is associated. These Bitcoin addresses are a combination of a public key and a private key
  2. A Bitcoin wallet is a piece of software that allows access to multiple Bitcoin addresses for a particular user. Hence, a user can have multiple addresses with Bitcoin balances, all stored in a single wallet client. The image below explains the hierarchy:
  3. A transaction signed with the private key creates a unique alphanumeric digital signature, which can be verified by anyone using the corresponding public key to ensure the original source’s legitimacy, without revealing the source or the message.
  4. Once transactions are made by a user, the transactions end up in a pool of unconfirmed transactions called mempool (short for “memory pool”). They are then picked up from the mempool by the miners in order to validate and add to the next block on the blockchain. A large mempool size indicates that the network has longer than average confirmation times and requires higher miner fees per transaction.
  5. The entire history of the blockchain as well as the unconfirmed transactions, are stored in full nodes of the network. The full nodes are also responsible for broadcasting information in the decentralized network.
  6. After miners pick up the transactions to be included in their block, they need to find a valid unique identification string for the block, known as the hash. This means finding a randomized input to the SHA-256 algorithm such that the resulting output (hash) meets certain network constraints. The process of finding this hash, which was previously referred to as “the computational puzzle”, is called mining.
  7. Computation power is needed to determine the above hash. The total hashing power that the network’s miners have is known as the total hash rate (measured in Terahashes/sec). Given the average time T between mined blocks and a difficulty D, the estimated hash rate per second H is given by the formula H=232(D/T). 
  8. Network difficulty is the amount of computing power needed to mine a single block on the Bitcoin blockchain. A high difficulty means that it will take more computing power to mine the same number of blocks. The difficulty adjustment is directly related to the total hash rate of the network.
  9. The Bitcoin network is designed so that the amount of time it takes to mine a new block stays constant at about ~10 minutes, which is known as the block time. As more and more miners join the network the protocol increases the network difficulty. This makes Bitcoin more secure against any attacks at the expense of more power required to do the same work.
  10. Block rewards are paid to miners for performing the computation to generate the correct hash. Every 210,000 (approximately 4 years), block rewards are halved to control the circulating supply of Bitcoins. The current block reward stands at 6.25 Bitcoins, which is newly minted and provided to the miner who proposed the block.

To further understand the network deeper, readers can take a look at explorers such as blockchain.com, statoshi.info, btc.com, bitnodes, and OXT.me, which provide a real-time look at Bitcoin’s network activity, distribution of miners and full nodes, and data on wallets that hold large amounts of Bitcoin.

From our research, we have found that the total hash rate is an extremely important metric that helps understand the real-world usage and impact of Bitcoin. As Bitcoin gains value, mining becomes a profitable endeavor and more miners add to the network’s hash rate, which in turn increases the network difficulty. The total hash rate is not entirely correlated to the price of Bitcoin, as it is hard to respond to the volatility of Bitcoin’s price by adding or removing devices in mining farms. We have observed the following trends about the total hash rate:

  1. The short-term fluctuations do not affect the total hash rate and it is on a constant rise. This suggests that miners, old and new, are participating more and more in the network, which is a healthy sign for the long-term security and utility of the network.
  2. The increase in hashing power also suggests that there is internal competition between miners to maintain the largest share of the total hash rate despite diminishing block rewards. At a macro level, this shows a bullish view of miners on Bitcoin.

Moreover, the total hash rate is also a key parameter in estimating the energy consumption of the Bitcoin network. We discuss that in the next section.

Energy Consumption of the Bitcoin Network

Source: Stephen Chow

In the recent bull run, the total hash rate of the Bitcoin network has surged to new all-time highs. By estimating the output of an average mining device and the electricity costs in regions where mining is concentrated, we can approximate the energy consumption of the Bitcoin network. One such model, known as the Cambridge Bitcoin Electricity Consumption Index (CBECI), has led to several debates in popular discourse. Some key points from the model that set the stage for further discussion are: 

  • The annualized electricity consumption of the Bitcoin network is estimated at 147.41 TWh per year, which is roughly 0.68% of the global energy demand.
  • To put that into perspective, if Bitcoin were a country, it would be the 25th most energy-consuming nation in the world.

Environmental Impact of Bitcoin

Despite the high consumption numbers, the picture drawn is too simplistic and unfair to the actual reality of Bitcoin mining. The number one thing we need to understand is that electricity is a local phenomenon with the following properties:

  • Energy is not globally fungible and varies in price and its environmental impact during production
  • Globally, 8% of electricity is lost in transmission
  • Some sources produce more electricity than they can sell, causing the residual to go to waste due to inefficient and costly methods of energy storage

Thus, what Bitcoin offers energy producers is a global buyer that can consume energy which would otherwise go to waste. We know from data that the largest Bitcoin mining farms are situated in areas that overproduce energy beyond their local consumption capacity. Countries like China, Iceland, and Russia, which operate sophisticated large-scale operations, dominate the global mining share with a high degree of renewable energy penetration. 

China has over 50% of the global mining share, where hydroelectric power is a major source of power. Our main assumption is that miners, wherever they are located, utilise

 the same power mix (renewable, fossil and nuclear) as the average reported in their region. This drastically reduces the actual CO2 footprint from Bitcoin mining across the world. A similar observation is made in Iceland, where the main power source is geothermal energy. Below is a breakdown of global renewables penetration in Bitcoin mining based on a 2019 report by CoinShares research, which includes data from Morgan Stanley Research, EIA, and SATBA:

RegionGlobal mining shareRenewables PenetrationShare of renewablesShare of fossil/nuclear
Sichuan54%90%48.5%5.5%
Remaining China11%44%5%6%
Western Regions31%62%19%12%
Rest of the world4%18%0.6%3.4%
Global Total100%73%27%

Please note that there might be some inaccuracies and changes due to the time passed between the above study (2019) and now (2021). Nonetheless, we can assume the share of renewable energy to be more or less consistent given that people are moving towards more environmentally-friendly sustenance (IEA report, pg. 6-13).

Bitcoin and Renewable Energy Adoption

We argued above that Bitcoin offers a unique opportunity to energy producers by acting as an energy sponge. This attribute makes it possible for Bitcoin to not just reduce its carbon footprint but fuel the growth of renewable energy adoption. The biggest hurdle for large-scale deployment of renewable energy technology is the intermittent nature of sources such as solar/wind/hydroelectric power. For a renewable energy source to service a grid it must have some degree of controllability over its generation or have supporting battery technology that can store the excess for it to be economically viable on large scale.

Enter Bitcoin: Using a model created by ARK Investment Management LLC, it can be demonstrated that for solar energy plants, a large-scale Bitcoin mining operation would allow producers to sell excess solar power and meet the full demand of the grid without lowering profitability. 

Bitcoin mining could encourage investment in solar systems, enabling renewables to generate a higher percentage of grid power with no change in the cost of electricity. The graph below illustrates the hypothetical impact that bitcoin mining could have on the adoption of solar systems (solar + batteries). Based on a constant cost of electricity, it traces what percentage of power solar could provide to the grid. The y-axis is the power of the solar installation, the x-axis is battery capacity. The size of each circle is proportionate to the size of the bitcoin mining operation.

Bitcoin Miners are Going Green!

As we have seen so far, Bitcoin miners have always gravitated towards renewable energy for their mining efforts as it is simply more economically viable for miners in many places. However, there is also an active ongoing effort in the mining community to transition to renewable energy. Miners have launched efforts like Crypto Climate Accords (inspired by the Paris Accords) and Bitcoin Clean Energy Initiative to take greener strides as Bitcoin becomes more mainstream. 

  • On May 13th, 2021, Argos Blockchain announced that it purchased two hydroelectric-powered data centers in Canada as part of its green mining vision.
  • On May 14th, 2021, Greenridge Generation Holdings Inc. said that it will be launching an entirely carbon-neutral mining operation in New York. The firm will be purchasing carbon offsets from US greenhouse reduction projects for this effort.

Some of the factors that could make a country a great spot for Bitcoin mining would be reliable and high-speed internet connection, cost and source of electricity,  and suitable climatic conditions (for cooling mining equipment). Following countries could explore positive mining regulations so as to invite mining businesses on their shores-

  1. Canada – Canada ranks 17th in terms of global average internet speeds with 149.35 Mbps. The average electricity price in the country is US$ 0.174 per kWh, according to the data provided by energyhub.org
  2. Norway – Norway follows Canada and is ranked 18th with an internet connection speed of 146.53 Mbps. As for the electricity costs and location, Norway relies heavily on hydropower and has cold, snowy winters and mild summers, making it a suitable place to build mining farms.
  3. Iceland – In June 2020, a report by the United Nations Environment Programme (UNEP) stated that almost 100% of Iceland’s electricity comes from renewable sources, with the country embracing geothermal power. This shouldn’t be surprising, given that Iceland is home to over 200 volcanoes and numerous hot springs, which facilitate tonnes of underground water to be converted to steam for power generation. 
  4. Kuwait – Kuwait ranks 34th globally with a download speed of up to 110.33 Mbps and its average electricity price is US$ 0.029 per kWh—including the cost of power, distribution, and taxes. This country seems to have the lowest electricity cost, making it a good option for profitable BTC mining. If the government can come up with positive mining regulations, it might see a good flow of mining business on its shores.
  5. Sweden – Sweden ranks 14th globally with average download speeds of 158.73 Mbps. In January 2021, thelocal.se reported that Sweden’s electricity price was pushed down because of the mild winter, combined with lengthy precipitation and relatively windy weather. The favorable climate and cheap electricity costs in Sweden make the country a good location for Bitcoin mining operations.

To summarize, Bitcoin’s environmental relationship depends on where it is being mined. Electricity is only as clean as the grid that produces it. If Bitcoin mining utilizes energy from natural gas or coal-based thermal power plants, then it’s not entirely environmentally friendly. However, even hydroelectric dams and wind farms come with environmental consequences. There is no upper limit on the price of Bitcoin and therefore no limit on how much energy can be dedicated to mining Bitcoin – such is the biology of Bitcoin. The on-chain metrics for the Bitcoin network give interesting insights into the behavior of investors, miners, speculators, institutions, etc. It would be an interesting study to keep track of the parameters mentioned above along with traditional technical indicators to gauge the market sentiment for Bitcoin.

Disclaimer

The views, information, and opinions expressed are solely those of the authors in their personal capacity and do not reflect the official position or views of Woodstock. The authors have taken the utmost effort to ensure the research is up-to-date and accurate. However, no warranties or representations, express or implied, are made as to the timeliness, completeness, or accuracy of the information. Readers are advised to obtain independent professional advice before making any investment decisions or investing. Woodstock does not endorse the views expressed by the authors. Under no circumstances shall Woodstock, its affiliates, partners, directors, employees, or advisors be liable for any loss suffered by a reader on account of the views, information, and opinions expressed herein.

One thought on “Understanding the Bitcoin Network and its Energy Consumption

Leave a Reply

Subscribe to our Newsletter & Research Insights
%d bloggers like this: