Improving Transparency and Sustainability of Digital Assets

By Wai Lum Kwok, Senior Executive Director – Authorisation at Abu Dhabi Global Market

Digital assets hold considerable potential for transforming financial services. They can broaden financial inclusion and facilitate cross-border trade flows, for example, through cheaper, faster alternative payment methods. They can also improve the resilience of the financial system, for example, by allowing greater transparency and certainty over trade settlement.

As with any industry and new technology in the past, digital assets must overcome concerns regarding sustainability to achieve this potential. One aspect is the amount of energy consumed by digital assets such as the Bitcoin network. As of 16 June 2021, the Cambridge Bitcoin Energy Consumption Index (CBECI) estimated that the annualized electricity consumption of the Bitcoin network was 92 terawatt-hours (TWh). This is equivalent to nearly 80% of the United Arab Emirates’ (UAE) estimated electricity consumption for 2019 (119 TWh).

The significant energy drain of digital asset networks such as Bitcoin has raised questions over their long-term benefits to the economy. The ongoing growth in digital assets and mining demand for silicon chips is associated with a corresponding increase in e-waste, as mining hardware grows obsolete and is discarded.

Policy makers and ecosystem stakeholders should take active steps to understand the underlying drivers and risks in these environmental concerns. If not appropriately addressed, these issues will result in a higher environmental footprint and impact adoption of the technology.

Consensus mechanisms

The largest contributor to blockchain-based digital assets’ environmental footprint is the need to expend significant computational power to have the right to commit a transaction to the blockchain for the network to confirm and provide global consensus. Achieving consensus on the state of the blockchain is essential to distributed systems like the blockchain.

Consensus mechanisms based on proof of work (PoW) can require particularly high levels of computing power and hence electricity consumption relative to other mechanisms. For example, the Bitcoin consensus mechanism requires multiple participants to independently solve a cryptographic algorithm. This is inherently energy inefficient because participants are duplicating work.

In contrast, other types of consensus mechanisms e.g. proof of stake (PoS), are more efficient from an environmental point of view. Unlike Bitcoin’s PoW model, a single qualifying participant is randomly selected to determine consensus.

Data gaps

Evaluating the environmental impact of digital assets is challenging because estimation methodologies can differ significantly in approach. For example, the CBECI takes a bottom-up approach that estimates electricity consumption based on the types of hardware available for mining. In contrast, the Bitcoin Energy Consumption Index takes a top-down approach that estimates electricity consumption based on miner income.

Moreover, given the global nature of digital asset networks and the distribution of computing power, the energy mix and usage profile in a particular location may vary and have different environmental impact. Some mining pools may tap on renewable energy going forward, while others may continue to use more traditional grids running on fossil fuels to support the PoW consensus-based blockchains. The global disparity in energy mix makes it difficult to predict the future viability and sustainability of the PoW mechanism for blockchains.

This lack of well-founded data makes crafting effective policy challenging. The effectiveness of any policy intervention (such as restricting the use of PoW- based digital assets) will be difficult to assess if there is no data to measure and attribute the impact of the policy against other market forces in the digital asset ecosystem (such as a sustained drop in digital asset prices).

Potential steps forward

The ADGM has a strong interest in helping digital assets achieve their potential in a sustainable manner. In 2018, the ADGM introduced the first comprehensive regulatory framework in the MENA region for digital assets, including virtual assets, digital securities and stablecoins. In 2019, the ADGM took further measures to advance its Sustainable Finance Agenda, including the Abu Dhabi Sustainable Finance Declaration. Such measures have furthered the UAE’s intent to strengthen its capacity to promote a green and inclusive economy and ensure the sustainability of the UAE’s economic growth.

Based on the challenges outlined above, policy makers could consider exploring the following potential avenues for greater involvement:

Move away from the use of energy-intensive consensus mechanisms for digital assets:

While it may be challenging to determine the exact environmental impact of digital assets, it is quite clear that the energy consumption to operate their networks is significant. Policy makers could work together with industry stakeholders to develop technologies and encourage the use of more sustainable typologies for network consensus and resource requirements for distributed ledgers. Where warranted, we could consider means to moderate the use of such assets. This could include placing caps on holdings of PoW- based digital assets, placing additional prudential requirements on those holdings or imposing levies on transactions of such assets.

Improve transparency into digital asset energy usage:

To better inform and calibrate policy interventions, policy makers could consider measures to encourage digital asset participants to disclose regular, timely and accurate data on computing power being expended on the blockchain network and provide location-specific distribution.

Discourage the use of non-transparent digital assets:

Policy makers and industry stakeholders could consider measures to discourage the use of digital assets where participants do not publish information on energy consumption. Where possible, policy makers should leverage the inherent transparency of the blockchain to ensure that interventions are well targeted.

Environmental, social and governance (ESG) investors also have an important role to play. When making investment decisions, ESG investors should take into account the ESG impact of the specific digital assets under consideration, including whether participants in such assets have been sufficiently transparent about their technologies’ energy use. This would augment policy interventions by imposing market discipline on digital assets.

These discussion points and proposals are intended to provide a starting point for further deliberation and dialogue amongst all participants on the relevant issues in order to find solutions to the environmental impact and sustainable use of digital assets.

Read more from the report, Digital Assets: Laying ESG Foundations