The Dynamics of Bitcoin Mining and Energy Consumption, Part II: Mining Incentives and Economics

This is Part II of a series—Part I is here.

Blockchain systems aren’t really single technologies. They are complex architectures with many interacting parts, and hundreds of different architectures exist. For this discussion, the relevant piece of the architecture is the consensus algorithm. That is the group of rules that determine which nodes in a blockchain network are responsible for validating transactions, packaging them into blocks, and storing them in a distributed data structure. One consensus algorithm in particular, Proof of Work (PoW), is the cause of all the hand-waving about blockchain energy consumption.

What Is Proof of Work?

PoW functions by pitting special nodes against one another in a race to solve a mathematical puzzle that requires a huge amount of computational power (energy) to solve but is trivial for others in the network to verify. Miners are willing to invest resources into the race because the winner gets a prize (12.5 Bitcoin, or ~$90,000 USD). Like race cars, more powerful systems are more likely to win the race and the prize. Miners are incentivized to keep investing in compute equipment as long as they win often enough to net a profit—resulting in massive IT facilities like the one in Mongolia.

In the Bitcoin network, a new block is up for grabs every 10 minutes. To keep this interval constant, the difficulty of the PoW puzzle dynamically adjusts based on the total mining power of the network. In simple terms, as cars get faster, the racetrack gets longer—and drivers have to burn more gas to finish.

Proof of Work Difficulty and Mining Power Trends: 2016-2018

(Sources: Guidehouse Insights, Blockchain.Info)

Mining Activity is Ruled by Economics

We can think about mining economics in terms of a simple profit equation, with the implicit assumption that miners will operate as long as profit is greater than zero:

Profit = Revenue - Costs

Costs (hardware, facilities, electricity, personnel) are the most stable component of the miner profit equation. This is because revenue is comparatively volatile: miners are rewarded in Bitcoin, and successful miners receive 12.5 Bitcoin, but the corresponding value in “real money” changes on a minute to minute basis. Miners must convert their rewards to real money eventually to pay their bills, and almost no one accepts payments in Bitcoin.

Economic Complications

A key point is often overlooked: in the Bitcoin network, miner rewards halve every 4 years. For a given mining facility to remain profitable—all else held equal—the value of Bitcoin must double over the same period. If it doesn't, the revenue opportunity for miners shrinks and they have to reduce costs to remain profitable.

As the value of Bitcoin increases, more miners are incentivized to join the network or invest in new, power-hungry equipment. If the value drops, the incentive flips, and miners will leave the network or shrink their operations. As miner compute power leaves the network, PoW adjusts its difficulty downward, reducing energy consumption.

What Does This Mean for Future Energy Consumption?

Unfortunately, it doesn’t mean that energy consumption isn’t a problem. It just means that energy consumption is unlikely to continue growing at the prodigious rates seen over the last few years. There is only one doomsday scenario: the value of Bitcoin continues to double every 4 years, pulling more miners into increasingly difficult PoW competitions.

As we’ll see in Part 3, that scenario is highly unlikely (unless you’re this guy). Now that we have a basic framework in place, we can discuss the various factors that will affect PoW mining and energy consumption in the future, and what this means for utilities that have to make plans today.