Approaches in allocating emissions

There is no single universally-accepted method for allocating emissions and/or energy usage. There is no consensus on how to distribute the responsibility of any single transaction between miners, users, investors, dapp developers etc.

There are three approaches one could take, namely, holding-based, transaction-based and hybrid of the both.

Holding-based

Allocating GHG emissions to cryptocurrency holders based on their share of ownership in the total network.

Existing accounting guidance for financed GHG emissions typically allocates emissions based on the ratio of value owned by an entity, relative to the total value of the asset.

In the holding-based method, the same logic is applied, as all owners in the cryptocurrency network are responsible for the ongoing GHG emissions that mining and validating generates.

A cryptocurrency holder or service provider’s share of total network GHG emissions is equal to the percentage of total network value they hold. This method works well for networks where the block reward makes up the vast majority of the miner payout. Those that hold more of the cryptocurrency have greater impact on its value, influencing the value of the block reward, and incentivizing GHG emissions-intensive mining and validation.

However, under the holding-based method, transactions are not assigned any GHG emissions. This is problematic for networks where transaction fees account for a significant share of the overall reward, creating a strong incentive for mining and validation.

The holding-based method does not properly account for the climate impacts of user transactions.

Transaction-based

Allocating GHG emissions to stakeholders based on their share of transaction fees in the total network.

In the transaction-based method, GHG emissions are allocated to stakeholders based on their proportional share of total network transaction fees. Network GHG emissions are divided among entities by comparing the value of the transaction fees paid by the reporting entity to the total transaction fees across the network for a given period of time.

Depending on the overall compensation, transaction fees can provide a meaningful incentive for miners or validators to invest in hardware and electricity, which ultimately causes GHG emissions. Therefore, the more fees paid by a user to the network, the higher the accountability of the user for network emissions.

However, this method does not incorporate the impact that holdings have on driving the underlying cryptocurrency value and thus, validator block reward incentives. Users that solely hold cryptocurrency would therefore be held less accountable for emissions, while users that mainly conduct transactions are assigned the major share of GHG emissions, despite limited miner incentivization.

The transaction-based method does not properly account for the climate impacts of holding cryptocurrency.

Hybrid

This hybrid approach combines the two most apparent approaches and allocates emissions based on holding and transaction volumes. This allows capturing the specificities of many different cryptocurrencies and tokens with one consistent approach, by accounting for their underlying mining revenue structures. The framework can be applied to both proof-of-work (PoW) and proof-of-stake (PoS) protocols. Furthermore, it can be applied to applications running on these networks as well as second layer approaches such as the Lightning network.

For both transactions and holdings, claims exist that the respective activity is not contributing to the electricity consumption of the network: With regard to holdings, some claim that the pure act of holding coins and storing this information in memory requires only very low amounts of electricity consumption. Additionally, some coins might have been minted to an early phase of the network in which the mining was comparatively low computational expensive and thus should not account for the ongoing process for securing the network. With regard to transactions, some claim that the pure act of verifying new transactions is not computationally expensive and even if no transaction would occur the network’s electricity consumption might not significantly decrease. To unpack this conflict, it is helpful to understand the incentivization of the miners to spend money on electricity: Miners receive a reward for solving a mining puzzle in the form of a block reward and transaction fees from included transactions.

For transactions, it is clear that the entity executing the transaction is responsible for the transaction fee (and the thereby resulting incentivization). Consequently, the share of transaction fee in total miner revenue reflects the share in electricity consumption which transactions need to account for. For holdings, it is clear that they massively profit from the ongoing securing of the network as diminished faith in the network would lead to a major price decrease of holdings. Thus, holdings need to account for a certain share of the electricity consumption which should be equally spread across the coins independent of their age to maintain their fungible nature which is an integral part of any currency (coins also equally profit or suffer from price variations). Still, it might remain less obvious why the incentive of the block reward is the responsibility of entities that hold the respective currency.

Assuming constant demand for the respective currency, inflation (the creation of new coins) devalues the holdings of holders, implicitly leading to a value transfer of the entity holding cryptocurrency to the miner. Thus, the value of existing holdings and their faith in the network incentivize the miner to participate in the mining process and earn the block reward. In light of the argumentation above, we argue to account for both holdings and transactions, as both contribute to the miner’s earnings and ,therefore, their incentive; the distribution between block reward and transaction fee is, therefore, a suitable approach.

In PoW, we suggest differentiating between block reward and transaction fees for the holding- and transaction-based allocation, respectively. In PoS, we may differentiate between two sources of energy consumption: Providing the infrastructure (e.g., network running without any transactions) and the marginal energy consumption added by transactions.

Application across blockchain networks and consensus algorithms

Based on the requirements outlined above, a hybrid accounting method appears most promising. It offers a high degree of consistency as no binary decisions (which could be taken differently depending on the user’s incentive) are required. As a result, cryptocurrencies and tokens with similar incentive structures are treated similarly in the accounting and allocation process. This is also favorable in terms of continuity. Users of the hybrid approach can anticipate how changes in the incentive structure of the protocol will affect the accounting and allocation process since the underlying methodology persists over time. In terms of completeness, the hybrid approach makes it possible to cover a wide range of cryptocurrencies and tokens as it enables one to account for the specificities of different systems over an entire spectrum and can also include activity on the application and the second layer.