Bitcoin Mining, Blockchain & Renewable Energy: Part 2 (Crypto / Digital Tokens and Finance)

With Praveen Jayachandran, IBM Research

This is a two part series on Bitcoin Mining, Blockchain and Renewable Energy. The first part covered the drivers & trend relation between bitcoin mining and the demand for energy in key markets (China, and colder locales w/ cheap energy - renewable or otherwise). Also read Praveen's companion article. In this second part we overview how the blockchain technology underlying bitcoin, and the concept of digital / cryptographic tokens, Initial Coin Offerings (ICOs) can be used to drive more peer-to-peer finance for a higher supply of renewable energy, especially across emerging markets.

Note: This article pre-supposes an understanding of blockchain, or a decentralized ledger, with a defined consensus mechanism. For overviews on blockchain checkout these articles: Praveen's overview; Cash, Cashless & Blockchain. Here is a video that gives a high-level overview of what blockchain is and how it works. For an outline of barter, cash, ledgers, blockchain, please read past article and some applications (here and here) .

BitCoin and Crypto Tokens: (Hat Tip: BitsonBlocks Blog)

Cryptographic tokens exist as entries on a secure distributed ledger, a.k.a blockchain. You own these ‘tokens’ (or digital resources) because you have a key that lets you create a new entry on the ledger, re-assigning the ownership to someone else. Two types of tokens are:

(a) Intrinsic tokens (native or built-in): resources that have some utility. These coins form the core of the blockchains, part of the incentive mechanism to reward people who validate transactions and create blocks. {Eg: BTC on Bitcoin blockchain, ETH on Ethereum, XRP on Ripple network}.

(b) Asset-backed tokens: claims on an underlying asset (eg: gold, USD, diamonds, 1 kWp of solar), from a specific issuer. The transactions as tokens get passed between people are recorded on the blockchains, and to claim the underlying asset, you send your token to the issuer, and the issuer sends you the underlying asset (eg: see figure below, from BitsonBlocks). Colored coins are digital tokens based upon the Bitcoin blockchain. Every bitcoin transaction provides an optional text field which can be used as an identifier to make a normal transaction represent more than just a mere transfer of bitcoin. One can use these identifiers to allow bitcoin represent any asset outside the Bitcoin blockchain (e.g., stocks, cars, property rights etc). Such bitcoins which have other assets attached to them are called “Colored Coins”.

FT reports that Hernando de Soto, an acclaimed development economist from Peru, joined forces with Patrick Byrne, to launch an unusual project to fight poverty. What they hope to do is to use decentralised digital ledgers — similar to those used for bitcoin — to record the formal and informal property holdings of dispossessed communities, with the idea of giving them more security. 

Utility Tokens and Security Tokens (PolyMath)

Tokens have become a vehicle for peer-to-peer crowdfunding of projects. Kickstarter had popularized the idea of getting seed funding for early stage ventures via the web. But utility tokens and Initial Coin Offerings (ICOs) on the blockchain take peer to peer crowd funding to the next level: an open, distributed, and liquid model & platform for crowdfunding.

Utility tokens are services or units of services that can be purchased. Like bitcoin, a utility token is a digital asset that can be transferred (not simply copied) between two parties over the internet without requiring the consent of any other party.

Balaji Srinivasan in his blog observes: "...tokens are not equity, but are more similar to paid API keys. Nevertheless, they may represent a >1000X improvement in the time-to-liquidity and a >100X improvement in the size of the buyer base relative to traditional means for US technology financing — like a Kickstarter on steroids. This in turn opens up the space for funding new kinds of projects previously off-limits to venture capital... 

When a new token is created, it is often pre-mined, sold in a crowdsale/token launch, or both. Here, “pre-mining” refers to allocating a portion of the tokens for the token creators and related parties. A “crowdsale” refers to a Kickstarter-style crowdfunding in which internet users at large have the opportunity to purchase tokens.

Given that tokens are digital, what do token buyers actually buy? The essence of what they buy is a private key.... (i.e. a paid API key like you buy cloud based services). Like your password, your private key grants you access to the digital token stored on a decentralized blockchain database like Ethereum or Bitcoin. However: unlike a password, neither you nor anyone else can reset your private key if you lose it. If you have the private key, you have possession of your tokens. If you do not, you have lost access. Tokens can be transferred to other parties without the consent of the API key issuer. Tokens are inherently useful. And tokens are tradeable. As such, tokens have a price... Token launches are typically international affairs, with digital currency transfers coming in from all over the world.

Tokens aren’t equity, because they have intrinsic use and because they are non-dilutive to the company’s capitalization table. A token launch differs from an equity sale — the latter is regulated by the 1934 Act, while the former is more similar to a sale of API keys. Note that (tokenized) equities can only be sold in the US to so-called “accredited investors” (the 3% of adults with >$1 million in net worth) "

The Startup Grind blog adds: The SEC announcement any token that can’t pass the Howey test should be considered as a security and fall under the 1934 Security Exchange Act. 

The Howey test consists of the following:

• Is it an investment of money or assets?
• Is the investment of money or assets in a common enterprise?
• Is there an expectation of profits from the investment?
• Does any profit come from the efforts of a promoter or third party?

Many companies raising ICOs (initial coin offerings) are structuring the raise and definition of tokens such that, these tokens are claims to future customer purchases.

Coinbase publishes a securities law framework for blockchain tokens. Tim Draper has published an open letter to SEC recommending:

1. If the purpose of a token is for investment, it must register with the SEC.

2. If the purpose of a token is for societal transformation, and all proceeds go to the support and development of the token, it need not register.

3. If the purpose of a token is to raise money for a company, and the money is used to support the company, it must register with the SEC.

Cryptotokens can very well be issued, transferred and destroyed on permissioned blockchain systems as well. There are already burgeoning examples of private equity administration being handled on a permissioned blockchain platform such as Hyperledger Fabric, such as the work by Northern Trust and IBM. There are multiple benefits to such a platform. Ensuring that only permissioned entities are participating on the platform permits easier KYC verification of investors, rather than the investors being pseudo-anonymous as in the permissionless ICO platforms. Transactions and data can be held private and on a need-to-know basis, allowing a company to stay private and grow steadily until it is ready for an IPO. With stronger security and privacy features, they also lend themselves to easier compliance and audit.

Permissioned blockchain systems also allow greater performance and scale in terms of transactional throughput, to match the scale needed for such markets. Indeed, energy trading platforms on permissioned blockchain networks are gaining popularity and Nagrid . We will see more examples later.

A new class of tokens emerging are "Asset backed" security tokens (STs), which offer KYC, AML and securities law compliance to legally offer STOs (security token offerings). Polymath is a company that is pioneer in this space. Overstock CEO launched a platform called "tZero", an SEC regulated alternative trading system. It is expected that 2018 will be a key year for STs to take off, especially if it does so approved by regulatory bodies such as SEC.

One worry with the Polymath model is that it is still not a permissioned blockchain network. It appears that a combination that may allow securitized tokens (STs) to take off should include: (a) permissioned blockchains so we (and regulators / public interest protectors) know who is on the platform (b) robust KYC / AML due diligence of market participants (c) Full compliance with SEC regulations that will allow a broader set of market participants (d) very high levels of risk management and transparency from the issuers to give confidence to investors that their money will not be taken for an unexpected ride.

Crowdfunding and Initial Coin Offerings (ICOs)

Over the last couple of years, raising money through ICOs have really taken the investment scene by storm. In 2017, startups raised nearly $5 billion through ICOs compared to an estimated $21 billion through traditional venture capital firms. Both help startups raise funds, so what is really the difference? What are the pros and cons of raising funds through ICOs?

When venture capital firms fund a startup, they do so in exchange for equity or ownership, and in addition may take on a more active role in the direction of the company by becoming a part of the board of directors. Such investment is regulated in most jurisdictions with the basic Know Your Customer (KYC) and Anti-Money Laundering (AML) norms to more advanced do's and don'ts governing all parties involved. While these regulations are intended to ensure fairness, there is also criticism of a growing number of intermediaries who control the information flow and the access to funding, and make it extremely complicated for a promising startup to find the capital needed to establish their business. 

An Initial Coin Offering (ICO) (or a "token generation event") is where an entity offers people some units of a new cryptocurrency or crypto-token in exchange against cryptocurrencies or regular fiat currency. The new ICO tokens could be backed by an asset or could be consumption units sold at a discount (eg: Powerledger POWR utility tokens discussed later).

Compared to standard fund raising, ICOs are a completely decentralized way to raise funds through crowd-sourcing without any regulation (at the time of this writing) or legal protections, that leverages crypto-tokens on a blockchain platform. In one form, called the currency ICO or equity tokens, they directly mimic an IPO where private equity shares of the company are given away in exchange for capital. The Ethereum ICO is a classic example. In another form, the ICO raises funds for a particular project where the crypto-token acts as a substitute for a (future) access to a service or right. There is also usually associated with one or more smart contracts that are or will be developed, that only accept the crypto-token for performing its project functions. This is akin to purchasing a limited-time license or paying to invoke a cloud API, except that it can be traded. Investors in this case are betting on the success of the particular project (and not valuing the company) in making the service or right more valuable at a future date than it is now, or are directly interested in accessing the service provided. These tokens can also be traded and their value may fluctuate, but they dont represent ownership or equity in a company.

The concept of ICO took off in early 2013 when Ripple Labs started to develop the Ripple payment system and created around 100 billion XRP token. The company sold these token to fund the development of the Ripple platform. Several other cryptocurrencies have been funded with ICO, for example, Lisk, which sold its coins for around $5mio in early 2016. Most prominent however is Ethereum. In mid-2014 the Ethereum Foundation sold ETH against 0.0005 Bitcoin each. With this, they receive nearly $20mio, which has become one of the largest crowdfunding ever and serves as the capital base for the development of Ethereum. In general digital / crypto tokens can be issued on other blockchain platforms (eg: Hyperledger) as well.

Companies merely write up a whitepaper and launch an ICO: this is worrying to say the least, and the following article in the energy context by Scott Clovenna and Shayle Kann points out a number of issues. Many whitepapers do not clearly outline the risks and paint rosy pictures of the future.

While this model of public fundraising could be revolutionary, it also has its pitfalls. The US SEC put out warnings with respect to ICOs, as it could easily be misused by fraudsters and scammers and many other countries have issued similar or even stronger warnings. The SEC has started taking action in ICO cases. In any case, it is "buyer beware" for such ICOs and token sales. China and South Korea recently banned ICOs with a view of protecting naive investors and ensuring social stability. With no regulations, there are also concerns about how many tokens the ICO creators are withholding themselves, insider trading ethical considerations, lack of any kind of audit mechanisms, and whether the funds are even used for the proposed project.

Energy and Blockchain: Landscape & Pot Pourri

There have been a number of early players at the intersection of energy and blockchain. Lets examine a few:

PowerLedger is a blockchain-based solution company that aims to decentralize how electricity and other utilities are sold. PowerLedger lets users sell their excess electrical supply using POWR tokens. POWR is the currency that facilities the Power Ledger economy. Power Ledger had a token generation event in early 2017. The team procured $34 million AUD by selling their utility token, POWR. It serves as the measure of value used to allow for direct energy trading between businesses and households. The holders of the token hope that they have purchased POWR at a wholesale price and can flip it for a retail price later. What is not clear is the value of subsequent trades on the secondary market. POWR can be transferred across borders.

According to the company: "By having a ERC20 token, we can allow contribution from around the globe to crowd-fund renewable energy assets. In these events we will give POWR holders precedence. Token holders create a network which gives the Platform value, and in return, they receive ownership of the network. Using a token model, there is now an incentive to be an early adopter or user of the network. In Power Ledger’s case, it allows future users of the Platform to pre-purchase electricity at a discounted rate, as demand drivers may increase the value of POWR. By purchasing in the Token Generation Event (token sale), users could get POWR first before the utility model kicks in. This is comparable to pre-ordering a product and paying an upfront deposit to reserve your sale.... Tesla Motors used this model to fund the production of their first electric cars, as a $5,000 USD down payment was asked of future car owners to 1) reserve their spot and ensure they received a Tesla first and 2) to give the company the liquidity they needed to manufacture the cars. "

The way the energy is moved from one person to another is via a unit called 'Sparkz' which is a tokenised unit of electricity or a digital representation of the energy that is being moved from the buyer to the seller.

Grid operator TenneT, renewable/storage players (sonnen, Vandebron), and IBM launched a pilot project in the Netherlands to use IBM blockchain (a permissioned blockchain network over the Hyperledger Fabric) and electric vehicles to help ease grid imbalances as supply and demand fluctuate throughout the day.

In Brooklyn, NY, a project by LO3 to build a blockchain-based rooftop solar community is exploring ways to work with local utility ConEdison and regulators to build a firmer foothold from which to accelerate renewable energy adoption. A solar community emerged via a phone app and blockchain that allowed for information to be shared about available solar capacity, potential buyers, and transaction details (accounting for electrons). The expectation is that blockchain technology reduces transaction costs by keeping a single copy of transaction records, avoiding the need for reconciliation and settlement and reducing the possibility for an error.

A new consortium (Energyweb, promoted by Rocky Mountain Institute (RMI) and Grid Singularity) has emerged to moderate the emergence of Blockchain in Energy. This is an alliance body aimed at introducing an open-source blockchain designed for the electricity market, identifying use cases and helping build an ecosystem of participants. RMI envisions that blockchain technology can allow potentially millions of energy devices (HVAC systems, water heaters, electric vehicles, batteries, solar PV installations, and so on) to transact with each other at the electric power distribution edge.

The SolarCoin Foundation has launched a digital asset, SolarCoin (see image below), which uses a blockchain called ElectriCChain. The ElectriCChain gathers non-confidential data related to solar owners. The Goal of ElectriCChain is to build a network of more than seven million solar installations, which according to International Energy Agency numbers will reach more than 200 million over the next 15-25 years. The SolarCoin concept is that if you have solar panels, you can download a SolarCoin wallet. Then you get a SolarCoin for each megawatt-hour of power your solar installation produces. The foundation holds 99.4 percent of all the coins that will ever exist—the rest will be mined by the public—and they are now giving them out to anyone who can prove they have added solar electricity to the grid.

The value of SolarCoin will likely increase as more and more people join the program and contribute towards valuation increase by buying solarcoins. When it hits around a million users, which the Foundation expects to happen by the end of 2019, it is claimed (note: take with a big grain of salt) that SolarCoin could be worth a lot more per megawatt-hour. SolarCoins have been issued in 23 out of 215 countries and the cryptocurrency is expected to last 40 years. Over time, it could help support 97.5 petawatt-hours of power from some 200 million solar plants.

A South African blockchain startup called Sun Exchange raised $1.6 million in seed funding to launch a solar power crowdsale platform. It proposes to back its tokens via a single solar cell which is leased to counterparties. Here is the statement from their website: "Buy solar cells and lease them to schools and businesses in the sunniest places on Earth. Mainly Africa. The Sun Exchange arranges your monthly lease rental collection and distribution. Get paid in Bitcoin or local currency." After you buy the token, you are now the proud owner of some solar cells (i.e. micro-investment) soaking up glorious African sunshine, as per their FAQ. Sun Exchange just handles the leasing and fee collection, insurance and paperwork etc.

Summary:

A lot of exciting activity is happening around ICOs, digital tokens, and peer-to-peer participation in digital / crypto tokens. The operative issue however is risk, risk, risk.

A challenge in most of the current models is one of trust. As a participant in an ICO, you have to trust a new company, with little or no track record, that puts up a high level white paper, operates in a different part of the world and promises great societal changes if successful. Regulatory grey areas abound especially in cross-border transactions or conversion to / from bitcoin or ethereum coins to participate in some of these ICOs. If the tokens are not backed by assets, the risk levels are higher: the "feel good" factor will not compensate for the risk of devaluation (or outright collapse) of the token value which can be unilaterally set by the overseas small company. Even if the tokens are backed by assets, you are trusting the company to marshal the cash flows from the assets to you. SEC and other regulators are taking a closer look at unregistered security sales.

Despite these challenges, the sheer movement and mobilization of peer to peer funds means that this approach needs to be carefully watched; and more positive non-bubble examples of success needs to happen to build market confidence. Regulatory intervention is likely to happen in many jurisdictions to protect the general public.

A number of examples of blockchain in Energy are emerging. Exciting times ahead indeed, but proceed with extreme caution! It is interesting that larger and branded players are exhibiting natural caution to the blockchain trend. Also the recent sale of a public yieldco to Capital dynamics (a private player) means that large private institutional finance is open to large, well vetted deals at low transaction costs and pricing. This is likely to be a bigger story in the channelization of large scale finance to renewable energy projects. Until there are robust self-regulation and risk management mechanisms in blockchain based finance, this will continue to be a highly visible, but small part of the real finance ecosystem.

Twitter: @shivkuma_k

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