U.S. state and federal lawmakers, as well as federal regulators, are increasingly focusing on the role of blockchain and distributed ledger technology (“DLT”) in the ongoing effort to combat climate change and facilitate the transition from carbon-based fossil fuels.
Here are six key developments and players to keep an eye on, covering two broad categories:
- Carbon emissions initiatives related to data mining operations (points 1, 2 and aspects of points 3 and 4); and
- Efforts to improve the integrity and transparency of energy markets and related digital assets (paragraphs 5, 6 and aspects of paragraphs 3 and 4)
On June 3, 2022, the New York legislature passed a bill that temporarily halted certain bitcoin and other cryptocurrency mining operations running on carbon-based power sources. The bill sets a two-year moratorium where the state will not issue new permits or approve renewals of existing permits for electrical production facilities that (a) use a carbon-based fuel and (b) wholly or partially supply, “behind-the-meter” electrical energy consumed by cryptocurrency mining operations that use “proof-of-work” (“PoW”) methods to validate blockchain transactions.1 If the bill is signed into law by Governor Hochul, New York will be the first state in the country to ban new crypto-mining infrastructure, potentially encouraging other states to follow its lead and drive a growing share of mining networks to more crypto-friendly states like Texas. Critics have warned that such bans not only harm the intended targets and their workers, but may also discourage renewable energy-based mining due to concerns about “regulatory creep”.
At the federal level, new legislation was proposed on June 7, 2022 by U.S. Senators Lummis and Gillibrand, who wanted to take a more industry-friendly approach to cryptocurrency mining. The new legislation, called the law on responsible financial innovation, aims to “create a complete set of rules for digital assets”. The legislation places no restrictions on mining; rather, it requires the Federal Energy Regulatory Commission, in consultation with the Commodity Futures Trading Commission (“CFTC”), to analyze various issues related to the impact of mining and staking cryptocurrencies on energy markets and the environment and submit an annual report to select congressional committees. Issues to be analyzed in the report include: (a) energy consumption for mining and staking of digital asset transactions and the effect on energy prices and base load levels, (b) use of renewable energy sources in connection with mining and staking; and (c) a process for regulated entities to make publicly available information on energy consumption.
3. In the meantime, the Biden administration is beginning to create its own guidelines for reducing the footprint of PoW-based cryptocurrencies. On March 9, 2022, President Biden signed an executive order urging various executive departments and agencies to work together to investigate a range of DLT issues and setting time frames for these agencies to report their findings and policy recommendations. In particular, the order instructs the White House Office of Science and Technology Policy, in consultation with, among others, the Minister of Finance and the Minister of Energy, to investigate and report on “the links between [DLT] and energy transitions “and” the potential of these technologies to prevent or promote efforts to tackle climate change, “including the impact of cryptocurrency consensus mechanisms on energy use, potential mitigation measures and alternative consensus mechanisms. The order also instructs the Financial Stability Oversight Council (” FSOC “) to report on the risk to financial stability and regulatory gaps posed by digital assets and recommendations to address such risks.The report will build on the FSOC’s previous recommendations for addressing climate-related financial risks, issued in October 2021 in response to a previous order.
With its seat in the FSOC, the CFTC is expected to play a leading role in responding to these initiatives. In March 2021, CFTC Chairman Rostin Behnam established a climate risk unit in the agency whose task is to address the climate implications of digital assets, in addition to its broader focus on the role of derivatives in the pricing and addressing of climate risk. Chairman Behnam has at times sounded a skeptical tone regarding the role of digital assets in environmental sustainability, referring to a “clear dislocation” between the energy consumption needed for mining and the financial result from digital assets. He has emphasized the need for transparency in digital asset markets, and proposes certain energy-related disclosures in connection with digital asset purchases as a mechanism to drive the industry to proof-of-stake models. While the CFTC’s jurisdiction over the underlying “spot” (or “cash”) markets is limited to exercising its anti-fraud and anti-manipulation authority, Chairman Benham has cited “several unique elements” in the digital asset cash markets (such as a number of retail investors such as is engaged in speculation, custody and cyber security issues) that sets it apart from other cash markets and suggests that “it would benefit greatly from CFTC monitoring.” He also called on Congress to expand the CFTC’s power over cryptocurrency markets, noting that the agency’s focus on market integrity through oversight of exchanges, clearing houses and data warehouses makes it “well placed to play an increasingly central role” in monitoring such markets.
On 2 June 2022, the CFTC issued a Request for Information (“RFI”) to seek public comment on climate-related financial risk in both derivatives markets and underlying commodity markets, with a view to informing the Agency’s “next step” in promoting innovation, ensuring financial integrity and avoid systemic risk.2 Among other topics, RFI asks to comment on the role of digital assets and DLT, including whether digital asset markets create climate-related financial risk, as well as any risk-reducing benefits that these technologies can offer. RFI also affects the voluntary carbon market (“VCM”),3Ask for comments on aspects of these markets that are subject to fraud or manipulation or deserve increased CFTC supervision and any steps the CFTC should take to improve integrity and promote transparency and liquidity in these markets, including the prospect of a VCM Participant Registration Framework. Although the RFI was approved by all five commissioners, one, Summer Mersinger, expressed concern that some of the issues (including those related to DLT and VCM) extend beyond the scope of the CFTC’s jurisdiction over underlying cash markets, and warned in a simultaneous statement that “RFI reflects either an unintentional ‘assignment creep’ at best, or a power grab to extend the CFTC’s authority at worst”.
6. On the same day that RFI was issued, the CFTC Advisory Committee on Energy and Environmental Markets (“EEMAC”) held a public meeting to discuss issues related to VCM, including the market structure for carbon compensation trading, product standardization efforts and the proper role of the CFTC in these markets. Market participants mentioned a number of difficulties in scaling up these markets, including the need for data collection and transparency to ensure the quality and integrity of credits, the issue of “double counting” and concerns about market fragmentation. Several participants asked the CFTC to help resolve a “confusion crisis” by establishing an overall framework based on standardized pricing and a common set of attributes. In his remarks, Chairman Behnam noted an opportunity to build on experience from cryptocurrency markets, where the CFTC has played a significant role in bringing cases despite its limited jurisdiction in the underlying crypto markets. Work is underway in the private sector to use DLT and smart contracts to address some of the issues highlighted above, including improving the transparency and traceability of carbon credits through public and unchanging data disclosure on the blockchain and facilitating efficient transfers and repairing market fragmentation by: “tokenize” carbon credits and then “retire” the credits in the registry to prevent double spending.4 It remains to be seen whether the CFTC will utilize DLT or smart contracts to formulate its regulatory response to the concerns identified at the meeting.
Footnotes
1 Bitcoin and Ethereum, the two largest cryptocurrencies by market value, are currently dependent on a “proof-of-work” model, in which miners compete to solve complex mathematical problems to verify transactions, which require plenty of energy to achieve the necessary computing power. Etherum is in the process of moving to a more efficient “proof-of-stake” authentication method, which will eliminate competition and limit its environmental impact. Other technologies, such as side chains and so-called Layer 2 solutions, have been developed to help reduce energy consumption.
2 comments to RFI must be sent August 8, 2022 or before.
3 VCM has recently been examined as a result of its rapid growth, with VCM trades peaking at $ 1 billion for the first time in 2021 and expected to reach $ 50 billion by 2030. Chairman Behnam has stressed that voluntary carbon credits are commodities and that CFTCs primary role is to identify and address fraud or manipulation in the underlying VCM. When key exchanges launch futures and other derivatives based on carbon offset, the CFTC will examine whether there is a proper correlation between these derivatives markets and the underlying VCM cash markets.
4 For example, KlimaDAO, a Regenerative Finance (ReFi) project, uses certain decentralized financial technologies to allow high-integrity carbon credits issued through the Verra and Gold Standard registers to bridge the blockchain. Toucan Bridge created by Toucan Protocol allows carbon credits to be linked to the blockchain, with users receiving project-specific TCO2 tokens that can then be transferred. Regen Network, another ReFi project, is building a chain registry using a proof-of-stake protocol for verifying carbon claims.
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