Introduction/What is The Merge
Whether one is deeply entrenched in the blockchain/cryptocurrency industry or merely an avid consumer of financial and technological news, the past few weeks would likely have seen one come across mention of ‘The Merge’. This impending upgrade to Ethereum, arguably the most important layer-1 blockchain1Layer-1 blockchains are main underlying networks within their ecosystems. Technically speaking, a layer-1 protocol processes and finalises transactions on its own chains, and generally has its own native token used to pay transaction fees. See: https://academy.binance.com/en/articles/what-is-layer-1-in-blockchain today, has been widely reported, albeit less well-understood. This paper aims to expound upon the key features of the Merge, debunk myths surrounding it, as well as offer some insight on the consequent economic and regulatory implications. Furthermore, this paper hopes to provide its readers with an informed perspective on the significance of the Merge within the broader vision for Ethereum.
What is The Merge?
The Merge refers to Ethereum switching to a more energy-efficient data and transaction verification system by merging with the Beacon Chain – a Proof-of-Stake (PoS) blockchain2https://ethereum.org/en/upgrades/merge/.
Since its inception in July 2015, the Ethereum blockchain used by the public has operated with a Proof-of-Work (PoW) consensus algorithm, which relies on operators (‘miners’) competing to solve mathematically complex problems to secure the network in exchange for crypto rewards3https://www.investopedia.com/terms/p/proof-work.asp. Specifically, for Ethereum, miners who successfully create a block receive two ethers (ETH), while those creating an ommer/uncle block4Uncle blocks are valid blocks created by a miner effectively concurrently as, but nonetheless after, a block was successfully added, and typically occur due to network latency. receive ETH 1.755https://ethereum.org/en/developers/docs/consensus-mechanisms/pow/.
Despite its merits as a tried and tested algorithm which kept Bitcoin and Ethereum secured and decentralized for many years, PoW poses problems in terms of scalability and sustainability. E.g., for the month of July 2021, amid 2021’s cryptocurrency rally, Ethereum was responsible for 55.01 TWh of energy consumption – 0.24% of the world’s energy consumption share, comparable to Switzerland’s figure of 56.35 TWh6https://reader.elsevier.com/reader/sd/pii/S2352864822001390?token=4EFF45FA37F34D6D2A903DB9F38092631476C29DC15273FDD0DB7EC32330E3479EE4604656968DB0370F1CA35B57B8C0&originRegion=eu-west-1&originCreation=20220908033436.
The Beacon Chain is a PoS blockchain whereby consensus is reached through operators (‘validators’) offering crypto assets as collateral for a chance to be selected to verify a block of data7https://www.investopedia.com/terms/p/proof-stake-pos.asp. Unlike PoW’s competition-based mechanism, PoS’s selection mechanism is largely random, thus reducing the energy consumption verification on the blockchain incurs.
Launched on December 1st, 2020, Beacon Chain has since operated as a separate blockchain to the main Ethereum blockchain (Mainnet), which allowed for extensive debugging and testing leading up to its incorporation into Mainnet. As the Merge does not involve Mainnet being replaced, and as Mainnet’s entire history will be preserved8https://ethereum.org/en/upgrades/merge/, (i.e., ETH balances, etc.), the transition should appear seamless to the average retail user.
Strictly speaking, the Merge is a two-step process, comprising of a network upgrade9The Bellatrix upgrade is a hard fork, a protocol upgrade requiring all network participants to upgrade their system, resulting in a new blockchain that is not backwards compatible. for the Beacon Chain triggered once a prespecified number of transactions has occurred (‘epoch height’10In the context of blockchains, an epoch is a unit of time, though specific definitions vary across blockchains. For Ethereum, it is the time taken to process 30,000 blocks. https://www.cnbctv18.com/cryptocurrency/crypto-blockchain- epochs-and-why-we-need-them-explained-14671951.htm), and a transition from PoW to PoS, triggered by a Terminal Total Difficulty11https://ethereum.org/en/glossary/ – when the cumulative metric for the difficulty in verifying a new block through PoW calculations hits a threshold. The first step – dubbed Bellatrix – was activated at epoch 144896 on the Beacon Chain on September 6th 2022 and is now live12https://cryptoslate.com/bellatrix-upgrade-goes-live-before-the-ethereum-merge/, while the transition from PoW to PoS – aka Paris – is expected to occur on September 15th 202213https://twitter.com/VitalikButerin/status/1566993505326710785?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1566993505326710785%7Ctwgr%5E773f51b9907528668c054015dc27dc2ee6cafdc5%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fcryptoslate.com%2Fbellatrix-upgrade-goes-live-before-the-ethereum-merge%2F.
Diagram 1 – The two-step process culminating in switch to PoS Ethereum
Source: The Ethereum Foundation Blog, https://blog.ethereum.org/2022/08/24/mainnet-merge-announcement
As well as allowing Ethereum to operate on PoS, Beacon Chain will lay the foundation for future scaling solutions on the blockchain. However, it is important to note that the Merge is only the prerequisite to, and not the realization of such solutions.
What the Merge is not: Debunking prevalent myths surrounding the Merge
The Merge will not reduce gas fees – Despite widespread reports14https://cointelegraph.com/explained/will-the-ethereum-20-update-reduce-high-gas-fees through the second quarter of 2022 speculating that Ethereum’s upgrade would result in lower gas/transaction fees, as the Merge is simply a switch in the consensus mechanism, it will not in itself, significantly affect the determinants of network capacity or throughput, and thus will not result in lower gas fees15https://ethereum.org/en/upgrades/merge/.
Transactions will not be noticeably faster – As noted by the Ethereum Foundation, under two definitions of transaction ‘speed’, the Merge would result in minor improvements. With respect to the time needed for a block of data to be published, the Beacon Chain facilitates the creation of a block every 12 seconds, roughly 10.8% faster than the ~13.3 seconds target under PoW. In terms of transaction finality, PoS achieves a clear finality for a set of data through validators’ votes in a manner not supported by PoW16Under PoW, blocks could always be reversed, though it becomes exponentially more difficult (i.e., expensive) with every passing block mined on top of that, but never quite reaches zero. For PoS, once a transaction has been finalized, undoing it is only possible through obtaining and burning over one-third of the total staked ETH.. Neither of these two changes would likely result in a discernible improvement in perceived transaction speed for the average user.
Staking annual percentage rate (APR17Annual percentage rate is the annual rate charged/paid for borrowing/lending capital. It is distinct from annual percentage yield (APY) in that the latter takes into account the effect of compounding over a year. E.g., a 1% monthly interest has an APR of 12% (0.01*12 = 0.12) , but an APY of 12.68% ((1.01^12) – 1 = 0.1268). See: https://www.investopedia.com/personal-finance/apr-apy-bank-hopes-cant-tell-difference/) will increase markedly – The reallocation of transaction fees to validators instead of miners will increase the APR in the staking pools for Ethereum. The amount of fees a validator receives is proportional to the network activity. As of September 2nd 2022, the Ethereum Foundation estimates that APR for staking will increase to ~ 7% post Merge, which is 69.9% higher than the staking pool annualized reward rate (ARR) of 4.12% and 51.5% higher than the 4.62% validator reward as of 8th September 202218https://www.stakingrewards.com/earn/ethereum-2-0/.
Diagram 2 – Debunking common myths surrounding The Merge
Source: The Ethereum Foundation, https://ethereum.org/en/upgrades/merge/
Overview – The Merge within the larger Ethereum roadmap
It can be seen then, that while the Merge will mark a fundamental shift for Ethereum, it would not in itself, resolve all the major issues hindering widespread adoption of the blockchain. Diagram 3 below highlights these issues – scalability, security and sustainability – where the Ethereum Foundation had broken down planned improvements into three major steps, with the Merge being the second step before sharding is introduced in 2023-2419https://ethereum.org/en/upgrades/. It is through the introduction of sharding that the team aims to expand Ethereum’s data storage capacity and increase its throughput, resulting in reduced network fees20https://ethereum.org/en/upgrades/.
Diagram 3 – The Merge is the second of three stages towards sharding-enabled scalability
Source: The Ethereum Foundation, https://ethereum.org/en/upgrades/
Speaking at the annual Ethereum Community Conference (EtCC) on July 21st 2022, Ethereum cofounder Vitalik Buterin identified the Merge as but one of five major development objectives for Ethereum – The Merge, The Surge, The Verge, The Purge, and The Splurge21https://www.coindesk.com/tech/2022/08/01/ethereum-after-the-merge-what-comes-next/. The Surge refers to the introduction of scaling solutions (e.g., sharding and rollups, to be discussed later), while the Verge further addresses the issue of scalability while ensuring security in maintained, through exploring an alternative data encryption solution. Finally, the Purge refers to the removal of excess data to streamline the network, while the Splurge would see additional improvements to the network. Diagram 4 illustrates this roadmap.
Buterin stated that upon completion of this roadmap, Ethereum would be able to process 100,000 transactions/second (TPS)22https://www.coindesk.com/markets/2022/07/21/vitalik-buterin-discusses-ethereums-upcoming-merge-and-surge-at-ethcc-in-paris/ – an astronomical leap from present, where over the month leading up to 9th September 2022, Ethereum achieved an average rate of 19.80 TPS23https://ethtps.info Note that this figure includes blocks processed by on-chain scaling solutions such as optimistic rollups, but not off-chain solutions such as zero-knowledge (ZK) rollups.. This marked improvement in transaction speed is neither an imminent nor a forgone conclusion however, as Buterin himself estimated that following the Merge, only 55% of the roadmap would have been completed24https://www.coindesk.com/markets/2022/07/21/vitalik-buterin-discusses-ethereums-upcoming-merge-and-surge-at-ethcc-.
On the other hand, as Buterin pointed out via a Twitter exchange regarding Ethereum’s roadmap, the five developmental goals are not stages to be completed sequentially, but rather, somewhat modular improvements occurring in parallel25https://twitter.com/VitalikButerin/status/1551603545752870912. This suggests that a delay in planned upgrade would not necessarily preclude Ethereum benefitting from progress in other areas of developments.
Diagram 4 – The five developmental facets of Ethereum
Source: CoinDesk and Miles Deutscher, https://www.coindesk.com/tech/2022/08/01/ethereum-after-the-merge- what-comes-next/
Important implications from the Merge:
Tokenomics
The distribution of ETH supply will change following the Merge. As can be seen from Table 1 below, using the Ethereum Foundation’s estimates’26https://ethereum.org/en/upgrades/merge/issuance/ of 2.08 ETH execution/layer-1 issuance reward per block generation event (2 ETH for canonical blocks included in Mainnet and 0.8 for ommer blocks27An ommer block (uncle block before EF opted for a gender-neutral name) is the leftover block when two blocks are created and submitted to the ledger at the same time, where one only (canonical block) is added to Mainnet. On Ethereum, ommer block rewards incentivize decentralization and boost security. Source: https://www.investopedia.com/terms/u/uncle- block-cryptocurrency.asp) and a block time of 13.3 seconds, annual layer-1 issuance – the ETH issued to miners under the PoW system – would be 4,931,946 ETH.
For pre-merge consensus/layer-2 issuance, the Ethereum Foundation assumes 13,000,000 ETH are staked (10.90% of total supply at the end of 2Q2022) with 4.5% annual staking rewards rate, equivalent to 585,000 ETH/year or 1,603 ETH/day issued to stakers under PoS. This results in a total pre-merge issuance of 5,516,946 ETH/year or 4.62% of total ETH supply as of 2Q2228The specific issuance figures are slightly different from those on the Ethereum Foundation’s site due to the more specific computations detailed here, as opposed to the approximation employed by the Foundation to facilitate understanding. The resultant 4.62% inflation rate here is the same as the figure from the Ethereum Foundation. Source: https://ethereum.org/en/upgrades/merge/issuance/. Pre-merge, 89.4% and 10.6% of ETH issuance accrue to miners and stakers, respectively.
Post-merge, issuance on the execution layer will be zero, as PoW ceases operation on Mainnet, while issuance from PoS will continue as before29https://ethereum.org/en/upgrades/merge/issuance/. Thus, total annual issuance of ETH will fall markedly to 585,000 or 0.49% of total ETH supply, representing an 89.4% drop in issuance.
Supply of ETH is of course, governed by not only the issuance of new ETH, but also by the burning of pre-existing ETH. Fee burning for Ethereum went live with the August 2021 London upgrade30https://ethereum.org/en/history/#london, and will continue post-merge. As the Ethereum Foundation noted, assuming an average gas price of at least 16 gwei, 1,600 ETH or more would be burned every day, which would bring net ETH inflation to zero post-merge31https://ethereum.org/en/upgrades/merge/issuance/. Increased activity on Ethereum would increase the burn rate, and it is straightforward to demonstrate that under plausible circumstances Ethereum would become deflationary (i.e., annual net issuance is negative).
Preserving the remainder of parameters used by The Ethereum Foundation and setting average gas price to 105.2 gwei – the average value through 202132Computed with data from https://etherscan.io/chart/gasprice – produce burn rates of 10,500 ETH/day or 3,832,500 ETH/year. This results in a net change in ETH supply of -3,247,500 or a -2.72%/year. It could be argued however, that for Ethereum to become as congested as implied by this higher gas estimate, there would likely be increased activity taking place on the blockchain across the board, including increased staking, which would in turn, affect issuance. More generally, to gauge the likely trajectory of ETH supply, it must be noted that staking rewards are likely to increase following the Shanghai upgrade, as stakers would then be able to withdraw their stakes and would likely need to be incentivized via a higher annualized rewards rate (ARR) to continue staking. It was reported in March 2022 that notable market players anticipated that post-merge staking rewards could be as high as 10-15%33https://www.coindesk.com/markets/2022/03/21/traders-bet-on-ether-staking-after-eth-20-upgrade/. At the time, Blockchain analytics firm IntoTheBlock estimated the range to be 7-12%, though in April 2022 the firm adjusted the figure down to 6-8% due to decreased network activity34https://cryptoslate.com/ethereum-post-merge-staking-rewards-will-likely-be-lower-than-anticipated/.
Column three of Table 1 covers the stylized scenario where PoS has an ARR of 12.5%, with 25% of total ETH supply being staked. To determine the staking ratio, this study examined the staking ratios of all 25 major protocols with ARRs presently within the 10-15% range and chose Zilliqa as the protocol/token combination occupying a product space closest to Ethereum – both blockchains aim to build an ecosystem of financial services and NFT decentralized apps (dApps) where the native token is used to pay for gas35https://www.zilliqa.com/what-is-zil. Ethereum’s richer ecosystem – and wider set of utilities for ETH vs. ZIL – suggest for a given ARR, a lower percentage of ETH would be staked. Thus, from the 32.77% staking ratio for Zilliqa, which offered a 12.12% ARR as of 10th September 202236https://www.stakingrewards.com/cryptoassets/?page=4&sort=tableReward_DESC, the stylized example assumes an ETH staking ratio of 25%. Under this scenario, net change in ETH would be -0.09%/year. It can be seen then, that ETH remains deflationary under the assumption of markedly increased ARR and staking activity37Note that as the amount of ETH staked increases, all else being equal, ARR falls. Given parameters (e.g., average gas price of 74 gwei) as of 11th September 2022, increasing staked amount to ETH30mn reduces ARR to 3.04%. The assumption is being made then, that network activity in the stylized scenario is high enough to support both a higher ARR and a higher staking ratio. The higher average gas price used in the computation is consistent with this, and if anything, represents an underestimate, where higher average gas would result in ETH being even more deflationary. Source: https://ultrasound.money.
Table 1: Updating key tokeneconomics estimates
Source:
Burn rate; Staking rewards; Ultra Sound Money: https://ultrasound.money
Computation methodology; The Ethereum Foundation: https://ethereum.org/en/upgrades/merge/issuance/
Gas price; Etherscan: https://etherscan.io/chart/gasprice
Mining rewards; BitInfoCharts: https://bitinfocharts.com/ethereum/
Staking ratios for projects with 10-15% ARR staking rewards; Staking Rewards: https://www.stakingrewards.com/cryptoassets/?page=4&sort=tableReward_DESC
What does a deflationary ETH entail? Here the paper must caution the reader against simply embracing the oft invoked notion that a deflationary token will appreciate in price. The market price of any token is determined by the interaction of its demand and supply. To the extent that demand for ETH increases or is largely unchanged following the Merge – which could stem from increased optimism from investors, greater adoption of Ethereum amongst environmentally conscious institutions, etc. – conventional economics wisdom dictates that its price would increase. Microeconomic theory also provides some insight on the likely magnitude of such an increase. As Diagram 6 illustrates38Example is proprietary, but demand and supply curves derivations taken from: https://ocw.mit.edu/courses/14-01sc- principles-of-microeconomics-fall-2011/resources/mit14_01scf11_graph03/ and http://dl.rasabourse.com/MIT.Mircroeconomics.Jeffrey%20M.%20Perloff%20- %20Microeconomics%20(2014,%20Pearson).pdf, the lower the price elasticity of quantity demanded for a product is (i.e., the steeper its demand curve), the stronger the price response to a shift in its supply curve (AC > AB). Consequently, the more Ethereum immerses itself into the real economy and the more indispensable its dApps and underlying technology become, the greater one can expect the long-term positive price impact from the Merge to be.
Diagram 6 – Inelastic price elasticity of demand entails a larger price response from supply shift
Source: MIT OpenCourseWare, https://ocw.mit.edu/courses/14-01sc-principles-of-microeconomics-fall-2011/resources/mit14_01scf11_graph03/; Perloff, J. M. (2015), http://dl.rasabourse.com/MIT.Mircroeconomics.Jeffrey%20M.%20Perloff%20-%20Microeconomics%20(2014,%20Pearson).pdf
Effect on Ethereum’s energy consumption pre/post Merge:
A widely heralded benefit of the transition to PoS is reduced energy consumption, with the Ethereum Foundation itself and various publications citing a reduction of ~ 99.95%39https://ethereum.org/en/energy-consumption/; https://www.binance.com/en/news/top/7197619. However, this figure was derived from base parameters as of May 2021, many of which are now grossly outdated. Specifically, the calculations on the Ethereum Foundation Blog cited 140,592 validator nodes with 16,405 unique addresses on the Ethereum network, of which the author presumed 52,695 validators were operated by exchanges and staking services40https://blog.ethereum.org/2021/05/18/country-power-no-more.
As of 11th September 2022, there were 426,201 validators on Ethereum’s Beacon Chain, with 80,145 unique addresses41Figures from Dune Analytics, sourced September 11th, 2022, 9 AM EDT. Source: https://dune.com/hildobby/ETH2-Deposits. Subtracting the approximate sum of validating nodes attributable to exchanges and staking services (316,27042Figure summed from validators under the top 25 depositors by market share, which goes from staking service Lido (30.34%) TO NEUKIND.COM (<0.01%), excluding Vitalik Buterin’s validators (0.05%), whose staking is categorized as an individual’s staking effort, albeit one on an exceptionally large scale.) yields 109,931 independent validators. Utilizing the estimates referenced by the Ethereum Foundation Blog for energy consumption per centrally operated and independent nodes, of 100W/5.5 validators (18.18W/node) and 100W/5.4 validators (18.52W/node) respectively, the total PoS energy consumption is estimated to be 7.79MW. This computation is shown in Table 2 below, where Bitazza Research’s computations yield an estimate ~200% higher than the original 2.62MW figure43The Ethereum Foundation Blog figure was 2.62MW, while replicating the computation here yields 2.59MW, with the discrepancy being due to rounding error..
Table 2: Updating key sustainability estimates
Source:
Estimates of power consumption for private and commercial PoS validator nodes; The Ethereum Foundation Blog: https://blog.ethereum.org/2021/05/18/country-power-no-more
Number of validators, unique addresses on the Beacon Chain; Dune Analytics: https://dune.com/hildobby/ETH2-Deposits
Table 3: Energy reduction estimates with bottom-up PoW baseline
Source:
Bottom-up PoW Ethereum electricity consumption/CO2 emissions estimates; Kyle McDonald: https://kylemcdonald.github.io/ethereum-emissions/
Top-down PoW Ethereum consumption/emissions estimates; Digiconomist: https://digiconomist.net/ethereum- energy-consumption
How much energy saving does the figure above entail? For that, one needs an estimate of the pre-merge energy consumption of Ethereum. To reach an estimate of a 99.95% reduction in energy consumption44https://blog.ethereum.org/2021/05/18/country-power-no-more, the Ethereum Foundation Blog employed the widely cited Digiconomist Ethereum energy consumption figure, which as of May 2021 was 44.49 TWh/year or roughly 5.08GW/hour45https://blog.ethereum.org/2021/05/18/country-power-no-more. Utilizing the analogous figure for September 11th, 2022, of 83.16TWh/year46https://digiconomist.net/ethereum-energy-consumption and Bitazza Research’s estimate of 7.79MW/hour energy cost of running PoS Ethereum, yields an energy reduction of 99.92%, only marginally lower than the widely cited 99.95% figure.
However, there have been some, in this author’s opinion, well-considered criticisms of Digiconomist’s estimates. In reaching his estimates, economist Alex De Vries adopts a top-down approach that infers the energy expense and therefore consumption miners would be willing to incur given the prevailing price of Ethereum47https://digiconomist.net/ethereum-energy-consumption. While intuitively appealing for the economic symmetry it affords, such as approach relies on arbitrary approximations (e.g., for Bitcoin, 60% of revenue goes to electricity costs48https://www.coincenter.org/estimating-bitcoin-electricity-use-a-beginners-guide/) and even more problematically, would overestimate the amount of energy consumption during periods of rapidly rising electricity prices49This is because to estimate energy consumption the estimated total cost of electricity is divided by the average price of electricity during the time, which would be skewed by very recent outliers.. Opting instead for Ethereum’s energy consumption estimated via a bottom-up approach, which stood at 22.6 TWh/year as of September 11th, 202150https://kylemcdonald.github.io/ethereum-emissions/, the reduction in energy consumption associated with the switch to PoS would be 99.70%.
On one hand, there appears to be little meaningful difference between the pre-existing estimate and this paper’s updated ones. However, the large scale involved means even minute differences entail considerably more/less energy savings. For example, the 5.20MW discrepancy between the May 2021 estimate and this paper’s more recent estimate would be enough to power 5.82 US households for a month (at 893 kWh/month)51https://www.eia.gov/tools/faqs/faq.php?id=97&t=3, implying that the switch to PoS alone would power an additional 4,192 households every month. Moreover, the discrepancy highlights that in the fast-moving world of blockchains and cryptocurrencies, utilizing the most timely data available is of paramount importance.
Implications of reduced energy consumption
Increased political and corporate goodwill
Markedly reduced energy consumption means that the Ethereum ecosystem stands to benefit indirectly from mollifying increasingly climate conscious regulators. On September 8th, 2022, the White House Office of Science and Technology Policy published a report imploring the government to mitigate pollution stemming from crypto production52https://www.bloomberg.com/news/articles/2022-09-08/crypto-mining-threatens-us-climate-efforts-white-house-warns. The report called upon the federal government to develop a richer database of power consumption and work with states to set standards. Ethereum’s transition to PoS ahead of such regulations should allow the blockchain and the ETH token, as well as operators of Ethereum-based protocols to escape the most stringent regulatory censure. Ethereum will also likely benefit from increased political goodwill – or lessened political animosity– in other major jurisdictions across the world. For example, in Europe the fact that by some measures PoW Ethereum is consuming as much electricity as Finland53https://digiconomist.net/ethereum-energy-consumption/ would have put the blockchain firmly in the crosshairs of regulators at a time where the European Central Bank (ECB) is working to harmonize licensing requirements54https://cointelegraph.com/news/european-central-bank-addresses-guidance-on-licensing-of-digital-assets and the citizens of Europe are suffering from a prolonged energy crisis55https://www.economist.com/leaders/2022/09/08/how-to-deal-with-europes-energy-crisis.
Improved environmental credentials could also benefit the Ethereum ecosystem directly, as companies seeking to improve their own standings look to incorporate the underlying technology into their business models. In this regard, the payments industry represents a low-hanging fruit. In August 2022, Visa launched Visa Eco Benefits in the Asia Pacific, a suite of sustainability solutions to aid cardholders’ understanding of the environmental impact of their transactions56https://visaapnews.asia/post/691525382282805248/visa-launching-eco-friendly-payment-solutions-in. Cardholders can compute the carbon footprint of their Visa transactions and access carbon offsetting solutions. Motivating the launch is increased environmental awareness on behalf of the consumer. For instance, a 2022 Visa/YouGov survey found 66% of Asia Pacific consumers expect their banks to offer eco-friendly payment solutions57https://visaapnews.asia/post/691525382282805248/visa-launching-eco-friendly-payment-solutions-in. Broadly incorporating PoS Ethereum into its network would enable Visa to both appeal to environmentally conscious consumers, and more readily achieve its pledge to reach net-zero emissions by 204058https://href.li/?https://usa.visa.com/about-visa/newsroom/press-releases.releaseId.17851.html.
Improved environmental credentials would also make Ethereum and protocols building atop it more appealing, all else being equal, to financial institutions seeking to reduce their financed emissions. On March 4th, 2022, Deutsche Bank disclosed that the financed emissions from its global corporate industry loan book for 2021 stood at 30.8 million tonnes of CO2 equivalent per year (MtCO2e/y)59https://www.db.com/news/detail/20220304-deutsche-bank-provides-disclosure-on-financed-co2-emissions-and-updates-, with oil & gas and utilities accounting for 32% and 25% respectively. For comparison, PoS Ethereum would, using the 7.79MW figure derived, roughly equate to 29,506 (tCO2e/y)60Computed using the eGRID US national annual average CO2 output rate from the US Environmental Protection Agency (EPA). Source: https://www.epa.gov/energy/greenhouse-gas-equivalencies-calculator#results; https://www.epa.gov/energy/greenhouse-gases-equivalencies-calculator-calculations-and-references, or ~ (1*10^-7)%. This was followed by a Bloomberg report on March 14th 2022 that the ECB was pushing lenders to disclose financed emissions figures, with progress expected by 2023, indicating that climate risk would be reflected in future capital requirements61https://www.bloomberg.com/news/articles/2022-03-14/ecb-says-banks-still-need-to-make-progress-on-climate-disclosure#:~:text=The%20European%20Central%20Bank%20is,on%20the%20emissions%20they%20finance. Faced with the prospects of increased capital requirements and higher funding costs, banks may find greater economic justification for partial diversification away from emissions-heavy projects offering relatively high return on risk-adjusted capital (RORAC) to those in the blockchain industry, which entail lower RORACs but also lower carbon footprints62Blockchain and cryptocurrency projects offer the possibility of outsized returns orders of magnitude larger than most oil & gas and utilities projects, but the relatively steady cash flow offered by the latter two industries and the high failure rate of the former suggest return on a risk-adjusted basis would still be lower for blockchain and cryptocurrency projects. Source: https://www.investopedia.com/terms/r/rorac.asp.
Carbon trading
Looking ahead, there also exist opportunities in the carbon market63See Appendix as its improved energy- efficiency means Ethereum could facilitate companies’ attempts to earn surplus carbon credits64See Appendix and monetize them.
At present, the scope for companies utilizing PoS Ethereum selling carbon credits through official/mandatory markets is limited, as the largest of these markets do not assign carbon credit to industries blockchain-centric companies would likely be categorized in. The EU Emissions Trading System (EU ETS), for example, covers only CO2 from the electricity and heat generation, energy-intensive manufacturing such as oil refineries and steel works, and commercial aviation, where participation for companies in these sectors is mandatory65https://ec.europa.eu/clima/eu-action/eu-emissions-trading-system-eu-ets_en. While China’s ETS – launched in July 202166https://chinadialogue.net/en/climate/the-first-year-of-chinas-national-carbon-market-reviewed/ and already the world’s largest67https://www.forbes.com/sites/energyinnovation/2022/04/18/chinas-emissions-trading-system-will-be-the-worlds-biggest-climate-policy-heres-what-comes-next/?sh=3b0ebc0f2d59 – is expected to soon incorporate six more industries in line with the government’s vision68https://www.forbes.com/sites/energyinnovation/2022/04/18/chinas-emissions-trading-system-will-be-the-worlds-biggest-climate-policy-heres-what-comes-next/?sh=3b0ebc0f2d59, inclusion of the blockchain industry is unlikely given the nationwide ban on cryptocurrencies69https://cointelegraph.com/news/chinese-mining-giant-canaan-doubles-profits-despite-the-blanket-crypto-ban.
Nonetheless, at least in the European Union, where many countries have legal crypto-centric industries, rising concerns over the underlying technology’s energy consumption may eventually result in a mandated carbon market for the financial and/or technology sectors. Moreover, there is also the fast-growing voluntary carbon market, with companies keen to bolster their corporate social responsibility (CSR) profiles driving growth in demand. McKinsey forecasts that annual global demand for voluntary carbon credits could reach 1.5 to 2.0 gigatons of carbon dioxide (GtCO2) by 2030, 15x its 2020 value70https://www.mckinsey.com/business-functions/sustainability/our-insights/a-blueprint-for-scaling-voluntary-carbon-markets-to-meet-the-climate-challenge. Attaining carbon credits for the voluntary market – verified emissions reductions (VERs) – requires compliance with generally less stringent conditions than for government-issued mandatory emissions reductions (MERs)71See Appendix. For example, Verra, the non-profit issuer of the most widely traded voluntary credit72https://verra.org/project/vcs-program/, those under the Verified Carbon Standard (VCS), accepts applicants across most industrial sectors, explicitly precluding only “projects that can reasonably be assumed to have generated GHG emissions for the purpose of their subsequent reduction”73https://verra.org/wp-content/uploads/2022/06/VCS-Standard_v4.3.pdf, as well as much of the electricity generating industry74https://verra.org/wp-content/uploads/2022/06/VCS-Standard_v4.3.pdf. As of 12th September 2022, tech-based offset credits traded at $2.1375https://carboncredits.com/carbon-prices-today/ Price on September 12th, 2022, 9:30 AM EDT., which implies a modest but not immaterial market value for the PoS-induced energy reduction of approximately 6.56MtCO2/year of $13.95mn76The pre-merge emissions figure is from https://kylemcdonald.github.io/ethereum-emissions/. While consistency would typically dictate the figure is derived via the same method as the post-merge estimate (the EPA calculator), the pre-merge figure’s much larger value means accurately computing the difference is more affected by ensuring as accurate an estimate for the pre-merge value as possible..
More generally, its status as a more environmentally friendly blockchain opens the door for Ethereum to participate in sustainability-oriented projects, of which there appears to be growing appetite. A noteworthy example is the World Bank’s recently launched initiative to buy and tokenize voluntary carbon credits to be marketed to institutional capital77https://www.reuters.com/business/environment/exclusive-world-banks-ifc-taps-blockchain-carbon-offsets-2022-08-17/. Reliance on PoW would have precluded Ethereum and projects built atop its infrastructure from being included in such projects. As it stands, Ethereum is well-positioned to partake in said initiative, as well as other projects across the blockchain-enabled Regenerative Finance (ReFi) space78See Appendix.
Diagram 7 – Benefits of PoS for Ethereum and its ecosystem
Source: Bitazza Research
Looking ahead: The Surge & The Verge
As mentioned earlier, the Merge is but one of five simultaneous developmental modules for Ethereum, and as the reader welcomes the Merge, it is worth noting a few points regarding the remaining plans for Ethereum.
Not all solutions are equal
The Surge involves increasing Ethereum’s scalability, through both on-chain and off-chain solutions79https://vitalik.ca/general/2021/04/07/sharding.html. On-chain solutions involve altering the infrastructure level of the main Ethereum blockchain (layer-1 Mainnet). Presently, sharding is the focus of this scaling effort80https://ethereum.org/en/developers/docs/scaling/, with the Merge leaving Mainnet better positioned for it. Off-chain solutions are implemented separately, or in some cases, atop of the layer-1 Mainnet. As such, they require no change or upgrade to Mainnet and could already be readily implemented even prior to the Merge. This allowed some proposed off-chain solutions to launch ahead of the Merge, optimistic rollups and zero-knowledge (ZK) rollups being two notable examples81https://ethereum.org/en/developers/docs/scaling/.
Rollups are data processing techniques which aim to reduce transaction costs by first processing them on a layer-2 chain and bundling (rolling up) the transactions in a single transaction to be recorded on the layer-1, splitting the cost of any one transaction across multiple users82https://www.coindesk.com/learn/what-are-rollups-zk-rollups-and-optimistic-rollups-explained/. As well as relying on the layer-1 consensus mechanism to ensure data validity – PoW and soon PoS for Ethereum – each type of rollups introduces additional safeguards.
Optimistic rollups presume all transactions within a rollup are valid and rely upon ex post fraud proofs to ensure validity in cases of disputes83https://www.coindesk.com/learn/what-are-rollups-zk-rollups-and-optimistic-rollups-explained/; https://ethereum.org/en/developers/docs/scaling/optimistic-rollups/. A drawback of this approach is that an individual wishing to withdraw her deposit must wait for the dispute period to elapse, which could be as long as two weeks84https://www.alchemy.com/overviews/optimistic-rollups. Withdrawing funds from optimistic rollup protocol Optimism takes seven days85https://help.optimism.io/hc/en-us/articles/4411908369563-Do-I-have-to-wait-7-days-to-get-my-funds-out-, for example. Such delays would be problematic for many business applications, especially within the realms of DeFi. ZK rollups on the other hand, rely on zero-knowledge proofs – complex mathematical algorithms which allow the validity of a transaction to be verified without revealing its inputs86Specifically, ZK-rollups employ SNARK (Succinct Non-Interactive Argument of Knowledge) protocols. E.g., it is non-interactive as provers and verifies do not need to exchange information beyond the initial proof submitted to verify a transaction’s correctness, whereas early zero-knowledge solutions required provers and verifies to exchange multiple messages for verification. Source: https://www.alchemy.com/overviews/snarks-vs-starks. In ZK rollups, such validity proofs are submitted with every batch on transaction data sent to Mainnet and verified on-chain, which means transactions are declared valid immediately and challenges/dispute periods are unnecessary87https://www.alchemy.com/overviews/optimistic-rollups.
It could be argued then, that ZK rollups are where proponents of off-chain scaling solutions should focus their optimism. With this in mind, it must also be noted that ZK-rollups are not without their issues, notably that their automatic submission of validity proofs for every batch of transactions entails relatively high on-chain verification costs and expensive specialized hardware to generate and verify proofs for every transaction block88https://www.alchemy.com/overviews/optimistic-rollups. That a scaling solution aimed at, amongst other things, reducing transaction costs on Ethereum could lead to higher costs in other ways is an irony which should not be lost on the reader.
Diagram 8 – Optimistic vs. zero-knowledge (ZK) rollups
Source: Alchemy, https://www.alchemy.com/overviews/optimistic-rollups
Not all the necessary solutions have been emphatically found
Sharding has been referred to by Buterin himself as “the future of Ethereum scalability”89https://vitalik.ca/general/2021/04/07/sharding.html, a key to achieving thousands of transactions/second on the blockchain. Essentially, sharding is a database management system in which a data is divided into smaller quantities of data and different nodes, to facilitate faster and less costly computation and/or processing90https://www.geeksforgeeks.org/what-is-sharding/. In the context of blockchains, random sampling sharding91The sharding utilized for Ethereum affords greater security from malicious actors, but the broad concept is the same, with random sampling being easier to understand. Source: https://vitalik.ca/general/2021/04/07/sharding.html would see a PoS chain randomly split up the work of verification amongst validators. For example, with 10,000 validators and 100 blocks to be verified, the first 100 validators in the shuffled list would be assigned to the first block (forming a ‘committee’), the second 100 to the second block, and so on92https://vitalik.ca/general/2021/04/07/sharding.html. Upon verifying a block of data, a validator sends out a signature attesting they did so, entailing that ultimately each validator is required to verify only one block and 10,000 signatures – considerably less work than verifying 100 entire blocks93https://vitalik.ca/general/2021/04/07/sharding.html. This process is illustrated in the diagram below.
Diagram 9 – Sharding through random sampling
Source: Vitalik Buterin, https://vitalik.ca/general/2021/04/07/sharding.html
As well as reducing the work required to process a given amount of data, thus increasing a blockchain’s throughput, the introduction of sharding also leaves a blockchain better placed to capitalize on improved computing power. E.g., if computing power/node doubles, each validator controlling a set number of nodes would be able to both process a block twice as large and verify twice as many signatures. In this instance, a PoS system could reduce staking requirements to double the number of validators and create twice as many committees of the same size as before. With 200 committees, 200 blocks could be verified simultaneously, with each block twice the size, resulting in a blockchain capacity 4x the original amount94https://vitalik.ca/general/2021/04/07/sharding.html. Extending this logic, the sharded chain’s computing capacity is generally given by O(C2), where C is the computational capacity of a single node95O(C) refers to order of complexity of C. It is often used to describe how the runtime of an algorithm changes as its data size changes. E.g., O(1) describes a constant runtime algorithm which is independent of the number of inputs. An algorithm summing up inputs for example, has order of complexity 1; irrespective of the number of terms to be summed the process takes one step. Source: https://www.happycoders.eu/algorithms/big-o-notation-time-complexity/; https://ocw.mit.edu/courses/6-0001-introduction-to-computer-science-and-programming-in-python-fall- 2016/resources/mit6_0001f16_lec10/.
Alas, sharding is not necessarily the panacea it first appears to be. To accurately determine the validity of blocks they did not verify themselves, validators need to be able to check that both computations involved were accurate and that the data used is available, without personally carrying out the computation or downloading the data (lest the efficiency gained is lost). As Buterin himself noted, while the former issue has readily available solutions (fraud proofs and ZK-SNARKs used in rollups), scalable verification of data availability poses greater challenge96https://vitalik.ca/general/2021/04/07/sharding.html. Here ZK proofs are not sufficient as they do not ensure that the data used for computation remains available97https://vitalik.ca/general/2021/04/07/sharding.html. Note that even if both computation and data are valid, unavailability of data prevents the construction of proofs that future blocks are valid and is thus problematic98https://github.com/ethereum/research/wiki/A-note-on-data-availability-and-erasure-coding. Fraud proofs on the other hand, suffer from the fisherman’s dilemma: it is not possible for anyone not trying to download the underlying data when a block was published to determine whether the data was available or not. If an individual suspects it is not, he could demand a fraud proof (acting as a fisherman), upon which the publisher could then publish the data, whether he intended to ensure the data’s continued availability or not99The inability to uniquely identify bad actors means actor-specific penalties cannot be employed, while setting net rewards for raising an alarm to be positive, negative or even zero, all suffer from issues of moral hazard. E.g., if net rewards are positive, fishermen would always have the economic incentive to raise false alarms..
Diagram 10 – The Fisherman’s Dilemma
For observers joining in at T3, it is impossible to distinguish between the scenario/states 1 and 2.
Source: Vitalik Buterin, https://github.com/ethereum/research/wiki/A-note-on-data-availability-and-erasure-coding
To elaborate, with optimistic rollups, fraud proofs are used to ensure computational validity where computations would be simultaneously submitted on-chain as a challenge is raised. Utilizing fraud proofs to ensure data availability for sharding cannot do this, as it is precisely because there is too much data to be readily published that sharding would be employed. While technological solutions have been proposed, notably data availability sampling100https://hackmd.io/@vbuterin/sharding_proposal#ELI5-data-availability-sampling, some have argued that the problem is fundamental to sharding and consequently unavoidable101https://vitalik.ca/general/2021/04/07/sharding.html. The key point for the reader here is that sharding poses problems that have yet to be fully resolved, whose resolutions would require novel solutions.
This theme is a recurring one along the Ethereum roadmap. The Verge, which seeks to upgrade the cryptographic system underpinning Ethereum by replacing the current system which utilizes Merkle trees102Specifically, Ethereum uses Merkle Patricia Trie/tree. Source: https://ethereum.org/en/developers/docs/data-structures- and-encoding/patricia-merkle-trie/ with one based on Verkle trees103https://twitter.com/milesdeutscher/status/1550315295402668032?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1550315295402668032%7Ctwgr%5E66b4427a5be6bbf8a4c7705211c97b90e43f2607%7Ctwcon%5Es1_&ref_url=https%3A%2F%2Fwww.coindesk.com%2Ftech%2F2022%2F08%2F01%2Fethereum-after-the-merge-what-comes-next%2F. A Merkle tree is a data structure which organizes data into nodes with traceability for each transaction within in the overall block (through assigning a code/hash to each transaction, thus linking transactions together via a tree-like structure104https://www.investopedia.com/terms/m/merkle-tree.asp). Verkle trees purport to improve upon Merkle trees by utilizing a new way to describe data (‘polynomial commitments’) to offer smaller proof-sizes. For example, a Verkle tree would require less than 150 bytes to produce a proof for a tree with a billion data points, vs. 1 kilobyte for a Merkle tree105https://cointelegraph.com/explained/merkle-trees-vs-verkle-trees-explained. However, whereas Merkle trees were developed in 1988 and have been utilized extensively in computer science since (e.g., the real-time collaborative editing software Apache Wave106https://github.com/artem0/merkle-tree), the concept of Verkle trees was only recently introduced in 2018107https://cointelegraph.com/explained/merkle-trees-vs-verkle-trees-explained by John Kuszmaul and his mentor crypto researcher Alin Tomescu as part of MIT’s PRIMES (Program for Research in Mathematics, Engineering and Science) for high school students108https://www.csail.mit.edu/news/student-project-mits-primes-high-school-program-helps-make-ethereum-more-efficient109https://math.mit.edu/research/highschool/primes/index.php and there appears to be little, if any, instances of their practical deployments. As such, it would be imprudently optimistic to presume that the Verge would be completed imminently or without complication.
Conclusion
The Merge brings with it improved energy-efficiency and reduced ETH issuance, likely enough to put supply for the native token on a deflationary path. The full effect of the Merge on ETH price however, will also depend upon how the transition affects demand for the token and the ecosystem it powers, as well as the relevant price elasticities of demand and supply. The improved environmental credentials for Ethereum on the other hand, should prove to be unambiguously positive for its growth, both through facilitating more conciliatory regulations and through incentivizing greater capital inflows from traditional financial institutions.
Considerable enthusiasm for the Merge would therefore appear warranted. However, it is better viewed as a Cambrian shift towards greater adoption and scalability rather than a milestone along a straightforward path with a paradigm blockchain solution as a foregone conclusion. In particular, the reader wishing to deeply understand the remaining progress required should closely follow developments pertaining to the economics of ZK smart contracts and rollups, the robustness of data availability sampling methods, and the practical implementation of Verkle trees.
Appendix
Carbon credits, also known as carbon offsets, are permits allowing owners to emit a specific quantity of CO2 and/or other greenhouse gases. One credit permits the emission of one tonne of greenhouse gas110https://www.investopedia.com/terms/c/carbon_credit.asp. A carbon credit may be classified as certified emissions reductions (CERs), issued by the government for mandatory markets, or verified emission reductions (VERs), used in voluntary markets111https://climatetrade.com/voluntary-market-and-mandatory-carbon-credit-market/#:~:text=Basically%2C%20the%20main%20difference%20is,voluntarily%20offset%20their%20carbon%20footprint.
Carbon markets are markets which enable the buying and selling of carbon credits – permits allowing an entity to emit a certain amount of CO2 and/or other greenhouse gases112https://www.investopedia.com/terms/c/carbontrade.asp#:~:text=Carbon%20trade%20is%20the%20buying,dioxide%20or%20other%20greenhouse%20gases. Mandatory carbon markets are set up by governments for companies legally mandated to offset their emissions. Voluntary carbon markets exist outside the compliance market, allowing private companies and individuals to voluntarily purchase carbon credits113https://climatetrade.com/voluntary-market-and-mandatory-carbon-credit-market/#:~:text=Basically%2C%20the%20main%20difference%20is,voluntarily%20offset%20their%20carbon%20footprint.
Regenerative finance refers to the concept of deploying capital in a manner to affect positive environmental and/or social change114https://medium.com/coinmonks/regenerative-finance-innovation-for-a-sustainable-future-315580e11f90. More specifically, the term has been used to invoke utilizing blockchain technology and cryptocurrencies to tackle climate change115https://www.linkedin.com/pulse/what-refi-intersection-crypto-climate-mitchell-board.
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