IN BRIEF
- The energy industry has been and will continue to explore various use cases for blockchain.
- Understanding the fundamentals of the technology will enable lawyers to counsel their clients effectively as they consider whether to integrate blockchain into their day-to-day operations.
- This article discusses the core technical components of blockchain technology.
The energy industry is exploring a variety of technological innovations that will make energy cheaper, greener, and more reliable.* For instance, distributed energy resources, microgrids, and battery storage have the potential to fundamentally reshape energy markets. Blockchain is another such innovation that has garnered attention from utilities, energy electricity suppliers, prosumers, FinTechs, and other industry participants. Some of the buzz relates to blockchain’s potential to enable high-volume, peer-to-peer electricity transactions across the distribution grid. Industry participants also recognize blockchain’s advantages within traditional energy market structures, such as the potential efficiency gains from improving data traceability, integrity, and security and automating functions.
Advising clients on the costs and benefits of implementing blockchain solutions and their attendant regulatory challenges requires a basic understanding of the technology. To that end, this article provides a high-level overview of blockchain’s core technical components: cryptography, decentralization and consensus protocols, and distributed ledger.[1]
Baseline Concepts
Three baseline concepts will be helpful to keep in mind. First, blockchain is digital ledger technology. One definition of blockchain is distributed computing architecture through which every network node (or computer) executes and records the same transactions, and new transactions are grouped into blocks that reference prior blocks of transactions. In other words, blockchain is a computing code that groups information into blocks and records the information onto a digitized record in near real time that is accessible by multiple parties.
Second, there is no singular blockchain or application. Rather, blockchains can be developed for a variety of purposes and customized to record various data.
Third, blockchain and cryptocurrencies are not synonymous. Cryptocurrencies are a type of encrypted digital token that are used for payments.[2] Although transactions involving cryptocurrencies are recorded on a blockchain, a blockchain does not necessarily need a cryptocurrency to serve a useful function.
Cryptography: Public and Private Keys
Public key cryptography is a fundamental component of every blockchain. Every user of a particular blockchain has a “private key,” meaning a unique digital signature, and a “public key,” or a digital account identification number. These keys are a unique pair generated by an algorithm. As their names indicate, the public key is publicly disclosed (like a street address) but the private key is not (like a house key). Users verify the transactions they want to initiate over a blockchain by “signing” their transactions with their private key (meaning they combine their private and public keys, but the private key itself is not disclosed). A transaction is valid only if the private key that signs the transaction matches that user’s public key. Once a transaction is signed, the transaction will be broadcast to the blockchain’s decentralized network of nodes, or computer systems, to be verified via the network’s consensus protocol.
Decentralization (Peer-to-Peer) and Consensus Protocols
Blockchains generally are referred to as “decentralized,” or peer-to-peer, because no central entity acts as a trusted intermediary through which information flows and who is responsible for verifying transactions. Rather, a network of unassociated computers confirm transactions according to an agreed-upon verification standard.[3] Given that verification relies on a preset protocol, none of the people who operate a computer in the network need to trust or even know each other; they simply must trust the blockchain consensus mechanism. Once a transaction is initiated, the transaction is broadcast to the network and bundled into “blocks” with other transactions broadcast around the same time. Once a block is full, the block is converted into a unique set of letters known as a hash. Picture a piece of lined paper; each individual transaction takes up one line. Once all the lines are full, the piece of paper is deemed a unique unit, and that unit is given a short name.
One computer that is part of the network will be chosen randomly to apply the rules of the network’s preset verification standard, known as a consensus protocol, to determine whether each transaction has the correct combination of private and public keys. That computer will then relay its work to the network for verification. If the network agrees on which transactions contain appropriately matched key pairings, the blocks containing those transactions are approved. Upon approval, those blocks will be recorded on the blockchain, making them a part of the transaction history of that blockchain. Blockchains are referred to as immutable because all new information must be consistent with all previously confirmed information, which makes manipulating the record by changing past data points a laborious, expensive, and nearly impossible (under most circumstances) proposition.[4]
Entities that operate computers in the network are compensated for their work with either transaction fees paid by the entities initiating the transaction, or by receiving a unit of a digital asset generated by the underlying blockchain’s algorithm. The process of confirming transactions has a different name based on the nature of the consensus protocol. For instance, nodes on the Bitcoin blockchain are called “miners” because they receive newly released Bitcoins in exchange for confirming transactions. The consensus protocol used is called “Proof-of-Work” because each computer must conduct difficult computations to verify blocks. Although there are varieties of consensus protocols and reward structures, the key point is that many computers operated by people who do not need to know or trust each other are able to verify transactions among two or more parties by checking transactions against a preset verification standard.
Distributed Ledger
Finally, blockchains are distributed ledgers. Every computer that is part of a blockchain’s network has access to the entire record of that blockchain.[5] Thus, the blockchain is distributed rather than controlled by a select recordkeeper or group of recordkeepers. Not every computer must have the same level of access to the data, however. For example, settings can be put in place so that certain industry participants, such as purchasers and sellers of electricity, could add information by initiating transactions, whereas others, such as regulators, could review only the information that has already been verified. Given that the same data is shared with multiple unrelated entities, it is difficult for any single entity or group of entities to alter the data without the other participants noticing. By combining these features, blockchains create a shared, immutable record of transactions that is updated and maintained without reliance on any particular third party.
Other Important Concepts: Public Versus Permissioned Blockchains, and Smart Contracts
Two other important concepts to keep in mind are the distinction between public and permissioned blockchains, and smart contracts. Blockchains are decentralized and distributed, but they do not necessarily need to be public records. A public blockchain is a blockchain that allows anyone to join the network and to access its data. The Bitcoin blockchain is the most famous example of a public blockchain. Anyone can download the blockchain and, by doing so, access the full history of its data and help confirm transactions.
On the other hand, many other blockchains, particularly enterprise blockchains, are permissioned. Only entities that are granted access to a permissioned blockchain can access its data and confirm transactions. Permissions can be customized to restrict what data a user can access or whether that user can add data. Data privacy is also handled differently between these types of blockchains. In public blockchains, the parties’ identities are anonymous or pseudonymous, but the details of a transaction are often public. Permissioned blockchains generally adopt the opposite privacy features, with known parties transacting on a private ledger.
Smart contracts are programmable computer code that modify information on a blockchain automatically once specific conditions are met. In essence, they are if-then statements that can be programmed to update a blockchain based on events. For instance, two parties could write a smart contract that would transfer automatically a certain sum of money from one party to another on a certain day or once a claim is settled, and that information would be recorded to the blockchain. Smart contracts can be written with technical code or natural language, depending on their purpose and the underlying blockchain system.
Conclusion
The energy industry has been and will continue to explore various use cases for blockchain, experimenting with different parameters and consensus protocols to capture efficiency gains and adapt to the shifting marketplace. Understanding the fundamentals of the technology will enable lawyers to counsel to clients effectively as they consider whether to integrate blockchain into their day-to-day operations.
* Daniel Cohen is an associate with K&L Gates, LLP, in Washington, D.C. His practice focuses on regulatory compliance counseling and government affairs representation for blockchain-based platforms, payment companies, and financial institutions. He thanks Buck Endemann and Ben Tejblum for their comments and insight.
[1] For an in-depth discussion of blockchain’s technical aspects and its existing and potential use cases, see Buck Endemann, Ben Tejblum, Daniel S. Cohen, et al., Energizing the Future with Blockchain, 39 Energy L. J. 197 (2018). This article will not delve into more advance concepts, such as hashing, or the various types of consensus protocols, among others.
[2] They are also referred to as virtual currencies. Encrypted digital tokens can serve other functions; for instance, they can represent a security, commodity, or act as a prepaid instrument such as a gift certificate. In the energy industry, some companies have created digital tokens to represent available electricity for sale. Regardless of their function, the digital tokens are recorded onto a blockchain.
[3] However, in practice, individuals and companies often join together, forming “pools” in order to share the rewards for confirming transactions. Fundamentally, blockchains are not operated by a centrally controlled entity, unlike bank accounts, for instance.
[4] A public blockchain known as Ethereum Classic was hacked in January 2019 by an attack from entities that controlled a majority of the computing power of the network. Ethereum Classic used the proof-of-work protocol, which requires significant computing power to confirm transactions. To date, significantly larger networks that use proof-of-work, such as Bitcoin, and large blockchains that use other consensus protocols have not been hacked directly.
[5] For some blockchains, nodes have access to only a select portion of the transaction history in order to reduce the amount of data processing required. This feature of a blockchain can be customized to meet the users’ needs.