Blockchain’s pivotal role in de-risking transactions in the energy sector
Managing Directors Michael Miller and Tom McNulty discuss how blockchain is enabling greater accuracy and risk deduction during transactions in the energy industry.
While blockchain is commonly associated with Web 3 technologies like cryptocurrency, industries outside of the tech industry can and are taking advantage of the benefits that blockchain offers. Within our own firm, we’re seeing increased interest and investment in businesses that apply patent-pending blockchain technology for use with commodities transactions. Out of all the possible sectors, we anticipate that the widespread introduction of blockchain within the energy industry may make the greatest impact.
The energy sector is famously risk-averse and resistant to changing its well-established systems and processes. However, blockchain enables greater speed, accuracy, and risk reduction during transactions and settlements — with no compromise when it comes to security. Technology companies designing blockchain solutions for the energy industry are doing so with the industry’s risk aversion and legacy system investment in mind; offering incremental blockchain solutions which can plug into legacy systems and work in parallel or incrementally with them, allowing companies to ease into Web 3. Looking ahead, we expect to see some early adopters begin to use blockchain before it becomes much more commonly employed within the energy sector, ultimately becoming ubiquitous due to its ability to eliminate errors and to efficiently accelerate settlements.
The rise of blockchain
Though it was initially used to support Bitcoin, at its core, blockchain is a shared and distributed ledger that both parties in a transaction use, rather than each individual party maintaining, recording, and settling in their own respective ledgers. Anything added to the shared ledger must first be validated by all participants to ensure its accuracy, and all recorded entries are permanent. This means there can be no tampering with or editing of a transaction unless a new recorded transaction is entered. The record-keeping is completely open to all parties, who can view all aspects of a transaction, including all changes to it. Distributed ledger technology is software that is simply a logical evolution from paper/pencil accounting to spreadsheets to cloud-based accounting software; and now distributed ledgers.
Blockchain/distributed ledger technology improves efficiencies by eliminating the need for intermediaries to facilitate a transaction and the need for each participant to record and track transactions within its unique ledger. For energy companies, this greater accuracy and speed, lower risk, and improved accountability means that transactions can be settled in mere minutes instead of days or weeks — or even months. Given the large scale and complexity of energy commodity transactions, these advantages are valuable.
Blockchain ensures greater transaction accuracy and speed
The energy industry relies upon decades-old conventions for payment, and transactions can take weeks to settle between the delivery of physical commodities and payment. By contrast, by employing “smart contracts” agreed to by transaction parties, blockchain can accurately complete up to 100,000 transactions per second, which revolutionizes how energy companies can settle payments, as well as reducing human intervention, error and cost. The ledger must balance in real time for each transaction, rather than clearing individual accounts; this greatly reduces the risk of accounting errors, in addition to shortening the settlement cycle. Should any adjustments need to be made, it is recorded as a separate unique transaction on the shared ledger for all parties to see.
Accelerated settlement through blockchain lowers settlement risk
Long settlement and invoice cycles create high levels of unsecured credit exposure and operational risk should the counterparty default. With money tied to a pending transaction for weeks or months, companies find that significant volumes of capital are unavailable to other parts of the business, where it could be used to pay dividends, or pay down debt, or to invest in new energy businesses. By accelerating the transaction cycle, blockchain can help de-risk transactions — eliminating the likelihood of a counterparty defaulting by the time payment comes due — and free up capital that was previously tied up.
Blockchain affords greater accountability throughout the transaction
Because blockchain is a shared ledger, it enables greater transparency and ultimately accountability throughout the energy value chain, a benefit that is of particular interest should Scope 3 emissions need to be quantified. As an open, shared, and accurate ledger, blockchain provides companies the ability to trace carbon dioxide, methane, sulfur dioxide, and other emissions all the way back to the wellhead. This due diligence can be completed by simply referencing the ledger, rather than undertaking a slower and more difficult manual due diligence process. A buyer of a lithium-ion battery, for instance, would be able to trace emissions all the way back to the origin of the supply chain for each commodity used within it.
Blockchain’s future for the energy industry
The interest in blockchain has extended beyond just venture capital firms or the tech industry, with blockchain becoming a popular target for investment on a broad scale across a range of industries. For those in the energy industry, it would be beneficial to begin ramping up their exploration of blockchain technologies to ultimately capitalize on its greater accuracy, speed, and risk reduction benefits. Taking steps now may also set companies up for success in the future, should greater accountability and tracing be required for Scope 3 missions or other future environmental regulations.