June 2018, Vol. 245, No. 6


The Unsinkable: A Look at Blockchain’s Potential and Pitfalls

By Michael Brooks and Philip Wiseman, Bracewell LLP

Imagine a world where every dekatherm of natural gas is allocated and title is electronically recorded at the wellhead or tailgate of a gas processing plant, and every subsequent change in ownership is recorded along the way such that there is a readily available chain of title when it reaches the burner-tip.

Imagine, too, that each pipeline that transports or stores the gas adds a tag that identifies the location of the gas and the customer and contract to which it is allocated. Finally, imagine all of this is automated, immutable and easily auditable. For better or worse, blockchain has the potential to make this world a reality.

In a world that tracks natural gas using blockchain technology, consider the following possibilities: 

  • Country of origin could be permanently associated with title to natural gas, clarifying import/export reporting and fee requirements
  • The jurisdictional status of natural gas transported or stored in the United States might be provable based upon the chain of title and transportation history recorded in a blockchain
  • Reporting requirements could be satisfied via automation or by merely giving government agencies visibility to selected data contained in a blockchain
  • Transactions could be confirmed instantaneously, delivery confirmed automatically, and payments transferred using virtual “coins” created as part of the platform
  • Smart contracts could enable purchases, sales, and scheduling to be confirmed simultaneously

Even if blockchain is never used to physically track natural gas molecules but instead is applied only to discrete segments of the industry, such as executing, confirming and settling natural gas transactions, it could greatly reduce costs and increase efficiencies by cutting out the manual redundancies imbedded in the status quo.

Ultimately, many scheduling, confirmation, and trading activities and processes could become obsolete and remaining functions could be carried out using artificial intelligence (A.I.). However, before falling down a rabbit hole, let’s take a practical look at how blockchain technology works and consider some of its strengths and weaknesses as applied to natural gas.

How It Works

Blockchain was created to remove the need for a “trusted third-party.”  Consider most interactions between counterparties today, particularly where money is involved. Transacting parties routinely rely on intermediaries, such as VISA or PayPal, to confirm and guarantee the assets involved and payments promised.

Behind the scenes, these intermediaries maintain separate ledgers and navigate a series of arduous maneuvers to mitigate the risk of double-spending (i.e., counterparties spending money they do not have). However, what if everyone shared a single ledger that could be trusted to accurately reflect the current state of affairs? This is the promise of blockchain.

Blockchain commonly refers to peer-to-peer network management of a distributed, shared ledger (or database).  Think of a Google Docs Excel file, but then add a requirement that the file will be saved to every computer on the network, each change will be confirmed by a majority of the network, and every change will be permanently recorded in chronological order. Although specific blockchains can vary, the term generally describes some combination of the following key characteristics:

  • Peer-to-peer network – participants in the network interact directly rather than through an intermediary
  • Distributed ledger – each participant in the network maintains a digital copy of the ledger
  • Sequential, non-editable blocks of data – each change to the ledger is recorded by adding a new, time-stamped block of data (no prior blocks can be edited)
  • Consensus – changes to the shared ledger must be confirmed by a majority of the network
  • Cryptography – the data is encoded, and adding new blocks of data requires solving a mathematical problem that mitigates the risk of fraudulent additions.

Benefits, Pitfalls

If you listen to proponents of blockchain, you could easily get the impression that blockchain is a perfectly secure, perfectly transparent, and impeccably fast technology that is going to revolutionize every industry. If you listen carefully enough, the hype might conjure images of the Titanic launching from Belfast Harbor on its maiden voyage. It might remind us of the now infamous declaration that “Not even God himself could sink this ship.” Just as with the Titanic, blockchain has great promise, but it is not unsinkable. 

To effectively exploit blockchain technology, industry participants need to be able to consider not only its promise but also its shortcomings.  The following attributes of blockchain will be particularly relevant as the industry explores the possibility of incorporating blockchain into its activities.

Security: Advocates tout the security derived from a distributed ledger and consensus confirmation.  In short, because the ledger is distributed (i.e., copied in many different places), and its history is preserved by requiring it to be continuously confirmed by consensus of the network participants – each maintaining their own copies to compare to any new iteration – any would-be hacker could only fraudulently change the ledger if it could convince the network that its phony ledger was genuine. This can happen, particularly on a small network, but it is estimated to be much more difficult to overtake 51% of a robust network than to overtake one centralized ledger.

Importantly, the security provided by distributing the ledger relates to the immutability and reliability of the ledger, not the confidentiality of the information contained within it. In fact, distribution of the ledger likely has an inverse relationship to the security of its confidentiality. This is because each recipient of the ledger necessarily has access to it and can be an access point for a bad actor.

Of course, participants may attempt to maintain the confidentiality of information contained in a blockchain, even from other participants in the network, by using encryption, but cryptography is not fool proof. 

For example, imagine gas producers, marketers, and end-users participating in a blockchain that distributes an encrypted ledger to every participant. Could any amount of encryption get the participants comfortable with sensitive information being stored on their competitors’ computers? Would the platform be worthwhile if sensitive information is withheld?

As the industry looks to take advantage of the opportunities offered by blockchain, participants will need to keep in mind risks to their proprietary information and also their legal obligations to employees, customers or counterparties to protect confidential information. Cybersecurity and privacy risks might require participants to limit the type of data included in a distributed ledger.

Transparency: Another potential benefit of blockchain is the transparency that comes from a shared ledger. By all network participants sharing the ledger, parties can confirm transactions in real time, reducing delays and transaction costs.

Capturing all relevant data in the blockchain also creates an opportunity to reduce reporting burdens by either creating automated reporting from the database or, more efficiently, granting government agencies access to the blockchain (or portions thereof) to end the need for reporting. However, here again, sharing data (even if encrypted), increases the opportunity for that data to be viewed by others.

Moreover, if government access to information becomes effortless, then regulators may push for even greater visibility into a wider range of activities previously only seen upon specific request. Market participants will have to weigh their desire for transparency and ease of reporting against the need for data security and privacy to tailor applications to obtain the most appropriate mix.

Permanency: One of the most significant attributes of blockchain is the permanency of the ledger. If an immutable record is a primary goal, then a distributed ledger of sequential, non-editable blocks of data may be the most reliable solution. This makes blockchain particularly promising for tracking ownership. 

Land title, mineral rights, and commodity ownership all could be accurately and permanently catalogued using blockchain. However, once again a strength of blockchain may create a challenge for its application to natural gas markets.

What happens when an error occurs? For example, what if a party makes a fat-finger mistake or a meter error results in a misallocation? What happens if rates are subject to refund or the ledger does not match physical imbalances?  A successful blockchain application in the natural gas industry would need to account for potential errors and create an efficient response mechanism for correcting them.

Autonomy: In its purest form, blockchain is wholly autonomous once launched.  There is no need for a central administrator, and no single network participant can seize control of the entire ledger once begun. This autonomy is important to the security of the blockchain — if one computer can make changes to the blockchain unilaterally, then we lose part of the security benefits of a distributed ledger. 

However, this autonomy may create challenges in a world where perfection is more aspirational than attainable.  Without an administrator or other means to override the network, any events not anticipated and addressed at the inception of the chain may be incompatible with the chain’s protocols.

For example, what if a court or regulator orders a transaction reversed or seeks to freeze assets; what mechanism could be used to achieve this outcome?  What if a participant ceases to exist or otherwise abandons an asset recorded in the chain? Without a central authority, how can these scenarios be managed?

In many applications, it likely will be necessary to retain a trusted administrator (or panel of administrators), sacrificing some of the benefits of blockchain while still taking advantage of the speed and transparency of an automated, distributed ledger.

Title-Based Regime: To the extent that a natural gas blockchain is title-based, traditional market features may change. For example, naked short-selling is inconsistent with a title-based market. That is, whereas today market participants are free to sell natural gas they have yet to acquire, in a title-based blockchain, this may not be possible.

Likewise, if the blockchain can track country of origin or other distinguishing characteristics, such as renewable identification numbers (RINs), then markets might be bifurcated into discrete natural gas products similar to electricity markets in which environmental attributes can be associated with or severed from electricity. Such changes could tie markets more closely to physical reality but also could reduce liquidity

Looking Forward

The prospect for blockchain reducing costs and increasing efficiencies in commodity markets, including natural gas, is already gaining traction internationally. 

For example, in 2017, BTL completed a pilot project to test a blockchain-based, natural gas trading platform in Europe and has since announced the next phase of the project in an effort to span the lifecycle of a natural gas trade from trade reconciliation to settlement.

TMX Group, parent to the Natural Gas Exchange (NGX), also has announced the development of a blockchain prototype “to optimize the NGX natural gas settlement process for clients by providing a transparent view of gas movements across locations and enabling participants to more accurately report their positions.” 

The company added that the “prototype also has the potential to enhance delivery and payment processing, mitigate the risk of, and expedite remediation of, supply shortfalls, and provide secure transactional data.”

Another project, involving a consortium of trading houses, energy companies, and banks involves an effort to use blockchain “to create a secure, real-time distributed platform to manage physical energy transactions from trade entry to final settlement.” These efforts are evidence of buy-in by some of the biggest players in energy commodity markets.

As the natural gas industry considers potential applications for blockchain technology, stakeholders will need to understand the trade-offs that come with the technology and likely will need to resort to a hybrid that adopts key features of the technology while retaining other existing or improved safeguards and controls. 

The first and most productive questions to entertain will focus on the various attributes of blockchain as compared to the needs of the industry. For example, what data needs to be recorded? Does it need to be communicated to others? Who needs to see the data and who should not see the data? Is transparency valuable or is privacy more important? Is it more important that the record be immutable or that the data be kept confidential?

The greatest applications likely will come from marrying features of blockchain to specific shortcomings in the status quo, recognizing the technology’s own shortcomings, and addressing those with conventional or alternative technologies. P&GJ

Michael Brooks is a partner in Bracewell’s Washington, D.C. office and focuses on  energy, commodities and derivatives law. He represents energy companies and commodity trading companies in a regulatory, compliance and enforcement matters.

Philip Wiseman is an associate in the firm’s Houston office, focusing on the power industry, including renewable energy and natural gas matters, as well as energy projects.

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