Excerpted from Xfin:
“With the EFF’s announcement that they would being accepting BitCoin donations, the alternative money community began to take a larger interest. I certainly did, and found that there are good and bad things about this form of money. In the end, BitCoins create a perverse incentive to consume energy to “create money.” Here is why.
What is a bitcoin and how do you create one? — A BitCoin is created whenever a user’s computer churns though a SHA-256 hash repeatedly from a hash until it results in a number less than a given number. Statistically, hash functions are supposed to have very unpredictable content–that is what makes them secure. Whenever a BitCoin client churns through a hash starting from a given number issued to the network, it burns CPU time (and thus energy). The probability of getting a hash to be “less than” a given 256-bit number is quite low. Successfully determining how many SHA-256 rounds it takes for a particular nonce to hash to a number lower than some value is called the “proof of work.” If while your computer receives a new “block” from the network (meaning another computer successfully won some BitCoins), your computer must start over with a new nonce.
How much energy does it require to mine the average BitCoin? — With my “older computer,” the hash rate averages around 2000 khps on a microprocessor going full-bore consuming about 65W. The current difficulty shows that a new BitCoin can be mined by a computer at this speed on average every 113 days. So, 113 days × 24 hours = 2712 hours. 2712 hours × 65W = 176280 Wh or 176.28 KWh. The average cost of a KWh in the United States is 10.45 cents. So we’re looking at spending $18.42 to create 50 BTC (at the moment). So the electrical cost is about $0.36/BTC. BitCoins are trading now already at values below this, so I can only assume that they’re being sold at a loss or others may be externalizing the costs of electricity and not taking this into account. If you were to pay your electric bill in BTC, you would have a positive feedback loop (always a bad thing) that consumes more energy to earn money to pay back the power company. It doesn’t matter how efficient your processors are—you’re spending more money to make money.”
The full article is a very good explanation of how BitCoin functions.