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The Smart Grid Needs Smart Regulations

Coming federal stimulus billions meant to spark the power grid's overhaul will miss their mark without state incentives to boost efficiency

It's the night before Christmas in the energy sector, with the Energy Dept. expected to announce $4.5 billion in federal stimulus awards soon for projects aimed at ushering in the smart grid. The aim of the money is a far-reaching upgrade of the system that distributes energy to homes and businesses across the U.S., adding two-way communications and control technologies throughout the newly networked grid.

But those investments may have little impact if they're not accompanied by new state-level regulations that give both utilities and customers strong incentives to better manage and reduce their electricity consumption.

The first area in need of change is how utilities are compensated. An electric utility's revenue is tied primarily to the amount of power it sells. That was fine 50 years ago, in a world with seemingly unlimited resources and little evidence of climate change, but not today. As it stands, utilities have little motivation, if any, to encourage customers to find ways to reduce demand or to practice energy efficiency themselves—two core tenets of the smart-grid vision.

To encourage utilities to foster energy efficiency, we'll need regulations that establish new rate structures and business models. These will create incentives for utilities to earn revenue in ways that are not entirely linked to additional sales. Otherwise, asking a utility to sell less power is analogous to asking Starbucks (SBUX) to sell less coffee. Furthermore, since utilities are granted monopolies at regulated rates, a reduction in sales is equivalent to demand (and profit) destruction.

From Demand Destruction to Demand Response

Smart grids aim to replace demand destruction with a practice called demand response. Utilities intentionally reduce overall demand by sending signals to customers to turn down energy use in exchange for financial rewards. For example, a utility might offer a discount to users who run their dishwashers in other than peak-demand hours.

The second challenge is overcoming the user's passive relationship to energy. In the U.S., customers have long been numb to energy costs because prices were dirt cheap. This resulted from flat rates that didn't really express the true, variable costs of energy generation and delivery. However, significant increases in the cost of electricity are coming, and fast. According to the Energy Dept., electricity prices are forecast to rise 50% over the next seven years, while the Energy Information Administration, which compiles energy statistics for the government, expects nationwide demand for electricity to grow by 30% by 2030.

The reform needed to encourage consumer energy management: eliminating the single fixed retail rate for electricity. Until dynamic rates that reflect current market conditions are implemented, smart-grid technologies such as smart meters and smart appliances, and home-energy management systems like those being developed by Google (GOOG) and Microsoft (MSFT), will have little effect in altering consumer power usage. Customers will have no impetus to shift their consumption to off-peak hours. A smart meter without a smart rate schedule is not smart at all.

Just because the cost of electricity per kilowatt-hour will jump doesn't mean a customer's bill has to rise. If a single customer is willing to shift demand from peak to off-peak (when more, and thus cheaper, supply is available), that change can cut costs for all parties, including the utility and every other customer. But today those savings are not passed on, providing no incentive to curb energy use. The win-win-win (for the utility, the consumer, and society at large) will not be created until dynamic prices are introduced.

Fifty Public Utility Commissions

The elephant in the room in initiating what will be a paradigm shift in the electric power market is that the federal government can't currently address these regulatory issues. The fact is that each state's public utility commission (PUC) regulates the retail price of electricity and rate of return a utility will earn. Therefore, these changes cannot be made with the stroke of one pen but will need approval by 50 different PUCs. The good news is that PUCs are responding to the Energy Dept.'s statements about the need to explore dynamic pricing and new business models that reward demand-response initiatives. As an example, the Ohio PUC recently announced it will give Duke Energy (DUK) incentives to put energy-efficiency programs in place.

This is the promise of the smart grid: moving from demand destruction to value creation. While utilities may be loath to reinvent a business model that has served them for decades, the revolution in information technology that has transformed other industries—such as desktop computing, enterprise networking, and wireless communications—will have a similar effect on the electric-power business. The smart grid, which in large part sits at the intersection of energy, IT, and telecommunications, is a market that, according to John Chambers, CEO of Cisco Systems (CSCO), "may be bigger than the whole Internet."

At Greentech Media, we interact every day with startups and utilities that envision energy marketed less as a commodity and more as a suite of services. Just as cell-phone plans now bundle voice, SMS, and data, the smart grid will lead to energy-pricing plans that include basic service plus add-ons such as smart charging of electric vehicles during off-peak hours, distributed renewable energy services, and countless other new services and applications. The Energy Dept. stimulus represents a massive investment in the smart grid, but technology can only take us so far. There's plenty of money to be made, but we can't go from iPhone to iHome, from Facebook to Gridbook, without the right state policies.

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