It's the night before Christmas in the smart grid sector with the Department of Energy soon expected to announce $4.5 billion in federal stimulus awards reserved for Smart Grid projects. Will those investments matter without new state-level regulations that incentivize both utilities and customers to better manage and reduce electricity consumption?

The first challenge is how utilities are compensated. An electric utility's revenue is primarily tied to the amount of power it sells. That was fine 50 years ago, in a world with seemingly unlimited resources and no hint of climate change, but no that longer makes sense today. Under this model utilities have little motivation, if any, to: (1) encourage customers to find ways to reduce demand, or (2) practice energy efficiency themselves – two core tenets of a smart grid vision.

The crucial regulatory reform needed to encourage utilities to foster energy efficiency will be found in establishing 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 to sell less coffee. Furthermore, since utilities are granted monopolies at regulated rates, a reduction in sales is equivalent to demand (and profit) destruction.

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 their energy use in exchange for financial rewards. Demand Response, also referred to as the "Fifth Fuel," can serve as an addition to the four traditional fuels used to generate electricity: coal, natural gas, nuclear and renewables (once the baseload minimum power is generated). The nickname the "Fifth Fuel" suggests that Demand Response deserves to be acknowledged by regulators in a similar manner to new supply.

The second challenge is the end user's passive relationship to energy. In the U.S., customers were numb about energy costs because prices were dirt-cheap. This came as a result of 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 DOE, electricity prices are forecast to increase 50 percent over the next seven years, while the EIA expects nationwide demand for electricity to grow by 30 percent by 2030.

The critical regulatory reform needed to encourage consumer energy management will be 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, home energy management systems and smart appliances) will have little effect in altering consumer use. 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 per kilowatt-hour will increase doesn't mean a customer's bill has to rise. If a single customer shifts her load from peak to off-peak (when greater, cheaper supply is available) it has the effect of reducing 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.

The elephant in the room is that the Federal government cannot currently address the regulatory issues that revolve around what will need to be done to initiate a paradigm shift in the electric power market. Each state's public utility commission (PUC) regulates the retail price of electricity and rate of return that 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 DOE's statements about the need to explore dynamic pricing models and new business models that reward Demand Response initiatives. As an example, the Ohio PUC recently announced that it would incentivize Duke Energy to put energy efficiency programs in place.

This is the promise of smart grid: moving from demand destruction to value creation. While utilities may be loath to re-invent 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. In large part, the smart grid sits at the intersection of energy, IT and telecommunication, and because of this it is a market that, according to John Chambers, CEO of Cisco, "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 plans, the smart grid will lead to energy pricing plans that include basic service plus add-ons, like smart charging of electric vehicles during off-peak hours, distributed renewable energy services, and countless other new services and applications. The DOE stimulus represents a massive investment in smart grid, but the 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.

An edited version of this article originally appeared in BusinessWeek on Oct. 6, 2009 as The Smart Grid Needs Smart Regulations.

David J Leeds is a Smart Grid Analyst with GTM Research. For more information on smart grid technologies and applications, read The Smart Grid in 2010 a free report published by Greentech Media.

Interact with smart grid industry visionaries from North American utilities, innovative hardware and software vendors and leading industry consortiums at The Networked Grid on November 4 in San Francisco.