Investing in the Smart Grid

Investing in the Smart Grid
July 12, 2009

With the likely passage of the “Cap and Trade” bill, many investors are jumping on the renewable energy bandwagon. And why not? With the government about to mandate a cap-and-trade program that will drive up the cost of electricity, there are many new opportunities to capitalize on the flow of investment dollars from public and private sources. They also are looking for investment opportunities through stocks of smart grid companies.

This headlong push into alternative power generation is causing investors to take a new look at the old electrical grid system. While there have been attempts to move to a market based power generation system, most of these efforts have failed to achieve their original goals.

Moreover, the electricity transmission and distribution system remains much the same and is a big problem. For example, T. Boone Pickens has announced he is curtailing his plans to build the world’s largest wind farm in West Texas. Part of the reason is the lack of adequate transmission lines to carry electricity from the remote wind sites to cities. This is where a smart grid investment program makes sense for investors.

Investing in the Smart Grid
This old electrical grid system is designed to distribute power from consistent generation facilities that are close by. Building large wind farms in West Texas requires a way to move that power to urban areas that need it. Moreover, what happens if the wind stops blowing during the hottest days of the summer?

Our current electrical grid system is ill suited to handle the variability of new sources of electrical power. Solving the transition to new power sources is only half the battle. After generating the power, you need to distribute it to where it is needed at the right time, in the right amounts and at a lower cost.

You can make an interesting comparison with the current electrical grid and communications network. If Alexander Graham Bell, the inventor of the telephone, were to come back today, he would not recognize the modern day communication system with digital based internet and wireless networks with their cell phones, Web 2.0, YouTube and Twitter.

On the other hand, if Thomas Edison were to return, he would readily recognize our electrical transmission and distribution scheme, as he was one of the grid’s earliest architects. While it has grown significantly, the basic design remains the same.

The smart grid is the conceptual answer to the vast changes needed to adapt the current electrical system to one that is more efficient, adaptable, and capable of handling the variability of the sources of power while helping customers use electricity more efficiently. Like the evolution of the internet and the dotcom boom and bust, this is a huge opportunity with many unknown risks.

The Opportunity
According to Cisco (CSCO), the smart grid offers major investment opportunities that are bigger than the internet for those prepared to take advantage of them. Jeff Immelt, CEO of GE (GE) believes the smart grid will be the biggest investment of the first half of the 21st century. President Obama is counting on investments by the government and companies in the smart grid to help the United States release it from its dependence on foreign oil.

According to a 2009 report by the American Society of Civil Engineers, $2 trillion will need to be invested in our electric infrastructure by 2030. The Brattle Group estimates that it will take $1.5 trillion to between 2010 and 2030 to pay for the upgrades necessary for the additional infrastructure for tomorrow’s electrical system.

These investments will take place throughout the electrical grid, in the home, in buildings, on campuses, neighborhoods in cities and across continents. Already we are seeing a few of these improvements. Some homes have smart meters that track electricity use in detail, providing the information to utilities.

Eventually, homeowners will be able to access this data so they can make adjustments in their power consumption. The cost of these meters is quite high and is passed on to consumers. The hope is that once consumers have access to the information on their electricity usage, they will take steps to cut their consumption of electricity offsetting the cost.

The Risks of Investing in the Smart Grid
This raises the question whether there is a cost-benefit trade off from many of the investments to achieve the goal of a smart grid. Many people equate the smart grid to the growth of the internet. Much like the investment that came with the growth of the internet, there were some that provided valuable benefits. Others never paid off.

I suspect we will see many smart grid investments experience the same fate. For example, as reported by the WSJ on APRIL 27, 2009, the home smart meters cost $250 to $500 per installed device. At this price, it is not clear if the meters will provide sufficient benefit to cover their costs.

The parallel to investing in the internet is an interesting analogy. The big winners were able to attach themselves to the “killer application” that drove business to them. However, there were many losers who failed to achieve their promise. Finally, those who provide many of the components and installed the infrastructure did well, even if they were not big winners.

OK, what is the killer application of the smart grid? The best definition I found for a killer app comes from NetReturn.com:

A new good or service that establishes an entirely new category and by being first dominates it creating an enormous return on the initial investment.

Some people believe the smart grid killer app will be the electric plug in car. Not sure, that meets the definition very well.

Anyone remember the smart home? It has been trying to get off the ground for a number of years. This was another idea some put forward that has not received much success, as the payoff has been hard to generate.

Smart Grid Companies and Stocks
There is a number of start-up and established smart grid companies creating products for this market. Smart grid stock pure plays such as Comverge (COMV)), RuggedCom (RCM.TO) and EnerNOC (ENOC) all became public in the second quarter of 2007. Some very large companies like GE, Honeywell (HON), Cisco, and Google (GOOG) have smart grid offerings. Keep in mind, the size of their smart grid services is relatively small when compared to their total sales.

Companies that provide and install many of the components of a smart grid should offer good returns; much like the companies who sold picks and shovels to the miners. Stocks of smart grid companies like ABB Ltd (ABB), Siemens A.G., and GE are likely to benefit as electric utilities build the new infrastructure for the smart grid.

One way to approach this market is through an ETF that holds stocks in a smart grid fund. The Cleantech Index CTIUS, created by The Cleantech Group LLC is the basis for exchange-traded funds (ETFs) that hold smart grid stocks in the PowerShares Cleantech Portfolio ETF (AMEX: PZD) and the KSM Cleantech ETF in Israel. The index includes large companies like ABB and Siemens as well as smaller firms like Vestas Wind systems (VWS.CO), Itron (ITRI), Trimble Navigation (TRMB) and RuggedCom [RCM.TO]. These ETFs hold stocks of companies that focus on clean technology, not just smart grid companies.

Investing in smart grid stocks will offer exceptional opportunities. It will also create substantial losses for those who do not tread carefully. While it is tempting to bet on what will be the killer app for the smart grid, a more conservative strategy is to focus on the companies that can show real cost benefit from their products or services and who generate positive cash flow.