As system flexibility develops into a mainstream feature of the market, utilities need to show creativity to adapt and avoid being left behind, says Andrew Perry.

The evolution of the UK energy system into an innovation-led, decentralised market will pose a fundamental challenge to the traditional low-risk, cost-focused approach of many long-established utilities.

New smart technologies, creative business models and a gradual updating of the regulatory framework are all catalysing this transformation. They are also creating a set of strategic complexities, risks and opportunities for utilities, as well as ushering in a new group of agile start-up competitors that are trying to harness these elements to drive market disruption.

How quickly and effectively incumbent utilities respond to these changes may well be a crucial factor in helping to determine whether they continue to play a leading role in the UK energy market in the long term. And nowhere are these changes more evident than in the field of flexibility.

Flexibility broadly covers the management of generation or consumption to ensure system balance. Previously, this was almost exclusively managed through flexible fossil-fuel generation, but new challenges are posed by renewable intermittency and nuclear inflexibility. In parallel, technology development has opened up opportunities to shift demand to match generation and to use battery storage.

Technology-led commercial innovation is already making its mark on the energy system. In the second half of 2016, battery storage began to come of age as a mainstream system tool in the UK when 1.2GW of capacity was bid into the enhanced frequency response (EFR) auction in August, while 500MW of battery storage projects were awarded 15-year contracts in December’s capacity market auction.

Companies like Stem in the US, and Sonnenbatterie, in partnership with Lichtblick, in Germany, are developing creative commercial approaches that enable the full value from storage to be captured and the barriers associated with the upfront capital costs to be mitigated. Other projects, like Open Utility’s Piclo marketplace in the UK (in partnership with Good Energy) and MVV’s “Strombank” in Germany are exploring how peer-to-peer trading and local marketplaces that manage the allocation of demand and generation can become a reality.

With so many companies now in the market, and more joining, the commercial nettle is being grasped quickly. For example, with the removal of barriers to elective half-hourly settlement due in the early part of this year, Green Energy UK is already offering a business-as-usual, time-of-use tariff for domestic customers.

Energy regulator Ofgem has also begun to consider the regulatory implications of such innovations, with a call for evidence on a smart and flexible energy system. This opens the door to potentially significant changes in the rules, such as providing greater clarification to the way storage is treated from a connection and charging perspective and introducing mandatory half-hourly settlement for all domestic and business customers. Should these changes come about, they could greatly increase the commercial rewards that can be derived from flexibility and help accelerate innovation.

Flexible use of storage and demand response are fast becoming an integral part of the energy system. Utilities can no longer afford to adopt a wait-and-see policy. They need to focus on developing actionable commercial propositions that use flexibility-related products and services.

Moreover, there is no playbook for these business models. They are forming dynamically through commercial trial and error in the market. In an increasingly competitive context, utilities need to act with a commercial boldness and creativity that pushes market boundaries .

The market for offering flexibility services to relatively sophisticated large industrial and commercial customers is crowded and margins are tight. A bigger opportunity may centre on smaller commercial and domestic users. To take advantage, utilities should regard their regulatory obligations, such as the domestic smart meter rollout and mandatory half-hourly settlement of profile classes 5-8, as commercial opportunities. If they do not, other companies will jump ahead.

Additionally, success requires organisational commitment and consistency of focus on a new way of doing things, space to allow new propositions to develop, and to fail quickly. This can be difficult for large incumbent utilities because of their traditional business models and cultural barriers to fast-paced commercial innovation.

To overcome these types of challenges, utilities should consider how they can create an environment that allows fresh ideas and a different cultural approach to flourish, while maintaining a commercial focus.

Acquisition is not necessarily the answer. Many start-ups lose their way post-acquisition as they are shoe-horned into a corporate framework that does not fit them. This problem can be compounded by the fact that start-ups open to acquisition are often in a position where they have taken their concept as far as they can or want.

To mitigate these issues, utilities should consider making strategic investments in smaller businesses while setting out a clear view of how the utility can offer a comparative advantage to assist in the start-up’s growth and development.

Alternatively, to develop capabilities organically, utilities should avoid simply setting up another vertical business unit within the organisation. To create a fresh culture, the utility should think about setting up its own start-up under its corporate umbrella. This business should be allowed to hire new people and may benefit from being based in a different location.

The changes transforming the UK energy system are creating a wealth of strategic and commercial opportunities for utilities. Success, however, is not guaranteed for incumbents. The rewards for those who act quickly and decisively may be great, but the risks of doing nothing are even greater.

Andrew Perry, engagement manager, Oliver Wyman