Merit Order - why do electricity prices go up and down?

When energy production from renewable sources is high, such as on sunny days or when the wind is strong, the amount of available energy on the market increases. Renewable energy sources have very low marginal costs - which are practically zero, because once a power plant (such as a wind or photovoltaic farm) is installed, the cost of generating additional energy is minimal, consisting mainly of operating and maintenance costs.

In the Merit Order system, which sets the order in which power plants are put on the market based on their marginal costs, the sources with the lowest costs are used first. When renewable energy is plentiful, they bring a large amount of low marginal cost energy to the market, which shifts the supply and demand curve, leading to lower energy prices.

However, this situation can also lead to problems, such as excess energy, which can exceed demand and ultimately lead to negative energy prices, where producers pay to get rid of excess energy. In this article, we detail this solution.

In the wholesale electricity market in Europe, a mechanism based on marginal costs from different generation sources is used to set prices.

Thus, it is obvious that the marginal cost curve will look different in France and in Poland (it is about the available technologies for electricity generation that can be put into operation), while in principle the idea of price volatility will remain the same.

Let's try to understand together through an example how the price of energy changes based on marginal costs and the mechanism of supply and demand:

• Determining the power demand of the system at a given time.
• Given the marginal cost, i.e., the cost that a power plant must incur to produce at least 1 additional MW in a given hour, we are able to draw up a so-called “merit order.” We line up the power plants on the curve from left to right according to their lowest marginal cost.

Thus, on the left, we start with renewables, which have zero fuel costs, followed by nuclear power plants and then lignite and hard coal power plants (stacked also sequentially starting from highest to lowest efficiency), and further to the right, gas-fired power plants with a significant cost of natural gas for power generation, and completely to the right, oil-based power generation.

The marginal cost is formed practically only by variable costs i.e. the cost of fuel, fixed costs are not included.

• Having a merit order curve and assuming demand at a given level, we are able to determine which power plant sets the marginal cost and assign the price of energy that must occur in the market for that power plant to want to produce 1 MWh.  Assuming that the marginal one is a gas-fired power plant with an efficiency of 50%, and assuming that at a given time the price of gas is €50/MWh, the marginal price of electricity for the system will be €100/MWh.

• If the market at any given time offers an electricity price of €80/MWh, that power plant will have no incentive to produce and will refuse to operate. A refusal to produce is a failure to supply enough volume to meet demand - this will force the price of energy to rise to keep the market in balance.

Note that power plants with the lowest variable costs i.e. RES, among others, have the highest fixed costs, and conversely, power plants with the lowest fixed costs (gas-fired power plants) very often have a problem with when they can be turned on to generate a profit. Going further, the power plants with the lowest variable costs (RES) receive the largest cash flow from selling electricity and covering huge investment costs (and here, unfortunately, there are exceptions, see the recent shutdown of photovoltaics due to a situation of very high supply and insufficient demand, hence, among other things, negative energy prices in an increasing number of EU countries, such as France, Germany, the Netherlands and even Poland).

Now let's trace how the marginal cost curve will behave when the demand structure changes (low demand/high supply).

After a period of extremely high prices (such as in 2022), the economy slowed down by which the demand for electricity fell, coal and natural gas prices fell. At the same time, 2023 and 2024 will see much greater availability of nuclear power in Europe and renewable energy.

The Merit Order situation thus took the following form:

Thus, we understand that the energy market is subject to the laws of supply and demand, and we can conclude:

• When gas, coal or uranium prices fall, the marginal costs of power plants fall because lower fuel costs allow (encourage) power units to switch on at lower energy prices and generate positive margins.
• The left side 'pushes' the right side out of the system, i.e., excess RES pushes out gas-fired power plants first then less profitable coal-fired power plants (In the case of excess RES, there may be shutdowns of renewable units to ensure the safety and stability of the system (baseload)).
• If there is a shortage of capacity in the system, the merit order mechanism pushes prices upward to create incentives for gas/coal units to switch on.
• It is worth adding that gas-fired power plants are very 'flexible' sources of power generation and are a very good complement to unstable RES sources. The operation of gas-fired power plants depends on the margins that can be generated (profitability of generation) in relation to the price of gas, the price of CO2 and the price of electricity.  Gas-fired power plants will therefore compete primarily with coal-fired power plants where the profitability calculus of a given source may shift once towards coal-fired power plants, at other times towards gas-fired power plants precisely in relation to the price of coal and gas and CO2 and possible generation margins. More on margins for gas and coal power plants (the so-called Spark Spread or Clean Spark Spread or Dark Spread or Clean Dark Spread) in a separate article.