What does merit order mean?

In the energy industry, the term ‘merit order’ describes the sequence in which power plants are designated to deliver power, with the aim of economically optimizing the electricity supply. The merit order is based on the lowest marginal costs. These are incurred by a power plant and refer to the cost of producing a single megawatt hour under recent conditions. The merit order is separate from the fixed costs associated with a power generation technology. According to the merit order, power plants that continuously produce electricity at very low prices are the first to be called upon to supply power. Power plants with higher marginal costs are subsequently added until demand is met.
The merit order is just one possible model for creating a functional electricity market. It assumes that power plant operators are always trying to cover the cost of the next megawatt hour produced; they would not produce it otherwise. Power plants with low marginal costs can therefore offer a lower price for their electricity, and they are in turn called upon more often than power plants with higher marginal costs. The merit order is designed to shed light on how pricing works on the electricity market; it is not a fixed "law" that coordinates the use of power plants.

Electricity price

On the electricity exchange, supply and demand determine the prices at auction. The ‘market-clearing price’ (MCP) is the lowest bid to buy power that is still accepted in an auction. The power plant with the most expensive marginal costs – the marginal power plant –  determines the price on the exchange for all power plants involved. The energy industry calls this price formation mechanism ‘uniform pricing’ since all power plants receive the same price for their feed-in, even if they have offered different prices (in contrast to the ‘pay as bid’ mechanism, which applies to continuous trading).
If a power plant offers a lower price than the marginal power plant, it can generate a surplus. This ’contribution margin’ offsets their own fixed costs.

Merit order effect (MOE)

Permanently declining electricity production costs – especially in renewable power production – have caused the merit order sequence to shift, with conventional power plants taking a position further back. The effect is quite visible with the increasing feed-in of renewable energies (such as photovoltaics, wind energy, or biomass). Fluctuating photovoltaic and wind power plants with marginal costs close to zero are advancing into the market and pushing conventional power plants toward the end of the merit order during peak load periods. The energy industry describes this phenomenon as the merit order effect (MOE) of renewable energies. Only the residual load – the remaining electricity demand that renewable energies cannot cover –  must be provided by conventional power plants.

Criticism of the merit order model

The merit order model is a static description model that is well suited for representing short-term electricity price formation. Calculating the long-term development of electricity prices, however, requires a market model that takes long-term effects into account. Such an electricity market model would include factors such as operator decisions on deployment, expansion, and decommissioning as well as fixed operational costs. The latter point is particularly relevant: no power plant operator will want to build additional plants if selling electricity only covers marginal costs. For example, the enormously high investment and dismantling costs of nuclear power plants are not correctly reflected in the merit order model. The same can be said for the total costs associated with renewable energies.
The model also requires all electricity to be sold on the electricity exchange, which does not always happen. As an example, some plant operators consume the electricity they produce without feeding it into the grid. Without taking these factors into account, the merit order model can overstate the ability of renewable energies to influence prices. Therefore, the merit order model does not fully reflect reality, leaving the full extent of the merit order effect up for debate.

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