The merit-order principle describes a key mechanism for price formation in short-term wholesale electricity markets, particularly in day-ahead auctions. It determines the order in which power plants are used to generate electricity and the resulting electricity price. For companies, grid operators, and market participants, the merit-order principle is a key foundation for understanding electricity price fluctuations and market movements.
Definition of terms
The merit-order principle refers to the order in which power plants are deployed on the electricity exchange based on their variable generation costs. Power plants with the lowest marginal costs are deployed first, followed by more expensive plants in accordance with demand.
The price of electricity is determined by the most expensive power plant still needed to meet current demand.
Basic Principle of Merit Order
The merit order is based on a simple logic:
- Power plants are sorted by increasing variable costs
- Low-cost generators feed electricity into the grid first
- As demand rises, more expensive power plants are being added
- The power plant that was most recently needed determines the market price for all of them
Typical order:
- Renewable Energy (Wind, Solar)
- Lignite and hard coal power plants
- Gas-fired power plants
- Oil-fired or reserve power plants
However, the specific order of deployment within the merit order is not static but can change at short notice. Rising or falling CO₂ permit prices, as well as sharply fluctuating fuel costs—particularly for natural gas and coal—significantly influence the variable marginal costs of individual power plants. As a result, the order in which generation facilities are deployed can shift dynamically, which has a direct impact on the price of electricity and the merit order effect.
Pricing in the Electricity Market
Supply and demand meet in the electricity market. Demand determines how many power plants are needed. The price of electricity is determined at the point where the supply curve and the demand curve intersect.
Special feature:
Under the so-called uniform-price mechanism, all successful bidders in a trading period receive the same market price. This creates economic incentives for efficient and flexible generation.
Factors Affecting the Merit Order
Several factors influence the order and the resulting electricity price:
- Fuel Prices (Gas, Coal)
- CO₂ Credit Prices
- Availability of Renewable Energy
- Weather Conditions
- Power Plant Outages
- Grid Congestion (Congestion Management in the Electric Grid)
These factors can shift the merit order in the short term and lead to sharp price fluctuations.
The Role of Renewable Energy
Renewable energy sources have very low marginal costs and therefore rank at the top of the merit order. High levels of electricity fed into the grid from wind and solar power plants can:
- displace more expensive power plants
- lower the price of electricity
- reduce the operating time of fossil-fuel power plants
This effect is often referred to as the merit-order effect.
Impact on Electricity Prices
The merit-order principle explains why electricity prices can vary widely:
- High demand and expensive peak-load power plants are driving up prices
- High Renewable Energy Feed-in Reduces Prices
- High fuel or CO₂ prices contribute to price spikes
Negative electricity prices can also be explained by the interplay of supply, demand, and the technical minimum load.
Implications for Businesses
The merit-order principle is relevant to businesses because it:
- Explains fluctuations in electricity prices
- Influences Procurement Strategies
- serves as a basis for price formation in the day-ahead and intraday markets and makes flexibility economically quantifiable
Energy-intensive companies, in particular, benefit from an understanding of market dynamics.
Relationship with energy storage and flexibility
Energy storage systems and flexible consumers can respond specifically to price fluctuations caused by the merit order:
- Purchasing Electricity at Low Prices
- Avoiding the Use of Expensive Peaking Power Plants
- Reducing Network Load During Periods of High Prices
Storage systems can reduce peak loads, take advantage of price signals, and—with appropriate control—contribute to grid stabilization.
Distinction from related terms
Not to be confused with:
- Day-Ahead Market & Spot Market: Trading platform for next-day electricity deliveries
- EPEX Spot Intraday Market: Short-term electricity trading within a single day
- (Capacity Market vs. Energy Market): Compensation for maintaining generation capacity versus energy trading
- Control Power: Balancing Short-Term Grid Fluctuations
- Redispatch 2.0: Grid-Side Interventions to Prevent Congestion
- Grid Fees and Surcharges: Price Components Outside the Market Price
Summary
The merit-order principle describes the order in which power plants are brought online based on their variable generation costs, thereby explaining how prices are formed in the electricity market. Power plants with low marginal costs are brought online first, while more expensive plants are brought online only when demand increases. The electricity price is determined by the most expensive power plant still needed to meet demand and is then applied to all generators in operation. Because of their low marginal costs, renewable energy sources often have a price-dampening effect, which can lead to a merit-order effect. Overall, this principle helps explain why electricity prices can fluctuate significantly and why flexibility—such as through energy storage or controllable consumers—is becoming increasingly important in a market-based energy system.
