The Merit Order Effect

By Natalia Olsson Orio

The merit order effect is a phenomenon within the topic of energy that is comparably new and has not been talked about enough, especially since energy is a very hot topic today. The merit order effect is, simply put, a lowering effect of the wholesale electricity price when the percentage of renewable energy sources increases in the energy mix. As we are moving towards replacing our energy sources towards more sustainable ones, this is an important phenomenon to be aware about and to expand research on. It has not been thoroughly studied if the merit order effect will last in the long run, but what little studies have been made suggest this is only a temporary effect. The merit order effect may also cause the electricity market to need to be re-designed.

The merit order effect is something that needs to take more space in the energy discussion as we move towards a world that aims to become

In a study by Gielen, Boshell, Sayigin, Brazilian, Wagner and Grini from 2019, the authors wrote the emissions of CO2 related to energy constitute about two thirds of the global greenhouse gas emissions. The authors further explain that there has to be a global energy transition from fossil sources to sustainable and renewable ones if the Paris Agreement’s 2 degree goal is to be reached. However, the renewable energy sources that hold most potential are ones that are variable and difficult to manually control to make sure the electricity supply meets the demand, López Prol and Schill write in their paper from 2021, which fluctuates over both in time during the day and throughout the year. The lowering effect on the price of increasing the share or renewably sourced energy in the energy mix may also demand a restructuring of our electricity markets, according to Breakthrough Energy.

Before going into the explanation behind what exactly happens for the merit order effect to occur, there is some important information that needs to be gone through. Different

Prol and Schill, as well as Breakthrough Energy. Dispatchability describes how easily an energy source can be controlled manually. For instance, the conventional energy sources such as gas turbines, are classified as dispatchable energy sources, since they can be turned off and on to only produce electricity when demand is high, thus having high operational flexibility. There are some renewable energy sources that are dispatchable, such as bioenergy, hydropower and geothermal energy, but they have limited potential. The renewable energy-generating technologies that are easier to develop and that have higher potential are non-dispatchable: different kinds of solar power and onand offshore windpower. Why these are called non-dispatchable is because the energy these sources generate are determined by the sun and the wind, which are factors us humans cannot control manually. As such, only the amount of energy that the sun and the wind allows will be produced; there is low operational flexibility.

Another important thing to know about is the relationship between dispatchability and variable costs, and the U.S. Energy Information Administration (EIA) provides a thorough explanation of this. Variable costs are determined by how much operational flexibility an energy source has; a source that has low operational flexibility has low to no variable costs, because there simply is nothing to control; what’s being generated is what is being generated, due to the amount of sunshine or wind. Energy sources that can easily be controlled, however, have high variable costs; they can easily be turned off and on and easily control how much energy is to be generated. Due to the variable costs being lower for non-dispatchable energy sources, these are the ones to first be dispatched on the electricity market. Another reason is that these sources cannot be used to regulate so that supply meets demand; that is what the dispatchable sources are for. The dispatchable sources are used in the times of day and year when non-dispatchable renewable sources are not enough to meet demand, and so are the last sources to be dispatched onto the electricity market.

Onto the actual merit order effect, which López Prol and Schill write in detail about in their paper from 2021. The price and the quantity of electricity will be determined by the point where supply meets demand. What is slightly different from the electricity market to other markets is its shape.

Here it can be described as having a staircase shape (see Figure below), where the different levels represent different amounts in variable costs (or dispatchability, as the variable cost is in essence determined by a source’s dispatchability). The lower levels represent sources that have no to low variable costs, and the higher the level, the higher the variable costs.

If the share of renewably sourced energy increases, then the share of zero variable cost sources increases. As the share of zero variable cost sources increase, this will cause the wholesale electricity price (which is the price that consumers pay for electricity) to decrease. Increasing the share of renewably sourced energy causes the share of fossil sourced energy to decrease. As such the variable costs decrease, and the price for the consumers decreases.

This is a very fortunate effect for consumers, Antweiler and Muesgens write in their paper from 2021, however, it is not clear if this effect will last in the long run. Theoretically, this should only be a short-term effect. Gelabert, Labandeira and Linares have explained it in their paper from 2011 as when the electricity price decreases, this will cause a long term signal indicating that it is not worth investing in this; the revenue is decreasing. The investments would then over time deteriorate, and eventually the electricity price will increase again, because there is only so much electricity that can be renewably sourced. Antweiler and Muesgens, on the other hand, have come to the potential conclusion that the merit order effect could be a by-product of a slow paced capacity adjustment of fossil sourced electricity; the supply of fossil sourced electricity takes time to adjust to how much electricity renewable sources can supply when they expand.

Because the wholesale prices decrease due to the merit order effect, there might be a need for a restructuring of the electricity market as we know it today, Breakthrough Energy writes. If the wholesale price decreases, that means less revenue for investors, and so they may turn away from investing in dispatchable and non-dispatchable renewably sourced energies, which is not desirable. Increasing renewably sourced energy on the electricity market is essential, as we need these technologies to provide at least 42% of the total global electricity generation by 2040 if the Paris Agreement is to be met, according to López Prol and Schill.

We need to open up this discussion to make sure we are prepared for the transformation that is needed and the effects of increasing the share of renewable sources of electricity, if we are to be successful.♦