The Merit Order And How It Affects Electricity Prices


Niklas Hirmke


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What Is The Merit Order?

The Merit Order describes the Order, of which energy source gets used first – from the cheapest (renewables) to the most expensive (gas). The cheapest source of energy production always feeds in first. However, the Merit Order does not represent a legal law, but an economic law, that attempts to describe how the electricity price on the electricity market comes about. The right supply quantity is based on the lowest incremental costs. These are the costs incurred by a power plant for the last megawatt-hour needed and produced. The Merit Order is independent of the fixed costs of the power generation technology. According to the Merit Order, those power plants that continuously produce electricity at a very low cost are the first to be connected to the grid.

Power plants from renewable energies, such as wind and sun, are used first for electricity generation because the costs for electricity production, and thus the marginal costs, are lowest here. However, since the demand for electricity cannot yet be met exclusively by renewable energies, nuclear, coal, and gas-fired power plants are added and this continues until the demand for electricity is met, as you can see on the picture below.

Why Electricity Production With Gas-Fired Power Plants Is So Expensive And Why It Is Still Needed

Nuclear, brown coal, hard coal and coal-fired power plants are used to meet the baseload of electricity demand. The baseload is the demand for electricity, which is consumed very reliably and predictably. Shutting down nuclear and coal-fired power plants is an expensive and complex process. Therefore, they are used to reliably generate electricity over the long term.

Renewables on the other hand are not as consistent as the three forms of production mentioned above, because renewables are dependent on wind and the sun. Thus, solar energy is not available at night and wind energy is also only available when there is enough wind, which is not 24/7.

Gas-fired power plants are still used to cover the demand for electricity at peak times (peak load). Gas-fired power plants are characterized by a high degree of flexibility, as they have a short start-up time to full load and are ready for electricity production very quickly.

The following graphic illustrates the difference between baseload and peakload.

How Reduced Gas Supplies Cause Electricity Prices To Rise Due To The Merit Order

As is common in a market-based economy, electricity prices are driven by supply and demand. Electricity is not substitutable. Private households, as well as the entire economy, can’t live and work without electricity.

If Russia cuts gas supplies and the supply of gas decreases as a result, gas prices will rise. Gas-fired power plants are the last link in the Merit Order. Thus, due to the Merit Order Model, gas-fired power plants are decisive for the electricity price, which in succession then rise. This can be seen in the following chart.

Uncertainty about how much gas will be supplied, and whether it will be supplied at all, is unsettling the markets. This is also the reason for the extreme price fluctuations in recent months.

You can read why a gas embargo would calm electricity prices here in our blog.

The Merit Order Model And Its Connection To Electricity Prices For Power Purchase Agreements

Ostrom has Power Purchase Agreement (PPAs) with several wind and solar parks in Germany. The electricity demand that isn’t covered by these PPAs, is purchased by Ostrom on the spot market. You can read more about the differences between short and long-term power supply contracts here in our blog.

In the case of the PPAs with our partners, the price of electricity is fixed on a monthly basis. Therefore, the price is also dependent on the developments of the electricity market.