Understanding power markets: Merit order and marginal pricing
Today’s electricity markets no longer reflect the real costs of building and operating today’s mix of generating capacity. What’s worse is that they have the potential to frustrate the net-zero transition.
In the UK, in common with many power markets in the industrial world, electricity prices follow the price of natural gas. As we are seeing in the current energy crisis, this is saddling consumers with sky-high bills. It is also generating windfall profits for existing renewable energy operators and nuclear plants.
This is leading many – including policymakers and regulators – to question the structure of wholesale energy markets, and to call for their reform. Power markets in the UK and other countries need to be overhauled if we are to successfully decarbonise our electricity supply. First, however, it is important to understand how they currently work.
Pricing at the margin
Electricity is hard to store; supply and demand need to be physically balanced at all times. This can be done (well) by a centralised administrative system but, in common with many other markets around the world, power price formation in the UK market is based on marginal pricing. Each generator is required to bid in the price it will accept to generate power for each 30-minute interval (in some other markets, this time band is different) throughout the day.
These bids are based on the operating costs that each generator faces, taking into account the costs of starting up or shutting down generation. Wind and solar plants tend to have the lowest operating costs, followed by nuclear power plants, while natural gas-fired plants typically have the highest operating costs – and certainly do so given current gas prices.
The prices bid in by the various generators form what is known as the merit order. This is a theoretical stack of generating capacity, from cheapest to most expensive, that is available to supply power during each 30-minute increment.