What is the merit order effect?

The merit order effect describes a core mechanism of electricity price formation on the wholesale market. It explains why the increased use of renewable energy sources such as wind and solar power can lead to lower exchange electricity prices. The basis is the so-called merit order, which refers to the sequence in which power plants are dispatched according to their variable costs.

What does merit order mean?‍

The term merit order describes the ranking according to which power plants are used to generate electricity. This order is determined by marginal costs, meaning the cost of producing one additional kilowatt-hour of electricity.

Typically, the order is as follows:

• Renewable energy sources such as wind and solar power (very low marginal costs)
• Run-of-river hydroelectric plants and nuclear power stations
• Lignite and hard coal power plants
• Gas- and oil-fired power plants (high marginal costs)

As demand increases, generation moves further along this order.

How does the merit order effect arise?‍

The merit order effect occurs when electricity from renewable sources is fed into the market. Since wind and solar power have almost no fuel costs, they are positioned at the very front of the merit order.

Their feed-in displaces more expensive power plants, especially gas- or oil-fired units, which are then used less frequently or not at all. Because the wholesale electricity price is set by the most expensive power plant still required to meet demand, the overall spot market price falls. Further details on how the merit order effect is calculated are summarised in an analysis by the Fraunhofer ISI.

Why does the merit order effect influence electricity prices?‍

The electricity market operates on the principle of a uniform market price. All dispatched power plants receive the price of the last, most expensive plant needed to meet demand. When this plant is replaced by cheaper generation, the market price falls for all participants.

As the share of renewable energy increases, the merit order effect therefore has a price-reducing impact. However, this effect is not uniform. Since wind and solar generation depend on weather conditions, their feed-in fluctuates significantly.

What impact does the merit order effect have on the electricity market?‍

The merit order effect has several structural consequences:

• Lower average wholesale electricity prices
• Increased price volatility in the electricity market
• Economic pressure on conventional power plants
• Stronger dependence of prices on weather conditions and demand

These effects are typical of electricity markets with a high share of renewable energy.

What are the limitations of the merit order effect?‍

Although the merit order effect lowers wholesale electricity prices, it does not automatically benefit all electricity customers. Grid charges, levies, taxes and long-term supply contracts can weaken or completely offset the effect.

In addition, the merit order effect does not replace structural measures needed to ensure security of supply and grid stability.

What criticism is directed at the merit order system?‍

In recent years, the merit order system has come under increasing criticism, particularly in the context of sharply rising energy prices. Critics argue that electricity prices for all market participants are determined by the most expensive power plant still required, often a gas-fired plant. As a result, high wholesale prices can occur even when a large share of electricity is generated at much lower cost from renewable or other inexpensive sources.

Especially during periods of high gas prices, this mechanism has fuelled the perception that electricity prices no longer reflect average generation costs. In political and energy policy debates, there is therefore discussion about whether and how the current market design should be adjusted to better align price signals with a generation mix dominated by renewable energy, without undermining the functioning of the electricity market.

The merit order effect is a fundamental mechanism of electricity price formation. It explains why renewable energy tends to lead to lower prices on markets such as the day-ahead market, while at the same time increasing price volatility and permanently changing the dynamics of the electricity market.