Market dynamics
Article 4 of 20 · Energy markets and market dynamicsMerit order and marginal price formation: a guide for businesses
Direct answer
The merit order is the ranking of power plants by ascending marginal cost: cheapest sources such as solar, wind and nuclear first, then gas, until demand is met. The most expensive plant still needed to meet that demand sets the price for all electricity supplied. That single price is called the clearing price.
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Merit order and marginal price formation: scattered information versus Energy Intelligence
On the wholesale market, electricity is traded per hour or quarter-hour, including on the EPEX SPOT day-ahead market. Producers offer their capacity and buyers state their demand. Why does power cost almost nothing one day and a lot the next? The answer lies in the order in which plants are dispatched and in how the price is formed. For any company buying electricity, this mechanism explains the swings on the bill. This describes the Dutch market.
- Plants are dispatched from cheap to expensive; the lowest marginal costs come online first.
- The last, most expensive plant dispatched sets the clearing price that all producers receive for that hour.
- Abundant cheap solar and wind lowers the price; with little renewable output, gas is often price-setting.
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What is the merit order?
The merit order ranks all available plants by their marginal cost: the cost of producing one extra unit of electricity. Sources without fuel costs, such as solar and wind, sit at the front, alongside nuclear power that cannot easily ramp down. Gas plants follow, as they produce at a higher cost. The market dispatches these sources from cheap to expensive, until total demand is met. This is called economic dispatch: it produces electricity at the lowest possible total cost. The order shifts every hour, because solar and wind do not always deliver the same amount.
- Ranking by ascending marginal cost, from cheap to expensive.
- Solar and wind at the front due to their very low marginal costs.
- Gas plants follow later because fuel makes their output more expensive.
- Dispatch stops once demand is met.
- The order changes each hour with the supply of solar and wind.
How is the price formed?
On the market a supply curve and a demand curve meet. The supply curve is the merit order: from the cheapest plant to the most expensive. The intersection of supply and demand determines which plants run and at what price. The most expensive plant still needed to meet demand sets the price for everyone. All producers that were cheaper receive that same price. This is called marginal pricing, and the resulting price is the clearing price. Each bidding zone thus has one price per period. In the Netherlands this runs through the European day-ahead coupling, which sets a single price for each hour.
- Supply curve and demand curve intersect at the clearing price.
- The last, most expensive plant dispatched sets that price.
- Cheaper producers also receive the clearing price.
- One price applies per bidding zone per hour or quarter-hour.
- In the Netherlands that price is set via the European day-ahead coupling.
What does your business gain from this?
Understanding the merit order means understanding why the power price moves. On sunny or windy hours many cheap sources sit at the front, so the clearing price falls. When there is no wind and no sun, a gas plant is often the last source dispatched, and it sets the price higher. The price therefore largely follows the weather and the fuel cost of gas. That insight helps in planning consumption: shifting energy-intensive processes to cheap hours can pay off. Note the limits: this explains the wholesale price, not your final bill, which also includes grid costs and taxes.
- The price falls with abundant solar and wind, and rises when gas is price-setting.
- The wholesale price mainly follows the weather and the gas price.
- Shifting consumption to cheap hours can lower costs.
- The merit order explains the wholesale price, not the full final bill.
- Grid costs and taxes sit apart from this market mechanism.
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