25.11.2022 | Merit Order: Priority to the cheapest power plants

Why natural gas drives up the price of electricity

The use of the most expensive power plant determines the price of electricity, not the cheapest. How can this be?

Electricity prices in European wholesale trading, where the prices for Switzerland are also made, have risen significantly since the middle of last year. There are many reasons for this. First, the Corona pandemic caused the demand for electricity to skyrocket, then there was a lack of production capacities due to power plant outages, especially in France.

In addition, the dry and hot summer literally heated up electricity prices: excessively high water temperatures led to problems with the cooling of nuclear power plants. Their output had to be reduced. The drought, in turn, caused water levels to drop, which had a negative impact on hydropower. 

Gas prices explode

And that's not all. When the price of natural gas rises, it drives up the price of electricity. The former has reached a record high in recent months. Insufficiently filled gas storage tanks, higher CO2 prices and the crisis on the gas market as a result of the Russian aggression have led to an unprecedented increase in the price of fossil fuel.

Currently, the situation has calmed down somewhat. Many countries have managed to fill their natural gas storage facilities, including Germany, a major consumer of Russian natural gas. Germany has the largest storage capacities for natural gas in the EU. In addition, our northern neighbour was able to partially replace Russian natural gas with supplies from Norway and the USA (liquefied natural gas). Nevertheless, the prices for natural gas remain at a historically high level.

Promotion of solar and wind power

But why does the price of natural gas push up the price of electricity, especially since natural gas is also used for electricity generation, but mostly for heating?

The answer lies in the so-called merit order. It regulates the order in which power plants feed their electricity into the grid. Priority is given to those power plants that show the highest economic efficiency (merit) on a marginal cost basis. Marginal costs are the costs for generating an additional megawatt hour of electricity, i.e. the variable costs such as those for fossil fuels and CO2 certificates.

Solar and wind power plants currently have the lowest marginal costs, because solar radiation or wind can be had for free. They are therefore the first to benefit. The promotion of these relatively young forms of renewable production is deliberate and was one of the goals for which the Merit Order was designed in the 1990s and introduced in the course of the EU-wide liberalisation of the energy markets. 

However, Europe's electricity needs cannot be met with solar and wind power alone. It needs electricity from nuclear and hydroelectric power plants. If there is a further demand, lignite and coal-fired power plants will be added. If that is still not enough - especially at peak times - gas-fired power plants are used. At present, however, they have to buy the fuel on the market at an extremely high price.

Most expensive supplier sets price for all

In practice, this gradual connection works smoothly. The electricity suppliers notify the electricity exchange for short-term trading (day ahead and intraday), the so-called spot market, of the quantities of electricity they want to sell and their marginal costs. The exchange system compares the supply according to the merit order with the demand received, based on marginal costs, so that the power plants can be switched on accordingly until the demand is met.

The electricity price is then determined by the most expensive supplier that is still taken into account. And now comes the crucial point: the most expensive supplier sets the price for the entire quantity of electricity required. So every power plant gets the same price for the amount it produces.

This is why the currently very high prices for natural gas are fully reflected in the exchange price for electricity - and why power plants that can generate electricity cheaply, such as solar and wind power plants, but also hydropower plants and nuclear power plants, are currently benefiting massively. Naturally, the lower their generation costs are below the market price, the greater the margin.

Proven system

The merit order system has worked well since the 1990s and ensures that demand is gradually met at the cheapest producer prices. At the same time, it promotes renewable energies and rewards the technologies that are cheap to operate, while keeping the more expensive power plants that can deliver electricity quickly and reliably in the market.

In the course of the current energy crisis, the EU states nevertheless decided at the end of September that the revenues of energy companies should be capped at 180 euros per megawatt hour. This primarily affects those who can generate electricity cheaply, such as solar, wind or nuclear power plants. The surplus is to be used to relieve citizens financially. However, they are not affected one-to-one and with a delay by the high electricity prices in European trade. More on electricity prices for end consumers can be found here. 

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