The merit order is a way of ranking electricity-producing power plants based on ascending order of price. The aim is to ensure the economically ideal power supply. The power stations, which continuously produce electricity at very low prices, are first switched to feed-in according to the merit order. Thereafter, long-term power plants with higher marginal costs are increased until the demand is covered.
The merit order as basis for the day ahead market mechanism
Power exchange markets are operated by a middleman, to whom generators and consumers submit their bids. In Italy, the intermediate party for both the day-ahead (MPG) and the intraday market (MI) is Gestore Mercati Energetici (GME). For every hour the generation bids are aggregated to one supply curve. Renewables have a very low marginal cost (sun and wind are for free) and are therefore found at the bottom of the curve. Nuclear has also a low running cost and follows in the ranking. For low (or non-existing) carbon permit prices, the running costs of a coal plant are typically lower than those of a combined cycle gas plant (CCGT, also known as STAG plant). Peak plants, which are meant to cover rare peaks in demand (for example on a cold winter day) are often diesel or gasoline fueled and therefore have the highest running cost. An illustration of the merit order curve is given in the figure below.
The market operator will also aggregate the demand bids to form the demand curve. The intersection of the demand and the supply curve determines the clearing price and the clearing volume. All market participants who sell energy will receive this clearing price for the electricity they inject in the grid. Equally, the market participants who take off electricity will all pay that same clearing price.
When analyzing the merit order curve, one will notice that an increase in renewable energy bids will drive down the clearing price (for the same demand curve) and push the more expensive units out of the market. This is the reason, why wholesale market prices in most of Europe’s major electricity wholesale markets have been decreasing strongly since the beginning of the so-called Energiewende, the transition towards renewable generation. Despite an increase in consumer prices for both households and industry, also in Italy the wholesale prices have been constantly decreasing since 2012. The reason, why this is not reflected in lower electricity bills for the end-consumer is that the energy component is only one third of the bill. The other two thirds consist of taxes, levies and distribution tariffs.