Electricity market price pool

The merit order effect: how renewables enter electricity markets

Recently the role of the “merit order effect” in the National Electricity Market (NEM) has been discussed in a number of articles about renewable energy.

Since most people know little about the electricity market, this article will explain how this effect works to the benefit of renewable energy in the current electricity market system.

I’ll follow up tomorrow with a survey of current discussion around whether the electricity market as it currently exists is really working, and outline some of the strains that are being placed on it by the entrance of renewables.

Edit 22/12/2011: The followup article is now available here.

Background: electricity privatisation

Author Sharon Beder, in her 2003 book Power Play, related the increased pollution resulting from the greater use of Victoria’s brown coal power stations, following privatisation in the 1990s and the setting up of the NEM.

Beder wrote:

“The amount of electricity generated by brown coal plants, the most polluting in terms of greenhouse gases and other emissions, has increased from about 23 per cent to 31 per cent of sources since 1992. The increasing dependence on brown coal is because deregulation causes companies to seek the cheapest source of electricity with no consideration for environmental impacts. Brown coal is cheap, and dirty, old brown coal plants that have paid off their loans can produce electricity at low marginal costs.

“A report commissioned by electricity distributor Origin Energy found that this meant that Victorian brown coal plants had, to a certain extent, displaced the cleaner NSW black coal plants and SA gas plants in electricity generation. Even outside Victoria baseload electricity tends to be generated by old coal plants rather than the newer gas-fired plants that emit less carbon dioxide. The latter tend to be used for peak loads because marginal costs are higher.”

“Low marginal costs” means that they don’t have large up-front costs when they generate electricity. Brown coal is very cheap to obtain, it does not (yet) trade on the international market.

But now, renewables are entering into the market and have virtually zero marginal cost, so they can bid into the market pretty well as low as they like. By entering into the spot market (“price pool”) at the low end, they displace generators who bid in at high prices, typically gas peaking plants.

The price pool: how it works

To illustrate the price pool, which is typical of how electricity markets around the world operate, I’ve produced two charts. It should be made clear that these charts are simply an abstract representation to illustrate my point.

The first is to explain the price pool, how prices are determined for any given period of electricity generation.

Electricity market price pool

In the electricity market, the generators bid to sell a certain amount of power for each block of time throughout the day, each block being a period of 5 minutes. If you’re keen, you can look at current NEM spot market data here.

They bid to sell a certain amount, at a stated price. The NEM operator then calculates how much energy will be needed, and allocates the bids starting with the cheapest, until the projected demand is met.

The price received for the generators who find their bid accepted is not the price they each bid, but the price of the highest bidder who was accepted for that block of time. Any higher bids, that are not found to be needed, do not sell their energy for that time period.

In this system, the coal powered generators tend to bid in low because they can’t just switch off like gas turbines can, and their fuel is relatively cheap (especially brown coal). It’s the gas power stations that bid higher, and when they are used will raise the pool price for that period.

In fact, many gas plants are only used infrequently for high peak demand loads when a lot of electricity is required to run aircon on hot days. Some peaking gas plants may run as low as 5% of their capacity, averaged over the year, as Mark Diesendorf pointed out in his 2007 book “Greenhouse Solutions with Sustainable Energy”. They make up for this low capacity utilisation by charging high prices when they do come online.

Here’s a second chart, illustrating what can potentially happen when a significant amount of renewable energy enters the grid, such as from wind farms:

Renewables in the electricity price pool
As you can see, in this case, the amount of wind power would bring down the price. Wind farm owners have no interest in holding out for a better price: if the wind is blowing, they might as well sell the electricity they generate, so it bids cheap.

The South Australian example

You don’t have to go to Denmark or Spain to register that wind farms are having a large positive impact on electricity supply. South Australia now get 20% of their electricity from wind farms. Wholesale electricity prices in SA are at their lowest since the market began. The following graph was presented in a draft AEMO report, “2011 South Australian supply and demand outlook” (draft, March 2011).

South Australian energy use to 2011
What we can see is that SA’s coal and gas are staying roughly the same, but the import of Victoria’s 85% brown coal electricity (dark blue), has dropped in almost inverse proportion to the share of wind power (light blue).

Over the same period, despite an increase in annual electricity use, carbon emissions declined from 9.8 million tonnes CO2e to 8Mt.

The anti-wind power brigade tell us that for every wind farm, you need to build an open-cycle (peaker) gas power station to back it up for when the wind isn’t blowing. In fact, the amount of gas power built in this time is only proportionate to the growth in peak demand; it is still roughly the same percentage of overall capacity.

The obvious conclusion is that renewable energy works: it delivers clean energy as it’s supposed to, and has a bonus on energy prices.

Prices have indeed been rising across Australia, due to the need to replace ageing infrastructure (power poles and lines, for example); also due to rising peak demand spikes. But the subsidies to renewable energy make up a tiny fraction of the overall price increase, and if renewables reduce wholesale prices nationwide then this could well outweigh the investment in subsidising them.

To conclude this section, here is one illustration of peak prices jacking up the overall wholesale cost, the following graph is from the Zero Carbon Australia 2020 stationary energy plan:

Electricity market volatility
Stand by for part two of this tomorrow, where we will look at some of the implications of this system for the rollout of renewables!

7 thoughts on “The merit order effect: how renewables enter electricity markets

  1. Great analysis.

    One of the unintended consequences of injecting wind into the generation mix is that it forces out gas, not coal. Coal, of course, is more polluting and produces twice as much CO2.

    This can be solved by putting a carbon tax on coal and gas. This is essentially what happened in Ontario, Canada. You can find more details at:


    Has anyone ever figured out what a market based system would look like with zero fuel costs? A number of jurisdictions are approaching that if they have plenty of renewable energy sources (typically hydro).

    1. Forcing out gas instead of coal is probably a perverse outcome; and yes, carbon pricing could well mitigate that. A lot of the debate around gas among Australian renewable energy advocates is centred around new gas plants; we would rather renewables. I have included this (and a reference to your comment) in today’s followup article.

      I imagine a market could theoretically operate with renewables, withzero fuel costs; I guess the competition would be centred around energy storage and despatchability in order to complement inflexible generators like wind and solar PV. The big challenge is how do you get from the current setup to that system without chaos in the meantime; hopefully today’s article at least sets out the issues, I don’t think I have all the answers!

  2. Thanks for explaining the makeup of the pricing model Ben, and also how wind power can have the impact of lowering overall price of electricity.
    When replacement plant cost, carbon pricing along with other legacy impacts are fully implemented (the proper way to look at long term energy costs in my view), we will then realise the real impact of major shifts in decisions we make today for future energy mixes.
    The cost of renewables continues to decline in real terms, and the technology options for wind and solar look very attractive.

  3. This is a very real effect and the biggest result is a transfer of ‘super profits’ from old generators with written off capital costs, to electricity consumers.

    When price goes up due to high cost marginal generators kicking in (usually gas peaking plant), all the low cost generators with written-off capital make bumper profits.

    Electricity consumers should be lobbying to make sure the Renewable Energy Target stays in! – It will subdue electricity price rises.

  4. Further to this, also take a look at a paper Windlab put together that reviews AEMO data on South Australia:
    It was found that C02 emissions reduced compared with business as usual because of 3 reasons:
    1. direct replacement of conventional generation with wind saved 1.6 million tonnes of CO2 emissions
    2. the emissions intensity of fossil fuel generators in Australia improved saving 0.6 million tonnes
    3. the use of lower emissions South Australian energy rather than higher emissions Victorian energy saved a further 0.3 million tonnes.

    (total emissions intensity down by 23%).

    Another interesting fact is that although 200MW extra peaking plant was added over 5 years, the electricity generated from them decreased from 501GWh to 325GWh. So the higher emissions peaking plants were used less often (not sure if this is directly related to more wind in the system).

    To summarise, wind does not necessarily displace high efficiency gas first. In South Australia the high emitters, coal from Victoria and gas peakers, have declined in response to the greater amount of wind.

    A great result – lets have more of it!

  5. Wind did receive less money for there energy than other forms of generation but when it comes to the final price paid by consumers , you must include any subsidies for wind ( Recs etc) in the final consumer price .

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