The electricity market has not failed, it is working properly. So how is the price of electricity created?

Limit prices and the “merit order” principle

In the electricity markets, “limit prices” and the so-called “merit order” principle (explained below) confuse people down to heads of state.

Marginal prices mean that electricity prices are set according to the variable costs of the marginal facility, i.e. the most expensive power plant that is needed to satisfy demand (the so-called closing power plant). This is often illustrated using a “merit order” curve – a graph that shows the cost of generating electricity from existing power plants that are listed on the exchange.

So what does the “merit order” principle mean? In order to satisfy the demand for electricity, other sources are gradually connected to the system according to the level of their marginal costs. With increasing demand, it is always necessary to connect another more expensive source, while prices always depend on the most expensive source. The order in which individual power plants are switched on according to their financial demands is called the “merit order”. All producers receive and all consumers pay the same price.

Setting limit prices does not only apply to electricity markets

Commodity prices, like electricity prices, also depend on margin. Oil, gas, copper, milk, solar panels are all subject to price caps.

Let’s look at a simple example.

Two farmers grow wheat, one very modern and mechanized with low production costs of $2/kg, the other traditionally with a high proportion of expensive manual labor with costs of $10/kg. Both farms produce the same quality wheat. To meet demand, both must supply wheat to the market.

A more expensive farm will not sell below $10/kg, otherwise it would be unprofitable. A more efficient farm knows it can sell for $10/kg because that’s the price consumers will pay or they wouldn’t have the wheat. So why should it sell for less than $10/kg? He won’t either.

In other words, there will be a uniform price because the goods are the same, and this price will be determined by the marginal producer’s cost. The same goes for electricity.

In fact, the “merit order” curve is just another name for the supply curve, and the whole “merit ortel” principle is a de facto supply and demand model.

Limit pricing is not an artificial rule

Fixing marginal prices is not some administrative rule invented by a certain institution or person. It is not an arbitrary choice between different market pricing principles. On the contrary, it is the natural way in which prices arise in free markets.

If you want to get rid of cap pricing, you have to force people to change their behavior. They won’t do it voluntarily. If you want producers to sell electricity below the cap, you have to approve taxes, subsidies or enforce bans.

The “merit order” principle is descriptive

It is not a guide to how markets should work, but a description of how individual decisions lead to market outcomes. It is a description that tells us how prices arise as a result of decentralized decision-making. The “merit order” principle is thus descriptive, not prescriptive.

Electricity prices are not tied to gas prices in any way

Talk of “uncoupling” electricity prices from gas prices has led people to believe that there is some sort of law or rule that ties these prices together. It is not so. It is economic mechanisms, not regulation, that cause these prices to move hand in hand. By the way, this only applies under certain market conditions.

There is no single price, prices change every quarter of an hour

The fundamental difference between electricity and other commodities is that, unlike wheat, electricity cannot be stored. Therefore, the market price in the spot markets changes in a matter of minutes, and on a large scale. Let’s take the example of Germany:

  • Last Sunday at noon the price was €13/MWh.
  • On Monday morning, the price was €800/MWh

Reason? On Sunday, there was little demand and plenty of solar. So prices fluctuate, but the principles by which it is created at any given moment remain the same.

Margins are necessary to finance investments

Power plants left on the influence graph to the left of the final power plant receive a “contribution margin”. These margins are necessary to finance investments. From an economic point of view, profits arise if contribution margins exceed the amount required to cover investment costs.

In the long run, profits disappear

There is an extension of the “merit order” model called the “screening curve model” that shows how new investment reduces margins. At equilibrium, all electricity producers achieve margins that are just enough to pay for the investment over the life of the plant. In the current crisis, high prices are an incentive mechanism to attract new investment, on a large scale and with great speed.

Forward markets exist and matter

All of the above information relates to short-term spot markets. Wholesale electricity markets are much more complicated and include forward contracts, power purchase contracts and other long-term contracts. When we think about policy interventions, we need to consider long-term markets. The current crisis also highlights the need for longer-term contracts to protect consumers against price spikes.

The current crisis also highlights the need for more long-term contracts to protect consumers against price spikes.

Is the government fighting the energy crisis enough?

The electricity market is working perfectly fine

The electricity market, the mechanism that balances supply and demand, is operating normally. It works exactly as you’d expect it to with all-time high gas prices. What is wrong is not the market, but the result it produces. And that’s a heck of a difference. High prices are an existential threat to many households and businesses.


What needs to be done?

None of the above is to say that electricity markets produce the desired results. I don’t think that’s the case at the moment. Since March, I have therefore been advocating for measures that would mitigate the effects on the most vulnerable population groups. However, the claim that “this market system no longer works” is simply not true in my opinion.

Translated and taken from the Neon Neue Energieökonomik website with the permission of the author.

The article is in Czech

Tags: electricity market failed working properly price electricity created

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