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11 Jan 2022
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Quantifying the UK Merit Order Effect

Unlike thermal generation, such as coal or gas, renewables have no fuel costs. This means that when generators are bidding to sell their power, renewables can do so at a much lower price than almost any other fuel type. In turn this displaces more expensive thermal generation and means that the overall price at which the market clears ends up being lower than it would have without renewables, this is often coined the Merit Order Effect (MOE) and is shown visually in figure 1a.

Figure 1: a) Reduction in market-clearing price with increased renewable generation. b) Fitted supply curve from observed price and fuel generation.

FEA has carried out analysis whereby the supply stack of non-renewable generation has been approximated for every settlement period within the day-ahead market (example fit shown in figure 1b), we have then used this to calculate the price reduction caused by renewables for each half-hour over the last decade. The results can be seen in figure 2 and show that the MOE has grown with renewable capacity, with the long-term trend averaging £9/MWh at the start of 2020.

Figure 2 - Rising MOE over the 2010’s

For consumers on variable tariffs, this is great news - they can maximise their consumption when electricity is both green and cheap - for the majority though the benefits are more nuanced. Because thermal generators are being displaced from the supply stack they try and raise revenues through other methods, primarily by increasing the price that they will supply at when there is no choice but to source power from them (high demand/low renewable periods). For these reasons it is not possible to directly translate the MOE to medium/long-term savings, instead it should be viewed only as an effect seen within individual electricity trading settlement periods.

Renewable generators though should be aware of the MOE for less positive reasons as it represents a reduction on their profits, the higher penetration they reach on the grid the lower their revenues become. This is often referred to as price cannibilisation and is worse for renewable generators whose generation is highly correlated with the national fleet.

Figure 3 - Falling clearing prices for CfD auctions.

It is in part for this reason that the new Dogger Bank wind farm developments (3.6 GW total capacity) are sited almost 300km from the coast, their large distance from other farms helps mitigate against price cannibilisation. The threat of lower revenues relative to receiving the average market price also helps explain why the latest Contracts for Difference (CfD) auctions cleared so low (figure 3), as it guarantees a fixed price they will receive which won’t be subject to any cannibilisation risks. For the government though this may lead to higher subsidy pay-outs than were previously expected.

Ayrton Bourn
FEA Non-Executive Director
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