The merit-order effect and the coupling of electricity and gas prices

What are the trends in energy prices to date?

Concerns about a reduction in gas supplies from Russia have driven gas prices in Germany higher and higher. Power stations paid nearly 227.0 per cent more for natural gas in June 2022 than in June 2021. The price of natural gas was 182.6 per cent higher for industrial buyers and 159.5 per cent higher for retail traders. Likewise, gas bills have trebled for many consumers. Alongside the rapid increase in prices on the gas market, electricity prices have also risen at the same time. For instance, prices on the European Power Exchange (EEX) in Leipzig are constantly breaking new records (August 2022). Within a year, the price has increased more than tenfold, having risen from €50 to €565 per megawatt hour (MWh). Consumers are also feeling the effects. The average price they paid for electricity in August 2022 was €0.42 per kilowatt hour (KWh), with this price set to rise in future.

But why does the price of electricity go up when the price of gas rises?

The reason for this is the merit order, which determines the order in which power plants can bid on the power exchange. The merit order is not a regulation. Instead, it is a model that describes how the deployment of power plants in Europe is regulated based on power market demand at 12 noon the next day. The basic principle is to first call on power plants that produce electricity more cheaply to deliver power. If there is sufficient demand, plants that produce at a higher price are also called on. This step is taken when the low-cost electricity produced by wind and solar plants or hydropower plants is no longer sufficient to meet demand. Other power plants, such as nuclear, lignite and gas/coal-fired plants, are called on one by one down to the most expensive and/or last plant in ascending order, that is, the marginal power plant. At the moment, those are primarily gas-fired power stations. The total premium increases accordingly. This is based on the most expensive power plant, which determines the marginal cost, or the additional costs incurred due to an increase in the amount of power produced. As a result, major spikes in the price of gas are immediately reflected in higher electricity prices. Meanwhile, wind and solar plants that generate electricity at a cheaper price can expect additional profits.

Here is a simple example

Let us assume that customers register demand of 80 gigawatts (GW) that cannot be met by renewable energy, hydroelectric power, nuclear power and lignite-based power, in ascending order. In this example, coal-based power, with a marginal cost price of €250 per MWh, is needed to meet demand. The power sold at auction the next day then costs €250 per MWh. If demand continues to rise to 100 GW, meaning that gas-fired power plants, whose marginal cost price is €500 per MWh, must also be brought online, then electricity will cost €500 per MWh the next day, regardless of where it is sourced. Because electricity is priced uniformly and because gas-fired power plants – the highest-cost energy producers – are primarily connected to the grid at the moment, the high cost of gas is leading to rising prices on the electricity market.

Does that not seem unfair to consumers? What do policymakers have planned to rectify the situation?

The fact that electricity producers are raking in millions in profits as a result of the merit-order model is great for the economy, but not for end consumers since the rising cost of electricity is being passed on to them in the form of higher prices. The German government is currently not intervening in this pricing mechanism. As a result, companies who operate renewable plants, nuclear power stations and coal-fired plants are in some cases generating huge profits. On 26 August 2022, however, Federal Minister of Economics Robert Habeck announced plans to reform the electricity market, with the aim of decoupling the price consumers pay for electricity from the rising price of gas. This is intended as a medium-term measure. The goal is for consumers as well as industry to benefit greater from the fact that renewables are produced at such a low cost and have this reflected in their electricity bills. To achieve this, excess profits generated on the electricity market owing to the merit order for power plants with very low production costs will be addressed. However, it was also indicated that the merit order should remain in place, and changes would only be made to address problematic effects for electricity customers. Given the complexity of these reforms, one is looking towards a medium-term planning horizon, since this would require the involvement of European partners and an engagement at the European level. In the short term, an excess profits tax, along with prompt relief for consumers and programs to aid the economy, would remain the focus of efforts in this area.

Consumers should be prepared to wait

The coupling of gas and electricity, all-time record prices, the excessive profits of electricity producers who benefit from the merit-order model and, last but not least, the households and industries who have to foot the bill for rising electricity prices are all talking points in the dynamic debate on pricing and the merit order on European power markets. The German government is party to the discussion, though it has regrettably not come forward with any firm or concrete measures. That is why there is only thing that consumers can do: hope for short-term relief and wait until the planned reforms for decoupling the price of gas and electricity are fully fleshed out. We will keep you posted with all the latest updates.

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