Electricity market and pricing
Pricing on the wholesale electricity market depends on the generation and demand bids submitted by power plants and electricity traders. The power plants’ generation bids are ranked by “merit order”, i.e. in ascending order of price, based on the plants’ production cost for the last MWh of electricity generated. As per the merit order, power plants that produce electricity cost-effectively are the first to be brought online. After that, the plants with the next lowest generation bids are progressively added until the demand is met. Thus in liquid markets, the electricity price reflects the marginal costs of the last power plant in the merit order needed to meet demand.
In market systems in which renewable energy sources (RES) are added to the market via electricity exchanges, shifts within the merit order can be observed due to the growing share of RES feed-in. Since wind and solar are able to offer marginal costs of close to zero, plants offering costly peak load power are falling off the list of the plants available to cover demand. Only the residual load, which renewables are unable to cover, still needs to be compensated by conventional power. Note: Apart from the selection of power plants based on price alone, in some cases plants have to be included for the purpose of ensuring system security (e.g. for redispatch purposes).