There are a lot of things I don’t know about the merit order used in electricity markets right now. For example, I don’t know what exactly is the legal basis for that. I don’t know who gets to apply this merit order. I don’t know the history of this particular market design. I don’t know how it relates to economic theories.
I intend to find out more about these matters. But that will not stop me from sketching my idea on how the electricity market should be organized instead. That idea may be completely worthless. But it is probably somewhat more realistic than the idea to use “photovoltaic strips to harness the energy coming off the planet” to solve global warming, which I blogged about earlier today. It is worth at least writing down for further reference later on.
I will use three sellers in a simple model. Solar park A will bid 1000 MWh at EUR 1 per MWh (0.1 cents per kWh), since they have marginal cost close to zero. Coal plant B will also bid 1000 MWh at EUR 38 (3.8 cents per kWH), and gas turbine operator C will bid another 1000 MWh at EUR 53 (5.3 cents per kWh).
Let’s assume that there are ten buyers on the market (D, E, F, G, H, I, J, K, L and M), and they all buy 300 MWh.
What happens under the present merit order system is that they all pay EUR 15,900, and every seller gets paid EUR 53,000.
That leaves A with EUR 52,000 over their bid in income, B with EUR 15,000 over their bid, and C with zero. That means C is expected to cover fixed costs with zero income, which can not work over the long run. B may make a profit if fixed costs are lower than the 15,000, and A will still be unable to cover fixed costs with the 52,000 (I am talking about solar in Germany, where 5.3 cents euro are not yet achievable).
Now, here is how I would like to see the market operate. I will call this model “modified merit order” for the time being, until I come up with a better name.
For starters, every seller would bid whatever they need to cover their marginal cost plus their fixed cost. I would get rid of the idea of bidding prices that are sustainable only under the assumption that the clearing price will be higher because of some other bid by some third seller that may or may not happen.
So in my modified market order, solar park A would bid 1,000 MWh at EUR 110 (11 cents per kWh), gas turbine operator C would bid 1,000 MWh at EUR 63 (I assume fixed cost of 1 cent per kWh, which may be wrong, but that is not important for this theoretical model). Assuming the same fixed cost of 1 cent per kWh for coal, B would bid 1,000 MWh at EUR 48.
Adding up all those prices I would get EUR 110,000 for A, another EUR 48,000 for B, and finally EUR 63,000 for C, for a grand total of EUR 221,000 for those 3,000 MWh. Then I would divide that by the amount of electricity in the market, for a clearing price of EUR 73.7 per MWh.
All ten buyers would pay 300 times that, which happens to be EUR 22,100.
So there are basically two changes to the present merit order system: For one, everybody would bid their actual cost, and stop bidding based on marginal cost. Marginal cost is a completely artificial way of setting prices. Any system based on marginal cost only has no chance of making any sense in the long run.
The other is that every seller gets paid exactly what they bid, and not some different price based on what other market participants do or don’t do.
Just as before, every buyer gets the same price.
Obviously, this can only be done if the market exchange works as a central counter party.
There is one more modification necessary to make this work with renewable energy sources that are currently still too costly to compete in that system.
That is priority for renewable never mind the price. That is exactly what the German Law on Priority for Renewable Energy requires in its Article 8. However, sellers would be limited by law on the highest price they can ask. For example, if the feed-in tariff for a big solar installation is at 11 cents (as it will be in Germany from April on), they will always have a guarantee that they can sell their electricity at cost plus profit with priority (at least as long as the renewable share is still under 50 percent), but they can’t start bidding 30 cents.
If you organize the market in this way, obviously wholesale prices are going to go up. But on the other hand, there will be no more surcharges. Both effects should just about cancel out. Changing the market design in this way is without influence on the cost of renewable energy, it is just a question on how to distribute the burden.
Okay, I am over 800 words now. Time to wrap this up for the moment. I think the basic idea should be clear by now. I will leave it for later posts to discuss the various merits and problems of this proposal.