Why Is Merit Order Compatible With Antitrust Law?

Feb 10 2013 Published by under European and German energy law

The market design for wholesale electricity markets is broken. It doesn’t make any sense and needs to be changed.

With this post, I want to call attention to the relation of the “merit order” market design to antitrust law.

“Merit order” means that the most expensive generator in the market sets the price for everybody. “Most expensive” means “highest marginal cost”.

I have discussed this already with my post titled “The Weird World of Electricity Pricing” last November. Using an example from that post, here again is the basic idea of the “merit order” market:

Solar park A bids for 0.1 cents per kWh, since they have basically no marginal cost (the fuel is free). Gas turbine owner B bids for 5.3 cents per kWh, to reflect high gas prices. Assuming that B is the highest bid, everybody (including A) gets paid 5.3 cents.

Why is that not setting the price for solar energy at an artificial level, which is the definition for “market manipulation” under Regulation 1227/2011 on wholesale energy market integrity and transparency? The price for the solar energy is fixed disregarding completely what A has bid.

Market participants under a merit order market are supposed to pay their fixed costs with the difference between the merit order price and their bid. But those fixed costs are not related in any way to that difference. They could be higher, as with solar right now, or lower, as with coal or nuclear plants already paid for.

In the latter case, the generators get an extra windfall profit from this market design. It is exactly this kind of windfall profit from fixing prices at an artificially high level that usually is frowned upon by antitrust law. Why is there any reason to allow for an exception with the merit order market design? And why do all the people worried about price hikes coming from renewable energy don’t discuss this basic market design flaw, leading to ripping off consumers by the tune of billions?

Just to be clear, I think that the merit order market design needs to go anyway. It doesn’t make sense. But the fact that it is just about the opposite of what is happening under antitrust law in every other market is just one more reason to think about alternatives.

Imagine enterprises on any other market setting their prices uniformly based on the highest cost of any market participant. That would be a clear case of antitrust violation. I recall that the EU Commission has fined producers of power transformers EUR 67.6 million for a much less serious form of cartel.

 

4 responses so far

  • jmdesp says:

    I had intended to comment on your previous “Weird World of Electricity Pricing” blog earlier, but didn’t have the time.

    I don’t intend to look disrespectful but you’ve got a bit confused here. There’s nothing special in the energy market. It works exactly the same as any other free, auction market governed by supply and demand :
    http://en.wikipedia.org/wiki/Supply_and_demand

    As the wikipedia entry says “Under the assumption of perfect competition, supply is determined by marginal cost”. Here the marginal cost is the cost for the most expensive supplier, therefore yes, all suppliers who are able to produce at a price that is lower than the supply and demand fixed price obtain a high profit margin.

    This has been initially identified by economist Ricardo as the Ricardian Rent, because this is also what happens with agricultural production, every farmer gets the same price even the one who owns a very productive land that enables him to produce for much cheaper :
    http://en.wikipedia.org/wiki/David_Ricardo#Accumulation_of_Inequality_of_Distribution_of_varied_quantities_of_Accumulatable_Scarce_Necessary_Means_of_Production (read also what follows about Malthus’s criticism and the reference to Say’s law)

    The common alternative is to set a fixed price that allows each producer to get a fixed margin of profit. You have already identified previously the bad points of that other approach.

    In my opinion, if the market is broken that’s partly because of FIT, I know they enabled to build a lot of renewable power quickly, but this doesn’t remove the fact that, to have on the same market some power which price is fixed by supply and demand and some other that has a fixed price, inherently disrupt it. It’s also partly broken because a lot of capacity has been added whilst demand didn’t rise, which means that the electricity market is oversupplied. The last disruption is that actually if you split things hour by hour, sometimes wind/solar produce a lot, and the market is strongly oversupplied, but at some other time they don’t produce much, and the market is not oversupplied at all.

    In my engineer’s view, it was a mistake to build so much renewable capacity *before* building enough storage capacity and to have a much higher ability than there is now to balance the production with the demand. With more storage, this would allow the utilities to retire more production units, maintain a more balanced price, instead of exporting electricity at a very low price. I don’t believe they are really ripping off consumers, the market is so unstable and unbalanced currently, that they need a high price margin to maintain a stable profit, and not risk becoming unprofitable.

  • Karl-Friedrich Lenz says:

    Thank you for taking the time to comment. I appreciate that, especially since I am looking ahead right now to posting about how I would fix this broken market (I note that we agree that the present system is not working ideally).

    I will come back to address some of your points once I have written that post.

  • Karl-Friedrich Lenz says:

    Okay, I’m back from posting “One Price For Buying, Many For Selling”

    http://k.lenz.name/LB/?p=8772

    Now to your points. I agree that Wikipedia explains “supply and demand” in that way. That does not change any of my problems with the merit order market order. They are:

    The generator setting the price (the one with the highest marginal cost) gets paid zero for fixed cost. That can’t be sustained over the long run. Under present market conditions it makes sure that gas operators lose money, which is unfortunate for the climate, and doesn’t make any sense at all as a system to organize a market.

    Everybody else gets paid the difference between their marginal cost and the gas operator marginal cost, but that difference is completely unrelated to their fixed cost. This distorts the market to favor operators of nuclear plants already paid for. There may be different opinions on the advisability of favoring nuclear in this way. I am just observing that there is no rational reason to pay any operator much more than the sum of their fixed and marginal cost over an extended period of time.

    And the point of the particular post above was that while economic theory operates on “ideal markets”, in real life fixing only one price is illegal. If anybody else started running this kind of price fixing scheme, they would find themselves very quickly contemplating documents like the 2006 “method of setting fines” of the EU Commission

    http://ec.europa.eu/competition/antitrust/legislation/fines.html

    These fines run in the hundreds of millions of euros, as well they should. Violating antitrust law by fixing prices, eliminating competition, is a major rip-off on consumers. Pointing to the fact that economic theory requires one market price is not a defense against an antitrust charge.

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