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The merit order effect – actually, it’s a good thing

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The Merit Order Effect, put simply, means lower electricity bills for consumers. That’s because it means lower-cost electricity in the wholesale market when additional renewables are introduced into the mix.

The effect has been demonstrated in Germany, where they have very significant deployments of renewables. The German government has identified that consumers saved €840 million in 2010 thanks to renewable induced Merit Order Effect.

These savings that can occur on the electricity market are thanks to renewables; they make our bills cheaper and can partially or fully offset the cost of funding renewables through feed-in tariffs or other renewable promotion schemes. In Germany, where the government started a significant deployment of renewables 10 years ago, the cost of funding those early deployments was, of course, higher; so the Merit Order Effect in the German case just reduced the overall cost to consumers of the shift, but did not deliver a net dividend through absolute lower electricity bills.

In Australia, where we do not have a significant deployment of renewable technology as yet, we are fortunate enough to benefit from the heavy lifting that Germany has done in getting renewables significantly down the technology development and cost curve. Therefore we are able to benefit from Germany’s Merit Order Effect in our market – but to enable this we require significantly lower renewable incentives which cost less.

At this point in time, on the downward drive towards grid (retail and wholesale) parity, the benefit from deployments of renewables such as solar photovoltaic and wind in Australia is clearly available to all as lower-cost bills.

Pushback

Protectors of the status quo have reacted, initially, by denying the Merit Order Effect. It is hard to run this line when the German government recognises and actively publishes data on pass-through costs to consumers of their renewables progams. They publish both the cost of funding each renewable technology and the resultant Merit Order Effect. In Australia, a team based at UNSW has looked at the Merit Order Effect from wind power.

The energy industry actually notes what is occurring with the merit order and has been watching it for years to figure out the timing for new power plants. In fact, brown coal generators in Victoria have even gone so far as to claim that the Merit Order Effect associated with the Victorian Renewable Energy Target would reduce wholesale prices too far and effect their business plans, and have been lobbying for it to be recoiled.

The next stage of the pushback has been to claim that the effect is too hard to quantify. This argument has now been blown out of the water, with recent work by ROAM consulting confirming earlier work of the University of Melbourne Energy Research Institute, showing significant Merit Order Effect for the first few gigawatts of solar installed on the grid (Australia currently has 1400MW approx); and then a sustained and significant Merit Order Effect out well past 5GW of solar. (Similar studies need to be carried out for technologies other than solar PV, such as wind and solar thermal with storage, to complete the picture for what renewables can achieve in reducing our energy bills.)

The next argument was based on contracted power: that 70-80 per cent of electricity in the wholesale market (known as base or black power) is contracted and therefore the electricity generators only see a secure constant rate of revenue, and therefore retailers or third parties holding those hedge contracts see the benefits and generators/retailers can’t pass that on. The point, here, is that contracts are based on using the past to predict the future. Once a counterparty sees a change in the wholesale electricity market that is semi-permanent or permanent, they will recontract with that in mind. They are not going to buy the rights to market the power from a baseload plant for a price that is higher than what they can onsell those rights for.

Many of these contracts run for three or five years, with a select amount running much longer. After three-to-five years all, of the existing contracts wash out in the subsequent contract renegotiation phase and the savings from Merit Order Effect are passed through to price conscious consumers. If the large vertically-integrated power producers/retailers fail to pass on the savings from the Merit Order Effect, then independent power retailers can buy directly off the spot market, undercut them and steal away their market share. This is the check and balance that keeps the price that is passed through to consumers inline with the new (merit order effected) reality actually occurring in the wholesale market.

What we know about the Merit Order Effect is that it has the biggest impact in the first tranche of installs. In Australia, that’s around 3,000MW of photovoltaic (Germany has 30,000MW today, for comparison) Then it sustains at a slightly lower level; this is mostly because transmission constraints on the NEM are effectively removed at this penetration of PV.

We then know that, while the Merit Order Effect decreases as the deployment continues, so does the cost of renewables, therefore we can value renewables based on a lower MOE and still justify financing based on wholesale market savings and giving a net benefit to all electricity consumers.

So what does the Merit Order Effect look like to a trader watching the National Electricity Market? On a mild workday, houses do not heat up or cool down significantly, therefore there is not much in the way of heating or cooling load in the residential sector. If the day is mild enough, without being cold, then the cooling load is very low in commercial buildings also; it’s a quiet and uneventful kind of day on the National Electricity Market for traders, where prices are relatively low in the spot market.

Then there is the mid price day. In this case, prices ratchet towards $300MWh in the mid-to-late afternoon; it’s a bit warmer and there’s almost a bit of excitement on the trading floors.

Finally there is the high price day, where the price is well above $300MWh and could be as high as $1000, $5000 or $12,500MWh. Much of the money being made in the electricity market is due to the mid- and high-price days. That’s where the supply headroom narrows as demand increases, sending prices northwards.

The one thing that is often misunderstood about the effect of this phenomenon is that it’s not just the hydro dams or gas peakers that might be used less than 1 per cent, or as much as 5 per cent, of the hours of the year that are making money during these events. The biggest beneficiaries of these high price events are the large coal guys who, despite the all too common chest drumming about their ability to supply at $30, $40 or $50 a MWh, get repriced to the same price as the last unit who bid into the market, and that is often one of those very expensive peaker plants in the thousands-of-dollars a Megawatt hour.

Then, along comes PV, introduced on the back of feed-in tariffs. It’s production is timed according to a paper by the University of Melbourne Energy Research Institute to correlate with 85 per cent of these mid- and high-price events that occur in the National Electricity Market. And how does it look to an energy trader? Without the PV it would be choppy, volatile and prices would be high. With rooftop solar, the “negative demand” created would make the national electricity market look like it’s having just another mild, quiet boring day.

But what about gas peakers and other plants primarily selling capacity to meet that other 15 per cent of demand? While there isn’t much they can do about the 85 per cent reduction in times, they will still be needed. If they were over capitalised, and couldn’t produce at the adjusted Merit Order Effected market rate, then they would have to renegotiate finance with their bankers. If they couldn’t afford their gas contract, then they might have to pass up renewing their gas contract and shift the plant over to running kerosene. Imagine a petrol station-sized site, with a petrol station-worth of kerosene; this is what would run the plant in the new 15 per cent of runtime paradigm.

And for new build to meet the 15 per cent of peaks that solar isn’t meeting; well, if required, they’d be kerosene also with onsite fuel storage, and they’d be much cheaper capital options to build than today’s peakers that contract gas. They will also have many more options to locate geographically, given that they no longer need to be near the gas grid as well as the electricity grid.

The most recent argument against valuing the Merit Order Effect has been coming from lobbyists, who say that it is transitory in nature. This is not the experience in Germany, where it has been recognised for the past seven years by researchers and communicated by the Federal Ministry of Environment, Conservation and Nuclear Safety.

In Australia, we’d see the same outcome. For the transitory hypothesis to be correct, the wholesale spot market must catch up to where it was prior to the solar-induced Merit Order Effect, so that new build plants can be profitable. This would require a growing demand to eat away at surplus supply headroom. But not only is our overall annual demand going down, peaking at 210TWh in 2007 and falling to 194TWh this year, but the growth in peaks is disappearing in all states except Queensland. Beyond Zero Emissions internal analysis predicts that Queensland will plateau this year or next, meaning there will be no growing peak in that market either.

In addition to this growth, so that supply headroom gets eroded, the new plant being installed would have to be the high-cost gas-contracted plant. But this option was only used when there were the equivalent 100 per cent of events that we used to have on the market, pre rooftop PV days.

Under the new MOE, solar paradigm grid of the future, those events have reduced by 85 per cent, and therefore the cheaper diesel/kerosene option is the choice amongst financiers for any new generators, if required. In terms of annual volume, any increase would have to be at a rate that is faster than the introduction of more production through the installation of more solar capacity. However, as stated before, we’re not seeing an increase, but a demand decline which is, in addition to the annual negative demand, induced by the 1400MW of solar installed to date.

And finally, by 2016, A123 systems, a lithium Ion battery manufacturer backed by cost figures from Nissan shows that chemical electrical battery storage will be available at around $190 a watt. A123 system says that in 2016, LiON batteries will be cost competitive with gas peakers. We all heard about the end of baseload from Grant King of Origin, but now we have the end of the gas peaker, with cheaper advanced battery technology. Just like Solar PV plants with an industry that can quickly mobilise, storage is a technology that requires no permitting, and with that inertia advantage we may never see another gas peaker built in Australia post 2016.

Recently, at a forum, AGL said Australia’s National Electricity Market was one of the most volatile markets in the world, and that any economist would tell you that high volatility markets are, unfortunately, bad for consumers. AGL economists are now preparing to publish a report on the value of the Merit Order Effect to consumers. The main line – and one that I agree with – is that the Merit Order Effect causes a wealth transfer from generators to ordinary consumers like myself, as well as large industrial consumers like aluminium smelters. Is that a problem?

What I do not agree with is the claim in AGL’s upcoming paper that future conventional (seemingly fossil fuel-based or peaker plants) will be rendered more expensive when the market catches up (the lag from a Merit Order Effected market to when new assets are needed). I do not agree on the basis that there is no evidence that the market is growing in base or peak. Future base power will be met by renewables (wind and PV) and any firming power will be met by batteries, or if it is conventional plant, then much cheaper diesel/kerosene peakers that are used far less frequently. The likelihood is for load shifting, as artificial midnight loads are moved to solar production times in the middle of the day. And then there’s the fact that we will not need those conventional plants, as there will be no social license for them in the future.

All that said, AGL is was right on that point, and Australian governments need to do something to reign in wholesale electricity market volatility and the answer can be found with Solar PV backed by a Feed-in tariff we have that opportunity to realise this future at a net saving on bills to consumers. The Merit Order Effect guarantees that savings in introducing renewables give us a smooth transition to a renewable powered future.

Would the market correct itself?

Point 1: This would require increasing demand or increasing peak demand.

Point 2: Even if increased demand occurred without renewables being able to supply it there is a lot of headroom in the system. In 2007, we consumed 210TWh, while in 2013/14 we are expected to consume just 194TWh. Furthermore, if there is a growth in peak demand (which I would argue – and AEMO figures are backing this up – there isn’t, even Queensland is peaking in its growth of peak demand) then because of the number of hours being significantly reduced when the peak demand occurs a different kind of cheaper power plants will.

Matthew Wright is Executive Director of the climate and energy security think-tank Beyond Zero Emissions http://beyondzeroemissions.org

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  • Chris Cooper

    “any firming power will be met by batteries, or if it is conventional plant, then much cheaper diesel/kerosene peakers that are used far less frequently ”

    Good point about avoiding the need for expanding the need peak generation capacity. But what about the whole raft of options available today which are cheaper and even more beneficial to consumers than those you’ve mentioned.

    Options such as distributed PV, energy efficiency, demand response and residential smart meters with critical peak pricing and A/C load control (assuming tariffs structures are appropriately designed to benefit the ‘average’ household) are much cheaper and greener than the options you’ve mentioned and are consistently overlooked by many in the debate surrounding energy prices/bills.

    • http://beyondzeroemissions.org Matthew Wright

      Hi Chris,

      Thanks for your contribution. I agree with the propositions you have put forward as being the most economic way to handle peak capacity on the grid. However I was putting forward what would happen in a very simple world if the people running the electricity system stuck to their myopic view and that the one variable that changed was the addition of Solar Photovoltaic creating merit-order-effect.

      What Solar PV alone does not cater for is a considerable peak of peaks at 7PM. Combined with some load shifting then it certainly does. And the option that I did mention in what was already a very long article was batteries coming into grid parity. (this market may start with a small system say 3-5kWh. My home system 5kW inverter grid-tie with battery backup is currently 9.5kWh which I installed at considerable expense back in 2001)

  • Tim Buckley

    Matthew
    Well put – keep banging the drum on the Merit Order Effect please. Germany proves your point, and one day the Australian government will require the AEMO to act in the interests of Australian electricity consumers by supporting solar and wind.
    It will then be interesting to see how viable Origin, TRUenergy and AGL’s current push into gas peaking plants will look by 2016. Stranded fossil fuel assets would be my guess. And they will probably then turn to the government looking for a handout to close them.
    As to Chris’ point, bring on the Merit Order Effect, plus smart residential meters, tighter energy efficiency measures, Demand Response Management and Time of Use pricing (so customers are rewarded to voluntarily curtail A/C use). We need all of the above to cost-effectively decarbonise the Australian economy.
    Tim Buckley, Arkx Investment Management

  • Chris Fraser

    Very well explained Matthew. I am glad that perhaps, maybe, batteries could figure in a future ZCA2030 Plan. Though i was sort of hoping you meant that chemical storage would come down to $190/kWh in 2016.

    • http://beyondzeroemissions.org Matthew Wright

      Chris, there is a possibility that batteries could hit $190 kWh in 2016 and this is being forecast by the likes of Nissan and A123 systems.

  • Frank

    A request:

    Could someone please give a tutorial on how the NEM works?
    Thanks

    Frank

  • Rob

    Nice article. Can you please clarify the battery comment. Do you mean $190/kWh? And would this this a theoretical but practically inaccessible 100% discharge kWh rating? This might be a bit too technical, but can you point to any cycle life versus depth of discharge for these particular batteries you refer to?

    Thanks for the article, it’s great to see the material you put together being circulated.

  • Warwick

    I genuinely admire Matthew Wright’s enthusiasm in promoting renewables but pushing the idea of the “Merit Order Effect” unfortunately falls short of the real situation. There are three key criteria where the MOE falls apart:

    1) Ignores total revenue to generators, both renewable and fossil fuelled. Generators earn revenue through financial contracts and pool revenue. Renewable generators also earn REC’s or other environmental credits. Without considering all of these revenue sources you do not get the whole picture…i.e. kind of like a printer manufacturer giving away printers for free then charging a monopoly premium for cartridges and then claiming printing costs are falling because printers are now free.

    2) Any analysis of step changes or forecasts of the electricity market relies on subjective forecasts of generator behaviour. If you assumed introducing 5GW of solar PV and have not changed bidding behaviour, then the analysis is already severely flawed because generators will bid energy into the market based upon their cost of generation and game theory (i.e maximising revenue above costs). The “value” of this forecast is inherently variable as can be seen when the value of the “MOE” presented by Melbourne energy institute is supposedly 35c/kWh despite the 2009 calculated value being twice the 2010 value of $600m. i.e. it shows the folly of setting a fixed tariff in such a variable market…I’m sure this methodology would arrive at a much lower value in 2010 or 2011 based upon the impact of la nina.

    3) Other generation bids in at zero or less, should they also not be able to get the so-called MOE feed-in-tariff? They also have the effect of reducing spot prices, as do pink batts or going on holiday…

    So fight the good fight for renewables but don’t pretend it will make it electricity cheaper by paying Feed-In-Tariffs at 10X the wholesale price, it’s simply unsustainable The public should be informed that renewables are currently more expensive as the existing market pricing does not reflect the externality of pollution of fossil fuelled technologies but the prices of renewable technologies are improving and will not be as expensive as opponents claim.

    • Jake

      Hey Warwick,
      With regards to income gained from RECs, are you claiming that REC income is a hidden cost to bill-payers?

      • Warwick

        I’m not saying aything is hidden, just that the MOE analysis simply overlooks all revenue sources. With regard to REC’s both LGC’s and SRES, the regulator determines the percentage (9.15% and 23.96% respectively). So you know what percentage the retailer buys but not what price they paid as that depends upon what commercial contracts they entered into.

        Unfortunately, the impression might be given the percentages involved that all consumers have 33.11% renewable but the actual renewable component will likely be less than 10% at the end of the year. This is because 15 years worth of deemed production is honoured as certificates immediately and then multiplied by 3 (2 from July). i.e. in reality we only get 1/45 (15 years * 3) of the claimed MWh each year for only 15 years.

    • http://beyondzeroemissions.org Matthew Wright

      Certain kinds of “gaming” the market would be illegal, I think one generator got investigated for suspect behaviour in South Australia by AER and then cleared. It is very difficult to prove of course.

      • Warwick

        Matthew,

        The gaming that you refer to is under s46 of the Competition and Consumer Act 2010 and was previously covered by the Trade Practices Act 1974. The difficulty is actually defining “abuse” of market power…

    • Dylan

      Hi Warwick, thanks for your comments

      I would like to offer some rebuttals to your arguments:

      1) Contracting:
      Completely agree and understand that there is a very high level of contracting in the electricity market. As you are aware contracting is used as a strategy to eliminate price risk, and it it common for generators to enter into long-term Power Purchase (PPA) directly with retailers or large industrial customers. However, only a handful of large power stations have long-term PPAs (Loy Yang A & B for example). The far more common contract structures are short-to-medium bilateral hedges, with typical hedge books only going forward 3-5 years (with typically less than 20% contracted beyond 3 years).

      As the underlying wholesale price decreases it surely is expected that price of contracts and other derivatives will change to reflect the changes in the underlying price. So while I completely agree that changes in the wholesale spot price would not instantly flow through to generators and retailers in full – any re-negotiated OTC contracts, and the futures price moving forward should reflect the impact of the merit order effect. Sure, the generators wouldn’t want to negotiate a lower strike price – but why would retailers lock in a higher loss than is necessary to manage their risks?

      2) Bidding Behavior
      Again, I would agree with you and think that using static bidding behavior is an overly simplistic approximation – however I would argue it is a necessary simplification to do the the analysis, (short of recreating a NEM and the dispatch process in parallel universe).
      Having said that, I don’t believe it makes the analysis null and void in any sense. Whilst generators would more thank likely bid differently in the presence of solar (even for 1 GW installations) – it is I think inaccurate to think that bids can simply be raised “maximizing revenue above costs”. If it were possible for generators to manipulate the market to such an extent, then surely they would be doing it now? There is no reason they would have to wait for PV capacity to be installed start gaming the market and “maximizing revenue above costs”.

      This would perhaps be a possibility if there were collusion in the market, or abuse of market power, and is a whole separate issue outside of the Merit Order Effect. I would suspect this kind of behavior is possibly illegal – or at least something the ACCC would be interested in investigating. With sufficient competition, there would be limited opportunities to game the market. In fact, there is an argument to be made that the merit order effect will actually increase competition (relatively) – due to the fact there are the same number of generators ‘competing’ (or competitively bidding) into a smaller market. This could in fact have the impact of further reducing prices.

      Whilst likely bidding behavior is a theoretical argument in Australia – it is far from theoretical in Germany. Some plots reported on this website recently illustrate the extent to which the merit order effect is impacting the German market (which is also an energy-only gross pool spot market). Admittedly there may be some opportunistic bidding occurring (see the peaks in early morning and late afternoon) but this is hardly goes any way towards offsetting the merit order effect: there is a material reduction in wholesale prices (particular during the day). If modifying bids to recover costs in a competitive market were a possibility, I would interest to know why it isn’t occurring in the German Market.

      Ultimately though, some generators would may to mothball (if revenues fall too low) – which will then re-adjust the merit order (or counter to some extent the merit order effect). This has occurred in Germany (and Italy) with some gas generators mothballing (purportedly due to high PV penetrations).

      3)Other generation?
      The merit order effect acts as an offset to such schemes as feed in tariffs.

      Other generators (including gas) will of course also create a “merit order effect”. In fact as any new generation capacity has come on line in the NEM there is an associated ‘Merit Order Effect” – including for new coal added capacity since the beginning of the NEM – this is a normal phenomenon for an energy only market. The key difference is, these technologies are not financed or incentivised by feed in tariffs – they respond to the market and market signals. There is no feed-in tariff scheme to offset.

      There a variety of reasons that we have feed-in tariffs for solar (and not for gas) – and while we have continue to tariffs schemes for these varying reasons, it is reasonable to consider the overall cost of the schemes (considering the overall impact on the wholesale market and electricity price). I don’t quite understand the logic behind trying to argue for that the merit order effect is an equally valid offset for gas – simply because there is no scheme to offset it against.

      • Warwick

        Thanks Dylan, I agree that the so-called MOE exists, where that is identified as an increased occurrence of low pool prices occur but this will also increase price volatility which will counteract much of this “gain”. In all this does not unambiguously mean a reduced price for consumers, also any estimate of the so called value is essentially arbitrary and depends upon the assumptions made in bidding powerstations i.e. if the modelling is done at a half-hourly level over 2 years and there are approximately 100 dispatchable power stations in the NEM, each with 10 bid bands for each of the 48 half hours each day, then you’re looking at over 35 million assumptions alone.

        with regard to your points raised…

        1) Contracting: you’re absolutely right that if pool prices are low for a sustained period that OTC and futures prices will likely fall but to assume that means lower prices for all is wrong. Retailers are usually obliged to contract as close to 100% of their contracted load as practical by their risk management policy whilst generators usully have greater freedom. Additionally if low prices have been more frequent, gas peakers will contract less gas and be far less inclined to sell hedges. As the level of contracting by generators falls they will attempt to make as much money as possible in the times of peak demand such as when the temperature is sitting above 40C when the clouds roll in shading the PV.

        Fundamentally, prices will be more volatile and that is more costly to retailers in attempting to hedge their loads. Ulimately, it is uncertain that this proposed change would result in cheaper prices to consumers.

        2) Static bids is a massive oversimplification if you assume 5GW of solar would have no impact on bidding behaviour. Taking this static bids assumption, why not argue instead of hypotheticalling adding 5GW that you could take out just one power station? Say a 2GW power station in Victoria without changing the bids on the other power stations. This analysis would then result in power prices averaging hundreds of dollars over the year if you also used the same bids and a total spot price bill for the market many times higher than roughly $1bn a year we see at present. Then taking the same line as the MOE argument put forward, wouldn’t that power station be able to then argue “my presence in the market is saving $Xbn/year, aren’t I entitled to a Feed-In-Tariff?”

        3) Other generation. The argument being put forward is that solar PV will depress spot prices because it effectively bids in $0/MWh and is distribution connected. Solar PV is already subsidised through SRES for being renewable, so why should other generation not be entitled to the same Feed-In-Tariff for providing the same peaking service? i.e. there are a handful of gas fired peakers that could bid in at zero, are distribution connected and are flexible enough to have a profile that matches solar, or alternatively why not offer it to diesel generators?

        So all up, yes a MOE effect exists but only in so much as it may increase the frequency of low spot prices but its value is unknown as the influence of spot price volatility will also counter the effect of this and make it uncertain as to whether or not consumers will actually be better off. Adding an additional electricity tax to pay for another Feed-In-Tariff is not in the best interests of consumers.

        As an aside, there are suggestions that PV prices are falling fast and potentially the economics of avoiding retail prices could make home PV an attractive economic proposition without subsidies. If this happens then the argument for a Feed-in-Tariff evaporates. We need to be cautious about hastily locking in long term feed in tariffs at very high prices when technology improvements and cost reductions are very rapid.

  • Glen

    I recently attended an ev convention where the keynote speaker was an expert in lithium battery technology. My takeaway from the presentation was that the technology would improve about 30 % in energy density over the next 4 years and the price would be affected by economies of scale in manufacture in china and fall to levels as stated by Matthew in the article. < $200 per kw/h ( Elon Musk is also predicting this)

    With vehicle to home tech from Nissan and Mitsubishi , grid tied inverters with battery backup and smart meters we may all be feeding the grid more at peak times and increasing the merit order effect. Apologies to the big power generators.

  • Damien Moyse

    Hi Dylan and Warwick

    Enjoyed your discussion, thanks.

    Just one question / point, on other generation getting a feed-in tariff for their MOE.

    The cheaper generators that can bid directly into the wholesale market, causing a MOE, get compensated by their received wholesale price.

    Surely the issue at stake with PV and other distributed gen is that they cannot trade into the wholesale market and are prevented from being remunerated for their MOE.

    And surely that is what the FiT is for – to correct the market failure of the NEM not choosing the cheapest generation option available from both centralised and demand side generators?

    And thanks Matt too for the article.

    Cheers

    Damien
    ATA