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

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