Analysing the merit-order effect

Tim Nelson
Tim Nelson
24 June 2014

Sadly, so much debate on renewable energy at the moment is based upon partial analysis and opinion. One of the critical points that people misunderstand relates to the 'merit-order effect'. The proposition is simple: because renewables have very low short-run marginal costs (i.e. the wind or sun is free) then increasing the proportion of renewables in the mix reduces wholesale electricity prices. Well presented videos are currently putting this forward on platforms such as YouTube.

However, what does the scientific literature say about this? Well, it makes the obvious point that higher long-run marginal cost technologies cannot be deployed at a lower cost to society than lower long-run marginal cost technologies. Edenhofer et al (2013, p. 519) make the salient point: "‘lower average prices caused by higher renewable energy penetration lead to a reduction of overall capacity, which in turn increases the frequency of scarcity events and respective scarcity prices. According to theory this will bring the market back to the long-term equilibrium in which long-run average costs and average revenues are balanced for all capacities and where, as a direct result, the capacity level is efficient".  One of my own papers sums it up nicely by quoting Gelabert, Labandeira, and Linares 2011 p. S65: "the merit order effect is transient because the reduction in prices will in turn result in lower investments and therefore higher prices in future periods."

None of this means that building more renewables isn't a good idea. There are sound reasons for increasing investment in renewable energy. However, it is important that policy is set based upon fact, not partial analysis and misquoting of the scientific literature. In the long-term, more investment in renewables can only be forthcoming if total revenues for new renewable generators equal or exceed their long-run marginal cost. That is why I have been talking about policy reform being required for some time.