How wind power can lower electricity prices

Wind Energy and Electricity Prices. Exploring the ‘merit order effect’

A literature review by Pöyry for the European Wind Energy Association (EWEA)

This report focuses on the effect of wind energy on the electricity price in the power market. As the report will discuss, adding wind into the power mix has a significant influence on the resulting price of electricity, the so called merit order effect (MOE).

The merit order effect has been quantified and discussed in many scientifi c publications. This report ends the first phase of a study on the MOE carried out for EWEA by consultants Pöyry, evaluating the impact of EWEA’s 2020 scenarios on future European electricity

The basic principles of the merit order effect are provided in the fi rst part of the document, which gives the reader the necessary background to follow the subsequent literature review. The literature review itself contains methods and tools not only to quantify the merit order effect but also in order to forecast its future range and volume.

The papers reviewed in this literature survey cover a wide range of aspects linked to the price and MOE of wind power penetration in each country. Although each paper in a specifi ed category works with different sets of assumptions, they essentially draw similar conclusions:

• An increased penetration of wind power reduces wholesale spot prices. There were instances of zero spot prices in the studies reviewed, part of which could be attributed to wind generation. Wind power also affects the merit order, resulting in MOE ranging from 3 to 23 €/MWh.
• Wind replaces CO2-intensive production technologies.

The literature discusses the MOE of increased wind power in terms of the technology replaced by wind and its position in the merit order curve. During periods of low demand, the technology that sets the price in the wholesale market is usually hard coal in the countries reviewed in the papers. Wind replaces hard coal power plants during hours of low demand and gas fi red power plants during hours of high demand in all these countries.

• Wind can replace part of the base load. Some of the papers discuss the potential of wind power to replace part of the base load in the respective countries or regions. The resulting argument was that wind power could replace a portion of the base load if there is a greater integration of wind producing areas such as Denmark, Germany and the Benelux into one power market.

• Consumers pay lower prices. The MOE and the subsequent effect of wind generation on prices was also analysed from the point of view of the end users. It shows that if both the direct and indirect cost savings from renewable energy generation were taken into consideration, the net effect of the RES support scheme would be negative, that is, the consumers would pay lower prices.

Power markets

As part of the gradual liberalisation of the EU electricity industry, power markets are increasingly being organised in a similar way. This applies to a number of liberalised power markets, including those of the Nordic countries, Germany, France and the Netherlands. Common to all these markets is the existence of five types of power market:

• Bilateral electricity trade or OTC (over the counter) trading: Trading takes place bilaterally outside the power exchange, and prices and amounts are not made public.

• The day-ahead market (spot market): A physical market in which prices and amounts are based on supply and demand. The resulting prices and the overall amounts traded are made public. The spot market is a day-ahead market where bidding closes at noon for deliveries from midnight and 24 hours ahead.

• The intraday market: There is quite a time difference between close of bidding on the day-ahead market and on the regulating power market (below). The intraday market was therefore introduced as an ‘in between market’, where participants in the day-ahead market can trade bilaterally. Usually, the one-hour long power contract is traded. Prices are published and based on supply and demand.

• The regulating power market (RPM): A real-time market covering operation within the hour. The main function of the RPM is to provide power regulation to counteract imbalances related to day-ahead planned operation. The demand side of this market is made up of transmission system operators (TSOs) alone, and approved participants on the supply side include both electricity producers and consumers.

• The balancing market: This market is linked to the RPM and handles participant imbalances recorded during the previous 24-hour period of operation.

The TSO acts alone on the supply side to settle imbalances. Participants with imbalances on the spot market are price takers on the RPM/balance market.

The day-ahead and regulating markets are particularly important for the development and integration of wind power in the power systems.

Supply and demand curves

Inelastic demand is a characteristic of goods that are a necessity. The substitutes for these goods are few and difficult to obtain. Power and electricity fall into this category as they are vital goods seen as essential for the existence of modern civilisation.

As demand is inelastic, minor changes in the supply can result in major price changes. Adding wind power into the generation mix will affect the supply curve, the supply curve will shift, and a new price will be determined as a result of market dynamics.

Supply and demand in the power market

Typically, the power portfolio is made up of a range of power technologies: wind, nuclear, combined heat and power plants, and condensing plants and gas turbines. The ordering of the power supply of each of these players depends on the amount of power they can supply and the cost of this power.

In a power market, the supply curve is called the ‘merit order curve’. Such curves go from the least expensive to the most expensive units and present the costs and capacities of all generators. Each unit is shown as a step in the ‘curve’. The differences between costs are mainly due to the technology used and the fuel it consumes. As shown, the bids from nuclear and wind power enter the supply curve at the lowest level, due to their low marginal costs, followed by combined heat and power plants, while condensing plants are those with the highest marginal costs of power production.

Note that hydro power is not identified, since bids from hydro tend to be strategic and depend on precipitation and the level of water in reservoirs.

How does wind power influence the power price on the spot market?

Wind power is expected to influence prices on the power market in two ways:

• Wind power normally has a low marginal cost (zero fuel costs) and therefore enters near the bottom of the supply curve. Graphically, this shifts the supply curve to the right, resulting in a lower power price, depending on the price elasticity of the power demand. The price is reduced from Price A to Price B when wind power decreases during peak demand. In general, the price of power is expected to be lower during periods with high wind than in periods with low wind. This is called the ‘merit order effect’.

• As mentioned above, there may be congestion in power transmission, especially during periods with high wind power generation. Thus, if the available transmission capacity cannot cope with the required power export, the supply area is separated from the rest of the power market and constitutes its own pricing area. With an excess supply of power in this area, conventional power plants have to reduce their production, since it is generally not economically or environmentally desirable to limit the power production of wind. In most cases, this will lead to a lower power price in the sub-market.

When the supply of wind power increases, it shifts the power supply curve to the right of the figure. At a given demand, this implies a lower spot price on the power market, as shown. However, the impact of wind power depends on the time of the day. If there is plenty of wind power at midday, during the peak power demand, most of the available generation will be used. This implies that we are at the steep part of the supply curve and, consequently, wind power will have a strong impact, reducing the spot power price significantly.

But if there is plenty of wind-produced electricity during the night, when power demand is low and most power is produced on base load plants, we are at the flat part of the supply curve and consequently the impact of wind power on the spot price is low.

Impact of wind power on spot prices

Structural analyses are used to quantify the impact of wind power on power spot prices. A reference is fixed, corresponding to a situation with zero contribution from wind power in the power system. As more wind comes onto the system the effect is calculated at different levels. Five levels of wind power production and the corresponding power prices are depicted for each hour of the day in December 2005.

The reference is given by the ‘0-150 MW’ curve, which includes those hours of the month when the wind was not blowing. Therefore, this line on the graph provides approximate prices for an average day in December 2005, in a situation with zero contribution  from wind power.

The other lines on the graph show increasing levels of wind power production: the 150-500 MW curve shows a situation with low wind, increasing to storm levels in the >1,500 MW curve. As shown, the higher the wind power production, the lower the spot power price. At
very high levels of wind power production, the power price is reduced signifi cantly during the day, but only falls slightly during the night. Thus, there is a significant impact on the power price, which might increase in the long term if even larger shares of wind power
are fed into the system.

Of course, ‘noise’ in the estimations does exist, as there is some overlap between curves for the different categories of wind power. Thus, a high amount of wind power does not always imply a lower spot price than low wind power production, indicating that significant statistical uncertainty exists. And of course, factors other than wind power production also influence prices on the spot market. But the close correlation between wind power and spot prices is clearly verified by a regression analysis carried out using the West Denmark data for 2005, where a significant relationship was found between power prices, wind power production and power consumption. When wind power reduces the spot power price, it has a significant influence on the price of power for consumers.

When the spot price is lowered, this is beneficial to all power consumers, since the reduction in price applies to all electricity traded – not only to electricity generated by wind power.