On the long-term merit order effect of renewable energies

The merit order effect describes the lowering of the average wholesale electricity price due to increased capacity of renewable energies. This effect has been observed in many places. While it is beneficial for consumers, it has triggered concerns about the economic viability of legacy plants. Is this merit order effect a permanent feature of high shares of renewable energy, or merely a transitory phase? This article develops a simple theoretical model to shed light on this question. It introduces intermittent renewable energies into a conventional mix of base load and peak load and investigates the effect when base and peak load remain unchanged in the short-term, and when they fully adjust in the long-term. We find that the merit order effect is a temporary phenomenon that is caused by the slow pace of capacity adjustments. We also find that the introduction of renewables has a mild beneficial long-term effect when base load is provided monopolistically, as renewables compete with base load to a limited extent. Consequently, concerns about the adverse consequences for conventional power plants resulting from renewable capacity are only partially justified. While in the short-term the generation portfolio suffers from “stranded assets”, market forces will gradually reduce overcapacity. We also confirm that renewable expansion can be complemented by energy-only markets to incentivize efficient investment in conventional capacity.