The international energy space is undergoing a significant shift as renewable energy systems continue to become part of electricity markets across the globe. This shift has resulted in significant economic transformation to reach far beyond environmental benefits. With renewable technologies such as solar, wind, etc. approaching grid parity as they increase, they induce market structural change through a process referred to as the “merit order effect”. This process brings about wholesale electricity price shifts. This influences investment choices and reshapes market structures. This article illustrates how merit order effects operate, their market implications, and the multifaceted issues/ opportunities they pose as renewables set off on an unprecedented growth path. 

Economic Fundamentals Of Merit Order Effects

The merit order effect is one of the most important market consequences of high penetrations of renewables. In this part, we explore the fundamental economic forces behind this phenomenon and their influence on electricity price dynamics:

How Merit Order Pricing Works in Electricity Markets

In competitive electricity markets, power plants dispatch on the basis of their marginal costs, forming what is referred to as the “merit order.” Traditional fossil fuel plants have large fuel costs that dictate where they fall in this order, while most renewables come with near-zero marginal costs. Furthermore, when a large amount of abundant renewable generation is brought into the market, it moves the whole supply curve rightward. So, this drives out higher-cost generators and creates lower clearing prices. This underlying shift in market economics also produces price suppression effects that are good for consumers but difficult for traditional generator business models.

Price Suppression and Market Value Decline

With growing renewable penetration, wholesale electricity prices normally fall during periods of high renewable generation. The price suppression effect benefits consumers through cheaper electricity but also lowers the market value of all generators. It includes renewables themselves. Statistical estimations across various markets demonstrate this “cannibalization effect”—as variable renewable market value declines as market share increases. Moreover, the value decline accelerates as penetration increases. This leads to diminishing economic returns for additional renewable capacity in the event of no complementary flexibility measures.

Evolution of Price Volatility Patterns

Although renewable deployment tends to repress average wholesale prices, it also raises price volatility. Markets see more frequent episodes of very low prices during periods of high renewable generation and steep price spikes during scarcity events. This volatility presents new trading opportunities but makes long-term investment planning more difficult. Additionally, research indicates that markets with high renewable penetration tend to form bimodal price distributions instead of normal distributions, with clusters around very low and very high prices. The modified market volatility also demands a fresh framework for risk management along with updated market regulatory components.

Distributional Impacts Across Stakeholders

Various market agents experience complex distributional impacts due to the operations of merit order effects. The wholesale price decrease delivers benefits to all customers but conventional power plants experience financial loss leading to potential reliability problems. This is from premature retirements that lack replacement generation capacity. Furthermore, renewable generators themselves suffer declining capture prices as their penetration grows. Moreover, network operators face emerging congestion patterns, while storage suppliers uncover new arbitrage opportunities. Such stakeholder impacts are the keys to optimizing fair transition policy and avoiding decarbonization-market failure.

Merit Order Effect And Energy Market Dynamics: System-Wide Adaptations And Market Responses

As merit order effects amplify, electricity markets are changing to secure system reliability while also ensuring economic efficiency. Within this section, we will see how market configurations and system operating are responding in high renewable penetration systems:

Capacity Mechanism Developments

With energy-only markets struggling to sustain investment signals amid price suppression, capacity mechanisms have gained prominence across multiple jurisdictions. These mechanisms provide separate revenue streams for availability. It counterbalances the merit order effect’s impact on energy revenues. Furthermore, different designs have emerged, from centralized capacity markets to decentralized reliability obligations. Moreover, implementation experiences show that capacity mechanisms must carefully balance adequacy assurance with avoiding over-procurement and stranded assets. In addition, future-looking capacity markets increasingly use renewable contribution factors and flexible resource valuations to remain relevant in renewable-dominated systems.

Flexibility Premium Emergence

As renewable penetration grows, system flexibility has transformed from a secondary value to a leading market value driver. Rapid-ramping resources, storage assets, and demand response capacity are earning increasingly higher premiums in balancing markets. This is essentially establishing a “flexibility merit order” in addition to the energy merit order. Furthermore, this trend manifests through rising peak-off-peak price spreads, growing ancillary service market sizes, and specialized new market products for flexibility. Moreover, technical and regulatory innovation is directed today toward maximizing flexibility from every system resource. This includes renewables through sophisticated forecasting and control platforms.

Market Coupling and Geographic Integration

Geographic integration in the form of interconnection development and market coupling is a potent antidote to local merit order effects. Broader balancing regions smooth renewable variability, increase system flexibility and reduce price volatility. Moreover, cross-border transmission investments and market-clearing synchronization have demonstrated material economic value where high levels of renewable penetration exist. The analysis also shows that merit order effects are cross-border and that renewable deployment in one market influences prices in connected markets. So, such geographic spillover emphasizes regional planning coordination of integrating renewables.

Price Formation Reforms

Legacy marginal cost pricing mechanisms fail in high-renewable systems where zero-marginal-cost resources abound. Thus, numerous markets have implemented price formation reforms that better reflect scarcity value and reliability needs. Furthermore, innovations include operating reserve demand curves, scarcity pricing mechanisms, and locational marginal pricing improvements. The reforms aim to maintain investment signals under merit order effects while properly valuing flexibility and location-specific values. Additionally, some jurisdictions are going even further into more fundamental pricing paradigm changes. It includes potential movements toward reliability-differentiated pricing or convex hull price-setting practices.

Impact Of Renewables On Electricity Prices: Long-Term Strategic Implications

Merit order effects show not just a transitional issue but a wholesale transformation of electricity economics. In this section, the strategic impacts on energy system planning and policy design are analyzed:

Infrastructure Investment Realignment

The merit order impact is evoking core realignment in energy infrastructure investment. Capital inflows are moving towards flexible complementary technologies. It includes storage, interconnection, and smart grid systems from baseload generation. Moreover, traditional utilities face challenges from the shift, but opportunities are unfolding for new market entrants with new business models. Investment portfolios now focus on optionality value and flexibility features in addition to pure generation capacity. Additionally, with these dynamics being embedded by financial institutions in their risk calculations, capital prices are also diverging between flexible and rigid assets, speeding up the transition.

Business Model Innovation

Merit order effects are driving mass business model innovation throughout the electricity value chain. Furthermore, traditional generation-based utility models are moving toward platform and service-oriented models. Besides, new revenue opportunities emerge through capacity contracts, flexibility services, and customer-side optimization. Progressive companies are developing integrated solutions that combine renewable generation with storage, demand response, and trading optimization. Digital technologies also enable sophisticated hedging and real-time optimization to deal with volatility. So, such innovation trends signal a fundamental shift in energy business architecture away from simple generation asset ownership.

Policy Framework Evolution

Policy frameworks are evolving in response to merit order effects. It is moving beyond mere deployment support to more sophisticated market integration strategies. In addition, carbon pricing instruments assist in internalizing externalities and to a certain degree reverse merit order price suppression. Market structures increasingly involve long-term price signals in conjunction with short-term efficiency. Furthermore, two-part market structures that distinguish between adequacy assurance and energy dispatch optimization are being investigated in some jurisdictions. Moreover, support mechanisms for renewables themselves are transitioning from fixed subsidies towards more market-compatible designs. It includes contracts-for-difference with symmetrical payments or renewable capacity obligations.

Consumer Engagement Transformation

As merit order effects transform wholesale markets, they open up new consumer participation opportunities. Furthermore, time-of-use pricing tariffs increasingly mirror wholesale market conditions. This enables consumers to take advantage of low-price hours during periods of high renewable generation. Moreover, aggregation models allow smaller consumers to access flexibility markets and capacity mechanisms. Distributed resource consumers can also maximize self-consumption to minimize market exposure during peak-price hours. So, these developments collectively point toward a more responsive demand side. It is one that actively manages renewable variability rather than simply absorbing fixed retail prices.

To Sum Up

Merit order effects are a fundamental economic revolution that is driven by renewable energy’s specific generation traits. Although generating immediate gains through price suppression, merit order effects impose structural market overhaul to provide system reliability over the long term as well as ensure sustained investment. The future depends on advanced policy measures that optimize consumer benefits along with system viability.

Energy players can experience these opportunities and challenges first-hand at the forthcoming 3rd Global Summit for Net Zero Energy Sourcing & Power Purchase Agreements on March 27-28, 2025, in Berlin, Germany. This is the top industry conference where renewables procurement strategies, market trends, innovative PPA structures, etc. are discussed by the experts/ pioneer organizations in the evolving energy paradigm.