What is the merit order, and how are power prices set?

Almost every explanation of a power price movement eventually arrives at the same conclusion. Prices rose because gas was expensive. Prices collapsed because the wind blew. Prices went below zero because solar output overwhelmed midday demand. 

Each of those statements is, in effect, a statement about the merit order, whether or not the term is used. The merit order is the ranking that determines which power stations run in any given hour and, more importantly, which one sets the price that every generator receives. 

Understanding it shows how a series of disconnected market headlines is converted into a single mechanism. It also explains one of the most counter-intuitive features of electricity markets: the cheapest plant on the system almost never sets the price. 

What is the merit order?

The merit order is a supply stack. It lists all the generation available to a market, sorted from the cheapest to the most expensive to run, and is rebuilt for every delivery period. 

The crucial word is “run.” Generators are ranked by short-run marginal cost, meaning the cost of producing one additional megawatt-hour from an existing plant. Construction costs, financing, and grid connection charges do not factor into the ranking at all. Those costs are already sunk, and a plant deciding whether to generate in a particular hour is only comparing its operating cost against the price it can capture. 

This is why a newly built offshore wind farm, with an enormous capital bill, sits below a fully depreciated coal station in the stack. The wind farm’s fuel is free; the coal station has to buy coal and carbon allowances before it produces any power. 

The stack varies based on factors like fuel prices, carbon costs, plant availability, maintenance, and especially weather. A system can appear completely different at 4am on a windy Sunday compared to 6pm on a quiet weekday evening in January, even if the physical fleet of power stations remains unchanged. 

How generators are ranked from cheapest to most expensive 

Three variables do most of the work in setting a thermal plant’s position in the stack: 

• Fuel cost: the market price of the gas, coal or biomass the plant burns, usually referenced against a hub price such as TTF (Title Transfer Facility, the Dutch gas benchmark) 

• Thermal efficiency: how much fuel energy the plant converts into electrical output, which determines how many units of fuel are needed per unit of power 

• Carbon cost: the price of emissions allowances under the EU Emissions Trading System (EU ETS) or the UK ETS, multiplied by the plant’s emissions intensity. 

A worked example clarifies the interaction. A modern combined-cycle gas turbine operating at roughly 55% efficiency requires about 1.8 MWh of gas to produce 1 MWh of electricity. If gas trades at €30/MWh, the fuel component alone is about €55/MWh. That plant emits about 0.35 tonnes of CO2 per MWh, so a €70 carbon price adds roughly €25/MWh. The plant’s short-run marginal cost is about €80/MWh, before any variable maintenance. 

An older, less efficient gas plant on the same system encounters identical fuel and carbon prices but requires more of both for each unit of output. As a result, it operates higher in the dispatch order and runs fewer hours. In power markets, efficiency is more than just an engineering measure; it directly influences how often a plant can generate revenue throughout the year. 

The resulting order across a typical European system runs from wind, solar and run-of-river hydro at the bottom, through nuclear, then into the thermal fleet, with the least efficient gas turbines and oil-fired peaking units at the top. Where coal and gas sit relative to one another depends on the prevailing relationship between fuel and carbon prices, a question the market revisits continuously. 

Why renewables sit at the bottom of the merit order 

Wind and solar have near-zero marginal cost. There is no fuel to buy and no emissions allowance to surrender, so the cost of producing an additional megawatt-hour is limited to minor variable maintenance. 

This positions them at the lowest priority, so they are dispatched whenever physically available. Unlike a gas plant, a wind farm doesn't wait for a price signal; if the wind blows and the turbine is connected, generating is nearly always the best option. 

As a result, renewables seldom determine the price but always influence it. Each megawatt hour of wind or solar power reduces demand on thermal plants, lowering the cost of the marginal plant. This is known as the merit order effect, explaining why prices in Germany, Spain, and the Nordics can drop significantly on days with high renewables, even when fuel prices stay the same. 

Nuclear sits near the bottom for related but distinct reasons. Fuel is a small fraction of its cost base, and the technical and economic penalties for cycling output up and down are significant, so nuclear plants generally run continuously and bid low to ensure they are dispatched. 

Push this dynamic far enough and prices do not simply approach zero, they fall below it. That mechanism, and the assets that profit from it, is covered in What are negative power prices? Why they happen and who benefits. 

How the merit order sets the market-clearing price 

The stack on its own only tells half the story. The price emerges where demand intersects it. 

In a day-ahead auction, buyers submit the volumes they want and the prices they are willing to pay, and the exchange matches that demand against the supply stack. The last unit of generation required to meet demand is the marginal plant, and its bid sets the clearing price for that delivery period. 

The critical feature is what happens next. Every generator that cleared the auction receives the same price, regardless of its bid. A wind farm that offered its output at zero and a gas plant that offered at €80/MWh both receive €80/MWh if the gas plant is marginal. This is known as marginal or pay-as-clearing pricing. 

Although it might seem counterintuitive, this design is intentional. Since a generator’s bid influences whether it operates rather than its earnings, the rational approach is to bid truthfully at marginal cost, ensuring an optimal dispatch sequence. The difference between a plant’s marginal cost and the clearing price, called infra-marginal rent, enables generators to recover capital expenses that the merit order alone does not account for. 

This is also why demand and supply conditions translate into price so abruptly. Adding a few gigawatts of demand on a tight winter evening does not raise the price incrementally; it can shift the intersection point to a much steeper part of the stack, where the next available unit is dramatically more expensive than the last. The same auction logic then applies throughout the trading day, as described in What are day-ahead, intraday and balancing markets? A simple guide to power trading. 

What happens when the merit order shifts 

Because the stack is rebuilt continuously, its shape and ordering are always in motion. Several forces do the reordering: 

• Relative fuel prices: which determine whether coal or gas is the cheaper thermal option 

• Carbon prices: which penalise higher-emitting plant disproportionately 

• Renewable output: which changes how far up the stack demand reaches 

• Plant availability: where outages remove cheap capacity and force the market onto more expensive units 

• Cross-border flows: which effectively add or remove supply at the margin. 

Coal-to-gas switching vividly illustrates practical reordering. Since coal produces about 2.5 times more CO2 per megawatt hour than gas, increasing the carbon price raises coal’s marginal cost more rapidly than gas’s. If the carbon price becomes high enough relative to the gas price, the order of power sources shifts, significantly impacting emissions and electricity prices. Conversely, when gas prices surged in Europe, coal regained its economic advantage despite the carbon costs. 

Availability shocks reorder the stack just as effectively. The extended outages across the French nuclear fleet in 2022 removed a large block of low-marginal-cost generation from the European system, forcing demand onto gas-fired plant across a wider area and lifting prices well beyond France’s borders. 

The longer-term shift is structural. As wind and solar capacity grows, the bottom of the stack widens, and there are more hours in which renewables alone cover demand. That compresses thermal running hours and concentrates the remaining revenue into fewer, more volatile periods. 

Conclusion 

The merit order is not a market rule so much as an organising principle. It explains why power prices track gas prices in some hours and ignore them in others, why a windy afternoon and a still evening produce completely different outcomes, and why generators with no fuel costs still earn the price set by those that do. 

What is worth watching is how the stack's shape changes from here. Batteries and flexible demand do not fit the traditional model neatly, because their marginal cost is not a fuel bill but an opportunity cost, set by the price they expect at another point in the day. They also appear on both sides of the curve, adding to demand when charging and to supply when discharging. 

As those assets scale, the stack shifts from a fixed ranking of power stations to a dynamic reflection of when energy is worth using. The underlying logic will not change, but the plants at the margin increasingly will.