The Merit Order and Price-Setting Dynamics in European Electricity Markets

During the last three years, European wholesale electricity markets have experienced unprecedented levels of price volatility. These veered from the record low prices observed during the pandemic in 2020 to the record high prices reached in the summer of 2022 as a consequence of Russia’s aggression against Ukraine. The fluctuations in the gas price were the main driving force behind these electricity market dynamics. Natural gas-fired power plants are often the marginal technology units in the merit order, setting the price in the electricity market. For this reason, many have questioned the functioning of electricity markets and called for the decoupling of gas and electricity prices. With the transition to a cleaner generation mix based on renewables, how is merit order price-setting dynamic changing
in EU power system? Will the outsized role of gas decrease with a rising proportion of solar and wind in the mix? This Science for Policy brief aims to provide some answers by analysing the price-setting dynamics in the European power market in 2022 and 2030. The objective is to clarify how wholesale electricity prices are set and how merit order dynamics are evolving as the share of renewable energy sources increases. The results are based on an economic equilibrium model simulating the EU wholesale market hourly dispatch.