Organisation of the electricity market
The electricity market is organised in such a way that units with a lower variable cost have priority over units with higher costs. This rule is called „Merit order”. During the demand peak („PEAK”), a larger number of generating units is involved in satisfying demand than in off-peak hours („OFF-PEAK”), when electricity is generated only in the most economical units. Electricity in the peak is more expensive than outside the peak, but with the rapid development of photovoltaic sources in the summer, the price difference has decreased significantly. Conventional power plants can adapt their production to demand and market conditions as part of their technical capabilities. On the other hand, the supply of electricity from renewable sources depends only on atmospheric conditions.
The cost of electricity is made up of the following:
- cost of investment, i.e. construction of the power plant. This cost is amortised over the plant’s lifecycle.
- fixed costs, i.e. on-going maintenance: employee wages, repairs, equipment, etc. These costs are incurred regardless of whether the plant is producing electricity or not. From 2021, some power plants and combined heat and power plants receive revenues from the capacity market in return for the unit being ready to supply electricity to the system. These revenues help to compensate for the fixed costs incurred.
- variable costs, i.e. how much it costs to generate each additional MWh of energy. The level of variable costs directly depends on the level of production. The main component of variable costs is the cost of fuel and cost of CO2 emission.
For different types of power plants, the relation between these costs varies. For example, for wind farms or photovoltaics, the cost of investment and its share in total costs are high. However, operating, fixed and variable costs are relatively low. In the case of conventional plants, variable and fixed costs are more balanced, largely depending on the cost of fuel and cost of CO2 emission.
Due to the rising prices of CO2 allowances and the decline in the prices of RES installations, the standardized cost of energy generation per 1 MWh (the so-called LCOE) is higher in Polish power plants for conventional energy than for renewable energy.
The price on the wholesale market is driven by variable costs, and more precisely – by the marginal cost to produce 1 MWh of electricity. Based on the level of these costs, from the lowest to the highest, a supply curve (merit order) is created. The point where the demand curve crosses the supply curve is the current market price of energy.
Fixed costs are incurred regardless of whether a given plant operates or not. Therefore, they have no present impact on the price of electricity.
High costs of investing in renewable sources (i.e. sources with low variable cost) are financed outside the electricity market, from subsidies that all consumers pay for.
Not all capacities are always available on the market. Therefore, the price is driven by their availability and by demand for electricity – lower at night, higher during the day, and seasonally shifting – higher in the winter, lower in the summer.
In Poland, we have limited water resources and limited capability of using solar energy, which translates into a limited number of plants fuelled by these forces of nature. This is why the most important renewable source is wind energy. It is wind conditions that largely determine the level of available capacity.
The most important factor in capacity availability is thus the weather. Therefore, the level of the availability of renewable capacities is variable, and there must always be an appropriate conventional capacity reserve, ready for immediate use whenever weather conditions make it impossible to generate energy from wind.
It is because variable costs have an impact on the price of electricity. For conventional plants, the main costs are: cost of fuel and cost of CO2 emission allowances.
Wind farms, hydro plants and photovoltaic units do not incur these costs. Therefore, they are always first in the merit order. CHP plants are similar – their primary role is to produce heat, while electricity is generated in addition to that. Given the cost of fuel (coal, gas) and CO2 allowances, conventional plants are further out in the merit order. The variable production cost in conventional plants, of course, depends on the efficiency of fuel processing at the plant. Therefore, new units will offer cheaper electricity than existing ones.
The mechanism for setting prices based on variable costs was effective in a free market situation, undistorted by the subsidising of select technologies.
Subsidising the costs of investing in renewables has distorted the energy market, worsening the economics of conventional unit operations because these cannot operate at full capacity. In many markets, the operation of permanently or temporarily unprofitable assets is being limited. This may not be allowed on the market for electricity, which is one of the basic human needs. In disadvantageous weather conditions (e.g. no wind), there would not be enough energy, which would cause a blackout. This is destructive for the economy and for the regular life of people.
This is where the concept of capacity market comes in – as a market supplementary to the electricity market. Generating units receive additional funds from the capacity market in return for the unit being ready to supply electricity to the system. Thanks to the capacity market, available generation sources may receive a partial compensation resulting from the decline in wholesale prices, which previously covered variable costs and fixed costs. This allows for the ongoing maintenance and modernization of the power plant in order to ensure uninterrupted and reliable energy supplies.
The capacity market and the electricity market
The capacity market is a market separate from the electricity wholesale market and only indirectly influences electricity prices by ensuring stable power supply and a safe reserve.
Without the capacity market, the price on the wholesale market would have to increase (ceteris paribus) by reducing supply.
Thanks to the revenues from the capacity market, units that would otherwise have to be shut own, reducing supply could remain in the merit order.
In addition, maintaining the power system reserve at an appropriate level reduces the price risk (limiting sudden increases in prices stabilizes the price) and the risk of interruptions in electricity supplies.
It is a market where electricity sellers compete with end users.
Retail market price includes:
- electricity price from the wholesale market,
- electricity distribution costs,
- additional taxes and fees (directed to support RES or cogeneration)
From 2021, a capacity fee is collected – to finance the capacity market