meritorder

Merit order is a method used in wholesale electricity markets to determine the sequence in which available generation resources are dispatched to meet expected demand. Units are ranked by their short-run marginal cost of production, typically the incremental fuel and variable operating costs, excluding fixed capital costs. The resulting supply stack is ordered from lowest to highest marginal cost. The market clears at the price of the most expensive unit needed to satisfy demand, so the price paid by all market participants is set by the marginal unit’s cost.

In practice, renewable resources with very low or near-zero marginal costs are dispatched first, followed by conventional plants in ascending order of their marginal costs (for example, hydro, nuclear, coal, gas, then oil). Dispatch can be affected by transmission constraints, ramp rates, startup costs, and other operational factors, so the actual marginal unit may differ from a simple cost ranking. The phenomenon where increasing amounts of low-marginal-cost generation push down clearing prices is known as the merit-order effect.

Merit order underpins price formation in many day-ahead and real-time electricity markets worldwide. Markets may use pay-as-clear or other pricing rules, but the clearing price is typically tied to the marginal unit’s cost. Critics note that strict reliance on marginal cost can undervalue capacity and reliability, potentially affecting long-term investment signals, especially when transmission constraints or subsidies distort the true economic costs of different technologies.