The extreme rise in electricity prices on the exchanges has startled many people and drawn their attention to a market that consumers otherwise do not have to worry about.

The electricity market remains opaque for many people and raises more questions than it answers: Why is the electricity price linked to the expensive gas price?

Why does the most expensive power plant determine the price and not the cheapest?

And what is the ominous “merit order principle” all about?

Johannes Pennekamp

Responsible editor for economic reporting, responsible for "The Lounge".

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To answer these questions, the easiest way would be to compare the electricity market to other markets.

The German electricity market was liberalized in 1998.

However, the attempt to compare electricity with cars, apples or other everyday goods is doomed to failure: electricity cannot be produced and stored on a large scale.

Consumer demand fluctuates comparatively little with rising or falling prices, so according to the Cologne economist Axel Ockenfels it is relatively inelastic.

Political decisions also influence the market.

All this makes the electricity market special.

The "merit order" principle

In principle, however, the fundamental economic laws – supply and demand – also apply to the electricity market.

On the supply side are the electricity producers, from the homeowner with a photovoltaic system on the roof to the operators of nuclear, coal and gas power plants.

Opposite them on the demand side are the buyers, ultimately all households and businesses.

How and at what electricity price do both sides come together?

The decisive factor for this are the so-called marginal costs, which can also be described as variable costs.

They arise as soon as a wind turbine or power plant starts to produce electricity.

These costs are lowest for renewables because wind and sun are available free of charge.

On the other hand, if coal or gas has to be bought and burned, the marginal costs are much higher.

All quantity and price offers from the producers are then collected on the electricity exchange and sorted from cheap to expensive, resulting in an aggregated supply curve (see graphic).

It starts with the cheapest electricity producers, who come into play first, and increases with those producers who have higher marginal costs.

This sequence is referred to as a "merit order".

The resulting supply curve intersects with the steep demand curve.

It is determined by how much electricity consumers currently need.

The market price results from the point of intersection.

To understand: If consumers need a lot of electricity at lunchtime, demand and the point of intersection shift to the right, and the price rises.

If demand is low at night, the price falls.

Electricity from gas power plants is often irreplaceable

It is important to understand that the price is not determined by any expensive power plant, but by the most expensive power plant that is needed just to serve the consumer demand.

Assuming the market price is 50 euros per megawatt hour, then all suppliers produce whose marginal costs are less than 50 euros or exactly 50 euros.

Those who can produce for 20 euros pocket the difference, i.e. 30 euros, as a "producer's surplus".

Roughly speaking, that's his win.

Anyone who offers electricity for 51 euros, on the other hand, flies out of the market.

So you could say that it is not the most expensive power plant that determines the price, but the most expensive of the cheap power plants.

This is a completely normal mechanism that also works in other markets.