Merit-order dispatch

Learning objectives

By the end of this lesson you should be able to:

Understand what economic dispatch means.
Explain the concept of merit-order dispatch.
Understand why generators are dispatched according to their short-run marginal costs.
Recognise why the merit order changes over time.
Appreciate the strengths and limitations of merit-order dispatch.
Understand why merit-order dispatch became the foundation of many modern electricity markets.

Introduction

Imagine you are responsible for supplying electricity to an entire country.

Every second, electricity demand changes.

Some power stations are inexpensive to operate.

Others are much more expensive.

If your objective is to minimise the cost of supplying electricity, which generators should you use first?

The answer seems obvious:

Use the cheapest generators first.

This simple idea lies at the heart of modern electricity markets.

It is known as merit-order dispatch.

Before we examine how electricity prices are determined, we must first understand how electricity is dispatched.

What is economic dispatch?

Economic dispatch is the process of deciding which generators should produce electricity at any given moment.

The objective is simple:

Supply the required amount of electricity at the lowest possible operating cost while respecting the physical constraints of the electricity system.

Economic dispatch is one of the oldest optimisation problems in power systems engineering.

Although modern electricity markets have become increasingly sophisticated, this fundamental objective remains unchanged.

The basic idea

Imagine a power system containing four generators.

Generator	Marginal Cost (£/MWh)	Maximum Output (MW)
Wind Farm	0	500
Nuclear Station	15	800
Gas Turbine	80	1000
Diesel Generator	250	300

Suppose electricity demand is:

1,600 MW

Which generators should operate?

The least-cost solution is:

Wind: 500 MW
Nuclear: 800 MW
Gas: 300 MW
Diesel: 0 MW

The diesel generator remains unused because it is more expensive than the available alternatives.

This ordering of generators from lowest to highest operating cost is called the merit order.

Building the merit order

The merit order is created by ranking generators according to their short-run marginal cost.

This means:

How much does it cost to produce one additional unit of electricity?

The cheapest generators appear first.

The most expensive appear last.

As electricity demand increases, progressively more expensive generators are brought into service.

Why marginal cost?

An important question arises.

Why don't we dispatch the generators that were cheapest to build?

Or the newest generators?

Or the cleanest generators?

The answer is that economic dispatch focuses on short-run operating decisions.

Once a power station has been built, its construction cost cannot be changed.

Economists refer to these as sunk costs.

When deciding which generators should operate today, the relevant question is:

Which generator can produce the next unit of electricity most cheaply?

This is why dispatch decisions are based on marginal cost rather than total cost.

How demand affects dispatch

Electricity demand changes continuously throughout the day.

During periods of low demand, only the cheapest generators may be required.

As demand increases, progressively more expensive generators enter service.

Imagine demand increasing throughout the day.

At night:

Wind
Nuclear

may be sufficient.

During the morning:

Gas generation may also become necessary.

On a cold winter evening:

Even diesel generators might be required.

The merit order therefore changes not because generators become more expensive, but because demand increases.

The merit-order curve

Economists often represent the merit order using a simple graph.

The horizontal axis shows cumulative generating capacity.

The vertical axis shows marginal cost.

Each generator contributes a block of capacity at its operating cost.

The result resembles a staircase.

As demand increases, the system moves further along the staircase, bringing progressively more expensive generators into operation.

This simple diagram is one of the most important concepts in electricity economics.

Merit order changes over time

The merit order is not fixed.

Several factors can change the operating costs of generators.

For example:

fuel prices,
carbon prices,
weather conditions,
generator availability,
maintenance outages.

A gas-fired power station may become more expensive if gas prices increase.

Wind generation may move earlier in the merit order when wind speeds are high because its fuel is effectively free.

The dispatch order therefore evolves continuously.

Renewable generation

Renewable generators often have very low operating costs.

Wind turbines and solar panels do not require fuel.

Once installed, producing one additional unit of electricity typically costs very little.

As a result, they usually appear near the beginning of the merit order.

This means renewable generation is often dispatched whenever it is available.

However, availability depends upon weather conditions.

The amount of renewable generation in the merit order therefore changes from hour to hour.

Why merit-order dispatch became popular

Merit-order dispatch has an attractive property.

If every generator reports its true operating cost, the system can meet demand at the minimum possible operating cost.

This makes the approach economically efficient in the short run.

Following electricity market liberalisation, many countries adopted market designs intended to reproduce this outcome through competition rather than central planning.

Merit-order dispatch therefore became the foundation of modern wholesale electricity markets.

An example

Suppose demand is initially:

1,000 MW.

Only wind and nuclear generation are required.

Later that afternoon demand rises to:

2,200 MW.

Now the gas turbine must also operate.

Finally, during an exceptionally cold winter evening, demand reaches:

2,450 MW.

The diesel generator is now required.

Notice that the dispatch changes because demand changes.

No generator has become cheaper or more expensive during the day.

Strengths of merit-order dispatch

Merit-order dispatch offers several important advantages.

Low operating costs

Electricity is generated using the least expensive available resources.

Transparency

The dispatch process follows a simple and understandable principle.

Efficiency

Available generating resources are used efficiently in the short run.

Competition

Generators compete to provide electricity at the lowest operating cost.

Limitations

Although merit-order dispatch is a powerful idea, it is based on several simplifying assumptions.

For example, it assumes that:

generators truthfully reveal their costs,
operating cost is the only relevant objective,
sufficient generation already exists,
network constraints can either be ignored or handled separately.

As electricity systems become increasingly decentralised and complex, these assumptions become more difficult to satisfy.

We will return to these limitations later in the module.

Merit order versus market prices

One important point should be emphasised.

Merit-order dispatch determines:

Which generators operate.

It does not determine how much those generators are paid.

The pricing mechanism is a separate question.

Modern electricity markets typically combine:

merit-order dispatch, and
a pricing rule.

The next lessons explore how these prices are calculated.

A key insight

Merit-order dispatch is the process of meeting electricity demand by using the available generators with the lowest operating costs first.

It provides a simple and economically efficient method for determining which generators should operate, making it the foundation of many modern electricity markets.

However, deciding who should generate is only one part of market design.

The equally important question is how those generators should be paid.

Key takeaways

Economic dispatch determines which generators operate to meet electricity demand.
Merit-order dispatch ranks generators according to their short-run marginal costs.
The cheapest available generators are dispatched first.
As electricity demand increases, progressively more expensive generators are brought into service.
Renewable generators often appear early in the merit order because they have very low operating costs.
Merit-order dispatch minimises short-run operating costs and became the foundation of many liberalised electricity markets.
Dispatch decisions determine which generators operate, but not how they are paid.

Looking ahead

Merit-order dispatch relies on one central concept:

marginal cost.

Understanding what economists mean by marginal cost is essential for understanding how electricity prices are determined.

In the next lesson, we examine marginal cost, exploring why economists focus on the cost of producing one additional unit of electricity rather than the total cost of building and operating a power station.