Recently, the term price cannibalisation has been cropping up in the public discourse around the energy system transition, addressed by a variety of viewpoints and interests. For instance, some argue that it brings high investment risk for renewable projects, e.g., here, whereas others downplay it by highlighting that those fears maybe exaggerated, e.g., here.
Regardless of the viewpoints, it is important for the general audience to understand the mechanics behind this effect, which is the purpose of this short write-up.
While this paper (available Open Access) provides an academic treatise of the nuances involved considering the case of California, in the following, I explain the effect using an illustrative example of a day-ahead electricity market clearing.
Day-ahead electricity markets are where most of the volume of electricity is traded currently and they operate on the principle of marginal pricing. This implies that the marginal cost (€/MWh) of the marginal generator (the most expensive generator that needs to be run to fulfil the ‘marginal demand’ or the last MWh of demand) in a given period (e.g., hour, in case of the hourly day-ahead markets) is the price of electricity in that hour.
In the above example, if the demand at a given hour were 240 MWh, the market clears with marginal generator as G2 and therefore, it’s marginal cost (fuel cost of 15 €/MWh in the case of the fossil-fuel based generator shown) is the price of electricity. This price, is in fact, received by all producing generators, i.e., Generator G1 receives a revenue of 100 × 15 = €1500 at a production cost of 100 × 10 = €1000, making a neat profit of €500. Whereas the marginal generator collects a revenue of 140 × 15 = €2100 at break-even.
Now imagine that this is an hour in a cloudless sunny day around midday and that solar PV producers G4 and G5 (not shown in Figure 1, each with 100 MW capacity each and producing at full capacity) are also bidding into the market at their marginal (read, fuel) cost of 0 €/MWh.
This shifts the entire offer curve (merit-order curve) to the right, therefore, the new market price is set by G1 which is now the marginal generator and the price received by the producers is now 10 €/MWh. This is neat for solar PV producers, since they get paid €1000 each at no cost of production.
Sounds great, right? And it is indeed! This profit represents a market signal, which is supposed to work towards incentivising more solar project developers to build and operate solar PV plants in the region.
Now, imagine the electricity demand remains fixed at 240 MWh and a sixth solar PV producer G6 with a capacity of 50 MW joins the generation pool. Suddenly, one of the solar PV producers becomes the marginal generator and as a result, the price is set to 0 €/MWh and no producer makes any money in that hour in the market.
The above illustrates the price cannibalisation effect in action for a given hour of the year. The entry of the third renewable producer in the region eats into the profits of all producers, hence the vivid cover image of this article, depicting renewables devouring themselves.
As the overall generation pool shifts more towards such zero-marginal cost producers, more hours with zero (or very low) or even negative prices occur (particularly during high solar production hours), which reduces the average price that can be received by new projects willing to enter the market. This, in turn, adversely affects the revenues that market participating projects can make and therefore, diminishes the interest of investors and bankers in such projects.
For more curious readers, I can highly recommend this fantastic resource on the basics of electricity market and price formation process, including a special focus on the intriguing case of negative prices published by EPEX SPOT, a market operator in Europe.
<hr><p>Price cannibalisation effect was originally published in Clean Energy for Billions on Medium, where people are continuing the conversation by highlighting and responding to this story.</p>