I hold positions in several solar power generation companies and funds in the UK. How do they make money? Clearly they sell electricity! But it turns out it’s more complicated than that.
There isn’t a simple flat rate per kWh (even though that’s what I get for the electrity I sell back to the grid from my solar PV installation). Instead electricity is priced by the system of marginal pricing.
What Is Marginal Pricing? 🔗
Marginal pricing in the UK electricity market is a system where all generators are paid the price bid by the most expensive generator needed to meet total demand, regardless of their own cost of production.
It is based on the system of uniform price auctions:
A uniform price auction otherwise known as a “clearing price auction”, pay-as-clear or marginal price auction, “marginal price system” (MPS), is a multiunit auction in which a fixed number of identical units of a homogenous commodity are sold for the same price. Each bidder in the auction may submit (possibly multiple) bids, designating both the number of units desired and the price he/she is willing to pay per unit.
Broadly, electricity generators propose prices for a given period (eg a specific 30 minutes on a particular day). The cheapest suppliers are used first. This order of use is the “merit order”. The key part is that all suppliers that supplied this period get paid a rate based on the most expensive supplier.
Let’s break this down into more detail.
Step One: Ranking By Cost 🔗
Every half-hour, power plants in the UK submit bids to the system operator to supply electricity. The merit order is simply a list that ranks these bids from the lowest cost to the highest cost.
Step Two: Bidding 🔗
Cheap Generators (Low Marginal Cost): Renewable energy sources like solar and wind have a very low running cost (their fuel is free). Nuclear power also has a low marginal cost. These plants submit the lowest bids, often close to zero. They are placed at the top of the merit order.
Expensive Generators (High Marginal Cost): Power plants that use fuel, especially natural gas, have a much higher running cost. The cost of their fuel directly impacts their bid. These plants submit the highest bids and are placed at the bottom of the merit order.
Step Three: Meeting Demand 🔗
The system operator then dispatches generators from the top of this ranked list, starting with the cheapest, until the total demand for electricity on the grid is met.
Step Four: The Final Price 🔗
The last and most expensive plant needed to meet demand is called the “marginal generator.” Its bid price sets the final, uniform price that is paid to all generators for that half-hour period, regardless of where they were in the merit order.
The upshot of all this is, if gas formed part of the mix in a half hour period, the gas price sets the solar (or wind or any other cheaper source) price.
How often is gas used? According to this research, 98% of the time!
Note that in theory, this high price is supposed to incentivise renewables versus non-renewable sources. I’ll leave that debate for another day.
How solar operators make their money 🔗
So, back to the original question: how do solar operators make money. Two main ways:
- solar generation, as above
- government-backed subsidies
Let’s look at a specific solar company (actually a fund), NextEnergy. According to its revenue breakdown, 50% comes from subsidies of one sort or another.
Relation between solar earnings and gas prices 🔗
Given that solar earnings are at least partly based on gas prices (ignoring the weather!), how strong is the connection?
Well, here is a graph:
In 2022 Russia invaded Ukraine, and gas prices shot up. There seems to be some kind of correlation here. Can we be more precise?
Solar Revenue As A Function Of Gas Price 🔗
I did some quick analysis in R to see if this idea held up. You can see the files here.
For simple regression we end up with this relation:
The stats are as follows:
F-statistic: 2.451 on 1 and 8 DF, p-value: 0.1561
Unfortunately this isn’t a great correlation.
Notice however from the first graph that the effect, if there is any, seems to lag by a year. We can include this in our model (see the last part of the R code), and we find this relation:
The stats for this model are now
F-statistic: 7.676 on 1 and 7 DF, p-value: 0.02767
This is a significantly better fit.
Why a one year lag? It’s possible, indeed likely, that there are power purchase agreements in play here, where energy is sold in advance at fixed prices. This would bear further investigation.
Conclusion 🔗
NextEnergy has a most recently reported dividend cover of -0.22 (yes, negative). If you look at that source you’ll see that dividend cover was healthiest during the Russian invasion. If gas falls further out of favour and prices fall, then solar operators like this will be squeezed further, at least in terms of their offered dividends.
None of this is to say that you shouldn’t invest in solar! I’m maintaining my positions. Rather, in investment terms the situation is complex and mired in political decisions, so don’t leap in blindly. Not all countries use marginal pricing, and there are calls for the UK’s system to be reformed, perhaps splitting gas from renewables.