Marginal Cost

Marginal cost is the cost of producing one additional unit of electricity from a resource. In power markets, it usually includes variable fuel cost, variable operating and maintenance cost, and where relevant, emissions cost or other output-dependent charges.

This concept is central to dispatch and price formation because competitive energy markets generally rely on marginal rather than average cost. A plant may have high capital cost and low marginal cost, or the reverse, and that distinction strongly affects how it operates and earns revenue.

Key Aspects of Marginal Cost:

• Output-Dependent Cost: Marginal cost includes only the cost elements that change with an incremental increase in output. Fixed costs such as capital recovery, much of fixed O and M, and sunk investment are excluded.
• Dispatch Relevance: In economic dispatch, resources with lower marginal cost are normally used before those with higher marginal cost, subject to technical and network constraints. This is the basic logic behind the merit order.
• Price-Setting Role: In many electricity markets, the marginal cost of the last unit needed to meet demand determines the market-clearing price. That is why plants whose own marginal cost is lower can earn inframarginal revenue when prices are set by more expensive units.
• Technology Differences: Thermal units often have marginal costs strongly driven by fuel and emissions, while wind and solar usually have very low short-run marginal cost once built. Batteries and demand response may have more complex opportunity-cost based marginal behavior.
• Not the Whole Economic Story: Marginal cost is fundamental for operating decisions, but it does not by itself determine long-term investment viability. Technologies with low marginal cost may still need other revenue streams to recover fixed costs.