Annual report and accounts Archives

Market background

The UK is undergoing an energy revolution – a transition to a low-carbon economy requiring new energy solutions for power generation, heating, transport and the wider economy. Through our flexible, lower carbon electricity proposition and business to business (B2B) energy solutions, the Group is positioning itself for growth in this environment. More details can be seen on page 4 of our annual report.

Our strategy

Our purpose is to help change the way energy is generated, supplied and used.

Through addressing UK energy needs, and those of our customers, our strategy is designed to deliver growing earnings and cash flow, alongside significant cash returns for shareholders.

Our ambition is to grow our EBITDA to over £425 million by 2025, with over a third of those earnings coming from Pellet Production and B2B Energy Supply to create a broader, more balanced earnings profile. We intend to pay a sustainable and growing dividend to shareholders. Progression towards these targets is underpinned by safety, sustainability, operational excellence and expertise in our markets.

Summary of 2017

We made significant progress during 2017, but were below our expectations on the challenging scorecard targets we set ourselves in pellet production and biomass availability, the latter reflecting the significant incident we experienced on our biomass rail unloading facilities at the end of 2017, which extended into January 2018. Energy Supply performed well with Opus Energy in line with plan and Haven Power exceeding its targets. Through a combination of this performance and the progress of our strategy we have delivered EBITDA of £229 million, significantly ahead of 2016 (£140 million) and with each of our three businesses contributing positive EBITDA for the first time.

The Group scorecard is reported in full in the Remuneration Report (pp. 81-107 of our annual report) and the KPIs are also shown below. They reflect the diversity of our operations and our need to maintain clear focus on delivering operational excellence.

On a statutory basis we recorded a loss of £151 million, which reflects unrealised losses on derivative contracts, previously announced accounting policy on the accelerated depreciation on coal-specific assets as well as amortisation of newly- acquired intangible assets in Opus Energy. We also calculate underlying earnings, a profit after tax of £2.7 million, which excludes the effect of unrealised gains and losses on derivative contracts and, to assess the performance of the Group without the income statement volatility introduced by non-cash fair value adjustments on our portfolio of forward commodity and currency futures contracts.

During the year we refinanced our existing debt facilities, reducing our debt cost. We also confirmed a new dividend policy which will pay a sustainable and growing dividend (£50 million in respect of 2017), consistent with our commitment to a strong balance sheet and our ambitions for growth. At year end our net debt was £91 million below our 2x net debt to EBITDA target, providing additional headroom. There is more detail on our financial performance in the Group Financial Review on page 46 of our annual report.

In the US, our Pellet Production operations recorded year-on-year growth in output of 35%, with our first two plants now producing at full capacity. During the second half of 2017 we also completed the installation of additional capacity enabling our Morehouse and Amite facilities to handle a greater amount of residue material, supporting efforts to produce good quality pellets at the lowest cost.

As part of our target to expand our biomass self-supply capability we completed the acquisition of LaSalle Bioenergy (LaSalle) adding pellet production capacity. LaSalle commenced commissioning in November 2017 and due to its close proximity to our existing US facilities, once complete, will provide further opportunities for supply chain optimisation.

As in 2016, we benefited from the flexibility of self-supply. This often overlooked attribute of our supply chain enables us to manage biomass supply across the Power Generation business’ planned outage season and to benefit from attractively priced biomass cargoes in the short-term spot market.

In Power Generation, we experienced a significant incident on our biomass rail unloading facilities, including a small fire on a section of conveyor. We fully investigated the incident and following repairs over the Christmas period have now recommissioned the facility, with enhanced operating procedures. This is a timely reminder of the combustible nature of biomass and the need for strong controls and processes to protect our people and assets.

Our biomass units continued to produce high levels of renewable electricity from sustainable wood pellets for the UK market – Drax produced 15% of the UK’s renewable electricity – enough to power Sheffield, Leeds, Liverpool and Manchester combined. In doing so, we are making a vital contribution to the UK’s ambitious targets for decarbonisation across electricity generation, heating and transport – an 80% reduction by 2050 vs. 1990 levels.

We benefited from the first year of operation of our third biomass unit under the Contract for Difference (CfD) scheme which provides an index-linked price for the power produced until March 2027. The unit underwent a major planned outage between September and November, with a full programme of works successfully completed.

The flexibility, reliability and scale of our renewable generation, alongside an attractive total system cost, means we are strongly placed to play a long-term role in the UK’s energy mix. To that end we continue to see long-term biomass generation as a key enabler, allowing the UK Government to meet its decarbonisation targets and the system operator to manage the grid.

The UK Government recently confirmed support for further biomass generation at Drax Power Station and we now plan to continue our work to develop a low-cost solution for a fourth biomass unit, allowing us to provide even more renewable electricity, whilst supporting system stability at minimum cost to the consumer.

Our heritage is coal, but our future is flexible lower-carbon electricity. We are making progress with the development of four new standalone OCGT plants situated in eastern England and Wales and our work to develop options for coal-to-gas repowering with battery technologies. If these options would be supported by 15-year capacity market contracts, providing a clear investment signal and extending visibility of contract-based earnings out to the late 2030s.

In B2B Energy Supply, we completed the acquisition of Opus Energy, a supplier of electricity and gas to corporates and small businesses. The transaction completed in February 2017 and Opus Energy has continued to operate successfully within the Group, achieving its targets and making an immediate and significant contribution to profitability. Alongside this good performance we have also implemented the operational steps necessary to realise further operational benefits of the acquisition, and we now source all of Opus’ power and gas internally.

Haven Power delivered a strong performance with the sale of large volumes of electricity to industrial customers. Through our customer focus and efficiencies, margins have improved and the business generated a positive EBITDA for the first time.

Together, our B2B Energy Supply business now has over 375,000 customer meters, making it the fifth largest B2B power supplier in the UK.

We are delivering innovative low-carbon power solutions, with 46% of our energy sold from renewable sources. As the power system transforms, we will be working closely with our customers to help them adapt to a world of more decentralised and decarbonised power. We see this as a significant opportunity for the Group in the medium to long term.

In October 2017 we completed the sale of Billington Bioenergy (BBE) to Aggregated Micro Power Holding (AMPH). Consideration for the transaction was £2.3 million, comprised of £1.6 million of shares in AMPH and £0.7 million of cash.

The sale of BBE is aligned with our strategy to focus on B2B energy supply. However, through our shareholding in AMPH, we will retain an interest in the UK heating market, whilst gaining exposure to the development of small-scale distributed energy assets.

Political, regulatory and economic background

We continue to operate in a changing environment. The full impact of the UK’s decision to leave the EU is still unknown.

The immediate impact on the Group was a weakening of Sterling and an associated increase in the cost of biomass, which is generally denominated in other currencies. Through our utilisation of medium-term foreign exchange hedges the Group protected the cash impact of this weakness. In 2017, Sterling has generally strengthened, and we have been able to extend our hedged position out to 2022 at rates close to those that we saw before Brexit.

In terms of UK energy policy, the Government’s main focus has been on what it sees as unfair treatment of domestic consumers on legacy standard variable tariff (SVT) contracts. SVT are not a common feature of the B2B market. At the microbusiness end of this market, which is closer in size to domestic, most of our customers are on fixed price products and are active in renewing contracts.

The UK Government’s response to its consultation on the cessation of coal generation by 2025 has confirmed an end to non-compliant coal generation by October 2025.

We believe our assets, projects and ability to support our customers’ electricity management will support the Government’s ambition to maintain reliability when coal generation ceases.

Running a resilient, reliable grid is not simply about meeting the power demand on the system; there are also system support services which are essential to its effective operation. As the grid decentralises and becomes dependent on smaller, distributed generation, the number of plants able to provide these services is reducing. Biomass generation, our proposed OCGTs and our repowering project would allow us to meet these needs, but this will not come for free. A reliable, flexible, low-carbon energy system will require the right long-term incentives.

In November 2017, the Government confirmed that the UK will maintain a total carbon price (the combined UK Carbon Price Support – CPS – and the European Union Emissions Trading Scheme – EU ETS) at around the current level. CPS has been the single most effective instrument in reducing the level of carbon emissions in generation and we continue to support the pricing of carbon, a view echoed in a report prepared for the UK Government by the leading academic Professor Dieter Helm.

Against this backdrop we continue to make an important contribution to the UK economy. According to a study published by Oxford Economics in 2016, Drax’s total economic impact – including our supply chain and the wages our employees and suppliers’ employees spend in the wider consumer-economy was £1.7 billion, supporting 18,500 jobs across the UK.

Safety, sustainability and people

The health, safety and wellbeing of our employees and contractors is vital to the Group, with safety at the centre of our operational philosophy. We also recognise the growing need to support the wellbeing of our employees and their mental health.

During the year we continued to use Total Recordable Injury Rate (TRIR) as our primary KPI in this area. Performance was positive, at 0.27, but we expect this to improve in the coming year.

The incident at our biomass rail unloading facilities in December did not lead to physical injuries but was nonetheless a significant event and caused disruption into 2018.

We consequently launched an incident investigation to ensure our personal and process safety management procedures are robust.

To promote greater awareness around wellbeing we have embedded this in our new people strategy and expect to focus more energy and resources on this important area during 2018.

Strong corporate governance is at the heart of the Group – acting responsibly, doing the right thing and being transparent. As the Group grows the range of sustainability issues we face is widening and recognising the importance of strong corporate governance, we have published a comprehensive overview of our sustainability progress in 2017 on our website. This also highlights future priorities to broaden our approach to sustainability and improved reporting of environment, social and governance (ESG) performance. We have also completed the process which allows us to participate in the UN Global Compact (UNGC) – an international framework which will guide our approach in the areas of human rights, labour, environment and anti-corruption.

During 2017 we published our first statement on the prevention of slavery and human trafficking in compliance with the UK Modern Slavery Act. We have added modern slavery awareness to our programme of regular training for contract managers and reviewed our counterparty due diligence processes.

We have continued to maintain our rigorous and robust approach to biomass sustainability, ensuring the wood pellets we use are sustainable, low-carbon and fully compliant with the UK’s mandatory sustainability standards for biomass. The biomass we use to generate electricity provides a 64% carbon emissions saving against gas, inclusive of supply chain emissions. Our biomass lifecycle carbon emissions are 36g CO₂ / MJ, less than half the UK Government’s 79g CO₂ / MJ limit.

Our people are a key asset of the business. Through 2017 we developed a new people strategy. The strategy focuses on driving performance and developing talent to deliver the Group’s objectives. We have established Group-wide practices, including a career development and behaviour framework focused on performance and personal development.

Research and innovation

A key part of our strategy is to identify opportunities to improve existing operations and create options for long-term growth. To that end we have established a dedicated Research and Innovation (R&I) team led by the Drax engineers who delivered our world-first biomass generation and supply chain solution.

We are actively looking at ways to improve the efficiency of our operations, notably in our biomass supply chain.

Biomass is our largest single cost and as such we are focused on greater supply chain efficiency and the extraction of value from a wide range of low-value residue materials.

In B2B Energy Supply we are using our engineering expertise to help offer our customers value-adding services and products which will improve efficiency and allow them to optimise their energy consumption.

In the following sections we review the performance of our businesses during the year.

Performance review: Pellet Production

Our pellets provide a sustainable, low-carbon fuel source – one that can be safely and efficiently delivered through our global supply chain and used by Drax’s Power Generation business to make renewable electricity for the UK. Our manufacturing operations also promote forest health by incentivising local landowners to actively manage and reinvest in their forests.

Operational review

Safety remains our primary concern and we have delivered year-on-year reduction in the level of recordable incidents.

Output at our Amite and Morehouse pellet plants increased significantly, although was below our target for the year.

We have remained focused on opportunities to improve efficiencies and capture cost savings as part of our drive to produce good quality pellets at the lowest possible cost. We still have more work to do in this area to optimise quality and cost, as our performance was below target for the year.

As part of our plans to optimise and improve operations we added 150k tonnes capacity at our existing plants, bringing total installed capacity to 1.1 million tonnes and increasing the amount of lower cost sawmill residues we are able to process and used in our pellets.

CASE STUDY

Low-cost, high-impact capacity increase

By-products of higher value wood industries, such as sawdust from sawmills, offer a low-cost source of residues for use in our pellet production process and during 2017 we added an additional 150k tonnes of capacity at our pellet plants to allow us to use more of this material. By investing in giant hydraulic platforms known as ‘truck dumps’, operators at Amite and Morehouse can unload a 50-foot truck carrying either sawdust or wood chips and weighing 60 tonnes in less than two minutes, increasing processing capacity, reducing the cost of processing and increasing the use of lower cost residues.

Find out more: www.drax.com/uk/truckdumps and www.drax.com/uk/sustainability/sourcing

At our Baton Rouge port facility greater volumes of production from our facilities drove higher levels of throughput with 17 vessels loaded and dispatched during the year (2016: 11 vessels).

In April, in line with our strategy to increase self-supply, we acquired a 450k tonne wood pellet plant – LaSalle Bioenergy (LaSalle). Commissioning of the plant began in November 2017 and we expect to increase production through 2018. LaSalle is within a 200-mile radius of our existing facilities. By leveraging the locational benefits of these assets we aim to deliver further operational and financial efficiencies.

CASE STUDY

Locational benefits of Gulf cluster

The location of our operations allows us to leverage benefits of multiple assets and locations for operational efficiencies

All sites within 200-mile radius

Operational efficiencies

Common plant and joint strategic spare parts
Maximise reliability, minimise capital outlay
Flexibility through outage cycle
Human capital

Shared logistics to Baton Rouge

Rail and road
Increased port throughput

Complementary fibre sourcing

Optimisation of supply between plants

Find out more: www.draxbiomass.com

Financial results

There was a significant improvement in 2017, with EBITDA of £5.5 million (2016: £6.3 million negative EBITDA), driven by increasing volumes of wood pellets produced and sold to the Power Generation business. Sales of pellets in the year ending 31 December 2017 totalled £136 million, an increase of 84% over 2016.

Gross margin increased, reflecting higher production volumes. Raw fibre procurement, transportation and processing comprised the majority of cost of sales and as such this remains an important area of focus and an opportunity for the business. Through incremental investment in plant enhancements we expect to see further benefits from efficiencies and greater utilisation of lower cost residues.

Total operating costs have increased, reflecting an increase in operations at Amite, Morehouse and the Port of Baton Rouge, alongside the addition of LaSalle.

We acquired LaSalle for $35 million and have invested an additional $27 million as part of a programme to return the unit to service.

Pellet Production financial performance

	2017 £m	2016 £m
Revenue	135.7	73.6
Cost of sales	(96.7)	(55.5)
Gross profit	39.0	18.1
Operating costs	(33.5)	(24.4)
EBITDA	5.5	(6.3)

Key performance indicators

Area	KPI	Unit of measure	2017	2016
Operations	Fines at disport	%	9.6	7.6
Operations	Output	,000 tonnes	822	607
Financial	Variable cost/tonne	$/tonne	77	82

Looking ahead

Through 2018 we expect to continue to deliver growth in EBITDA from our existing assets. Our focus is on the commissioning of LaSalle alongside opportunities for optimisation and efficiencies in our processes, to deliver good quality pellets at the lowest cost.

We remain alert to market opportunities to develop further capacity as part of our self-supply strategy.

Performance review: Power Generation

Drax Power Station remains the largest power station in the UK (almost twice the size of the next largest). During the year the station met 6% of the UK’s electricity needs, whilst providing 15% of its renewable electricity, alongside important system support services.

With an increase in intermittent renewables and a reduction in the responsive thermal generation historically provided by coal, the system of the future will require capacity which is reliable, flexible and able to respond quickly to changes in system demand and provide system support services. These long-term needs inform our biomass generation and the development of options for investment in gas – Open Cycle Gas Turbines (OCGTs) and coal-to-gas repowering.

STRATEGY IN PROGRESS

Gas power station development

We are developing options for four new OCGT gas power stations, two of which already have planning permission and could be on the system in the early 2020s, subject to being awarded a capacity agreement.

A high-tech new control room at Drax Power Station will allow engineers to have real time remote control of our OCGT assets via a fibre-optic cable network. Able to fire up from cold and produce power in minutes rather than hours, our OCGTs will help maintain system security as intermittent renewable sources of power increase and older thermal plants close.

Investment case

Option to develop 1.2GW of new OCGT gas
Investment decisions subject to 15-year capacity agreement
Multiple revenue streams, with high visibility from capacity contract
Low capital and operating cost
Attractive return on capital
Broader generation asset base and location

Find out more: www.drax.com/uk/about-us/#our-projects

Regulatory framework

In October the Government published its Clean Growth Plan, setting out its plans for delivery of its legally binding target to reduce 2050 carbon emissions by 80% versus 1990 levels across electricity generation, heating and transport. This reinforces the Drax proposition – flexible, reliable, low-carbon electricity.

In November the Government updated its intentions regarding the future trajectory of UK Carbon Price Support (CPS), indicating that the total cost of carbon tax in the UK (the total of CPS and the EU Emissions Trading Scheme) would continue at around the current level (the tax is currently set at £18/tonne) whilst coal remains on the system.

We believe that CPS has been the single most effective instrument in reducing carbon emissions from generation and that having an appropriate price for carbon emissions is the right way to provide a market signal to further reduce emissions in support of the UK’s long-term decarbonisation targets.

The UK Government has now confirmed an end to non-compliant coal generation by 2025. We support this move subject to an appropriate alternative technology being in place. With this in mind we have continued to develop options for our remaining coal assets to convert to biomass or gas, to provide the reliable, flexible capacity which we believe will be required to manage the increasingly volatile energy system of the future.

Most recently with confirmation of Government support for further biomass generation at Drax Power Station we plan to continue our work to develop a low-cost solution for a fourth biomass unit, accelerating the removal of coal-fired generation from the UK electricity system, whilst supporting security of supply.

Generation capacity and system support

2017 saw the first full year of operation of our biomass unit under the Contract for Difference (CfD) mechanism, which provides index-linked revenues for renewable electricity out to 2027.

Our other biomass units are supported by the Renewable Obligation Certificate (ROC) mechanism which, similar to the CfD, is also index-linked to 2027. This acts as a premium above the price of power we sell from these units. We sell power forward to the extent there is liquidity in the power markets which, combined with our fuel hedging strategy, provides long-term earnings and revenue visibility.

Lower gas prices, higher carbon costs and the continued penetration of intermittent renewables have kept wholesale electricity prices subdued.

With increasing levels of intermittent renewables we are continuing to see opportunities to extract value from flexibility – short-term power and balancing market activity, the provision of Ancillary Services and the value achieved from out-of-specification fuels. To capture value in this market we continue to focus resource on optimising availability and flexibility of both coal and biomass units. This whole process requires a high level of teamwork between the operational and commercial teams across the Group to capture and protect value.

Over the period 2017 to 2022 we expect to earn £90 million from a series of one-year capacity market contracts for our coal units, demonstrating that they still have a role to play. The first of these contracts commenced in October 2017, adding £3 million to EBITDA.

Lastly, we continue to source attractively priced fuel cargoes – out-of-specification coals and distressed cargoes, which help keep costs down for the business and consumers. We do this for both coal and biomass. This is a good example of how our commercial and operational teams work together to identify opportunities to create value for the business, as these fuels typically require more complex handling processes.

You can follow the market and see prices at electricinsights.co.uk

STRATEGY IN PROGRESS

Repowering away from coal

Options for Drax Power Station to operate into the late 2030s and beyond moved up a gear in 2017 with the development of an option to repower two coal units to gas. Drax gave notice of the nationally significant infrastructure project to the Planning Inspectorate in September 2017. One of the units could be eligible for the capacity market auction planned for December 2019.

Local community consultations began in November 2017 and continued in February 2018 on options including up to 3.6GW of new gas generation capacity, a gas pipeline and 200MW of battery storage in line with Government plans to end non-compliant coal generation by 2025 and Drax Group’s strategy of playing a vital role in the future energy system.

Find out more: repower.drax.com