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Drax’s interim results show good volumes in biomass generation and the pellets business which also saw a good increase in EBITDA. Flexgen continues to perform although upgrading work tempers these results. The balance sheet remains strong and a new buyback programme runs ahead of the release of working capital from the ROC programme.
Drax Group plc
Drax has launched the fourth and final tranche of its £300m share buyback programme with a target of repurchasing up to £75m of its shares. The move comes coincidentally after the decision by the company not to chase the purchase of the Harmony Investment Trust following a counter bid at close to NAV by funds managed by Foresight Group. We do not think this means that the company will not pursue other opportunities for investment in other real assets but we do think it emphasises the strong financial discipline exercised by the company. Last night also saw progress on the bridging mechanism with key enabling legislation making progress in Parliament.
Drax will not increase its bid for HEIT which means it is unlikely to acquire the assets in the face of a higher bid from Foresight. While we think the company could add value above the reported NAV of the fund, there is little point chasing these particular assets and we welcome the capital discipline demonstrated in yesterday afternoon’s announcement.
A strong first quarter has resulted in increased guidance for the full year from Drax and we have increased our forecasts accordingly with a knock-on increase in FY 26. The biomass units have been a key driver of performance but across the portfolio the company continues to be a major contributor to system support. Our central case valuation increases to 996p from 986p.
A competing and recommended bid for the Harmony Energy Income Trust creates some uncertainty over Drax’s position. While we welcomed Drax’s bid for this portfolio of battery assets when announced, if Drax does walk away we would not see this as a major setback and there are plenty of opportunities in the market. More importantly the level of interest in these flexible asset points to the value of Drax’s existing FlexGen portfolio.
Drax has put in place a joint venture to create incremental value from the biomass units at Drax power station with an offtake route for the pulverised fuel ash created in generation. The JV should add £5m to adjusted EBITDA post 2027 and the product itself will help to lower the carbon footprint of the concrete for which it is an additive.
Drax has bid just short of £200m for the 791MWh of battery storage assets represented by the Harmony Energy Income Trust. This will take the company’s FlexGen portfolio to c.4.5GW and add short duration and fast reacting storage to the mix allowing greater participation across what we see as a growing market. We think the company has paid a fair price to which it can add value within this expanded portfolio.
Drax has seen success in yesterday's UK Capacity Market auctions provisionally winning an estimated £24m of additional revenue for the hydro and pumped storage assets across FY 28 and FY 29. This builds on success at previous auctions with pricing at £60/kW/year, only slightly below the 2024 T-4 level of £65/kW/year. The company has also provisionally won a longer-term agreement to cover refurbishment at one of the Galloway hydro assets.
Drax has seen a strong year with better volumes driving good financial performance. The medium term has now been materially de-risked thanks to the bridging mechanism and we expect this year to see support for the Cruachan II expansion through the proposed cap and floor mechanism with both events highlighting the importance of Drax in supporting the UK energy market. Further opportunities in BECCS are now augmented by battery opportunities and discussions on a 1.2GW data centre at the Drax power station site.
Drax has agreed continued support for the biomass units at the Drax Power Station. This will allow these flexible units to continue to provide essential support to the market as demand for flexibility rises and bridges the period before Drax can add carbon capture to create a negative emission solution, essential to delivering the UK’s decarbonisation goals. While the agreed strike price is attractive, the volume is capped and collared between 5TWh and 6TWh, less than the c.14TWh currently generated. However, the units can sell merchant power above this subject to a gain sharing agreement and Drax expects the units to generate an EBITDA of between £100m and £200m. Our central case valuation is trimmed to 988p from 1,023p to reflect the units achieving £167m in FY 28 based on strong pricing in a tight market.
Drax has agreed heads of terms to supply a sustainable aviation fuel (SAF) production facility in the US with sustainable woody biomass. The deal will be for up to 1m tonnes of pellets to be supplied to Pathway Energy annually under a multi-year deal. Commercial SAF production is expected to commence in 2029 and there is potential for Drax to supply biomass to two additional Pathway projects for similar volumes in the 2030s. This potential deal supports Drax’s long-term pellet production targets, aiming for 8Mt of pellet production by 2030, depending on UK BECCS policy.
Drax’s trading update signals better performance across the UK generation portfolio as recent low wind drives better volumes and price for flexible generation. This is a strong confirmation of the recent NESO report on achieving clean power by 2030 which highlights flexible generation including biomass and BECCS as essential to balancing more intermittent renewables as these come onto the grid. We have adjusted our forecasts to reflect this and also better performance in the pellets business.
The government appears to be following the Lords’ Science and Technology Committee’s recommendation that they “get on with it” when it comes to supporting long duration energy storage. Confirmation of a cap and floor revenue support model that could be open to applications in 2025 is clearly positive and the timing would allow Drax to bring the Cruachan expansion online as expected in 2030. With a strong government commitment to more intermittent renewables, yet also delays on new baseload capacity such as Sizewell C, demand for long duration storage represents a growing and long term opportunity in our view.
While the UK Government’s confirmation of funding for CCS (Track 1) was positive it is even better to see rapid progress on the ground with signs that key projects are already moving towards debt funding. For Drax the potential funding of a storage and transport pipeline fills in a key piece of the jigsaw allowing progress to be made on the two biomass with carbon capture installations at the Drax power station.
The launch of subsidiary Elimini, allows Drax to focus its efforts on growing demand for carbon dioxide removals (CDR). CDR is already essential to hit net zero emissions but with growing pressures from data centre energy demand, is becoming more necessary. Drax now has the vehicle to capture this important theme as it develops.
Poor reporting relating to the newly acquired Pinnacle Renewable Energy during FY 22 has resulted in a £25m redress payment for Drax by Ofgem but the regulator has found no evidence that ROCs were issued incorrectly. More importantly, Drax is now compliant with the reporting requirements and will additionally add an external audit process on biomass profiling. We see this as drawing a line under historic issues and should give comfort that the company now has the process in place to comply with the requirements of any future support including the bridging mechanism for the biomass units.
A new expanded revolving credit facility and a new term loan add to a period of strong progress in building financial strength at Drax. With opportunities to invest balanced with returns to shareholders under the buy back programme we see the balance sheet as well supported.
Drax has shown a strong set of interim results and a positive outlook for the full year and we are increasing our forecasts accordingly. With a healthy balance sheet, the company has initiated a 2-year £300m buyback programme and signalled a 12.6% growth in the full year dividend. Beyond this, Drax continues to develop strong opportunities with pumped hydro and BECCS in the UK and BECCS in the US.
The sale of a large part of the SME customer book from Drax’s energy supply business will not change EBITDA expectations but we do see the move as a helpful de-risking. Smaller customers tend to represent more volatile demand and are less resilient to economic changes such as those seen during the COVID-19 lockdown. With the Customers business fully recovered from weaker trading during that period we see this sale as a sensible tidying up.
Drax’s share price is now starting to reflect the underlying strength of the business in addition to the market’s realistic appraisal of underlying policy uncertainty. The key near-term valuation drivers for the company are around a bridging mechanism for subsidy support (CfD, ROC) for Drax’s biomass units past 2027, following approval for two BECCS units at Drax Power Station. The company continues to guide to an updated mechanism this year, and we expect a valuation re-rating once clarity is achieved. At our 865p TP, Drax trades on an undemanding FY25E EV/EBITDA of 2.8x and a P/E of 4.7x. BUY.
Zonal pricing is now under consideration for implementation in the GB power market. While this is very much not a given, this note summarises the key reports on its potential impacts. We find that while there is an overall reduction in revenues across generation, this may be less than originally predicted and new regional price differences and timing differences may favour storage in Scotland and delay new gas plant construction nationally. We think this later second order impact improves the environment for other providers of flexible generation, potentially offsetting any hit from the first order impacts of a zonal system.
DRX IES NESF AMP
The Q1 trading update from Drax shows continued strong performance from its flexible portfolio with continued business in system support and the company expects full year adjusted EBITDA to be in line with the market consensus. The three OCGTs are now looking to commission in September and the balance sheet has been refreshed leaving the company well placed to take advantage of growing need for system support in the GB power system.
Drax’s latest term loan ensures the company will meet its target of repaying Q4 debt maturities. Drax ended FY23 with net debt of £1.08bn, down from £1.21bn in FY22, giving it a net debt-to-adjusted EBITDA ratio of 1.1x, down from 1.6x previously and well below its target leverage ratio of 2x. The key near-term valuation drivers continue to focus on a bridging mechanism for subsidy support (CfD, ROC) for Drax’s biomass units past 2027, following approval for two BECCS units at Drax Power Station. We continue to estimate that this will be clarified this year, and we expect the company’s valuation to reflect the removal of this uncertainty. At our 865p TP, Drax trades on an undemanding FY24E EV/EBITDA of 2.8x and a P/E of 9.1x. BUY.
A new term loan for Drax allows it to meet the commitment signalled at the full year results to repay Q4 debt maturities. The company remains financially strong with FY 23 showing cash generation of £1,111m and a net debt to adjusted EBITDA ratio of 1.1x, down from 1.6x in FY 22. We think this leaves the company well able to fund its key investment opportunities.
Drax’s importance in the UK’s energy mix has been recently highlighted by the Government’s decision to rule out mothballing in the consultation on transitional support for the biomass units. We see this as emphasising a growing demand for the type of assets Drax has, with a multiyear pinch point likely in the second half of the decade where Drax can benefit from growing system balancing revenues. Drax is targeting at least £250m of recurring revenue from Flexible Generation and Energy Solutions post 2027 which our analysis suggests is very achievable. We have revised our long-term forecasts accordingly and our central case valuation increases to 1,077p from 1,018p.
Drax reported a solid set of FY23 financial results, with no material surprises. 2023 was not without its challenges in terms of Drax’s share price performance, largely due to policy uncertainty, however we expect many underlying questions to be answered for the company this year. The key near-term valuation drivers for the company are around a bridging mechanism for subsidy support (CfD, ROC) for Drax’s biomass units past 2027, following recent approval for two BECCS units at Drax Power Station. Recent media coverage suggests this will be clarified this year, and we expect the company’s valuation to reflect the removal of this uncertainty. At our 865p TP, Drax trades on an undemanding FY24E EV/EBITDA of 2.7x and a P/E of 8.8x. BUY.
Drax has issued its full year results showing strong performance from the pumped storage and hydro assets and a notably strong recovery in the energy supply business. The company has also set out strong targets for EBITDA post 2027 from its flexible asset portfolio and from pellet sales with more third party sales targeted. The remaining biomass units are currently under consultation for support between 2027 and 2030 when full support for BECCS is likely with recognition of the essential role of these units in contributing to energy security recognised in the consultation paper.
Drax has seen success in the UK Capacity Market auction adding £249m of income in the period from October 2027 to September 2028. Pricing has been strong reflecting a tightening of the market in this period and we expect that to continue to the end of the decade at least. As a key provider of flexible, dispatchable capacity to the GB power market we see Drax well placed in this environment. The pumped hydro and run of river hydro assets provide notable flexibility and the Drax biomass units remain critical for dispatchable services to the grid.
Following departure of the covering analyst, we are suspending coverage of Drax, withdrawing our forecasts, target price and recommendation with immediate effect.
The National Audit Office (NAO) has completed its review of the UK Government’s support for biomass which concludes that currently there is a lack of adequate evaluation of sustainability compliance. The report calls for improved assurance and transparency in sustainability requirements, urging the Government to review and allocate adequate resources for effective oversight. Crucially however, the report did not find evidence that companies are not complying with sustainability criteria. On balance we see the report as a net positive for Drax, increased oversight will invariably lead to further validation of biomass as a long-term contributor to the UK’s future low carbon energy mix.
The NAO has criticised a lack of evaluation of government approaches to monitoring biomass sustainability. It does not say that these approaches are inappropriate, merely that they cannot be demonstrated to be appropriate. It therefore supports a detailed review of monitoring which we see as consistent with already announced plans. Overall, we do not see anything here as particularly onerous for Drax and see better monitoring as building credibility for the BECCS solution.
The Department for Energy Security and Net Zero (DESNZ) has published today a consultation on a transitional support mechanism for large-scale generators (here). Our read of the consultation document (key highlights on following pages) is that there is a reiteration of support for power BECCS, that there are security of supply concerns, and a case for intervention. Four policy options have been put forward: (i) CfD unconstrained; (ii) CfD with a generation collar; (iii) Availability Payment; and (iv) Regulated Margin. No indication has been given on the potential level of support, and it is anticipated that negotiations with eligible generators will take place this year. Notwithstanding the absence of numbers, we view the consultation as positive and supportive of there being an earnings stream from Drax Power Station post March 2027. The consultation indicates an expectation that the National Audit Office (NAO) is to publish a report shortly on the Government’s support for biomass. Publication could help alleviate uncertainty overhanging Drax. The consultation is open for six weeks and will close on 29th February. The accompanying impact statement (here) includes a table that sets out an annual net cost of the options considered, but as DESNZ makes clear this “…provides an incomplete picture of the value of the options considered and is included for illustrative purposes” and further states “…a negative value in this table may still provide value to society where it retains the option of deploying power BECCS.” This should go some way to diffusing the cost narrative that some seek to promote.
The consultation is out on bridging support for ROC funded biomass units including three units at Drax. Details of the final support package won’t be known until after the consultation closes and negotiations take place during 2024, but the very fact that this is being consulted on means support is likely at a level that will deliver a profit to Drax. Even if a final decision runs beyond any election, leaving such a significant amount of low carbon flexible capacity unsupported from 2027 would be a major risk to system security and this is recognised in the consultation paper.
DCO granted for BECCS at Drax Power Station DESNZ SoS Clare Coutinho has approved the Development Consent Order (DCO) for Drax’s plans to convert two of its biomass units at Drax Power Station to BECCS. The SoS received the Examining Authority’s report on 17th October and made the DCO on 16th January 2024, with it coming into force on 7th February 2024. We highlight two of the SoS’s conclusions from the decision letter of 16th January 2024: “…the Secretary of State considers the benefits of the Proposed Development outweigh its adverse impacts.” “…the Secretary of State considers development consent should be granted for the Proposed Development. The Secretary of State considers that the national need set out in the relevant NPSs outweighs the Proposed Development’s potential adverse impacts, as mitigated by the proposed terms of the Order.” We are not surprised that planning approval has been granted and view the DCO as a positive step, although we recognise that there are many other pieces to the jigsaw that still need to fall into place. We reiterate our view that the country needs Drax, and we await a government consultation on a bridging mechanism post the end of RO/CfD support in 2027, which we suggest would be a positive catalyst. We are, however, cognisant of the overhang from the Ofgem investigation, and the pending NAO report on biomass. Judicial review is the only means of challenging the decision Annex A of the DCO letter states: “Under section 118 of the Planning Act 2008, an Order granting development consent, or anything done, or omitted to be done, by the Secretary of State in relation to an application for such an Order, can be challenged only by means of a claim for judicial review. A claim for judicial review must be made to the Planning Court during the period of 6 weeks beginning with the day after the day on which the Order or decision is published.”
Policy support for long duration energy storage in the UK looks set to use a cap and floor model which we see as a positive move, helping to reduce funding uncertainty for projects going forward. The consultation identifies a need for long duration flexible electricity capacity of at least 30GW and up to 50GW by 2035, making this an important area of opportunity in the UK power market. The consultation closes on 5th March so we could see final policy being announced during 2024.
DRX IES 7QN
Today’s statement on Carbon Capture Utilisation and Storage confirms UK government support for the technology generally and represents progress towards support for Bioenergy Carbon Capture and Storage at Drax. In particular we see the recognition of world-leading economic benefits in the long term vision paper as important in building long term support for BECCS at Drax.
Drax’s trading update confirms consensus expectations and the pumped hydro business in particular is seeing strong performance. Biomass is also finding new outlets with demand from a growing biofuels market and we see this continuing in the medium term. We have increased our forecasts for FY23 and FY 24 to reflect better capture of power market volatility at Cruachan putting EBTIDA at £1,158m and £1,181m respectively and our central valuation moves to 1063p from 1049p.
Hedging updated… The hedged position for 2023 is now 11.0TWh ROC/hydro/gas proxy @ £169.1/MWh (vs. 11.7TWh @ £162.7/MWh). For 2024, the hedged position is now 10.8TWh @ £148/MWh (vs. 11.2TWh @ £147.5/MWh). The hedged position for 2025 is now 8.4TWh @ £115.3/MWh (vs. 5.2TWh @ £126.2/MWh). In total this equates to c.£4.4bn of contracted sales vs. c.£4.2bn previously. For 2024, our pre-existing estimates suggest an average price of £151.7/MWh, while for 2025 our average price is £120.5/MWh, albeit that there is open volume in 2025. …FY23 guidance confirmed Drax expects that full-year adjusted EBITDA (pre EGL) and the EGL will be in line with analyst consensus expectations (range of £1,100-1,199m, and £198m respectively). Our pre-existing estimates are £1,186m and £199m respectively. Drax has also noted the strong performance of the hydro assets; it expects 2023 full year Adjusted EBITDA for pumped storage and hydro to be significantly above full year 2022 (£171m). Our pre-existing estimate is £197m. Full-year results will be published on 29th February 2024. Awaiting bridge details No visibility on timing in respect of the ongoing Ofgem investigation, but Drax believes that the NAO’s review of the UK Government’s biomass strategy will be published in December. A consultation on a post 2027 bridging mechanism between the end of the RO/CfD at Drax Power Station and BECCS will commence shortly, and further details on the Track-1 expansion / Track-2 carbon cluster sequencing programme are also expected to be published shortly.
Canada’s latest Fall Economic Statement (FES) underlined the country’s support for both CCUS and biomass power generation. Drax has since followed this by identifying Canada as an ideal location to deploy bioenergy with carbon capture and storage (BECCS), given its access to one of the world’s greatest fibre baskets, well-established sustainable forestry sector, and suitable geology for CO2 storage. Drax continues to target 6Mtpa of carbon removals in North America by 2030 and Canada’s latest support adds further validity to this strategy in our view. BUY.
Support for bioenergy with carbon capture and storage (BECCS) has been given a boost through the inclusion of supportive legislative proposals in Canada’s Fall Economic Statement. This follows strong support from the UK Government in its August Biomass Strategy which included a clear analysis of the science. Drax is targeting annual CO2 removals in North America of 6Mt by 2030 and this move increases the potential for developing well-supported projects in our view.
The National Audit Office (NAO) report into the UK government’s support for biomass is about checking that policy represents value for money and a normal response to policy announcements. We see Drax’s BECCS deployment as the only near-term solution at scale that can create negative emissions and it is difficult to see alternatives as offering better value for money in our view.
Drax’s stock fell by 10% on Friday afternoon following the announcement by the National Audit Office (NAO) that it will produce a report on the government’s Biomass Strategy, published on 10th August, setting out facts on three issues: (i) the government’s current biomass strategy and how this contributes to the government’s overall strategy of achieving Net Zero by 2050; (ii) how support for biomass has been implemented, how its support has been funded including future spending allocations, how sustainability criteria are monitored and enforced; and (iii) how government has identified the main risks to successful implementation, the long-term environmental implications, and the future plans for biomass. The NAO is the UK’s independent public spending watchdog, but in delivering its work, the NAO’s role is not to question government policy. In an environment where investors are twitchy about the slow pace of the post March 2027 bridging mechanism, the power BECCS model, and the ongoing Ofgem investigation into Drax’s compliance with RO reporting requirements, we can understand frustration with yet another look under the hood, but we view Friday’s reaction as significantly overdone. Headlines sell; we suggest that a fact-based NAO report is markedly different to a “probe of biomass policy” as one newswire put it. It would therefore be helpful to all stakeholders if the NAO could expand on its intentions, additionally explaining why it has taken over a month post publication of the Biomass Strategy to announce the intention to produce a report.
We last wrote on Drax in early August (here) when the stock was trading at 607p. Since then stock has backtracked and is now trading around 540p vs. our (unchanged) target price of 1,015p. This has got us thinking about what is moving in the right direction, and where there might be headwinds. We bemoaned the glacial pace of government towards the publication of the Biomass Strategy. It finally landed in mid-August (here), backing biomass “Through biomass, we can achieve both low carbon energy sources and some of the negative emissions necessary to reach net zero”, with a clear view re prioritisation of use. Short term (2020s), government will continue to facilitate sustainable biomass deployment (our emphasis) through a range of incentives and requirements covering power, heat and transport; Medium term (to 2035) government intends to further develop biomass uses in power, heat and transport sectors with a view to transition away from unabated emission uses of biomass, where possible, to uses such as BECCS; Longer-term (to 2050), the strategy sets out that biomass uses that can produce negative emissions (i.e., those that capture and store CO2) should be prioritised in the long term to support UK’s net zero target. If we are being cynical, the document drifted into a lot of ‘this could be done’, ‘that could be done’, losing sharpness, but cut through the ‘fluff’ and it’s about a finite sustainable resource for which there will be international competition, and the best use of that resource. With its integrated model, Drax has the opportunity to deliver negative emissions, and also controls raw material sourcing. continued overleaf
The UK government has provided further support for BECCS through the publication of its much-anticipated Biomass Strategy. This has served to add greater clarity and validation in terms of the role of biomass in the UK’s energy transition which had come under increased scrutiny over the past 12 months. We continue to view BECCS as the only carbon capture solution that actively leads to negative emissions while also generating low carbon power. On this basis, we believe there remains a lot to play for with regards to Drax’s UK BECCS proposition, especially when considering its considerable importance to the government’s target of removing 5Mtpa of CO2 by 2030. We reiterate our BUY stance, with a small reduction in our TP to 900p (from 940p/share) to reflect latest forward pricing and accounting adjustments.
The UK government has today published its Biomass Strategy which includes clear support for bioenergy with carbon capture and storage (BECCS). The strategy is based on an analysis of the science summarised in a separate policy paper prepared by the Department for Energy Security and Net Zero’s Task and Finish Group. Another report examines issues around the public dialogue on the issue which at best remains divided. This has resulted in policy support for biomass and BECCS being seen as a key risk factor for Drax. Today’s papers go a long way to mitigating that risk with the UK government being prepared to show leadership around a technology supported by the evidence as critical to delivering a net zero outcome.
Estimates updated (Figure 1) to reflect the latest disclosed hedged position, a rephased assumption of expanding pelleting capacity to 8mt, and higher corporate cost/devex from FY24E, although the latter is likely to be volatile and linked to the potential timelines of the plethora of strategic investment opportunities that Drax has. We continue to present EBITDA gross of the EGL, with Drax having indicated that it will present adjusted figures on both a net and gross basis. FY23E EBITDA moves up by 0.5% to £1,186m, but FY24E trimmed by 9,4% to £1,148m. FY23E EPS (undiluted) moves up by 0.6% to 119.3p, with FY24E cut by 9.9% to 134.2p. We are below that FY24 consensus for EBITDA, although we understand that this number includes at least one outlier on the high side. Our approach to valuation remains unchanged, albeit that we have moved our valuation point out to FY24E. We continue to average three valuation scenarios, with the combination of our updated estimates, the shift in the valuation point, and a slightly higher WACC of 7.2% (vs. 7.1%) nudging our target price down to 1,015p. We continue to see a significant value opportunity, with Drax a cash generative company that could choose to buy back equity if the UK government continues to drag its feet and investment cannot be progressed in a timely manner. As we have previously suggested, Drax could also be an M&A target for those seeking CO2 reduction.
Drax’s first half results show that it continues to benefit from providing key system support and flexibility to the GB power market. Generation has been particularly strong with a volatile market and forward sales driving notable strong performance in the pumped storage and hydro assets. Pellet production has also shown some modest growth despite outages and the customer business is very much back on track post COVID. Going forward the company continues to make progress on the development of its US BECCS business with two new-build sites now selected and targeting c.6Mt of CO2 removal by 2030 adding to an overall target of 20Mt.
EPS beat, EBITDA slightly below our estimates Drax has reported 1H23 results this morning. Adjusted EBITDA (excl. EGL) was £453m, up 101% vs. 1H22A but below our estimate of £481m. EPS of 46p, up 130% vs. 1H22A (INVe 39.7p). Dividend of 9.2p, up 9.5% vs.1H22A (INVe 9.3p). Net debt of £1,274m was in line with our estimate of £1,250m. At a divisional level, generation posted EBITDA of £457m (INVe £468m), pellet production posted EBITDA of £48m (INVe £54m), and B2B posted EBITDA of £37m (INVe £27m). Drax has alluded to a strong system support role, the latter in line with our thesis that flexibility will be increasingly important in a system that has more volatility and intermittency. A presentation is already available and a webcast will be held at 8.30am (Link) FY guidance in line with consensus Guidance for FY23 Adjusted EBITDA remains in line with analyst consensus, the latter now at £1,172m (INVe £1,180m). This compares to that which Drax’s communicated on 23rd May, where Drax expected this metric to be in line with analyst consensus of £1,162m (range £1.1-1.2bn). The FY dividend is expected to be 23.1p, slightly below our pre-existing 23.2p estimate. Hedged positions are now: FY23 – 11.7TWh ROC/hydro/gas output @ £162.7/MWh (vs. 12.5TWh @ £158.6/MWh). FY24 - 11.2TWh @ £147.5/MWh (vs. 10.5TWh @ £149.1/MWh). FY25 – 5.2TWh @ £126.2/MWh (vs. 3.2TWh @ £137.3/MWh). Average prices (ex CFD) in our pre-existing estimates are £157.2/MWh (FY23E), £156.3/MWh (FY24E), and £120.5/MWh (FY25E), albeit with material open volume in 2025. Ongoing discussions with the UK government re BECCS Discussions with the UK government re a post 2027 bridging mechanism and BECCS are ongoing.
We have updated our estimates (Figure 1) to reflect the latest disclosed hedged position, updated power price assumptions, the £150m share buyback, and a new assumption that Drax will receive a bridging mechanism from April 2027 to December 2029, ahead of deployment of large-scale power BECCS by 2030. We continue to present EBITDA gross of the EGL, although the accounting policy may change. FY23E EBITDA moves up by 1.7% to £1,180m, but FY24E is trimmed by 6% to £1,266m. EPS moves up by 11.7% to 118.6p, and by 6% to 149.0p, respectively, as a lower EGL take and the buyback play through. Delays to the clarity of policy are not helpful to the UK’s net zero journey, and could well jeopardise energy security, as policy measures in other countries could divert investment away from the UK. The damning conclusions of the Chair’s foreword to the Climate Change Committee’s 2023 Report to Parliament – ‘It would be a terrible error if we in Britain hesitate just as the rest of the world wakes up to the opportunity of Net Zero’ – should be a wake-up call to all political parties and policy setters. We need to crack on (Figure 2). For Drax, we view the much delayed, now expected in July, Biomass Strategy, as a potential positive catalyst as hopefully it will provide clarity on the use of sustainable biomass. We also expect FES 2023, to be launched by the ESO on 10th July, to underscore the need for negative emissions, including BECCS. The broad approach to our valuation is unchanged, albeit with the point at which we look at scenarios pushed out to 2030. We average the three valuations, and move our TP to 1,070p (from 1,080p). We see a significant value opportunity, and a cash generative company that could choose to buy back equity if investment cannot be progressed in a timely manner. Drax could also be an M&A target for those seeking CO2 reduction.
Growing need for biomass (Figure 1 overleaf) provides Drax with multiple outlets, but carbon removals are at the heart of a c.£7bn investment plan set out at yesterday’s CMD (Figure 2). Net-negative CO2 emissions will be required to deliver net zero, with BECCS looking like the biggest contributor (Figure 3). Support mechanisms are needed; some governments get it (Figure 4). Shorter-term, the IPCC suggests a need for 80Mt of BECCS by 2030. 20Mt is in development, of which Drax accounts for 14Mt (Figure 5). A clear need/opportunity for a technology that offers more than electrons and removals (Figure 6). Drax’s plan extends to both sides of the pond (Figure 7). The UK risks losing leadership given the pace of policy development (Figure 8), but the country needs Drax if the lights are to stay on (Figure 9). The looming general election, and a possible by-election in Selby & Ainstry could focus minds. The opportunity looks larger in the US and Drax alluded to good progress (Figures 10 & 11). Two sites selected in the US South, aiming for FiD in 2026, commissioning in 2030. Nine further sites in progress, but unlikely all could be progressed as some will compete for the same fibre baskets (Figure 12). BECCS is the largest part of the c.£7bn investment plan (Figure 13), and Drax is of the opinion this can be funded from cash flow generation, landing net debt/EBITDA <2x by 2031 (Figure 14). Our own analysis is supportive. There are too many moving parts to reflect in estimates at this juncture, but with conservative assumptions, we suggest the two new build BECCS plants could add c.300p of value, with more to come from the pipeline. Execution risk? Yes. Plausible that Drax could double in value? Yes!
Drax has issued an update ahead of its capital markets day which it will hold this afternoon. It has developed its ambition to build a major global business based on the negative emission bioenergy and carbon capture (BECCS). Last year’s IPCC working group three (WG3) report now part of the sixth assessment report made clear the need for carbon dioxide removal (CDR) with up to 9.5bn tonnes of CDR needed by 2050. BECCS remains the most immediately available CDR technologies deliverable at scale. Drax is developing into a global leader in this technology which will be needed at scale if dangerous global warming is to be prevented.
CMD at 2pm today => Two US sites selected for new build BECCS, target FiD in 2026 Drax continues to develop plans for a new-build BECCS power unit capable of producing c.2TWh and capturing c.3Mt of carbon per year. Two initial sites in the US South have been selected and are progressing to option, although the precise details remain commercially sensitive. The two sites combined could enable the capture of c.6Mt of carbon per year by 2030. Total investment would be in the region of $2bn per plant, with a target FID in 2026 and commercial operation by 2030. Nine further sites in North America are being evaluated, creating a pipeline of development opportunities into the 2030s. The commercial model for US BECCS includes PPAs, long-term CDR offtake agreements and a direct pay tax incentive under the Inflation Reduction Act of $85/t, although no guidance has been provided on expected returns. In addition, Drax is developing an option for a project to add a carbon capture process to an existing pellet plant in Louisiana. The project would have the capacity to capture over 100k tonnes of CO2 per year from the pelleting process, has a capital cost in the region of $150m, and is targeting FID in 2024/25 and commissioning in 2026. The target for 8Mt capture at Drax Power Station in 2030 remains. Ability to fund the expanded £7bn investment envelope a strong positive message Drax has previously outlined a fully funded plan to invest c.£3bn in two BECCS units at Drax Power Station, pellet production and pumped storage hydro. Drax has indicated that it can fully fund the £7bn of opportunities and return net debt to Adjusted EBITDA below 2x by the end of 2031 given its expectation of cash generation from existing assets and new investments. A range of funding options, including project finance are being assessed. FY23 outlook unchanged, happy with consensus The outlook for 2023 remains unchanged and Drax continues to expect FY23 Adjusted EBITDA to be in line with analysts’ consensus estimates. FY23 consensus stands at: EBITDA £1,162m (INVe £1,160m), EPS 110.6p (INVe 106.2p), DPS 23.1p (INVe 23.2p).
The Drax trading update reaffirms guidance in line with market consensus with higher pellet production costs offset by continued strong generation trading and notably system support sales. The UK governments commitment to BECCS has been made clear and is necessary to hit the country’s GHG reduction target for 2030 but timing uncertainty means slower immediate investment in UK BECCS from Drax. Investors are rewarded with a £150m share buy back programme running for the rest of the year.
Hedging update The hedged position for 2023 is now 12.5TWh ROC/hydro/gas output @ £158.6/MWh (vs. 12.4TWh @ £158.1/MWh). For 2024, the hedged position is now 10.5TWh @ £149.1/MWh (vs. 9.0TWh @ £149.2/MWh). The hedged position for 2025 is now 3.2TWh @ £137.3/MWh (vs. 1.9TWh @ £135.7/MWh). For 2023, our pre-existing estimates suggest an average price of £157.2/MWh, for 2024 our average price is £163.1/MWh, and for 2025, our average price is £120.2/MWh, albeit that there is material open volume in 2025. FY23 EBITDA guidance reiterated, capex lowered, buyback announced For 2023, Drax continues to expect full-year adjusted EBITDA to be in line with consensus, with the current analyst range at £1,100-1,200m. Our pre-existing estimates are at £1,160m. EPS consensus is at 109.7p (range 100.2-130.9p, INVe 106.2p), and DPS consensus is at 23.1p (INVe 23.2p). Reflecting the reprofiling of investment in UK BECCS outlined below, Drax now expects capital investment in 2023 to be in the range of £520-580m (was £570-630m). Our pre-existing estimates have £590m capex in FY23E. Drax plans to return up to £150m to shareholders via a share buyback, expected to commence in Q223 and to be completed by year-end. The programme is not expected to have any impact on Drax’s medium- and long-term growth plans which continues to include UK BECCS, US BECCS, pellet plant and pumped storage hydro expansion. UK BECCS paused, highlights pace of policy development Drax's plan for investment in UK BECCS was based on a first BECCS unit commissioning in 2027 and a second by 2030. Since Power BECCS is not currently in the Track 1 process and Government's aim is to support BECCS by 2030, Drax has paused further investment in its UK BECCS project in 2023 and will revise its UK BECCS investment schedule, subject to further clarity on support for BECCS at Drax Power Station. Discussions with Government will include a bridging mechanism for biomass power generation between the end of the current renewable schemes in 2027 and the commissioning of BECCS.
It’s been a volatile few weeks for Drax since the UK Government published its “Powering up Britain” strategy and Track 1 status selection, leading to market uncertainty around Power BECCS. This prompted investor questions around policy support, strategy outlook, and capital allocation. To answer these questions and many more, Liberum caught up with Andy Skelton, CFO of Drax, for our latest Fireside Chat.
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Although Power BECCS was not included in the immediate Track 1 process, the UK government has confirmed that it will set out a process for the expansion of Track 1 and has launched Track 2. Importantly, BECCS will now be eligible for both. The government has also confirmed that it will work closely with electricity generators currently using biomass to facilitate a transition to Power BECCS. On this basis, we believe there remains a lot to play for with regards to Drax’s UK BECCS proposition, especially when considering its considerable importance to the government’s target of removing 5Mtpa of CO2 by 2030. BUY, TP 940p (from 952p/share).
The decision by the UK Government not to select Drax for its Track-1 carbon capture programme does not mean that the Government has walked away from supporting Drax’s UK BECCS ambitions. Support will continue to be assessed under a separate process. We see limited alternatives to meeting the government target of removing 5Mtpa of CO2 but the uncertainty of the process shifts focus to Drax’s opportunities in North America. Additional support for long duration storage is also part of the government package announced today.
Following the recent FY22 results, we have updated our estimates. For FY23E, we lower our CfD unit output assumption, reflect the updated hedging position, a nudge up in the cost of biomass, the cost of a double outage on the ROC units, and increased development spend. This sees our FY23E EBITDA estimate fall by 5.8% to £1,160m, with our EPS estimate falling by 15% to 106.2p (undiluted). However, we suggest that additional optimisation opportunities could present themselves as the year progresses, and should the shutdown of the coal units be delayed by a year due to governmental request, this is something we suggest would be accretive to our estimates. FY24E and FY25E are impacted by reflecting updated hedging positions, updated commodity/power price assumptions, and increased biomass cost assumptions, with our EPS estimates falling by 12.6% and 17.8% respectively. Despite the near-term earnings cut, our target price only nudges down slightly to 1,080p, as the £63/kw/yr clearing price in the recent T-4 Capacity Market auction causes us to nudge up our long-term peak power and Capacity Market assumptions, benefitting our segmental DCF approach to valuation. We now split our valuation of generation into biomass, hydro and gas. We value biomass at £1,550m (1.6x FY23E EV/EBITDA), and hydro at £1,725m (11.7x FY23E EV/EBITDA). In our view, an electrified economy with greater intermittency on the supply side will require an increasing amount of both carbon free flexible generation and storage. Through BECCS and the Cruachan expansion, Drax has growth options, and we look for May’s CMD to provide more clarity on the pathway.
Although a small cut to our TP, we continue to see an attractive risk-reward opportunity in Drax relative to its European peers, especially taking into account the company’s recent share price weakness. The shares are trading on a FY23E P/E of 7.1x (against an average European utility peer group of 20x) and an EV/EBITDA of just 2.9x (again well below average European peer group of 10.2x and vs Drax five-year average of 5.2x). This is despite renewed visibility on earnings to 2027 and clarity on UK fiscal policy particularly around the impact of windfall taxes. We continue to highlight BECCS (Bioenergy with carbon capture and storage) as the long-term value driver both in the UK and North America. BUY
We think the strong performance from the Drax pumped storage gives grounds for upside as it demonstrates the flexibility the company has across its GB portfolio. We have upgraded our numbers on a better, long term storage spread compared with FY 21 and our central case valuation rises to 1,111p from 1,030p as a result. Our central case now also includes the assumption of CCS on two units at Drax.
FY22 results – EBITDA beats expectations Adjusted EBITDA was £731m, up 84% vs. FY21A and above our estimate of £712m and company-collated consensus of £699m. EPS of 85.1p, up 221% vs. FY21A (INVe 89.7p, consensus 83.1p). Dividend of 21p, up 11.7% vs. FY21A (INVe 21.0p, consensus 21.0p). Net debt of £1,206m was above our estimate of £998m due to a £234m collateral outflow. At a divisional level, generation posted EBITDA of £696m (INVe £667m), pellet production posted EBITDA of £134m (INVe £121m), and B2B posted EBITDA of £26m (INVe £34m). Within generation, there was a strong performance in pumped storage/hydro, up 151% to £171m, underscoring how flexibility is increasingly important in a system with more volatility and intermittency. A presentation is already available (HERE) and a webcast will be held at 9am (LINK). Hedging advances, Drax indicates underpins expectation Drax has now hedged 12.4TWh of FY23 ROC output at £158.1/MWh, and 9TWh for FY24 at £149.2/MWh. At 8th December, hedged ROC output stood at 11.2TWh at £154.4/MWh (FY23), and 7.4TWh at £154.6/MWh (FY24). Drax is suggesting that forward selling of pumped storage and hydro underpins expectations, and pointing out that EBITDA consensus is £1,147m with a range of £1,014-1,232m. We are top of the range. Company-collated consensus for FY23 stands at 111.0p (EPS) and 23.1p (DPS). Pellets, BECCS, Cruachan, OCGTs FY23 capex guided to £570-630m, o/w £120m maintenance, £30m enhancements; £430m strategic (>£200m OCGT and >£100m pellet plant developments). Capital allocation remains focussed on the core business and strategy, including new biomass pellet plants, the development of options for BECCS, and the expansion of the pumped storage power station at Cruachan.
Drax has beaten expectations with its full year results largely as a result of strong performance from its pumped storage asset at Cruachan in Scotland. With the GB system seeing a higher spread between peak and off peak prices the asset has benefited from trading but also from more provision of system support services. While these effects may not be so pronounced in FY 23 we see the asset continuing to perform strongly. Combined with the dispatchable biomass assets, Drax is fulfilling its ambition to be a leader in dispatchable, renewable power.
Success in the T-4 Capacity Market auction for Drax adds to the existing benefits of the company’s pumped storage and hydro assets. This auction was largely driven by other battery storage assets entering the market and we see this as potentially positive for pricing in future auctions. Drax has already signalled that the Cruachan Pumped Storage project did well in FY 22 and we expect this to be confirmed in the preliminary results statement due tomorrow.
Electricity storage and especially long duration storage is essential to deliver decarbonisation with a total addressable market of a similar order of magnitude to that for hydrogen, biofuels or carbon capture. It has the potential to become a major sub sector of the energy market.
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A fine for an inadvertent rules breach feels to us like a symptom of an unusually volatile market in which Drax is working hard to maximise value. We continue to see the Cruachan asset as benefiting strongly in the current market because it can deliver the flexibility that volatile demand and supply require. Drax has already reviewed procedures, but we do not see changes as materially affecting the value of the asset or the company’s trading ability.
Updated guidance from Drax points to an Adjusted EBITDA beat relative to analyst consensus estimates for FY22E, as a result of a stronger than anticipated performance in pumped storage and hydro. The company will also benefit from the allowable element of the Electricity Generator Levy (EGL) which will take account of exceptional fuel costs, a positive clarification for the company and reflects a much-needed policy to support dispatchable generation against a volatile energy price backdrop. Crucially, we expect further clarity on the UK Government’s stance on BECCS this year, especially with regards to the timeframe for the selection of Track 1 Power-BECCS with draft heads of terms for the contracts by the end of June 2023. We have updated our forecasts to reflect upgraded guidance and reiterate our BUY rating, increasing our TP to 967p/share (from 950p/share).
The mitigation of the Electricity Generator Levy to take account of exceptional fuel costs is clearly positive for Drax and reflects the need for policy to support dispatchable generation in an increasingly volatile energy system. We have updated our forecasts to reflect this change and to update for current pricing. Our central case valuation rises to 1,030p from 963p.
HM Treasury published yesterday a supplementary technical note for the Electricity Generator Levy (EGL), alongside draft legislation. There are a number of changes, two of which we view as significant for Drax; (i) indexation of the benchmark price; and (ii) the method and criteria for recognition of a limited set of exceptional costs relating to the acquisition of generation fuel and feedstock, which can be set against exceptional receipts. In scope generation will be subject to a 45% tax charge on a measure of ‘Exceptional Generation Receipts’ calculated as Generation Receipts – Electricity Generation x Benchmark Price – Allowable Costs – Allowance. The benchmark price is set at £75/MWh from 2023 until 2024, and will be adjusted each year from April 2024 in line with the change in the Consumer Prices Index in the preceding calendar year. Generators will be able to reduce exceptional generation receipts by a measure of the amount by which generation costs exceed historic levels. To claim this relief, generators will be required to calculate a baseline fuel cost, which will be the lower of fuel costs/MWh over a period of least twelve months between 1st Jan 2017 and 1st March 2020, and £65/MWh. With Drax’s biomass costs at c.£75/MWh over this period, we conclude that Drax will be able to claim a deduction for biomass costs above £65/MWh. Over the period to 31st March 2028, we now estimate a total EGL for Drax of £544m vs. £1,239m in our previous estimates. This sees our EPS estimates rise by 59.9% in FY23E, by 46.1% in FY24E, and by 54.5% in FY25E. Our target price moves up to 1,110p. The changes are positive. BUY.
Following Drax’s trading update yesterday, we have updated our estimates to reflect Drax’s hedged positions across FY22-FY24, commentary regarding higher biomass costs, increased $/t capex on the pellet capacity expansion, and North American development expenditure. Although higher hedged prices across FY22-24 more than offset increased biomass costs, the Electricity Generator Levy, as it stands, applied to excess revenue, and not recognising costs, has a negative impact, and sees our FY23E EPS fall by c.22%, and FY24E fall by c.10%. Drax has been making a case that higher costs for biomass should be taken into account in setting the threshold for the EGL, and the technical guidance published by HMT in November holds open the possibility that exceptional costs could be considered. Drax anticipates an update from government “shortly”. By way of sensitivity, we estimate that a £10/MWh increase in the threshold would add c.13p to our FY23E and FY24E EPS respectively, with an upwards valuation impact of c.50p/share. We view a possible update from government as a potential catalyst, positive if an allowance is made. Our valuation approach remains unchanged, as do the strategic scenarios which we model. However, multiple moving parts, including higher biomass costs, no change to the EGL, and a lower WACC (6.8% vs. 8%) nudge our target price down to 955p. This still points to significant upside, and again we reiterate our view that Drax has an array of options that sit well with the net zero journey, with the balance sheet strength to deliver. We continue to believe that our ‘the country needs Drax’ thesis is very much intact. BUY
The trading update from Drax confirms its position at the heights of the GB electricity system with the company playing a crucial role in providing support during stressful times. The company expects EBTIDA for FY 22 to be slightly above the top end of the analysts’ range. While some uncertainty exists over how biomass prices will be treated in the Electricity Generators Levy windfall tax there is at least acknowledgement that there will be some relief. Continued development of Bioenergy Carbon Capture and Storage (BECCS) both in the UK and North America brings a strong long term investment story in our view.
Hedging improvement… The hedged position for 2022 is now 10.7TWh ROC output @ £90.2/MWh (vs. 11.7TWh @ £87.2/MWh), and 0.3TWh hydro output @ £255.6/MWh (vs. 0.3TWh @ £133.1/MWh). For 2023, the hedged position is now 11.1TWh ROC output @ £154.5/MWh (vs. 8.8TWh @ £98.3/MWh), and de-minimis hydro output (vs. 0.1TWh @ £242.0/MWh). The hedged position for 2024 is now 6.1TWh ROC output @ £159/MWh (vs. 4.5TWh @ £109.5/MWh). For 2023, our pre-existing estimates suggest an average price of £125.9/MWh, while for 2024 our average price is £148.6/MWh, albeit that there is material open volume in 2024. …biomass costs increasing, but FY22 guided up However, Drax is pointing to biomass costs in excess of £100/MWh for 2023, above the c.£94/MWh we have in our model, while the interaction with the Electricity Generator Levy needs to be considered. For 2022, there is an upgrade to guidance, with Drax expecting that full-year adjusted EBITDA will be slightly above the top end of the current analyst range of £651-681m. Our pre-existing estimates are at £675m. FID taken on 0.6mt of pellet capacity Drax has taken a FID to invest in two new pellet production projects - a 450kt new-build pellet plant at Longview (Washington State), including the development of a new port facility at this location, and a 130kt expansion of its Aliceville site (Alabama). The combined investment is expected to be in the region of $300m, inclusive of the effect of inflation on construction cost. The historic ‘rule of thumb’ was an investment cost of c.£200/t, and clearly this is above that level. However, the investment includes port infrastructure, and co-location of the pellet plant and port will remove transportation costs.
If the UK has any chance of achieving net zero by 2050, its Drax. The company has seen the most pronounced reduction in emissions of any listed renewables company in Europe, and its strategy could deliver 12Mt of negative emissions by 2030, leading the world in rolling out its transformational BECCS technology. Nearer term, the recent Autumn Statement has served to establish fiscal clarity and materially de-risk the outlook for UK Power Generation which we analyse in detail in this note. On this basis, we add Drax to our coverage universe, initiating with a BUY rating and 950p/share target price (>50% upside potential).
Energy from biomass or waste can be genuinely low carbon and sustainable, representing a major tool in the decarbonisation toolbox. The ability to add carbon capture technology creates an immediately available negative emissions solution and adding liquid fuels allows the decarbonisation of sectors previously seen as challenging. Demand for all these solutions is likely to grow as decarbonisation and energy security become essential requirements in the energy mix.
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The UK’s chaotic political backdrop over the past few months was not helpful to the utility space, Drax included. The Electricity Generation Levy could yet prove detrimental to energy security and/or the cost of new build, but at least we have a semblance of clarity, for now. We have updated our estimates to reflect higher power price assumptions across FY23-FY25E, a stronger US$, higher inflation, and the Electricity Generation Levy. The net impact is that we cut our EPS estimates by 21.5% in FY23E, by 27.5% in FY24E, and by 7.3% in FY25E. We maintain a view that BECCS is critical to not only the UK’s net zero journey, but also that Drax plays a key role in energy security in the UK. BECCS plants were invited to complete the project submission by 19th October to join the Track-1 shortlist for FOAK power BECCS business model support, and we understand that successful applicants could be announced before year-end. The government’s biomass strategy is also supposed to be published in late 2022, though with the political turmoil that has been a constant throughout the year, we would not be surprised to see some slippage, although not something we view as negatively impacting Drax’s BECCS plans. Our valuation point is rolled over to FY23E, and we also use a higher WACC (8% vs. 7.2%). Our target price moves down slightly to 1,000p. This still points to significant upside, and we reiterate our view that Drax has an array of options that sit well with the net zero journey, and has the balance sheet strength to deliver. We believe that our ‘the country needs Drax’ thesis is very much intact. BUY.
The Electricity Generator Levy has been set at 45% of profit above a power price of £75/MWh. While slightly higher than some expectations, when we update for higher current prices, the overall impact on our valuation is negligible. The long-term impact is also minimal in our view and the removal of uncertainty over the extent of the taxation is beneficial. Drax remains essential to the decarbonisation of the UK power industry as the main viable route to negative emissions at scale.
The Energy Price Act 2022 received royal assent on 25th October, paving the way for a cost-plus-revenue-limit to be applied non-CFD renewables and nuclear, although we still await the consultation with the precise mechanics. However, given the change of Prime Minister since the Bill’s introduction to Parliament, we cannot rule out the extension of the energy prices levy to the energy generation sector as an alternative. We have undertaken sensitivity analysis on both mechanisms, although we repeat our concerns that both could jeopardise investment in generation in the UK. Our published estimates do not mark-to-market open positions, but if we do, and then apply a windfall/revenue cap, we see a slight positive net impact from a windfall tax (greater with BECCS/Cruachan investment), and neutrality for a revenue cap at £85/MWh & 15% retention. A 15% drop in forwards would impact by 55-75p/share, while FX (stronger $) could impact by 39p/share vs. our existing valuation. Both still point to significant upside. We visited Drax’s pelleting operation in the southern US last week, viewing the process end to end. The visit included meeting with a forest consultant, foresters (suppliers to Drax), a pellet plant (Amite), and port operations and logistics (Baton Rouge). Key takeaways include that the sawtimber yield is key, and active forest management is a necessity to produce sawtimber-sized trees quicker. With CO2 sequestration the greatest in a tree’s late teens to mid-20s for the species grown in the southern US, actively managed forests can absorb more CO2 than those in decline. Forest residues, and thinnings are by-products of forestry management. An off-take market (including pelleting) improves the economics, can encourage investment, and is preferable to decomposition and/or burning on site.
The UK government’s announcement of a renewables price cap remains short on detail. Drax remains a key strategic element in the GB power system and should have a strong bargaining case. We continue to see the potential switch from the Renewables Obligation to the greater price certainty of a Contract for Difference as a possible win-win outcome but the introduction of the cap suggests that strike price negotiations with the wider industry have proved difficult. The recognition of the need for dispatchable generation perhaps puts Drax in a stronger position. Its non-RO assets, particularly the Cruachan pumped hydro scheme can continue to benefit from what is likely to remain a volatile GB power market.
Drax’s acquisition of the remaining 10% stake in Alabama Pellets is a useful tidying up of the holding in our view, bringing control over additional capacity and increasing economic exposure to this valuable business. With the potential to develop BECCs capacity in North America, we see additional pellet supply as important in de-risking that development process.
An offtake agreement for carbon credits on new biomass projects in the US shows that Drax is actively pursuing this option which can help to build diversity and create route to market options for the growing pellets business. We also think it shows that Drax can evidence to third parties that its biomass generation is a genuine low carbon solution which meets the increasingly demanding sustainability requirements of both voluntary and formal credit methodologies.
UK Prime Minster Liz Truss has outlined a package to offset the impact of high gas prices on the UK electorate. While a lot of the initiatives focus on household bills, a number have a direct impact on clean energy companies. We see the amendment of the Renewables Obligation with a CfD mechanism as potentially de-risking for clean energy companies. Commitment to energy export is positive for hydrogen and e-fuel producers and the confirmation of no windfall tax is a relief for larger clean energy companies.
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The UK Government has published its consultation on supporting bioenergy carbon capture and storage (BECCS) in the UK. In doing so the Business Secretary Kwasi Kwarteng has reaffirmed that “The government is fully behind biomass energy to provide more power in Britain, for Britain”. Additionally, the government is “minded to” bring in contract for difference (CfD) based support which we think plays to Drax’s strengths.
The acquisition of a new pellet plant in British Columbia shows Drax already delivering on its target to add 0.5Mt of capacity in the second half of 2022. The move is well timed with biomass demand growing, notably in Japan where biomass is showing signs of becoming a key solution to meet new efficiency standards brought in with recent legislation.
The current high power price environment is a clear positive for Drax, as evidenced by the contracting of an incremental 3.2TWh over the past three months at an average price of c.£220/MWh, on our estimates. Drax’s updated hedged prices are notably higher than the previously disclosed position, but mark-to-market risk remains firmly to the upside, with potential incremental monthly post-tax cashflow of c.£40m across FY24-25 vs. our estimates should current power prices persist. We accept that the current level of power prices will increase scrutiny, and we have been clear that we believe Rishi Sunak’s February package was insufficient, and, although the May package was much improved, we have been equally clear that the government has been slow in acting, and that more needs to be done to help consumers. The cost of such action will need to be paid for, but given the global competition for capital, and GB’s urgent need for capacity, we think a windfall tax would be misguided and plain wrong. REMA is a broad starting point for market arrangements fit for a ‘low carbon’ world, but transformational change will take time, while National Grid ESO’s FES 2022 is supportive of BECCS and flexibility. Our ‘the country needs Drax’ thesis is very much intact. The updated hedged position, the winter 22/23 coal units contingency service, and a higher contribution from supply in FY22, are all earnings positive, offset by an assumption of flat pellet production cost year-on-year, and now only reaching $110/t in FY27E vs. $100/t previously, and a higher tax charge. Our target price moves up to 1,060p, pointing to significant potential upside. Drax has an array of options that sit well with the net zero journey, and has the balance sheet strength to deliver.
Drax’s interim results show strong growth with good performance across the company. Generation especially reflects the company’s leading position in UK dispatchable power. Support to GB system security continues with the making available of generation for next winter and the strong commitment to biomass energy with carbon capture and storage (BECCS) development both in the UK and now in North America. We see our recent upgrade with a new central case valuation of 945p as justified by these results.
EBITDA beats Drax has reported 1H22 results this morning. Adjusted EBITDA was £225m, up 21% vs. 1H21A and above our estimate of £214m and Blooomberg consensus of £201m. EPS of 20.0p, up 37% vs. 1H21A (INVe 16.2p). Dividend of 8.4p, up 12% vs. 1H21A (INVe 8.3p). Net debt of £1,101m was above our estimate of £960m. At a divisional level, generation posted EBITDA of £205m (INVe £184m), pellet production posted EBITDA of £45m (INVe £53m), and B2B posted EBITDA of £24m (INVe £12m). Drax has alluded to both optimisation of generation, and a strong system support role, the latter in line with our thesis that flexibility will be increasingly important in a system with more volatility and intermittency. A presentation is already available and a webcast will be held at 9am (Link) FY22 guidance unchanged, FY23 & FY24 hedging moves up Guidance for FY22 Adjusted EBITDA is unchanged from Drax’s upgraded expectations communicated on 6th July, and net debt/EBITDA significantly below 2x by end-2022 is also no change. The FY dividend is expected to be 21.0p, slightly above our 20.7p estimate. Drax has now hedged 11.7TWh of FY22 ROC at £87.2/MWh, 8.8TWh of FY23 at £98.3/MWh, and 4.5TWh at £109.5/MWh (FY24). At 22nd April, hedged ROC output stood at 11.1TWh at £74.9/MWh (FY22), 7.7TWh at £79/MWh (FY23), and 3.1TWh at £84/MWh (FY24). The updated hedged positions are notably higher than the last update. Planning submitted for BECCS & Cruachan Drax is continuing to evaluate options for the OCGT projects, including sale, but continues to invest as appropriate to fulfil obligations under the Capacity Market agreements and to maximise value from any sale. Planning applications have been submitted for both BECCS at Drax Power Station, and the Cruachan expansion.
The country needs Drax, Drax rides to the rescue At the request of the UK Government, Drax has entered into an agreement with National Grid which will see its two coal-fired units remain available to provide a “winter contingency” service from October 2022 to March 2023. The units will not generate commercially for the duration of the agreement and only operate if and when instructed to do so by National Grid. Drax will be paid a fee for the service and compensated for costs incurred, including coal costs, in connection with the operation of the coal units in accordance with the agreement. With the T-1 Capacity Market auction for 2022/23 at £75/kW/year, we suggest that the fee could be in the region of c.£40m for the six month period, with c.£20m in FY22. Drax has indicated that it expects no impact on the BECCS project at Drax, and continues to expect to take a final investment decision in 2024. The government is expected to publish a power BECCS business model consultation during the summer. Drax upgrades FY22 expectations As we commented in our recent note (Buy into weakness, 4th July), Drax optimises the operation of its biomass units, and by association its pelleting operations. In a short statement yesterday evening, Drax has indicated that it continues to do so, and it is “reprofiling biomass generation and supply from the summer to the winter, enabling it to provide high levels of reliable renewable electricity generation in the UK throughout the winter when demand is likely to be higher”. Cruachan is also performing strongly. With the additional benefit of the coal contract, Drax has upgraded its expectations for FY22, expecting that Adjusted EBITDA for 2022 will be slightly above the top of the range of analyst expectations (£584m-£635m, consensus £613m), subject to continued good operational performance. We view this is a clear positive, and our interpretation of this statement is that consensus is likely to move, and could settle around £650m-£655m for FY22 Adjusted EBITDA.
Drax continues to provide critical capacity to a stressed power market and now adds contingency this winter by delaying closure of its remaining coal-fired units at the government’s request. The agreement provides a useful fee for Drax. Additionally, prioritising winter running of biomass will also aid security when it is most needed and again Drax should benefit from this. Against these factors the revised guidance makes clear sense and we have increased our forecasts accordingly. Our central case valuation rises to 945p from 903p.
Drax announces 1H22 results on 26th July, with a presentation to be held the same day. Our estimates are set out in Figure 1 overleaf. We are looking for EBITDA of £214m, up 14.9% on 1H21, EPS of 16.2p (up 11.2%), and an interim dividend of 8.3p (up 10.4%). Our net debt estimate is £960m. In the 27th April trading statement, Drax alluded to optimisation of the four biomass units, as well as planned maintenance on two units in March and April. Consequently, we expect that the financial performance of the generation business will be weighted towards 2H. To the extent that this sees output shifted towards 2H, there is a flow through to the pellet production business. This, together with a cost drag in 1H as the commissioning of new pelleting capacity at Demopolis and Leola was completed in April, points to a 2H weighting in pelleting. By the time of the results we are hopeful that common sense will have prevailed, with the possibility of a windfall tax on electricity generation consigned to the bin, where we believe it belongs. The REMA consultation could be out, and if so, we look for Drax’s early view on the proposals. Drax is in discussions with the government regarding a limited extension of the two coal units, is progressing BECCS/Cruachan, albeit with both needing support frameworks, and is assessing options for the SME business, as well as its OCGT developments. We look for updates on each of these. We acknowledge that REMA introduces an element of uncertainty, but argue that Drax has a portfolio of assets that the GB electricity system needs, complemented by optionality within its global offering. Buy into weakness.
The spectre of windfall tax, a report in The Times about electricity market reform, and broader market conditions have seen Drax lose a quarter of its value over the past month. We maintain our view that a windfall tax on generation could both jeopardise investment in much needed capacity, and push up required returns for investment to the detriment of tomorrow’s consumers. This is clearly unfair. Coming at a time when coal plant is set to be kept open over winter to boost security of supply, this strikes us as an example of poor policy setting, driven by short-termism. We can only hope that policy setters stay true to the ambition of decarbonising the power sector by 2035, and that common sense prevails. Should it not, and a levy be imposed on generation, we suggest that the possible impact on Drax has been exaggerated, also highlighting that our pre-existing valuation is not based on aggressive power price assumptions. Assuming a sunset date of December 2025, our estimates suggest that a levy of 25% coupled with tax relief on investment would impact our valuation by 86p/share (Figure 1), while an alternative of a cap on gas prices for generation of £40/MWh (Figure 2) would only impact by 10p/share. A lower cap on gas prices at £20.50/MWh (60p/therm) would impact by 55p/share. Each of these is significantly below the >£2/share fall witnessed over the past month. A Review of Electricity Market Arrangements (REMA) was mentioned in April’s British Energy Security Strategy, and again when the Energy Profits Levy for oil and gas was outlined last month. Hence, this is not new news. Again, we are of the view that there has been an over-reaction. Not only would it be wrong to double count, but change will take time (Figure 3), while the BECCS retrofit will reduce Drax’s merchant exposure from March 2027.
While it is difficult to predict the extent to which Drax could be impacted by any windfall tax, if at all, we think investors should remember that the company is also key to the delivery of both short and long term energy strategy in the UK. At the short end simply keeping the lights has seen Drax reportedly asked to delay the closure of the two remaining coal units at its Yorkshire site. In the longer term Drax has the only near term negative emissions solution of any scale in the UK with its first bioenergy with carbon capture and storage (BECCS) unit due to commission in 2027. None of this makes Drax immune to a tax but we think it is not without a negotiating position of some strength.
The current high power price environment is a clear positive for Drax, as evidenced by the contracting of an incremental 1.8TWh over the past two months at an average price of c.£170/MWh, on our estimates. Higher power price assumptions push our FY22-24E EPS estimates up, but mark-to-market risk remains to the upside, with potential incremental monthly revenue of £50-60m across FY23-24 vs. our estimates should current power prices persist. The GB electricity system has an increasing need for flexibility, and on the supply side, of both long and short duration. We visited Drax’s Cruachan pumped storage plant last week, the jewel in Drax’s hydro portfolio – a portfolio which we see delivering EBITDA of £70m on average across the next five years. Cruachan 2 is under development, and we include 12p/share in our sum-of-parts valuation as we expect Drax to develop the project, subject to securing planning and a supportive remuneration framework. Coal may yet take one last breath given GB energy security concerns and, although Drax will need to invest in its OCGT projects, we still expect these to be sold – recovering as a minimum the investment to date. A global drive for decarbonisation and energy independence points to long-term demand growth for biomass, supported by policy development. Adjusting for the impact of our pellet production business estimates factoring in a below market transfer price to Drax post 2027, our valuation of this activity is at a discount to peer Enviva, suggesting we may be erring on the side of caution. Higher earnings estimates, notably in FY23E and FY24E, are the key driver of a target price that rises to 1,050p from 790p. BUY.
Generation hedging price moves up The hedged position at 22nd April for the ROC units was 11.1TWh at £74.9/MWh (2022), 7.7TWh at £79/MWh (2023), and 3.1TWh at £84/TWh (2024). This compares to 10.9TWh at £70/MWh, 6.9TWh at £70/MWh & 2.4TWh at £70.6/MWh as of 21st February. Our pre-existing forecasts assume that RO volume achieves a blended price of £79.5/MWh (2023) and £78.7/MWh (2024). We view the update as very supportive in this respect. Biomass output in 1Q22 was down on 1Q21, but this follows on from a strong Q421, and is something we consider as a function of the ROC compliance period ending in March. Drax has commented that it profiles output across the year. Drax has been asked by the UK government to consider a limited extension of its coal operations and this remains under review. Drax completed the commissioning of 400kt of pellet production capacity in April. No material change in fibre cost has been seen, although an incremental increase in North American transport costs has been noted. Guidance upgraded Year-end net debt to adjusted EBITDA guidance has been upgraded to ‘significantly’ below 2x by the end of 2022; our pre-existing estimates point to 1.7x. EBITDA guidance is now around the top end of the consensus range for 2022 (£606m). As of 25th April, consensus for 2022 is for EBITDA of £571m (INVe £572m), undiluted EPS of 63.3p (INVe 64.9p) and DPS of 20.6p (INVe 20.7p). For 2023, the corresponding numbers are £740m (INVe £711m), 95.7p (INVe 97.4p) and 22.7p (INVe 22.8p). Drax is continuing to evaluate options for both the SME business and for the OCGT portfolio, although a development agreement has been signed with an EPC contractor for three of the OCGTs. Drax continues to expect to take a FID on the BECCS projects in 2024.
Drax Group has issued its Q1 trading. This has seen electricity prices remain strong and the company has improved its forward hedging on the back of this. Ancillary services revenues have also been strong in the period and the company now expects full year EBITDA to be at the top of the range of analyst expectations. As a result, we have increased our forecasts and our central case valuation rises to 903p from 846p.
Drax is positively exposed to higher power prices, and assumptions of achieved power prices that are £10-20/MWh higher across FY22E-24E than previously modelled move our generation EBITDA estimates upwards, despite higher modelled fuel and grid costs. Conversely, we are a little more cautious on the pelleting business EBITDA in FY22E and FY23E, with the net result being that our consolidated EBITDA estimates for those years are broadly unchanged (Figure 1). Given Drax’s largely open power position in FY24 and beyond, our estimates show more material upgrades from FY24E, positioning us well above consensus in FY25E (Figure 1). Higher long-term power prices, and a record price in the recent T-4 Capacity Market auction, are both supportive to a merchant generation model at Drax post the RO/CfD expiry in March 2027, but we are cognisant of the year-to-year volatility this brings, and we now value post-2027 merchant generation with a 300bp uplift to our group WACC. Nevertheless, this still sees our merchant-based valuation move up to 719p (Figure 3) from 668p. Previously our target price was based on averaging three scenarios of merchant operation post 2027, a third party supply pellet model, and BECCS. Retaining this approach would see a slight trimming of our target price, but given higher prices, and a clear narrative that the UK is seeking a greater degree of energy independence, intuitively this strikes us as wrong. We see the need for BECCS at Drax as reinforced by current global events, and now base our target price on a two BECCS units basis, with it moving to 790p from 765p. We remain very much positively disposed to Drax. BUY.
A better near-term pricing environment should result in better captured prices for Drax across the board and we have factored in an increase in our assumptions for FY23 and FY24. This follows our revised assumptions on capacity market pricing published earlier in the week. Our low base case valuation rises to 748p from 724p and if we include biomass expansion this rises to 902p from 846p. We now see this central case valuation as most relevant in assessing the company and our forecasts are based on this assumption. We still see valuations above £10 being achievable with new investment in BECCS and expansion at Cruachan.
Drax full year results were ahead of our forecasts with the company benefiting from strong wholesale pricing and a recovery in the customer business. These results were the last to see any revenue from fossil fuelled generation as the company completes its transformation into a renewable energy producer and moves towards being carbon negative by 2030. It produced 12% of the UK’s renewable output making it the largest renewable generator in the country by output.
EBITDA a slight beat Drax has reported FY21 results this morning. Adjusted EBITDA was £398m, down 3.4% vs. FY20A and slightly above our estimate of £392m and consensus of £386m. EPS of 26.5p, down 10.6% vs. FY20A (INVe 30.1p, consensus 27.7p). Dividend of 18.8p, up 9.9% vs. FY20A (INVe 18.8p, consensus 18.7p). Net debt of £1,044m was slightly above our estimate of £990m. At a divisional level, generation posted EBITDA of £372m (INVe £343m), pellet production posted EBITDA of £86m (INVe £102m), and B2B posted EBITDA of £6m (INVe £8m). Drax has alluded to a strong system support role in line with our thesis that flexibility will be increasingly important in a system with more volatility and intermittency. A presentation is already available and a webcast will be held at 11am, both via LINK. Hedging advances, net debt/EBITDA below 2x by end-2022 No explicit guidance for FY22, save net debt/EBITDA which is now expected to be below 2x by end-2022. Drax has now hedged 10.9TWh of FY22 ROC at £70/MWh, and 6.9TWh of FY23 at £70/MWh. At 1st December, hedged ROC output stood at 10.1TWh at £61.1/MWh (FY22), and 5.8TWh at £61.2/MWh (FY23). No news on the OCGT portfolio yet Drax is continuing to evaluate options for the OCGT projects, including sale, but continues to invest as appropriate to fulfil obligations under the Capacity Market agreements and to maximise value from any sale.
Drax’s capacity market wins confirms good pricing in a tightening market. The narrow impact moves our central case valuation up marginally to 724p from 719p but we also see this as a wider signal of the how UK market is developing and that is supportive for Drax in our view.
Drax reports FY21 on 24th February, with the presentation available at 7am (here). We look for EBITDA of £392m, slightly down vs. the previous year, but in line with Drax’s guidance that points to a level around £391m. Granular detail is set out in Figure 1 overleaf. Drax’s 1st December trading statement indicated that 10.1TWh of FY22 ROC output had been hedged at £61.1/MWh, and 5.8TWh of FY23 ROC output had been hedged at £61.2/MWh. With forward prices for FY23 subsequently trading above this level (Figure 2), we look for the average achieved price for FY23 to move up. Participation of the coal units in the Balancing Market in FY22 is an additional positive. The T-4 Capacity Market auction runs on 22nd/23rd February, and Drax has 871MW of de-rated capacity pre-qualified (Figure 3), including 285MW of OCGT capacity (299MW connection capacity) for which Drax is seeking a 15-year new build contract. Drax has four OCGT projects, and we expect these will ultimately be sold. We look for an update on the options available. Drax has previously indicated that it is assessing operational and strategic solutions for the SME supply business, and given Drax’s strategic direction, we suggest that a disposal is a potential option. We look for an update in this respect. Although we expect that Drax is likely to reiterate an expectation that net debt to adjusted EBITDA will be around 2x by the end of 2022, both our and consensus forecasts point to a stronger financial position, and we look to Drax to offer more colour on EBITDA expectations for FY22.
We have upgraded our forecasts to take account of better pricing and expansion of biomass. We have also valued new investment in BECCS, expansion at Cruachan and reviewed CCS deployment in the UK. Our base case valuation rises from 551p to 719p with a central valuation including biomass expansion at 846p. If the full investment potential is realised, we see a higher valuation above £10 being achievable.
Drax is progressing the biomass and carbon capture (BECCS) development at two units at the Drax Power Station site with the appointment of Worley to undertake the FEED study. The target completion of the first unit is 2027 and while we think this is achievable it is good to see early progress.
Drax adds 15% to 3rd party pellet supply => supportive of targets Drax has announced that its subsidiary Pinnacle Renewable Energy Inc has agreed to acquire the pellet sales contract book of Pacific BioEnergy Corporation, adding 2.8mt of orders for biomass supply to high-quality counterparties in Japan and Europe. The contracts are for delivery between 2022 and the mid-2030s, with 0.3mt for delivery in 2022. Total incremental revenues over the contract period are around C$675m, increasing Drax’s long-term third-party sales book by 15%. At its recent capital markets day, Drax outlined its ambition in pellet production and supply, including a target to double third party sales to 4mt by 2030. Today’s announcement has already secured 15% of the needed incremental supply volume. We view this as yet more evidence of Drax having a long-term sustainable business post the expiry of the RO/CfD support for Drax’s biomass units in 2027, and consider it supportive of our positive stance on the stock.
A 15% growth in third party biomass pellet sales represents good initial delivery against Drax’s target of doubling third party pellet sales by 2030. The deal helps to underpin volumes over a long period and builds on existing market penetration in Japan and Europe. We expect demand to build further from these regions.
We have previously argued that biomass/BECCS is part of the UK solution (Fig 1 of full report) for net zero, but this looks true around the globe (Fig 2), driving a significant growth opportunity for pellet supply (Fig 3). Drax is looking to capitalise on this, with an increased ambition of 8mt by 2030 (Fig 6). BECCS is currently cheaper than DACS for engineered GGR (Fig 8). Drax is engaged in bilateral conversations with the UK government over a BECCS financial model, and aims to bring a 1st unit online in 2027 (Fig 9). Overseas expansion is an option, with 4mt of new build capacity mooted (Fig 10). Sustainable sourcing is everything. Drax is not running round with a chainsaw chopping down trees (Fig 11), nor is it using sawlogs (Fig 12). Lots more wind capacity and thermal retirements are driving a need for new dispatchable capacity (Fig 14), and pumped storage ticks the boxes (Fig 15). Drax intends to develop Crauchan II if an appropriate (cap and floor) remuneration framework (Fig 16) can be secured. A key message is that Drax believes its strategic options can be financed using cash flow and balance sheet capacity, whilst growing the dividend at c.10% per annum (Fig 18). No change to our modelling approach, which is to include pellet capacity expansion, but not BECCS/Cruachan until remuneration frameworks are clearer. We make earnings revision in the early years (Fig 19), due to higher hedged power prices, higher BSUOS and corporate costs, inflation and F/X. We maintain our approach to averaging the valuations suggested by merchant operation post 2027, a third party pellet supply model and BECCS. Changes to all three see our target price move up to 765p (vs. 660p, Fig 20). Buy.
Drax Group plc Fintel PLC
We have previously argued that biomass/BECCS is part of the UK solution (Figure 1) for net zero, but this looks true around the globe (Figure 2), driving a significant growth opportunity for pellet supply (Figure 3). Drax is looking to capitalise on this, with an increased ambition of 8mt by 2030 (Figure 6). BECCS is currently cheaper than DACS for engineered GGR (Figure 8). Drax is engaged in bilateral conversations with the UK government over a BECCS financial model, and aims to bring a 1st unit online in 2027 (Figure 9). Overseas expansion is an option, with 4mt of new build capacity mooted (Figure 10). Sustainable sourcing is everything. Drax is not running round with a chainsaw chopping down trees (Figure 11), nor is it using sawlogs (Figure 12). Lots more wind capacity and thermal retirements are driving a need for new dispatchable capacity (Figure 14), and pumped storage ticks the boxes (Figure 15). Drax intends to develop Crauchan II if an appropriate (cap and floor) remuneration framework (Figure 16) can be secured. A key message is that Drax believes its strategic options can be financed using cash flow and balance sheet capacity, whilst growing the dividend at c.10% per annum (Figure 18). No change to our modelling approach, which is to include pellet capacity expansion, but not BECCS/Cruachan until remuneration frameworks are clearer. We make earnings revision in the early years (Figure 19), due to higher hedged power prices, higher BSUOS and corporate costs, inflation and F/X. We maintain our approach to averaging the valuations suggested by merchant operation post 2027, a third party pellet supply model and BECCS. Changes to all three see our target price move up to 765p (vs. 660p, Figure 20). Buy.
Trading update – what caught our eye FY21 guided to top end of EBITDA range (£391m). We are at £374m. Contracted power sales – 34.3TWh sold forward for 2021-2023 at an average achieved price of £61.3/MWh, above the 29.3TWh at £52.3/MWh at the H1 results (25 July). For the ROC units, Drax has sold 10.1TWh at £61.1/MWh for 2022, and 5.8TWh at £61.2/MWh for 2023. Customers – Drax is continuing to assess operational and strategic solutions to support the development of the SME supply business. BECCS - East Coast Cluster selected as a Track 1 Cluster, Net Zero Strategy and Biomass Policy Statements supportive, Drax expects to take a decision on commencing a Front End Engineering Design (FEED) study shortly. Capital Markets Day – initial highlights Targeting a 100% increase in pellet production, from 4mt today to 8mt by 2030, with a 100% increase in sales to third parties, from 2mt today to 4mt by 2030, principally to markets in Asia and Europe. Continued focus on reducing the production cost of biomass to around $100/t (Free On Board, $ equivalent of the £50/MWh target). Strategic capital investments (c.3mt of pellet capacity, UK BECCS and Cruachan II), which Drax expects to fund from cash generation and existing balance sheet between 2022 and 2030, aiming for <2x net debt to Adjusted EBITDA by 2030. Targeting 4mt pa of negative CO2 emissions outside of UK by 2030.
Third party supply of biomass pellets gives Drax optionality, but we view retrofitting BECCS at Drax Power Station as the #1 priority. The recent deluge of policy documentation is favourable towards the realisation of BECCS, which we now see as a tangible reality. The Net Zero Strategy, complemented by a biomass policy statement places an emphasis on sustainable biomass, and prioritisation of its use, but it appears that power BEECS could be towards, or at the front, of the queue. Further support for this argument comes from National Grid’s FES 2021 where all scenarios that are consistent with net zero by 2050 envisage deployment of power BECCS from the late 2020s. The selection of the East Coast Cluster as a Track-1 CCS Cluster is a further positive, as it suggests that T&S infrastructure could be operational by the mid-2020s, supportive of Drax’s ambition to have the first BEECS unit operational in 2027. A planning consultation commenced on 1st November. We suggest this brings us one step closer to BECCS at Drax. Outline commercial frameworks have been put forward; the two that appear most likely both incorporate CfDs. Our analysis suggests that two BECCS units could be worth c.£1/share to Drax, and averaging the valuations suggested by this, merchant biomass operation post 2027, and moving to a third party supply model, we move our target price to 660p/share (from 615p). Mark-to-market risk remains positive, and we view the upcoming capital markets day (1st December) as a catalyst. We remain Buyers.
Longspur Research and Radnor Capital Partners have launched the Active Net Zero Clean Energy Index to allow investors to measure the performance of companies actively enabling climate solutions.The key emphasis is on the word “active”. This pan-European index eliminates greenwashing by penalising fossil fuel activities and focuses on actual achievement and positive contribution, rather than promises for the future. Our proprietary selection methodology is systematic, rules based and quantifiable. The methodology is aligned with the EU Taxonomy, the IPCC 1.5oC Report pathways, and the IEA Roadmap.In this note, we examine the Active Net Zero Clean Energy Index performance as well as breaking down the Active Net Zero Clean Energy Universe into its individual components. We also examine the growth of the Climate & Energy themed fund universe and explore what exposure these funds actually offer to investors.
DRX ITM PHE AMP SIT VLS R06
Power prices have ramped over recent months (Figures 1-4) driven by rising gas prices (Figure 5), higher CO2 prices, low wind resources, and plant/ interconnector unavailability, but is this good for Drax? Yes, but it’s nuanced. Drax is hedged for FY21, and although Drax has been running coal in the Balancing Market at the behest of the ESO at £4,000/MWh (Figures 8 and 9), we note the unit 4 at Drax (RO biomass) is on an unplanned outage, with Drax having to hold back Cruachan as a consequence, to ‘self-insure’. So for FY21, there are both positives and negatives. Looking forward, to FY22 and FY23, we have not revised our medium term power price and commodity price assumptions, but we have assumed that Drax has continued to hedge FY22 and FY23 output since the July update, and nudged our ROC output up. We assume that Drax has achieved forward market prices during this time, and that the current pricing environment will persist through winter. In simple terms, we assume six additional months of hedging. This pushes up our FY22E EPS by 44%, and FY23E by 34% (Figure 10), but as our mark to market analysis (Figure 12) suggests, risks still appear skewed to the upside. We also see additional opportunities from the current pricing environment: (i) the need for flexibility is underscored, and once all biomass units are back on line, Drax should be able to run Cruachan harder; (ii) additional biomass output is also a possibility, subject to fuel sourcing/handling, where an additional 1 TWh of generation, up to and beyond the ROC cap, could add £60-70m EBITDA to our FY22E; and (iii) the value of the Capacity Market backed OCGT projects is also supported, and we expect Drax to sell these. The value that might flow from these opportunities is additional to our base case valuation, the latter supporting a target price of 615p (vs. 565p). Buy.
The UK government has announced its long awaited hydrogen strategy and also launched a consultation on funding hydrogen production. The strategy confirms support for both green and blue hydrogen production as well as for the replacement of natural gas in around 3m homes. Subject to the consultation, the price differential between fossil fuel solutions and hydrogen will be subsidised by the use of contract for differences based on the existing UK support for offshore wind. As with the earlier energy white paper, a lot of decisions on detail have been deferred for later publication but broadly this is very supportive of the development of a wide ranging hydrogen industry in the UK. We also see it as a move which is likely to encourage support for this key emissions solution elsewhere in the world.
DRX ITM PHE AMP SIT VLS
H1 consistent with FY consensus expectations First half EBITDA was slightly below our expectations but this was almost entirely due to phasing effects. Underlying performance and the biomass cost improvement trajectory supports FY consensus which stood at GBP377m prior to the results. Some upside to FY22-23 consensus Forward hedging was slightly better than we expected and taking into account the ongoing progress on reducing biomass cost and our expectation that 2022 should be free of COVID effects, we raise our 2022 estimates and now stand above consensus at GBP527m EBITDA and 52p EPS (consensus at GBP503m/49p). On the back of our power price assumptions, we forecast further growth in FY23 to GBP610m EBITDA and 68p EPS. The 10% increase in this year''s DPS is welcome but we assume that in the future preservation of capital ahead of a possible big capex program linked to BECCS is likely, so we leave our 2022 onwards DPS growth estimate of 5% p.a. unchanged. Net zero opportunity Drax''s ambition remains to have 2 biomass units with BECCS operational by 2030, and the planning application process has already started. Subject to indication of support from the UK government, Drax plans to launch a FEED study at the end of this year and be in a position to make an FID in 2023/24. The government''s competition to decide the sequencing of CCS projects and regional clusters has started with Track 1 announcements on final selection due October 2021 and a time when the Track 2 process will also be announced. Reiterate Outperform We maintain our price target of 495p, which values the opportunity of third-party pellet sales beyond 2027 but not the optionality from BECCs.
Drax’s interims see the first contribution from Pinnacle Renewables as well as continued strong revenues from system support. The period has seen the company completely cease commercial coal operations, sell its gas-fired projects and move biomass carbon capture and storage (BECCS) plans forward with planning now submitted for CCS at the Drax site. The company has also commenced the planning process for expansion of capacity at Cruachan. Overall, we see Drax as making strong progress to develop as a flexible negative emission company.
ROC output re-profiled, higher hedged prices Drax reported 1H21 results this morning, and will hold a presentation at 9am. EBITDA of £186m (o/w £165m was from continuing operations), was below our £208m estimate. EPS of 14.6p was below our 17.5p estimate, although DPS of 7.5p was broadly in line with our DPS forecast of 7.4p. Net debt of £1,029m, was slightly higher than our £960m estimate. Power generation EBITDA of £185m was below our £193m estimate, with some re-profiling of ROC volumes from 1H to 2H which saw volumes bought back at market prices in 1H & resold at 2H market prices. The contracted power position over 2021-23 is now 29.3TWh @ £52.1/MWh vs. 24.4TWh @ £48.5/MWh, suggesting a big step up in price on the additional volumes sold. The price uplift spans in all three years, underscoring the logic in the re-profiling of ROC volumes in FY21. However, biomass costs have risen due to historic FX hedging. Pellet production EBITDA of £40m was below our £47m, with new capacity not commissioning until 2H. The cost of production fell to $141/t (vs. $154/t in 1H20). B2B EBITDA loss of £(5)m was broadly in line with our £(2)m estimates. FY21E EBITDA guidance is unchanged, with Drax referring to recently published consensus. Our FY21E EBITDA of £377m is line with consensus (£377m), as are our EPS of 26p (consensus 26.8p), and DPS of 18.5p (consensus 18.4p). Strategically Drax has commented on the biomass opportunity & its ambitions, BECCS, and the development of an opportunity to expand the Cruachan pumped storage to >1GW (from 400MW). Options for the SME supply business are still being considered. A Capital Markets Day will be held in November.
Looking for EBITDA, EPS and DPS growth Drax reports 1H21 results on Thursday, and will hold a presentation at 9am (LINK). We look for EBITDA of £208m, up c.16% vs. 1H20. Our EPS estimate is 17.5p, c.62% ahead of last year, while our DPS estimate of 7.4p, c.9% above the prior period, represents 40% of our FY estimate. We look for net debt of £960m, slightly higher than our FY21E forecast. Our FY21E EBITDA forecast of £377m is line with consensus (£377m), as are EPS of 26p (consensus 26.8p) and DPS of 18.5p (consensus 18.4p). Generation EBITDA down, B2B & Pellet production up Generation – We look for generation EBITDA to fall by c.10%. A large part of this is due to the disposal of four CCGTs which completed on 1st Feb, with those CCGTs having contributed £18m of adjusted EBITDA in 1H20. We assume that the CFD outage is weighted towards 2H, that there was a benefit in 1H from high balancing market prices, and that coal costs remain despite the end of commercial coal generation, given the Capacity Market contracts that are in place. B2B – we forecast a slight loss of £(2)m, vs. £(37)m in 1H20, a period impacted significantly by Covid-19 (demand reduction, buybacks of power, and bad debt provisioning). Pellet production – we look for a near doubling of the EBITDA contribution to £47m, given the increased capacity at DBI, and the inclusion of Pinnacle for 2.5 months. Reshaping Drax – plenty to talk about Strategically there is lot going on with Drax, and we look for updates on the CCUS plans (including participation in the East Coast Cluster, and discussions with government around remuneration frameworks); an update on the plans for Cruachan 2 and the likelihood of a suitable support mechanism being brought forward; capacity expansion in the pelleting business; options for realising value from the OCGTs with Capacity Market contracts; and the intentions for the B2B supply business, where a part disposal is a possibility.
Drax will acquire a further 130,000 tonnes of biomass pellet capacity through the acquisition of minority stakes in projects owned by Pinnacle Renewables. While marginal (c.3%) of capacity, it makes sense to add where it can. We see the global bioenergy carbon capture and storage market as a major opportunity for Drax and all new capacity should benefit the company.
Drax buys 20% minority in Alabama Pellets Drax has announced that it has agreed to acquire a 20% minority interest in Alabama Pellets, LLC, the JV which owns the Demopolis and Aliceville pellet plants, from The Westervelt Company for $29.7m cash consideration. The acquisition will increase Drax’s interest in Alabama Pellets to 90% and provides it with economic control over a further c.130kt of annual biomass production capacity. The acquisition of Pinnacle Renewable Energy Inc. included a change of control provision over Alabama Pellets, and Drax has been in discussions with Alabama Pellets JV partners regarding future working relationships, including their minority interests. The remaining JV partner, Two Rivers Lumber Co., LLC, holds a 10% economic interest. The acquisition does not change Drax’s total annual nameplate capacity of 4.9mt, but we suggest that it should assist in optimising integration of Pinnacle’s operations into Drax’s wider pelleting business.
The announcement that the UK will set in law a target to cut greenhouse gas emissions by 78% by 2035 compared to 1990 levels adds to the tailwind behind electrification of the economy, and should sharpen the thought processes as to how the UK will meet these targets. On the same day, BEIS published a call for evidence (The Role of Biomass in Achieving Net Zero), which is open until 15th June, with the formal government response to be part of the Biomass Strategy, to be published in 2022. The aim is to strengthen the Government’s evidence around biomass, and will also inform considerations on the role of Bioenergy with Carbon Capture and Storage in reducing greenhouse gas emissions across the economy. BECCS is mentioned a further 29 times in the document, and although no policies are elaborated, we are of the opinion that the Government is open to BECCS playing a major part in delivering net zero: “…it seeks information on how the deployment of BECCS could be supported, how biomass use could be prioritised to best deliver our net zero target, and whether and how the Government could target sustainable biomass use towards the highest priority applications.” “…the CCC estimates that removals of 58 MtCO2/year could be required from engineered GGR methods, such as BECCS and Direct Air Carbon Capture and Storage (DACCS) in 2050.” We continue to believe that Drax’s narrower biomass-led strategy gives it a strong hand in CCUS power contract negotiations, and view this week’s announcements as helpful. Updated estimates reflecting latest hedging positions, and the completed Pinnacle acquisition, boost FY21E EPS by 18.7%, and a lower WACC of 7.5% (vs. 8%) sees our target price move to 500p.
Drax has had a good Q1, benefiting from a volatile UK power market which has highlighted the benefits of its flexible portfolio. The company can also now be seen as a fully renewable energy company and is making strong progress towards being a negative emissions company. The early completion of the Pinnacle acquisition allows it to benefit from growing opportunities in BECCS, acknowledged in last month’s IRENA World Energy Transitions Outlook as key to delivering a 1.5oC outcome.
Shareholder support clears the way for the Pinnacle acquisition, now expected to complete in April. We continue to see the deal as a major expansion of optionality for Drax and allows it to become a major upstream supplier to the growing opportunity in bioenergy, carbon capture and storage (BECCS). With additional recent funding progress at the Zero Carbon Humber initiative, Drax is in a strong position across the BECCS supply chain in our view.
Drax has seen success in yesterday’s Capacity Market auction, securing contracts which extend support for the Cruachan pumped storage project and the hydro projects in Scotland. It has also won long term contracts for three of the four small gas peakers it has under option. Any development of these remains subject to the Group’s decarbonisation plans. The market clearing prices were broadly in line with previous years. There is some speculation that prices will be stronger in future rounds as coal and nuclear capacity exits the market. As things stand this is useful additional income for the projects bringing an additional £10m of revenue to the pumped storage and hydro assets during the delivery period.
Strategy on track Drax continues to progress with its strategy of enhancing the value of the post 2027 options for its biomass plants and biomass self-supply. The acquisition of Pinnacle Renewable Energy, announced earlier this month, is in line with that strategy and should be modestly both EPS accretive and value enhancing. Completion is expected in Q2 / Q3 and we have now updated our estimates to reflect it. Operational performance on track 2020 results were better than our expectations, with the COVID impact in the Customers business contained and the generation business navigating the volatile power market conditions favourably. Forward hedging as disclosed is broadly consistent with our expectations. We have factored in a slightly bigger impact from the 2021 CfD outage than previously assumed given the details provided on the call and we have increased our financial expenses estimates, beyond just the scope effects. Reiterate Outperform. 2021 will be a key year for Drax with the government moving forward on BECCs and more visibility expected by year-end on whether the Humber region will be selected to move forward for the early phase projects. We have updated our valuation to reflect our latest estimates and slightly higher cost of capital due to the higher rates as well as to add the DPS payable in the coming 12 months. We set our price target at 435p, which factors in 95% probability of the lowest value post 2027 option (biomass 3rd party supplier). We reiterate our Outperform rating.
The Drax prelims show continued progress in generation and pellet production with the impacts of COVID 19 on the customers business within expectations. The company is delivering cost reductions in its pellet supply business and this business will be significantly expanded with the proposed acquisition of Pinnacle Renewable Energy, turning the company into a major vertically integrated biomass business.
Drax Group has announced the acquisition of Pinnacle Renewables, a major provider of biomass pellets based in Canada with operations in British Columbia and Alabama. The combination will make Drax the world’s leading biomass provider. We see biomass and carbon capture and storage (BECCS) as the key route to the negative emissions required to bring about a net zero world. Drax’s move should allow it to capture a significant proportion of the value of growing demand for this solution in our view.
Greater clarity from the UK Government on funding for carbon capture and storage (CCS) is welcome for Drax. We expect the deployment of CCS to allow the company to continue operating its biomass units profitably beyond 2027 when current support mechanisms end. This initial guidance for simple CCS suggests that CCS costs can be covered and a marginal positive valuation impact from running ahead of unabated plant is possible. However by delivering biomass and CCS (BECCS), Drax offers a fully negative emissions solution. We expect stronger support for this, potentially allowing baseload running. Drax remains one of the very few opportunities for investors in negative emission solutions.
Housekeeping exercise on our estimates following last week’s announcement of an agreement to sell the CCGT portfolio to VPI Holding Limited. We assume the transaction completes on 31st January. CCGT EBITDA has broadly tracked Capacity Market revenues in 2019 and 1H20, and our previous estimates had £39m Capacity Market revenues for CCGT in FY21E given the £22.50/kW/year clearing price for delivery year 2020/21. With lower clearing prices in future delivery years, the impact of EBITDA sold is greatest in FY21E. We estimate that depreciation of c£20m, and annual capex of c£25m will also fall away. We have also lowered our FY21E B2B EBITDA by £5m to £10m in light of the potential impact of the latest round of lockdown measures announced by the government on Saturday. The net impact is a c10% drop in EPS in FY21E, but negligible change in FY22E. Our target price remains unchanged at 380p. We have previously welcomed the disposal, as it reinforces the green credentials of the group, and we continue to be attracted by Drax’s flexible generation portfolio, strategic options, and the positive noises about BECCS in the Energy White Paper. Buy.
The sale of Drax’s portfolio of combined cycle gas turbines (CCGTs) removes some revenue in the near term but the ability to reinvest the proceeds in the pellet business should replace this quite quickly in our view. While the loss of near term income has an impact on valuation this should be offset by a better long term future in the pellet business. As a result our base case valuation increases from to 515p from 505p.
System balancing costs have risen again, in part due to Covid-19, but are forecast to remain high into charging year 2021/22, and, we suggest, beyond. Drax’s flexible generation portfolio positions it well in this market, and we see flexibility as a sustainable growing earnings stream, and a source of value to Drax. BSUoS charges are currently levied 50% generation/50% demand, but a change has been proposed that would see generation exempted, which if adopted, could be effective from April 2023. Downward pressure on wholesale prices is likely, but with a cost offset for transmission connected generation. Protected by a strike price, Drax’s CfD unit could see a £15m+ benefit. Drax continues to hold a number of strategic options, of which BECCS is one. More granularity on CCUS business models is expected next year, but we also look to the Energy White Paper, due before year-end for additional colour. Drax is moving to the FEED stage on its BECCS project next year, but a Final Investment Decision is unlikely before 2023/24. Repositioning the pellet production business as a global supplier post 2027 is an alternative, and strikes us a viable proposition, and one that could easily add >50p/share of value vs. our base case of unsubsidised biomass generation post RO/CfD expiry. We suggest this sets a value bar for BECCS to beat, strengthening Drax’s hand in CfD negotiations. Updated estimates see EBITDA tweaked in FY20E and FY21E, and we now see modest upside from marking open volumes to market. Our target price moves up to 380p. We believe there is further to run in Drax, and reiterate our Buy rating.
Drax has made further progress on debt financing, refinancing its revolving credit facility, drawing on its previously announced infrastructure facility and using its recent bond issue to redeem earlier loans. While much of this is tidying up, it provides efficient longer-term financing visibility at a time when the company has strong investment opportunities notably in biomass supply. The group cost of debt is now well below 4% at c.3.7%.
Historically exposed to coal, Drax had to adapt to ecological constraints. Which we believe it has failed to do. We have therefore decided to terminate our coverage in order to allocate our resources to companies that are in tune with tomorrow’s challenges.
Drax has announced additional loan facilities which will reduce its all-in cost of borrowing to below 4% and we see this as helping to give Drax the firepower to expand its US-based biomass feedstock business efficiently. We see this business as having growing importance as several governments look towards biomass carbon capture and storage as a key component of the net zero tool kit.
Drax is a major enabler of the energy transition. It is the only UK investment opportunity of scale that can offer exposure to BECCS, long duration storage and low carbon spinning reserve, all essential to deliver what is now a legal requirement for net zero emissions by 2050. We initiate coverage with a central case valuation of 505p.
Solid Interim results, on track to meet FY expectations The H1 financial performance underlines the substantial derisking of revenue streams that Drax has delivered in recent years. Although both EBITDA and EPS were in line with our estimates we note that the COVID-19 impact was more front-loaded than we assumed (we had assumed very little in bad debt provisions in H1) and the tax charge was impacted by deferred assets revaluation, suggesting that on an underlying basis, results beat our forecasts. We therefore move our FY20 EBITDA from slightly below consensus to slightly above consensus. Biomass strategy gaining momentum Better System Support revenue was a positive surprise for us in H1, but more importantly the fruit of the efforts to reduce the biomass supply cost were faster than we anticipated despite COVID19 headwinds. We have now reflected this in our estimates, which also boosts our 2021 EPS. Post-2027 options undervalued, but visibility will take time We model a reduction in biomass costs to GBP50/MWh by 2027, in line with company guidance. But as we assume no support merchant power prices, we assume operations cease in 2027 as it would be unprofitable to run biomass generation. As management highlights though, beyond the normal biomass generation, the options of BECCs also remains valid while the possibility of changing the business to one of pellet exports is also a viable option. We do not attach any value to these options in our SOP, nor does the share price reflect any such value; until more visibility is gained, amongst other things, on government policy, this appears to us a conservative but realistic approach. Reiterate Outperform and raise TP to 310p Reflecting our updated earnings estimates (no changes to power price assumptions), including the updated forward hedging information released and the slightly faster DPS growth than we assumed, we nudge our TP up to 310p and reiterate our Outperform rating.
1H20 adjusted EBITDA slightly ahead of our expectations 1H20 adjusted EBITDA of £179m, up 29.6% vs. 1H19, and slightly ahead of our £174m estimate. Adjusted EPS of 10.8p vs. 2.0p in 1H19, and ahead of our 10.1p estimate. DPS of 6.8p vs. 6.4p in 1H19, broadly in line with our 6.9p estimate. Net debt of £792m broadly in line with our £820m estimate. (Further details in Figure 1 overleaf) Generation boost offsets Covid-19 hit in B2B Generation EBITDA of £214m was ahead of our £193m estimate, with biomass generation of 7.4TWh (up 1TWh vs. 1H19), and system support revenues up £5m to £66m as Drax benefitted from greater flexibility needs in the system due to Covid-19. EBITDA from hydro and gas generation rose by £18m to £54m, underscoring the value of these assets acquired from ScottishPower at end 2018. Pellet production EBITDA of £25m, in line with our expectations, with 0.75mt produced vs. 0.65mt in 1H19. Pellet production cost of $154/t vs. $161/t in FY19, and heading towards our $145/t for FY20E. The 0.35mt expansion of existing sites is underway, and investment in 0.12mt of satellite plants has been announced, with $40m investment to be made. B2B Energy Supply EBITDA loss of £37m, worse than the £20m loss we forecast. Reduced demand, hedge unwinding and a doubling of bad debt provisions all impacted. Outlook confirmed, 17.1p dividend indicated Drax has indicated that the outlook for FY20 adjusted EBITDA, inclusive of c.£60m Covid-19 impact is in line with consensus of £393m. The expected dividend for FY20 is 17.1p, slightly ahead of market consensus of 16.9p. The investment outlook for the year now stands at £190-210m vs. previous guidance of £230-250m, of which £78m was invested in 1H20. This is due to non-essential maintenance (e.g. Shoreham) being delayed, and a £30m reduction in strategic investments in biomass. These are delays, rather than cancellations, to projects which Drax has not yet announced.
Generation – biomass was 2H weighted in 2019, with ROC optimised to 2H and two outages in 1H. We see higher biomass output in FY20E, a reduced 2H weighting, and added benefits of the likely uptick in revenues from the provision of flexibility services given the material interventions made by National Grid ESO during Covid-19 impacted 2Q. We would not be surprised to see 1H flexibility revenues putting upwards pressure on our FY assumptions for the generation division. Pellet Production – with weather impacting pellet production in 1H19, we expect a material jump in EBITDA in 1H20E, albeit with a slight skew to 2H20E given optimisation of ROC generation and pelleting capacity expansion in the US during 2020. B2B supply – likely to be materially impacted by Covid-19, with the majority of the impact in 1H. As a non-domestic supplier, Drax will be hit by lower demand, the impact of unwinding hedges, and elevated bad debt risk. Should Drax outturn at/around our 1H expectation, this could put downwards pressure on our FY20E for B2B, offsetting the positives of flexibility. Dividend – Drax’s dividend policy is to ‘pay a sustainable and growing dividend’, although no guidance has been provided as to what constitutes growing. Our estimates assume 8% FY growth and a 40/60 interim split. Should our 6.9p 1H20E be bettered, we would interpret this as a positive. Guidance – we look for Drax to express comfort with FY20 EBITDA consensus (£394m per FactSet), and leverage of c.2x net debt/adjusted EBITDA. Our £820m 1H20E net debt assumes greater working capital requirements in B2B, with some capex re-phasing to offset.
Outlook broadly in line with expectations Drax has published a trading statement this morning which is broadly in line with our expectations. The 2019 final dividend of 9.5p will be paid subject to AGM approval today. FY20 adjusted EBITDA currently in line with consensus (INVe £391m, cons at £398m), inclusive of £60m CV19 impact, of which c80% is in B2B supply, and now expected to be loss-making (INVe £16m loss). Year-end net debt expected at around 2x EBITDA (INVe 1.9x). The strategic focus remains the same, though the timing of the 2020 investment programme is being reviewed, and short-term investment is expected to be lower. We understand that the outlook elaborated this morning has been based on a reasonable downside scenario. Risk of lower recycle prices, but provision of system services should largely offset Risk of lower ROC recycle prices, dependent on the depth and duration of demand reduction, but Drax expects that there will be partial offset through increased system services activity. We have already seen increased market activity by the National Grid ESO, and as per the National Grid ESO Summer Outlook, this is expected to continue through the summer. We have previously highlighted Drax as being well positioned to provide flexibility, and it should benefit from this elevated level of intervention. Biomass supply chain intact and robust Biomass generation is the most material area of activity for Drax, and a disruption/suspension of the supply chain could have a negative impact on output. However, this has not been the case to date. There is a good supply of biomass throughout the supply chain, there is operational redundancy and storage capacity built into the supply chain, and the pellet production process is semi-automated. Energy, rail, port and forestry are designated key sectors in the USA, and in the UK, Drax is part of critical national infrastructure, with components of the supply chain considered key sectors.
Drax is exposed to the $/£ rate, but a five-year forward hedging policy mitigates risks in the near-term. Post 2027, biomass generation economics become challenged if sterling never recovers. Power prices are depressed, but FY20E and FY21E are protected by hedging. MTM on FY22E points to a 13% EPS hit, but longer-term we view the Capacity Market and flexibility as providing a hedge. Drax’s RCF provides liquidity, and £72m of Capacity Market payments were received in January. Refinancing needs are 2022 and beyond, although the RCF is up for renewal next year. Supply business at risk from higher net debt, and we would expect Drax to be flexible in its approach to payment collection, but FY20E is likely to be negatively impacted. EBITDA breakeven in supply would hit our FY20E EPS by 16%. There is sufficient biomass en route to Drax to cover a month’s generation, but an Armageddon scenario would be the complete collapse of the supply chain. We expect that Drax would be designated as strategic by the UK government, and given delivery priority. The current share price assumes no recovery in gas or electricity prices, nor any offsets through higher Capacity Market revenues, or a greater contribution from flexibility services. We consider such a scenario unlikely.
Drax delivered in 2019, hitting EBITDA consensus, and meeting targeted biomass cost reductions of $5/t, a good start to the multi-year programme. Hedging protects FY20E EPS, which sees a slight boost from lower depreciation of the coal plant following the recent closure decision and associated asset write-down in 2019. Outer-years see earnings cuts with achieved power prices positioned £3-4/MWh lower, and pellet opex reflecting the growing size of operations, partially offset by a higher-than-expected clearing price (£15.97/kW/year) in the T-4 CM for delivery year 2023/24. (See Figure 1 overleaf for a summary of earnings changes.) We see little risk to FY21E from sustained power price pressure, while our assumptions for FY22E are only slightly above forward prices (Figure 3). Longer-term, we expect revenue growth opportunities for Drax’s biomass, gas, and pumped storage assets from a growing need for system support, balancing market, inertia, and flexibility services (Figure 4). We suggest that greater disclosure from Drax in this respect would be a help to investors. Our valuation falls 7% to 358p, although given our unchanged approach to the biomass/pellet transfer price in 2027, our valuation of generation nudges up, while that of the pellet business falls (Figure 6). Indeed, we may turn out to be conservative, as our post 2027 combined biomass/pelleting EBITDA is less than half of Drax’s £100m aspiration. Refocussing the pelleting business to the global business may yet prove to be a greater source of value. Drax may not possess the stability of networks in these uncertain and volatile times, but the recent coronavirus/oil shock induced weakness is a chance to add to holdings. We are Buyers with a 360p target price (previously 385p).
Drax reported a set of FY19 results which were in line with expectations. EBITDA increased by +64% to £410m and EPS tripled to 29.9p (5% higher than the consensus at 28.4p). The proposed dividend is in line with expectations (15.9p). The main contributor to this growth was the Production division (+52% in H2) on the back of a slight positive volume effect (pellet production was up by 4%) and a reduction in the costs of production by 3%.
In line 2019 results, with trade-off between generation and pellet production Adjusted EBITDA came in at £410m (INVe £412m, consensus £410m), adjusted EPS was 29.9p (INVe 28.7p, consensus 29.5p), and net debt was £841m, below our £953m estimate. Power generation EBITDA of £408m (INVe £421m), pellet production EBITDA of £32m (INVe £16m), and B2B supply EBITDA of £17m (INVe £20m). 15.9p dividend as expected. 2020 protected from power price risk Biomass cost reduction of $5/t delivered in 2019 in line with guidance, and 2022 target of a £13/MWh saving on 1.85mt reiterated. No guidance on headline numbers given for 2020, but Drax has 15.8TWh hedged at £53.9/MWh for 2020, vs. 11.4TWh at £54.6/MWh disclosed at 1H19. For 2021, the hedged position is 8.7TWh at £50.5/MWh vs. 4.8TWh at £51.1/MWh. 2020 looks protected from recent power price declines. End of Old King Coal Drax has announced that it will end commercial coal generation in 2021, formally closing the two remaining coal units in September 2022 at the end of current capacity market operations. Given the failure to secure CM contracts, and Drax’s review into coal operations, this does not come as a surprise. Opex costs are expected to reduce by £25-35m once the closure is complete, and one-off closure costs of £25-35m are expected.
Our new Drax model provides greater granularity, and captures a broader range of drivers in an increasingly complex GB market. The Capacity Market is one such variable, and the T-3 auction for delivery year 2022/23 cleared at £6.44/kW/year, with Drax securing contracts for 2,333MW of de-rated capacity, but no coal. As we expected, Drax was not successful in securing new build contracts for pre-qualified OCGTs/CCGT. Power prices and biomass cost are the key drivers of the investment case, and the stock has materially underperformed the UK utility space on power price weakness, and the absence of tangible evidence that biomass costs are reducing. Our updated forecasts factor in lower power prices, and although we see downside mark-to-market risk in FY22E, it appears to be negligible for FY23E. We suggest that power price concerns are overplayed, and highlight revenue opportunities such as the provision of inertia to the ESO. As outlined in November’s capital markets day, initiatives to reduce biomass costs by $35/t over 2018-22 are underway, savings we factor into our model. In our opinion, demonstrating progress against this ambition on a regular basis is crucial for the equity story. Switching to a sum-of-the-parts valuation sees our target price trimmed to 385p. Closing the Drax power plant at 2027 would cut 89p from our valuation, still 9% above current levels, while a refocussing of the pellet business to supplying the global market would offer valuation mitigation. Recent weakness offers an opportunity to revisit the stock, and we see attractive upside. Buy.
Biomass The company is targeting self-supply of biomass target of 5mtpa by 2027, comprising the 1.5mtpa of existing capacity, the 0.35mtpa of low capacity previously outlined and a further 3mpta of capacity being evaluated. This would support the company’s target to reduce biomass costs by c. 30% to c.£50/MWh. This goal is to reduce costs to ensure biomass operations are economic without subsidy in 2027. Gas Generation Drax sees flexible gas generation as part of its strategy as an enabler of greater renewable and low carbon generation and to support the development of hydrogen. Any investment decision would reflect the company’s objectives of delivering earnings visibility and be underpinned by a 15 year capacity agreement to support a low double-digit rate of return. A range of funding options would be considered in line with the company’s objective of maintaining net debt:EBITDA of c.2x. We do not think a recourse to equity is likely. Trading The company indicates that trading is in line with the FY19 Adj EBITDA guidance of £90-110m, with the acquired assets performing strongly. Following the planned outages of two biomass units during the summer and a delayed return to service, Drax intends to run all four ROC units at higher utilisation levels in Q4, ideal timing for winter power demand. With the Capacity Market restored, the EBITDA that was at risk is now included in FY19 expectations (£75m payments had been impacted and are now due, with cash settlement in Jan 2020). Management also restates its commitment to the dividend policy established in 2017. Our View A straightforward update with much of the focus of today’s event likely to be on developing lower cost biomass operations, which we see as a key item for the group.
Unique play in the E&P space – Diversified is not an explorer or developer; instead it takes a different approach by buying and consolidating mature, long-life, low-cost producing assets with consistent cash flows and doing this at historically low valuations. The company’s philosophy is simple – using in-house expertise to run a low-cost strategy and maximise the value of neglected assets. The relatively mature producing assets give the company a predictable and consistent production profile, low operational costs and minimal operational risk, which materialises into significant free cash flow generation. We expect Diversified to generate an average FCF yield of 22% over the next four years! Cash locked in, delivery is key – The past 3 years have been hugely transformational with c.$1.5bn of transactions since IPO in early 2017, driving the company towards production of over 90kboepd. Diversified is now the largest oil & gas producer on the AIM market and is currently targeting a premium listing in H1 2020. The right assets are now in the right hands and we expect management to efficiently manage these assets until end-of-life. With a comprehensive hedge book, operational delivery is now key to delivering cash flows and returns to shareholders. Valuation – We set our price target at 125p. The shares trade at a c.20% discount to Core NAV and the company’s commitment to shareholder returns offers an attractive opportunity for investors from a yield and capital appreciation perspective, in our view. Catalysts – M&A update (ongoing), targeted premium listing (H1 20).
DRX CGEO GHG QQ/
Growth plans Post the capacity payments resolution, we look for insights on investment options into new generation capacity. Drax has around £2bn worth of projects that are permitted and ready for development. We think it is unlikely that it will undertake investment plans that would require equity or put the dividend at risk, or overstretch management resources. The two key gas projects under consideration comprise 1) Damhead Creek CCGT for 1.8GW near London, and 2) up to 2x 1.8GW at the Drax site to replace the existing coal units. Ultimately, the decision will be driven by the terms that can be agreed for capacity payments. Strategically, it may be more sensible to advance Damhead Creek first then await greater clarity on UK energy policy for the coal conversions at Drax since this could be tied to carbon capture if UK policy evolves to support this in the medium term. Biomass We expect an update on plans to help the company to reach a cost of <£50/MWh for the wood pellets. We would like to see a confident and clear plan delineated to achieve the cost target to give confidence that the biomass operations can continue when current support mechanisms expire (2027). We believe that the UK needs Drax long term, but the economics to support it require clarification. We hope the company will outline thoughts on possible longer-term support (e.g. capacity market eligibility), hedging and FX exposure given it has long-term hedges (through to 2024) in place at US$1.45/£ (biomass is imported from the US). Long term objectives We look for an update on the company’s carbon capture plans and various technology options. However, we do not anticipate major investment decisions on CCS before c. 2024. We may also get some insight on Cruachan pumped storage - both the services it can provide to the grid and its importance, and scope for expansion. Other – the retail business is small, but we would welcome updates on how this still fits and whether it is still core. Our view We believe Drax presents a value and growth opportunity, underpinned an attractive forecast yield of c. 6%. Although the growth path needs clarity, we see meaningful optionality in its various projects to drive further value.
Another good year with total revenues up 7.7% (H1 +5.3%) & LFL +5.5% (1H19 +4.4%), benefiting from consistent investment. This implies 2H19 LFL sales +6.7%, an acceleration on H1 which was expected given last summer’s weak comparable from the hot weather & World Cup. All revenue streams grew. Profit growth ahead of expectations (INVe & company consensus £25.9m) with management guiding to FY PBT growth in excess of 10%. We upgrade FY19e/FY20e by 2%/1.3% to reflect guidance. DPS increased similarly. The slightly smaller upgrade in FY20e reflects a slight slip in opening programme. Performance driven by constant investment in customer experience and operational improvements. 7 refurbishments completed in FY19 with another 7-8 expected in FY20. Pins on strings are now in 11 centres with another 2 added in H2. Investment in the new website (launched in April), digital capabilities and its dynamic pricing/CRM system continues to pay off. The roll-out of the new scoring system, due to complete in FY21, is proceeding to plan. Another capital return is being considered, with the Board due to update at its FY results on 13th December. Last year BOWL returned 4.33p (£6.5m), an equivalent yield of 1.9%, and we forecast a similar amount this year. We are forecasting year end net debt of £3.8m or net debt/EBITDA of 0.1x. Undemanding valuation (CY20e PE 15.9x; ordinary div yield 3.1%) which in our view does not reflect the highly cash generative, returns focused unit roll-out with multiple growth opportunities and good visibility on new site opportunities to FY23. We upgrade our TP to 270p (prev 265p) to reflect the upgrades. Buy reiterated.
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A positive site visit that again highlighted to us the scale and optionality in the core Drax power plant whilst also a reminder that Drax is not a one asset offering post the Scottish Power deal. The range of services offered to the grid from the current plant, and potentially the new build, look increasingly important to the UK against the backdrop of rising renewables and declining coal and nuclear generation (including questionable timings on HPC). We believe the UK needs Drax (it supplies c. 12% of the UK’s renewable power) and that capacity market issues will ultimately be resolved favourably and trigger investment to accelerate growth. Capacity Market – There may be some progress visible here, with a Reuters report last Friday (4 October) citing three sources indicating that the situation will be resolved. We hope for a formal decision before 31 October when the current commission’s turn of office ends. If a final decision is not made by then, delays to a resolution appear likely. However, whilst we estimate the impact on this year’s EBITDA from a failure to resolve the issue at circa 17%, longer term, the need for capacity in the system to respond to demand and supply changes will need to be priced in. We would expect upward pressure on power prices, greater volatility and a larger ancillary services market. Flexibility – whilst the Drax power station was first built in what might be seen as a bygone era (opened in 1973), in a world of wind and solar, we believe the rise of renewables enhances the value of Drax’s biomass generation on the grid. It is a major asset providing a range of services to the grid that renewables cannot match, most notably inertia, a key component of managing volatile renewable generation. Further, the generation units have considerable embedded flexibility designed not only in bringing each boiler on and off line, but also the ability to run each boiler from full power (650-700MW) down to 250MW (flexibility that nuclear cannot match). Cruachan pumped storage also provides a range of increasingly valuable services to balance rising offshore wind generation in Scotland. Long term – Drax’s biomass strategy is carbon neutral with scope to be carbon negative as work continues on developing a CCS solution. A frequent misunderstanding of the company’s biofuels strategy is the belief that virgin timber is processed in the US for use as fuel at the Drax plant. This is incorrect – wood pellets are sourced from waste wood from the timber industry in North America. Therefore, the biomass is carbon neutral. We note also that the 3.8GW gas repower of Drax’s remaining two coal units was granted UK government approval last Friday, which would add a net 2.5GW of capacity if developed. Alongside four OCGT projects and the Damhead Creek CCGT (1.8GW), all permitted, this gives Drax a wide range of options (see figure 2 overleaf). The development of these projects is dependent on securing capacity market contracts, but will not involve the issue of equity by the group. Continued overleaf
Generation EBITDA driven by biomass and acquired assets Drax reported 1H19 results this morning. Adjusted EBITDA of £138m (vs £102m in 1H18) with the growth driven by the assets acquired from Iberdrola and biomass generation, offset in part by lower contributions from the customer business and core services. The contraction in customer EBITDA is due to volume reduction and integration/system costs, offset in part by lower net debt costs & growth in meters. Net debt of £924m is in line with our FY estimate of £911m, and Drax has reiterated its target of 2x net debt/adjusted EBITDA for end-2019, subject to reinstatement of the capacity market, which the company expects to happen in H2. 2019 H2 weighted, guidance unchanged It has previously been highlighted that 2019 performance will be weighted towards H2, and the outlook for the FY is unchanged. Key drivers are the profiling generation of the ROC units to H2, an increase in pellet production and cost reduction, delivery of performance target in the acquired hydro/gas assets, and improving the performance of the customers’ business. Drax has indicated it expects a FY dividend of 15.9p/share, 12.7% up vs 2018, and above our estimate of 15.3p/share. Contracted power sales now stand at 11.4TWh at £54.6/MWh (vs 8.6TWh at £53.3/MWh at FY18) for 2020, and at 4.6TWh at £51.1/MWh (vs 2.9TWh at £50.1/MWh at FY18). We see this as supportive of our medium-term estimates. Longer-term strategy to reduce biomass costs, and CCUS/gas development options Reducing biomass costs both in feedstock and in the UK are integral to Drax’s strategy for biomass operation beyond 2027, with CCUS and gas development further options.
The group published reassuring H1 figures with an encouraging Generation division and negative elements that should fade over time. Full-year EBITDA and net debt guidance remain unchanged, in the plausible scenario of a re-establishment of the Capacity Market in H2.
Drax reported a set of FY18 results broadly in line with estimates (<1% short). The group posted a 9% growth in adjusted EBITDA, translating the continued ramp-up of the wood pellet business as well as a resilient market share in the B2B supply division, which helped to offset an outage in Q1-18 and higher coal/carbon prices in the UK.
Drax released a mixed set of H1 results, marked by two unplanned outages in the generation business, partly offset by the positive performance of the US pellet and B2B supply divisions. The group confirmed its FY targets and expects to pay a £56m FY18 dividend.
• All divisions achieved improved earnings, finishing on the positive side. • Substantial EBITDA improvement supports OCF and net debt levels above expectations. • A £50m dividend payment (12.3p/share). Positive £50m share buy-back surprise.
The group published its half-year results showing a strong top-line as revenues increased by 21% to £1,800m and EBITDA rose 70% yoy to £120.8m, which was within expectations. However, higher depreciation expenses, losses on derivative contracts and a doubling of interest expenses have pushed the group to a net loss of £-16.8m. On an adjusted basis, net income fell by 47.3% to £8.9m, translating into an EPS of 2.2p/share which is below expectations. The group maintained its full-year guidance for EBITDA to achieve £240m (already 50% achieved), although no information was given at the net income level, so that the market’s expectations of £42.2m seems difficult to be attained. The group proposed an interim dividend payment of £20m, which represents 40% of the expected £50m full-year payment, translating into 4.9p/share and a payout ratio of 222% on adjusted net income.
Drax has published its FY16 results which are weak at the top-line level with revenues reaching £2.95bn (-4.7% yoy) and EBITDA reaching £140m, which is 2% below market expectations and represents -17.2% yoy mainly due to the removal of the renewable subsidies in the UK and lower power prices. However, a strong performance in the trading business and £177m of unrealised gains from derivative contracts have boosted the reported net income profit of the company to £194m, representing a 246% yoy increase. On an adjusted level, the profit of the group was £21m representing a 54.3% yoy contraction and an EPS of 5p, which is broadly in line with expectations, but below ours. Net debt decreased by 50.2% yoy to £93m, ahead of forecasts, due to a strong cash flow performance (+29% yoy from operating activities) and an increase in cash reserves due to a £86m positive free cash flow. The group has proposed a dividend payment of 2.5p per share (-56% yoy), which is at the consensus level and represents a 50% payout ratio. It expects a 2017 EBITDA in line with market expectations at £229m. The company has decided to put the current dividend policy under review (50% payout ratio). No information is expected before H1 17 after consulting the shareholders.
Drax has published today its trading update in which it states that it expects earnings to be at the lower end of its guidance (£135-169m). It also includes the approval of the CfD contract for the third biomass unit by January 2017 with a strike price of £100/MW. In addition, the group has provided a strategic update in which it mentions that it has completed two separate transactions, the first one being Opus Energy, a retail provider for the UK market with over 256k customers, for £340m, translating into a 10x EBITDA price. This would allow Drax to be within the top 7 suppliers in the UK (within the “big 6”). The second acquisition is the purchase of four Open Cycle Gas Turbine (OCGT) plant projects with a total capacity of 1,200MW for only £18.5m, translating into a price of £14.5k/MW. These projects will be developed if they are backed by 15-year Capacity Market contracts.
Drax’s sharp drop in H1 EBITDA to £70m from £120m, while disappointing, was well flagged by management and signposted by commodity moves. Of far more interest, we believe, are the impending regulatory changes that will modify Drax’s earnings profile. The company expects to hear about state aid on contracts for difference (CFDs) this autumn. This will mark a continuation of Drax’s transformation from its historic earnings sensitivity to swings in electricity, coal and carbon prices to a more stable, regulated earnings profile. Provided the regimes introduced are profitable, we believe regulatory certainty and enhanced profitability will drive a stock re-rating.
A difficult first half year for the company driven mainly by the Levy Exemption Certificates (LEC) removal, lower volumes sold and further pressure on commodity markets with EBITDA reaching £70m (-41.7% yoy) and adjusted net income falling 59% yoy to £17m, translating into an EPS of 4.2p. As a result, the dividend has been cut by the same amount to 2.1p, in line with the 50% payout ratio.
Weak results for the group, as revenues increased 9% yoy to £3,065m but margins contracted pushing EBITDA to a 26% yoy decrease, reaching £169m, falling 2% below expectations driven by the the removal of the LEC _(Levy Exemption Certificate)_ subsidy and decreasing power prices. The adjusted EPS decreased by 52% yoy to 11.3p and missed forecasts by 8% given also that there was top-line pressure as the group had higher depreciation expenses linked to the biomass investment. On a reported basis however, EPS reached 14p (-56% yoy), being better than expected due to one-off gains on derivative contracts to hedge on forex movements and lower prices. Net debt doubled within a single year to reach £187m, which is 50% higher than forecasts as capex is above expectations, reaching £183m (although it decreased 10% yoy), despite an improvement in operating cash flows and a £134m cash position. The dividend proposed at 5.7p is in line with expectations and represents a 50% payout of the adjusted EPS. Concerning guidance, the group has confirmed a challenging outlook for 2016 driven by the continued pressure on commodity prices and the loss of LEC subsidies. The group should concentrate on cash flows rather than earnings with additional cost cutting and capex measures expected.
Really good half-year results for the group. Revenues increased in all divisions, pushing sales up by 20% yoy to £1.51bn, beating estimates by 5.2% due to greater electricity generation output (+20% yoy) with a significant increase in biomass generation, increase in sales in retail (+22% yoy), and higher volumes delivered (+21% yoy). The improvement in revenues has pushed EBITDA upwards by 17% yoy to reach £119.9m, 14.7% better than market expectations with operating profit at £67.1m going up from only £4.5m a year ago. Bottom line, the group has passed into positive territory with £38.8m of net income (from a net loss of £6.7m), beating consensus estimates by 11.3%.
