CfD decision brings Drax down to earth

Biomass has been a sector on the defensive over the past few years. Claims by environmental NGOs that burning wood for power could be “dirtier than coal” gained traction despite vehement rebuttals from the industry. That has been implicitly reflected in a series of cutbacks to policy support.

Through all this, Drax was the valiant exception. As the largest single power station in the UK, Drax has strategic importance government cannot afford to ignore. Rather than cling to coal in the face of climate change objectives, Drax led the biomass conversion agenda and, on the whole, brought government along.

It was all the more shocking, then, that government on Wednesday dropped one of two Drax biomass units off the list of renewable projects to secure an early support contract (see table of winners). Both units topped the provisional rankings in December, but one is now deemed “ineligible”. Drax shares fell 13.5 per cent in the course of the day, wiping more than £400 million off the company’s value.

That was the downer on what was otherwise a good day for renewables. Eight large-scale projects worth £12 billion and 4.5GW of power generation capacity got the first contracts for difference (CfDs) of the new subsidy regime. Seven of these were in line with December’s assessment of “provisionally affordable” projects. Then there was a happy result for SSE, as its previously omitted Beatrice offshore windfarm made the cut.

But why the change of heart? The Department of Energy and Climate Change (Decc) was not forthcoming with the rationale for its decision. A spokesperson would only say the second Drax unit “was assessed as not continuing to meet all of the qualification criteria”.

Dorothy Thompson, chief executive of Drax, said in an analyst call the decision was “unexpected and disappointing” and the government “has not provided an adequate explanation”. She added: “Nothing has changed, as far as our plans are concerned, between being deemed eligible in December and now.” The company is mounting a legal challenge.

The only clue Drax offered was Decc had told them the decision concerned “mobilisation of capital”. Analysts at RBC Capital Markets interpreted this as Drax being “a victim of its own success”, as its conversion was so far advanced it was not seen to need the extra assurance of an enabling CfD.

Consultants at Cornwall Energy say the answer could lie in the budget profile. Decc has set a cap on funding for the early CfDs that starts low and rises to £1 billion a year in 2020. Supporting two biomass units at Drax would hog the budget in the early years, according toCornwall’s analysis. Beatrice, on the other hand, is slightly cheaper and not due to start generating until 2019.

Political considerations may have played a part. SSE radically scaled back its offshore wind programme in March to focus on Beatrice. It made clear a final investment decision would depend on securing an early CfD, putting the onus on government to save it from the chop. Given the government’s ambitions to be a world leader on offshore wind and a recent run of axed projects, to let another scheme fail would have been somewhat embarrassing.

Beatrice also happens to be the only Scottish scheme approved. Energy has become a key battleground in the Scottish independence debate and the Better Together campaign likes to argue Scotland benefits from UK-backed renewable subsidies. That line falls flat if only English and Welsh projects get contracts.

Where does this leave Drax’s biomass conversion programme? While it is undoubtedly a setback, Decc’s decision is not necessarily terminal. One biomass unit is already up and running. This latest decision affects the plans for a second and third unit. Drax is evaluating the case for converting a fourth burner out of a total six.

The unit denied an early CfD is eligible for support under the old Renewable Obligation (RO) regime, albeit on less favourable terms. With a CfD, power from a biomass conversion is guaranteed £105/MWh. Under the RO, it gets 0.9 RO Certificates, currently worth £41.50/MWh, plus the wholesale power price. The difference amounts to an estimated £10/MWh less under the RO than the CfD.

Thompson said: “Everything now needs to be reassessed.” However, the company remains “fully committed” to the biomass conversion strategy, she added. “The investment case for our biomass conversions remains very strong.”

Analysts appeared confident that while earnings may take a hit, the biomass conversion programme would stay on track.

Deutsche Bank said Drax was still “an attractive proposition with scope to drive strong earnings growth over the next few years”.

Investec took a similar view, saying that while the unexplained change heightened the sense of policy uncertainty facing all energy investors, Drax remained in a relatively strong position.

The need for reliable renewable power capacity will “eventually trump Decc irrationality”, said Investec analyst Harold Hutchinson. “As the UK’s largest ‘conventional’ plant, the country can ill afford to lose Drax.”