How 4.4% yielding Drax kicked out coal and went green
North Yorkshire-based Drax (DRX) is the UK’s largest single source renewable energy company, supplying around a tenth of the UK’s energy needs. It is playing a key role in helping the country reach its goal of becoming net carbon neutral by 2050.
Drax has transitioned from a traditional coal and gas-fired energy supplier into 100% biomass, utilising wood pellets. The company ended commercial coal-fired energy production in March 2021 and completed the sale of existing gas generation in January 2021.
It gets paid subsidies to burn biomass which end in 2027. By scaling up its biomass supply chain and reducing costs Drax expects to be profitable without the subsidy by the time it is removed.
The long-term goal is to become carbon negative by 2030 by deploying proven bioenergy carbon capture and storage technology to remove the carbon dioxide produced when burning the biomass.
What is biomass?
Biomass is plant or animal material used as fuel to produce electricity or heat, such as wood, energy crops and waste from forests, yards or farms.
It is considered a low carbon source by the UK and the EU because a key source of material is commercially managed forests.
Academic work has shown that biomass can achieve carbon payback periods as low as wind and solar. Carbon payback refers to the amount of time it takes before the system can produce as much electricity as it consumes including construction and environmental impacts.
Drax is vertically integrated and sells over 90% of its own energy supply through two business-to-business suppliers, Haven and Opus.
The former targets large industrial and commercial clients while the later focuses on small and medium sized businesses.
Drax also has overseas operations. It operates a waste wood and dust business based in Louisiana, and it recently acquired Canadian wood pellet producer Pinnacle Renewable Energy.
Biomass for climate mitigation has been recognised as sustainable by the European Union and the UK and is deemed a low carbon form of electricity generation.
Norway’s $1 trillion sovereign wealth fund now recognises Drax as a low carbon energy producer having initially put the company on its blacklist due to the (now former) coal generation business.
The acquisition adds 2.9 million tonnes of biomass production capacity and significantly reduces its cost of production. The enlarged supply chain will have access to 4.9 million tonnes of capacity by 2022.
The company’s bioenergy business comprises 13 manufacturing sites in the US and Canada which produce compressed wood pellets for customers in Europe and Asia as well as for its own use.
PROVIDING FLEXIBLE ENERGY
The UK energy grid is required to run at a specific frequency (50 Hz) and any deviation larger than 1% could spark cascading failure resulting in partial or full failure of the network.
The increased use of renewable energy in the UK has created more volatility of supply because of the intermittent nature of wind and solar and limited energy storage options.
Because of their volatile supply, which could push the frequency out of the desired range, renewables are not able to have a synchronous connection to the grid.
Traditionally, steam-driven generators of the coal and gas power stations maintained the network’s frequency by dampening down interruptions. This is sometimes called providing inertia.
Renewables cannot supply inertia and this limitation provides an opportunity for Drax and other operators.
Seeing the wood from the trees
A growing tree consumes carbon dioxide from the atmosphere and converts it into carbon in the wood via photosynthesis.
When Drax burns biomass, it releases carbon dioxide back into the atmosphere. By using material from forests that are in a continual state of growth and consuming CO2, the burnt biomass is replaced, creating a neutral outcome.
Longspur Research analyst Adam Forsyth cites the example of the southeast of the US where only 2% of the forest is harvested in any year which means that 98% is kept in various stages of regrowth.
This results in a net increase in the amount of carbon stored in the forest every year as more carbon dioxide is removed from the atmosphere by growing trees than mature trees.
In addition, most of the mature wood in the forest is used for construction which means it keeps the carbon stored for longer. Drax only uses sawmill residues, low grade roundwood, branches and bark for its pellet production.
The US has over 750 million acres of forest land which equates to 35% of its landmass. Inventories have increased by at least 50% since 1950 and they are protected by regulation. Forsyth believes Drax’s needs out to 2030 would only represent around 6% of total supply.
Drax’s assets provide flexible generation which provide support to the network so that it can handle the volatile supply of renewable energy as well as inertia.
A good example is the company’s Cruachan pumped storage scheme in Scotland which provides energy when the wind doesn’t blow, or the sun doesn’t shine.
The scheme is effectively a giant battery produced by two reservoirs which sit between a hanging valley.
A compressed air system in its turbines allows a fast response in under 30 seconds which means Cruachan is highly responsive, while it can store energy for up to 16 hours.
Drax also owns two hydroelectric schemes at Lanark on the river Clyde with two generating plants and in Galloway which has six plants.
Most of the energy produced by Drax is from biomass burnt at its power station in Selby, Yorkshire near the Humber estuary.
HOW DOES DRAX MAKE MONEY?
Drax generates three separate sources of income: power generation, energy supply and pellet production.
The UK energy market is comprised of three different segments which include the wholesale market, which is what people think of as the supply market; the capacity market which effectively is insurance to keep the lights on; and the ancillary markets which are a range of services that help to keep the system running.
Drax also runs a trading operation where the company trades its own contracted output. This is an important asset as it allows the company to take advantage of its positions across the market, but it doesn’t disclose the profits of this segment separately.
The lion’s share of EBITDA (earnings before interest, tax, depreciation, and amortisation) comes from energy generation.
For the year to 31 December 2020 adjusted EBITDA was £420 million including the gas generation assets which have been sold.
Power generation EBITDA was £446 million underpinned by a 5% increase in output. Strong trading from ancillary services and the trading operation offset outage times related to implementing social distancing measures.
The Cruachan pumped storage and hydro assets in Scotland contributed significantly (£118 million) to the overall gross margin from system support activities.
Pellet production contributed EBITDA of £52 million, up 63% on the year reflecting a record period for output with 1.5 million tonnes produced.
Drax’s role in improving carbon storage
In theory, taking carbon dioxide produced from burning biomass and storing it underground means that every tonne captured by growing trees is permanently removed from the atmosphere.
This is one reason why the UK’s committee on climate change has backed bioenergy carbon capture and storage to help deliver a net zero carbon economy.
Drax will play a key part in the process partly due to the location of its power plant in the Humber, where it is a member of the Zero Carbon Humber initiative.
The idea is to build CO2 transportation infrastructure to carry the gas into storage facilities under the North Sea.
The technology already exists and has been proven in the oil industry, but it is expensive. Drax is exploring solutions which have the potential to reduce the overall cost.
It is likely that the Government will provide subsidies for companies building the infrastructure and operating bioenergy carbon capture and storage technology to attract the necessary investments.
Finally, the pandemic impacted the energy supply businesses resulting in an EBITDA loss of £39 million.
Drax has a very clear capital allocation policy. The priority is to maintain a strong credit rating which in practice means keeping net debt to EBITDA below two times. Adjusting for discontinued assets, the ratio was 1.6 at the end of 2020.
The other priorities are to continue investing in the core business and to pay a sustainable and growing dividend. Any surplus capital will be paid back to shareholders.
Drax has grown its dividend by a compound annual growth rate of 25% a year since 2015 according to Stockopedia and the prospective dividend of 18.4p per share provides a yield of 4.4%.
SHARES SAYS: Drax ticks a lot of boxes for income and growth investors looking for a play on the transition to a green economy.
Biomass is widely regarded as a sustainable low carbon resource and Drax’s plans to capture and store the carbon from burning biomass will turn it into a negative emissions company.
We like the optionality that the company has created through building an independent biomass supply chain.
While there are execution and political risks, these are more than reflected in the undemanding rating of the shares, trading on 16 times 2021 earnings.