Will Drax get what it needs from the government's electricity market reforms?
Drax Group (LSE: DRX) is the second coal-fuelled company to report good profits in the last week. The first, Hargreaves Services (LSE: HSP), supplies much of the coal used by Drax in the Drax Power Station, which generates about 7% of the UK's electricity.
Generating electricity by burning coal remains profitable. Drax's revenue rose from £1,648.4m to £1,835.9m in 2011, and operating profits rose by 31%, from £279.2m to £366.2m.
However, a combination of factors led to a reduction in underlying earnings per share from 64p in 2010 to 56p in 2011. In line with Drax's admirable policy of paying out 50% of earnings to shareholders as dividends, this also means the company's total dividend has fallen, from 32p to 27.8p, a yield of 5.3% at the time of writing.
Carbon Apocalypse 2013
In 2011, Drax produced 11.9m tonnes of CO2 emissions in excess of its 9.5m tonne allowance under the UK National Allocation Plan, part of the EU carbon emissions trading scheme.
This is more profitable for Drax than burning low-carbon fuels, despite the fact that credits for these extra emissions have to be purchased. The problem is that the current scheme ends this year, and burning coal is set to become more expensive.
In April 2013, the government's Electricity Market Reform package will be launched, which, according to Drax, will make "will result in coal generation becoming progressively and relatively less economic than other major forms of generation like gas, nuclear and renewables".
More subsidies, please
In 2011, Drax burned 1.3m tonnes of sustainable biomass fuels, alongside 9.1m tonnes of coal, generating 7% of the UK's renewable power. Drax is now confident that it could convert to become a biomass-fuelled power station and will invest £50m this year to increase its biomass capacity to 20%.
This is necessary to get some of the benefits offered in the Electricity Market Reform package -- but Drax is lobbying for more support before it commits to a wholesale switch to biomass.
On the brink?
The real question is whether Drax really will go under if sufficient subsidies are not available or whether this is a kind of brinkmanship designed to maximise shareholder returns from burning biomass.
I don't have access to that information, but my instinct is that Drax's current protests are a negotiating tactic and that it will survive quite well on a gradually changing balance of coal and biomass.
I suspect that Drax and its appealing yield will be around for some years to come. Let me know if you agree in the comments below.
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