Named after a village in north Yorkshire, Drax (DRX) is an electricity generator – for what it’s worth, it runs the UK’s biggest single plant. However, scratch the surface and you might be forgiven for concluding that its real identity is a subsidy junkie – a company that cannot live without hand-outs from the UK’s electricity consumers. As the group announced its results for 2022 last week, its bosses were at it again – seeking a new source of supply to feed their monster’s addiction.
To date, Drax’s subsidies have been a by-product of driving down the emission of greenhouse gases from generating electricity chiefly via so-called ‘renewables obligation certificates’. It produces these in huge quantities and sells to suppliers who are compelled to buy them, passing the costs onto their customers (you and me). Now its bosses see the opportunity to go one better – to grab a bucket-load of the subsidies that will be on offer in developing the capture and storage of CO2 emitted from power plants that burn fossil fuels.
While announcing the 2022 figures, its chief executive, Will Gardiner, took the chance to do a neat bit of arm-twisting. The UK government must quickly sort out its subsidy regime to help scale up carbon capture at the Drax plant, he said. Then came the implied threat. Failing that, Drax “stands ready” to focus development of carbon capture on its activities in the US, where there are generous incentives offered by the ridiculously-named Inflation Reduction Act (Trade Protection Act is much more apt).
In this context, Drax has an ace to play. For the UK government, anxious to signal its virtue on the world stage, Drax offers the prize of negative emissions; at least, it certainly does at its Yorkshire plant. With the help of scaled-up carbon capture, it can perform a wondrous transformation. Not only can it reduce a given amount of CO2 emissions to zero, but it can also turn those emissions into a negative number; just the sort of trick needed for another number to stand any chance of being realised – that global emissions of greenhouse gases will be net zero by 2050.
The crucial factor here is that almost all the emissions at Drax’s plant already count as zero even though four out of its six generating units burn wood. No matter that burning wood to produce electricity is a dirtier business than burning coal, for the simple reason that there is less energy in wood waiting to be released than in coal. Wood has a magical property that coal lacks. It counts as a renewable source of energy. As such, the CO2 released when it’s burned in a power station does not really exist; at least, not according to the layers of supra-national organisations, quangos and standards setters that police and adjudicate these things.
Drax says the legal frameworks and scientific principles underpinning the assessment that biomass is a renewable energy source are clear. The legality is not in doubt. As to the science, that most certainly is contested. Sure, plant a tree and it will suck in CO2 as it grows and retain it through its maturity. But there is what might be labelled ‘a timing issue’. Burn wood today and the CO2 will be instantly released. The time it takes for new trees to claw back an equivalent amount of gas is measured in decades, quite a few of them at least. Meanwhile, more trees will be burned tomorrow and tomorrow and tomorrow. Drax produced 3.9mn tonnes of wood pellets in 2022 to burn in generating plants (mostly its own) and is likely to exceed that amount this year. When will that CO2 be clawed back? And each day 2050 gets closer.
Is subsidies regime a gift that keeps on giving for Drax?
Perhaps the kindest description of this zero-emissions game – played by biomass plants throughout the developed world – is that it is a contrivance. However, the addition of carbon capture into the equation has the potential to bring Drax’s subsidies habit to a whole new level. As it is, subsidies transform the group’s income statement. In 2022, Drax generated £852mn from the sale of ‘renewable’ certificates to third parties, a 58 per cent increase on 2021’s £539mn. In both years those amounts dwarfed the group’s operating profits – £469mn in 2022 and £170mn in 2021. True, another aspect of the UK’s subsidies regime – contracts for difference (CFDs) – sucked money out of Drax in 2022. The effect of ultra-high electricity prices meant that settling its CFDs resulted in a £46mn loss, a £281mn turnaround from 2021 when settling them brought in £235mn.
Even so, the subsidies regime is a gift to Drax that just keeps on giving – or, at least, it does until 2027 when the current rules end. Then Drax faces the possibility of corporate life without its regular fix, a scenario that makes subsidies for carbon capture all the more pressing.
There is a potential irony here. The case for subsidising the generation of renewable electricity by burning wood was always doubtful, yet the case for subsidising carbon capture is much stronger. That much should be self-evident. The former is arguably an illusion, the latter does what it says – it captures the CO2 before it gets into the atmosphere. The process is known as ‘bioenergy with carbon capture and storage’ (BECCS). It captures the woody CO2 before it is belched out of the Drax plant’s chimneys, transports it and stores it underground. The irony would arise if the UK’s subsidies for carbon capture were not as generous as they might have been because of the growing controversy surrounding the subsidies for burning wood.
Yet if scaled-up carbon capture works and if the subsidies are satisfactory then, other things being equal, Drax could do the honourable thing and return to burning coal. After all, no additional CO2 would be released and Drax would generate more power thanks to the superior energy density of coal over wood. The nearby Selby coalfield, to which Drax owes its existence, could be reopened, local jobs would be created. All would be well.
Of course that stands as much chance of happening as Arthur Scargill being Drax’s next chairman. The Selby super-pit has been closed for nigh-on 20 years and much of the site redeveloped, partly to store gypsum produced at Drax as a result of removing sulphur dioxide from its exhaust gases. Besides, various lobby groups would be traumatised by the thought of a coal field being reopened or coal to be burned in power generation.
But the underlying reason why Drax would have to continue burning wood would be to establish and maintain the illusion of negative emissions. For many, that’s a political imperative; for Drax, it’s an existential one.
In practical terms, however, the question is, should you hold shares in this company; shares that, priced at 636p, trade on a multiple of less than six times forecast earnings for 2023 and offer a likely dividend yield of 3.3 per cent or so? For a moment, side-step the emotive stuff about generating power from a fuel source that was superseded by coal some 400 years ago or – on the other hand – Drax’s ability to help save the planet, and we are left with a company whose shares are lowly rated, but perhaps deserve little more.
Consider a few of its performance measures (taking the average of the past five years): operating profit margin, 5.4 per cent; return on equity, negative; return on total capital, 11.4 per cent; cash flow return on capital, 11.6 per cent. Could be worse; nothing to write home about; then again, what else might we expect from a utilities group?
Except, of course, Drax isn’t just any old utilities group. All of those that earn their corn by generating electricity are stuck in the middle of one of the western world’s most pressing issues. But, by the fact of what it does and what it might do, Drax occupies a special position. It is certainly not that it’s too big to fail, but its position – politically, emblematically, even technologically – makes it too important to fail.
I don’t buy that notion. I didn’t more than 10 years ago when I sold the Bearbull Income Portfolio’s holding in Drax, as management pushed further into biomass-fuelled generation, and I don’t now. Let’s be candid. Part of the reason for selling the holding in 2012 was because of the uncertainty that Drax’s bosses could make the move work. But the decision was also influenced by the thought that “addressing the issue of climate change by burning lots of wood chip to generate electricity was a great example of logic that’s passed through the looking glass”, as I wrote at the time.
If that was so back then, think how many more rabbit holes the logic of climate change has twisted and turned through now that companies operate under the tyranny of ESG. Not a happy thought.
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Bearbull portfolio update
Meanwhile, by a margin, the worst performing holding in the Bearbull portfolio is its shares in Primary Health Properties (PHP), whose price – at 109p – is down 29 per cent from when I bought 15 months ago and through its stop-loss level. Sure, I bought PHP for the reliability of its dividends rather than lively price performance. Besides, interest rates were starting to tick up even then, so it was likely the present value of its annuity-like earnings and dividends would shrink. Even so, a nigh-on 30 per cent contraction was not part of the plan.
Happily, however, results for 2022 confirm that PHP is pretty much the same as it has been in the 20 years since its shares were listed. The occupancy rate of the 513 GPs’ surgeries and healthcare centres it owns remains as high as practicably possible (99.7 per cent), with 90 per cent of rents effectively paid out of the public purse. Its rent roll has nudged up 3 per cent to £145mn and the average term of unexpired leases has barely changed at 11 years. True, higher interest rates have exerted a toll. The average cost of debt has risen from 2.9 per cent to 3.2 per cent; its net asset value has dropped 3.5 per cent to 113p per share and, as concomitant to that, its net initial rental yield has risen from 4.6 per cent to 4.8 per cent.
No matter. A combination of the predictability of PHP’s revenues and the conservatism of its bosses mean the planned dividend for 2023 is 6.7p, just 3 per cent higher than 2022’s 6.5p. Still, for those buying in now, that offers a 6.2 per cent yield and the unusual prospect of acquiring a holding below net asset value.
It is unlikely PHP’s shares will recoup their lost ground quickly – and the path of interest rates will obviously be a driving factor – but the price has stabilised since its downward lurch in the autumn and surely offers more upside than downside in the coming years.
bearbull@ft.com
