DBRS Ratings Limited (DBRS Morningstar) downgraded Drax Group Holdings Limited’s (Drax or the Issuer) Long-Term Issuer Rating and Short-Term Issuer Rating from BBB to BBB (low) and R-2 (middle) to R-2 (low), respectively. Both trends remain Stable.
The rating action was driven by Drax's increased exposure to the non-generation business mainly from pellet production which DBRS Morningstar views as higher risk compared with its power generation business. In 2021, the pellet production segment together with the customer business contributed approximately 20% of the consolidated EBITDA, from an 11% the prior year. The risk is somewhat mitigated by Drax's significant portion of the pellet business (65% in 2021) being used as self-supply for its biomass generation. However, as Drax continues their strategy to grow this segment from 3.1 million tonnes (Mt) to a forecasted 8 Mt by 2030, DBRS Morningstar expects the non-generation business’ EBITDA contribution to grow over the next few years.
The Issuer is the sole, direct, wholly owned subsidiary of Drax Group plc, the ultimate parent. The Issuer also owns 100% of Drax Corporate Limited, which holds the portfolio of power generation assets in the UK. The ratings continue to be supported by (1) the significant portion of near-term contracted generation (approximately 85% of gross margins), primarily under the UK government's renewable obligation certificates (ROC) and contracts for difference (CfD) schemes, providing stable predictable cash flows until 2027; (2) the limited exposure to commodity price risk; (3) the supportive regulatory regime in the UK for renewable generation assets; (4) Drax's size as the largest renewable energy company in the UK; and (5) the solid credit metrics for the assigned ratings. The ratings also reflect the following risks: (1) the higher business risk associated with the increased exposure to non-generation business particularly the pellet production; (2) the limited opportunity to renew the generation contracts under ROCs or CfDs beyond 2027, although Drax will have the ability to participate in capacity market (CM) auctions; (3) the relatively high cost of fuel associated with sustainable biomass power generation assets, making Drax less cost competitive after 2027 when the majority of the contracts expire; (4) the continuing competition in the UK from smaller energy suppliers and bad debt management in the Issuer’s customers energy retail business noting that the customers segment has a smaller contribution to EBITDA overall; and (5) the operational risk stemming from unplanned outages and unforeseen transportation delays. The Stable trends reflect DBRS Morningstar’s expectation that the Issuer’s credit metrics will remain resilient over the medium term.
Drax is an important power market participant in the UK with approximately 4.5 gigawatts (GW) of capacity (including 1.3GW from coal assets available until September 2022), contributing about 5% to the UK's electricity in 2021. The Issuer is the UK's largest renewable energy producer; providing the UK with 12% output from its biomass and hydro generation assets. The Issuer is involved in three primary activities: (1) power generation and system support services, (2) pellet production, and (3) customer business. Since 2012, Drax transformed its business to a low-carbon generator, reducing carbon emissions by over 95% with its long-term investment in sustainable biomass. In line with the UK’s 2050 net zero carbon emissions targets, Drax ended commercial coal generation in 2021 (with some units to remain available to support the grid until Q3 2022). Additionally, in 2021 Drax sold its combined cycle gas turbine assets consisting of four power stations with a capacity of approximately 2 GW, and acquired Pinnacle Renewable Energy; a Canadian producer and supplier of sustainable biomass. The acquisition is part of Drax’s strategy to increase its biomass production capacity for the purposes of self-supply to reduce its cost of biomass.
Drax’s 2021 financial results exhibited satisfactory operating performance, driven mainly by the pellet production business as well as the solid contribution from the generation business. Adjusted consolidated EBITDA was approximately GBP 398 million in 2021, over 5% improvement compared with the GBP 377 million in 2020. In 2021, pellet production capacity doubled following the acquisition of Pinnacle thus increasing the segments EBITDA by 65% year over year. This was somewhat offset by approximately a 17% drop in the generation EBITDA as a result of a major planned outage at one of the Biomass units as well as the sale of the gas units.
DBRS Morningstar expects the Issuer’s overall key credit metrics to remain stable in the near term but expects its credit risk profile to weaken somewhat because of the increased exposure to the higher risk non-generation business. Additionally, DBRS Morningstar notes the expiry of some of Drax's contracted portfolio by 2027 with limited opportunity to renew or replace these contracts. Notwithstanding the rating action, if Drax’s financial metrics and/or its credit risk profile deteriorates beyond a range acceptable for the current ratings, including (1) its cash flow-to-net debt ratio drops meaningfully below 20% on a sustained basis and/or (2) it reports a weaker-than-expected operating performance because of higher unplanned outages and/or pellet transportation delays, DBRS Morningstar may take a negative rating action. Although not likely, if Drax’s cash flow-to-net debt ratio improves materially to over 35% on a sustained basis and its exposure to the higher risk business is reduced to predominantly self-supply, DBRS Morningstar could take a positive rating action.
DBRS Morningstar considers the environmental risk factor to have a reasonable possibility of a credit impact on the Issuer in terms of the carbon and greenhouse gas (GHG) costs. DBRS Morningstar considers that the Issuer faces increased regulatory pressure to reduce GHG emissions in line with the UK's legislative commitment to net zero emissions by 2050, which may result in additional costs that may be incurred from closing of coal plants and/or investing in schemes to develop technology to reduce CO2 emissions.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
All figures are in British pounds sterling unless otherwise noted.
The principal methodology is Rating Companies in the Independent Power Producer Industry (10 May 2021), https://www.dbrsmorningstar.com/research/378166/rating-companies-in-the-independent-power-producer-industry, which can be found on www.dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include DBRS Morningstar Criteria: Guarantees and Other Forms of Support (4 April 2022), https://www.dbrsmorningstar.com/research/394683/dbrs-morningstar-criteria-guarantees-and-other-forms-of-support, and DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (03 February 2021), https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
The primary sources of information used for these ratings include publicly available information from Drax’s website as well as information provided by the Issuer, including (1) the corporate presentation (dated 24 March 2022); (2) consolidated financial model (dated March 2022); and (3) performance data and email clarifications (up to and including 27 April 2022). DBRS Morningstar considers the information available to it for the purposes of providing these ratings to be of satisfactory quality.
DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.
Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.
For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.
The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/396356.
These ratings are endorsed by DBRS Ratings GmbH for use in the European Union.
Lead Analyst: Rana Toukan, Vice President, European Corporate Credits
Rating Committee Chair: Andrew Lin, Managing Director
Initial Rating Date: 30 March 2020
Last Rating Date: 10 May 2021
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-- Rating Companies in the Independent Power Producer Industry (10 May 2021), https://www.dbrsmorningstar.com/research/378166/rating-companies-in-the-independent-power-producer-industry.
-- DBRS Morningstar Criteria: Guarantees and Other Forms of Support (4 April 2022), https://www.dbrsmorningstar.com/research/394683/dbrs-morningstar-criteria-guarantees-and-other-forms-of-support.
-- DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (3 February 2021), https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.
Information regarding DBRS Morningstar ratings, including definitions, policies, and methodologies, is available on www.dbrsmorningstar.com.