Morningstar DBRS Confirms Drax Group Holdings Limited's Long-Term and Short-Term Issuer Ratings; Maintains Stable Trends

DBRS Ratings Limited (Morningstar DBRS) confirmed Drax Group Holdings Limited’s (Drax or the Company) Long-Term Issuer Rating and Short-Term Issuer Rating at BBB (low) and R-2 (low), respectively. Both trends remain Stable. The Company is the sole, direct, wholly owned subsidiary of Drax Group plc, the ultimate parent. The Company also owns 100% of Drax Corporate Limited, which holds a portfolio of power generation assets in the UK.

KEY CREDIT RATING CONSIDERATIONS
The credit rating confirmation is driven by Drax’s strong performance in 2023, which was supported for the most part by the Generation business’ significant contribution to overall EBITDA (85% of EBITDA before corporate costs), the increased profitability of the Energy Solutions (energy supply) business, and, to a lesser extent, the pellet production business. Adjusted consolidated EBITDA reached approximately GBP 1 billion in 2023, a record level and a 38% increase year over year (YoY) despite the Energy Generator Levy (EGL) and planned outages on two generation units. Strong system support performance and elevated power prices during the year were the main drivers for the Generation business’ increased EBITDA. Cash flow from operations also grew YoY and, further aided by working capital inflow, was more than sufficient to cover capital expenditures and dividends. As a consequence, leverage metrics and in particular the cash flow-to-net debt ratio improved to about 49% in 2023 from about 37% in 2022, a level that continues to support the current credit ratings.

CREDIT RATING DRIVERS
If Drax’s financial metrics and/or its credit risk profile deteriorate beyond a range acceptable for the current credit ratings, including if (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, Morningstar DBRS may take a negative credit rating action. Conversely, if Drax’s cash flow-to-net debt ratio improves materially to over 35% on a sustained basis and its exposure to higher-risk business reduces to predominantly self-supply, Morningstar DBRS may take a positive credit rating action. In addition, Morningstar DBRS could take a positive credit rating action if there was significant progress and visibility towards a bridging mechanism to biomass with carbon capture and storage (BECCS) in the UK.

EARNINGS OUTLOOK
Morningstar DBRS expects Drax’s earnings profile to remain healthy over the next two years, underpinned by a high proportion of contracted generation at favourable prices. Going forward, power prices are expected to moderate and so will EBITDA in its Generation business although Drax’s hedging policy provides predictability. However, and although considered riskier than the Generation business, the Pellet Production and Energy Solutions businesses are expected to contribute to overall profitability and provide diversification benefits.

FINANCIAL OUTLOOK
The expectation for decreasing albeit predictable earnings going forward, combined with Drax’s intention to proactively repay upcoming maturities through a combination of existing cash balances and refinancing activities should contribute to strong credit metrics, which will continue to support the credit ratings in the next couple of years. Longer term, the lack of details on a bridging mechanism to BECCS beyond 2027 when current subsidies are due to expire, and Drax’s intention to invest considerable amounts into US and UK BECCS projects present some risks to the Company’s overall financial profile. No investment decisions have been made on the BECCS projects, but Morningstar DBRS notes that deleveraging and the maintenance of strong credit metrics are positive and would continue to underpin the credit ratings after 2027.

CREDIT RATING RATIONALE
The credit ratings are 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) 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 by output in the UK; and (5) currently strong credit metrics for the credit ratings. The credit ratings also reflect: (1) the higher business risk associated with the exposure to the non-generation business, particularly pellet production; (2) the expiration of subsidised generation contracts under ROCs or CfDs beyond 2027, although earlier this year the UK government announced a consultation on a bridging mechanism to BECCS; (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 its contracts expire; (4) the competition in the UK from smaller energy suppliers and bad debt management in the Company’s Energy Solution business (although Morningstar DBRS notes that this segment has a small overall contribution to EBITDA and has refocused on higher quality counterparties); and (5) the operational risk stemming from unplanned outages and unforeseen transportation delays. The Stable trends reflect Morningstar DBRS’ expectation that the Company’s credit metrics will remain consistent with the credit ratings over the medium term.

Drax is the largest source of renewable energy by output in the UK with a current generation capacity of approximately 3.2 gigawatts (GW) and is the world's second largest producer of biomass. Drax contributed about 4% to the UK's electricity demand in 2023 and about 8% of the UK renewable power. Drax employs over 3,500 people predominantly in the UK and North America and is involved in three primary activities: (1) power generation and system support services, (2) pellet production, and (3) energy solution business. Since 2012, Drax has transformed its business to a low-carbon generator, reducing carbon emissions by over 99% with its long-term investment in sustainable biomass.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
Morningstar DBRS considers the environmental risk factor to have a reasonable possibility of a credit impact on the Company in terms of the carbon and greenhouse gas (GHG) costs. Morningstar DBRS considers that the Company 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 to invest in schemes to develop technology to reduce carbon dioxide emissions.

Social (S) Factors
There were no Social factor(s) that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factor(s) that had a relevant or significant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the “Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings” (23 January 2024);
https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings

BUSINESS RISK ASSESSMENT (BRA) AND FINANCIAL RISK ASSESSMENT (FRA)

A) Weighting of BRA Factors
In the analysis of Drax the BRA factors are considered in the order of importance contemplated in the methodology.

B) Weighting of FRA Factors
In the analysis of Drax the FRA factors are considered in the order of importance contemplated in the methodology.

C) Weighting of the BRA and the FRA
In the analysis of Drax the BRA carries greater weight than the FRA.

Notes:
All figures are in British Pound Sterling unless otherwise noted.

Morningstar DBRS applied the following principal methodology:

“Global Methodology for Rating Companies in the Regulated Utility and Independent Power Producer Industries” (30 January 2024);
https://dbrs.morningstar.com/research/427244/global-methodology-for-rating-companies-in-the-regulated-utility-and-independent-power-producer-industries

The following methodology has also been applied:

“DBRS Morningstar Global Criteria: Guarantees and Other Forms of Support” (28 March 2023)
https://dbrs.morningstar.com/research/411694/dbrs-morningstar-global-criteria:-guarantees-and-other-forms-of-support

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

A description of how Morningstar DBRS analyses corporate finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.com/research/397223.

The primary sources of information used for these credit ratings include Drax’s annual report, interim financial statements, trading updates, as well as a presentation from Drax to Morningstar DBRS and subsequent exchanges between Drax’s management and Morningstar DBRS. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

Morningstar DBRS does not audit the information it receives in connection with the credit rating process, and it does not and cannot independently verify that information in every instance.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS trends and credit ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://dbrs.morningstar.com/research/430682

These credit ratings are endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Amaury Baudouin, Senior Vice President, Sector Lead
Rating Committee Chair: Anke Rindermann, Managing Director
Initial Rating Date: 25 February 2020
Last Rating Date: 28 April 2023

Information regarding Morningstar DBRS credit ratings, including definitions, policies, and methodologies, is available on dbrs.morningstar.com or contact us at [email protected].

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