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Edited Transcript of DRX.L earnings conference call or presentation 26-Feb-19 9:00am GMT

Full Year 2018 Drax Group PLC Earnings Presentation

London Mar 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Drax Group PLC earnings conference call or presentation Tuesday, February 26, 2019 at 9:00:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Andy Skelton

Drax Group plc - CFO

* Dwight Daniel Willard Gardiner

Drax Group plc - Group CEO & Executive Director

* Jonathan Kini

Drax Group plc - CEO of Drax Retail

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Conference Call Participants

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* Alexander Wheeler

RBC Capital Markets, LLC, Research Division - Associate

* Christopher Robert Laybutt

JP Morgan Chase & Co, Research Division - Research Analyst

* Fraser Andrew McLaren

BofA Merrill Lynch, Research Division - Director

* Iain Stewart Turner

Exane BNP Paribas, Research Division - Analyst of Utilities

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Presentation

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [1]

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Hi. Good morning, everybody. So welcome to our 2018 results. Thanks, everyone, for coming. So what I'd like to go through is I'm going to give a little bit of an introduction and talk a bit about our purpose and how our strategy flows from that, then go through an operations and business review of the year. Hand it over to Andy Skelton. Welcome, Andy, our CFO, who's here for his first set of results, of which he's only been able to prepare. No impact out of creating them, having started on January 1. And then I'll come back and do an update on our strategy at the end.

So the acquisition of the ScottishPower assets that we completed at the beginning of this year, I think, has really brought our purpose as a company very much into focus, which is to enable a 0 carbon, lower cost energy future. But let me try -- let me describe to you what I mean by that. So during the course of 2018, there were several reports that were issued that described what were the pathways that we might use to get to a world that only would warm by 1.5 or 2 degrees. All of them start with electrification as a sort of key part of the puzzle. And just to give you one thought I saw McKinsey report last week that noted that the demand for electricity is growing 7 times faster the demand for other forms of power globally, right? The second thing in that -- in those pathways is that the electricity mix would be very much dominated over time by wind and by solar, right? And again, in that same McKinsey report, they noted that actually in pretty much every market now globally, the lowest cost form of energy is wind or solar power, right? But at the end of the day, if you have a system that, let's say, gets to 75% or 85% intermittent renewables, there still needs to be another source of power that actually supports that system. And that actually is dispatchable as opposed to intermittent, right? And I believe very strongly that biomass has an important long-term role to play there as does hydro and as does gas, but maybe gas on an interim basis. Although I guess, interim in this context is probably the next 30-plus years, right? So if you think about all that and you say, what is our role? And I think our strategy is clear and it all links back to that purpose. And effectively, we want to be there to support the system when the wind is not blowing and when the sun is not shining. And I, again, believe that we have very attractive opportunities to deliver strong returns for our shareholders by delivering that purpose.

So if you look at Drax in 2019, it really reflects what's been over the last decade, a very significant transformation, right? So again, it's no longer about coal. I mean, last year, we generated 75% of our power using biomass, relative 25% using coal. But we're now not just biomass but we're also gas and we're also hydro, we're also pumped storage. We're a leading provider of dispatchable power. We're the third largest generator now in the U.K., able to generate enough power for about 13 million homes. Not only do we have the assets we have today but we have a great portfolio of opportunities to do more. We're also no longer just about generation. We're obviously a very significant retail player, right? We are the fifth largest business-to-business supplier in the U.K. We're the leading challenger brand. And as the world or as the U.K. moves to a world of smart leaders, we see a very significant opportunity to play there, right? If we can be a low-cost provider offering differentiated propositions, we think there's a very good opportunity in that business-to-business space, and we are investing on to deliver that.

The final point I would make is that we think that there's a very significant long-term opportunity for biomass, right? And there are really 3 pieces here. One is it supports the forest. So contrary, I think, to what would be many people's immediate reaction. Actually, providing an economic outlet for a significant piece of sort of the residues or the byproducts that come out of the forest, biomass is key to sustaining healthy forests, and we only will operate in places where that's absolutely the case.

Second point is it is a low carbon form of system support. And again, as I said before, that's an unusual thing that we can do there. And the third point is that biomass has the unusual capability of potentially providing negative emissions, right? By using bioenergy with carbon capture and storage, or BECCS, effectively there's an opportunity to be a negative -- a source of negative emissions, which again is an unusual position for us to be in, right? Now there's a lot of work we need to do to get there. First, we obviously need to bring the cost of biomass down so that it is viable and without government support, and we're working hard to do that. And clearly, again, there's needs to be a framework put in place for BECCS to work as well, and I'll talk more about that later on. But again, I think, fundamentally, we think this works as a business strategy. We think we can generate attractive returns. And ultimately, again, in this context, how we allocate capital will be a key issue for us.

So now let me talk a little bit about 2018. So in short, I think it was a year of some significant challenges for us. We had significant outages on our biomass generation units in the first quarter. There have been the legal challenges to the capacity market, which Andy will talk more about the financial impact of that. There was a mutualization of significant costs in the retail market, whether that was the cost of the ROC obligations in various failed suppliers or the cost of an unidentified gas. But in that context, I think we did a pretty good job and we had good financial performance with GBP 250 million of EBITDA, very much in line with market expectations. We delivered GBP 311 million of net cash flow from operating activities. And we delivered strong cash returns for our shareholders, completing a GBP 50 million buyback. And today, announcing or confirming our dividend, which is a 15% dividend per share growth, right? And also believe we also completed quite an attractive acquisition. So I think a very good year for Drax as a group.

So again, I think it's important to reiterate that safety, sustainability and good governance are very much at the core of what we do. We continue to have a very good safety performance. Although I always think that there's more we can do and we continue to be focused on doing the best we can every day to make sure everyone gets home in the same condition that they come to work. It's especially true with regards to biomass. I mean, as you all know, biomass it's a relatively new generation technology and we're always looking for ways to make sure that we're operating as safely as we possibly can be, right? The only other point I would make here again is that our biomass is fundamentally sustainable. That is absolutely essential to what we do. If that were not the case, the whole story that I have laid out for you would not work. And we must be -- and we are contributing to healthy and growing forests. And we continue to have initiatives to ensure that that's always the case.

I wanted to talk briefly about the capacity market. I'm not sure I have a lot to add to what you probably already know. But we continue to work closely with the industry with Energy UK and with BEIS to make sure we understand how this is going and we want to make sure that the -- I mean the government is aware of the urgency that we see in this issue being resolved. We continue to expect that the market will be reinstated in a form very much similar to what was there before. I think the Europeans Commissions' announcement last week that they've convinced a formal investigation to move the process forward is very much in line with that. And the actual opening decision that sits behind that, we expect to see shortly. And again, we expected to confirm that the approach that we are -- that we're expecting from them. On the flip side, I think the industry has gone through a lot of work to try to put in place a mechanism that would allow cash to continue to be collected from suppliers and be ultimately made available to generators when the system is reinstated. So we were disappointed. The Ofgem didn't support that initiative, although there is another option that is still under consideration.

Final point I would make is that I think in determining sort of the latest update to the retail price cap, I think it's important to note that capacity payments were included in those calculations. So we, again, believe it's very much in the government's intent that the system is sort of reinstated, right? And that's really -- that's the operating assumption that we're using.

So turning to the various -- our 3 different businesses. So as you all know, the first quarter for our Generation business was difficult. But they were then delivered a quite strong performance through the rest of the year, right? So for example, our CfD was available. It had 97% availability across the year, which, again, is very strong performance.

As you know, we converted our fourth unit to biomass in the late summer. And a result of that, we had about a 6% increase in our overall renewable Power Generation. And now last year, it delivered 12% of the U.K.'s renewable power. And again, we see growing opportunities for us to support the system. I'll give you a couple of examples. So the overall cost of balancing the system in the U.K. has grown from about GBP 500 million per year in 2010 to about GBP 1.2 billion last year. And that sort of market, if you will, is really where a lot of our assets will, over time, operate -- sort of increasingly operate. So for example, Cruachan, the pump storage facility that came with the acquisition we made is very much involved in that market. And that's where they get a lot of their earnings. And that's, again, since we've acquired them, we're seeing sort of very attractive opportunities for us to support the system within that marketplace, right?

The other point I would make is that we now have a very -- sort of very much a national and balanced portfolio of generation assets. So multiple technologies, lots of different locations. The technologies can -- to operate and support each other. So for example, if one of our units is not running, we can often pick up that position with another unit. And importantly also, we're able to support the system really from the top to the bottom from Scotland all the way down to Brighton and then importantly, also, around London. So we see lots of opportunities for us there.

So our Pellet Production business in the U.S. had a very good year. It was really driven by the commissioning of our third pellet plant called LaSalle BioEnergy. And we now have 1.5 million tonnes of capacity. And we increased our Pellet Production by 64% to about 1.3 million tonnes. We actually reduced our cost per pellet by 10%. And ultimately, this business contributed about GBP 21 million to the EBITDA of the group, which is up from GBP 6 million in the prior year, right? So the Pellet Production, this is a key part of our strategy, as you know. I'll talk more about it later. But delivering through good quality, low cost pellets is core to our ability to make biomass viable ultimately in the long term. And so that, very pleased with our U.S. Pellet Production business is doing very well.

Turning to the energy, the B2B Energy Supply business. I would say 2018 was a difficult year in this marketplace. As I mentioned before, there were external regulatory factors that we're challenging sort of ranging from the ROC mutualization, which I think you all know about or we can talk more about, also the challenges of an unidentified gas, right? There are other issues that were more specific to us and we had a difficult year managing our bad debt expenses. Some of our customers had their challenges. I would say that since the half year, we put lots of effort into tackling those issues. Andy again will talk more about it, and I think this is probably not the kind of challenge that's ever going to be completely solved. We always have to be very vigilant here, but I think we're in a significantly better place now than we were at the half year.

I would say for me, more importantly, in some ways on an underlying basis, the business continues to grow strongly. We increased our meter count to 396,000. We increased the gross profit in the business to GBP 143 million. So the core drivers behind the Opus business, that we acquired now a couple of years ago, are very much sound and continue to do very well, right? And the other thing that's now starting to come more into view is the opportunity that we think is going to be there as we put -- as we actually move into a smart-meter-enabled world, right? So we have more data about our customers. There's lots more that we can do. So we are investing in systems to enable us to be: a, a low-cost provider from a strategic position. We think that's very important, but also that will enable us to offer differentiated propositions for our customers. And we think there's a real interesting opportunity for us there.

And with that, I will turn it back over to Andy.

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Andy Skelton, Drax Group plc - CFO [2]

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Okay. Thanks, Will, and good morning, everyone. I'll now walk you through the financial review for the full year. So starting with the financial highlights on Slide 13. The adjusted EBITDA of GBP 250 million, grew 9% in the year. It represents a good performance, in line with expectations. And this, despite the challenges of the restricted biomass generation in the first quarter and suspension of the U.K. capacity market during the fourth quarter. The suspension of the capacity market had a GBP 7 million impact on EBITDA, as we continue to accrue all the costs in the Energy Supply business, but we did not accrue any revenue in Generation. The business continues to be strongly cash-generative. We had net cash from operating activities of GBP 311 million. After capital investments, after increased returns to shareholders and after servicing of debt, our closing cash was GBP 289 million and our closing net debt was GBP 319 million. This represents a net debt-to-EBITDA ratio of 1.3x, and that's ahead of the previous guidance of around 1.5x.

The acquisition of ScottishPower Generation was completed on the 31st of December, with net consideration of GBP 687 million and that excludes transaction costs. It was cash settled on the 2nd of January. The net consideration was GBP 15 million lower than the gross purchase price of GBP 702 million, and that reflects customary sale and purchase agreement adjustments, primarily in reflection of working capital.

Subject to the outcome of the European Commission's review of the U.K. capacity market and reestablishment of the scheme, we're targeting a net debt-to-EBITDA ratio of around 2x for 2019. The board has proposed a final dividend of 8.5p per share, given a full year dividend of 14.1p per share. This represents a 15% year-on-year increase on a pence per share basis. The total cost of GBP 56 million is in line with our previous guidance.

We believe that this level of dividend is sustainable through the business cycle, and we expect it can increase further over time as our strategy delivers higher future levels of EBITDA and cash. The GBP 50 million share buyback program that we commenced in April is now complete. In total, we bought back 13.8 million shares at an average price of GBP 3.61.

So moving on to Slide 14. We'll look at other income statement highlights. So following the adoption of IFRS 9, we've elected to present the income statement in a 3-column format. Adjusted results are stated after exceptional items and after certain remeasurements. For the rest of my presentation, all the references will be to these adjusted numbers. For 2018, the exceptional items include acquisition and restructuring costs, primarily in respect of the ScottishPower Generation acquisition. They include asset obsolescence charges, which reflect the write-off of coal-specific assets following the conversion of the fourth biomass unit and they reflect debt restructuring costs. The remeasurements relate to the impact of fair value accounting gains and losses on derivative contracts that are not designated into hedge relationships for accounting purposes. This change in presentation has had no impact on our presentation of EBITDA and it continues to be a nonstatutory measure. I'll walk through a bridge of the year-on-year EBITDA movements on the next slide.

Revenue has grown in each of the business units. In Pellet Production, the growth primarily reflects the commissioning of a third facility in LaSalle early in the year. In Energy Supply, the number of customer meters grew by 5%, and there was a full year's revenue from Opus Energy. In Generation, I'd highlight an increasing proportion of noncommodity price exposed earnings in the year.

The net finance costs include GBP 40 million of interest charges compared to GBP 32 million in the prior year. The GBP 8 million increase represents a full year of servicing debt associated with the Opus acquisition and other costs associated with working capital facilities.

The tax credit of GBP 5 million arises from the benefit of U.K. Patent Box claims. Under the Patent Box regime, we get a 10% tax rate on income related to our biomass activities. And as such, we continue to expect that this will have a positive impact on our effective tax rate through to 2027. The profit after tax of GBP 42 million compares with GBP 3 million in the prior year and it represents an adjusted basic earnings per share of 10.4p. That compares with 0.7p in the prior year.

So moving on to look at a year-on-year bridge of EBITDA. EBITDA grew 9% to GBP 250 million in the year. In the U.S., the Pellet Production was strong with a 64% increase in volumes of wood pellets produced. This is a primary driver behind the GBP 15 million year-on-year increase. The cost of sales in the Pellet Production mainly consist of fiber procurement, transportation and of processing. The impact of increased volumes and process improvements has reduced the cost per tonne by 10% year-on-year. This is a significant achievement. Continuing to deliver further improvements in the cost of producing pallets is a key area of focus and a significant opportunity to deliver further EBITDA improvements.

The EBITDA from Power Generation decreased GBP 6 million in the year. As noted, this is a good performance considering the reduced biomass generation in the first quarter and the U.K. government's suspension of the capacity market. Overall, EBITDA for the biomass generation grew despite the negative impact of the 2 unplanned outages in the first quarter. It reflects 91% availability in the year across units 1 to 3 with unit 1 achieving 97%. With the successful low-cost conversion of the fourth unit, output across the biomass units increased 6%. This also created a benefit from a reduced amount of EU carbon permits required to support coal generation.

We're also continuing to focus on optimization of ROC generation, biomass operations and the procurement of third-party biomass volumes. We also benefited from higher ROC prices, which supported better box spreads. The reduced EBITDA in the coal generation business reflects a 35% reduction in output from the coal units as commodity prices increased. It also reflects a decrease in Ancillary Services related to a specific 1 year Black Start contract that contributed GBP 10 million in 2017. Despite the GBP 7 million negative impact on EBITDA of the capacity market suspension, our income from the capacity payments grew GBP 5 million during the year.

So moving to Energy Supply. EBITDA of GBP 28 million was GBP 1 million lower in the year, and it reflects a number of offsetting impacts. Firstly, the gross profit grew GBP 26 million or 22%. And this reflects a 5% growth in the customer meters and inclusion of Opus for the full year. This increase in gross profit, as well noted, is after bearing additional costs, the mutualization of renewable obligations that are associated with competitor failure and also higher gas costs due to weather and mutualization.

The total bad debt expense in the year of GBP 31 million grew GBP 13 million and can be attributed in a large part to the challenging operating environment that our customers are facing. At the end of the year, it's worth noting that our balance sheet provisions of GBP 44 million, are GBP 16 million higher than the end of 2017. We'll continue to focus very strongly on managing our bad debt experience. It starts with the customer acquisition process and it continues with the management of debt throughout the collection cycle. We involve third-party collection services where appropriate. We've increased our use of credit insurance to manage this exposure. And we have access to attractively priced nonrecourse receivables facilities. Going forward, we think the continued rollout of smart meters will also help.

The Energy Supply business continues to invest in next-generation systems, both to improve efficiency and to reduce cost but also to address opportunities for further growth that are created in the smart meter world. The increase in OpEx during the year reflects inclusion of Opus for the full year, but an expansion of our cost base to manage the increase in customer numbers. Once these systems are in place, we'll be able to scale our operations more efficiently in the future.

Now turning to the next slide to look at a year-on-year bridge of net debt. As noted, we delivered GBP 300 million of net operating cash flow in the year. And this was helped by our working capital inflow of over GBP 100 million. The working capital inflow reflects 3 things: an inflow from inventories where December 2017 was a high point following the rail unloading incident; an inflow from payables as we continue to focus on optimizing our commercial terms for the long run and use working capital-efficient payment facilities in the short-term; and an outflow as we held increased levels of ROCs at the year-end following conversion of unit 4 to biomass. Through strong cash generation, we funded significant capital investment, and I'll talk more about that shortly. We've returned in excess of GBP 100 million to shareholders through dividends and a share buyback. And we've covered all of our debt service and costs. In so doing, we've maintained the strong balance sheet, reducing net debt by GBP 48 million and our net debt-to-EBITDA ratio from 1.6x to 1.3x.

So looking a little more on capital investments. Our capital expenditure in the year totaled GBP 142 million. Within that maintenance spend of GBP 55 million is in line with our guidance. And we continue to expect that maintenance will average GBP 50 million to GBP 60 million per annum going forward. Not all of the maintenance is an annual spend some of it is periodic, so it will move in that range. In 2019, there are 2 planned outages, so we expect the maintenance spend to be at the top end of the range.

In enhancement projects, we spent GBP 40 million. This includes the investment in the Energy Supply business and those next-generation systems and it also includes development of a new rail spur at LaSalle. We expect the new rail spur will reduce transportation cost by over $10 a tonne once it's fully commissioned.

In 2019, we'll continue to invest in next-generation systems for our Energy Supply business. And we'll undertake the first of a 3-unit, 3-year turbine upgrade program with Siemens, where we know that modest improvements to efficiency will deliver a fast payback.

On strategic investments in 2018, it included the conversion of the fourth biomass unit, an incremental investment in the development of options for new gas generation. We now have 2 OCGTs ready for when the capacity market is reestablished. And we've begun some site preparatory to work in respect to the repowering project.

In 2019, we'll continue to develop those options for new gas generation, subject to the reinstatement of the capacity market, and we'll invest in expansion of Pellet Production capacity to support operational efficiency and cost reduction. And this is part of our aim of meeting 30% of our biomass requirements from self-supply. Included within the Other of GBP 12 million is GBP 9 million for the purchases of capital spurs. As I noted earlier, availability is a significant driver of delivering continued operating performance. And this increased holding of capital spurs is part of ensuring we're able to deal with outages in the most efficient way. In 2019, we expect other CapEx to be in the GBP 5 million to GBP 10 million range. So altogether, if you include GBP 30 million to GBP 35 million for the newly acquired assets as we previously guided, our forecast capital spend for 2019 is expected to be in the region of GBP 170 million to GBP 190 million.

So now turning to Slide 18. Over the last 2 years, we've greatly improved our access to capital while maintaining a strong balance sheet that supports our investment in growth. During 2018, we made progress in staggering the maturity date of our borrowings. And this is something we'll look to continue to optimize.

In May, we refinanced GBP 200 million of floating rate notes, with GBP 300 million of fixed rate notes. This extended the maturity profile of our debt to November 2025, and it provided protection from an increase in interest rates. When swapped back into Sterling, the bonds also offer as an attractive rate of interest of around 5%. This complements the existing 4.25% GBP 350 million fixed rate note, which matures in 2022. We also have an RCF, which matures in April '21 with an option to extend by 1 year. It has a competitive margin. And at the year-end, there was no cash drawings on the RCF.

In early January, we cash-settled the ScottishPower Generation acquisition. And we only drew GBP 550 million of the GBP 725 million facility. This 19-month facility provides additional flexibility over the timing of refinance and it's competitively priced. Our expectation is that we will refinance all or parts of this through 2019. Our strong credit rating allows cheaper access to credit. It's supportive of our trading strategy and it remains robust to low points in the commodity cycle.

So moving on to Slide 19 to look at capital allocation. We're committed to making disciplined capital allocation decisions, and we think about the approach in 4 stages. Firstly, maintenance of a strong balance sheet. And that's defined as being a target net debt-to-EBITDA of around 2x. Secondly, a continued investment in the core business to deliver our strategy. Thirdly, a sustainable and growing dividend. The 15% increase on a per share basis in 2018 is consistent with this objective. The precise level of growth will vary year to year, depending on the operating environment and investment needs of the business. Finally, a consideration of a wide range of development projects across the group. These offer attractive returns but could require significant future investment. These investments are subject to external factors such as the capacity market, but also the demonstration of a strong investment case.

Turning to Slide 20 to look at the capacity market assumptions. As well as already noted, we expect that the capacity market will be reestablished during 2019 with retrospective payments for the period since suspension. Capacity payments for the Generation business, including the newly acquired assets, are expected to be GBP 68 million in 2019, GBP 42 million of this spans the 9 months of the current capacity period and GBP 26 million spans the 3 months of the next one which begins in October.

As part of the acquisition of ScottishPower Generation, we agreed a risk-sharing mechanism with Iberdrola, which could provide compensation of up to GBP 26 million in the event the capacity payments for the current period are not received and the gross profit floor is past. In this scenario, while the net cash impact of no capacity payments would be GBP 42 million, the risk-sharing mechanism will be treated as an adjustment to purchase price and, as such, the EBITDA impact would the full GBP 68 million. Until the capacity market has formally restarted, we'll continue to defer revenue recognition in the Generation business and continue to recognize all the costs in Energy Supply. In the event that the market is not reestablished, we'd expect there to be some offsetting benefit associated with lower energy supply costs. To be clear, our adjusted EBITDA expectations for 2019 are based on normal operation of the capacity market.

And finally, moving on to Slide 21 and summing up. In 2019, we expect to deliver an increasing level of stable earnings and to further strengthen our balance sheet. The acquisition of ScottishPower Generation accelerates this progress and it adds a high-quality, multisite, multi-technology portfolio, where 2/3 of its earnings are from noncommodity exposed sources. Added to this, we have index-linked renewable revenues. We have long-term biomass procurement contracts and we have a rolling 5-year FX hedging program, all of which provide a growing and predictable level of base EBITDA, subject to cost to maintaining high levels of operational performance. This is further enhanced by expected growth from our Pellet Production business.

In terms of our major options, the development of new gas, significant investments would be underpinned by index-linked capacity agreements. And so it would further enhance this earnings visibility. This is all a very different proposition from the group's heritage as a single-site carbon-intensive power generator.

With that, I'll hand back to Will.

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [3]

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So thank you, Andy. So what I had thought I'd do is just give you a quick update on some of the strategic initiatives that we're working on. So again, in the context here, it's all about delivering our purpose of enabling a 0 carbon, lower-cost energy future. We believe this is one where there will be an increasing demand for electricity, as I mentioned already. And ultimately, in a world in which the sort of system support piece, where we will deliver only 15% to 25% of the overall marketplace, right? I guess the points I wanted to make here is really that we see opportunities really across our business to helping to deliver the vision, right. Whether it's in biomass, where effectively if we can make this viable without subsidy, there's a long-term role in supporting the system with low-carbon generation. Whether it's across our Generation business as a whole, again, there's an opportunity for us to make additional investments to support the system with low-carbon power going forward or whether it's in our supply business, right, whereby giving control to our customers, we can allow them, again, to help participate through the demand-side response for example in supporting the energy system in the U.K.

Let me talk a little bit about -- more about sort of biomass and how we see that sort of playing a role in the overall system. So the first point, really that's important, is that biomass effectively is a key in low-carbon source of system support, right? Effectively it allows system support at low-carbon intensity which effectively you could do with hydro, but it's -- other than that, it's pretty much the best way to do that, right? Again, as I mentioned before, gas will, ultimately, be part of the picture, but biomass, we think, is an important piece of it as well in the long-term, right?

The second thing about biomass, which is very important, is the way that it supports forest growth, right, effectively by providing additional earnings for forest owners that they are -- have been reinvesting. Effectively, they're enabling forest to grow. So the forest cover in the southeast of the U.S., just by a way of example, has increased very substantially, say -- let's say since the 1950s as a result of further investments in those forests enabled by sort of an attractive and successful sort of forest economy.

The final point is really around BECCS, which is the opportunity to do sort of bioenergy carbon capture and storage. And let me just tell you where sort of we are in this whole sort of process of doing carbon capture. So we have effectively started a trial where we're capturing a tonne of CO2 per day. The purpose of the trial is twofold. One is to effectively prove the technology has -- it is working now and that is working very successfully, and the other thing is to start enabling us to understand what the economics of effectively carbon capture would be throughout the power station at scale, right? So obviously, it's a very different proposition to be capturing 10 million tonnes of CO2 a year as opposed to that 1 tonne of CO2 per day. And that's really we would hope to have significant progress on both of those fronts by the end of the year, right?

The second key thing that needs to happen or we expect to happen in 2019 is really the government has set out a taskforce whose objective is to actually establish a regulatory framework to enable carbon recapturing. So effectively, again, if you think about carbon and capture, there's really 3 pieces of the puzzle. There's capturing it, which is what we're working on, then there's the transport and then there's the storage or the usage of it, right? And effectively, there needs to be a regulatory framework in place to allow the whole thing to work and allow their whole system to be economically viable, right? So again, we're working with the government on that to effectively make sure that actually -- or we will not make any significant investments until that system is in place.

Same key piece sort of strategy I want to update you on is the biomass sort of optimization and cost reduction, right? And effectively, there are different places where this is ultimately coming from, right? So the first thing that we're focused very much on is how can I -- how can we reduce the cost of the pellets that we're actually producing. Remember today, that's about 20% of our usages from our own pellets. We have a target of growing that to 30%. And ultimately, that may grow further over time, right? And there's multiple ways in which we're reducing costs. So one is by reducing feedstock costs, which is primarily about using more effectively sawmill residues or sawdust as opposed to thinnings coming out of the forest. And an example of what we're doing there is the co-location of the Hunt Forest Products sawmill next to our pellet plant in LaSalle, right? That's now -- that's happened. They are actually up and running and actually producing lumber and actually is giving us residues, right? And so that's a very attractive low-cost source of feedstock for the LaSalle plant.

Second thing is about reducing process and transport costs. And again, a good example of that is the LaSalle rail spur. So by basically connecting LaSalle to the rail network in the southeast of the U.S. and then not use -- not trucking the pellets to Baton Rouge, we end up with a significant lower cost of transport. And again, as Andy mentioned, roughly speaking, 1/3 of the overall cost we delivered pellet is in the transport. So this is a significant benefit, reducing the cost per tonne by as much as $10, right?

The third area we're looking at is how can we be more efficient in terms of overall plant performance. This is both in our pellet plants, but also at the power station. So one of the investments we're making is in a turbine upgrade. Biomass plants in the power station, they effectively will improve our thermal efficiency and effectively get us more bang for our buck for each pellet that we use.

And the final piece is really using new technologies and new feedstocks, right? So this ranges from sort of the more proximate i.e., things that we are investigating quite actively now like using the gas or sugarcane residue and actually making pellets from that as a very low cost feedstock. Again, that's one thing we're looking at right now. So that's could widen -- what we call here, widening the fuel envelope.

Second thing we're looking at is also is more sort of technology-driven solutions, like extracting sugars from the wood. Then those sugars ultimately can be used for liquid fuels, for example. And effectively, it reduces significantly the net cost of the fiber that we actually would use to make pellets. And that's a more long-term thing.

I'll just -- in passing of things, it's worth mentioning. I mean, Andy mentioned the benefits of the Patent Box. For those of you who are familiar with that, effectively, that is a lower tax from the U.K. on anything that you have, which is earnings that are delivered by your own registered intellectual property, right? So Drax has a very strong history of delivering technological innovation and actually having that recognized, I think, it's a quite significant point. So lots of things happening there. I mean -- and we plan to have a Capital Markets Day later in the year, where we'll continue to update us -- or continue to update you on our progress on cost reductions.

So what I had laid out on the page here is the various different investment opportunities that we're looking at across the business. And I really what I wanted to do is not get into any of them in more detail because I think we've been through this with you all in the past. But to just talk through a little bit how we think about sort of each of the different sort of areas here, right? So the first thing and important thing is we look at the opportunities in the round, meaning that we are -- as we think about allocating capital, it's really across the whole portfolio, right? There isn't sort of a business unit specific piece. It's all of the different investments are compared to each other to find the best returns ultimately for shareholders, right? Second point I would make is that we absolutely believe that the U.K. will need new gas generation, right? And obviously, with the challenges for new nuclear, and we think that is even more true than it has been, right? So again, the capacity market has not cleared, an attractive price is in the past. Capacity market needs to be reinstated. We believe that will happen. But ultimately, we do believe that that will provide a price signal for investing in new gas in the U.K., right?

Third point, I think, is by adding Damhead Creek 2 as another project. For those of you who are not familiar with it effectively is that we have a site next to Damhead Creek which is effectively in the Thames Estuary sort of in Essex. Effectively, we have a site and a project that's for permitted and ready to go for -- again, a power station again to run -- I think, it's 1.6 gigawatts. Power station's pretty much ready -- sorry, 1.8, apologies, 1.8 gigawatts and it's pretty much ready to go. So we're working on getting that ready for the capacity market, right? And as you know, we think that our repowering is a very attractive project because of the benefits of using some of our existing infrastructure at the power station up in Yorkshire. Damhead Creek 2 has other benefits, which is locationally because it's very close to London, it's got significant economic advantages for that reason, right?

Fundamentally, then the next thing I'd say just last 2 projects. So Cruachan 2 is a project that ScottishPower's working on effectively to expand other multiple different options for expanding the pump storage up in Scotland. And the final one is BECCS, which I've talked about. I mean, both of those, I would say, have the same characteristics, then in order they're quite a bit further away. And they both require, I think, the right regulatory framework in order for them to be gotten off the ground. So I think it has its longer-term options for us.

So in wrapping up, as I think about 2019. So there's a lot of things we're doing. We're -- obviously, we are in the Power Generation business. We're looking at integrating ScottishPower and making sure that we keep our availability high as it has been. In the B2B retail business, we're about -- it's about continuing to grow our attractive sort of gross margin, continuing to drive the cost base and ultimately delivering the systems that will underpin our future strategy.

And then in our Pellet Production business, it's about producing as many low-cost pellets as we can and also continuing to investigate options for both lowering costs and further increasing our capacity. But beyond that, we are working to keep our investment options live and there's work going on to develop those further. And ultimately, we need to deliver results for our shareholders, right?

Final point is that in terms of our capital allocation, number one objective for 2019 is to get our balance sheet back to where it was, i.e. getting back to that 2.0 net debt-to-EBITDA target, which again we would expect to happen assuming the capacity market does return. Again having done that, we'll continue to look at our new investment options and make sure we balance appropriately the right mix of business growth and cash returns for our shareholders.

So with that, why don't we go to any questions that people might have.

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Questions and Answers

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [1]

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Chris?

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Christopher Robert Laybutt, JP Morgan Chase & Co, Research Division - Research Analyst [2]

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Chris Laybutt with JPMorgan. First, it is on the dividend. When can we expect, I guess, the next update? It also seems that you've got more growth through your P&L and cash flow and the balance sheet constraint. Will that be a consideration in the middle of the year? And if you give some sense for where you are at the moment, if you can? Secondly, I mean, you made it quite clear that this year is about getting the balance sheet down to that targeted level. Does that mean that M&A is off the table? If you came across a terrific opportunity, would you still look at it? Now is the pipeline deep? And what's in the pipeline at the moment that you're seeing coming to you? And in terms of retail, that 2025 target, which you presented at last year's Capital Markets Day, I guess, this is a question for you, JK. How confident are you of still reaching that target? And what are the moving parts that will get us there?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [3]

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Okay. So on the dividend, I think the approach that we will take this year will be the same as we've taken in prior years. I mean, we will come back to you at the half year and give you a sense of where we think the underlying dividend will be. And anything beyond that, we would discuss at the end of the year, right? But again, I think probably the key factors that will go into, obviously, we need to make sure that we integrate and deliver the ScottishPower acquisition as we expect to. And we also need to have more visibility on the -- where the capacity market comes out, right? On M&A, I would say fundamentally we're very much focused on getting the balance sheet in the right place. So that's definitely the #1 priority for this year. So that's what I would say there. And then on retail?

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Jonathan Kini, Drax Group plc - CEO of Drax Retail [4]

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Yes. So -- I mean, if you look at the underlying gross margin of the business, we're pretty happy with the growth that we've delivered in the past year. Further percentage on our market share and that delivery of that gross margin, I mean, that is against the sort of, I suppose, the headwinds of 3 major fundamental things with weather, (inaudible), this ROC mutualization and that's about GBP 5 million. Equally, we've done some good work in stabilizing our bad debt position and, obviously, improved the balance sheet there as well. So underlying, we're very happy and pleased with the performance. And with that continued growth and we definitely see that growth coming because there are some fairly heavy stresses on the larger players. Some of the newer players coming in are struggling financially. And so we see it as a real opportunity to continue that growth, which we've done for the last 3 years now. And then these new systems that we're putting in place, we can already see the benefits in the early parts of the development of these systems. That they're going to become a lot more efficient, and so we're going to be able to process more customers through these systems that significantly lower cost than we're actually holding today. So we're very confident and we'll talk about it again in the Capital Markets Day later in the year that we can still deliver on those targets that we set out.

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Iain Stewart Turner, Exane BNP Paribas, Research Division - Analyst of Utilities [5]

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It's Iain Turner from Exane. Can I just ask just 3 questions? Firstly, how you would stock up DamHead Creek 2 against repowering one of the units at Drax's main site. Obviously, they're the same size and how the economics of those would compare. Secondly, there's a lovely photograph at the front of your pack of the Cruachan reservoir. I wondered if you've given any consideration to raising the dam. I think it's something it was done at (inaudible) a few years ago. If you look at the picture, there's obviously room for a few more meters on there. And then thirdly, there's been some comment in the press about a contract -- a consulting contract between Drax and Lord Deben, who's the Chairman of the Climate Change Committee, who's been doing a lot of work on biomass. I just wondered if you had a comment on that and perhaps the new finance structure a chance to have a look at that with internal audit, I don't know whether you're going to comment on that?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [6]

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So why don't I take the last one? I mean, I think the key thing about that sort of a consulting contract there, I mean, we follow the processes as we should be. I'm confident that the Climate Change Committee has done the same. And so I think the work we've done with them is nothing to do with climate change. So I think that we've done all the things that we should have done for that thing. Maybe -- Andy, do you want to take the other 2?

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Andy Skelton, Drax Group plc - CFO [7]

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So in terms of the DamHead Creek versus repower, I think this is a decision we need to make later in the year and certainly going into the next capacity contract. I think the key things for us on DamHead Creek 2 is getting an idea on CapEx. So I think Will talked about the fact that there are more favorable transmission charges down in the south compared to around Drax. But what we need is a full sort of CapEx cost of that and that needs to be refreshed. So we're going to do that over the course of the year. And repower is all about getting our planning and also getting a firm figure around the CapEx there. So I think over the course of the year and certainly coming into the capacity market, which hopefully will be back the next February, that's when we need to look at the decision. But we have opportunities and choices, which is really good. The second point about raising the dam. I mean, as Will said, there are a range of options that we can look at Cruachan. These are long-term projects and certainly raising the dam is a high CapEx option. And that's certainly the extreme end base upgrading the turbines that we already have and there's a range of options there. And I think the key for us is getting the right regulatory support and the right framework in order to do that. So we have environmental studies that ScottishPower had already delivered. The key for us is what could be that regulatory framework to deliver a large scale CapEx project over a number of years. And then we can really firm up the options that we have of the plant there.

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Unidentified Analyst, [8]

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Could you please comment upon the performance of the share price at Drax?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [9]

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Can I comment on the performance, I'm not sure that I can, to be honest. I mean, it is what it is, I guess.

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Unidentified Analyst, [10]

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So what is the reason that the market has given a very low price target for the share? It's not much higher than the current share price, the market, the stockbroker, the company's broker?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [11]

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I guess, the way I think about that is that the -- Drax is a business which fundamentally is a very long-term business, right? We are making -- we have assets that we would expect to run through the 2030s. We're going to be making investment decisions that also will have implications through the 2030s. So for me, I'm very much focused on my team. We're very much focus on 2 things. We're very much focused, one, on making sure that as we operate and run the business that we deliver exactly what we need to deliver, right? So we are making our plants available as much as it can be that we actually can -- we deliver for our customers as much as we can be. So that's every day in year, that's fundamentally what we do, right? The other thing that we do is we have to make sure that we actually make the right decisions long term for what is in the benefit of all our shareholders, right? If we do those 2 things and we do them as best we possibly can, then the share price will take care of itself.

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Alexander Wheeler, RBC Capital Markets, LLC, Research Division - Associate [12]

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It's Alex Wheeler, RBC. Three questions from me please. First of all, are you planning to update the market on 2025 EBITDA targets at the CMD? And secondly, how should we think about outages post-2019? And finally, on the retail side. Do you think that Ofgem's review of micro businesses will have an impact on Drax's retail business?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [13]

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Okay. Why don't I take the first one and then maybe Andy the second and JK the third. So I think in terms of the 2025 targets, I think there's a couple of things that we already know. I think JK has talked about the retail target. I think in terms of our pellet plants, I mean, the objective of getting to 30% self-supply continues to be the same. I think that we have some of our ambitions about bringing the pellet cost down are probably new relative to those original targets. Clearly, the ScottishPower acquisition is new. So that's -- and then also, I think -- I mean, if you remember back, we'd actually had not announced the ideas of repowering at the time when we actually set those targets, right? So I think the answer is we will sort of come back to the, I think, Capital Markets Day probably in the fall. I'm not sure we've set a date yet, and we'll frankly just talk about our strategy and how we see those various things developing over time. Andy, do you want to add anything?

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Andy Skelton, Drax Group plc - CFO [14]

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Yes. So on outages, so we have 2 biomass outages this year on units 2 and 4. Going forward, there should be one biomass outage every year. So 2021 -- 2021 is the CfD outage, and then one per year after that. In terms of coal, I mean, we did an outage on unit 6 last year. It was a very -- sort of a very low maintenance outage and really reflecting the running regime on coal now. And clearly, that will also be impacted by whether we proceed with our repowering plans at the plant. So unit 6 was last year. I think the next coal one's at 2020 and 2021, but they're likely to be much lower scale, the biomass ones are the key ones in the future.

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Jonathan Kini, Drax Group plc - CEO of Drax Retail [15]

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Yes. And then on the sort of Ofgem's investigation. We welcome it because any review on competition for the U.K.'s largest challenger brand is got to be a good thing. The CMA review they did a couple of years back, will definitely be recommending to Ofgem to look at that, see if some of the remedies that we put in place sort of serve what they needed to, which we believe they have. But fundamentally, any review into competition is a good thing for a challenger brand and we'd also welcome the review in the CPI market as well, the third-party intermediaries who severe a lot of the customers.

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Fraser Andrew McLaren, BofA Merrill Lynch, Research Division - Director [16]

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McLaren from Merrill. Just 2 questions, please. You mentioned the reduction in the cost of the pellets your own plants. Can I just check where the benefit appears within the group, please? And secondly, electricity prices are rather lower now than when you approved the ScottishPower deal. To what extent does that impact on the acquisition piece and the outlook for earnings from those things?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [17]

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In terms of the cost of pellets, effectively the transfer price is set, so any reduction the cost would come through the EBITDA of the Pellet business. In terms of the pellet power prices, I mean frankly, the -- I would say, it's -- the new news since we've sort of owned the assets, I would say that the -- they are performing very much as we would have hoped they would in terms of being there for system support and some very good sort of results in that areas so far. And power prices, I would say, they will go up, they will go down. It doesn't -- I wouldn't say there's been any change in the acquisition case because of that.

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Unidentified Analyst, [18]

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It's [Tom] of National Bank, please. A couple of questions from me, please. Firstly, on your bad debt, I think you mentioned this in your presentation from cost of consumers. Could you give us a sort of feel for what the percent defaults you are seeing and whether this is increasing or staying constant and is that a feel for general market or Drax specific? And secondly, could you just talk me through this on cash flows on the capacity payments to retail as well, please. Are you currently pricing into your customers this sort of GBP 3 of megawatt hour-ish capacity payment? And what are you doing with that cash and is that sitting on your net debt number to be added back or what are you going to be doing with it?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [19]

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Andy, do you want to take the bad debt piece and then the cash flow?

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Andy Skelton, Drax Group plc - CFO [20]

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Yes. I'll answer the second question first. I mean, so we're receiving the cash, collecting it from the customers. We have accrued all the costs to be able to pass that on. So it goes over to the generation side. As I said, we haven't accrued the revenue on the generation side. We're actually in a relatively unusual position in that we have a balance there because we have the revenue on the generation and the cost on the retail side. And actually, whilst it doesn't balance completely, it's -- there's a reasonable good symmetry there.

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Unidentified Analyst, [21]

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It's about GBP 60 million, I think, is now for the full year, something like that for...

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Andy Skelton, Drax Group plc - CFO [22]

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Yes. And at the end of the fourth quarter, there was a GBP 7 million impact. So that's the revenue that wasn't accrued in generation. And again, an almost offsetting amount on the retail side.

So I mean, just add to that as well, which has been interesting feedback is, obviously, the larger payments of the capacity markets stick with the large customers which are generally on pass-through contracts. And they have all been very clear and expecting that to be recovered. So their expectation is the capacity market will come back. And hence, we're working with them accordingly. And then obviously, there's many contracts on fixed prices as well, so that they're fixed price contracts and, obviously, we're just continuing to collect on those. On the sort of debt itself, in terms of when you look at the actual breakdown of the debt sort of GBP 3 million of it is because we're looking at the full year on Opus and GBP 2 million of it is because we've got a much larger revenue now. So those 2 will take account. And then within the Haven board, we've finished now a 3-year piece of work on debt, which we've now cleared of all debt post [3 6 5.] So the actual increase in terms of debt is around about 5 year-on-year. And what we're seeing is there are increases in insolvencies on the High Street. Very much in Haven, that doesn't -- is not affected because its many larger businesses within Opus. About sort of 50% of our book is micro businesses and probably sort of 20%, 30% of that is within the retail part. So we are putting in processes to manage that. And obviously, keep a very close eye on that and that's what the work that Andy spoke about in the second half is being about making sure that we're focusing on markets that we can feel confident we can collect that from.

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Andy Skelton, Drax Group plc - CFO [23]

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So it's worth just noting on that, but in the GBP 31 million expense for the year, we added GBP 16 million of additional provisions which I know they are on the balance sheet at the end of the year. So whilst it's still too early to call success on our bad debt, I think we're in a better position than we were when we started the year. And with all the other activities we've done, we're confident that we're well placed as we exit the year.

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Unidentified Analyst, [24]

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So I suppose -- it was sounding sort of cheeky just the actual amount of cash sitting on your balance sheet that you're going to hand back on capacity markets. If it were to be reinstated on a retrospective basis, is how much?

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Andy Skelton, Drax Group plc - CFO [25]

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I'm not sure I know that number exactly. So I'll get back to you on that one.

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [26]

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If it were to be reinstated -- so if it were to be reinstated, actually we would had a net benefit there.

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Unidentified Analyst, [27]

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Okay. If it wasn't to be reinstated, sorry.

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [28]

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It wasn't to be reinstated, it's a smaller amount than the amount that actually -- I mean, the -- than the amount that we would benefit if it were reinstated. If that makes sense. Let's take it offline. Anything else? Yes?

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Unidentified Analyst, [29]

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[Adam Versace] from Cantor Fitzgerald. Just a sort of follow-up on the capacity market. And you seem to be signaling that you think a similar outcome might be likely. Are you actually now ruling out sort of more dramatic changes to the capacity market that are using the disruptions has an excuse?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [30]

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I guess I wouldn't be in a position to rule out a different outcome. But I think that our understanding is that the government's -- the path that they would like to go down, as we understand it, is much quite similar to where it has been. Someone, Chris?

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Christopher Robert Laybutt, JP Morgan Chase & Co, Research Division - Research Analyst [31]

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Chris Laybutt with JPMorgan. How comfortable are you with consensus for 2019 at the moment?

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [32]

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Andy?

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Andy Skelton, Drax Group plc - CFO [33]

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Yes. So we have published consensus last week, and I would note that, that consensus has GBP 406 million of EBITDA. I'd also note that there's a number of varying assumptions in there when it comes to the capacity market. I would also worth noting that the commodity price assumptions vary in a range also. So we'd note the GBP 406 million. And I think you can make your own conclusions from that.

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Dwight Daniel Willard Gardiner, Drax Group plc - Group CEO & Executive Director [34]

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Anything else? All right. Well, thanks, everyone, for coming. We will be here if you have more questions. And thanks again for coming.