Liquidity and capital resources

Net debt was £337 million as at 31 December 2007 compared to £321 million at 31 December 2006.

Cash and cash equivalents were £60 million as at 31 December 2007 compared to £155 million at 31 December 2006. The changes in cash and cash equivalents are analysed in the following table.

Analysis of cash flows

Net cash generated from operating activities was £313 million in the year ended 31 December 2007 compared to £525 million in 2006. The decrease reflected a reduction of £77 million in EBITDA in 2007, lower cash received under the TXU Claim (£6 million cash received under the claim in the year ended 31 December 2007 compared to £74 million in 2006), an increase of £55 million in income taxes paid and increased working capital utilisation in 2007, including a higher coal stock build and a significantly lower liability with respect to CO2 emissions allowances.

Net cash used in investing activities, which represented payments in respect of capital expenditure in both periods, was £68 million for the year ended 31 December 2007 compared to £27 million in 2006 (see Capital expenditure).

Net cash used in financing activities was £340 million in the year ended 31 December 2007 compared to £431 million in 2006. The 2007 amounts included equity dividends paid of £171 million and payments under the share buy-back programme of £84 million (inclusive of all expenses), together representing returns to shareholders totalling £255 million. Also included were term loan repayments of £40 million in June 2007 and £40 million in December 2007, the final bridge loan prepayment of £3 million, and purchases of our own shares to meet commitments under share-based incentive plans of £2 million. The 2006 amounts included new debt raised of £100 million, offset by equity dividends paid of £342 million, term loan repayments of £58 million in June 2006 and £58 million in December 2006 and bridge loan prepayments of £55 million and £19 million in January and July 2006 respectively.

The decrease in cash and cash equivalents was therefore £95 million in the year ended 31 December 2007, compared to an increase of £67 million in 2006. Drax’s policy is to invest available cash in short-term bank, building society or other low risk deposits.

Capital resources and refinancing

Since listing in December 2005, senior secured debt has fallen from £500 million to £405 million at 31 December 2007 (both before deferred financing costs), through a combination of scheduled debt repayments and the raising of additional secured debt. Scheduled debt repayments for 2008 are £35 million.

The Board continues to monitor developments in the debt markets and is committed to maintaining balance sheet efficiency. In September 2007, the Board announced its intention to undertake a refinancing of the Group’s current debt facilities (subject to market conditions). As a result of continuing turbulence in the debt markets the Board decided to postpone the refinancing until such time as it judges market conditions have improved and the Group will be able to secure more attractive terms.

Seasonality of borrowing

Our business is seasonal with higher electricity prices and despatch in the Winter period and lower despatch in the Summer months, when prices are lower and plant availability is affected by planned outages. Accordingly, cash flow during the Summer months is materially reduced due to the combined effect of lower prices and output, while maintenance expenditures are increased during this period due to major planned outages. The Group’s £100 million revolving credit facility assists in managing the cash low points in the cycle where required. The revolving credit facility was undrawn at 31 December 2007.

Contractual commitments

The following table illustrates our contractual obligations, excluding interest, as they fall due as at 31 December 2007.

Capital expenditure

At the turn of the year we announced that we expected to incur total capital expenditure of approximately £260 million over the three years 2007 to 2009. Of this, around £150 million specifically related to the turbines upgrade project, condenser and feed system plant improvements and investments in extending our biomass capability. The remainder comprised smaller value enhancing investments and other expected capital expenditure in support of current operations. Following capital expenditure of £83 million in 2007, we remain on track to achieve this target.

We now expect to incur capital expenditure of approximately £250 million over the three years 2008 to 2010, of which around £150 million specifically relates to the turbines upgrade project and investments in extending our biomass capability. We plan to fund this capital expenditure investment programme from a combination of operational cash flows and debt.

In relation to the turbines upgrade project, we expect to invest up to £100 million over a five year period, including approximately £70 million over the three years 2008 to 2010, to upgrade the high pressure and low pressure turbine modules on all six generating units to improve efficiency. Using proven technology we expect to achieve an overall baseload efficiency (that is, the ratio of energy out to energy in when operating at full capacity) approaching 40%. This represents a 5% improvement on current baseload efficiency of around 38%. When complete, the project is expected to deliver annual savings of one million tonnes of CO2 emissions allowances and approximately half a million tonnes of coal.

Installation, which is being undertaken during the planned outage programme, commenced in the third quarter of 2007, when we were able to fast track the upgrade of a high pressure turbine module on one of our units. The early start to the programme enabled valuable engineering experience to be gained, along with some modest efficiency gains, ahead of the upgrade of two high pressure and six low pressure turbines during the major outages on two of our generating units planned for 2008.

With regard to extending our biomass capability, we expect to invest around £80 million to meet our target to produce 10% of our output from burning biomass by the end of 2009. The largest single investment included in the £80 million programme relates to extending our direct injection capability from one generating unit to all six generating units, and to install the necessary processing and handling infrastructure to ensure we are able to handle up to one and a half million tonnes of biomass material per annum. In addition, we expect to make investments in off site processing facilities.

Achievement of the 10% target is expected to result in savings of over two million tonnes of CO2 emissions allowances, the displacement of approximately one million tonnes of coal and the generation of in excess of two and a half million ROCs per annum. Our dedicated renewables co-firing project team have made good progress in finalising the design of the new biomass handling and direct injection facilities required to meet our 10% co-firing objective.

In February 2008, we were granted planning approval by Selby District Council for the new facilities. Following a competitive tender process, we are on schedule to execute Engineering, Procurement and Construction contracts for the co-firing facilities in the second quarter of 2008, with building works commencing in the second half of 2008. The facilities will come on line during the course of 2009 with full completion being at the end of 2009 in line with our target.

In addition, we will continue to evaluate other investment opportunities which may result in additional capital expenditure. Further investment will be required beyond 2009 and prior to 2016 to meet the requirements of the LCPD.

Share-based incentive plans

Costs charged in the income statement in relation to share-based payments were £3.1 million in the year ended 31 December 2007, compared to £1.7 million in 2006.

Under the 2007 SIP Free share award, the Company purchased a total of 195,810 shares in April 2007 to be held in trust on behalf of qualifying employees, equating to 305 shares with a cash value of approximately £2,500 per employee based on the Company’s share price at the time of the award. The fair value of the 2007 Free share award (determined at the award date) of £1.6 million was charged to the income statement in full in the year ended 31 December 2007, on the basis that employees were granted specific rights in relation to shares held in trust on their behalf. Similarly, the fair value of the 2006 Free share award of £1.3 million was charged to the income statement in full in the year ended 31 December 2006.

In March 2007, the SIP was extended by introducing two further elements: Partnership shares and Matching shares. Qualifying employees can buy up to £1,500 worth (subject to an overriding maximum of 10% of salary) of Partnership shares (out of pre-tax pay) in any one tax year. Matching shares are awarded to employees to match any Partnership shares they buy. Under the Drax SIP the ratio is one to one for the 2007/2008 tax year, with the cost of Matching shares borne by the Group. As at 31 December 2007, a total of 104,367 Matching shares had been purchased and were held in trust on behalf of qualifying employees. The fair value of Matching shares awarded up to 31 December 2007 (determined at the award dates) of £0.8 million is being charged to the income statement on a straight-line basis over a one-year vesting period (Matching shares are forfeited if an employee leaves Drax within one year of the award).

ESIP awards over 361,582 shares were granted to executive directors and other senior staff in 2007, with performance measured over the three years to 31 December 2009 and potential vesting in April 2010. The fair value of the 2007 ESIP awards (determined at the grant date) of £0.9 million, which takes into account the estimated probability of different levels of vesting, is being charged to the income statement on a straight-line basis over the three-year vesting period to 19 April 2010. Similarly, the fair value of the 2006 ESIP award of £1.9 million is being charged to the income statement on a straight-line basis over the three-year vesting period to 19 September 2009.

There have been no further offers under the SAYE Plan since that made in July 2006. No shares have been issued or purchased to date with respect to the SAYE or ESIP.

Taxation

In December 2007, HM Revenue & Customs issued a consultation document entitled “Principles based approach to financial products avoidance: a consultation document” which is expected to lead to the introduction of new legislation concerning “disguised interest” from 1 April 2008.
It is thought likely that the new rules, if introduced in the form currently envisaged, could adversely impact the future tax efficiency of the Group’s existing financing structure. Until the consultation process is completed and the legislation drafted, however, it is not possible to predict with any certainty how the proposed legislation, if and when enacted, might affect the Group tax rate, and the Group is therefore keeping the situation under review.