Introduction

During 2007, we continued to deliver sound operational and financial performance, the latter despite dramatic price changes across the commodity markets which are critical to our business. As a result of an exceptionally warm Winter the electricity wholesale price weakened which, together with rising coal and freight prices, reduced the margins previously available to coal-fired generators. These, amongst other factors, contributed towards an EBITDA of £506 million, some £77 million lower than in 2006. In 2007, we effected our policy to return surplus cash to shareholders through a combination of an ordinary dividend, special dividend and a share buy-back, together totalling £160 million.

Our strategy is to grow shareholder value by exploiting the strategic and commercial value of Drax Power Station and by deploying and developing our core competencies to deliver additional value through fuel diversification and carbon abatement. The strategic priorities we set ourselves for the year focused our attention on the areas of trading, production and investment in improving existing plant performance and increasing fuel optionality.

In 2007, we made good progress with our two major investment programmes to upgrade the high and low pressure turbines of all six generating units and to increase significantly our renewable biomass throughput; both importantly contributing to our commitment to reduce our emissions of carbon dioxide (“CO2”) and helping to combat climate change.

We continued to execute with success our trading strategy, progressively hedging our output whilst targeting market or better dark green spreads and retaining balanced market exposure. Throughout the year, we maintained our focus on delivering added value from our trading capability. This year saw us enter into our first power option, first ship charter and first Kyoto instrument trade. On top of these we have made full use of the flexibility and reliability of the plant through taking advantage of opportunities presented by the ancillary services market including, for the first time, selling some forward contracts for frequency response services.

We achieved good results on plant reliability and availability and once again delivered a strong performance which ranked us highly amongst our sector peers. We undertook two major planned maintenance outages during the year along with a substantial capital expenditure investment programme. Our safety record compares favourably with that of our peers and international benchmarks. In 2007, our safety programmes generally delivered sound performance, but to our regret there was a fatality following an incident at our site involving a contractor undertaking some civil works. Delivering the highest standards in safety management remains a key area of focus and is central to our operating philosophy.

Trading overview

Our practice is to sell approximately one-third of our power in the near-term markets and the remaining two-thirds in the liquid forward markets. We broadly match our power sales with corresponding carbon and fuel positions. As a result, annual profitability is influenced by past, present and future commodity prices.

Commodity prices at the end of 2007 were dramatically different to those at the start of the year and within-year volatility was very high. The three commodity prices that most strongly influence the electricity wholesale market of Great Britain continue to be international traded prices for oil, coal and carbon. During the year there was a 70% rise in international crude oil prices. In the same period, and in contrast to 2006 which saw relatively stable coal prices, international coal prices increased by 90%. The price for carbon under the EU Emissions Trading Scheme (“EU ETS”) fell close to zero in 2007 whilst traded prices for carbon for delivery in Phase II of the scheme, which covers 2008–2012, rose by 45%.

For most of the year, gas-fired generation plant was the price setting plant for the electricity wholesale market of Great Britain with power prices generally moving with changes in domestic gas wholesale prices.

Gas prices were strongly influenced by international oil prices but also affected by weak Winter demand levels due to mild weather which, when combined with increased supplies of gas into Great Britain and high storage levels, resulted in some low prices in the first half of the year. The margins for coal-fired generation were sustained at attractive levels for much of the year except at times when the downward pressure from gas prices, combined with high international coal prices, depressed margins.

We continued to enjoy good liquidity in the traded electricity market out to 2012. This enabled us both to manage effectively our coal and carbon positions in line with our trading strategy and to increasethe volume of our forward sales. Compared to 2006, we have modestly increased our total forward sales which, given the absence of liquidity in the market post 2012, is a significant achievement.

Over the last two years we have been working hard to diversify and to optimise our fuel sourcing. We were particularly pleased to increase the diversity of our supplies of indigenous coal through contracts with local suppliers, Hargreaves (UK) Services Limited and Powerfuel plc.

We now have the capability to burn a wide range of coals at Drax, bringing with it the benefits of security of supply and preparedness for the challenges we face now that we are operating under the tighter environmental limits of the Large Combustion Plant Directive (“LCPD”) that came into force at the start of 2008.

Production overview

Throughout the year we maintained our focus on achieving leading performances in the areas of health and safety, environmental compliance and plant reliability. Specifically, in delivering against our production strategy we implemented selective investment to improve plant safety performance, improve plant efficiency, and maintain high availability and reliability compared to our sector peers. Through improved work processes we targeted better productivity and we worked on delivering the capability to burn a wide range of fuels, including a variety of coals, biomass materials and petcoke.

As we entered 2007, we were well aware of the significant challenge we faced in managing our health and safety performance amidst two major planned outages and an increased level of site project work, which together represented an increase of over 30% in the hours worked by our production teams and contractors compared to 2006.

Although our lost time injury rate worsened compared to 2006, we maintained the much improved performance levels achieved in 2005. This demonstrates well that the systems we have implemented over the last three years are becoming embedded in the health and safety philosophy and are proving effective as we increase the intensity of work at the plant.

The availability and reliability of our plant is key to delivering shareholder value. We have set ourselves a challenging, long-term target of 4.5% for Winter forced outages.

During the critical, high margin Winter months of 2007 we achieved better than our long-term target by delivering a forced outage rate of 4.2%. The forced outage rate for the full year at 6.9% was higher than that of 2006 due largely to taking advantage of low margin Summer periods to conduct elective outages which contributed to the calculation of our published forced outage rates. These outages allowed additional plant inspections and repair work which have provided us with a high degree of confidence in maintaining plant integrity.

Investment overview

Good progress was made on the two major investment projects announced at the turn of the year. Economic carbon abatement along with fuel diversification are key elements of our strategy to grow shareholder value. We believe that there is strategic value in our environmental leadership position in the coal-fired sector and, whilst holding the position of the most efficient coal-fired generator in the UK with the lowest CO2 emissions per unit of output, we strive for further improvement. Our decisions to invest up to £100 million to upgrade our high and low pressure turbines and to set ourselves the challenging target of producing 10% of our output from renewable biomass by the end of 2009 were driven by our will and commitment to economically reduce our emissions of CO2. On completion, these projects will save over three million tonnes of CO2 each year in support of our strategic priorities.

In the third quarter of the year, during the second major planned outage we were able to fast track the installation of a high pressure turbine module on one of our units. This enabled us to gain valuable engineering experience, along with some modest efficiency improvements, 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.

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 expected to commence in the second half of 2008. The facilities are planned to come on line during the course of 2009, with full completion being at the end of 2009, in line with our target.

In 2007, we co-fired close to 200,000 tonnes of renewable biomass and made significant progress with sourcing and test burning different biomass materials. During the year there was high price volatility in the agricultural markets driven particularly by the rapeseed and grain markets. UK prices for rapeseed and wheat both increased by over 75% in the year. The higher rapeseed prices have made the economics of the proposed development of a rapeseed crushing plant less attractive, and so we have not progressed this project. The price increases have also had an adverse impact on some of the growth momentum of our local perennial energy crop programmes as farmers increased annual food crop acreage to take advantage of market opportunity.

Drax remains committed to supporting and encouraging the growth of UK energy crops, although the significant rise in agricultural prices demonstrates the value of the diverse sourcing strategy for biomass which we have been pursuing. It is our strategy to secure biomass contracts from both domestic and international sources across the spectrum of energy crop and non-energy crop products. As part of this strategy, we are placing particular emphasis on environmental sustainability in our sourcing plans.

In the last year we also introduced new systems and procedures for controlling and managing projects. This is central to the successful execution of both the strategic projects detailed above and the large number of smaller projects that we have been implementing across the business, most notably plant enhancement projects which deliver environmental, efficiency and reliability improvements. These improved management systems supported our execution, within budget and on a timely basis, of projects included in the £83 million incurred under our capital expenditure investment programme in 2007.

Regulatory and market outlook

The Government published its Energy Bill on 10 January 2008 setting out policy proposals in response to the UK’s long-term energy challenges of tackling climate change and ensuring secure, clean and affordable energy.

The Energy Bill is consistent with the conclusions of the May 2007 Energy White Paper which confirmed that coal “will continue to play a significant role in global electricity generation for the foreseeable future”, recognising both the global abundance of coal and other important security of supply benefits that coal brings to the energy mix, such as its ability to respond quickly to changes in demand. We have long advocated the continuing need for coal in the energy mix, but we have always acknowledged that there can only be a place for coal, and other fossil fuels, if we address the environmental challenge.

The UK currently generates 4% of its electricity from renewable sources. The Energy Bill provides for a strengthening of the Renewables Obligation (“RO”) to drive greater and more rapid deployment of renewables. This accords with the EU objectives and the proposed target set by the EU for the UK of 15% renewable energy by 2020. The consequent growth in renewable generation will increase the diversity of the UK’s energy mix and lower CO2 emissions from the electricity sector.

There is clear recognition of the contribution that renewable biomass materials can make towards the UK’s renewables target. The new RO regime should support the growth of both standalone biomass power plants and co-firing biomass with coal. In April 2007, we saw the removal of caps and constraints on energy crop co-firing whilst the new regime provides for the doubling of the volume of permitted co-firing of non-energy crop biomass.

We are already committed to substantially increasing the proportion of power we generate from biomass through co-firing with coal. We believe that lessons learnt in both understanding the technology and, more importantly, in sourcing and logistics when combined with the incentives through the RO may present additional opportunities for creating additional shareholder value and fuel diversification.

The Government’s energy policy recognises that substantial investment in new generation capacity will be needed to address the emerging capacity gap left by retiring coal, oil and nuclear power stations and to meet anticipated increases in electricity demand.

The requirements of the EU’s LCPD, which came into effect on 1 January 2008, will bring about the closure of some 8.5GW of coal-fired capacity and some 3.4GW of oil-fired capacity between 2012 and the end of 2015. In addition, around 7GW of nuclear capacity is scheduled to close between now and 2020. Although some of the capacity gap may be addressed by actions on the demand-side, it is nevertheless expected that without new plant build, in the near term, the power markets will tighten. The ensuing market dynamics are likely to be beneficial to strategic generators such as Drax power station, with its proven technology and expected generation life, and may also present opportunities.

In January 2008, the EU outlined its proposals for the EU ETS beyond 2012. It is proposed that the scheme will be extended to a third phase covering the period 2013–2020. The cap on traded emissions by 2020 will be 79% of traded emissions in 2005 with a linear reduction of 1.74% per annum. It is proposed that all of the allowances for the electricity sector will be auctioned. We support a traded price for carbon but we oppose full auctioning for the electricity sector in Phase III.

We consider that to introduce full auctioning from 2013 is likely to prove a precipitous move which could be destabilising for the electricity sector and could lead to the early closure of less efficient plant at a time when the reserve capacity margins across the EU are forecast to reach critically low levels. The proposals now must be approved by both the Council of the EU and the European Parliament in order to become law.

Our people

It is the commitment and enthusiasm of our people that have secured the progress that we have made during 2007, and we recognise only too well their contribution to delivering against our strategy and delivering value to our shareholders.

In keeping with our significant developments made throughout the year, we have increased our headcount by around 10%. As in the previous year, we continued to recruit specialists with the skills and experience to take our business forward. In particular, the areas of business development, IT, risk management and trading have seen the largest growth; it is these areas that will enable us to explore and exploit new opportunities.

We placed particular emphasis on the development of our people during 2007, ensuring that all development needs identified during our appraisal process were addressed. Through a tailored competency-based management development programme for all staff with supervisory responsibilities we targeted all first line supervisors and during 2008 our plans are to target all our staff with a leadership role. The target set at the outset of the year for training events was exceeded and we shall be assessing the effectiveness of the development programme initiated as part of the 2008 performance appraisals.

Looking ahead

During the last two years our primary focus has been on delivering the strategy for the business which we laid out on listing the Company in December 2005. This focused on the strong alignment between our trading and production strategies and the achievement of leading performance in both areas. We believe that we have successfully delivered this.

Our strategic focus is now on producing value growth for our shareholders whilst maintaining leading performances in trading and production. We plan to increase shareholder value by developing our core competencies to deliver significant fuel diversification and carbon abatement. In the near term this will be through the successful implementation of our existing two major strategic projects, upgrading our turbines and biomass co-firing.

We believe that our biomass handling and sourcing capabilities are areas of emerging competence which have the potential to produce significant value. We therefore intend to further develop our biomass procurement and handling capability with a view to potentially expanding significantly our generation from renewable biomass fuels. This would achieve both additional carbon abatement and increased fuel diversification.

We also believe that the purchase of Kyoto instruments in place of CO2 emissions allowances could provide significant value potential for Drax, particularly in Phase III of the EU ETS when there should be greater opportunity for these trades, provided that there is a new international agreement on greenhouse gas emissions. We will ensure that we are well placed to capture this value potential and will work to further build our Kyoto instrument trading and origination capabilities.

All the analysis that we have done reinforces our view that the electricity wholesale market of Great Britain will provide increasing returns to available capacity as the retirement of some of the older plant reduces the margin of installed capacity above system demand. This will be positive for Drax and we believe that our strategic position and focus will give us the ability and opportunity to deliver value growth to our shareholders relative to the commodity markets in which we operate.



Dorothy Thompson
Chief Executive
3 March 2008