We manage the commercial and operational risks faced by the Group in accordance with policies approved by the Board.

Regulatory market risk

The UK Government and other relevant regulatory bodies have significantly changed the applicable regulatory regimes in Great Britain over the past few years, in an attempt to improve market information and transparency, enhance competition and liquidity, reduce the likelihood of market abuse and implement new EU legislation. In particular, new UK and EU legislation applicable to our sector continues to target reductions in emissions. We are exposed to further regulatory developments, which may favour other types of fuel or sources of power, and which could result in additional costs or lower output levels and reduce our profitability.

Plant operating risk

Extended forced outages or prolonged planned outages could have a significant adverse effect on our revenue and profitability. We may also incur additional costs in recovering from these outages, and penalties if we cannot fulfil our contractual obligations.

Forced outages may be caused by the underperformance or outright failure of our power generation plant, or other equipment and components including the information technology systems used to operate the plant or conduct trading activities. The duration of forced outages is influenced by the lead time to manufacture and procure replacement components and to carry out repairs. Although we always try to optimise our holding of spare components for use in the event of plant failure, we may not always have ready access to the relevant replacement parts.

Environmental and health and safety risks

The EU, UK and local environmental and health and safety laws and regulations which affect the power station are complex, frequently changing and are becoming ever more stringent. They cover many aspects of our operations, including limits on emissions of particulate, SOX and NOX, discharges to air and water, noise emissions, soil/groundwater contamination, waste and health and safety standards.

Changes in these laws and regulations may cause increased compliance costs, the need for additional capital expenditure and could affect output levels. Whilst we have robust systems in place to support and monitor compliance with these regulations, failure to do so could result in fines or penalties, civil or criminal liability, or even the limitation or suspension of operations.

Electricity market liquidity risk

Liquidity in the market for wholesale electricity is dependent on there being a sufficient number of counterparties willing to trade actively. Changes in the market structure or consolidation of the existing generation and supply businesses in the UK could result in a reduction in the number of active participants in the market with whom we are able to trade.

If we are not able to rely on wholesale market trading as a means of hedging our short to medium-term exposure to electricity prices, it may affect our ability to sell all of our output and/or the prices at which we sell it. As a result we could suffer reduced revenues and incur higher costs to achieve our trading objectives.

Refinancing risk

Recent volatility in financial markets has created a general level of uncertainty and increased refinancing risk.

Our senior secured debt matures under an amortisation profile ending on 31 December 2010. We have significant headroom under our existing facilities, and a reasonable expectation that these will be renewed when required.

Commodity risk

We are exposed to the effect of fluctuations in commodity prices, particularly the price of electricity, the price of coal (and other fuels) and the price of CO2 emissions allowances. Price variations and market cycles have historically influenced our financial results and are expected to continue to do so.

Our policy is to make forward power sales with corresponding purchases of fuel and CO2 emissions allowances when profitable to do so. We purchase coal under either fixed or variable priced contracts with different maturities from a variety of domestic and international sources. We purchase CO2 emissions allowances under fixed price contracts with different maturity dates from a variety of domestic and international sources.

Counterparty risk

As we rely on third-party suppliers for the delivery of coal and other goods and services, we are exposed to the risk of non-performance by these third-party suppliers.

We purchase a significant portion of our coal requirement under contracts with a number of UK suppliers. There is a risk that if a large supplier falls into financial difficulty and/or fails to deliver against the contracts, there would be additional costs associated with securing coal from other suppliers.

We enter into fixed price and fixed margin contracts for the sale of electricity to a number of counterparties. The failure of one or more of these counterparties to perform their contractual obligations may cause us financial distress or increase our risk profile.

The investment of surplus cash is undertaken to maximise the return within Board approved policies. These policies set out minimum rating requirements, maximum investment with any one counterparty and the maturity profile.

Interest rate risk

We are exposed to interest rate risk principally in relation to our outstanding bank debt. In particular, we are exposed to changes in the LIBOR interest rate of sterling denominated debt, as all of our debt is both denominated in sterling and has a variable LIBOR rate. We mitigate this risk with interest rate hedges on a proportion of our debt facilities.

Foreign currency risk

Foreign currency exchange contracts are entered into to hedge substantially all of our fixed price international coal purchases in US dollars, and our CO2 emissions allowances purchases in euros.

Tax risk

Under the Group’s previous financing structure, Drax Holdings Limited (a subsidiary company) was partially funded by a Eurobond payable to another group company. The whole of the coupon was previously prepaid, and an accounting based tax deduction has been claimed for the corresponding interest charged in the Drax Holdings Limited income statement each year. Were HMRC to successfully challenge the deductions claimed in respect of the Eurobond coupons for open years to 31 December 2008, it is estimated that the additional tax liability would be up to £90 million, together with interest and penalties.

In November/December 2008, HMRC issued draft legislation concerning the “Principles based approach to financial products avoidance” and the “Taxation of foreign profits of companies”. These provisions updated rules on, amongst other things, the tax deductibility of interest and were generally expected to reduce the tax effectiveness of the Eurobond financing arrangements.

Following consultation with leading tax counsel and after taking professional advice, we decided to unwind the Eurobond financing arrangements. The Eurobond was formally waived by the lending group company on 30 December 2008. As a result the whole of the remaining prepaid coupon was charged in the Drax Holdings Limited income statement giving rise to potential additional interest deductions with a tax effect of around £220 million. Because of the risks related to the unwind of the Eurobond structure, no benefit will be recognised in the Group’s financial statements with respect to the potential additional deductions until we are more certain they will be realised.