Flawed Analysis

It is difficult to overstate Drax’s importance to Canada’s pellet industry. Drax has converted three of its six coal power units to operate on wood pellets over the past three years. The third unit (known as Unit #1) is presently operating on 85 per cent wood pellets under support from the U.K.’s Renewables Obligation Scheme and will increase to 100 per cent pellets with support under the CfD (Control for Difference) Scheme if it can pass a state aid review which is presently being conducted by the European Commission.

European Union state aid rules ensure that the cost of any support scheme is limited and does not lead to unfair competition. Thus, as required, the commission is investigating Drax’s CfD contract.

The commission’s preliminary analysis concluded that Drax may have underestimated the economic performance of Unit #1; hence its CfD contract may be too generous. The commission also concluded that new demand by Drax for 2.4 million tonnes of wood pellets could significantly distort competition.

WPAC responded to the commission’s invitation to comment on its preliminary analysis and asked for the following points to be considered:

• The commission assumed that the pellet market will be distorted by 2.4 million tonnes of new demand. The fact is that Drax is already operating Unit #1 on 85 per cent wood pellets, equivalent to two million tonnes. Thus the market has already absorbed the majority of any market effects.
• The commission cites trade data from 2012 in supporting its conclusions. Yet the pellet market has continued to grow rapidly since 2012 and data from that year is simply not relevant. In 2012, the global pellet trade was 20 million tonnes. By 2015, the market had grown by 40 per cent to 28 million tonnes (sources: REN 21, FAO, and Hawkins Wright). According to the Global Trade Atlas, in the same three years, U.K. imports grew from 1.8 million tonnes to 6.5 million tonnes. Similarly, U.S. exports to the U.K. grew from 1.9 million tonnes in 2012 to 4.6 million tonnes in 2015 while Canadian exports to the U.K. grew from 0.8 million tonnes to 1.6 million tonnes. This massive increase in the pellet trade was accomplished without any market distortion.
• The commission does not take into account the many recently built pellet plants, nor those under construction. Canada added five new pellet plants in 2015 totalling about one million tonnes per year. These include Rentech’s Wawa and Atikokan, Ont. plants, Pinnacle’s Lavington, B.C. plant, and Canfor’s Chetwynd and Fort St. John, B.C., plants. In the U.S. and South America, there are five plants under construction: in Sampson, N.C., Urania, La., Colombo, S.C., Hazelhurst, Ga., and Rio Grande, Brazil – totalling 2.1 million tonnes of new annual capacity (source: Hawkins Wright Forest Energy Monitor, January 2016).
• The commission believes that increased demand for wood pellets may lead to distortions in the raw material market, adversely affecting pulp and paper or board manufacturers. This is not true in Canada. First, there are no board plants near pellet export plants. Second, the pellet industry’s wood paying capacity is substantially lower than that of the pulp and paper industry. Pellet plant and pulp mills do not compete for fibre. Pulp mills use wood chips as raw material for pulp and bark for their power boilers, while pellet plants use sawdust and harvesting residuals as feedstock.
• The commission points out that the current spot market for wood pellets is lower than pricing under long-term contracts, concluding that this indicates that Drax may have overpaid; hence the state aid under the Drax’s CfD contract may be too generous. The fact is that about 95 per cent of the industrial pellet trade is conducted under vigorously negotiated long-term contracts that enable pellet producers to earn only a small margin in exchange for long-term risk reduction.  Spot prices are only indicative of about five per cent of the market. In a situation where spot prices are lower than long-term contract prices, it indicates a market over-supply situation where traders are selling distressed cargoes at below cost in order to create short-term cash flow. This situation is by no means sustainable. Long-term contract prices are a more accurate indication of the market price for pellets.

WPAC was one of many interested parties who responded to the commission’s invitation to comment. It is now a waiting game to learn what the commission decides. One thing is for sure, for the sake of the Canadian wood pellet industry, we need Drax to succeed.