Drax shares plunged by 10% in the market open after the UK government rejected the British power producer's "Investment Contract" for one of its biomass conversion units.
The Drax stock price has since retraced some of its losses in early trading but it still down around 7% at 696.50p.
"Whilst we are pleased to have been offered an Investment Contract for our third unit conversion, we are disappointed by today's decision on the ineligibility of our second unit," said Dorothy Thompson, chief executive of Drax in a statement.
"Nothing has changed, as far as our plans are concerned, between being deemed eligible in December and now. We have, therefore, commenced legal proceedings to challenge the decision.
"Sustainable biomass provides a very reliable, flexible and cost effective renewable power source for the UK consumer. The performance of our first converted unit, which was converted last year to burn sustainable biomass in place of coal, continues to be strong.
"I am proud of what we have achieved to date and we remain fully committed to our strategy of transforming Drax into a predominantly biomass fuelled generator, initially through the conversion of three of our six generating units, with a fourth unit conversion under evaluation."
In December 2013, the UK Government advised that two generating units at Drax Power Station - the second and third unit conversions - were eligible for Investment Contracts under the early Contracts for Difference (CFD) mechanism, to support the conversion from coal to sustainable biomass.
Both units were also provisionally ranked equal first of all the qualifying projects and deemed affordable.
However, the government said it believes the second unit conversion is no longer eligible for an Investment Contract, but support for conversion instead is available under the existing Renewables Obligation (RO) regime, where eligibility has been confirmed.
"Drax has taken legal advice over the decision to exclude this second unit from the award of an Investment Contract. The advice confirms Drax has a good foundation to challenge this decision by the Government. Proceedings have therefore been initiated," it added.
What is a CFD?
A futures contract where the differences in settlement are made through cash payments, rather than the delivery of physical goods or securities.