* Shares in Drax fall 14 pct
* Legal challenge will test new UK subsidy framework
* Drax to continue with conversion regardless of outcome
* Dong Energy biggest winner of subsidy contracts (Adds further Drax reaction, Dong Energy contracts, lobby group comment, background)
By Karolin Schaps
LONDON, April 23 (Reuters) - British electricity producer Drax said it had started legal proceedings against the government over a decision not to support the conversion of one of its coal-burning units to biomass under a new subsidy scheme.
The government's move is a blow to Drax's plans to modernise its polluting coal plant in Yorkshire, northern England, to burn more environment-friendly biomass after two units were short-listed in December to receive contracts under the new government scheme.
"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," Drax Chief Executive Dorothy Thompson said in a statement on Wednesday.
Shares in Drax were down 14 percent at 0926 GMT on Wednesday.
The government is changing the way in which it supports renewable energy projects by replacing a mechanism for direct subsidy payments with a system whereby qualifying projects are guaranteed a minimum price at which they can sell electricity.
Drax's legal challenge will set a precedent in testing the legal framework of the new subsidy regime, due to start in April 2015, and its outcome could sway other investors in UK biomass conversion projects.
The government said the project for converting Drax's Unit 3 at the plant did not meet all its assessment criteria for the new contracts-for-difference (CfD) scheme.
It recommended that Drax continue to use the current direct subsidy scheme, which analysts say is less lucrative.
"We believe that this decision is disappointing. It has undoubtedly created some greater uncertainty," Angelos Anastasiou, a utilities analyst at Whitman Howard, said.
Drax said that regardless of the outcome of the legal challenge, it would continue with the biomass conversion project.
The government granted a CfD contract for the conversion of Drax's Unit 1, which will receive a guaranteed power price of 105 pounds ($180) per megawatt-hour from April 2015 when the new scheme is due to start, pending EU state aid clearance.
The government also awarded investment contracts to seven other projects on Wednesday, including two biomass plants and five offshore wind farms.
These included the Dudgeon offshore wind farm, proposed by Norway's Statoil and Statkraft, SSE's Beatrice offshore wind farm and a third biomass conversion unit at Drax's coal-fired power plant.
Denmark's Dong Energy was awarded contracts for its Walney Extension, Burbo Extension and Hornsea offshore wind projects, making it the biggest winner.
"These contracts will allow us to deliver over 5 billion pounds of investment in the pipeline of projects we have in the UK," Brent Cheshire, Dong Energy's UK chairman, said in a statement.
Britain's RenewableUK lobby group said it was important that all renewable energy projects receive support through the CfD scheme, not just those announced on Wednesday.
"We need far more onshore and offshore wind projects over the next decade if we're not to find our energy security threatened," RenewableUK Chief Executive Maf Smith said.
($1 = 0.5944 British pound) (Additional reporting by Nina Chestney; Editing by Kate Holton and Jane Baird)