Bills to rise as water firms urge watchdog to let the returns flow

It will hardly be the pre-election sweetener that government ministers yearn for. But in April 2005 - possibly only a few weeks before the country goes to the polls - water bills will rise. By how much is up for debate, but adding pounds to the bill is likely to be the conclusion of the next review of water prices held by industry watchdog Ofwat.

The process kicked off in earnest on Friday when the 26 water companies submitted their business plans to the regulator, making the case for a substantial price hike. But much more is at stake than domestic bills. The destiny of the country's water companies will be set in stone for five years by Ofwat and its director general, Philip Fletcher.

Ofwat is a hands-on watchdog. Mr Fletcher spells out how much companies can charge their customers, how much money they need to invest and their allowed returns, and even indicates whether they are allowed to merge. This has left little scope for the companies to do anything other than turn the taps on and off.

Not surprisingly, the City has never got excited by water. Northumbrian Water, for example, which floated on the junior Alternative Investment Market in May and is worth £588m, made a strong debut. However, its shares have been relatively flat over the past month, as fund managers can't see a strong reason to either buy or sell.

As the latest review kicks off, the water companies are demanding some slack. More money to replace the country's ageing water infrastructure, a higher allowed rate of return and fewer environmental obligations would do nicely.

"This time, customers are going to have to take more of the costs. This will not be insignificant and it will attract attention from the consumer groups," warns Bob Armstrong, the chairman of industry lobby group Water UK and managing director of customer sales for United Utilities.

Companies are expected to call for at least the reversal of the 12.5 per cent average cut in bills that came out of the last price review.

Mr Fletcher has indicted that he may be prepared to give a little. Last month he said "there is no pot of gold out there" - referring to costs saved by making the water companies more efficient. It is now recognised that the companies are operating at near peak efficiency.

Mr Fletcher and Ofwat are fiercely independent. Nevertheless, the industry is worried that such a crucial price review could get mired in politics, being so close to a general election. Mr Armstrong says: "The potential of significant price rises before an election will not go down very well. It clearly has an influence as there will be dialogues going on between ministers and Ofwat."

When the water industry was privatised 13 years ago, the companies had low levels of debt. The idea was that improvements to the water infrastructure would be carried out over 10 years, and that companies would emerge from this making money and bills would fall. However, a series of new environmental standards, both British and European, has placed new demands on investment. As a result, the five main quoted water utilities - AWG, Kelda, Pennon, Severn Trent and United Utilities, with a combined stock market value of £8.5bn - together have debts of around £10.3bn. Investment bank Merrill Lynch estimates that by 2005 the companies' debts will have risen to £14.5bn.

The tough conditions have forced some companies to look at alternatives to the stock market. But Glas Cymru, the Welsh water group, is the only company to date that has relied entirely on debt finance. This is because Mr Fletcher has made it clear that he'd rather see companies tapping into the equity markets than going into debt. Glas was an exception because it was on its knees.

United Utilities followed this diktat last month by launching a £1bn discounted rights issue to help pay for its investment programme.

As quid pro quo, the water companies now want the regulator to make the industry more attractive to the equity markets by increasing their allowed rate of return. At the last review, this was set at 4.75 per cent, post tax, with an extra 0.75 per cent for smaller companies.

Mr Armstrong says: "Philip Fletcher has been at pains to say he wants to retain companies with conventional equity investment. Therefore, he needs to give an adequate rate of return. At the last review, the rate fell through the floor. There is still that nervousness around. We would like to see a slightly higher rate, say 1 per cent more."

If Mr Fletcher refuses this request, some companies privately warn it could put their investment plans in jeopardy and even force an appeal to the Competition Commission.

A senior source at a water company says: "No one wants this, but we may have no choice. It's either higher bills in 2005 approved by the regulator, or higher bills at a later date in effect sanctioned by the Commission."