Promise of bigger water bills keeps investors on board

Industry only gets half the price rise it wanted so why didn't shareholders bale out?
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Water bills will go up by 13 per cent over the five-year period from 2005, the regulator proposed yesterday, in a settlement that seemed to offer something to consumers, environmentalists, the companies and the City.

Water bills will go up by 13 per cent over the five-year period from 2005, the regulator proposed yesterday, in a settlement that seemed to offer something to consumers, environmentalists, the companies and the City.

The water companies had sought the green light for a £21bn investment programme for the next regulatory period, which starts in 2005. This would have meant bills rising 29 per cent or by about £70.

Under its draft determination yesterday, Ofwat sanctioned £16bn of investment, which would lead to a £33 rise, or 13 per cent, in the average bill by the last financial year of the settlement, 2009-10. The regulator had accepted the need for customer bills to rise early in the process, to pay for the infrastructure enhancement work that it wanted to see.

The final regulatory outcome will be published on 2 December, after ministers have their say and the companies and special interest groups have had a last opportunity to influence the plan.

Not only did the regulator give companies much less than they asked for, but it slapped pretty demanding efficiency targets on them. So why did water company shares rise yesterday?

Shares in United Utilities, for example, increased by 2.45 per cent while Severn Trent shares gained 1.95 per cent.

With consumer groups and environmentalists seeing the proposals as broadly positive, surely the City might have taken the opposite view.

Well, the proposals are not an out-and-out positive for companies and investors, but it had been feared that Ofwat would come out with something even more challenging. In the event, there was much relief in the City. Philip Fletcher, director-general of Ofwat, seemed to have a point when he said it was a "fair, balanced package" that addressed consumer safety and affordability concerns, would further help meet environmental goals, and would allow "efficient companies to go on accessing the capital markets on reasonable terms".

The plans were "welcomed" by the Environment Agency - of the £33 rise in bills, a full £20 is accounted for by environmental improvements. The consumer group WaterVoice said the proposals were "better than expected".

As regards the water operators, Fraser McLaren, an analyst at ING, said: "This is not a walk in the park for the companies but it is a step in the right direction."

That is not to say there were no squeals of pain from the water companies. The German-owned Thames Water got a £2.7bn capital expenditure programme permitted but said it was "very concerned" that this would not allow it to deliver the necessary improvements.

John Sexton, the managing director of Thames Water, said: "The business plan we submitted in April clearly reflected the priorities of our customers and the needs of the environment. The £4bn investment programme we proposed is essential for us to be able to provide an efficient and reliable service going forward - a challenge made all the greater by climate change and the prospect of London's population growing by up to 800,000 by 2016, the equivalent of the population of Leeds moving to the capital."

Whatever the individual companies' situation, the overall £5bn difference between the regulator's and the combined companies' investment plans seems larger than it is. And there is room for an argument between now and the beginning of December.

The regulator and the companies used different assumptions in formulating their plans and a large portion (£900m) of the disparity comes from Ofwat demanding greater efficiency from the water groups. There are about £1bn of capital maintenance projects that Ofwat considered unnecessary. As long as the regulator does not still want to see the benefits that would have flowed from these, it does not really matter to the companies.

Then there are at least £2bn of schemes under the Quality Enhancement category alone that have neither been approved nor rejected. Some or all of these may well get the go-ahead during the five-year period.

These are projects that have not yet been satisfactorily identified or defined by the companies, in the view of the regulator, or would be required to meet new legal obligations that arise during the period. For instance, the forthcoming European Union directives on bathing water quality and the Water Framework Directive "may lead to material work programmes being eligible for inclusion in an interim determination of prices between 2005 and 2010", according to the weighty document put out by Ofwat.

Philip Fletcher, the director-general of Ofwat, said: "We believe we are setting a firm platform with safety values for significant divergence from that platform."

The settlement is front-end loaded, with around half of the increase it will produce in bills coming in the first year. That will mean a 7.6 per cent average increase for household bills from April next year, just ahead of the expected general election. If Ofwat had accepted the companies' proposals, there would have been a politically uncomfortable 13.4 per cent hike next year.

However, by leaving the door open to further projects coming in during the 2005-2010 period, bills could rise much more steeply during this time than the regulator is now allowing. This will become apparent to the consumer only if and when those extra schemes get the go-ahead, and certainly that will happen the other side of the election.

The Environment Agency yesterday picked up on this point and the rather murky procedure to change things after the regulator's final settlement. Its director of environmental protection, Andrew Skinner, said: "It is important that there is a clear process for companies to secure funding for this [further] work and we will be reviewing the 'change protocol' proposed by Ofwat today to see if it meets that need."

The regulator said its determination "left scope for all companies to outperform" and be rewarded for this through an upgraded incentive mechanism.

Ofwat will assume a post-tax cost of capital of 5.1 per cent. While this is at the low end of City expectations, the message here too is that investors can live with it. For instance, ING, the broker, said the overall proposals ought to allow United Utilities to maintain its high dividend payout.

While not a disaster for consumers, environmentalists or companies, each of these groups wants something better and will lobby furiously between now and December.

A one-off scheme that Thames Water and the green lobby will push hard on is the so-called Thames Tideway. This is a £2bn project to tackle the problem of London's Victorian sewage system, which releases raw sewage into the Thames if drains overload (as happened with heavy rain this week).

Ofwat yesterday said this particular scheme required ministerial approval and could not be included in its draft determination.

The Environment Agency said a feasibility study on the subject had just been completed and the regulator's five-year plans were the only mechanism for getting the Tideway built. Expect this and dozens of other concerns to give Mr Fletcher and ministers a headache between now and December.