The move could reignite a dispute between Ian Byatt, the regulator, and the Environment Agency over how much discretionary environmental investment could be included in the water price regime.
Mr Byatt last week announced plans to make a substantial one-off cut in water bills when the five-year price control starts in 2000, following the lead of the gas and electricity regulators. Bills in the following years would also increase by no more than inflation, compared with the current controversial price formula which allows for above-inflation increases to pay for statutory investment in sewerage treatment schemes.
In soon-to-be-published evidence for the new price review, the Environment Agency will release a shopping list of discretionary improvements, on top of legal obligations, which were left out of the current price formula. The agency said the additional investment could reduce or replace the one-off price cut, a move which could damage Mr Byatt's reputation with consumers.
"Instead of having such a big one-off reduction you could have a better environment with not such a big drop in bills. These are political judgements, but there are a great many environmental improvements which need to be made," said an Environment Agency source.
The demands will form one of the first serious tests of the Government's environmental policy. John Prescott, Deputy Prime Minister, is reviewing the industry's environmental obligations and has suggested a tougher approach to clean-up measures. The price review is a four-sided process involving the regulator, the companies, the Environment Agency and the Government. The Environment Agency source said: "Ian Byatt must take into account the advice of the Secretary of State. He has to take notice of that guidance on environmental measures."
High on the list of improvements would be the Environment Agency's long- standing demand to see better control over sewerage overflows, which discharge effluent into rivers during flooding. Another measure would be to cut the amount of drinking water the companies can legally extract from rivers, a policy which the Environment Agency said had threatened river wildlife.
Similar demands during the previous price review in early 1990s led Lord Crickhowell, former chairman of the Rivers' Authority, the agency's former incarnation, to appeal to the then environment secretary, Michael Howard. At the time Mr Byatt had hoped to curb increases in bills.
The regulator won most of the battle, largely because the improvements which had to be made by law were already so large. European drinking water and bathing water directives added billions of pounds to the companies' investment plans, leaving just pounds 500m for discretionary improvements between 1995 and 2000. Some companies were given no room at all for extra improvements.
Ofwat said there would be some space for additional spending in the next price formula, though figures were still being calculated: "Our objective is to get the one-off cut in bills and a flat profile thereafter. Ultimately this is a decision for the Secretary of State."
Robert Miller-Bakewell, water analyst at NatWest Markets, said the Environment Agency had more chance of persuading Labour than the previous government. His research suggested the water companies could have to make one-off cuts of up to 19 per cent in one case to bring down rates of return to Ofwat's target level of 8 per cent.