View from City Road: Dangerous current for water companies

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Do not be lulled into a false sense of security about water company shares just because they have outperformed the stock market by 11 per cent since the start of the year.

Strong dividend covers and good yields approaching 5 per cent on average have proved to be useful attractions at a time when interest rates have tumbled, the jury remains out on the true pace of recovery in the UK economy and the Budget, at a stroke, has lowered effective yields relative to bonds.

But these positive points ought not to divert attention from the problems the companies face in meeting their Brussels-inspired obligations on the environment and water quality. The bill, which as things stand will have to be paid by customers, is an investment programme totalling almost pounds 30bn.

For shareholders the problem is that the water companies are caught between the obligation to meet legal standards on water and sewage on the one hand and the understandable concerns of Ofwat, the supposed consumer watchdog, that bills are rising well ahead of inflation and are likely to do so for the foreseeable future.

Ian Byatt, the director-general of Ofwat, will have to weigh carefully the pressures on the sector when he finally sets new price control formulae to take effect in April 1995.

In the water companies' favour, Mr Byatt fully sympathises with the enormous problem of achieving EC standards and has himself questioned whether the obligations are always justified.

However the risk is that - assuming the massive cost cannot be avoided - he will at some stage rule it unfair that customers will have to continue to foot the environmental bill. He may decide that more of the burden of funding investment spending will have to be shouldered by shareholders. Something will have to give in those circumstances and it is likely to be future dividend growth.

At the moment the water companies are furiously canvassing customers for their views - as bills continue to soar, who is willing to pay, and for what? By the end of this month market plans will have been presented to most customers outlining options for differing prices and levels and quality of service.

The key to the problem for the regulator, water companies and their shareholders may well be to get ministers to take on board the gravity of the problem and to act irrespective of the wrath of Brussels.

There is a growing band of sceptics saying that some of the planned improvements in water quality are unnecessary, unwanted by a large number of consumers and not justified in scientific terms.

If the Government were to accept at least some of this case, customers and water company shares alike would breathe a sigh of relief.