Ofwat will next year set new price controls that will come into effect in April 1995. Companies would in future have to pay for improved services and higher dividends by increasing efficiency, Ian Byatt, the director-general of Ofwat, said.
He warned: 'During the next 10 years I will expect the companies to provide their existing standards of service at prices below today's level in real terms. Shareholders will get their rewards if the companies continue to improve efficiency.'
He added that the companies were now less risky than when privatised and no longer needed the high rates of return assumed when the original price limits were set.
Publishing his long-awaited document on the framework for setting the new price controls, he said: 'Maintaining the viability of the companies does not require the same expectation of profit as was necessary to float them.'
Mr Byatt said some increases in prices would be necessary to meet new quality and environmental obligations, but these should be limited to levels customers could afford. Prices had been going up at 5 per cent a year above inflation and 'the escalator should be stopped'.
In setting new price control formulae, Mr Byatt will assume a rate of return on new investments of around 5 per cent after tax compared with up to 10 per cent, for which the companies have argued.
The Monopolies and Mergers Commission has recommended a rate of return for British Gas of 6.5 to 7.5 per cent. However, Mr Byatt said that water companies carried less risk than gas.
He said the figures in the price controls would vary according to the circumstances of each company. Some, for example, have more onerous environmental problems, while others using extensive water metering have a bigger business risk than those charging a flat rate.
Mr Byatt intends to clamp down on discretionary spending by companies for quality improvements beyond their obligations. He said assets should be maintained but did not need to be 'gold plated'.
He is also concerned about the wide range of charges around the country for connecting new customers to water services, which can vary from about pounds 200 to pounds 1,000. Connections for water and sewage service will be limited to pounds 200 for each service under the new price regime, although the new charges may be phased in over time.
Analysts said the effect on companies was broadly neutral and the new rate-of-return figure, while lower than expected, was not far from City expectations. One said the effect on core water businesses - most water firms have diversified - might be to flatten profits, but they had scope for increasing dividends by reducing cover.
Water company shares fell despite a positive reaction from the industry. Severn Trent said the document was useful in setting a framework and there appeared to be considerable flexibility.
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