Michael Meacher, the environment minister, suggested there was scope for a one-off cut in water charges of 10 per cent when the new five-year pricing formula is introduced from 2000.
Shares across the sector fell by more than 3 per cent as the City took fright that the twin squeeze of higher environmental costs and lower prices might be worse than feared. Anglian closed 29p down at 883p, while Severn Trent ended 41p lower at 1062p and Hyder, owner of Welsh Water, lost 41p to 938.5p.
Robert Miller-Bakewell, water analyst for Merrill Lynch Global Securities, said: "This is an overdue reminder that there is a regulatory review in the background and that water is not just a steady utility stock that you can turn to when the market is turbulent."
The pounds 8.5bn figure is pounds 4bn more than the water industry has already budgeted to spend between 2000 and 2005 improving drinking water and bathing water standards and cleaning up rivers and coastal sewage discharges.
Another analyst said the Government was trying to face both ways, by emphasising its green agenda at the same time as demanding big price reductions. He added that although the pounds 8.5bn figure was large, a lot would depend on how it was spread among the water companies and how much the water regulator, Ian Byatt, allowed to be passed on to customers.
Andrew Stone of Daiwa Europe said: "You are seeing the political context which is always likely to be pro-consumer. Now we have to convert the political into the economic and that is up to Ofwat [the water regulator]."
Mr Byatt will unveil his initial proposals on water bills next month when he publishes "Prospects for Prices".
However, final price limits for each water company will not be set until November next year. The new price controls take effect from April, 2000.
Water charges have risen by 36 per cent in real terms since the industry was privatised in 1989. The average bill now stands at pounds 245.