The fine line we walk on water

Without high prices and high profits, would investment go down the drain?

There's plenty to talk about. The industry is in the doghouse again, vilified by the public, press and consumer groups alike. Every day 3.6 billion litres of water are wasted in the UK because of leaks, but against this background three companies in the South-east have been given permission by the Government to impose drought orders on their customers, which would forbid them from washing cars or watering sports grounds. And three more companies - including Thames Water, the biggest leaker of them all - have put in place hosepipe bans. The trade association Water UK has warned that the South-east is close to a drought so severe that it could be expected to occur only once in a century.

And all the while, the profits continue to flood in. Last week AWG (the owner of Anglian Water), United Utilities (which owns North West Water) and Pennon (South West Water) reported that group profits had risen on average by a quarter, helped by higher customer bills. And later this week, Northumbrian Water and Severn Trent are expected to report healthy results as well.

The industry's critics - and many customers - are asking how these privatised companies can be allowed to leak so much water and then claim a drought is on the way, or to increase their charges, and then rake in millions of pounds of profits. And this is supposedly the most tightly regulated industry in the UK. So why did Mr Miliband let the water companies off so lightly - and could they do more?

For all the mud being thrown, no one is suggesting that the industry be renationalised. Since privatisation in 1989, the rate of investment in the pipes, reservoirs and treatment works has almost doubled. Some £50bn has been pumped in, yet prices have risen by less than half in real terms, while other utility bills soar. Under public ownership, the companies were inefficient and badly managed.

Every five years Ofwat, the industry regulator, sets the prices that water companies are allowed to charge. It also allocates spending levels on maintenance, operation and security of supply - the building of new reservoirs, for example. If the companies also manage to exceed the savings targets set by Ofwat, shareholders keep the money until the next price review, when the savings are returned to customers in the form of lower bills.

The regulator treads a fine line between setting prices too low, which will damage investment and profits, and allowing companies to make too much money at the expense of customers. In the 1999 price review, analysts say Ofwat crossed that line in clamping down on charges. The share prices of most companies halved, making it harder to raise funding for investment. As Joe Mangion, managing director of Ecofin, a utility and infrastructure investment fund, says: "The price review in 1999 was nasty for the companies, and the equity markets shunned the water sector."

While the debate now is about whether the regime has become too lax, the regulator said in the last review, covering the period 2004-05 to 2009-10, that companies could make a return on their assets of 5.1 per cent. So for every £100 put in, investors can expect to get back £105.10 - barely more than the return from a high- street savings account.

As Doug King, the senior partner in the utilities team at accountants Deloitte, points out: "There is a lot of ignorance about the water sector and bills. If you put £6bn into a water company, you expect a return. And the majority of listed water companies' shareholders are pension funds, so it's in people's interests that they do well."

But there is no law against exceeding these returns - which the water firms normally do - provided they fulfil other obligations on investment and prices. The question is what these companies do with the extra money they are making. Do they return it to shareholders, to customers or, as the regulator hopes, save it for future investment?

The Consumer Council for Water reckons that households are not seeing enough of the benefits of privatisation. Last week, in the wake of a 25 per cent rise in profits, Pennon said it had paid a £20 one-off bonus to customers at a cost to the company of £14.5m. Yet shareholders received a windfall of £200m.

These payouts to households are little more than tokenism. With electricity and gas, people can switch to any supplier in the country to get a better deal. With water, they are stuck with their local supplier because this is not a commodity that can be moved around a national network or grid. So while the regulator sets the prices, companies have much more of an incentive to return any extra savings to shareholders, rather than customers.

Ofwat also sets targets on leaks. In 2004-05 Thames Water wasted 915 million litres every day because it owns some of the oldest (in many cases, Victorian) pipes in the country. In some parts of London, almost half the water being supplied to households is lost along the way.

But this wastage is only 10 million litres per day above the target set by Ofwat. Indeed, the targets have actually become more generous over the past five years. In 2000-01, Thames Water lost on average of 688 million litres per day. Because of the cold winter that year, cracks in the pipes - and the leakage levels - increased.

It would cost tens of billions of pounds to replace the UK's ageing pipes, so instead the regulator sets the leakage targets at an economic level - the point at which it would cost less to replace the pipes than the water being lost.

Chris Jones, the finance director of Welsh Water, points out: "If you wanted to restrict water shortages to a one-in-1,000-year occurrence, you could do it, but water bills would have to mushroom to pay for it."

So there's no easy fix. But companies - with the help of Mr Miliband and the regulator - could do much more to encourage customers to use less water. Under a third of the population have water meters, which reduce demand as customers pay for what they use. Companies are obliged to install them on request, but it is expensive both to fit them and send people round to take readings. Smart meters, which can be read remotely, need to be developed.

The construction of new reservoirs, particularly in the South, is also on the agenda. But issues such as planning and the cost of buying the land will need to be overcome before companies are able to build them. And in the end, all this will take many years and cost billions of pounds - meaning higher water bills for all.

The rulers of our reservoirs and the profits they pump out

United Utilities

A multi-utility business which was formed from the merger of North West Water and electricity company Norweb in November 1995, and floated in 1996. The UK water business serves seven million customers. The turnover at the water division in 2004-05 was £1.1bn, with an operating profit of £363m.

Thames Water

The German multi-utility group RWE, which is now looking to sell Thames Water, acquired the business in 2000. Thames Water has around 13 million customers. Its turnover in 2004-05 was £1.1bn, its operating profit £300m.

Severn Trent Water

A subsidiary of Severn Trent, which has operations in the UK, continental Europe and the US. Listed since 1989, it also owns the waste-management business Biffa. The company has three million water customers and turned over £991m in 2004-05. Its operating profit was £277m.

Anglian Water

Anglian Water went public in 1989 following privatisation, and changed its name to AWG in 2000. It serves around six million customers. Its turnover in 2004-05 was £790m, with an operating profit of £241m.

Yorkshire Water

A subsidiary of Kelda, which was created and floated in 1999. The group has 4.7 million customers. Water services turnover in 2004-05 was £640m, with an operating profit of £216m.

Northumbrian Water

Bought by French utility Lyonnaise des Eaux in 1995, which was then acquired by industrial services group Suez in 2000, Northumbrian Water was floated in 2003 after being sold to a private equity consortium. It has 4.3 million customers and turned over £488m in 2004-05, with an operating profit of £142m.

Southern Water

Now owned by private equity firm Southern Water Capital, the company has been held by a succession of private equity consortia since Scottish Power sold it in 2002. It supplies water to 2.3 million customers. Turnover in 2004-05 was £468m and the operating profit was £128m.

Dwr Cymru (Welsh Water)

The company has been owned since 2001 by Glas Cymru, a single- purpose not-for-profit company. It has around 1.2 million customers in Wales and parts of England. Turnover in 2004-05 was £486m, with an operating profit of £125m.

Jill Ferguson