How much do utilities have left in the tank?

Australian bank Macquarie had just bought Thames Water for a mouth-watering £8bn. A banker involved in the deal - one of the City's most senior mergers and acquisitions specialists - was drinking champagne at a City reception, basking in the afterglow of the deal. A fellow guest asked if he was worried that, as part of Ofwat's next pricing review in 2009, water regulator Philip Fletcher would cut what Thames is allowed to charge its customers.

The banker's answer came quick as a flash, reflecting the view of dozens of other money men who are stalking the rapidly dwindling ranks of publicly quoted UK utilities. "If he [Mr Fletcher] was good, he wouldn't be a regulator," he scoffed. "People like Macquarie know what they're doing - they're smart. What can he do about it?"

But the banker's confidence in the ability of the City's deal makers to make such highly valued bids work could be misplaced. Uncomfortable questions are now starting to be asked about the prices that are being paid, with some analysts publicly raising the spectre of an asset price bubble.

Adding to the heat in the sector, another utility company, ScottishPower, looks set to be taken over imminently (in this case a trade buyer, Spain's Iberdrola, is leading the bid). The expected offer price, 800p, compares with the unsuccessful 570p-per-share bid made by German rival E.ON a year ago. That looks miserly now.

ScottishPower's chances of attracting a top-dollar offer were helped by last week's results, which showed a staggering 77 per cent jump in first-half profits. Its rival, Scottish & Southern Energy, also posted a 35 per cent rise last week.

Anglian Water's owner, AWG, was bought last month by a private equity consortium for £2.25bn - 60 per cent higher than its market value a year ago. And Viridian, the Northern Ireland electricity group, has been taken out at a similarly high level by the Bahrain-based investment fund Arcapita. Overall, utility shares have grown twice as quickly as the FTSE over the past year.

So why is everyone piling into UK utilities - and are these prices sustainable?

Vincent Gilles, the head of European utilities and co-head of global infrastructure at investment bank UBS, estimates that globally there is $1.3 trillion (£700bn) of debt and equity finance available to be invested in infrastructure assets over the next few years. Much of this capital comes from pension funds that are catering for ageing populations and need new outlets for their money as low global interest rates depress the return from traditional safe-haven investments. In 2004, for example, the yield on UK government securities was around 2 per cent above inflation. Now, investors are getting a return of only 1 per cent over inflation (which currently stands at 3.7 per cent).

By contrast, analysts estimate that Macquarie will make an annual return of 10 per cent on Thames Water between now and the next price review in 2009. Most investors believe a 10 per cent guaranteed return for three years, even if this figure is cut by the regulator after 2009, looks a better bet than one of around 5 per cent on a government security over 20 years.

Richard Marwood, a fund manager at Axa, which holds over 2 per cent of ScottishPower, agrees: "The shift in yields for long- term investments such as bonds has had a dramatic impact on the prices being paid for utility companies. Under the current conditions, these valuations make sense."

Mr Gilles from UBS admits there is uncertainty over whether the prices are sustainable: "It's hard to prove there is an asset bubble at the moment. No one will know if buyers have been overpaying for utility assets until they are flipped or sold on."

While it is true that private equity and infrastructure funds are awash with capital looking for safe homes, which regulated monopoly assets like water seem to provide, there are different investment aims among these buyers. For example, private equity usually looks to sell on an acquisition in five years, while infrastructure and pension funds tend to look at investments over 20 years and beyond.

And utility companies are not uniform, and neither are their assets. ScottishPower, for example, is making most money from its power stations, which aren't monopoly businesses. As a result, the plants sell power at a market rate - not one set by the regulators. Profits may be high now, but there is no guarantee they will remain so.

By contrast, water companies are more attractive for infrastructure and pension funds because their prices are set in stone every five years. In reaching this decision, the regulator estimates the company's costs over the same period, and chief among these is the expense of raising debt for huge upfront investments in pipes and facilities.

Under the current price review, set in 2004, Mr Fletcher set the real cost of debt at 4.3 per cent. But in fact, borrowing costs are much lower, allowing companies to cash in. For example, United Utilities, owner of North West Water, has raised £1bn of long-term bonds at a real cost of between 1.3 and 2 per cent over the past year.

That's unlikely to last beyond 2009. Regina Finn, Ofwat's chief executive, admits that lower borrowing costs than those anticipated by the regulator is one reason water shares are so valuable. "We will be reviewing it at the next price review," she says.

The regulator has already told the industry that it plans to lower the allowed returns, so this should not come as a surprise to the likes of Macquarie and AWG's new owners. The question is how tough the regulator will be next time. It is ultimately educated guesswork, and buyers are taking punts based on astonishingly different visions of the future. The £8bn that Macquarie shelled out for Thames Water, for example, was £1.6bn more than rival bidder Terra Firma was prepared to pay, says one banker involved in the deal. "They have all got something factored into their models; the question is whether it is enough."

Angelos Anastasiou, an analyst at Evolution Securities, says buyers of utility companies should remember the lessons of the recent past. The 1994 price reviews for water and regional electricity companies were generous, encouraging a series of takeovers. But the next review in 1999 was less favourable. "The new owners of these companies did not seem to anticipate that this would happen," he says. "For some years, water companies traded at below their regulated asset-base valuations. The same pattern could be repeated now."

If he is right, and we are seeing a price bubble, it will be today's sellers of utility groups that are the chief beneficiaries. Buyers should beware that Ofwat and energy regulator Ofgem might tighten the screws.