Water firms fear profits will go down the drain

It comes out of your tap or washes through your loo. You get a bill every half year, and you have to pay for it before you use it. Water might seem the most simple commodity in the world, but 12 years after privatisation, the companies that own it in England and Wales are flummoxed. Few, if any, want to be in the business – the regulated delivery of water and sewerage services to homes. Sure they might want to manage it, but owning it is another matter.

The City has never quite got to grips with water companies. They are heavily regulated and on the whole haven't been allowed to restructure in a more City-friendly way. Attempts by the likes of Kelda (né Yorkshire Water) and AWG (formerly Anglian Water) to hive off their old regulated businesses into separate ones owned by the customer have been blocked by the regulator. The industry shows no growth and little prospect of growth, with another price review and some European Union anti-pollution rules about to make life worse.

As a result, most water companies are trading below their asset value – a clear stock market vote of no-confidence.

Crunch time is now looming. Water UK, the body representing the privatised English and Welsh water firms, believes that regulation has to be radically altered to ensure companies have full access to the debt and equity markets. "The pres-ent system isn't sustainable," says a spokes- man. "We are not arguing for a regulatory free-for-all, but the companies need to gain more confidence from the City."

Water UK says there is a "vacuum at the centre of government policy" and ministers need to map out longer-term policies for the industry – over and above the dreaded five-yearly price reviews.

Conducted by water regulator Ofwat, the reviews impose limits on the price charged to customers. The last review, in 1999, required companies to cut the average bill by 12 per cent. The 2004 review will start next year, and the industry is not optimistic about avoiding further reductions. Water firms such as Kelda believe any cuts will make it more expensive to raise debt finance and so harder to invest in the water infrastructure.

That's not the view of Ofwat head Philip Fletcher, who has argued that the companies, operating in a monopoly, still have efficiency improvements to make. But the regulator – whose role it is to ensure the companies deliver services but also that they can pay for them – does offer some leeway. At the request of three water businesses, including South West Water, Ofwat is completing an interim pricing review for publication early next month. It is expected to relax (very slightly) price controls on the three to take into account the cost of water metering, introduced after the 1999 review.

If a forthcoming EU Water Framework directive – requiring companies to clean up river basins – becomes law, Ofwat may conduct another review to take account of the extra burden on the industry.

The directive proposes that companies clean rivers so they are returned to their natural state. Critics say the plan is unworkable – what is the natural state of the Ruhr or the Mersey (where salmon were caught last month for the first time in living memory)? The cost to the UK water industry will run into billions, and ultimately the consumer will pay.

In the longer term, the Government is expected to introduce changes to the structure of the industry which could make it more attractive to the City. The changes will be proposed in a water Bill, due to be published in November 2002.

But more immediately, the Department for the Environment, Food and Rural Affairs is finishing a consultation paper on competition in the industry, expected to be published in January. Well-placed sources say it will encourage the creation of retail-only water companies. This may prompt the likes of Virgin and Centrica to enter the market.

At the moment their creation is forbidden. Earlier this year AWG planned to split into two by demerging its regulated business from retail. But Ofwat made it clear that under the existing licence agreements, this could not happen.

The creation of Glas Cymru, the debt-financed Welsh group, is to date the only deviation from the traditional equity-based water company model. It was born after the purchase of Welsh Water's parent company, Hyder, by a US group with no interest in the water business. It is a company limited by guarantee, financed by £1.9bn of bonds raised from the City. It does not have conventional shareholders and any excess profit is returned to customers. Finance director Chris Jones says it is on target with its plans to pay £23m to customers by 2005.

The structure was similar to a proposal to spin off Yorkshire Water from Kelda, which was blocked by the regulator. Many in the industry believe Ofwat backed Glas because of special circumstances: the company was on its knees.

Although Glas is the model for the Government's proposals for Railtrack, most believe it is a one-off.

A spokesman for Ofwat says: "The equity model is working well and has created efficiencies. Our message to companies is that if you want to change your business model then you have to put up very good reasons why."

Mr Jones argues that Glas works because it takes shareholders out of the equation, leaving "stakeholders" with an alignment of interests. "If we improve our credit quality by running a stable, efficient business, then the bond market rewards us with a cheaper cost of capital. This means we can cut bills."

That the regulator has not allowed a Glas Cymru II is because of who has been proposing it: the water companies themselves. But a chance to create a new, debt-financed business may come shortly when the financially strapped Enron puts Wessex Water up for sale. The potential buyers are mostly financial firms, such as WestLB, but another company limited by guarantee cannot be ruled out.

It is the nearest thing you get these days to a renationalisation.