Price drought on the way

Regulated utilities are under the cosh, as British Gas again showed in spades last week. Any lingering doubts about regulatory power were shattered as Clare Spottiswoode, director of supply for gas, proposed a far tougher pricing review than had been anticipated. To compound the agony, British Gas then delivered worse than expected interim results.

Shares in water companies, by contrast, seem on the face of it to have been a haven of tranquillity. Of course, there has been the outcry over fat-cat pay awards. And water companies likewise seem to be especially adept at public gaffes, the most spectacular one recently - after the Yorkshire Water debacle - being Severn Trent's advice that customers save water by paving over their lawns.

Even so, investors who bought shares in the sector at the time of privatisation in 1989 have enjoyed handsome returns in most cases. They have also avoided the turbulence that has dogged gas, electricity and British Telecom.

Over the past month however, water utilities have started to succumb to the fears hitting their utility peers. A basket of water shares has fallen some 8 per cent against the market in the period, with the decline accelerating rapidly last week. Over the past year, water shares have underperformed the market.

The question troubling investors is whether the sector remains value for money, or whether it is poised on the brink of a regulatory backlash. Concern grew on Thursday when the office of the water regulator, Ofwat, published its review of water tariffs. What went unremarked was the news it would review the "tariff basket". Ian Byatt, the director of Ofwat, said: "This review will consider the extent to which the current tariff basket is justified."

Ofwat hopes to publish a consultation document in July. Most analysts hope the changes will be minimal, but Mr Byatt's words may mean the opposite.

The review, he said, would also look at whether competition for larger customers meant their charges could be removed from the tariff basket.

Technical stuff, but fundamental. The tariff basket breaks down the different services a water company provides: unmetered water, metered water, sewerage and industrial effluent disposal.

Ofwat fears that some customers, for example domestic consumers, are being unduly discriminated against, and are cross-subsidising other businesses which are more open to competition, such as supplying industrial water consumers.

Water is the only utility sector to have a price control running at above the rate of inflation: RPI + K. The formula allows companies to increase their charges at or ahead of inflation, to compensate them for the capital expenditure burden the industry must shoulder - much of which is to bring it into line with European standards.

Water companies can charge different rates for different services. They are permitted to charge customers of one service more than RPI + K, provided that is rebalanced by a lower charge to others, to bring the rates in line with RPI + K.

The real threat to the water firms, therefore, is that Mr Byatt will decide that customers being charged too much have their bills cut , while water companies cannot raise their rates to industrial customers.

Ofwat itself admits that introducing competition into the industry is a difficult task.

But the risk is more clearly spelled out now than at any time in the past. It seems a regulatory tide is lapping around the ankles of the water companies. Labour has also entered the fray, with promises of tough penalties if consumers suffer supply interruptions as well as a windfall profits tax. The threats may not be as harsh, or contradictory, as those meted out so far by Labour, Tories and regulators to the other utilities, but they are still real.

Like electricity, valuations in the sector are not based on yields alone. There is a certain amount of takeover froth. Northumbrian Water is under the control of French water concern Lyonnaise des Eaux; South West Water is the subject of bids from Wessex and Severn Trent, now under the Monopolies and Mergers Commission.

Water bids are more difficult, however, and mean cuts in charges imposed by regulators. The companies also have less cash flow to gear themselves up and pay huge special dividends.

The recent price decline should be taken as a warning to investors of more to come. A likely incoming Labour government, and tougher regulation by Ofwat, suggests the sector will underperform the market. With the exception of obvious takeover candidates such as South West Water, the sector is a sell.

Company Price Current Gross yield

(pence) p/e

Anglian Water 543 8.1 5.6%

Hyder 708 7.6 5.5%

Severn Trent 566 7.4 6.0%

South West Water 660 9.3 5.0%

Southern Water 684 10.0 4.2%

Thames Water 558 8.1 5.5%

United Utilities 574 8.4 5.2%

Wessex Water 312 8.7 4.9%

Yorkshire Water 635 7.7 5.1%