Outlook: Water companies escape a soaking

HERE'S A fascinating irony. Since Labour came to power in May of last year, committed to curbing the supposed excesses of the "fat cat" water industry, water shares have been among the best performers in the stock market. This has been particularly the case since 17 July, when the onset of the bear market brought the defensive qualities of water and electricity fully into their own. But actually, these shares have been pretty consistent outperformers from the day Labour was elected. Is this a question, then, of Labour's bark being worse than its bite? There may be an element of that.

The windfall profits tax could have been a good deal harder on the water companies than it was, while so far the sort of numbers being talked about for higher environmental spending and lower bills are well within City expectations.

It may be that Ian Byatt, the water regulator, has a nasty shock in store for investors when he publishes his price review next month, but if so, he's keeping it very close to his chest. The 10 per cent one-off reduction suggested yesterday by Michael Meacher, the Environment Minister, was no worse than the City was expecting. Nor were his numbers for extra capital spending. Of the additional pounds 8.5bn announced, only pounds 4bn is real additional spending.

In any case, as far as the City is concerned, the more spending the merrier. Not only are water companies allowed under the conditions of their licences to earn a defined rate of return on all capital spending, but they also have the opportunity to better that rate through efficiency savings. The more spending, then, the less scope there is for reductions in bills and the more there is for enhancing profits.

Water shares suffered a bit yesterday after Mr Meacher's announcement, but this was hardly the sort of stuff to melt confidence in a sector which, set against what's going on in many other industries, seems to be a haven of safety and reliability. So much for "regulatory risk", the catchphrase attached to these stocks before Labour came to power. With the pound and interest rates so high, and the world economy teetering on the brink of recession, industries with regulatory risk seem the place to be.

The risk of oppressive regulation may in any case be something of an illusion. The lesson of British Gas, which famously accused the regulator of the biggest smash and grab raid in history, is that these utilities are capable of taking the very worst the regulator can throw at them and still come up smelling of roses. There is continued and considerable scope for efficiency gains in water companies, and that's before the wave of consolidation and merger activity being planned for this sector in the City.

Mr Byatt is going to have to raid shareholders' capital on a truly heroic scale to stop these companies continuing to deliver the real increases in dividends investors in the water industry have come to expect. He is bound to be harsh, but on past form, he's not going to be that harsh.