Rising tide of realism over water pricing

THE OFFICE of Water Regulation will be flooded with work for the next few months as Ian Byatt, the director general, determines the price-capping formulae to apply to the 10 regional water companies from April 1995. This is the most important reappraisal of the industry since privatisation four years ago.

The year-long consultation period that preceded the review came to an end at noon on Thursday, as several companies scrambled to submit strategic business plans and details of proposed capital expenditure.

The review is expected to produce a significant drop in the so-called 'K' factor - the element that, together with the rate of inflation, determines the increases in water and sewerage rates the water companies can levy.

The original K factors were established by the Government in the run-up to privatisation. They were set at what are now considered very generous levels - a sector average of 4.5 per cent in 1994-95 - partly because the Government was determined to float the old water authorities, and partly to fund a massive programme of capital investment. However, industry analysts expect the K factors to fall significantly, as capital expenditure plummets and the impact of soaring prices becomes increasingly clear.

Even as late as last summer, Mr Byatt was talking of the average water bill rising from pounds 190 in 1994-95 to pounds 306 by the end of the decade, after a capital investment programme amounting to pounds 52bn over 10 years. In Paying for Quality he predicted that 'existing obligations' could put pounds 36 on the water bill, while 'possible additions' could push the cost up another pounds 54, putting pounds 90 on the average household bill by 2000.

Alarmed at the prospect of losing droves of voters, the Government waged war in Brussels, where many of the water-quality directives originated, only to be told that these figures were massively inflated - a perspective shared by the National Rivers Authority. At a water industry conference Lord Crickhowell, chairman of the NRA, argued that schemes supported by the authority would cost about pounds 1bn over five years, adding less than pounds 3 to bills.

In fact the latest discussions between the water companies, the regulators and the Department of Environment have resulted in more realistic estimates of future capital expenditure. However, these have been shrouded in confidentiality on the grounds that they are price-sensitive - presumably because of their importance in determining K factors.

In a forthright speech, Lord Crickhowell lashed out at this secrecy, following on from what he clearly believes to be the deliberately alarmist tactics of the industry in exaggerating the potential costs of improving water quality. 'Never again in the course of future reviews can we allow public opinion to be manipulated and then neutered in this way,' he insisted.

The silence has left industry experts in something of a vacuum as they attempt to predict the outcome of a review that will determine the fate of the industry for the next 10 years. Just a few weeks ago Kleinwort Benson was forecasting an average K factor of 2.24 per cent for the next five years and 1.79 per cent for the following five. With annual inflation running at about 3.5 per cent, this would send bills up from pounds 185 in 1994 to pounds 335 by 2005 - an increase of 45 per cent.

However, Graham Moyse of Kleinwort Benson believes K factors may now fall to a sector average of about 1 per cent. 'While the size of the capital expenditure programme remains under review, it is perfectly reasonable to expect to see a reduced K,' he said.

Andrew Wheeler, industry analyst at NatWest Securities, agrees. 'The average K factor is going to be significantly less than 2 per cent and at least two companies will end up with negative K factors,' he predicted. 'We're big bears on the industry, but even so we are buyers,' he added, pointing to dividend cover of three times earnings.

In fact few analysts expect that Mr Byatt will be really tough on the water companies, especially those, like South West Water, with the costly task of cleaning up Britain's coastlines. As Nigel Hawkins, utilities analyst at Hoare Govett, noted, the director general has at least one unused trump card. He has yet to call for cost reductions as a means of controlling both prices and profits. The water companies have not pruned back in the way that other privatised utilities have.

Moreover, Mr Byatt will be reluctant to see interest cover drop to the point where credit ratings fall and borrowing rates rise. As Mr Moyse noted: 'The water companies have been deteriorating financially ever since flotation. They will have gone from cash-positive at flotation to gearing of as much as 80 per cent by 2005.'

All in all, then, it seems unlikely that Mr Byatt will crack the whip too harshly, although the water companies will probably respond in ritual fashion, with protests that he has been tough. It seems equally unlikely that most of them will take any grievances to the Monopolies Commission - one option if they are unhappy with the results of the review. But here politics may again intervene.

Some commentators suspect that Mr Byatt will be toughest on those companies that have a history of inefficiency, and that they may be stung into seeking a reference. Others argue that he cannot afford to be seen as a soft touch. 'Byatt is very aware of his public image, and if none of the companies goes to the Monopolies Commission, the market may see him as too lenient,' one industry observer said.

Whatever he decides, the water companies will be informed of their notional K factors in May, giving them two months in which to horse-trade. The outcome will be announced at the end of July, setting terms for the millennium and beyond. But it will be surprising if the intervening two months do not see the industry spring a few leaks.

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