Water and power may not mix

Welsh multi-utility Hyder could be hit hard by a windfall tax and a tougher regulatory regime

The new breed of multi-utility - where water, electricity, and occasionally gas, are all sold by the same company - will face their sternest test if a Labour government is returned at the next election.

As well as the prospect of a windfall tax, there are mutterings of a tougher regulatory regime. To be at the helm of one utility sounds tough; to have two or three sounds disastrous.

With Tory fortunes at their nadir, is there a case for holding on to shares in such companies, faced as they are by the threat of a windfall tax - and possibly, a tougher regulatory regime? More details of Labour plans may emerge at the annual conference in Blackpool which opens today.

Hyder, the Welsh electricity and water company, which is also dabbling in gas, typifies the pros and cons of this new sub-sector. Formed through the merger of Welsh Water and Swalec, the South Wales Electricity Company, which was concluded in January, the rationale for the deal has had a mixed reception from investors.

But whatever the misgivings, shares in Welsh Water (as was) like most utilities, have enjoyed a tremendous run over the past five years, and have comfortably outperformed the market. Doubts have grown this year, however, with the shares having had a much rougher ride.

Some would urge that now is the time to consider whether Hyder still qualifies as a long-term holding in the investor's portfolio. Fears about a Labour regime returned when, following the company's last results in June, it announced 900 job cuts. Frank Dobson, shadow environment secretary, said that profits and dividends remained "scandalously high", and that they reinforced Labour's case for a "windfall levy on the excessive profits of the water industry".

As a joint utility, the company could be hit doubly hard. Unsurprisingly, finance director Paul Twamley finds it hard to swallow the prospect of a special tax. "Ultimately, a windfall tax is arbitrary, and lacks any equity," he says, pressing for a tax on turnover not profits.

The latest thinking suggests a windfall tax could raise from pounds 3bn to pounds 5bn from water and electricity companies, with the water firms likely to come off slightly less the worse for wear.

Although these are big numbers, utilities will not go out of business. Dr Angela Whelan, of brokers Credit Lyonnais, believes the fears are overdone, that the tax may prove far smaller than anticipated, and that water shares are undervalued.

Such speculation apart, some compelling figures are finally emerging to justify the benefits of the merger. In its last set of yearly figures, the company had identified pounds 100m of savings over the next four years. Of that, emphasises Mr Twamley, pounds 46m was not available to the individual companies before the merger. Overall, cost savings by 2000 will total pounds 275m.

Those savings are the key to such mergers. Utilities have difficulty increasing turnover, and in the case of electricity, are under increasing pressure on margins and sales. Combining the billing departments of electricity and water companies is an obvious move - even though the full benefit, of a single itemised bill for both services, cannot be introduced because of regulatory practice.

The consequence of this is the prospect of an annualised rate of dividend growth of up to 14 per cent through to the next century - a sweetener to offset any levy.

Alongside the threat of a punitive tax, hovers the overweening pre-eminence of the regulators. Given the captive customer base, the only way to ensure a fair deal for the consumer, and a semblance of competition, is through the work of the regulator.

Diversifying the business brings benefits, but also exposes Welsh Water's original shareholders to the action of the electricity regulator, Professor Stephen Littlechild. Electricity regulation is more complicated, partly because of the nature of the market. Hyder has managed to cut a benign deal with Ofwat, the water regulator, but its electricity business may yet face tougher measures.

Nevertheless, cost-cutting is a finite road. Hyder is divesting its stake in unrelated businesses acquired from Swalec, including its 40 per cent stake in CableTel South Wales, worth about pounds 50m or so. After a bit more fine-tuning of this sort, the next quest is for growth outside the core utility businesses. Here the company is keen to play down the theme of diversification, saying any business it ventures into will rely on skills already present in the company.

Among the areas it is plugging away at is transport. Through the consortium UK Highways, it has a contract to upgrade and maintain the M40 as part of the Government's Private Finance Initiative. Last week, it won the mandate to build the Lewisham extension to the Docklands Light Railway extension. Hyder has a 40 per cent stake in the project.

Elsewhere in the world, Hyder Infrastructure Developments has 3000 staff, working on road, rail and port developments in China, Thailand, Kuala Lumpur and Hong Kong. Road deals in the UK are at an early stage.

Hyder is confident it can generate the sorts of returns on these projects that shareholders have grown accustomed to elsewhere in the business. But despite the encouraging signs, Labour remains a dark horse. The shares remain a hold, until current uncertainty is removed.