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Last Updated: Wednesday, 7 June 2006, 12:44 GMT 13:44 UK
Are water profits flowing too freely?
By Toby Poston
Business reporter, BBC News

Flashing light on top of water company van
Water companies have announced big profits in recent weeks

Summertime, and for many the watering isn't easy.

An estimated 13 million people in south-east England have been hit with water use restrictions, ranging from hosepipe bans to prohibitions on car washing and window cleaning.

Water companies and the government say that 19 months of below-average rainfall are to blame.

At the same time, statistics reveal that the water industry in England and Wales loses about 3.5 billion litres of water through broken and leaky pipes each day.

Meanwhile, households saw their water and sewerage bills rise by an average of 5.5% last April - well above inflation.

It is clear to see why many customers and consumer groups are up in arms at the performance of water companies.

Profits flowing

For investors, it has been a different story.

Recent days have produced bumper profits for a string of UK water companies.

Severn Trent announced that higher bills and cost-cutting had delivered an 18% rise in yearly profits to 270m ($507m).

United Utilities, which supplies customers in the north-west, reported a 21% increase in profits to 481m, while utility group Pennon - serving the south-west - saw profits rise 25% to 111m.

Anglian Water owner AWG recently announced that annual profits had trebled to 109m.

The current reporting season, one city analyst has predicted, could produce profits for the sector as a whole of 2bn.

Is it right that water companies can be generating such big profits while millions of customers are getting restricted supplies?

Privatisation

For perspective, it is important to understand that the UK water industry operates in a rather peculiar way.

Most of the industry in England and Wales was privatised in 1989, when regional monopolies were introduced under the regulation of industry watchdog Ofwat.

Among its powers, Ofwat controls the maximum price at which water companies can sell their water.

Every five years it conducts a "Periodic Review". After looking at business plans and investment requirements, it sets an annual price limit which is meant to allow enough revenue for operations, investment - and a profit.

If water companies exceed Ofwat's efficiency targets, the idea is that the extra money eventually comes back to customers in the form of lower prices when the next review comes around.

Big borrowings

The water industry likes pointing out that, for every 2 earned in profit, 3 is invested into improving services.

Water companies have invested more than 50bn in pipes, reservoirs and water treatment works since privatisation.

But this money has had to be borrowed - and to get a good rate from lenders the companies need their books to look good.

Bondholders, banks and investors all want to see that the water utilities are secure businesses which will offer them a solid return on their money.

Hosepipe
Hose pipe bans are already affecting households

The regular cycle of Ofwat reviews is a bonus here, allowing them to make a reliable estimate of company profits for five years at a time.

The yo-yo effect

However, the five-year reviews have had something of a yo-yo effect.

Following what was seen as a rather friendly review for the 1995-2000 period, Ofwat clamped down on charges in its review for 2000-2005.

As a result, investors deserted the sector. With share prices halving during the period, it became harder for the water firms to raise money for investment.

Once markets got the first indications that the 2005 review would be a return to generosity, the shares headed back up.

"We would like to get a more sustainable footing for setting price limits," says Janet Wright, economic regulation advisor for Water UK, which represents water companies.

"The yo-yo effect is not good for customers or investors,"

AVERAGE PRICE LIMITS SINCE WATER PRIVATISATION
1990 to 1995 - 5% above inflation
1995 to 2000 - 1% above inflation
2000 to 2005 - Fall of about 2%
2005 to 2010 - 4.2% above inflation
Price limits: Every five years Ofwat reviews water companies' business plans before setting an annual price limit for each company for the next five years.

Ofwat's 2005-2010 review set price limits that allowed water companies to raise prices by an average of up to 4.2% a year on top of inflation - meaning that the average household bill would rise by 46, or 18%, to 295 during the period.

It also said that companies could make a return on their assets of 5.1%, meaning that for every 100 investors put in, they could expect to get 105.10 back.

That is not a great return, but in line with many other investments perceived as low-risk.

Consumer complaints

The healthy profits announced by water companies in recent weeks have left many consumers complaining that bills have been allowed to rise too much.

Many find it hard to understand why they should be paying more for water when some areas are actually experiencing supply problems.

A recent poll for ITV News found that 79% of customers thought water company profits were too high.

"With prices going up and companies reporting strong profits, we will ask for reassurance on consumer's behalf whether prices have been allowed to rise too much, and whether they are getting what they paid for," says Dame Yve Buckland, chair of the Consumer Council for Water.

But analysts point out that this year's bumper profits won't be repeated during the rest of the 2005-2010 review period.

They say Ofwat has allowed water firms to ramp up prices this year in order to recover some of the costs they were hit with during the tough 2000-2005 review period.

"This is a cost recovery year for them, and it is just unfortunate that this has coincided with some smaller companies obtaining drought orders," says Verity Mitchell, an analyst with HSBC bank.

That may be good news for the water companies - but it is certainly cold comfort to someone whose hanging baskets are wilting in the heat.


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