Who turns water into money?

Water companies are making huge profits, even as they waste 3.6 billion litres of water a day, and call for drought orders in London. What is to be done? asks Simon Wilson

Are water companies raking it in?

Yes, they are. Profits are surging on the back of price increases. In the northwest of England, one of the country's largest water companies, United Utilities, made a pre-tax profit of £481m in the year to March 21% up on the previous year. But the average United customer faces price rises of 14.3% in the two years to 2007. In the southwest, Pennon, which owns South West Water, saw profits leap 24.6% to £110.9m in the same period. Its customers face even heftier increases in what they pay up an average of 26.1% in the last two financial years.

Who gets all the money?

The industry is renowned for handing out generous payments to shareholders. United Utilities has dished out a phenomenal £5bn to investors since privatisation, while Severn Trent has handed out £2.2bn. Part of the reason for this largesse is that (unlike electricity and gas) water is not a commodity that can be moved around a national network or grid so customers are stuck with their regional supplier. As a result, while the government regulator, Ofwat, sets prices after negotiations with the water firms, the firms have little incentive to keep prices low, and would much rather pass any extra savings they can make onto shareholders.

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But don't they reinvest a lot, too?

Yes, they do. For example, United Utilities invested almost £16m last year in its regulated businesses. That means that the firm has reinvested more than it made in profits for the 16th year running an impressive record. Indeed, since privatisation in 1990, water companies have made collective profits of some £26bn but have invested almost twice that, £50bn, in the decrepit water infrastructure.

Aren't businesses supposed to make profits?

Yes, of course. But the water companies who are in a privileged position as local monopolies regulated by Ofwat face a consumer and political backlash over perceived excessive profits and underperformance at a time of restrictions on using water and even drought orders forbidding non-essential usage. Over the past few weeks, the water groups have revealed record collective profits of £2.5bn, even though they manage to lose and waste 3.6bn litres every day. That's 60 litres for everyone living in the UK. Meanwhile the vast profits made by Thames Water, London's controversial German-owned water supplier, have sparked a torrent of bad publicity for the sector as a whole.

What's so bad about Thames Water?

Thames has imposed a hosepipe ban in London and is pressing for a drought order, yet it has the worst record of any of the water firms for fixing leaks missing its mandatory reduction target for the fourth year running. Ofwat has blamed Thames for worsening the effects of the present drought, and the company faces a fine of up to £140m for wasting 900 million litres a day enough to fill 350 Olympic swimming pools. But this month it announced a 31% profit rise to £346m, and a £276m dividend payment to its German owner. Utilities giant RWE bought Thames in 2000 for £4.7bn and is looking to sell or float the business at a big profit raising worries over the wisdom of allowing foreign businesses to own essential utilities.

What are the prospects for investors in the sector?

Mixed. In recent years, water companies have been highly attractive to financial and institutional investors: they are stable, high-yield businesses (United Utilities offers an impressive 6.5%) where profits are predictable as a result of long-term agreements with the regulator. (Recent profit announcements were all in line with City expectations.) But that sense of security may be about to change. Water companies began to see their share prices rise in early 2004, when Ofwat started sending encouraging signs over its 2005-2010 pricing policy. Since then, the political climate has changed. As the drought in the southeast of England gains ever more attention, and consumers feel the effects of price rises, Ofwat will be under government pressure to take a tougher line. In autumn 2007, negotiations for the next round of price settlements will start in earnest, introducing a significant risk factor into the companies' valuations.

YES

1. Where consumers do not have a choice of supplier, the benefits of competition are bogus: natural monopolies should be in state or municipal control even Victorian capitalists realised that.

2. Private monopolies have sucked £26bn out of the system in shareholder dividends while customers face higher prices and drought orders.

3. Britain faces a growing water crisis. It needs a national strategy for dealing with it that puts the public interest before profit.

NO

1. The rate of investment since privatisation is nearly twice as high as under public ownership more than £50bn since 1990 and water quality has greatly improved.

2. Profit-making firms make this excellent record possible, since it is profits that attract people to invest.

3. The average household bill is £295, or 81p a day good value for something that makes life possible. Price rises have been slower than they would have been under public ownership.

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If you would like to know more about investing in this sector, find out which water companies you should invest in and how to profit from the world's water crisis.