Rarely can a sector’s full-year reporting season have faced such an inauspicious start as that which awaits Britain’s quoted water companies next week.

All four of its constituents are set to file figures to the City, starting with United Utilities on Tuesday, and between them they are expected to report pretax profits of more than £1 billion.

However, that achievement is in danger of being overshadowed by events at the Old Bailey on Monday, when Severn Trent is due to be sentenced after pleading guilty to two charges brought by the Serious Fraud Office that it provided false data on leakages to Ofwat, the water industry regulator. Together with the £36 million fine already annnounced by Ofwat – the biggest penalty it has imposed to date – the repayment of the amount Severn Trent overcharged its customers, and an expected additional fine, the affair is forecast to cost the Birmingham-based company up to £125 million.

However, for the thousands of retail investors still holding privatisation shares from the late 1980s, the explanation for the UK water sector’s recent underperformance – share prices are down up to 8 per cent in nominal terms since the start of the year – lies not with Severn’s legal embarrassment but in events elsewhere. Most notably, the onset of the credit crunch means that the takeover premium that has buoyed the sector over the past two years is now steadily ebbing away.

In that time, no fewer than seven water companies were bought out (all but one of them, Bristol Water, by financial buyers), with the biggest deals and the highest premiums – those agreed for Southern Water and Kelda – falling in the last few months of last year. Although the attraction of predictable regulated returns, stable cashflows and a strenghtening asset base has not lessened, the availability of leveraged debt for the infrastructure and pension funds that were pursuing these deals has lessened, however.

If there is another reason why there are fewer likely buyers around, it is also linked to the other cause of the sector’s recent underperformance: this year’s start of the drawn-out regulatory review process, under which Ofwat will determine the returns that water companies will be allowed to make in the five years starting in 2010.

That procedure always creates uncertainty – the final outcome will not be known until November 2009 – but there are two particular concerns this time around. First, Ofwat has indicated that it is seeking to lower the level of the allowed returns for the first time in nearly a decade. Most estimates suggest that these will be struck at about 4.5 per cent, against 5.1 per cent currently. Second, Ofwat has said that a water company’s level of gearing remains a crucial consideration – with those companies with the highest gearing likely to receive the least favourable pricing settlement.

Here, Northumbrian Water, whose shares have been the worst performer this year, has proportionally more debt than its peers. It is also the only one of the four that is not expected to return capital to shareholders before 2010: United Utilties will hand out £1.5 billion, or 170p a share, in August following last year’s sale of its electricity business.

However, a lack of expected M&A activity and regulatory jitters are not the whole story. Water companies are commonly valued as proxies for government bonds, with their regulated assets and allowed returns serving as the principal and the coupon respectively. So with government bond yields having risen in recent months in line with rising inflation expectations, water company valuations have also come under pressure.

Then there are worries over the rising price of power, of which water utilities are heavy consumers. Most of a company’s requirements are covered by forward purchasing agreements, but with one-year forward prices having more than doubled over the past year, profits in the next two financial years could feel the strain. Finally, the steady shift towards water metering also carries a risk. If a customer’s use of water is significantly less than that forecast, the company’s revenues and return on capital will fall accordingly. Here, Pennon, the owner of South West Water, is notable for having the highest proportion of metered customers.

So what of the near-term outlook for water stocks? Next week’s numbers are unlikely to disappoint, and in some cases could even trigger upgrades to profit forecasts. Credit Suisse thinks that Pennon’s Viridor waste management business is faring especially well thanks to contract wins and increasing recycling activity. Coincidentally, next week should also bring the announcement of the final terms of the £3 billion 25-year Greater Manchester waste contract, Britain’s biggest waste-disposal deal, a joint venture between Pennon and John Laing.

Nor should the prospect of bid activity be wholly dismissed. The real yield on bonds remains low (making water companies tempting in relative terms), while infrastructure funds remain awash with capital, if not credit. Only this month, a fund backed by Morgan Stanley and Global Infrastructure Partners raised $10 billion. That suggests that, with profits secure for now, and dividend yields (with the exception of Pennon) in excess of 4 per cent, there are worse corners of the stock market in which to remain.

Explore Markets

• United States

• Europe

• Japan

• China

• Russia

• The Gulf

• India

• Africa

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive