Severn Trent at low tide

Share prices across the water sector sprung a leak in late July when the UK's water-industry regulator, Ofwat, delivered for the period 2010 to 2015. The regulator's recommendations are still only provisional, but, almost certainly, they will be the biggest single influence on water companies' profits in the coming five years.

The last price review in 2004 is now regarded as being too generous to water companies. They made higher-than-expected profits because the cost of their debt turned out to be cheaper than the regulator had reckoned. Although their cost of debt is now higher - and companies are also under pressure because of increased power bills and rising levels of bad debts - the regulator wants prices to fall. That's good news for consumers, but not so good for the water companies.

Shares in Severn Trent and have been singled out as likely to suffer most from Ofwat's provisional recommendation because their gearing ratio - debt to equity - is the highest of the water companies. They are two of only six companies on the FTSE 100 index whose share price has failed to benefit from the 40 per cent rise in the stock market since March. Severn Trent's price dropped 16 per cent in the weeks following Ofwat's announcement to a low of 921p. But is the sell off justified?

Ofwat sets an adjustment factor (the so-called K factor) for each water company for each year of the review period. To this, the rate of retail-price inflation is added, giving the amount by which each utility can raise - or has to cut - its prices for each year. At this stage, Severn Trent is facing five years of negative K factors, so may have to cut its water and sewerage bills.

It could also be squeezed if debt costs are higher than anticipated. Ofwat's figures are partly based on the assumption that the cost of capital to water companies will be 4.5 per cent. That is less than most City analysts had expected and Severn Trent may suffer if it can't persuade the regulator to nudge up the assumed cost of capital in its final decision, which is due in November.

Analysts agree that of all the water stocks, Severn Trent and United Utilities are the worst affected by Ofwat's proposals. And, at the beginning of August, ratings agency Standard & Poor's warned that it may downgrade its rating of both groups' debt if the revised proposals are unfavourable.

While analysts believe that Severn Trent can just about get by under Ofwat's preliminary proposals, there is not much headroom and operating costs will have to be kept under tight control. Any slip could well mean a cut in the dividend or, worse, Severn Trent's bosses may have to raise new equity capital.

Yet it may not be that bad. Severn Trent itself says that its capital spending is fully funded for the next two years, and that its average debt maturity is 20 years. In light of this, investment bank Morgan Stanley has concluded that the effects of the new price regime would be "tight, but manageable".

Besides, in the past, shares in water companies have always been at their weakest between the regulator's draft and final determination. So for investors looking for income this could be a good moment to buy in. Especially as Ofwat's draft proposals have always been tougher than its final decision. "Ofwat has now used its largest stick to try and beat improved efficiency out of the company," says , utilities analyst at stockbroker Brewin Dolphin.

And, operationally, Severn Trent is making progress. In 2008-09, the company outperformed its leakage targets and delivered higher-than-targeted cost savings. Against that, its bad debts and power costs also increased.