Britain's United Utilities expects penalty for poor performance

* Faces 7 mln stg penalty for annual performance

* Pretax profit down 5 pct, hurt by higher finance costs

* Rise in costs offset 4 pct increase in operating profit

* Total (LSE: 524773.L - news) dividend for the year up 2.2 pct (adds share price, comments on penalty, incentives)

By Justin George Varghese

May 24 (Reuters) - United Utilities Group Plc said on Thursday it expects to be hit with a 7 million pound penalty from Britain's water regulator for its service to customers in 2017 as it announced a fall in its annual profit.

Britain's water regulator Ofwat rewards water companies when they meet or exceed targets, such as project completions and customer service, but penalises them if they fail to meet them.

"We recognise that there are still areas in which we can improve against our water measures, and we are committed to achieving this," the company said in a statement.

United Utilities (LSE: UU.L - news) said its 2017 pretax profit fell 5 percent to 370.2 million pounds ($497 million) in the year ended March 31, while revenue rose 1.9 percent to 1.74 billion pounds.

The firm was hit by additional finance expenses, which rose about 17 percent for the year to 277.2 million pounds, mainly due to the impact of higher inflation on its relatively high level of index-linked debt, the company said.

The increase in net finance costs more than offset a nearly 4 percent rise in underlying operating profit to 645.1 million pounds, that beat analyst estimates.

During the first three years of the current 2015-2020 regulatory period the company earned a net reward of 2.2 million pounds from the regulator. But in the latest financial year it expects to be penalised 7 million pounds.

The company said the quality and reliability of its water service was impacted by a number of big bursts on its network.

Penalties are not fines, but instead the money is returned to customers in the form of reduced bills in the next price review period, which would be from 2020 onwards, a spokesman for the regulator said.

The company targets an outcome of between 30 million pounds reward and a 50 million pound penalty over the 2015-2020 period, it said in November.

Over the last year it has faced multiple fines for supplying water that was unfit for drinking and polluting a river with untreated sewage from Britain's Environment Agency.

Smaller rival Severn Trent Plc (Other OTC: STRNY - news) posted a 4 percent rise in full-year profit on Wednesday, helped by higher incentives and increased cost efficiency.

Severn Trent said it earned customer outcome incentives of 80 million pounds in the year, up from 47.6 million a year earlier.

Shares (Berlin: DI6.BE - news) in United Utilities, which supplies and treats water in north-western UK, fell 1 percent at 1335 GMT.

($1 = 0.7452 pounds) (Reporting By Justin George Varghese in Bengaluru, Editing by Sherry Jacob-Phillips and Arun Koyyur; Editing by Elaine Hardcastle)