(This JUne 28 story corrects paragraph 1 to say draft methodology for the price review, not the price review, will be published in July)
(Reuters) - J.P. Morgan forecast lower returns from water companies in England and Wales on Tuesday, saying industry regulator Ofwat's next price review, whose draft methodology will be published in July, will require them to be more efficient while meeting environmental goals.
Analysts at the U.S. brokerage said the water companies will manage cost inflation well, although Severn Trent will face higher operating expenses, prompting a stock downgrade to "underweight" from "neutral".
The Water Services Regulation Authority (Ofwat) has said climate change, increasing demand and affordability will feature high on the priority list for its next price review, which is due to be released on July 7.
"The regulator will challenge the companies to be more efficient while meeting environmental objectives – this may require further reinvestment in the coming years, limiting outperformance," the JPM analysts said in a note.
Ofwat said on Tuesday Britain's South West Water is under investigation for possible violations involving its wastewater treatment works, following action against Thames Water, Anglian Water, Northumbrian Water, Wessex Water and Yorkshire Water in March.
Scrutiny of water companies has intensified in the past year after a government U-turn put legal controls on the amount of wastewater that companies can release.
An earlier vote in parliament against such a move triggered a public backlash.
(Reporting by Aniruddha Ghosh in Bengaluru; Editing by Alex Smith and Devika Syamnath)