BRITAIN'S energy watchdog is preparing to slap a tough set of price controls on National Grid and other network operators, setting the stage for a showdown with the utilities over the coming months.

Ofgem said National Grid, Scottish Power and Scottish Southern will be allowed to earn a 4.2pc return on their transmission networks in the coming five years from 2007, substantially lower than it offered for the previous period.

The energy networks will be permitted to spend Pounds 4.2bn in investment over the period, less than the total Pounds 6.7bn they had requested. The companies may be able to spend up to Pounds 5bn, Ofgem added.

It is now up to National Grid and the Scottish utilities to come back to the regulator with new proposals, as a period of horse- trading ensues.

Ofgem's move comes after fellow regulator Ofwat was criticised for being too generous in its recent settlement for the water industry.

Companies such as Thames Water have been racking up huge increases in profit even though many missed leakage targets and imposed restrictions on water use.

Ofwat agreed to a 5.1pc return in its pricing review.

National Grid will be most heavily affected by the Ofgem limits. Analysts at Dresdner Kleinwort Wasserstein said the proposals 'materially' affect the utility's valuation. The stock slipped 31/ 2p to 5961/2p.

Separately, National Grid said it was taking legal action against one of its employees, a contractor and several subcontractors over a potential multimillion-pound fraud.