Sir Ian Byatt, the chairman of the Water Industry Commission for Scotland, believes such a radical change in ownership is needed to avoid huge increases in charges to domestic customers.

He has also called for the privatisation of Scottish Water's new business-supply arm, due to begin trading in 2008.

The proposals are expected to be bitterly opposed by MSPs and unions who will see it as the first step to full privatisation of the company.

But Sir Ian says he has come to the conclusion that the utility has to change if it is to secure the billions of pounds needed to introduce improvements to the water and sewerage system.

He believes that the company, which is owned by ministers on behalf of the taxpayer, cannot in the long-term rely on loan funding from the Executive which faces a spending squeeze from the Treasury in London.

Working with Alan Sutherland, the Commission's chief executive, Sir Ian has set out a detailed blueprint for turning Scottish Water into a not-for-profit mutual company, similar to Welsh Water, or possibly a co-operative.

After an analysis of the likely effect of the public spending squeeze from the Treasury, they concluded that the Executive's £200 million-a-year loan to Scottish Water is vulnerable.

Sir Ian and Mr Sutherland believe that spending on water will be at risk if the slowdown in funding from the Treasury forces Executive ministers to choose between the utility and putting cash into areas like health and education.

Their answer is to remove the utility from the public sector to allow it to go to banks to raise the £400 million and £500 million a year it needs to invest in everything from replacement pipes to sewage treatment.

In an exclusive interview with The Scotsman, Sir Ian, who was previously in charge of regulating the private water companies in England, said there was already "a big investment programme but we think that investment programme will go on being high".

He said there was "no end" to all the water quality and environment edicts that will come out of the European Commission in Brussels so there had to be a "high and continuing investment programme" in Scotland.

Sir Ian added: "If the Executive starts to run out of money the cost position then changes. If they [Scottish Water] cannot borrow £200 million, where does the money come from? It has got to come directly from the customers. Instead of paying interest on the £200 million, the customer has to start paying the £200 million and that can drive bills up very fast."

Sir Ian did not spell out details of the possible new structure, but if Scottish Water became a mutual it could be owned by the customers or by a group of high-profile individuals, the way Welsh Water is set up.

If it were a co-operative, it could be owned by a combination of customers and workers.

Under both models, the company would be able to borrow money from the markets, but in either case, the regulator would still set the charge levels.

Sir Ian's views are bound to provoke controversy as many Labour and Liberal Democrat MSPs - who want the utility to remain publicly owned - suspect that his ultimate aim is to privatise Scottish Water.

However, Sir Ian said: "If the critics said to me that you have come from England and Wales to privatise the water industry, my answer to that is 'not at all'.

"I've come to carry out Scottish law and Scottish law is the public-sector model. However, we all need to keep our eyes on the way the world is working.

"The last thing I want to see is a huge increase in prices of water in order to meet environmental obligations. The source of that money is very important and I am just asking people to think creatively and widely on that."

Asked if Scottish Water privatisation was inevitable, he replied: "I don't believe it is inevitable. The key lesson from England is the creation of incentives. Once you change those incentives from taking money from politicians to getting money through commercial operations, people get costs down.

"We've been trying to set up in Scotland that type of incentive; not exactly the same as they would be in the private sector, but they are the set of incentives we believe are appropriate."

A Scottish Executive spokeswoman said: "The Executive's position is clear. Scottish Water remains in the public sector."

Asked about mutualisation, a spokesman for Scottish Water said: "Any change to the current model is a matter for ministers. Our job is to make Scottish Water a success in the public sector."

Falling short on delivery plan

SIR Ian Byatt played a central role in events that led to the resignation of the previous Scottish Water chairman, Professor Alan Alexander.

In his report to Ross Finnie, the environment minister, Sir Ian said that a "delivery plan" drawn up under Prof Alexander fell short of the requirements.

Sir Ian said that under the new chairman, Ronnie Mercer, a former Scottish-Power executive, there was now the basis of a "proper relationship" between the regulator and the utility.

He said the original delivery plan had not fulfilled the commission's objectives. "It fell short, in particular, on the overall performance indicator, which was service to customers. It fell short in terms of insufficient action on leakage. And the timescales doing the major studies for Glasgow, Edinburgh and the Ayrshire coast would take too much time."

Asked if Prof Alexander was right to resign, Sir Ian replied: "We don't own Scottish Water, and the way in which the Scottish Executive manages Scottish Water is the Executive's job, not our job."

Private sector will be able to take a stake in new firm

SIR Ian Byatt's second radical proposal is for the private sector to be the main shareholder in the new company Scottish Water will form to supply business customers - the effective privatisation of part of the company.

Under an act of the Scottish Parliament, from 2008, up to 140,000 businesses in Scotland will be able to buy water from a range of suppliers - mirroring the system for electricity or gas.

Scottish Water is set to establish a company, provisionally called Scottish Water Retail, to supply billing and customer help but is likely to face competition from firms such as Scottish & Southern Energy.

Sir Ian said: "It is important the retail part of Scottish Water should be seen to be separate because nobody is going to want to come into this market if they think this retail part is being helped by the wholesale part.

"They want a proper, level playing field."

The new company would need to have a separate management and board.

Sir Ian added: "If it was turned into a joint venture with Scottish Water having a minority share, it would be able to raise money from the markets and would be able to engage in other kinds of activities, going into gas and electricity if it wanted to."

The new companies will be competing to service business worth £300 million in revenue but Sir Ian believes profits available could be around £5 million after tax.