* Frerot boosted by withdrawal of possible challenger
* Board meets Wednesday, could discuss CEO renewal
* Institutional shareholders, funds back Frerot strategy
* Drastic job cuts in water unit seen counter productive
PARIS, Feb 26 (Reuters) - French water and waste giant Veolia's chief executive, Antoine Frerot, looks set to survive a second boardroom coup in two years as a top candidate to replace him backed off, but tensions will remain with some shareholders who want deeper cost cuts.
The board of Veolia, the world's biggest environmental services group, meets on Wednesday to review the firm's 2013 earnings, which will be published on Thursday. While the leadership issue is not on the agenda, a company source said board members could decide to discuss the issue and possibly declare their support for Frerot in a bid to end confusion.
On Tuesday, David Azema, the head of French state holding company APE, told Reuters he was not a candidate for the job, although two sources familiar with the situation told Reuters Azema had been informally asked by minority shareholder Dassault to challenge Frerot, whose four-year mandate ends in April.
Sources say the Dassault family - which controls French warplane maker Dassault Aviation and owns 6.0 percent of Veolia - is unhappy with the pace of restructuring at Veolia, whose stock is down some 40 percent since Dassault bought its stake in 2008. Dassault did not respond to requests for comment.
Azema's withdrawal and the lack of an alternative candidate seem certain to strengthen Frerot's hand.
"I think Frerot will not be replaced. If they fire him now, there will be a crisis of governance. Today, there is a 99 percent chance that his mandate will be renewed," a source in the anti-Frerot camp conceded. He declined to be identified.
Whether the board comments about Frerot on Wednesday, it is due to vote on the renewal of his mandate on March 11.
"A change in CEO today could be disruptive to the restructuring story, we believe," Morgan Stanley analyst Emmanuel Turpin wrote in a recent note.
Dassault's attempt to oust Frerot comes nearly two years to the day after a similar challenge led by state-controlled utility EDF, which at the time had a 4 percent Veolia stake and whose CEO, Henri Proglio, is the former CEO of Veolia and one-time mentor of Frerot.
Unhappy with how Frerot was unwinding Proglio's debt-fueled global expansion drive at Veolia, Proglio tried to replace him with conservative French politician Jean-Louis Borloo.
The attempt failed and in February 2012 the board confirmed Frerot as chairman and chief executive. At the end of 2013, EDF sold its Veolia stake, closing an acrimonious chapter between the two former allies.
A source in the Frerot camp told Reuters that Dassault's leadership challenge was due to its desire for more drastic staff cuts to restore profitability and boost the stock price.
Veolia is set to cut a total of 1,600 jobs in its French water business, of which 900 would occur through natural attrition (500 in 2013 and 400 this year) and 700 through redundancies. It will also reassign 500 outsourced jobs to internal staff.
These cuts have been agreed with the unions and Frerot has said that to cut more jobs would be counterproductive.
One of Veolia's top institutional shareholders, who owns several million shares, told Reuters he agreed with that approach.
"I am not convinced huge staff cuts would be positive for the company. They might boost the stock for a few months, but in the long term a new round of layoffs would increase the risk that the business plan is not delivered," he said, adding that municipalities would harden their stance against the firm.
The shareholder said that unless earnings deteriorate dramatically, he sees no reason to remove Frerot.
"He set out a restructuring plan at the end of 2011 and for now he has been delivering on it," he said.
With Veolia's traditional French water business under pressure from a trend towards recommunalisation of water supplies and its cyclical waste business under pressure from the economic crisis, Frerot has sought growth in areas such as toxic waste treatment and water treatment for oil and mining companies, reducing the focus on municipalities and targeting industrial clients.
Frerot has also halved Veolia's debt, which is set to stand at just over 8 billion euros ($11 billion) at the end of 2013, and vows to fund new investments from cash flow and through divestments.
A second fund manager, who also controls several million Veolia shares, said his firm also backs Frerot.
"I think that there is no alternative. If there is someone else with a better plan, I have not seen it," he said.
Veolia's fragmented share ownership is dominated by funds that together own 60.6 percent of the stock, but no single fund owns more than three percent of capital.
"The funds are not represented in the board, but they expect the board, notably the independent board members, to look after their interests," Frerot told Reuters on Tuesday.
The top institutional shareholders are Norges Bank Investment Management with 2.89 percent, Pictet with 1.36 percent and Aviva with 1.21 percent, Thomson Reuters data show. Amundi and The Vanguard Group also own nearly one percent.
Veolia's top shareholder is the French state, with an 8.9 percent stake, but the government has said it will not interfere in management appointments.
($1 = 0.7282 euros) (Editing by Ken Wills)