Utilities Sector

What Is the Utilities Sector?

The utilities sector refers to a category of companies that provide basic amenities, such as water, sewage services, electricity, dams, and natural gas. It is a large sector, and an important part of the U.S. economy, with a market capitalization of over $1.5 trillion (as of March 2021).

Although utilities are private, for-profit companies, they are part of the public service landscape—providing as they do such staples for daily living—and are therefore heavily regulated. Investors typically treat utilities as long-term holdings and use them to generate a steady income for their portfolios.

Key Takeaways

  • The utility sector is a category of company stocks that provide basic services including electricity, natural gas, and water.
  • Utilities earn a profit but are a public service and, as a result, have substantial regulation.
  • Typically, investors buy utilities as long-term holdings for their dividend income and stability.
  • The utility sector tends to do well as a defensive play against macroeconomic downturns.
  • The movement towards "clean" energy, along with competition-enhancing legislation, initiatives, and investments in renewable energy resources, has some analysts forecasting strong growth for the utility industry in the 2020s.

Understanding the Utilities Sector

Utilities typically offer investors stable and consistent dividends, coupled with less price volatility relative to the overall equity markets. As a result, utilities tend to perform well during recessions and economic downturns. Contrarily, utility stocks tend to fall out of favor with the market during times of economic growth.

The many types of utilities available include large companies that offer multiple services such as electricity and natural gas. Other utility companies might specialize in just one type of service, such as water. Some utilities rely on clean and renewable energy sources like wind turbines and solar panels, to produce electricity. Investors may also purchase regional utilities or invest in exchange-traded funds (ETFs) containing baskets of utility stocks located throughout the U.S.

Utilities Supplier Segments

While electric utility companies used to be regionally monopolistic, broadly speaking, the industry is breaking down into the following four supplier segments:

  • Generators: These operators create electrical power. 
  • Energy Network Operators: Grid operators, regional network operators, and distribution network operators sell access to their networks to retail service providers.
  • Energy Traders and Marketers: By buying and selling energy futures and other derivatives and creating complex "structured products," these companies usefully help utilities and power-hungry businesses secure a dependable supply of electricity at a stable, predictable price. 
  • Energy Service Providers and Retailers: In most U.S. states, consumers can now choose their retail service providers.

Debt Levels of the Utilities Sector

Utilities require a significant amount of expensive infrastructure and consequently carry large amounts of debt on their balance sheets. These debt loads make utilities hypersensitive to changes in the market interest rate. And because utilities are capital-intensive, they require a continuous inflow of funds to finance infrastructure upgrades and new asset purchases. The significant debt load also results in high utility debt-to-equity (D/E) ratios, which can impact companies’ credit ratings, making it difficult to borrow funds, which ultimately increases their costs of operations.

Consumer Impact on the Utilities Sector

Because many states let consumers move from one utility operator to another, consumers typically choose the least expensive local operator. Higher-cost producers are eventually eliminated from the market unless they can cut their costs in time.

Long-term power purchase agreements between companies and consumers also impact profits. When utility generation costs increase, companies must continue to honor the contract agreements and sell utilities at the current agreed-upon rate, which decreases their profits.

How Investors Trade Utilities

Because utility stocks pay reliable dividends, investors often favor them over lower-dividend paying equities. After the financial crisis of 2008, the Federal Reserve cut interest rates, to stimulate the economy. As a result, investors flocked to utilities, as safer investments. Simply put: utility companies are a viable defensive choice for investors during macroeconomic downturns.

However, as the economy improves and interest rates rise, investors can find higher-yielding alternatives than utilities. As rates rise, so do the yields of U.S. Treasury bills. For example, if a utility pays a dividend yield of 3%, but increases interest rates spike bond yields to 4%, the utility company would have to increase its dividend payout to match the rising yields of Treasuries. Therefore, utilities do well when interest rates decrease because their dividends are greater than Treasury yields. However, as the economy improves, utilities tend to sell off as interest rates rise back to normal levels and their dividends become once again lower than Treasuries.

Advantages and Disadvantages of the Utilities Sector

Utilities are stable investments that provide a regular dividend to shareholders, making them a popular long-term buy-and-hold option. Dividend yields are usually higher than those paid by other stocks. During times of economic downturns with low-interest rates, such stocks become attractive. Primarily because they exhibit lower volatility and provide a desirable source of predictable investment returns from the dividends they pay on their shares. Investors may invest in utility company shares, industry sector ETFs, and utility bonds or other debt securities.

Due to the utility sector's intense regulatory oversight, it's difficult for it to raise rates to increase revenue. Utilities require expensive infrastructure that needs routine updating and maintenance. To meet these infrastructure needs, utility companies often float debt products that, in turn, increase their debt loads. This debt also makes these services particularly sensitive to interest rate risk. Should rates rise, the company must offer higher yields to attract bond investors, driving up their costs. 

  • The utility sector offers stable, long-term investments with a regular and attractive dividend.

  • Utilities act as a haven investment during times of economic downturns.

  • Utilities offer many options for investment including bonds, ETFs, and individual company stocks

  • Intense regulatory oversight causes difficulty in raising customer utility prices to increase revenue.

  • Expensive utility infrastructure requires continual upgrades and maintance.

  • During times of high market interest rates, utilities become less attractive and must increase their bond yields.

Examples of Utilities

Investors can buy into individual utility stocks or bonds, or they can invest in ETFs that comprise baskets of many utilities. For example, the Utilities Select Sector SPDR Fund (XLU) is one of the largest utility sector funds, with a whopping $13.4 billion in assets under management. The ETF also is one of the most actively traded utility ETFs, with more than 14 million shares traded daily. The fund typically pays a dividend yield of around 3% with a low expense ratio of 0.10%.

In comparison, the XLU's dividend yield beats out the yield for the S&P 500 equity ETF—SPDR S&P 500 Trust ETF (SPY)—which pays around 1.41%.

Furthermore, if the benchmark 10-year Treasury yield trades below 3%, investors might consider buying the utility sector through the XLU or individual stocks. It's important to check with your broker for current market pricing since Treasury yields, and dividend yields for both utilities and equities change with market conditions.

Special Considerations

The advent of the 2020s brings the prospect of interesting changes and initiatives to the utilities industry. President Joseph Biden has announced intentions for the U.S. to rejoin the Paris Climate Accord and called for the country to achieve a 100% clean energy economy and net-zero greenhouse gas emissions no later than 2050, committing $2 trillion in investment to achieve this goal.

New regulations have also occurred. In Sept. 2020, the Federal Energy Regulatory Commission (FERC) approved a final rule, Order 2222, which opens the organized wholesale power markets to providers of novel sources of energy, and grid services, commonly called DERs (distributed energy resources). "This bold action empowers new technologies to come online and participate on a level playing field, further enhancing competition, encouraging innovation, and driving down costs for consumers," FERC announced.

An early 2021 power and utilities industry outlook report by Deloitte identified five trends for the utilities industry.

  • Enhanced competition, sparked by regulations such as FERC's Order 2222 that open up the market to smaller, innovative firms using renewable energy sources, like wind or solar power
  • Expansions in infrastructure, to manage new renewable energy sources
  • Greater electrification of transportation, and longer-range batteries for cars and trucks
  • Oil companies and other traditional-energy players entering the renewable-energy field
  • A greater emphasis on disaster readiness

According to Douglas Simmons, a Fidelity utility sector portfolio manager, the fundamentals of utilities in 2022 look very robust overall, driven by the ongoing shift toward renewable energy sources and away from fossil fuels.

Renewable energy resources are expected to grow from 10% of the current US energy mix to 39% by 2030, according to Fidelity's "Opportunities in Utilities" analysis report.

But not all analysts are as optimistic. Charles Schwab Senior Investment Strategist David Kastner in a February 2021 analysis of 11 equity sectors, foresees the utilities industry as underperforming, at least in the short term. He cites company valuations that are high, relative to the sector's historical average and, as the economy recovers from the 2020 recession, the prospect of rising interest rates and inflation—factors that tend to have a negative impact on utilities stocks.

What Is a Public Utility?

A public utility is a company or business that supplies an everyday necessity. The word "public" refers to the fact that it services the public at large, not its corporate status—most public utilities are privately owned, for-profit businesses, not non-profits.

What Are Examples of Utilities?

Utilities commonly include:

  • Water
  • Electricity
  • Natural gas
  • Sewage and sanitation

Communications services are often considered utilities, but are not part of the official utilities sector.

What Companies Are in the Utilities Sector?

The utilities sector encompasses a range of companies in different industries. They include providers, producers, and suppliers such as:

  • Energy companies
  • Electricity companies
  • Water companies
  • Natural gas companies
  • Sanitation and waste disposal companies

In addition, some companies are multi-utilities—that is, they are diversified and deal with several different types of utilities.

What Is the Largest Utility Company?

Globally, the largest energy provider in the world is Enel Energy is headquartered in Rome, Italy, with a $90 billion market cap and operating across 37 countries and 5 continents.

What Are the Best Utility Stocks to Buy?

Among the best utility stocks to buy are:

  • For value: NRG Energy Inc. (NRG)
  • For growth: Public Service Enterprise Group Inc. (PEG)
  • For return: The AES Corp. (AES), NextEra Energy Inc. (NEE)

The Bottom Line

The utilities sector is an industrial category of stocks, consisting of companies that provide basic everyday amenities, including natural gas, electricity, water, and power. Utilities companies are private, for-profit entities, but since they provide a public service, they are subject to substantial government oversight and regulation.

Typically, investors buy utilities stocks as long-term holdings. These equities typically feature stable prices and good dividend income. The sector also tends to do well as a defensive play against macroeconomic downturns—even in hard times, people need running water, light, and sanitation services.

In the U.S., the movement toward "clean" energy, along with competition-enhancing legislation and a presidential administration committed to renewable energy resources, has some financial analysts forecasting strong growth for the utilities industry in the 2020s.

Article Sources
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