Utilities and the Utilities Sector: Pros and Cons for Investors

What Is the Utilities Sector?

Sector investing offers targeted opportunities into the stocks of companies in specific segments of the economy. The utilities sector includes companies such as electric, gas, or water utilities or those that operate as producers or distributors of power.

As of July 2022, the sector had a market capitalization of over $1.58 trillion. Although utilities are private, for-profit companies, they are part of the public service infrastructure and are heavily regulated. Those who include utilities in their portfolios hold them as long-term investments and commonly use them to generate income through dividends.

Understanding the Utilities Sector

Utilities include large companies that offer multiple services such as electricity and natural gas or 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.

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. Conversely, utility stocks tend to fall out of favor with the market during times of economic growth.

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.

As of July 2022, higher inflation raised new challenges for utilities. During the inflation of the 1970s and 80s, utilities faced large debt, soaring fuel costs, blackouts, increased regulation, and bankruptcies. Utilities that succeed through economic challenges will likely continue to rank among the best investments for safety, generous income, and steady wealth building.

How Investors Trade Utilities

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

If interest rates rise, investors can find higher-yielding alternatives than utilities. When a utility pays a dividend yield of 3% but increases in interest rates increase Treasury bond yields to 4%, the utility company would have to increase its dividend payout to match the rising yields.

Aside from investing in the individual stocks of utility companies, investors may also purchase regional utilities or invest in exchange-traded funds (ETFs) or sector funds containing a basket of utility stocks of companies located throughout the U.S.

The Fidelity Select Utilities Portfolio (FSUTX) includes the holdings of 29 utility companies as of March 2022 and an annual dividend yield of 1.52%. The Utilities Select Sector SPDR Fund (XLU) is one of the largest utility sector funds, with $15.5 billion in net assets, and is one of the most actively traded utility ETFs, with more than 18 million shares traded daily. The fund typically pays a dividend yield of around 3%.

The XLU's dividend yield beats the yield for the S&P 500 equity ETF, SPDR S&P 500 Trust ETF (SPY), which as of July 2022, pays around 1.56%.

Pros and Cons of the Utilities Sector

Utilities are stable investments that commonly provide a regular dividend to shareholders, making them a popular long-term buy-and-hold option. Dividend yields on utility stocks trend higher than those paid by other equities.

During times of economic downturns with low interest rates, utilities become attractive. They exhibit lower volatility and provide a desirable source of predictable investment returns from the dividends they pay on their shares. Profit margins for utilities can vary from company to company, depending on their location and the regulations they face.

Utilities, however, face intense regulatory oversight and 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. 

Public Utility Companies

The utilities sector consists of companies that provide electricity, natural gas, water, sewage, and other services to homes and businesses. Public utilities are privately owned companies that are regulated by public utility commissions that operate at a variety of jurisdictional levels, usually at the state level.

These commissions are overseen by the National Association of Regulatory Utility Commissioners. NARUC members are responsible for assuring reliable utility service at fair and reasonable rates. In 2022, utility companies in the United States with a strong investor interest included:

• NRG Energy (NRG) is an integrated power company that generates electricity and provides energy solutions and natural gas to residential, commercial, and industrial customers throughout the United States and Canada.
• OGE Energy Corp (OGE) is a holding company with investments in energy and energy service providers offering physical delivery for electricity in Oklahoma and western Arkansas.
• PG&E (PCG) is a holding company that, through subsidiaries, provides electricity and natural gas sales and delivery to customers primarily in California. 
  

How the Utilities Sector Is Changing

In 2020, President Joe Biden called for the country to achieve a 100% clean energy economy and net-zero greenhouse gas emissions no later than 2050, committing nearly $2 trillion in investment to achieve this goal. The energy and utility industry has an opportunity to advance its grid modernization and clean energy efforts by tapping into funds allocated in the Infrastructure Investment and Jobs Act which includes $65 billion earmarked for upgrading the national power infrastructure.

A 2022 industry outlook report by Deloitte identified five trends for the utilities industry which include enhanced competition, expansions in infrastructure, greater electrification of transportation, an emphasis on disaster readiness, and traditional energy players entering the renewable energy field.

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

Utilities remain wary of regulations that may force the closure of power plants, though the sector largely supported the tax credits proposed in a bill called Build Back Better, which aimed to provide more than $300 billion in direct subsidies for wind, solar, transmission, storage, carbon capture, and nuclear projects. Build Back Better failed to pass the Senate and was replaced by the Inflation Reduction Act (IRA), which was signed into law in August 2022. The IRA appropriates $369 billion for climate and clean energy initiatives, including tax incentives that should reduce the costs of the renewable energy transition for utilities companies.

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. Typically, investors buy utilities stocks as long-term holdings. These equities typically feature stable prices and good dividend income. 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 sector in the 2020s.

Correction—March 20, 2024: This article has been corrected to state that investing in utilities becomes less attractive when interest rates and bond yields are high.