Investing in utility stocks and shares is often seen as a defensive move. This is primarily due to the essential services that these companies provide. While they may not grow at extraordinary rates, the continuous demand for their recurring services often creates a predictable and reliable source of income.

That’s actually the reason why utility shares tend to perform relatively well during economic downturns like a recession – people still need access to electricity, water, and heating. Let’s look at the potential of investing in this stock market sector, the big players, and the risks and challenges companies in this sector face.

What are Utility Stocks?

Utility stocks and shares are companies that provide essential services such as electricity, natural gas, water, and power. While most other sectors are cyclical, the utility industry’s services are needed all year round. Yet there are some cyclical elements, such as increased usage during winter when people use more gas or electricity to heat their homes.

The implication of this is that utility stocks spring little surprises in earnings thanks to their predictability. While this is loved by the dividend investors, growth investors are often not attracted by the sector.

Big utility companies could provide different forms of service, while smaller ones could specialise in offering a particular service. Generally, utility companies could be categorised into any of the four groups below.

• Utility Generators – These companies are responsible for generating electrical power. NRG Energy Inc and Greencoat UK Wind are examples of utility generators.
• Energy Network Operators – These firms operate the infrastructure network that enables electrical power to be distributed to homes, construction sites, office buildings etc. A leading business in this space would be CenterPoint Energy.
• Energy Traders & Marketers – Groups that specialise in the buying and selling of energy futures and derivatives. These are typically business-facing financial firms that help businesses secure stable energy prices throughout the year. Companies like Brookfield Renewable Corporation and UGI Corp fall under this category.
• Energy Service Providers – These companies are responsible for getting the utilities to the final consumers. For example, Consolidated Edison and Centrica.

Due to the essential services utility companies provide, the sector is highly regulated. This makes entry quite difficult and ultimately wipes out any form of pricing power. But this also has a tendency to allow some utility shares to rise and dominate with large market shares due to the limited amount of competition.

Having said that, with the world shifting toward renewable energy, new companies are emerging that could eventually threaten current sector titans.

What are the Main Risks and Challenges of Utility Shares?

For the most part, utility shares have been a relatively stable investment over the years. And is often the home to a vast number of dividend stocks. But as attractive as that sounds for dividend investors, investing in utility stocks is not risk-free. Some of the most prominent risks and challenges utility stocks face are:

• Intense Regulation – While this makes utilities to be stable, intense regulation makes it difficult for utility companies to easily raise rates to increase their revenue. Undoubtedly, this affects the company’s growth prospects. And for unprofitable groups, this can be a tremendous handicap.
• Expensive Infrastructure – To meet their customers’ needs, utility companies need heavy infrastructure. And apart from building it, the constant maintenance and equipment upgrades are hardly cheap. Therefore, with relatively limited cash flows, many groups turn to debt financing to meet their intense capital requirements.
• Interest Rates – Because of their heavy reliance on debts, utility shares often become overleveraged, which becomes problematic when interest rates are on the rise.

Key Financial Metrics to Know Before Investing In Utility Shares

Before investing in any sector, it’s paramount to understand it and know how to analyse the companies within, and utility shares are no exception. With that in mind, here are some key financial ratios that, in my experience, are useful tools to judge the performance of utility stocks.

• Debt-to-Equity, Debt-to-Capital – This ratio compares the level of debt and equity used in financing a company. It’s a quick way to check whether a firm has become too reliant on debt financing.
• Debt-to-Asset – Similar to the Debt-to-Equity ratio, this metric reveals how effectively the company has been spending its borrowed money. Suppose the value of assets is low relative to loans outstanding. In that case, it may signal bad capital allocation skills from management that require further investigating.
• Interest Coverage, Debt-to-EBITDA – Reveals a utility stock’s ability to meet its interest obligations using underlying earnings.

Key Terms when Investing in Utility Stocks

The utility industry is not exactly the most complicated sector out there. But it still has some jargon that can confuse newcomers investing in utility shares. Here are some key terms that investors ought to know about:

• Billing Cycle – Refers to the time interval in which the meters of all a class or subclass of customers are read.
• Deferred Payment Agreement (DPA) – An arrangement that allows a residential customer to pay overdue bills in instalments over an agreed-upon length of time.
• Cost of Service – This refers to what it costs utility companies to service their customers.
• Rate of return – Refers to the rate of earnings a utility company realises.
• Backup Power – Refers to a system that provides power in the circumstance that a primary power loss occurs.
• Cogeneration – The production of two energy forms from a single fuel source simultaneously.

What is the Market Size?

At the end of 2021, utility stocks had a market size of $5.49trn. This is according to a report by The Business Research Company. After analysing the industry, the research group estimated this market size will grow to $5.97trn by the end of 2022. After that, the steady growth will continue at an annualised rate of 7.9% until 2026, reaching $8.11trn.

Interestingly, investments in renewable energy generation capacities are expected to drive growth in the utility sector. Some companies may even need to invest in overhauling the existing infrastructure as they transition to greener energy sources. Moreover, all companies will heavily invest to meet the 2050 Paris Climate Agreement deadline. This is expected to drive growth in the utility sector in the coming years.

Top Utility Stocks in the UK by Market Capitalisation

Below are the top five utility stocks listed on the London Stock Exchange in order of market capitalisation.

Top Utility Stocks in the US by Market Capitalisation

The table below shows the top five utility stocks in the United States by market capitalisation.

Should I Invest in Utility Stocks

As I said earlier, utility stocks are known for their defensive nature in times of economic uncertainties. Also, dividends paid by utility companies encourage passive income investors to invest in utility shares. And that’s despite the risks they face from the regulatory and high-debt environment in which they operate.

Therefore, personally, I believe this stock market sector has a place in my investment portfolio as it provides a nice level of balance. But I admit it may not be suitable for every investor out there.

Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has published a premium report on Greencoat UK Wind. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.