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Stocks of utility companies are among the safest investment bets in the market, but they have their share of weaknesses. A growing regulatory burden and increased debt loads remain a concern. But an even bigger issue is the interest rate backdrop.

The Fed posture following the December lift-off has not been favorable for rate-sensitive sectors like utilities. Though the Fed has not increased rates following the December hike, another round of interest rate hike is expected to come in the second half of 2016 if economic conditions remain favorable.

Let’s look into the factors which might deter investors from investing in the utility space.

New Regulations

The U.S. Environmental Protection Agency (EPA) finally came out with a new plan to curb carbon pollution from domestic power plants. The finalized Clean Power Plan calls for CO2 reduction of 28% by 2025 and 32% by 2030 from 2005 levels. Coal producers had to undertake the tedious and financially stressful task of reducing their carbon footprint. As a corollary, big names in the coal mining space, like Peabody Energy and Arch Coal, had to file for bankruptcy protection in the face of falling demand.

A good many U.S. utility operators preferred to shut down their old coal-fired generation units, rather than inject fresh funds to make these units fit for new emission standards. Per a recent release from the U.S. government’s Energy Information Administration (EIA), coal’s usage in power generation would fall to 18% of U.S. electricity generation in 2040, compared with 33% in 2015.

Debt Levels

Utilities are capital intensive and need to have a continuous inflow of funds to carry on their organic growth and infrastructure upgrade projects. This is essential in maintaining an uninterrupted supply of basic amenities like electricity, fresh water and gas. Utilities generate funds from operations which are to some extent used to meet their capital requirements. But these funds are mostly used for dividend payouts. They take recourse to external sources of financing to meet their capital requirements.

While interest rates remain low by historical standards and the market’s evolving Fed outlook seems to call for even fewer rate hikes this year, the access to capital markets has steadily been declining. This issue will likely become even more acute as the Fed tightening cycle becomes more visible.

The Federal Reserve finally raised the interest rate in Dec 2015. Fed officials had plans to raise interest rates gradually in 2016. Market experts believe that the Fed might increase interest rates once more in the second half of 2016. We believe that a rising interest rate environment could add to the troubles of the utility operators, as it will increase their cost of capital, restraining their ability to pay consistent dividends. So, while investing in a utility, one must take note of its outstanding debts.

Competition with Bonds

These reliable dividend payers are in competition with bonds as an investment option. The increase in interest rates will definitely make bonds with its yields another attractive investment option for risk-averse investors, driving them away from the utility space.

Safe but Limited Growth Potential

Investment in these highly regulated defensive utilities is considered to be a safe option. Even though utilities pay regular dividends and go for buybacks, the scope of capital appreciation is quite limited for investors in this space. Share prices in this sector do not jump the way they do in the technology sector, so the returns are never dramatic.

Bottom Line

Despite the drawbacks of the utility industry, it is still undoubtedly one of the most stable industries to invest in. The focus on clean energy is going to be top-most on the agenda in the coming years. We expect utilities to take advantage of the shale boom in the U.S. and the falling prices to develop more power plants based on natural gas. Combined-cycle natural gas power plants not only help to lower pollution but also result in energy efficiency.

A makeover in the utility space is already underway, with utilities shutting down coal-fired units and focusing more on green energy generation. The crucial question is will they be able to sustain this momentum following the hike in interest rates?

Despite stringent emission standards, the extension of investment tax credits and production tax credits is a positive for the utilities. We expect regulatory backing to naturally boost production of more electricity from renewable sources.

We recommend investors to stay away from California Water Service Group (CWT - Free Report) , South Jersey Industries, Inc. (SJI - Free Report) , Unitil Corp. (UTL - Free Report) and TerraForm Power Inc. (TERP - Free Report) as these stocks currently carry a Zacks Rank #4 (Sell). These companies registered an average negative earnings surprise of 61.9%, 53.6%, 2.03% and 590.2%, respectively, over the last four quarters.

Check our latest “Utility Industry Outlook” for more details on the current conditions prevailing in the market from an earnings perspective, and how the trend is going for this important sector of the economy now.

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