Has climate change made utilities a risky bet? What income investors need to know

Published Mon, Aug 21 202312:11 PM EDTUpdated Mon, Aug 21 20232:17 PM EDT

With yields generally considered safe, utility stocks have long been a favorite income play for retirees. Yet climate change may put those plans at risk. The wildfires in Maui are just the latest example of severe weather and the peril facing utilities. Hawaiian Electric , which currently has a 10.5% dividend yield, has been battered amid concern over its potential liability for the fires, which killed at least 114 people. Some 850 are still missing. Shares have tumbled nearly 63% since Aug. 7, the day before the wildfires raged out of control and ravaged Lahaina. While the cause of the blaze is still under investigation, several lawsuits have already been filed against Hawaiian Electric, which operates Maui Electric. The suits accuse the company of negligence and failure to turn off power in areas where high winds could down lines and cause a fire. Hawaiian Electric told NBC News it was focused on restoring power and emphasized the cause of the fire hasn't been determined. It declined to comment on the pending lawsuits. Meanwhile, in a conversation with Evercore ISI, the company's management said they will have to consider liquidity and the level of uncertainty when they make their quarterly dividend recommendation to the board of directors, analyst Michael Lonegan wrote in an Aug. 16 note. Utilities in general have had a tough year. The Utilities Select Sector SPDR Fund 's total return is -8.6% year to date, while the SPDR S & P 500 ETF Trust is up 15% over the same period. However, investors can pick up about 4% yield on stocks that have dividends that are considered safe, which makes them attractive to investors seeking income. XLU YTD mountain Utilities Select Sector SPDR Fund Right now, utility executives and Wall Street analysts are grappling with understanding the impact of climate change on the sector, said Neil Kalton, equity analyst at Wells Fargo Securities. "It is evolving and it is evolving fast," he said. "We think the majority of utility C-suite executives would tell you that operating and maintaining the grid today in 2023 has become more challenging than it was 25, 30 years ago," he said. "It is really to do with the frequency of severe weather events and it is manifesting in the West through these catastrophic wildfires." In fact, the western part of the country does face the highest wildfire risks, according to the Federal Emergency Management Agency. Therefore, the companies that operate there are the ones facing a growing problem, Kalton said. Here are some of the names he believes are most at risk. California utility companies are already trading at about a 15% to 20% discount on a price-to-earnings basis relative to their peers largely due to the risk of wildfires, Kalton said. "What we haven't really seen yet is other utilities face similar discounts," he said. "There has been a complacency among equity investors as how to think about this risk." Climate change's impact Climate change is altering not only the Earth's temperature, but also precipitation patterns, said Zachary Zobel, risk associate director at Woodwell Climate Research Center. Those patterns are moving more towards a "boom or bust cycle," he said. Yearly rainfalls are not really changing but there are fewer events, which leads to longer dry periods, he explained. That leads to what Zobel calls "fine fuel," like tall grass as opposed to tall trees, drying out quickly. In addition, droughts are becoming more likely, due to both the precipitation pattern and the increase in the planet's temperature. The result is not necessarily more fires but more acres being burned. "What it really boils down to is how rapidly a small fire can turn into a big fire," Zobel said. "What's causing these larger fires is a lot about the speed at which it can go from a spark to out of control." Climate change could affect utilities in other areas, like sustaining damage during hurricanes and floods. But wildfires are different in that the companies can be found liable for causing the destruction. In June, Berkshire Hathaway 's PacifiCorp was found liable for wildfires that occurred in 2020 after the company did not shut down power lines during the storm. The jury awarded the plaintiffs more than $73 million in compensatory damages, while punitive damages still need to be determined. PacificCorp has vowed to appeal and said it is confident it will prevail. Pacific Gas & Electric has faced scrutiny for its alleged roles in California's wildfires. It has been blamed for at least 31 fires that killed 113 people and burned almost 1.5 million acres, a judge wrote in a 2022 report. In early 2019, the company filed for bankruptcy. The same year, the company pleaded guilty to 84 counts of involuntary manslaughter for the 2018 Camp Fire, which killed 84 people. PG & E reached a $13.5 billion settlement with victims of wildfires in the state in 2017 and 2018. Last year, PG & E agreed to pay $55 million for fires in 2019 and 2021. Where to invest The utilities affected by wildfires are only a small percentage of the overall sector, Wells Fargo's Kalton pointed out. The majority of the publicly traded utilities are in the eastern two-thirds of the country and not in high risk areas, he said. If buying a utilities fund, just be aware if any of the names are in a high risk area, he said. However, it's also important to remember that while utilities are generally seen as a safe dividend play, it's important to be diversified, said certified financial planner Marguerita Cheng , CEO of Blue Ocean Global Wealth and a member of the CNBC Financial Advisor Council. "You don't have to just rely on just one sector to get dividend income," said Cheng. "Look for companies that have a history of consistently paying their dividends." One way to find those companies is to look at the ProShares S & P 500 Dividend Aristocrats ETF (NOBL), which tracks the S & P Dividend Aristocrats index. To make the benchmark, companies have to show 25 years of consecutive dividend growth. — CNBC's Michael Bloom contributed reporting.