Moody's Investors Service on June 18 downgraded its outlook on the regulated utilities sector to "negative," citing lower cash flows and higher debt levels as federal tax reform and increased capital spending continue to weigh on the sector.

Although investor-owned utilities secured their top priorities when Congress late last year made sweeping changes to the country's tax code, their cash flows have declined due to a lower contribution from deferred taxes, resulting in many top utilities tapping equity markets to strengthen their balance sheets. A number of state regulatory agencies have ordered companies to return excess revenues to their customers.

Utilities are also spending more on capital projects, including investments in renewable energy capacity, smart grid infrastructure and system resilience measures. These often require debt financing. Companies' dividends are also rising, according to analysts led by Moody's Senior Analyst Ryan Wobbrock.

Taken all together, these trends prompted the ratings agency to lower to negative its view of the regulated space — a first for Moody's since it starting releasing sector outlooks.

Moody's move came nearly five months after all three ratings agencies — Moody's, S&P Global Ratings and Fitch Ratings — each warned that federal tax reform could drag on the regulated sector's credit quality.

"Regulated utilities will be exposed to a higher level of financial risk for the next 12 to 18 months," Wobbrock said in a statement accompanying his agency's note.

Utility executives are working to shore up their financials, Moody's acknowledged, but Wobbrock and his team believe "it will take longer than 12-18 months for the majority of the sector to show any improvement from such efforts." He cited the Moody's utility peer group showing a 10-year high ratio of debt to earnings before interest, taxes, depreciation and amortization, and the highest debt-to-equity ratio since 2008.

"With respect to financial mitigation measures, we see more activity in the pursuit of regulatory cost recovery relief than we do with management teams executing material changes to financial policies," Wobbrock said. "Thus far, there has been no discernible adjustments to dividend policies and most utilities continue to incorporate a heavy reliance on debt financing for their sizable negative free cash flow funding needs."

Moody's said its outlook of the regulated sector could be raised back to "stable" if consolidated cash flow improves by 15% to 20% or the ratio of consolidated funds from operation to debt produces a 17% to 19% return. Conversely, if ratios continue to decline, or if litigation rather than settlements is used to resolve state regulatory proceedings on tax reform, the agency said its view of the space would stay negative.

S&P Global Market Intelligence and S&P Global Ratings are both owned by S&P Global Inc.