What if the stock market's safest sector was doomed?

Utilities seem indispensable. Yet suddenly there is talk on Wall Street of a looming "death spiral" for the business, with solar power being the culprit.

Hyperbole? Yes, but only up to a point. Back in May, the Dow Jones Utility Average came within a whisker of its precrisis all-time high set early in 2008. High dividends sell well with investors when interest rates are so low, especially when such payments are backed by something as solid as the electricity grid.

But danger can come out of a clear blue sky or even a cloudy one. Take a look at Germany. Generous subsidies there caused solar panels to sprout all over what is hardly a tropical paradise. As traditional utilities E.ON EOAN.XE +0.60% andRWE RWE.XE +0.15% have struggled to adapt, their combined market value has slumped 56% over the past four years in a rising German stock market.

The death-spiral thesis runs thusly. Subsidies and falling technology costs are making distributed solar power—panels on roofs, essentially—cost-competitive with retail electricity prices in places like the southwestern U.S. As more people switch to solar, utilities sell less electricity to those customers, especially as they often have the right to sell surplus power from their panels back to the utility.

The result: Utilities must spread their high fixed costs for things like repairing the grid over fewer kilowatt-hours, making solar power even more competitive and pushing more people to adopt it in a vicious circle.

But distributed solar power is still in its infancy. In sunny California, costs shifted onto customers without panels from those with them amounted to just 0.73% of that state's utilities' revenue last year, according to Moody's. So why worry?

The utilities sector divides into two broad camps. Regulated utilities operate integrated networks of power plants, transmission and distribution grids. They agree to spending plans and an allowed rate of return with state regulators, determining customers' monthly bills. Meanwhile, merchant generators operate power plants selling electricity to the highest bidder.

Despite the perceived threat to regulated utilities, it is actually the merchant generators who look more exposed to distributed solar power for now.

As a rival power source, solar takes market share from traditional generators. And once panels are installed, the sun's energy is free, so it will displace more expensive sources such as gas-fired plants. This serves to reduce prices overall, so solar power cuts both volume and price for traditional generators. Not the sort of outlook that garners a high earnings multiple.

David Crane, chief executive of merchant generator NRG Energy, NRG -0.07% calls the spread of distributed energy the biggest change to hit the industry since the grid was built many decades ago. To adapt, NRG is investing in solar and other distributed sources, essentially taking cash generated today by its traditional business and redeploying it into growth opportunities.

For regulated utilities, the idea that solar panels will enable everyone to leave the grid, making such networks redundant, is overstated. Solar power is intermittent. Batteries can help, but ISI Group estimates their price needs to drop by a factor of 10 to be competitive with grid power.

Moreover, distributed energy's small penetration means the existing grid is needed for a while to come. So regulators have to balance encouraging renewable power with the continuing need to prevent blackouts. Last month, regulators curbed Arizona Public Service's planned charge to solar-panel owners to mitigate the costs of grid maintenance being pushed onto nonowners—but didn't reject the idea of that fee altogether.

Even if panels don't deal regulated utilities a fatal blow, investors still have cause for concern. Solar panels aren't the only technology out there. For most of the U.S., natural gas from shale is a bigger energy opportunity. Gas isn't free like sunlight. But it is still cheap—and available day or night. And besides power stations, it can fuel generation equipment that fits in a basement. Stirling engines, for instance, burn gas to make power and also capture useful heat.

Such machines potentially can be used alongside solar panels, allowing owners to switch between different sources. At that point, connection to the grid really can become optional.

Mass adoption is likely years away, but it is no longer over the horizon. NRG is piloting Stirling-engine products now. And while solar and wind power represent just 4.2% of the U.S. generation mix, they were only 1.3% five years ago, and the pace of adoption is accelerating. What looks too expensive or esoteric today can quickly make gains; think mobile versus fixed-line phones.

Distributed power will keep eating away at the traditional utilities' share of an electricity market that is barely expanding anyway. U.S. electricity consumption this year is forecast by the Energy Department to be 2% below the peak in 2007. Efficiency efforts keep eroding electricity requirements.

"Essentially, we do not see the recent slowdown in electric load growth as cyclical anymore; it is a new and permanent feature of modern life," says Julien Dumoulin-Smith of UBS.

That structural element is why, even if the sound of bells tolling is faint, the impact on utility stocks will be felt much sooner. Greg Gordon and Jon Cohen of ISI Group point out that absent expected growth in demand, regulators may be reluctant to approve regulated utilities' investment plans. Why saddle bill payers with the cost of an asset built to last 40 years if it might only be needed for 15 or 20? And in this business, less investment means less allowed return—and, therefore, earnings.

For utility stocks, that squeezes the "terminal value": the number put on forecast cash flows stretching into infinity that underpins a large chunk of most companies' valuation. Messrs. Gordon and Cohen calculate a theoretical price/earnings multiple of more than 15 times for a utility with assets expanding at 3% a year, and with a terminal value. Cut growth to zero and take away the terminal value, and that earnings multiple drops by a quarter.

And in contrast to the past decade, U.S. interest rates look set to rise. So utilities will also find their dividends a less effective draw for investors, even as the competitive threat gathers steam.

The gyres may look exceedingly wide, but that spiral is taking shape.

Write to Liam Denning at liam.denning@wsj.com