Don't get burnt

The speech was important, not because climate change science requires another voice behind it, or (as some have argued) Mr Carney overstepped his role as governor by "intervening" or issuing a "call for action". Instead, the speech's significance lies in the credence given to the hitherto maligned concept of a 'carbon budget'. This is the amount of carbon dioxide we can safely release into the atmosphere until 2050 if a global mean temperature rise is to be capped at 2 degrees Centigrade (°C). Letting the climate warm beyond this level would risk the chance of climatic feedback loops and catastrophic increases of 4°C or more.

The theoretical impact on fossil fuel companies is enormous. On their balance sheets sit proven reserves of oil, gas and coal, which if used in their entirety would generate around 2.8 trillion tonnes of CO2. The scientific consensus is that only between a third and a fifth of those reserves can be burnt to stay within 2°C of warming. "If that estimate is even approximately correct," warned Mr Carney in his address, "it would render the vast majority of reserves 'stranded' - literally unburnable without expensive carbon capture technology, which itself alters fossil fuel economics.”

As the share price of energy companies is partly determined by the net present value of proven reserves - in other words, how much money a company can expect to make from its existing barrels - this has huge implications for investors. Energy companies' credit ratings also depend on their reserves, and the amount reinvested to replace them. Naturally, big oil hasn't taken the whole concept lying down. Last year, in the face of mounting investor concern, Royal Dutch Shell (RDSB) dismissed the idea of a carbon bubble, disputing the methodology behind the stranded assets theory and pointing to the continued global growth in demand for energy, which it says can only be met by a mix of sources that includes 40 to 60 per cent fossil fuels to 2050 and beyond. Of course, the oil sector has a lot invested in the status quo, but independent voices say the same. For example, a 2014 report by the International Energy Agency (IEA) suggested almost 75 per cent of global energy demand in 2040 will need to be met by fossil fuels.  

As such, Shell can have some confidence in its belief that none "of [its] proven reserves will become stranded". But amid a debate on whose hydrocarbons will have to be left in the ground, there appears to be growing industry consensus that some will have to be abandoned. Last month, BP's (BP.) chief economist, Spencer Dale, acknowledged that "it is increasingly unlikely that the world's reserves of oil will ever be exhausted".

But how can investors be expected to price the looming "tragedy of the horizon" Mr Carney referred to in his address? Thinking purely in investment terms (as opposed to the profound moral concerns) what is meant by carbon risk? And is it worth investing in a company that might not be able to sell four-fifths of its stock?

The stranded asset risk

The table below is a crude, highly contingent comparison of the current market value of oil and gas companies in the FTSE 350 against the stranded assets model. Necessarily, this is highly theoretical, and assumes i) all future barrels sell for $70 ii) all capital expenditure is cut, and iii) just a fifth of reserves can be sold or burnt. Of course, this scenario would require the most radical change in energy policy in world history. What's more, it assumes that the proved reserves on the balance sheets of these companies represent an equal share of the average CO2 emitted by one equivalent barrel of fossil fuel. Given coal is more carbon intensive and less efficient than oil and gas, it is unlikely assets would be 'stranded' so evenly.

Taking all of this into account, we see that Shell and Cairn Energy (CNE) have a market value above the future sales of their total burnable proved reserves. In other words, if the world's governments decide at this month's Paris climate talks that listed fossil fuel companies can burn just 225GtCO2 (or a quarter of the predominantly nationalised industry's carbon budget) between now and 2050, the FTSE 350 oil and gas sector would find itself priced just 20 per cent below the value of its entire future sales. Profit represents a small portion of those sales.

Stranded FTSE 350 oil and gas producers

*At 31 December 2014. Oil and gas equivalent, assuming 1mmboe = 6BCF, and 3.15 boe = 1 tonne CO2. Market capitalisations and currency conversion correct as of 19 October. £1=$1.55

Given the intransigence of climate talks so far, this plainly isn't going to happen any time soon. Indeed, the pledges made by countries to date have put us on a path to temperature increases of 2.6°C to 3°C above pre-industrial levels. Added to this, a lack of zero-carbon sources of energy would make such a policy socially and economically impossible. But equally, the pressure on policymakers will intensify with each new disastrous weather event. Climate policy already casts a long shadow over the fossil fuel industry's future energy models, but this shadow will only lengthen if the Maldives disappears, coastal Bangladesh is destroyed, or Manhattan is flooded. And despite the protests of the oil majors, change in climate policy is a key reason why investment analysts at financial institutions, including HSBC and Legal & General, believe the stranded assets risk is growing.

Changing investment strategies

Even without a policy overhaul, there is a dawning awareness among investors large and small that long-term exposure to fossil fuels presents a big risk. Meryam Omi, head of sustainability at Legal & General Investment Management, says growing numbers of her firm's clients are worried about exposure to fossil fuels and carbon-intensive sectors, particularly coal. Despite or because of this, she remains an optimist. "Tackling climate change is not about losing financial value. It is about helping to build a much healthier energy system. If tackled holistically and strategically, our investments would benefit,” she says. However, it's still hard to imagine how carbon-intensive holdings can emerge unscathed from the energy transition.

The divestment movement is making itself felt in broader initiatives such as the Montreal Pledge, to which more than 80 investors with over $1 trillion of managed assets have agreed to disclose and gradually reduce the carbon footprints of their portfolios.

Those to have adopted such programmes include several university endowments, religious bodies and high-profile charities. The Guardian Media Group has divested from all fossil fuels and its newspaper is lobbying funds including the Wellcome Trust to do the same. Perhaps the most significant move came last December, when Norway's government announced that it would begin excluding companies from the nation's sovereign wealth fund deemed harmful to the climate on a "case-by-case basis". That probably seems a bit rich when you consider that Norway's coffers have been filled largely as a result of the actions of state-controlled oil giant Statoil.

The thesis behind divestment is that, over time, it will reduce demand for shares in fossil fuel companies. Given that most organisations currently pursuing divestment strategies hold an insignificant share of the issued capital of large oil companies, this seems unlikely. And even many sympathetic quarters now argue that the current broad-based - yet media-savvy - campaign is simply diverting attention and resources away from more viable solutions on climate change. But while the financial impacts of divestment are debatable, the reputational risks may well build as public opinion mounts against carbon-intensive economic activity.

Combustible reputation

Coal is an important lesson here. As lobbying pressure has intensified from organisations such as 350.org, around £650m has been wiped off the value of global coal investments by UK public pension funds over the past 18 months. That seems impressive on the face of it, until you realise that collectively, oil, gas and coal companies constitute one of the world's largest asset classes, worth nearly £3.3 trillion at current market values.

Indeed, it can hardly be of great surprise that few large investment firms are willing to sanction stranded cost analysis, even if it comes from the mouth of the governor of the Bank of England. Oil and gas stocks account for 13.6 per cent of the weighted average of the FTSE 100 index and they're the second greatest source (behind financial services) of dividend income.

Few areas of the investment universe offer comparable benefits in terms of scale, liquidity and yield, although recently published research from Bloomberg New Energy Finance suggests that sectors such as information technology, pharmaceuticals, food and beverage and real estate could benefit from any strategic shift.

Such an asset reallocation is unlikely to be smooth. If fossil fuel industries were forced into a rapid downward spiral, it would invariably undermine global financial stability, aside from any individual ramifications for insurers, savers and pension funds. On that count, Mr Carney can hardly be blamed for adding his voice to an issue that has profound consequences for capital allocation. In essence, the threat posed by plans to divest away from fossil fuels bears a similarity to global warming in that they're both manageable over time; it's the rate of change that presents a problem.

Ease of substitution the key question

But given our reliance on fossil fuels, just how likely is the prospect of an orderly energy transition? What does seem clear is that a substantive move away from coal-based investments is a far more realistic proposition than a wholesale divestment from oil and gas groups. Publicly traded coal stocks are relatively small by comparison with integrated oil companies. Just a handful exist in London, with 70 per cent of the fragmented subsector's value taken up by Harworth Group (HWG), formerly known as UK Coal and now resurrected as a property regeneration company.

We are also witnessing a determined switch away from coal-generated electricity in favour of natural gas; a trend clearly evident in global capital flows. Natural gas is now seen by many governments as a bridge to a reduced carbon-based future, while the debilitating environmental effects of large-scale coal burning is now even recognised by China's Communist Party.

Although it's not difficult to imagine an accelerated move away from coal-fired turbines, the substitution of crude oil - to which institutional investors are far more exposed - is another matter altogether. Although we're likely to see a gradual fall-away in demand for crude oil in developed economies as private motorists increasingly opt for hybrid or electric vehicles, it is still indispensable where road-freight, shipping and aviation are concerned - and that's saying nothing of the petrochemical industry.