Can managers go short on ESG risks?

Industry paper examines the possibilities – and caveats – of using short positions to support climate convictions

Can managers go short on ESG risks?

Through the decades, the responsible-investing space has grown increasingly over a number of dimensions. Aside from a melange of ranking and scoring systems, ESG performance metrics, and indexes, investors may also choose to engage in strategies that include negative screening, impact investing, and ESG integration.

But while the overwhelming majority choose to engage in fight-or-flight ESG investing, a new paper from the Alternative Investment Management Association (AIMA) argues that investors can unlock new possibilities by stepping outside the long-only paradigm.

“Short selling can be an excellent tool for achieving two common goals of contemporary responsible investment: mitigating undesired ESG risks, and, when taken in aggregate, creating an economic impact by influencing the nature of capital flows through ‘active’ investing,” said the authors of a recent AIMA industry guide titled Short Selling and Responsible Investment.

Focusing on carbon emissions as an example, the authors explained how, theoretically, an investment manager may wish to measure companies’ carbon footprint – and, consequently, estimate their exposure to risks such as carbon taxes and stranded assets. That could entail gathering data on companies’ scope 1 and scope 2 carbon emissions, and normalizing those values by the companies’ revenues.

With that data in hand, an investment manager could theoretically set up a long-short portfolio of companies, with short positions taken against those companies with too-large carbon footprints.

“[T]heir short position would act as a hedge against carbon risks, lowering the fund’s overall exposure to loss of value caused by carbon risk,” the authors said. “Indeed, if a manager considered the risks attached to carbon great enough, it could even be net negative on carbon risks, and run a fund that is theoretically ‘short carbon.’”

They further argued that short selling has the potential to lower carbon risks across the wider markets. If enough market participants engage in that type of short selling, they could increase the cost of capital for a particular targeted issuer, thus creating an incentive for the issuer to be less carbon-intensive.

“This could create a positive ESG impact, as the company may transition to clean energy, thus lowering the overall carbon emissions in the market,” the authors said. “This process would be even more pronounced in the case of public short selling campaigns.”

However, investment managers must consider certain caveats to short selling in the ESG context. As noted in the paper, there’s increasing pressure for managers to engage with portfolio companies and improve their ESG standing. That means managers running both long-only and hedge funds can find themselves in the awkward position of shorting a company they believe is exposed to outsized ESG risks on one hand, and engaging with that company to reduce those risks on the other.

“There is also the ever-present risk that any one metric will produce misleading results,” the guide said. For example, a measure that looks at scope 1 and scope 2 emissions normalized against sales may fail to account for carbon risks that materialize in other ways, or assign overly high risk exposure to companies that have moderate carbon footprints and drastically reduced sales.


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