A new report published by the Alternative Investment Management Association (AIMA) in collaboration with international law firm Simmons & Simmons examines how short selling can be used to achieve responsible investment goals
The paper focuses specifically on carbon footprinting, suggesting that taking short positions in carbon intensive businesses can be seen to lower the overall carbon footprint of a portfolio, while also explaining how shorting can create positive impact for wider markets.
With this paper, AIMA intends to debunk the belief that responsible and ESG investing must always be a long-term buy-and-hold strategy, suggesting rather that this type of investing is perfectly suited for the strategies employed by alternative investment managers, such as hedge funds.
According to the report: “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.
“Indeed, the Principles for Responsible Investment has recently acknowledged the potential utility of short selling when implementing responsible investment strategies.”
Carbon footprinting is the practice of measuring the carbon footprint of an investment portfolio to determine the extent to which a portfolio is funding harmful emissions and its potential exposure to the transition risks associated with climate change.
“In the former case, a firm may determine its carbon footprint as a prelude to decreasing its funding of carbon emissions,” the paper said.
“The latter case, however, is slightly more complex. It is premised on the notion that carbon emissions are associated with future business risks, and thus constitute potential investment risks.”
According to the paper, the most commonly used approach to measure carbon risk within a portfolio (weighted average carbon intensity or WACI) is not suitable to hedge fund managers, as the metrics are designed for long-only managers, and therefore do not account for potential short positions.
“In the case of a short position, carbon risks are not necessarily undesirable,” the paper explains.
“Should carbon risks materialise, and the value of the asset being shorted thus decrease, the manager would generate positive returns, rather than suffer losses. In other words, their short position would act as a hedge against carbon risks, lowering the fund’s overall exposure to loss of value caused by carbon risk.”
This means that hedge fund managers would be better off publishing a net carbon exposure figure, rather than disclosing their gross WACI score, which would include the carbon intensity of both their long and short positions, AIMA said.
In this way, short selling allows hedge fund managers to create a portfolio that is carbon neutral or, theoretically, every ‘short carbon’ in terms of its net carbon footprint (although AIMA admits this doesn’t get around the problem of funding carbon intensive businesses through the long positions).
The effect of short selling can extend beyond the actions of an individual manager, and eventually lead to market-level changes, according to AIMA, in a similar way voting against directors and resolutions by long-only investment managers can encourage companies to change for the better.
“If performed by enough market participants, [short selling can] increase the cost of capital for the targeted issuer, thus incentivising that issuer to protect itself against carbon risks by actively transitioning its business model to be less carbon-intensive,” the paper said.
This means that hedge funds can create positive ESG impact through short-selling practices if the short-selling is done on a wide enough scale.
“Crucially, such impacts may often be the positive side-effect of investment decisions taken for other reasons. For instance, a manager may choose to sell short a company in order to hedge against the carbon risks in its portfolio; in doing so the manager could contribute to creating a positive ESG impact.”
Meanwhile, according to UBS, hedge funds also have an advantage over long-only managers in that they can “inject liquidity” into the market, creating “positive market-related ‘externality’”. At the same time, “flows associated with their activity could potentially also help to conjoin information and markets, thereby being supportive for price disclosure”.
AIMA added that the positive effect of hedge fund investing would be particularly pronounced in the case of public short selling campaigns, although it noted these are less common and resource-intensive, as they involve unearthing information that was unknown or overlooked by the wider market.
However, in the case of carbon risk, the report suggests “it is easy to imagine a scenario in which a manager practicing active short selling discovers that an issuer’s carbon emissions have been understated, and publishes its findings”.
“This information would help other market participants protect themselves against the carbon risks in that issuer,” it said.
“This, of course, would also increase that issuer’s cost of capital, providing a strong incentive for it to limit its carbon emissions (and to report them accurately).”
However, UBS said the approach to ESG integration for hedge funds must depend heavily on the sector in question.
For example, “although fossil fuel businesses are typical exclusion sectors, therefore by implication unlikely to be on the structurally long side of ESG hedge fund positions”, UBS suggests that “tactical considerations around green transitions could also be taken into account in several ways in the context of long/short strategies”.
Even within such sectors as mining, UBS points to the risks of “stranded assets” on the one hand versus the ESG megatrend towards “green” or sustainable operations and supply chains on the other, meaning that for a hedge fund strategy the mining sector is “hard to call one way or the other” on ESG risks.
“Hence, likelihood and potential impact are key to calling the balance between risks running in opposite directions,” UBS said.
Similar issues arise in many other sectors, including resources and electricity and China’s internet sector, to name two examples. In such complex sectors, UBS said “a long-term investment horizon (and tolerance of volatility) is likely to be required to position for some ESG perspectives on the trend to be realised”.