Investors Miss Out on Gains When They Avoid Short-Selling for ESG

“Short selling allows investors to become shareholders for change in a company without creating more ESG risk,” says Harvard Management Co.’s Michael Cappucci.

Bing Guan/Bloomberg

Bing Guan/Bloomberg

Betting against companies that aren’t doing the work to meet environmental, social, and governance goals is an effective tool for sustainable investors. But it’s rarely used.

In a report released Monday, with a forward from Harvard Management Company, the Managed Funds Association argued that short selling can lead to more capital allocation to carbon neutral investments and can work to pressure companies to reduce their greenhouse gas emissions. If the practice of selecting stocks based on their ESG impact on capital allocation is effective, then shorting heavy-emitting companies should have a similar impact on capital allocation.

“Whether it’s in energy, transportation, or manufacturing, shorting securities offers two clear benefits. First, it further increases selling pressure on a specific security,” Michael Cappucci, managing director of sustainable investing at HMC, wrote in the forward. “Second, it allows investors the ability to become shareholders for change in a company without creating more ESG risk in their portfolio.”

For example, the report breaks down how climate hedging affects the liquidity of the stock supply. When investors take a short position in a carbon intensive stock and a long position in the market portfolio, they increase the demand for the market portfolio and increase the supply of carbon-heavy stocks. This dynamic can have a potentially permanent impact on the stock prices.

For this to work, the impact on the stock price will depend on the market’s reaction to how the shorted position impacted supply. Typically, the short position will decrease the stock price, particularly if the increased supply isn’t balanced out by an increase in demand.

As prices on carbon-heavy stocks decrease and the market portfolio grows, a wedge will form between the expected risk-adjusted return on carbon-heavy stocks and their price, the report said. Investors will then earn an excess risk-adjusted return on their carbon-heavy stocks, which they can attain by going long in carbon-heavy stocks and shorting the market portfolio — the opposite strategy.

Shorting carbon-heavy stocks has a direct, downward impact on equity prices, which means that it will also impact the cost of capital and, inevitably, capital allocation. The report provided two scenarios: In an analysis of short positions in the top 16 emitters, MFA looked at shorting’s effect on the weighted average cost of capital (WACC) and total capital allocation compared to a situation in which the assets aren’t shorted at all. In the second scenario, MFA looked at the same factors when the shorting of heavy-emitting companies is used by investors to hedge climate risks.

In the first scenario, WACC increased an average of 0.045 percentage points for the heavy-emitting companies as a result of short selling. The report also estimated that the increase in WACC will result in a decrease in capital allocation to the top 16 emitters, which could range from 1-2 percent.

In the second scenario, MFA turns it up a notch: The report simulated the impact on WACC and capital allocation when shorting is used to fully hedge climate risks. In this case, MFA shorted the top 16 heavy-emitting stocks up to 10 percent of total market cap, which is the maximum amount these stocks can realistically be shorted.

Through this scenario, MFA calculated a 3 percent increase in WACC and a resulting decline in capital allocation that ranged from 3-8 percent — about $50-80 billion.

For MFA, these scenarios prove that shorting has a real-world impact on the cost of capital (it goes up) and therefore capital allocation (it goes down) to heavily carbon-emitting companies.

Shorting has not been widely viewed as a robust method of reaching ESG goals. Popular methods of ESG-minded investors include divesting from “brown” — companies with poor ESG ratings — or engaging with the companies through methods like shareholder activism.

MFA argues that these aren’t investors only tools. In fact, investors can — and should — influence companies through pricing mechanisms such as short selling.

An added bonus: Because short positions provide investors with negative exposure to companies, MFA argues that the carbon emissions of those companies count toward the investors’ carbon emissions metrics. In fact, it would make sense to net the two — subtract the shorted stock’s carbon emissions from the carbon emissions of the other long holdings. This is mutually beneficial: The investor gets to offset their carbon footprint and their ESG efforts become more accurate and transparent.