Long-term engagement with companies on environmental, social and governance issues has been touted as a route to impact positive change, but a new paper from the Alternative Investment Management Association is arguing that short selling has a role to play in the realm of ESG.
“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,” noted the paper.
The paper demonstrated how institutional investors could use short selling to mitigate carbon risk to their portfolios, in addition to having a positive impact on the market more broadly. It noted the practice of carbon foot-printing a portfolio is becoming more common, adding that alternative investment managers have lagged somewhat in this area.
“The demand for carbon data seems to be increasing and, as institutional investors come under greater pressure to disclose their carbon footprints or to set internal carbon budgets, they may well expect their external managers to report their own footprints,” said the paper.
Looking specifically to this issue, an asset manager could lower carbon risk within the portfolio by hedging through short selling. At the same time, these actions could shift market sentiment, according to the paper.
Short selling on a significant scale could increase the cost of capital for carbon intensive companies, it said. In addition, long-term engagement strategies from investors have the potential to have a negative ESG impact because long-term investments have the opposite effect of stabilizing the cost of capital for a company.
“To use a concrete example, take for instance [a] thermal coal-based utility company. Setting aside the question of engagement and looking at it from a purely financial perspective, there seems to be a growing consensus that if enough market participants took a long position in such a company it would create an adverse ESG impact.
“In taking a long position in the company, investors would effectively be rewarding it for its practices by lowering its cost of capital and rewarding its management to the extent that they participate in a long-term incentive plan. At best, such an action would not encourage the company to change its ESG practices; at worst, it could disincentivize the company and its management from doing so.
“The opposite, however, is also true. By taking short positions in the company, investors could, collectively, increase its cost of capital and negatively impact the value of management’s interests under the company’s executive incentive plan, thus encouraging the company and its management to change their practices.”