Commentary: Short selling companies with large carbon footprints can reduce climate risk, express sustainability goals

Many believe that security ownership results in a "carbon footprint" of some kind for those owners. And if they sell their positions to someone else, the new owners will bear responsibility for that carbon footprint, and the original owners have absolved themselves. A hot potato, of sorts.

Proponents of divestment argue that if enough people are trying to avoid having such a carbon footprint, the number of sellers will increase, and the price of securities will fall. And if securities prices fall far enough, then an enterprise with a large carbon footprint will not be able to finance itself and will shrink (or change).

Our view is that shorting securities offers two clear benefits in this context. First, it further increases selling pressure on a specific security. Second, short selling allows those investors with a desire to agitate for behavioral change in an emitting company to do so without creating more carbon risk in their portfolio.

Turning to the first benefit, short selling creates selling pressure, and therefore contributes further to the fall in securities prices and an increase in the cost of capital for the company in question. It is important to note that the size of this short-selling impact is exactly the same magnitude, but with the opposite directional impact, of buying a security — they are two sides of the same coin.

It is also critical to avoid the trap of "double counting" carbon footprints that could result from sloppy thinking regarding shorting.

To see the potential pitfall, it is crucial to understand the mechanics of a short sale. In the simplest example, Short Seller A borrows a debt security (issued by a heavy carbon emitter) from Investor B, and simultaneously sells that debt security to Investor C. Investors B and C naturally take on the associated benefits and risks — both enjoy periodic cash payments related to the carbon emitter, and both are relying upon the carbon emitter to pay back the principal at maturity. Therefore, both B and C are "long" the debt, and have to report that fact, in exactly the same way, to their stakeholders — and to regulators if they are large enough. Both are betting that the cost of carbon emissions can continue to largely be ignored in the future, and that the company will survive and prosper. However, while Investor B still has its original carbon footprint, Investor C now has one as well, where there used to be only one. How can there be double the carbon footprint when overall emissions from operations have stayed the same?

The answer is that the carbon footprint has not doubled. Indeed, there is only one carbon footprint in total. Instead, there must be a negative carbon footprint somewhere, and it must reside with Short Seller A. Investor B has +1 carbon footprint, Investor C has +1 and Short Seller A has -1.

Given its short position, Short Seller A is responsible for the periodic cash payments to Investor B related to the debt security, and for the principal repayment at the end. Short Seller A is betting that at some point that the financial condition of the emitter will deteriorate, and thereby it will be at least partially relieved of its obligations to Investor B. Therefore, if being long a security helps a company lower its cost of capital and bestows a carbon footprint on that owner, being short must increase the cost of capital and give that short seller a negative carbon footprint.

If we begin to count short positions as having a negative carbon footprint, won't that let some investors "off the hook" from having to sell their carbon-related holdings?

To keep short selling in perspective, only 2% of all shares are sold short. So only a tiny fraction of investors' aggregate carbon footprint could ever be eliminated by investing in a hedge fund that has a negative carbon footprint. There is no way that logically accounting for the carbon footprint of a short position will eliminate the need for the largest investors to act on their overwhelmingly positive carbon footprints.

We argue that for (smaller) investors that want to go a step beyond divestment and fully decarbonize their holdings, that short selling allows them to express that sentiment and economic view. Indeed, short selling should be encouraged in that it further increases the cost of capital for those companies whose securities have been lent out and sold.

Turning to the second benefit, counting short positions as having a negative carbon footprint can help an investor manage their "carbon budget," and facilitate positive engagement with those companies that need to change.

Many investors argue that rather than divesting from a carbon emitter and thereby abdicating their responsibility for affecting positive change, that they would rather buy the equity of an emitter and agitate for that positive change as an owner, buying a seat at the table. But an investor may have established a total "carbon budget," and there is a limit to just how many risky carbon emitters that it can own.

Also, deciding to take an ownership stake in a carbon emitter might violate the fiduciary duty of the asset manager to maximize returns while minimizing risk.

For example, an asset manager might take a position on Exxon Mobil Corp.'s board with the idea that Exxon can be improved vs. its peers such as Chevron Corp. or its European competitors. However, improving the relative performance of Exxon might still generate poor returns if the entire fossil fuel industry faces increasingly challenging conditions (which is inevitable, if the planet is to survive).

This is a conundrum — how to be a change agent without taking the risk of being involved in an industry that is likely to underperform over time. It is likely that no amount of relative improvement in Exxon vs. its peers could make up for the industry shrinkage required to meet the goals of the Paris Agreement.

A potential solution lies in short selling Exxon's peers, so that the investor can profit from overall industry underperformance. This would allow the activist to make its decision to invest in Exxon without taking a net long position in the industry itself. The activist can then be confident that it is fulfilling its fiduciary duty — that it is betting only on Exxon's relative improvement, without taking the risk of betting on an overall industry very likely to underperform.

If we properly account for short positions as having a negative carbon footprint, an active investor in Exxon with equal short positions in its peers could be considered to have a zero footprint — therefore preserving its carbon budget for initiatives elsewhere.

Making it easier for investors willing to engage with companies to change carbon policies from within the emitters themselves would be a significant benefit of the proper accounting of negative carbon footprints. The last thing we want to do is penalize engaged but properly hedged investors by assigning them large carbon footprints because we are unable to count offsetting shorts.

James Jampel is founder and co-CIO, and Matt Niblack is president and co-CIO of HITE Hedge Asset Management LLC, based in Boston. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.