Can short selling be used as a carbon offset?

There has been a great deal of debate in the last few months on whether short positions can act as offsets to the carbon emissions of long positions in a portfolio, through the netting of carbon exposures. As investors increasingly make net zero carbon emissions commitments and increasingly aim for real world impact in their portfolios (for E and S issues), how short positions are accounted for is a critical issue.

This paper addresses the subject of whether a short position[1] in a carbon emitting company can be perceived as a carbon offset for a long position in another carbon emitting company within the same portfolio.

Carbon intentionality

Before we dive into the debate, there is a foundational question that needs to be answered by all investors and fund managers: “What is the “carbon intention” of your portfolio?”

Is it:

• (A) to reduce or manage the carbon riskof the portfolio (such as the transition to a low carbon economy, the risk of a global carbon tax, etc.); or is it

• (B) to reduce carbon emissions in the real economy.

If the answer is (A), then shorting high carbon emitting companies can reduce your carbon risk. The overall carbon risk of a portfolio can be demonstrated through the netting the carbon emissions of long and short positions. In this instance we can call this accounting carbon offsets or financial offsets.

If the answer is (B) then your intent is to reduce carbon emissions in the atmosphere. This cannot be demonstrated by netting the carbon emissions of the short and long positions, as shorting does not remove carbon from the atmosphere.[2]

Short selling as an ESG strategy

Proponents of using short positions as a carbon offset rely on the argument that shorting a stock exerts downward pressure on that stock’s price, impacting the cost of capital and hence the operations of the company. However, using shorts as carbon offsets and the role of short selling in an ESG oriented strategy should not be confused. Short selling absolutely can have a place in an ESG oriented or sustainable strategy. For instance, shorting an “unsustainable” company can contribute to the reallocation of capital to more “sustainable” companies, and shorts can also be used for climate arbitrage strategies.

There are many external pressures from stakeholders (regulators, investors, shareholders, employees, customers, etc.) of a company to become a more sustainable and resilient company, and while short sellers can be one of them, it is inherently difficult to prove direct causality between shorting and a reduction in emissions for a company.

Accounting offsets vs. real-world impacts

When it comes to carbon emissions, it is imperative to understand the difference between an accounting or financial carbon offset and a real-world offset (a reduction of carbon emissions in the atmosphere).[3]

Using accounting offsets to reduce carbon exposures in a portfolio may make theoretical sense, however, unless an accounting offset is presented transparently and in context with real world impacts, an “observer may be fooled into believing that the portfolio strategy had managed to remove carbon emissions from the atmosphere simply by shorting. This is not the case.”[4] Netting short positions may remove theoretical emissions from a balance sheet but will not remove actual emissions from the atmosphere.[5]

To date, there has been no clear guidance on how to account for short positions in ESG reporting frameworks, sustainability regulations, disclosure requirements, or the various sustainable finance labels.

Transparency is key for Net Zero commitments

A recent paper and market survey from MSCI [6] revealed that overall, asset owners expressed the view that mitigating real world emissions is not the same as mitigating economic exposure to emissions, and “reporting just net ESG and climate metrics for long-short portfolios potentially conflates, and may obscure, investors’ intent, impact, ownership and risk management”.

The UN convened Net-Zero Asset Owners Alliance [7] and the Net-Zero Asset Managers Initiative [8] both have as an underlying tenet that commits signatories to removing emissions from the atmosphere. For those investors that have these and other net zero commitments that involve the actual reduction of carbon emissions, then shorting a company should not be considered a carbon offset. Therefore, managers would be well advised to produce carbon reporting on both the long and short sides of the strategy and let clients / investors and any other stakeholders decide how they want to account for these emissions.

In summary

• Shorting strategies can help to reduce the carbon and transition risk of a strategy
• The carbon risk of a portfolio or strategy can be expressed through netted carbon exposures or metrics
• Theoretically, shorting could exert pressure on a company to change and reduce its carbon intensity
• However, shorting does not remove carbon emissions from the atmosphere

Therefore, it is of foremost importance to understand the carbon intention of your portfolio or strategy. If the intention of your fund is to go beyond reducing the carbon or transition risk of your portfolio, to truly remove carbon emissions from the atmosphere, then shorting should not be considered as a carbon offset.

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Footnotes

[1] When you short sell a stock, you borrow the stock to sell it in the market, and then hope to buy back the stock later at a lower price and return the stock. You profit on the difference between the price that you sold the stock minus the price that you bought back the stock, net of the borrowing costs.

[2] Investment strategies that will help you reduce emissions include investing in companies that are reducing the carbon intensity of their business models, engaging with companies to influence them to reduce their emissions, as well as investing in carbon capture offsets with long lived storage capacity.

[3] Care should also be taken in the portfolio metrics that are used to measure the carbon intensity of a fund. For instance, using a WACI (weighted average carbon intensity) as a standalone metric to measure the carbon intensity of a portfolio/fund may bias your portfolio in certain circumstances. For instance, if energy prices go up, the carbon intensity of Utility stocks will go down not because they have reduced emissions, but because the emissions per $M of revenues has gone down.

[4] https://insights.issgovernance.com/posts/caught-short-the-importance-of-clear-reporting-on-the-use-of-derivatives-in-climate-strategies/​

​[5] In an op-ed published Feb. 18 in the Financial Times titled “Short-selling does not count as a carbon offset”, Man Group Plc’s co-head of responsible investment, Jason Mitchell, states that netting carbon emissions conflates a financial impact with a real-world environmental impact; https://www.ft.com/content/65ec280b-e9b0-40f3-9e6f-b0b65827aab6​

[6] https://www.msci.com/www/research-paper/long-short-esg-investing-best/03136460396​

​[7] https://www.unepfi.org/net-zero-alliance/​

[8] https://www.netzeroassetmanagers.org/​