Investors should short big emitters to achieve net zero targets, paper suggests

Investors with Net Zero ambitions will not be able to rely on stock selection alone to achieve their goals, and must start to look at carbon offsetting techniques like short selling, according to one asset manager in the US. 

Boston-based alternatives specialist AQR Capital Management released a paper last week titled (Car)Bon Voyage: The road to Low Carbon Investment Portfolios, whose “central message” is that while inclusion and exclusion of securities “can lead to a substantial carbon reduction”, the approach “will not be enough for investors with the most ambitious reduction targets”. 

To realise these goals, investors will need to employ other strategies, such as shorting and offsetting through carbon credits, it claimed. 

Of the two approaches, the paper argued short selling is “more efficient” because it is financially motivated and therefore “likely aligned with an investment view”. “An allocator would short a high emitter when it is expected to fall in price,” it explained – whereas buying carbon offsets to hold or retire does not contribute to “future value” or manage climate risks. It added that a short-selling approach would probably be the relatively cheaper option, “especially if the cost of carbon offset projects and permits increase in the future”. 

Last week, Europe’s Institutional Investors Group on Climate Change (IIGCC), which represents investors with €35trn in combined assets, deemed carbon offsets not to be a credible tool for creating ‘Net Zero’ portfolios or companies in its Net Zero Investment Framework.

According to AQR’s study, it is possible to reduce a portfolio’s carbon footprint by 70% versus the S&P 500 with less than a 1% tracking error to the benchmark using divestment. But the tracking error “spikes” when decarbonisation is taken further, “almost exponentially as we approach net zero”.

Figure 2. Portfolios composed from S&P 500 stocks and built to miminmize the tracking error versus S&P 500, while targeting a given level of carbon reduction data versus that benchmark. Portfolios are optimized using the US Equity Barra risk model and reflect data as of 6/30/2020. Superimposed are the carbon reduction and TE of US equity ETFs that have an explicit Sustainable mandate. Source: AQR, MSCI, Trucost, Morningstar

A “major benefit” of shorting stock, the paper finds, is that it can help investors achieve “meaningful carbon reduction without concentrating their portfolio nearly as much as pure long-only security selection would”. 

It claimed a portfolio can achieve a net zero carbon footprint by shorting just 2% of the portfolio’s net asset value (NAV) “while still being fully invested”. 

“The resulting TE [tracking error] of the portfolio to the benchmark is only 0.32%, meaningfully less than the 10%+ required in long-only portfolios that target a 99% reduction”, the paper stated.

The accounting behind carbon shorts is based on the argument that emissions associated with a short position are the inverse of the emissions linked to the shorted stock; so, if an investor shorted stocks representing one tonne of carbon, its footprint would be negative that amount (see below). 

The paper concluded that there is a “strong case” for shorting based on emissions and finds that the benefits are “appealing enough” to justify the “costs and operational complexity”. Although it also acknowledged that “some investors have institutional constraints that prevent them from shorting”.

AQR was set up by controversial former Goldman Sachs trader Cliff Asness and is one of the biggest hedge fund managers in the world. 

The paper, which originally came out in October, was co-authored by the AQR’s Head of Responsible Investment, Christopher Palazzolo, Head of ESG Research, Lukasz Pomorski and Vice President, Alice Zhao.