Up until now there was really only a few ways in which investors could seek to account for the carbon impact of the companies they invested in. Either engage with management on change but essentially remain invested, divest partially or completely, or alternatively, seek to offset the carbon impact in some way through the purchase of carbon offsets or emission permits.
In a letter to Australian Prudential and Regulatory Authority (APRA), obtained by ‘The Age’ and ‘The Sydney Morning Herald’ in a freedom of information request, hedge fund titan AQR offered an alternative. According to the fund its Australian clients were now exploring the use of short selling stocks to reach net-zero targets in their portfolios:
“The usual approach of security selection (e.g. divesting from firms with the highest emissions) can lead to a substantial carbon reduction but may not be enough for investors with the most ambitious reduction targets. Such investors may need other techniques to achieve their goals, for example shorting high carbon-footprint companies or trading instruments such as carbon offsets and carbon permits.”
AQR explained that there are two ways in which short selling could help meet net-zero targets. The first is to hedge the risks of any remaining carbon intensive investment exposures, and the second is to increase the cost of capital for polluting industries.
Related article: How high do carbon prices need to be?
It’s important to be clear that divestment campaigns are active in the secondary market for an equity. To recap, it is the primary market at which a company raises funds through the selling of shares. In contrast, the secondary market involves the trading of those shares between different investors, and relates to their view of the future prospects for the company after the initial flotation on the stock market. Since divestment and short selling targets the secondary market there is no direct influence on the ability of corporations to raise money via stock or bond issuance. However, advocates for divestment/short selling argue that it isn’t about starving companies of capital, but removing their social license to operate, breaking their influence on both investment institutions and government.
The power of engagement
It only requires a small percentage of an investor base to become intransigent with a company’s failings (say how much fossil fuels it burns), before the management to have to succumb to their preferences. This minority rule phenomenon as Nassim Taleb refers to it, means that “intolerant virtuous people with skin in the game” can have an out-sized impact. For example, in mid-2021 an upstart activist investment firm called Engine No.1, campaigned for oil and gas major ExxonMobil to have at least two green activists on the board. Engine No. 1 ultimately succeeded in winning a shareholder vote despite owning 0.02% of the company’s stock.
Is it better to be on the inside, with a seat at the table and in a position to influence?Arguably it is those companies that are on the path towards decarbonisation that need the most support (however bad their starting point is), not being treat as a pariah. The alternative is being on the outside without a vote and no influence. If investors divest then the proportion of a fossil fuel company’s investor base concerned with ESG will naturally dwindle. Instead of being heckled by vociferous shareholders with an ESG axe to grind at the AGM, senior management will gradually face much less resistance to just carry on with ‘business as usual’.
Up until now that question of whether to engage or not to engage, has been viewed as simply from a ‘long only’ perspective – do I invest , or don’t I? The letter from AQR suggests that an alterative way of getting your point across is by being an activist short seller:
“However, carbon-sensitive investors are unlikely to hold large emitters at all, which limits their ability to engage (or even communicate with) such companies. We posit that establishing a short position is more effective for engagement than not holding any position at all. This is because corporate management teams are generally aware of what the short community think about their companies, and even if they disagree, there is at least some communication.”
If the assets of fossil fuel companies and other extractive industries are left unexploited or decline in value because of actions to reduce the threat of climate change, these unexploited assets are deemed to be “stranded”. A report by AQR, also sent to APRA, said investors with net zero emissions targets are shorting companies they believe will decrease in price when:
“…transition and/or physical climate risks materialise and [are] long in securities that are likely to be relatively less harmed in such an event”.
High profile short-seller John Hempton, who founded asset manager Bronte Capital, was quoted in an article with ‘The Age’ newspaper that high emitting companies were already fertile ground for short-sellers, because they are:
“economically unviable, socially unviable, [and] just a bad idea. You short a lot of these coal players for the same reason you once shorted buggy whips for your horse and cart, they smell of yesterday.”
Down, but not out
As regular readers of Materials Risk will know by now, oil, coal (thermal and coking) and gas are likely to be part of the energy mix for a lot longer than many hope or expect. Even if transportation makes a swift shift to electric vehicles, crude oil is embedded in the production of almost everything that we take for granted. That will be significantly more challenging to find low or zero carbon alternatives. Take another example, coal. According to the IEA, global demand for the fuel peaked at 8 billion tonnes in 2013, and despite a dip in 2020 coal consumption is forecast to rebound in 2021 and then remain around 7.4 billion tonnes per year through to 2025.
By pushing down the price of high carbon investments, AQR and others short selling resource stocks will simply give a free pass to investors willing to take the other side of the bet. Remember that for every seller in the market there must be a buyer, and the market must clear somewhere.
Part of the reason so called sin stocks outperformed in the past is that they are under-priced because so many investors shun them and so investors must be compensated to buy constrained stocks through higher returns. Another reason is that they are restricted in how they can grow their assets. This reduces the risk that incumbents will seek to increase capacity, and is a barrier to new entrants into the market.
It may be a surprise to some to know that one of the best performing commodities of 2021 has been coal. For example, Peabody Energy, the biggest coal mining company in the United States is up almost 500% since the start of the year.
There may be a right time to short high carbon resource equities (i.e. when they go the way of the buggy whip), but that time is not now. In the meantime investors that see shorting as a way to meet their zero-carbon portfolio targets may be seeing red.
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