Hedge funds eager to prove that short-selling is a legitimate ESG strategy just got some fresh material to back their case.
A study published by the Managed Funds Association indicates that targeted short-selling campaigns could slash up to $140 billion in capital expenditure at the biggest carbon emitters in the S&P 500 Index by pressuring them to clean up their acts.
“While the role of short-selling in ESG has long been a topic of conversation, our paper provides quantitative evidence showcasing its impact on the cost of capital for a company and effectiveness as a tool for integrating ESG into a portfolio,” Bryan Corbett, chief executive of MFA, told Bloomberg.
The analysis by MFA, which represents the alternative fund management industry, feeds into a heated debate on the extent to which short-selling can genuinely be used to support environmental, social and governance goals. A recent report from MSCI Inc. found limited evidence to back the claim that shorting raises capital costs, and questioned its value as an ESG strategy. But the hedge fund industry has been vocal in its defense, as firms jostle to ensure they don’t miss out on the billions of dollars flowing into ESG.
“Short-selling has a unique and complementary role to play in conjunction with other tools in helping investors achieve their ESG objectives,” Corbett said.
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Questions around the appropriateness of short-selling as an ESG strategy coincide with a more aggressive stance from financial regulators. Authorities in Germany recently raided the offices of Deutsche Bank AG and its investment arm, DWS Group, amid allegations of greenwashing. And over the weekend, news broke of a US Securities and Exchange Commission probe into ESG claims by the asset management unit of Goldman Sachs Group Inc.
At the same time, a lack of clear regulatory guidelines around ESG is a concern, according to Sonali Siriwardena, partner and global head of ESG at law firm Simmons & Simmons. “Short exposures, how is that to be treated? What about private investments which have limited data availability? Does that still require disclosure? What about sovereign bonds? That data is just as inaccessible,” she said in an interview. It would be “helpful” if regulators addressed the confusion surrounding such matters, she said.
But despite an incomplete ruleset, the fallout from questionable ESG accounting may be significant.
“The financial risk may be limited, but companies and asset managers may face significant reputational risk if these claims are subsequently exposed,” analysts at BofA Global Research said in a note to clients. “Longer term, they run the risk of class actions, while the scope of ESG litigation is broadening from climate and environmental issues to use of resources and human rights.”
The MFA analysis is based on the 16 biggest emitters of greenhouse gases in the S&P 500, which weren’t identified by name. Together, the firms account for roughly half the total so-called Scope 1 and 2 emissions in the benchmark. The analysis found that the increase in the supply of a stock caused by short-selling would result in a lower share price and an average relative increase in a company’s weighted average cost of capital of between 1% and 3%.
That in turn would prompt companies to shift their capital expenditure by as much as 8%, equivalent to $140 billion, the study found.
The hedge fund industry is lobbying hard to get regulators to recognize short-selling as an ESG strategy. Europe’s landmark Sustainable Finance Disclosure Regulation, enforced in March 2021, has so far given it short shrift. But there are some early signs that the EU may adopt a more accommodating stance.
Last month, the ESG reporting specialist at the European Securities and Markets Authority, Patrik Karlsson, acknowledged that it’s currently “not entirely clear” within the framework of SFDR how hedge funds should report their short positions. He also said ESMA is reviewing its practical guidance in the area, in response to industry complaints.
In the UK, the Financial Conduct Authority has signaled it will take short-selling into account as it builds its own ESG rulebook, the Sustainability Disclosure Requirements. The FCA told Bloomberg earlier this year that it has “explicitly sought feedback on the role of derivatives, short-selling and securities lending in sustainable investing” because “we need to ensure that our regulatory framework is appropriately designed to accommodate the breadth of ESG strategies observed in the market.”
The Alternative Investment Management Association, which has publicly bemoaned the lack of focus on shorting in the EU’s ESG regulations, described the FCA’s signals as “really helpful.”
(Adds comment from BofA research note)
–With assistance from Frances Schwartzkopff.
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