Articles - Short in the dark

Emissions disclosure guidance tells us to park derivatives, at least for now. This makes sense – the problem is complicated enough on more straightforward assets, so staggering the rules is coherent. Moreover, for any calculation methodology, I suspect there’ll be an option structure that breaks it, leading to nonsensical emission figures. But not all derivatives are created equal. Futures and forwards, for example, would appear far simpler.

 By Alex White, Head of ALM Research, Redington
 It’s hard to see how holding the same exposure to an index, via a promise to buy it tomorrow, can lead to a different emissions profile than holding the index itself.

 However, if you treat futures as equivalent to the underlying, what do you do about short positions?

 The most obvious solution is to subtract the emissions from short positions from a portfolio. There are strong arguments for this, which largely boil down to the fact that any other approach will lead to mathematical inconsistency.

 For example:
 • An index is made of 50% each in companies X and Y
 • Investor A holds an active fund with £60 in X and £40 in Y
 • Investor B holds £100 in the index, plus a long-short overlay which is long £10 in X, short £10 in Y

 Both investor A and investor B hold identical portfolios. But if the emissions from shorting B are ignored (or treated as longs, on the grounds that they create a market for trading B), then the investors (with identical portfolios) will show different emissions profiles.

 This is a high hurdle for any other approach to beat, and this is the only approach which makes the total emissions from all investors add up to the correct amount.

 It’s worth reflecting on why there would be pushback against treating short-side emissions as negative. Clearly, shorting a stock won’t stop climate change. It’s not reducing emissions (at least not directly), so it shouldn’t be treated the same way as, for example, a carbon sink.

 The problem with this argument is that it conflates different issues. Having a portfolio with no emissions is not the same as having a portfolio aligned to an economy with no emissions. I can halve my own emissions by selling half my portfolio, or reduce it by selling all the oil stocks, but neither stops the companies from running. If you sell your shares in Exxon, they keep on drilling.

 That doesn’t mean divestment is useless. The rationale for divestment is that reducing demand should increase the cost of capital, making emitting more expensive. There’s a means by which it can work, but unlike a boycott it’s an indirect one. Crucially then, if divesting has any effect, then shorting must have the same effect. The change from short-selling is mathematically identical to that from divesting.

 To expand on the example above:
 • Investors C and D both start with £100 investments in the index
 • In one case, they both divest from Y, reducing investment in Y by £50 each, and £100 in total, and hold cash instead
 • In another, C does nothing, and D both divests and then goes short £50, reducing investment in Y by £100, and holding cash instead

 Since the net effect on the company is the same, the aggregate emissions reported from both C and D combined should be the same in either case. This can only happen if shorting and divesting are treated equally.

 As an aside, the direct emissions attributable to each pound held in Y would go up, as the emissions (in the short-term) from Y would stay the same but be divided among fewer investors; indirectly, the hope is that Y has less capital for new, polluting projects, and therefore lower emissions in the longer-term.

 The crux of the issue is the distinction between reducing emissions in a portfolio and reducing emissions globally. Scopes 4 and 5 emissions (replacement and removal) are underway, but shorting won’t qualify for those – it’s not an offset. Still, that doesn’t mean that short positions shouldn’t be treated as negative holdings for portfolio statistics, including direct emissions, in precisely the same way divestments are treated.

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