Despite its rapid growth, responsible investment is still marked by its origins in the long-only world of ethical investing.
Responsible investment is still often incorrectly thought to refer to a specific type of long- term, buy-and-hold, engagement-heavy equity investing. While such an approach might make sense in the long-only indexed world, in which portfolio turnover is low and investment managers have little choice when it comes to the assets they hold, it is poorly suited to other segments of the investment management industry.
This perception has complicated the adoption of responsible investment in the alternative investment management industry. At its most basic, responsible investment simply refers to the formal integration of environmental, social, and governance factors into the investment decision. Such integration can take many shapes, and can be done for many reasons. While it can of course be driven by ethical concerns, it is also often driven by a desire to mitigate undesired investment risks, a desire to generate superior investment returns, or even a desire to reorient the flow of capital to certain industries and thus create an impact on the broader economy.
Confusion around this issue has led some to question whether short selling is compatible with responsible investment. However, if we consider some of the reasons why managers implement responsible investment, the utility of short selling becomes clear. Short selling can be an excellent tool for achieving two common goals of contemporary responsible investment: mitigating undesired ESG risks, and, when taken in aggregate, creating an economic impact by influencing the nature of capital flows through ‘active’ investing. Indeed, the Principles for Responsible Investment has recently acknowledged the potential utility of short selling when implementing responsible investment strategies.
In order to demonstrate the link between short selling and responsible investment, this paper uses the example of environmental risks. It presents a simplified, theoretical discussion of how such risks could be hedged. It also briefly outlines how short selling can have a positive effect on the wider markets, by raising awareness of carbon risks and encouraging issuers to limit their carbon emissions.