Environmental, Social, and Governance (ESG) is becoming increasingly important to many investors. The growing focus on the risks of climate change has permeated many fields, with prominent voices such as former Bank of England Governor Mark Carney arguing that asset managers have a significant role to play in promoting the transition to a net-zero economy. Allocators of capital, such as the Harvard Management Company, have made reaching a carbon- neutral portfolio a top priority. But how should one count the emissions generated by a portfolio? In particular, how should the emissions produced by companies that are sold short be counted? This paper showcases how short selling can be an essential tool to accomplish ESG goals by helping reallocate capital away from high-emissions companies all while maintaining investment performance.
Then, we introduce an equity demand model which shows that short sales have the potential to change the supply- demand balance for individual stocks and then estimate the effect of short sales on the allocation of capital. The paper then quantifies how the climate transition could have a differential effect on various sectors and how short selling allows investors to hedge that risk. In particular, the paper shows that short positions have the potential to reduce capital investment in the most emissions-heavy publicly traded companies by 3-8%.