With world leaders committing to reduced carbon emissions targets and with COP26 in November this year, achieving net zero is coming into sharper attention more than ever. Many expect further pressure on institutional investors that are already looking to reduce the emissions of their own portfolios.

The current movement toward net zero is admirable. While we applaud the increasingly common commitments from many allocators and managers, we are concerned that some may underappreciate the difficulties in achieving them.

Simply put, unless many public companies fully decarbonize, it’s infeasible to build a net zero portfolio purely through long-only security selection.

We wrote about this in our recent paper, “(Car)bon Voyage: The Road to Low Carbon Investment Portfolios.”

Before tackling the challenges of committing to a net zero portfolio, we need to agree on what net zero means. We interpret it literally, meaning an allocator intends to remove all carbon emissions embedded in their financial portfolio by some pre-specified date, usually set decades into the future.

In our view, a net zero commitment should be accompanied by a concrete plan of how to get there. Most allocators focus on intuitive and well-known design choices: divestment from the heaviest emitters, engagement with the remaining portfolio companies, and possibly an allocation to “green projects.”

However, these intuitive steps are insufficient in guaranteeing the desired outcome.

It is possible to build a long-only public equity portfolio with a drastically reduced emission profile, but attempting to reach true net zero causes huge distortions – as the desired reduction in emissions increases, the resulting portfolio gets unbalanced and concentrated.

While such portfolios may deliver, say, 90% reduction versus a benchmark, they cannot reach net zero, unless opportunities for negative emissions increase drastically in the future.

The situation will undoubtedly improve as more companies cut their carbon footprints. However, it is unlikely that the bulk of issuers will achieve net zero across all scopes of emissions anytime soon.

Therefore, making a net zero commitment and relying on long-only investing sounds a little like relying on a hope and a prayer.

We rarely see this discussed by investors committing to net zero, which we believe is a critical omission. If only a small fraction of issuers decarbonize, do the allocators repudiate their promise or begrudgingly build portfolios that lack diversification? Or are allocators open to additional design choices that arguably require some out-of-the-box thinking?

Christopher Palazzolo at AQR

Christopher Palazzolo

We highlight a few such design choices in our research. First, we note that carbon offsets can be used to remove residual carbon emissions from an allocator’s portfolio. This can be controversial, both because of potential concerns about the quality of offsets and the outright cost of running such a program (effectively an increased expense ratio), which may rise over time as demand for offsets increase.

Another alternative design choice is shorting. It too is controversial, but we think the potential negatives are manageable for most investors. First, one must consider how to account for the carbon footprint of short positions.

Clearly, ignoring shorts altogether when calculating a portfolio’s carbon footprint is incongruent with other aspects of portfolio accounting: if shorts matter for the returns you earn, for risk exposure you have, and for the dividends you receive or have to pay, then surely they should matter for carbon as well.

Additionally, if you count carbon from your portfolio’s long positions but ignore the shorts, the market’s aggregate math doesn’t work. The total carbon footprint of a company’s equities must equal:

(The total number of outstanding shares held including all shares borrowed from short sellers – the total number of outstanding shares sold short) X the average carbon emission per share

If we ignore any part of the equation, the numbers will not add up – it’s that simple. Additionally, while some may argue that shorting doesn’t allow for company engagement, nor does divestment.

Lukasz Pomorski at AQR

Lukasz Pomorski

However, an advantage of a shorting approach is it ironically allows greater long holdings in carbon emitters than a portfolio without shorting. Therefore, the long-short portfolio has even greater opportunities for positive engagement to affect emission reductions.

There may be biases against shorting, but they are not specific to ESG or climate concerns. Without shorting, we believe many of today’s asset owners will not be able to meet their net zero commitments when their target dates arrive.

Given this, our question to asset owners is: Why wait and risk being late to meet net zero commitments? We are managing net zero and net negative carbon portfolios today.

A well-constructed long-short portfolio can easily have larger emissions on the short side than on the long side. Such a portfolio may also help allocators manage climate-type risks and may even – thanks to shorting – offer an outright hedge that may offset such risks elsewhere in one’s allocation.

The ability to achieve a net zero target today through an implementable solution – rather than in the distant future through a potentially infeasible approach – is a hard-to-beat advantage. We firmly believe asset owners should consider shorting as a key tool in the toolbox to meet net zero commitments.

By Christopher Palazzolo, principal and head of responsible investment and EMEA, and Lukasz Pomorski, head of ESG research, at AQR Capital Management. AQR is a global investment management firm, which may or may not apply similar investment techniques or methods of analysis as described herein. The views expressed here are those of the authors and not necessarily those of AQR.