From Fossil-Fuel Divestment to Long-Short Equity
Our company’s journey from fossil-fuel divestment to long-short equity may not seem intuitive, but it has mirrored the evolution of strategies that investors are using to align their portfolios with financial considerations and impact opportunities associated with climate change.
Those in the sustainable, responsible investment ecosystem know FFI best for its exclusion list, The Carbon Underground 200TM (CU200). Since 2014, this list of the largest fossil-fuel companies ranked by embedded emissions in reported reserves has been used by market participants to screen over $8bn in assets.
Four years ago, we started efforts to expand our business beyond fossil fuel divestment in order to have a greater impact on what was, at the time, a nascent but growing movement among institutional investors to build more sustainable portfolios. Core to this effort was and is our evaluation of stranded asset risk and the identification of companies within the CU200 that are most vulnerable to the transition of the global energy sector from fossil fuels to clean energy. Instead of simply divesting from these companies, our view is that investors can utilize short positions on a select group of fossil fuel companies least positioned for the transition to accomplish both financial and impact goals. In essence, our position is that shorting fossil fuel companies is not only a natural extension of fossil fuel divestment, but a superior way to accomplish portfolio decarbonization objectives.
The logical corollary to the fossil fuel short thesis is a proportional investment in the clean energy sectors that are replacing the existing fossil fuel infrastructure, specifically within the renewable energy, energy storage and electric mobility sectors. Commensurate with the stranded asset research we began four years ago, we are now focusing on research and analysis of ‘clean’ energy industries, in collaboration with industry experts like Clean Edge Inc. The objective of this research is to identify and invest in those clean energy (and related) companies that have current and positively trending business fundamentals to profit from the shift in demand for low and non-carbon solutions for energy and transportation.
The natural implementation of the thesis and the product of our work is the FFI Energy Transition Long-Short (ETLS) Fund. While our team has, collectively, over 50 years of experience as hedge fund allocators, managers, and traders, we have not set out with the intention to create a traditional hedge fund. Rather, our objective in creating the ETLS was to deliver a ‘turnkey’ solution for investors that enables them to fulfill their decarbonization goals, have impact, and also position their portfolios for both the risks and returns associated with the energy transition.
What is a Net Zero Portfolio?
Institutional investors are increasingly adopting “net-zero” portfolio objectives as stakeholders clamor for more climate-aligned investment programs. Net zero is a concept that simply means that the carbon emissions put in the atmosphere need to be equal to those taken out. It is a concept that originated to guide climate policy, but has since evolved into an investment objective being adopted by an increasing number of asset owners and managers.
What net zero exactly means is still evolving, but the Institutional Investors Group on Climate Change (“IIGCC”) and The Investor Agenda provide frameworks for investors to implement net-zero portfolios. While those frameworks lack detailed guidance on how to achieve such objectives, two main elements of a net-zero investment strategy are clear: 1) decarbonize portfolios and 2) invest in climate solutions.
The Conflation of ESG and ‘Net Zero’
Aren’t ESG funds net zero? ESG funds evaluate companies by focusing on their operating characteristics and not the underlying products the companies produce. Companies with strong ESG scores (and even strong E scores) do not necessarily align with net zero nor have they made net-zero commitments. As such, ESG funds may provide some small incremental progress toward net zero, but they are not specifically designed to achieve such net-zero goals.
What about clean energy ETFs? Clean energy ETFs provide for investment in climate solutions. And those solutions contribute to avoided emissions (e.g., solar panels, when installed as part of a system, replace energy that would otherwise be generated by fossil fuel sources), but the IIGCC framework has stated that these avoided emissions cannot be counted against the GHG scope 1, 2, and 3 emissions of a given portfolio. These clean-energy companies generate GHG scope 1, 2, and 3 emissions and the inclusion of these companies in a portfolio can actually serve to add to a portfolio’s overall carbon footprint. As such, while investment in clean-energy companies is clearly beneficial, and part of a net-zero plan, they do not summarily benefit an investor’s portfolio decarbonization goals.
Shorting to Decarbonize
We at FFI are not the only practitioners who have recognized that short positions can be used to “offset” an investor’s carbon footprint.,, While the accounting treatment of the carbon footprint of short positions is not fully settled, in order for carbon accounting to work overall, all holders (long and short) of an individual company’s carbon footprint should be counted. Fossil-fuel divestment does not provide the negative carbon accounting benefit. In this way, shorting is a more efficient and effective mechanism to decarbonize portfolios than simply making adjustments to long-only holdings.
In addition to providing an offset, shorting high emitters is a way to manage the risks of, and generate returns from, the ultimate decline of companies that harm the environment. The massive disruption of the energy markets is underway, and it is now just a matter of when, not if, energy and transportation systems become green. Excluding fossil fuels from a portfolio can help an investor avoid that risk, but shorting can enhance the portfolio even further by positioning the investor for transition risks and returns.
Finally, while short positions don’t provide investors with ownership interest, they often do have influence on corporate behavior. Shorting has long been an effective way to put companies on notice about the need to improve their performance. For socially responsible and impact investors, similar to divestment, shorting can be used as a direct way to penalize companies for harmful business practices (such as exploring for and producing fossil fuels, which must be dramatically reduced in order to achieve net zero emissions). This penalty, so to speak, potentially manifests itself in lower share prices and the potential increase of the weighted average cost of capital (WACC) of those companies being shorted.
How to Think about the ETLS
While we may not have realized it four years ago, the ETLS strategy is a simple turnkey, net-zero solution achieved by the utilization of short positions in fossil fuel companies (to decarbonize portfolios) and long investments in clean energy companies (to invest in climate solutions).
The ETLS employs both long and short positions, is extremely liquid and is available as a co-mingled private fund, ‘fund of one’, or separately managed account. The overarching purpose of the strategy is important because we are committed to delivering a strategy that will be long clean energy and short fossil fuels until the point at which the risk return profile from that positioning becomes less attractive relative to an investment in the broad equity markets.
In summary, the ETLS is as a solution for long-term investors who want to:
- Implement a net-zero portfolio
- Demonstrate an investment strategy that is consistent with the Paris Climate Agreement
- Hedge against increasing carbon prices.
- Impact global decarbonization efforts
- Extract long-term profits from the inevitable energy transition
 Decarbonizing portfolios is generally accepted to mean reducing the GHG Protocol Scope 1, 2, and 3 emissions produced by portfolio companies.
 As the good folks at AQR have pointed out, achieving a net-zero portfolio, even by 2030 will be difficult without the use of shorts or carbon offsets.
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