A recent study conducted by Boston-based State Street has found evidence of “green shorting”, a phenomenon in financial markets where investors borrow shares of companies with a weak sustainability profile and sell them in the hope they can buy them back cheaper when the price declines.
The phenomenon tends to affect companies that perform poorly on material ESG attributes, State Street said. In equity lending markets, these companies are associated with higher fees and increased levels of borrowing demand, which is seen as a proxy for short selling, the firm concluded in a report on the effect of ESG on the equity lending market.
Stocks are usually shorted in financial markets by investors who expect a decline in value. When a lot of people want to borrow this security, the cost of borrowing these securities goes up. Hedge funds are known to actively look for stocks they can sell short.
“A lot of people out there are looking for companies that are poor, when looking from a ESG or green perspective,” said Rick Lacaille, executive vice president and global head of ESG at State Street. “There is obviously no point in shorting something if you believe the prices goes up, or if the market doesn’t recognise what you’ve recognised.”
ESG ‘deeply embedded’
State Street said its report found that ESG considerations are “deeply embedded” in the securities lending market and “are growing in importance”. Based on statistics, the firm said that ”a significant positive relationship” exists between equity lending supply and ESG performance.
A relatively high level of institutional ownership of securities is one contributing factor, State Street said. “As ESG has become an important factor in investment decisions, institutions have increasingly shifted ownership away from stocks that perform poorly on ESG characteristics to stocks that are considered more sustainable,” it said.
In 2021, a firm in the top third of ESG scores had on average 8 percent more of its market cap owned by institutions relative to a firm on the bottom third. This is 16 times higher than in 2015, indicating ESG is of growing importance in institutional holdings.
State Street also found that institutions are less willing to lend shares of companies with a poor ESG performance, which restricts the supply of these types of companies.
More expensive to short
With demand among borrowers being equal, State Street found that poorly ranked ESG stocks are more expensive to short, and thus providing an opportunity for lenders to earn higher revenue. Borrowing fees for the companies with an ESG ranking in the bottom third are almost twice as high.
Trying to assess borrower demand for stocks with a poor ESG profile, State Street found that considerable effort is being made among investors to determine unsustainable firms within industries and sectors with a high ESG risk. Shorting companies with a poor ESG profile in the energy sector, for example, is twice as expensive and shorting demand is double the level of their peers, the firm said.
Lacaille added that the construction industry also will be one that comes into focus as the world transitions to a net-zero economy, “Investors, globally, are already discriminating between these cement companies that are better prepared than others,” he said.
‘Time is not your friend’
Time is a critical factor when taking on a short position. Lacaille noted that investors need to consider the time to generate a return. “The issue for anyone shorting is that time is not your friend.”
“So you can get companies that have a weakness of some sort from an ESG perspective,” he said, referring to taking a short position. “When it comes to fruition you get a sharp fall. The problem is, as an investor, you don’t know when that is going to happen. You might have quite a long wait before a weakness becomes apparent. So it’s quite difficult. It’s a growing area. People who run hedge funds have turned their attention to these issues recently because it is an inefficiency, and that is a source of alpha.”