Is it ethical to invest in bombs and bullets?
The answer for many European investors was long an easy “no”. But the question got more complicated with Russia’s invasion of Ukraine — and it’s become still more so after Donald Trump’s return to the White House, as I explain below.
ESG funds
Can investment in defence industry be sustainable?
“I fully share your loathing of European free-loading,” the US defence secretary wrote this month in a group chat that will echo down the ages. “It’s PATHETIC.”
Whether Europe needs to spend significantly more on defending itself is no longer a serious debate. In light of a newly unreliable US security guarantee, the question now is how the huge sums required will be mobilised. And that is likely to force some big changes around definitions of “sustainable” investment.
As European governments scramble to strengthen defence spending, they’ve turned their sights on environmental, social and governance investment practices and regulations.
This month, 100 lawmakers from the UK’s ruling Labour party wrote an open letter urging financial institutions to “rethink ESG mechanisms that often wrongly exclude all defence investment as ‘unethical’”. France’s financial market regulator has promised new efforts to “ensure that sustainable finance regulations do not create undue obstacles to defence financing”. Germany’s Christian Democrats, which emerged on top in last month’s election, have also promised to remove ESG-related obstacles to investing in companies that make things such as artillery and tanks.
Are they barking up the right tree? The problem, according to last year’s landmark report on the EU economy by former Italian leader Mario Draghi, is not so much sustainable finance regulations as the way investors have interpreted them.
EU regulations do say that sustainable-branded investment funds shouldn’t invest in companies that make so-called “controversial” weapons, such as landmines and cluster bombs. But European weapons companies tend to avoid these categories in any case. The regulations impose no explicit restrictions on investment in companies that make conventional, or even nuclear, weapons.
Allianz Global Investors sustainable investing head Matt Christensen reckons the problem stems in part from the requirement that sustainable fund investments should “do no significant harm” to the EU’s environmental and social objectives. This doesn’t rule out arms investments — but since all weapons are designed to do some kind of harm, many asset managers have erred on the side of caution, imposing strict internal restraints on investment in the sector.
Aside from regulatory concerns, these moves have also been driven by worries about reputational risk, said Hortense Bioy, head of sustainability research at Morningstar. “In an environment where asset managers have been accused of greenwashing, there is a risk-averse approach,” she told me.
Another factor is that some of the ESG indices used by sustainable-badged funds have tough exclusions against weapons producers.
The result of all this is a significant underweighting of defence companies. Morningstar estimates that European sustainability-focused funds have 0.5 per cent of their assets invested in aerospace and defence, compared with a 1.3 per cent exposure for conventional funds. With 60 per cent of EU managed assets now in funds that aim to promote environmental and social “characteristics”, this low weighting is material for the wider market.
Even so, it’s questionable how much this has constrained Europe’s defence sector. Bioy points out that big listed weapons companies have had little problem raising capital in recent years — unlike smaller ones and start-ups, who tend to rely on bank finance and private markets, and whose funding troubles were highlighted as a key problem in the Draghi report.
But the underweight position has certainly hurt ESG funds’ performance during Russia’s war in Ukraine, which prompted a huge rise in the valuation of European defence stocks. A Morningstar index of European aerospace and defence companies has risen 175 per cent since the start of 2022.
Anticipation of further outperformance — the biggest surge in share prices has come since Trump’s re-election — may prompt a rethink on defence stocks by some sustainable fund providers. But governments need to give a firm nudge to those who need more encouragement, argues a recent policy paper from Silvia Merler at the Bruegel think-tank.
Notably, she contends that the European Commission should formally urge sustainability-focused funds to invest a minimum proportion of their assets in defence — an inversion of the current paradigm, where many have a self-imposed maximum limit. While this measure wouldn’t be mandatory, Merler argues, it would mitigate managers’ concerns about the reputational risks of defence investments.
Meanwhile, institutional investors have already started publicly discussing how they will respond to the new normal of European security. Some are taking a hard line. Hadewych Kuiper, managing director at Netherlands-based Triodos Investment Management, argued:
The very purpose of weapons, namely to cause death and destruction, is diametrically opposed to any sustainable or ESG objectives.
Others are signalling increased interest. Sonja Laud, chief investment officer of the UK’s biggest asset manager Legal & General, told me that it was likely to increase its exposure to the booming defence sector, including in sustainable funds — though she stressed L&G would continue to offer some funds that excluded defence stocks, as long as clients wanted them.
One of the most interesting interventions so far has come from Philippe Zaouati, the managing director of Paris-based sustainable investment manager Mirova. Zaouati wrote that the exclusion of defence stocks by many of his peers had created “a financial blind spot” around a sector that requires intense scrutiny.
Greater engagement by sustainability-focused investors in the defence sector, as Zaouati argued, could help to raise ethical standards and force transparency in a sector that has a history of extreme opacity and corruption scandals, and whose products present obvious risks of social harms.
Europe’s altered situation, with an increased threat from Russia and diminished support from the US, has changed the ethical case for investment in its weapons sector. Amid the industry’s certain growth, investors have a chance to push for lasting improvements in how it is run.
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