ESG investors often have to ponder the question: “What is a good sector to invest in now?” In response, defense usually ranks pretty low on the list, if at all. However, the invasion of Ukraine has prompted many to review their attitudes toward this sector and even actively consider investing in defense companies.
As ESG has moved into the mainstream, companies with a strong defense base have found themselves in a difficult position. Thales, which provides services for the defense market, has seen the equity share held by European investors outside its native France fall by 50% since 2016, according to the Financial Times.
In January, the chief executive of armored vehicle maker Rheinmetall revealed in the newspaper that its longstanding German bankers BayernLB and LBBW decided to end their working relationship. Meanwhile, says the Financial Times, some European banks are cutting their ties with companies that generate five to 10% of their revenues from defense-related activities.
ESG Investing and the War in Ukraine
The war in Ukraine is prompting thoughtful investors to consider putting their money into companies whose products can help democratic states defend themselves against foreign aggressors. The European Union (EU) appeared to perform a U-turn in February on proposals to class the defense industry as incompatible with socially sustainable finance. In addition, some companies such as Rolls-Royce, Thales, and Airbus have been calling for investors to regard the sector more favorably, arguing that security and stability are essential for sustainability.
Even before the current crisis, politicians were going through similar thought processes, with the EU debating the need for greater strategic autonomy in its own military capabilities last year. Germany announced in February that it will raise defense spending above the 2% threshold NATO members are committed to spend, although few actually do.
As the mood has evolved, portfolios have begun to bend in the direction of weapons and defense stocks, too. The sudden change in the fortunes of defense-related stocks is borne out by the numbers. Just after the Russian invasion of Ukraine, shares in defense Germany company Rheinmetall BAE Systems shot up by 58% and Italy’s Leonardo by 30%. Alongside this, Chemring shares leapt by 23%, while other groups such as Cohort, QinetiQ, and Babcock all saw double-digit increases.
One industry tracker, the Fidelity Select Defense and Aerospace Portfolio, rose 7.7% between the day of the invasion and the following day, compared with a gain of just 2.5% for the S&P 500 stock index, including dividends. Furthermore, just days after Russia’s action against Ukraine, Swedish bank SEB’s fund company, SEB Investment Management, announced that it would allow some of its funds to invest in equities and corporate bonds of defense companies and weapons manufacturers.
Tough Questions for ESG
The situation in Ukraine raises tough questions for ESG investors with no easy or clear answers. Charles Woodburn, CEO of BAE Systems, says: “You can’t have a focus on ESG without strong security underpinning that.” In March, two analysts at Citigroup argue: “We believe defense is likely to be increasingly seen as a necessity that facilitates ESG as an enterprise, as well as maintaining peace, stability and other social goods.”
Policy experts, like investors and the financial community, are divided over whether defense stocks can legitimately be part of an ESG portfolio. Lubos Pastor, a professor of finance at the University of Chicago told the New York Times: “Although self-appointed arbiters of responsibility may believe otherwise, leaders of our elected government, both Democratic and Republican, have always believed that having a strong military was socially responsible.”
In an effort to find a middle ground, SEB Investment Management included a caveat in its announcement: “All our funds will continue to exclude investments in companies that manufacture, develop, or sell weapons that violate international conventions (such as cluster bombs, land mines, and chemical and biological weapons). Also excluded are companies involved in the development of nuclear weapons programs or the production of nuclear weapons.”
Nevertheless, this leaves challenging moral questions regarding investing in defense. After all, a gun used to defend a home can also be turned on an innocent civilian and later trafficked to terrorist groups, drug cartels, and the like. Furthermore, the products of defense companies are often sold to and used in areas of the world where good corporate and political governance, due diligence, and transparency are limited.
Investors concerned with corporate social responsibility that are looking for defense companies to invest in will have to ensure that boards and business leaders are doing everything they can to comply with “Know Your Client” regulations and practices.
Pushback on Defense in ESG
Andrew Behar, chief executive of ESG advocacy and research group As You Sow, told the New York Times: “We don’t think that you should have any weapons systems in an ESG fund.” In a Bloomberg article, Sasja Beslik, a pioneer in sustainable finance and ESG investing, calls the idea of incorporating arms stocks in ESG portfolios “appalling.”
These voices are by no means alone in decrying the shift. In the Bloomberg article, Vicki Kalb, the EMEA head of ESG research at UBS Investment Bank, called it “emotional.” Investors who agree can vet mutual funds and ETFs for defense elements at Weapon Free Funds as they weigh positive screening versus negative screening.
ESG investors will continue to ask what is a good sector to invest in now, and the answer will always be affected by unpredictable global events as much as an investor’s goals. In a scarier world, looking at defense companies to invest in will become part of that decision-making process. That process may only become even more difficult in the ESG arena, where investments are tied closely to morality and ethics.