Nathan Griffiths: Are defence stocks sustainable investments?

July 16, 2024

By Nathan Griffiths, Sustainable Finance, EY Netherlands

A question increasingly being asked by institutional investors is whether defence stocks can be considered sustainable investments. A more important question may be: do they need to be?

It is unsurprising that this question has arisen given the geopolitical environment and the outperformance of the sector, with the likelihood that it will continue to perform well given the need for European governments to increase their allocation to defence spending. In April 2024 the UK government and the Investment Association jointly declared that, indeed, the sector should be eligible for inclusion in sustainable investment funds.

The simple answer to the question is of course that defence stocks are not sustainable investments.

The UK ministry of finance stated that ‘Investing in good, high-quality, well-run defence companies is compatible with ESG considerations as long-term sustainable investments is about helping all sectors and all companies in the economy succeed.’ It is an interesting definition and not one you will find anywhere else.

Consider first the general requirements of a sustainable investment that have been defined in the European regulatory framework, and particularly the Sustainable Finance Disclosures Regulation and the European Taxonomy. There are three fundamental principles at the heart of both:

1) There is a sustainable objective.

2) The investment does no significantly harm (DNSH) to other sustainable objectives.

3) There is a commitment to social safeguarding.

It can potentially be argued that the sector is consistent with the first and third principles. Protecting the lives of its citizens is one of the most important requirements of the state. Whilst Western European countries have spent the past three decades working on the assumption that war was a thing of the past in order to progressively reduce their military capacity, unfortunately other geopolitical actors have not consigned war to the record books.

Therefore, if the development of, and expenditure on, weapons is solely for the purpose of protecting citizens, it can be considered sustainable. So long as they are the ‘good kind’ and not controversial weapons such as cluster bombs, chemical weapons and land mines. This indeed is the basis of exclusion lists for ethical funds.

Yet however one looks at it, it is almost impossible to argue that defence stocks avoid doing significant harm to other objectives. Simply by definition they are harmful to people and to nature. It is also impossible to produce and operate advanced weaponry without generating huge greenhouse gas emissions. If the principle of DNSH is to mean anything, the sector cannot meet the requirements.

The more interesting question is perhaps not whether the sector should be considered sustainable, but why there is a desire to do so. Few institutional investment funds allocate solely to sustainable investments. Estimates place the proportion of assets under management allocated to sustainable funds at 30-50%.

The argument that the sector is excluded from equity capital financing because of ESG considerations does not ring true. It is important also to note that the sector is not definitively excluded from ‘light green’ ESG funds. Even with the new minimum requirements for ESG and sustainability labelled funds, there is room for holdings which are not aligned with the stated ESG characteristics being promoted.

Where it may be more problematic is the reputational risk that pension funds, banks and other financial intermediaries may be concerned about if they invest in, issue, or underwrite large scale financing activities. This is not captured simply in the proportion of sustainable assets they hold or finance, but rather the potential for damaging negative publicity from stakeholder groups with an un-nuanced view of the world. However, whether the sector is ‘officially’ designated as sustainable will not make a lot of practical difference if public sentiment turns negative.

We should not confuse sustainable investing with ethical investing. Except for those with an entrenched ideological positioning, most people understand that defence spending is necessary, and, further, that we have entered a period of history where such spending needs to increase. There is nothing inherently unethical or immoral about the sector. The current state of the world makes clear that, whether we like it or not, an effective military is a vital deterrent. But that does not mean they should therefore be labelled sustainable.

If sustainable investing is to be meaningful, it is important that it is founded on sound principles. Whilst governments may wish to influence the actions of capital markets, the distortionary impact of poorly considered interventions can only be negative. The intention should be to strengthen trust in the sector.