The Evolving Landscape of Defence Stocks and ESG Considerations
In recent years, the conversation around defence stocks and their compatibility with Environmental, Social, and Governance (ESG) criteria has undergone a significant transformation. This shift is largely driven by the geopolitical landscape, particularly the Russian invasion of Ukraine, which has forced a re-evaluation of the role defence companies play in national and global security.
Historical Context and the Impact of Ukraine
Prior to the Russian invasion of Ukraine in early 2022, defence stocks were often shunned by ESG-focused investors, lumped together with other ‘sin’ stocks such as those related to alcohol, gambling, tobacco, and pornography. However, the urgent need to arm Ukraine and deter Russian aggression has led to a rethink on this stance. The UK government, for instance, has publicly backed Ukraine, and British defence companies have become crucial in this effort.
This change in perspective is reflected in a joint statement by HM Treasury and the Investment Association, which declared that “investing in good, high-quality, well-run defence companies is compatible with ESG considerations” as long as it contributes to long-term sustainable investment across all sectors of the economy.
The Role of Geopolitics
The recent escalation in tensions, particularly with the return of Donald Trump to the White House and his ‘America First’ policy, has further highlighted the importance of European countries taking responsibility for their own defence. This has led to increased defence spending in the UK, with the government raising its defence budget from 2.3% to 2.5% of GDP, an increase of £5-6 billion annually. Public support for this move is strong, with two-thirds of Britons favouring increased defence spending over overseas aid.
ESG Considerations in Defence Investing
While defence stocks are gaining acceptance within ESG frameworks, several challenges remain. Traditional ESG screens often fail to account for the unique geopolitical risks associated with the defence sector. For example, defence companies operate globally, supplying arms to various countries, some of which may be deemed unpalatable by ESG standards. This complexity makes it difficult for investors to ensure that their investments align with their values and ESG criteria.
To address these issues, some investors are adopting more nuanced approaches. For instance, the Future of Defence UCITS ETF (NATO) employs a dual-screen strategy, combining standard ESG screens with a NATO screen. This ensures that companies included in the ETF are headquartered in NATO+ countries, mitigating risks related to geopolitical exposure and compliance with international standards such as the United Nations Global Compact (UNGC) and OECD Guidelines for Multinational Enterprises.
Managing ESG Risks in Defence
Responsible investors must carefully assess the ESG risks associated with defence companies. These risks include reputational and legal issues related to weapons manufacturing, compliance with international humanitarian law, and adherence to arms embargoes imposed by the UN Security Council or other multilateral entities. Investors should conduct thorough due diligence on the business relationships of defence companies, especially those operating in conflict zones or with states under international sanctions.
The Need for Reform
While the reclassification of defence stocks within ESG frameworks is a positive step, it is crucial that UK politicians offer corresponding reforms to ensure these companies operate in a manner that aligns with ESG principles. This could involve stricter regulations on the export of arms, enhanced transparency in business dealings, and robust human rights due diligence.
In conclusion, the integration of defence stocks into ESG portfolios is no longer a straightforward rejection but a complex consideration that requires careful risk management and due diligence. As the geopolitical landscape continues to evolve, it is imperative that both investors and policymakers work together to ensure that defence companies contribute to national security while adhering to the highest ESG standards.
By supporting reforms that enhance transparency, compliance, and ethical practices within the defence sector, we can create a more sustainable and responsible investment environment that benefits both investors and society at large. As we move forward, it is clear that the defence sector’s role in ESG investing is here to stay, but it must be accompanied by a commitment to ethical and sustainable practices.
