The West’s rush to supply weapons to war-torn Ukraine looks like a golden opportunity for defence companies to exit the ESG doghouse. Russia’s invasion and rising defence budgets are pushing some market players to engage with companies in the $485 billion military equipment industry that previously failed to pass muster on environmental, social and governance grounds. Despite pressing calls from President Volodymyr Zelenskiy for more tanks and missiles at last week’s Munich Security Conference, however, the sector will largely remain a no-go investment zone.
As with air-polluting coal, socially-minded investors including pension funds and insurers - particularly European ones - have long excluded or heavily restricted investment in defence companies on ethical grounds. These actors would generally not touch anyone making chemical weapons or cluster bombs, which are prohibited under international conventions. But they often also exclude from sustainable-labelled funds firms deriving more than 10% of annual revenue, and sometimes just 5%, from military equipment and services.
A year after Russia’s invasion of Ukraine, the mood is now shifting, the head of a European surveillance technology maker said on the sideline of the Munich forum. The event saw Vice President Kamala Harris, French President Emmanuel Macron and Nato Secretary General Jens Stoltenberg gather at the city’s historic Bayerischer Hof hotel. Risk committees, particularly at domestic banks, are now more frequently assessing the merits of financing defence companies, two senior bankers among the 850 or so conference participants said. Lorenz Meier, chief executive of US-based drones software firm Auterion, said he had been approached by venture capitalists and family offices in the past year, as his company’s revenue shot up.
For hedge funds and other actors willing to bet on the sector, the main pull factor is clearly NATO governments’ willingness to spend more. Reversing years of underinvestment, the 214 billion euros combined military budget of the 26-nation European Defence Agency is expected to grow by 70 billion euros by 2025 if member states fulfil their commitment to spend 2% of their GDP on defence. That’s chiefly what has driven shares in Germany’s $12 billion Rheinmetall, which makes Leopard 2 tanks now being offered to Ukraine, up 160% since the war erupted. Sweden’s Saab, which won big government contracts for anti-tank weapons and other equipment, saw a similar rally and is now worth $7 billion.
Softening ESG restrictions would woo a broader investment pool. Proponents of the approach argue military companies that help Ukraine perform a globally valuable social function by upholding democracy. Others suggest making a distinction between weapons used for defence and those amassed for attacks. Finally, exceptions could occur if national parliaments direct companies to meet certain military commissions, as was the case with Rheinmetall’s tank order. Spotting an opportunity, asset manager SEB Investment Management last March lifted restrictions for some of its funds to buy into companies that make non-banned weapons.
Such growing geopolitical tensions may support the case for a softening of current ESG criteria, particularly in Europe. Asset managers may consider raising the cap for the proportion of annual revenue derived from defence. Or they may lift restrictions for a limited number of companies.
Still, a broad relaxation of investment criteria would be a slippery slope. Distinguishing between weapons on the basis of their supposed offensive or defensive function would be very tricky. It would also put investors at odds with a UN sustainability target to uphold peace and justice and to significantly “reduce all forms of violence and related death rates everywhere”. Weapons or equipment that can result in the killings of human beings are a clear violation of the "do no significant harm" principle that is at the basis of all sustainable investment. Widespread popular support for defending Kyiv may also weaken if the war becomes be too long or too costly.
For long-term investors and large international banks looking for growth, the war on Ukraine offers a veneer of respectability to charge into defence. But it may ultimately prove too thin for significant numbers to actually do so. — Reuters