- Investments in defence stocks have fallen recently, but 52% of ESG funds, compared with 67% of regular funds, contain exposure to military weapons.
- Nearly one in ten ESG funds score the lowest possible grade for exposure to major military contractors, compared with almost two in ten across all funds (9% vs 19%).
- While ESG funds in general have less exposure to arms manufacturing than fossil fuels, they hold more exposure to these stocks than to tobacco companies.
Russia’s war on Ukraine has set alight an old debate about whether weapon makers’ stocks can be considered ESG investments.
Taking a similar line to that trotted out by the US’s National Rifle Association after a mass shooting, a handful of analysts at the word’s largest, most established investment banks are asserting that the current conflict in Europe shows ‘protection’ is necessary to preserve peace and democracy.
David Perry from J.P. Morgan argues the ESG credentials of such stocks should be re-evaluated, while in the Financial Times two Citi analysts state that defence 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”.
In January, Swedish financial group SEB reversed a blanket ban to permit six of its funds to now invest in weapons manufacturers, a policy decision prompted by the “serious security situation and growing geopolitical tensions… culminating with Russia’s invasion of Ukraine”, says Niklas Magnusson, SEB’s group press officer.
SEB’s former weapons exclusion policy was rated as comparably strong in a report titled ‘Don’t Bank on the Bomb’ and published by Dutch peace organisation Pax.
The case for weapons makers to be formally acknowledged as part of the ESG lexicon has been rumbling for some time. The EU’s potential revised social taxonomy, a non-binding classification system based on the existing taxonomy for sustainable finance that came into force in 2020, could well be one location. Inclusion within it would be a boon to arms manufacturers already benefiting from Russia’s invasion, as their soaring stock prices indicate (see chart below).
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A draft version of the EU report on the structure of the social taxonomy leaked to Responsible Investor in February was criticised for lacking precision on the topic.
The final update from the Platform on Sustainable Finance – an expert group at the European Commission (EC) – offers two methods for measuring which weapons are harmful: using internationally agreed conventions, or research on the "detrimental social effects of certain activities to identify significantly harmful activities". The EC will review this recommendation and decide whether to go ahead with the social taxonomy later in the year.
Most investors distinguish between controversial weapons – such as biological, chemical, cluster munitions or nuclear – and conventional weapons, produced by companies such as BAE Systems, such as guns and missile launchers.
Although certain conventional weapons may not be sanctioned by many democratic governments, it does not mean they do not cause harm to civilians. Data from the Stockholm International Peace Research Institute on the world’s leading 100 arms manufacturers, including those of conventional weapons, shows that the largest number of arms exports between 2019-2020 went to Saudi Arabia, which is involved in a civil war in Yemen that has led to thousands of civilian deaths.
ESG funds full of weapons
While politicians debate the ethical value of weapons manufacturing, plenty of ESG funds currently hold stocks of companies tied to the industry. More than half (52%) of funds classified as sustainable by research firm Morningstar contain a total of $7.3bn of exposure to military weapons, according to Capital Monitor analysis of shareholder advocacy group As You Sow’s database.
As You Sow takes its definition of military weapons from the aforementioned Stockholm International Peace Research Institute's database of the world’s largest weapons manufacturers.
“Our take is that funds that call themselves ESG should not have weapons in them – though there are plenty of funds that do,” Andrew Behar, chief executive of As You Sow, tells Capital Monitor.
Behar says the presence of military stocks in these ESG funds proves that the term 'ESG' requires a formally held definition that regulators can enforce.
Based on the EU’s Sustainable Finance Disclosure Regulation Article 8 and Article 9 ('light green' and 'dark green' funds), 26% and 13% of such products' portfolios, respectively, had some exposure to controversial weapons at the end of November 2021, according to a Morningstar February report.
Nearly one in ten (9%) ESG funds score the lowest possible ‘F’ grade for their exposure to major military contractors, compared with 19% for all funds, according to As You Sow’s classification system. ‘F’ means a 3% or higher exposure to the top 100 weapons manufacturers, while a ‘C’ grade is 1-2% exposure and an ‘A’ grade equals no exposure at all.
That said, ESG funds do have less exposure to weapons than regular funds. And in both cases overall exposure has been falling over the past two years. This fall, shown in the chart below, is likely due to public pressure on investors to move away from weapons.
To put this into context, while funds in general have less exposure to military (and nuclear) weapons than fossil fuels, they hold more exposure to these stocks than to tobacco companies.
Capital Monitor has examined the exclusion criteria for the ten ESG funds with the highest percentage exposure to military contractors, to understand how these stocks end up within them.
Seven of the funds (or their respective indexes) make no mention of weapons exclusion screenings in their prospectuses. Instead, they describe their broader ESG screening strategies. For example, the Columbia Sustainable US Equity Income ETF excludes securities with an MSCI ESG rating of BB or below.
It is worth noting that two major defence stocks, Thales and BAE systems, have MSCI ESG ratings of A and AA respectively.
The Nuveen ESG Mid-Cap Growth ETF, which tracks the TIAA ESG USA Mid-Cap Growth Index, bans all companies that earn either $3bn, or 50% or more, of their revenue from the manufacture of conventional weapons components or conventional weapons and weapons systems.
According to the Stockholm International Peace Research Institute's database, 40% of the top 100 arms manufacturers generate less than 50% of their revenues from weapons. For example, French company Thales – which has exported weapons to places including Saudi Arabia, the UAE, Egypt, Kuwait and Jordan – draws 47% of its revenue from weapons.
And while Thales earns less of its overall revenue from weapons than most other companies in the database, it had the 14th-largest sales revenues from weapons ($9bn) in monetary terms.
One fund with a general weapons screen is the actively managed Stance Equity ESG Large Cap Core ETF. It says companies that are "exclusively or primarily engaged in weapons, tobacco, or thermal coal are generally excluded from consideration". But it is unclear from the fund’s prospectus what the exact threshold is.
Goldman Sachs’ US Equity ESG fund has an exclusion for "companies that derive any revenue from controversial weapons", but there is no mention of conventional weapons.
None of these funds appear to be breaking their own rules – they simply apply their own, sometimes unclear, methodologies for distinguishing which defence stocks should be excluded from ESG funds.
A permanent shift
It is important to clarify that those in favour of weapons being classed as ESG are not advocating for a temporary suspension of weapons exclusions in ESG funds, but, rather, for a shift in how investors perceive defence stocks more generally – SEB included.
The war between Russia and Ukraine has also provided weapons makers with the opportunity to reassert their position on this too.
“We’ve been making the case for quite a long time that well-regulated defence companies provide social value… It's tragic that it’s taken a crisis such as this to make more people realise the value of well-regulated defence and the need to support the protection of nations and their citizens,” a spokesperson from BAE Systems tells Capital Monitor.
A spokesperson for Hensoldt tells Capital Monitor that it has always said that “without security, there is no sustainability.”
The company has been in contact with the German government on the particular issue of Ukraine, among other things, and making proposals for it to buy new products.
Support for the security argument has been bolstered by the German government’s U-turn on its policy of banning lethal weapons exports to conflict zones.
Although it seems hard to fathom, the case can be made that weapons and ESG are bedfellows. And, if certain vested interests get their way, this will continue to be the case for some time to come.
