Defense Stocks and ESG

We outline the key ESG issues related to defense and how we integrate these in our investment approach.

Key Points

• The war in Ukraine has led investors to review defense holdings and has prompted a wider discussion around how these stocks are considered from a responsible investment point of view.
• There are a number of key ESG issues that we look at in relation to defense companies, in particular around bribery and corruption, as well as weak transparency.
• We engage with defense companies where relevant to influence and improve behaviors, on topics such as human rights, environmental responsibility and governance issues.

Are Investors Changing Their Views on Defense?

Russia’s invasion of Ukraine has been a turning point for many nations, particularly in Europe, to reconsider their spending on defense. Three days following the invasion, German Chancellor Olaf Scholz announced a €100bn fund to modernize Germany’s military, as well as a commitment that Germany would spend a minimum of 2% of GDP on defense in the coming years.¹

The war in Ukraine has forced investors to review defense holdings – the primary beneficiaries of a potential increase in defense spending – and to consider the opportunity cost that not holding these companies may entail. This has also prompted a wider discussion around how defense stocks are considered from a responsible investment point of view and has driven sustainability managers to review their investment thesis for the exclusion of weapons businesses from certain investment areas. In recent years, the defense industry has argued that exclusionary approaches, with all their variations, have impaired investment in the sector. With banks and investors having cut ties with the industry, there are claims that sector valuations have been affected.² So far, the observation is that most investors have not made significant, immediate changes to their views on the topic; in fact, some are looking to strengthen their screening methodologies, definitions and policies on defense investments through stricter monitoring.

Bribery and Corruption

This is clearly a contentious topic, and there are a variety of material issues that must be considered from an investment perspective beyond the mere rebranding of weapons businesses as defense businesses. A key issue that we look at in relation to defense companies is bribery and corruption – this is a constant risk where large sums of money are involved, and although not as prolific as it was in the late 1990s and early 2000s, it still exists. According to Transparency International, “nearly three-quarters of the world’s largest defense companies show little to no commitment to tackling corruption.”³ Having in place a formal anti-bribery and corruption policy alone is not sufficient, given that these companies may be dealing with countries and regimes that do not function in the same way as democratic societies. Where companies are sometimes aggressively competing for business, they may hire third-party agents to deal with local officials, and in the process may lose their ability to monitor and control business conduct. The acceptance by Airbus, the largest aerospace multinational in Europe, of a €3.6 billion fine on a foreign bribery charge by the US, French and UK authorities in 2020 continues to linger as it faces investor litigation which seeks €300 million in damages.^4,5

This highlights the importance of engaging with companies and encouraging them to provide detail on their business activities. We look to understand a company’s exposure to corruption-prone nations; we seek information around their measures to minimize risk of corruption when dealing with governments, suppliers, agents, consultants, or intermediaries; and we want companies to provide evidence of these through whistle-blower mechanisms and third-party audits in their corporate reporting. We have found the work done by Transparency International to be helpful in understanding the quality of risk management controls at country and company level.    

Export Controls

In addition, we view the export control measures that defense companies have in place to be an important consideration. These are critical to avoid potential violations in the transfer of hardware or software which could attract penalties and economic sanctions from regulators. Beyond compliance, there is a broader responsibility for companies to avoid unintentional or indirect complicity in enabling human-rights violations in situations of conflict.

Human-Rights Implications

Such issues directly tie into product use and how its impacts modify an investment case. Defense companies should ideally consider their responsibility for what they sell and how that affects human, societal, and economic peace. It is not as straightforward when those companies work as contractors to governments which essentially control the sales and contracts of weapons to other nations. Such arrangements pose a challenge when engaging with companies that may not see this as being their responsibility given how little control they have over the onward sales of weapons in government-to-government deals. However, it is worth debating whether or not that rids the companies of their responsibility towards the human-rights implications of the end use of their products, in the same way that we have seen arguments around whether the oil and gas industries should be held accountable for pollution, or whether the tobacco industry should bear the burden of serious health effects (with smoking being the leading cause of preventable death in the US).⁶

Transparency

We would also highlight weak transparency as a further key ESG issue; for example, the US government Department of Defense, which is the largest defense buyer in the world, has received a ‘disclaimer of opinion’ on its financial statements every year so far owing to insufficient information for the auditor to form an opinion. There is a general lack of transparency in corporate dealings, given the sensitive nature of the industry and the importance it plays in relation to government and military contracts. This means that, as investors, it makes it more difficult for us to fully assess the key risks related to defense stocks.

A further risk is that if shareholders start to provide views on who governments can sell weapons to, it may be perceived as removing the rights of democratically elected officials to make defense decisions. This means that investors have to tread cautiously in their stewardship efforts. We have heard views from industry participants that improving precision of defense weapons helps avoid collateral damage so that when the need for warfare exists, precise and efficient strikes to eliminate the target may be carried out while minimizing significant unintended damage in the process. However, we question if a ‘perfect’ precision-guided munition or a ‘smart’ bomb poses a moral problem by making use of lethal force an easier option, thereby increasing its usage.⁷

Sustainable Investing and Defense

On the one hand, security is a key component of sustainability: it is a human right enshrined in international human rights treaties, is reflected in the United Nations Sustainable Development Goals (SDGs), and is a key foundation for long-term societies. On the other hand, we must acknowledge that weapons are pieces of machinery that can cause indiscriminate damage in the wrong hands. Ultimately, investors cannot distinguish between a defensive weapon and an offensive one – while there are clearly different levels of lethality, any weapon can cause harm in the hands of an aggressor.

Looking at the global regulatory landscape, we do not currently believe that investing in defense companies is compatible with the definition of a ‘sustainable investment’ under the European Union’s Sustainable Finance Disclosure Regulation (SFDR). An Article 9 product (one which specifically has sustainable investment as part of its objective, and which can only make investments that fall within the definition of a sustainable investment under SFDR) may not invest in a security that falls foul of the ‘do no significant harm’ principle (DNSH). However, an Article 8 product (one which promotes environmental or social characteristics but does not have sustainable investment as its objective) might still be able to invest in defense stocks, as it is not bound by DNSH, although companies would still need to meet the high bar of material ESG considerations outlined previously.

At Newton, our consideration of ESG issues is part of our broad, multi-dimensional investment approach that integrates financial analysis, thematic trends, macroeconomics, and valuation considerations. We believe a failure to consider material ESG insights is likely to give an incomplete picture of the merits and risks of an investment opportunity. Investment in defense companies is a prime example of our ‘mosaic’ approach. Our core strategies allow investments in the defense sector, and where such investments are undertaken, we consider all inputs in our risk and return expectations, without necessarily making investment decisions based solely on the ESG considerations. In addition, we engage with companies where relevant, with the aim of influencing and improving corporate behavior.

For our sustainable strategies, we currently seek to avoid investment in corporate issuers that derive a material portion of business (10% or more, typically measured as a percentage of revenues) from controversial weapons and conventional weapons.

Our sustainable strategies focus on identifying investment ideas that deliver positive impacts for the environment and society while avoiding investments in areas of high social or environmental costs. We seek to invest in high-quality sustainable business models, while at the same time avoiding the poorest performers, including those violating the UN Global Compact Principles or companies incompatible with the aim of limiting global warming to 2°C.

The defense industry presents an interesting case, with its companies having failed to comprehensively meet this higher bar for sustainable strategies, i.e., they have failed to mitigate the negative externalities that result in significant damage to human life and the environment. Their products can have a significant impact on the environment – such as the destruction of protected forests and agricultural fields, and the pollution of waterways resulting from situations of war and conflict – that requires remedies for decades into the future. The threat of deployment of weapons also derails economic development across all involved parties as key resources are diverted, just as we are seeing with the situation in Ukraine. However, there might be, as some would argue, a social benefit to consider – armed deterrence with well-equipped military capabilities that prevent conflict – which could provide a possible motivation to invest in the sector.

We acknowledge the defense industry’s essential role in national security, and we do not think that defense stocks are incompatible, per se, with ESG criteria, which is why we may choose to invest selectively in them in our core strategies. We also recognize the argument as to why we might not consider defense as an essential part of sustainable investments when we continue to invest in the sovereign debt of nations these companies serve. In our view, not everything needs to be bucketed as ‘sustainable’ or ‘unsustainable’ – there are things, such as defense, that are necessary for functioning societies. Sustainability is as much about net-positives as it is about trade-offs, and we struggle with the idea that, in the context of a broad and exciting sustainable investment universe, a defense company would reach the top of the list for a sustainable strategy, or that out of the 17 SDGs, investing in defense stocks makes the most valuable contribution to addressing societal problems.

Sector Engagement Efforts

We often engage with companies to help us understand how material ESG issues are being managed. In terms of the defense sector, we have raised our concerns around human rights, where these issues are relevant, especially in the context of a company’s involvement in regions of conflict, in order to encourage stronger board oversight. Our engagements also focus on the environmental responsibility of these companies which we consider relevant, given that defense accounts for a significant portion of governments’ emissions (50% in the UK and 80% in the US).^8,9 Finally, governance issues around corporate culture, compensation alignment, board accountability and controversial business exposures are part of our continuing due diligence to ensure companies make progress in adopting best practices.

Where material and relevant information exists. Analysis may vary depending on the type of security, investment rationale and investment strategy. Newton does not currently view certain types of investments as presenting ESG risks, opportunities and/or issues, and believes it is not practicable to evaluate such risks, opportunities and/or issues for certain other investments. In addition, Newton will make investment decisions that are not based solely on ESG considerations. In some cases therefore, Newton may conclude that other attributes of an investment outweigh ESG considerations when making investment decisions.

Sources:

1. Germany unveils ‘new era’ in defence policy with big military spending jump, FT.com, February 27, 2022 (https://www.ft.com/content/ffc46030-51c6-4d87-b81b-457a31fbcdc9)

2. Rise of ESG adds to pressure on European defence companies, FT.com, December 1, 2021 (https://www.ft.com/content/e14ea515-a6f3-4763-9def-7bc40d3b2e4a)

3. World’s largest defence companies not doing enough to tackle corruption, Transparency International, February 9, 2021 (https://ti-defence.org/defence-companies-index-on-anti-corruption-and-corporate-transparency/)

4. Airbus Agrees to Monitoring in $4 Billion Settlement of Bribery Charges, WSJ, February 1, 2020 (https://www.wsj.com/articles/airbus-bribery-charges-unveiled-after-4-billion-settlement-11580480153)

5. Airbus faces $339 million class action suit in the Netherlands, lawyers say, Reuters, December 16, 2021 (https://www.reuters.com/business/aerospace-defense/airbus-faces-339-million-class-action-suit-netherlands-lawyers-say-2022-01-07/)

6. Centers for Disease Control and Prevention, Fast Facts (https://www.cdc.gov/tobacco/data_statistics/fact_sheets/fast_facts/index.htm#:~:text=Smoking%20is%20the%20leading%20cause%20of%20preventable%20death.,diseases%20related%20to%20tobacco%20use%20by%202030.%203)

7. Study: Drone Strikes Have Been Effective in Pakistan, Voice of America News, March 7, 2010 (https://www.voanews.com/a/report-drone-strikes-in-pakistan-effective-86953007/165436.html)

8. Ministry of Defence Climate Change and Sustainability Strategic Approach, GOV.UK, March 30, 2021 (https://www.gov.uk/government/publications/ministry-of-defence-climate-change-and-sustainability-strategic-approach/ministry-of-defence-climate-change-and-sustainability-strategic-approach-accessible-version)

9. Decarbonizing defense: Imperative and opportunity, McKinsey & Company, July  1, 2021 (https://www.mckinsey.com/industries/aerospace-and-defense/our-insights/decarbonizing-defense-imperative-and-opportunity)

Authors

Sakshi Bahl

Head of Sustainability Research