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Investing in the Defence sector: challenge in striking a balance between strategic interests and ethics

“The supreme art of war is to subdue the enemy without fighting.”

Sun Tzu, The Art of War

After three decades of military budget cuts in Europe – a trend that was somewhat accelerated by the austerity measures triggered by the 2008 crisis – Russia’s invasion of Ukraine reminded us that, in addition to playing a strategic role, the Defence sector is a field where the balance between issues of national security, economic imperatives and ethical considerations is of utmost importance!

As they stand, relations between the world’s major superpowers, and particularly the United States, Russia and China, have hit rarely seen threat levels, sparking fears over global stability. The non-exhaustive list of triggers is quite long: Russia’s invasion of Ukraine, disputes in the South China Sea, tense situations in North/South Korea, Taiwan, the Near and Middle East, Niger, the Sahel, Sudan, not to mention Latin America, and so on. These risks have a direct influence not only on government decisions, strategic alliances and supplies of raw materials, but also on business investment decisions, thus introducing an additional element of risk and uncertainty.

In fact, regional conflicts such as those in the Middle East have persisted and evolved, creating complex challenges in terms of security and military strategy. For example, recent tensions off the coast of Yemen in the Red Sea ended up seeing global maritime traffic re-routed through the Suez Canal. Furthermore, the repercussions on global trade, shipping costs, supply chains, energy prices and inflation are not to be taken lightly should they persist.


Growing realisation on the part of governments

The President of Ukraine and his inner circle have repeated ad infinitum in recent months that European weapons stocks are dwindling. And for good reason: investments in the European Defence sector have slowed over the last 30 years, significantly limiting strategic reserves.

According to a 2022 study by British think tank IISS (International Institute for Strategic Studies), the main European countries have experienced equipment attrition losses (tanks, aircraft, ships and submarines) of 40% to 75% since the early 1990s. The era of peace seemingly in place since the fall of the Soviet Union now appears to be well and truly over. After Ukraine was invaded, the member states reacted in complete opposition to this trend! A very large number of European countries decided to raise their military spending budgets for the years to come.

Germany for one created a special €100 billion fund to modernise its military through 2028. For its part, France is expected to expand its military budget one-third by 2030, while Italy has earmarked an additional 0.5% of its GDP for Defence spending, Spain 0.7%, etc.

This new trend is now deeply entrenched, even if Europe has fallen somewhat behind. If we include the United Kingdom, Europe accounts for just 20% of Defence sector spending worldwide. Moreover, in the interest of “national security”, at this point there are no real common Defence structures for all member states...

True, there is the European Defence Agency, however it serves more as an advisor on how the member states can work together to improve their defence capabilities. On the other side of the Atlantic, with more than $800 billion allocated to military spending in 2022 (nearly 3.5% of GDP), the US has never truly lowered its guard. The US alone is responsible for nearly 42% of global Defence industry spending! In the same vein, and not surprisingly, China takes the No. 2 spot, with numbers ranging from $300bn to $700bn per year depending on the budget. Far from our own borders, other countries have also sharply increased their Defence budgets, such as Japan, Australia, South Korea and India.


Multiple challenges in sector financing

Although these budget hikes have been enacted, governments are dealing with a number of opposing factors when it comes to public spending. First off, rising interest rates have increased debt servicing costs, while inflation has bumped up contract costs. Second, upcoming elections – particularly later this year in the US – are factors that could easily reverse the trend.

We would also point out that the “ethical” side of weapons financing could raise some eyebrows among investors who may hesitate to invest in a sector so replete with undeniable reputation risks. Although “indirectly” financing the defence industry by purchasing government bonds (for example) does not seem to pose a problem, some investors would rather avoid the sector entirely just to keep things safe and simple when it comes to their image or convictions.

The issue is also complicated from a European institutional standpoint. The European Investment Bank (EIB) has been facing calls to change its policy to allow investments to be made in the sector by issuing loans, however any modifications to the list of excluded activities must be made by the EIB’s 27 member-state shareholders. And the fact that the EIB is starting to “invest” in weapons and ammunition could affect ESG investing:  nearly half of the €44 billion1 in EIB bonds issued in 2022 were “sustainable investment” certified...

Adding to these challenges is a lack of transparency demonstrated by industry manufacturers (information protected by Defence secrecy for example) as well as the substantial and subjective influence wielded by the governments (awarding of contracts, regulation of exports, etc.).

Lastly, defence sector companies could end up facing growing pressure from investors (particularly European investors) to segregate their civil-sector activities (which can be listed for trading) from their military-sector activities, seen as subject to exclusion from investment strategies. Standards pertaining to ESG and exclusion policies are much stricter in Europe than in the US or the rest of the world, after all. Next, the term “weapons” is still somewhat tricky. It tends to exclude companies with exposure to controversial weapons. The Rothschild & Co Group has established an exclusion policy governing investments in companies involved in the manufacture of controversial weapons. This policy applies to companies involved in the production of weapons prohibited by the Oslo Convention on Cluster Munitions (2008) and the Ottawa Anti-Personnel Mine Ban Treaty (1999).

Accordingly, groups such as Boeing and Lockheed Martin are excluded from our investment universe, as they are affiliated with unconventional weapons, and particularly cluster munitions via the production of certain combat aircraft and other missiles. Conversely, in response to investor interest, German manufacturer Rheinmetall, world-renowned for making the Leopard II tank and exclusively exposed to conventional weapons, was added to the national DAX index in late 2023.

We have to move away from manufacturing towards large-scale production of defence equipment. (…) Germany’s power alone is not enough.(…) A strong defence requires a solid industrial basis. And we Europeans can create this by bundling our orders and combining our funds, which would give the industry sound prospects for the next few decades.

German Chancellor Olaf Scholz, 12 February 2024

Could ESG investment policies ultimately be relaxed?

Financial produce managers were forced to adapt in 2021 when Europe implemented the SFDR2, aimed at distinguishing “green” investments from other types of investments. Note: financial vehicles with strong sustainability objectives are classified as “Article 9”, products incorporating ESG characteristics as “Article 8” and products without sustainability objectives as “Article 6”. Accordingly, investment funds classified as Article 8 and Article 9 and sold in Europe are still logically less exposed to weapons manufacturers than Article 6 funds.

According to a January 2024 study by Morningstar3, around 70% of Article 8 funds and 90% of Article 9 funds had no exposure to controversial weapons at end-December 2023, versus 56% for Article 6 products. The study also stated that, at end-September 2023, the  number of ESG funds holding equities issued by the Aerospace and Defence sector rose had risen 25% since the invasion of Ukraine (although a fair percentage of these funds were converted to “ESG” funds over the period).

From that standpoint, ESG and the Defence sector are not necessarily incompatible. The growing adoption of ESG standards in the Defence industry points to a trend towards greater accountability. What’s more, we would not be at all surprised if a certification were to arise incorporating Defence-tailored ESG criteria, which could benefit all sector manufacturers. Some companies have already taken the lead in this respect, such as leading Swedish bank SEB, which lifted certain bans in 2022, finding that investments in the Defence industry are critical to supporting and defending democracy, freedom, stability and respect for human rights. Then, in early January 2024, the French Banking Federation (FBF) stated that it was favourable to adopting a strategic exception.

Lastly, investment in the Defence sector remains both complex and tricky. Increased transparency from sector players will likely allow investors to take a more open-ended approach to their exclusion policies. Such transparency will need to cover both exposure to controversial weapons and ecological transition strategy in order to comply with green taxonomy requirements (SFDR).


Other stakes and challenges...

Of course, matters of national security are not exclusively limited to the defence sector. It would be restrictive to say that defence is limited to the manufacture or supply of weapons, combat aircraft, drones or other munitions.

For example, digital security – already seen in private- and public-sector technological infrastructures – are becoming so critical to national security that several governments have created a separate branch of their army on par with their air force (and sometimes their space force). Cybersecurity thus has rightfully earned its place in our portfolios.

Furthermore, security also concerns key sectors, sometimes revealing their key importance during the Covid-19 pandemic: medication supply, food sovereignty (or drinking water sovereignty), energy independence, patent protection and innovation, etc. Along the same line, security and defence of national interests are also conveyed through information and opinion wars. To that point, a challenge as clear as the provision of secure, unhackable semi-conductors is vital indeed. In our democracies, sometimes undermined by populism and lack of reflection, if not the outright risk of social destabilisation, this type of challenge is indisputably a matter of national security.

In conclusion, financing and investment in the defence sector are both faced with complex challenges, stemming in particular from the ethical concerns of investors and growing ESG regulatory pressures. Regardless, such investments are proving critical at a time when our democracies are entering a new cycle of rearmament and development of responses to multiple, sometimes vital threats. Consequently, by deciding to finance companies playing a key role in the defence or cyber security sectors, we are doing our part to help our nations address these cardinal issues. In doing so, however, we will endeavour to limit the influence of those with questionable - if not outright hostile - intentions as shareholders.

Our very peace and independence depend on it.


1 - EIB Investor Relations Presentation December 2023

2 - The SFDR (Sustainable Finance Disclosure Regulation) is a regulation aimed at promoting sustainability in the finance sector in Europe.

3 - Morningstar SFDR Article 8 and Article 9 Funds: Q4 2023 in Review

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