The defence sector in focus: Common ESG risks

There are several drivers that explain why investors are increasingly re-assessing their defence positions. Changing geopolitical risks, national security threats, and policy makers looking to bolster the defence sector mean that investors could be anticipating high expectations to invest and strong financial performance. However, reputational and legal risks associated with weapons manufacturing, arms embargoes, international human rights standards and other breaches of international humanitarian law give rise to caution.

Rising conflict, rising defence spend

The number of conflicts around the world has been steadily rising in the past 15 years. Fatalities and forced displacements are at the highest point over the past two and a half decades. The cost of global conflict is estimated at US$14 trillion per year with losses in annual GDP for countries directly involved (2-8.4%) and neighbouring countries (1.4%).

Knock-on effects from conflicts extend to supply chains, commodity prices and even inflation. Defence stocks generally capitalise on increases in defence spending, and from May 2023 to April 2024 have seen positive performance as, according to Bloomberg, “investors calculate increased geopolitical tension will bolster weapons sales”.

Asset owners – such as sovereign wealth funds, pension funds and university endowments – may seek to understand their beneficiaries’ preferences to inform their investment approach to the defence sector, as well as any political consideration that form part of the investor’s organisational mandate.

Total global military expenditure reached US$2443 billion in 2023, an increase of 6.8% in real terms from 2022, and the steepest year-on-year increase since 2009. In particular, the geopolitical risks driven by the invasion of Ukraine has recently triggered an increase in European defence investments.

While public investment has been increasing, a European Commission report from March 2024 highlighted the defence sector’s challenge related to accessing private financing from an investment industry increasingly conscious of ESG issues. As of March 2024, only 29.8% of EU and UK-domiciled ESG funds had exposure to the aerospace and defence sector (although there was a 4.6 percentage points increase since January 2022) and 36.4% for US domiciled ESG funds.¹

As a result, the European Commission and the UK government have taken steps to facilitate private investment in the defence sector by emphasising its central role in relation to national security, protection of civil liberties and establishing peace.

Consider the material ESG risks

While the current geopolitical landscape is driving a re-assessment of the defence sector, it is important for responsible investors to understand related ESG issues – over the short, medium and long term – and to avoid undue legal and reputational risks.

Well-known ESG risks related to the defence sector include:

• impacts on human rights – such as irremediable harm caused by end use, and application by governments or other groups in breach of international humanitarian law throughout the lifecycle of products;
• political instability – increasing risk of civil war in purchasing countries over time;
• corruption – high proportion of countries with risk of corruption in their defence and security sectors;
• metal pollution – metal emissions of weapon use and related environmental and health consequences;
• organic contamination – such as land contamination through military infrastructure and armed conflicts, and use of chemicals such as potentially toxic compounds and chemical warfare agents; and
• high levels of carbon emissions – the world’s armed forces and the industries supplying them are estimated to cause 5% of global carbon dioxide emissions.

Institutional investors should consider such factors in line with their fiduciary duties, as these factors may be financially material due to the associated reputational, liability, regulatory, and operational risks. Asset owners – such as sovereign wealth funds, pension funds and university endowments – may seek to understand their beneficiaries’ preferences to inform their investment approach to the defence sector, as well as any political consideration that form part of the investor’s organisational mandate.

Article 26 of the Charter of the UN aims to “promote the establishment and maintenance of international peace and security with the least diversion for armaments”, and certain investors are now looking at alternative investment opportunities, such as bonds earmarked to support peacebuilding, to contribute to these long-term goals and to mitigate the impact of conflict on economic growth.

Abiding by international conventions and norms

Investors typically screen their portfolios for weapons, including chemical and biological weapons, cluster munitions and antipersonnel landmines, which are regulated under international humanitarian law. While the Treaty on the Prohibition of Nuclear Weapons has not yet received broad ratification by states, many investors also exclude nuclear weapons. As of December 2023, 70% of Article 8 funds and 90% of Article 9 funds in the EU had no exposure to controversial weapons.²

A number of countries are under arms embargoes by the UN Security Council, the EU or other multilateral entities. The UN Human Rights Council and OHCHR experts also issue non-binding resolutions including arms embargoes for specific states and may specifically call out institutional investors. Financial institutions and their service providers can be held accountable by OECD National Contact Points. This was exemplified in a recent case related to an ESG data provider under investigation for facilitating investment in companies that were linked to state military and allegedly involved in breaches of international law, genocide, and crimes against humanity.

Investor risk management

We find a growing number of investors use environmental and human rights due diligence to manage related financial risks (see PRI guidance on how to identify human rights risks). For the defence sector, investors commonly consider the following steps:

1. Assess defence companies in relation to their products and services, including companies involved in the end-delivery of weapons or weapons systems and the supply of essential components throughout their manufacturing, to determine whether any of these are regulated by international treaties and / or conventions.
2. Review the business relationships of defence companies with states subject to international arms embargoes.
3. Identify ESG risks and engage to determine if defence companies are managing risks and impacts, including in their business relationships and throughout the full product lifecycle. Heightened human rights due diligence should be conducted for companies exposed to conflict and high-risk areas, and with risks of breaches of international humanitarian law.

Institutional investors are likely indirectly exposed to the defence sector through government bonds and may therefore carry out due diligence for their sovereign fixed income portfolio to address ESG risks. (See PRI guidance on human rights in fixed income investing).

ESG issues related to conflict, and associated financial risks, are not confined exclusively to the defence sector: information technology, communication services, and industrials, for example, could also carry risk if their products and services are used to contribute to harm, directly or indirectly, in conflict zones.

While the current geopolitical situation is driving a re-assessment of the defence sector, ESG risks and socio-economic impacts are material for investors. International humanitarian law and human rights standards provide clear and appropriate processes which can help investors to align with global norms, serve beneficiary interests and deliver against long-term investment goals.

 

The PRI blog aims to contribute to the debate around topical responsible investment issues. It should not be construed as advice, nor relied upon. The blog is written by PRI staff members and occasionally guest contributors. Blog authors write in their individual capacity – posts do not necessarily represent a PRI view. The inclusion of examples or case studies does not constitute an endorsement by PRI Association or PRI signatories.