Russia’s invasion of Ukraine over three years ago profoundly changed the conversation around the ESG characteristics of defence stocks. With the UK publicly backing Ukraine against the unprovoked attack, British defence companies quickly became a necessary cog in the arming of an ally and deterring the threat of Russian forces.
Indeed, in April 2024, HM Treasury and the Investment Association declared that “investing in good, high-quality, well-run defence companies is compatible with ESG considerations as long-term sustainable investment is about helping all sectors and all companies in the economy succeed”.
This, naturally, caused some consternation as armaments had historically been one of the five ‘sin’ stocks alongside alcohol, gambling, tobacco and pornography. However, it was evident the conversation was beginning to change.
While the debate on whether armaments have a place in a responsible or sustainable investment strategy had begun following the Russian invasion of Ukraine in early 2022, the dial has been turned up somewhat since Donald Trump returned to the White House. Since his election, it has become clear that the ‘America First’ message applies to military action, and thus the safeguarding of European territories will not be guaranteed by the US.
Clearly, in recent weeks, things have escalated somewhat and the future of US military support in Ukraine has been thrown into question much more quickly than anticipated. Trump and Ukrainian President Volodymyr Zelenskyy’s ill-fated Oval Office meeting has woken Europe up to the fact that the responsibility of defending Ukraine is going to fall on their shoulders.
The UK government has already reacted by increasing defence spending from 2.3% of GDP, to 2.5% (increasing the budget by £5-6bn per annum). There is pressure for it to go further, and the public is certainly on board. According to YouGov, two-thirds of Britons (65%) are in favour of increasing defence spending at the expense of overseas aid. This compares with just 20% of Britons opposing the policy.
From our own conversations, we are now seeing investors who have previously eschewed holdings in the defence industry wanting to invest in companies which are providing arms to governments and regimes they approve of. But, for an investor who believes that the UK government should be well placed to protect its citizens as well as play a role globally to protect others, this is an incredibly difficult position to navigate.
One thought for some investors is to continue to exclude non-UK listed defence players but permit investment in companies such as BAE Systems. However, in 2024, just under 50% of BAE’s revenue and 45% of sales came from the US. The UK accounted for roughly 26-27% of revenue and sales. In an environment where the US is calling into question its support for Ukraine, for some investors this will be seen as a red flag. Drill down even further and there will be a list of countries with regimes deemed unpalatable by responsible or sustainable investors where the likes of BAE Systems have exported arms to.
Given the global nature of the defence industry, it is very difficult to pick and choose the exposure you are comfortable with. It reminds me of a situation many years ago when clients wanted to exclude any defence manufacturers that sold arms to terrorists. There were two issues with this; first, the definition of a terrorist can be debated at great lengths – for years Nelson Mandela was categorised as one by the South African government; and second, defence companies do not tend to sell arms directly to proscribed organisations, a third-party is usually involved in the transaction.
Many investment firms have exclusions regarding controversial weapons such as cluster munitions and anti-personnel landmines as these are subject to international laws, and also are often used against civilian populations. Therefore, this type of exclusion is relatively easy to implement.
But can you invest in the defence industry and only give arms to the ‘good guys’? Given the global nature of companies and the difference of opinion on what constitutes ‘good’, this looks increasingly hard to accomplish.
War and conflict are inherently tragic events with consequences for all involved parties. Thus, when it comes to defence companies this will always be a grey area for investors. These companies may have become more compatible with ESG considerations for responsible and sustainable investors in recent years, but this is unlikely to ever be enough to allow them to be considered fully sustainable companies.
