SFDR Review to Offer Clarity on Defence
Disclosure rule could serve as pathway to bolster defence investment via sustainable funds.
A planned review and potential revamp of the EU’s Sustainable Finance Disclosure Regulation (SFDR) presents an opportunity for the European Commission (EC) to clarify the extent to which sustainable funds can invest in the defence sector.
Earlier this month, the EC presented a white paper outlining its plans to develop the bloc’s defence capabilities and more detail on its €800 billion (US$867 billion) ReArm Europe plan.
The paper confirmed that the existing iteration of SFDR does not prevent responsible investment in the defence sector but said that investors and the defence industry “may benefit” from additional clarifications on the application of the disclosure rules. This will be done as part of the EC’s formal review of SFDR later this year.
“We agree with the white paper’s statement,” Mathilde Dufour, Head of Sustainability Research at French asset manager Mirova, told ESG Investor.
“Clear guidelines would help investors navigate the complexities of responsible investments in defence, ensuring that they can adhere to ethical principles while addressing contemporary security challenges.”
SFDR first came into effect in March 2021, introducing sustainability disclosure requirements for fund managers to report at the entity- and product-level on how and to what extent their funds align with Article 8 and 9 fund categories. Compliance has been fraught with challenges.
“SFDR includes concepts – such as ‘sustainable investments’ and promotion of ‘environmental or social characteristics’ – which are broad and vague, [giving] firms a lot of freedom in terms of product design, investment strategy, and choice of assets,” said Phil Spyropoulos, Partner in Financial Services at law firm Eversheds Sutherland.
“It is possible for a fund manager to therefore decide that defence sector investments have environmental or social characteristics or are sustainable investments.”
However, under the current iteration of SFDR, all Article 8 and 9 funds must disclose whether they consider principle adverse impact (PAI) indicators, one of which specifically relates to controversial weapons.
In addition, Article 9 funds are required to pursue sustainable investment objectives and ensure compliance with SFDR’s ‘do no significant harm’ (DNSH) criteria, noted Hortense Bioy, Head of Sustainable Investing Research at data provider Morningstar Sustainalytics.
“In theory, one can say that it is not an obstacle, but, in practice, many managers of Article 9 funds – especially those with an impact focus – prefer to avoid the [defence] sector to minimise reputational risks,” she said.
Research suggests that almost 30% of Article 9 funds, 16% of Article 8 funds and 4% of Article 6 funds have zero tolerance for nuclear weapons involvement, while 3-4% of Article 9 and Article 8 funds restrict investment in companies that derive more than a nominal proportion of their revenues (1-5%) from weapons.
“Isn’t the main goal of SFDR to increase transparency on the integration of sustainability risks and how adverse impacts are considered in investment decisions?” posited Sabrina Giagheddu, Senior Legal Counsel for ESG and Sustainability at VanEck EU.
“Why should a topic as politically relevant and socially sensitive as defence be left in regulatory ambiguity?”
Options ahead
The EC is mulling either designing and implementing new categories that would more closely align SFDR with the UK’s Sustainability Disclosure Requirements (SDR), or formalising Article 8 and 9 as product categories.
Experts approached by ESG Investor have outlined some areas of clarification on responsible investment in defence that may be useful within this context.
“One point that may be of particular interest to the market is clarification on whether nuclear weapons are to be considered ‘controversial weapons’,” said Silvia Merler, Non-Resident Fellow at think tank Bruegel and Head of ESG and Policy Research at Algebris Investments.
“This is the parameter that would significantly limit the ability of banks and investors to fund EU defence companies specifically – which is what is relevant in the context of the ReArm Europe discussion.”
A more nuanced approach will be needed when assessing defence-related activities, said Aliénor Legendre, ESG Research Associate at MainStreet Partners.
“For example, certain technologies used by the defence sector – but not exclusively – could be more easily classified as sustainable or non-sustainable,” she said.
“This would provide a more informed basis for integrating defence-related investments into sustainable funds.”
Mirova’s Dufour called for more clearly defined ethical thresholds. She said that new transparency requirements for how funds are utilised should be established, which would allow investors to engage more confidently with the sector.
The emergence of green and social bonds shows that it is feasible to channel capital toward specific activities while maintaining a rigorous framework for fund allocation and impact monitoring, she added.
“As such, we could consider the concept of defence bonds, which would direct funding toward projects that are critical for enhancing European sovereignty in strategic and technological areas,” Dufour suggested.
Wider view
The wider sustainable regulation framework could also benefit from clarifications in this area, experts agreed.
For example, companies that derive revenues from controversial weapons currently cannot be included in EU Paris-Aligned Benchmarks and Climate Transition Benchmarks.
Meanwhile, the EU taxonomy, which defines economic activities that can be considered sustainable, may also prevent investment in the defence sector, given the industry’s ties to environmental harms.
Raza Naeem, Partner at law firm Linklaters, said that despite plans for a SFDR review, “ESMA’s fund naming guidelines require funds that have ESG terms in their name to exclude companies involved in any activities related to controversial weapons.”
“This could potentially be a bar [to sustainable funds investing in the defence sector], depending on how broadly you define a controversial weapon,” he said.
Grey area
The defence sector does not have to equate to “bad investment”, VanEck’s Giagheddu argued.
“The EU sustainable finance framework would benefit from an amendment to reflect the current geopolitical context, which taught us, for example, that we can distinguish between (and therefore allow or not) conventional defence and controversial weapons (for example, cluster munitions or nuclear arms),” she said.
“ESG criteria can still be applied and made mandatory to incentivise defence investments aligned with international law and human rights and to discourage investments in companies involved in anti-personnel mines.”
Fund managers are exhibiting a growing appetite for investment opportunities in the defence sector.
Research conducted for the Financial Times found that a third of EU and UK-based ESG-focused funds have invested €7.7 billion (US$8.4 billion) in the defence sector, up from €3.2 billion in the first quarter of 2022.
More recently, STOXX introduced the STOXX Europe Total Market Defence Capped index, which selects European-domiciled armament producers that have revenues from specific defence activities.
“The EC should now take this opportunity to clearly articulate its stance on defence investment, as the UK Financial Conduct Authority has recently done, and focus on how defence relates to key SFDR concepts,” said Merler.
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