Due Diligence Needed by Europe’s New Defence Investors
Ensuring increased private finance flows across the EU and UK hinges on mitigation of ethical, environmental and social concerns.
European governments looking to tap responsible investors for defence funding have been urged to introduce rules addressing likely exposures to ESG-related harms.
The need for NATO members to scale defence spending has heightened in recent weeks. US President Donald Trump demanded higher spending by allies before returning to the White House, and has since shown wavering support for the organisation and the defence of Ukraine, culminating in his decision to suspend military aid to the invaded country.
To reach the 5% of GDP threshold demanded by Trump, governments will require support from the private sector. When European Commission (EC) President Ursula von der Leyen unveiled a new defence investment plan, she explicitly highlighted the role of banks and investors.
However, there are worries that pressure to shore up national security will outweigh investors’ ethical, environmental and social concerns unless due diligence rules are developed.
“The loss of the US as a dependable ally for the defence of Europe, coupled with the territorial ambition of Putin’s Russia, requires a rapid and independent rearmament of Europe,” Phil Bloomer, Executive Director of the Business and Human Rights Resource Centre (BHRRC), told ESG Investor.
“But to retain public trust, this rearmament must hold to international ethical and sustainability standards, in terms of democratic control and the weapons systems adopted – especially indiscriminate weapons such as land mines and cluster munitions, and integrated technologies, including surveillance and targeting protocols.”
Although many sustainable funds across the UK and Europe already have exposures to the defence sector, Bloomer said there is need for “far better regulation of human rights and sustainability reporting”.
Without this, ESG-labelled funds risk exposure to defence companies complicit in arms sales to those involved in major human rights violations, such as ethnic cleansing, genocidal acts and pollution.
“Responsible investors and arms manufacturers need a level playing field which can only be delivered through risk-based human rights due diligence legislation, based on double materiality […] and backed by civil liability,” Bloomer said.
Such transparency has been expected to be promoted through the EU’s Corporate Sustainability Due Diligence Directive and Corporate Sustainability Reporting Directive, which are both now subject to simplification.
In the absence of sufficiently robust regulation, responsible investors should aim to conduct rigorous examinations of the potential impacts of investing in the defence sector, said Lewis Johnston, Director of Policy at UK-based non-profit ShareAction.
“At a minimum, a responsible investment approach requires strict avoidance of controversial weapons regulated by international conventions,” he said.
“[The investor] should engage the company on such impacts and divest if they do not see material impacts being appropriately managed.”
Freedom of choice
Earlier this month, UK Prime Minister Keir Starmer committed to increasing the country’s annual defence spend from 2.3% of GDP to 2.5% by 2027, reaching 3% by the next Parliament.
The remit of the UK’s National Wealth Fund has also been broadened, allowing the fund to spend its capital on defence alongside infrastructure projects focused on renewable energy and housing. It is hoped that this will help to crowd in investment from institutional investors.
The UK government is also calling for investment in advanced technologies with defence applications, including AI and quantum computing.
However, more than 100 Labour MPs and peers have signed an open letter warning that ESG-related policies are limiting defence spending from UK financial institutions. They have called on the finance sector to treat weapons manufacturers as ethical investments.
Some of the country’s biggest pension funds – including Nest and The People’s Pension – have pushed back, arguing they should be allowed the choice to exclude weapons makers from the investment portfolios.
Both Nest and the Universities Superannuation Scheme have told ESG Investor that defence firms already fall within their remit as universal owners.
“They will remain within our investable universe and, where appropriate, we encourage our fund managers to consider further investment,” the Nest spokesperson said.
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.
“This [letter signed by Labour MPs] appears to be yet another example of the government trying to dictate investment policy in a way that suits their needs, before those of savers,” said Clare Reilly, Chief Engagement Officer at PensionBee.
“Pension funds should stand up and decide what is in the best long-term interests of savers and not be mandated to do anything that is contrary to that.”
A UK-based investment and pensions professional argued that pressure from government to direct sustainable finance flows to the defence sector is likely the result of lobbying.
“It’s great PR for the defence industry when Russia is knocking on the back door of Europe,” he said.
“But commercially it is difficult for a sustainable fund with defence stocks to market itself to retail investors – the sense is that retail customers who are buying sustainable funds don’t want defence stocks. Whether this will change as the threat from Russia grows remains to be seen.”
The Financial Conduct Authority has since clarified that there is nothing in its rules that prevents investment or finance for defence companies.
Loosening the purse strings
The EU recently published its ReArm Europe plan, which aims to unlock €800 billion (US$866.7 billion) of additional defence spend. The plan includes provisions to raise and provide loans of up to €150 billion to governments across the bloc over the next five years to boost military spending.
Individual EU countries are acting separately, including Germany’s plans to lift its ‘debt brake’ rule to unlock limitless investing in the sector.
The EU now needs to ensure greater clarity on the “essential criteria” for the inclusion of the defence sector in sustainable investment portfolios, said BHRRC’s Bloomer.
Last year, the European Commission’s Directorate-general for Defence Industry and Space hosted the EU Defence Industrial Investment Forum, which included discussion of balancing sustainability priorities with ensuring national security.
A white paper on this topic is currently scheduled for later this month.
The need for clarification has been made more urgent by the European Commission’s sustainability regulation simplification agenda.
“Its proposal to massively reduce the scale of sustainability reporting is a blow to sustainable investors, including in defence industries – and the proposed evisceration of due diligence would leave defence investors more vulnerable to complicity in crimes against humanity,” said Bloomer.
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