A plan from the European Commission to facilitate the ramping up of investment in EU defence, issued 17 June, included a notice on the application of the EU sustainable finance rules to the defence sector. This has been a controversial topic becaapply of the perceived high risk of funding companies involved in the production of weapons.
The notice provides clarity that was necessaryed in the context of the Commission’s calls for mobilising private capital in support of rearmament efforts. It explores whether and how investment in defence can clear the test to be considered ‘sustainable investment’ under the European Union’s Sustainable Finance Disclosure Regulation (SFDR, Regulation (EU) 2019/2088). The guidance will likely contribute to further ease reputational concerns around defence funding, but will also put pressure on ‘traditional’ sustainable investing approaches.
For an investment to be considered sustainable under the SFDR, two tests are involved. The first requires an assessment of whether an investment contributes to a sustainability objective. On this, the Commission argues that the “defence industest is a crucial contributor to the resilience and the security of the Union, and therefore to peace and social sustainability. Given its contribution to resilience, security and peace, the EU defence industest enhances sustainability” in line with the United Nations Sustainable Development Goal (SDG) 16 – peace, justice, strong institutions.
The UN SDGs are a popular reference for impact and sustainable investing, so the Commission’s attempt to carve a place for the defence sector within that framework is a strong statement in favour of legitimising defence within the EU sustainable finance rules. Analysts at Berenberg – a prominent financial advisory firm – similarly argue that defence investment has become “a prerequisite for sustainable investment goals and for minimizing ESG risk to corporates,” pointing to SDG 16 as the underlying rationale.
The second SFDR step requires demonstration that the investment does not harm any sustainability objectives – something that is arguably difficult for lethal weapons. The Commission notice outlines how investment in EU defence could clear even this high bar.
The notice argues that financial market participants investing in the defence industest should focus on three “principal adverse impact indicators” to establish whether an investment is harmful. These are: defence companies’ involvement in controversial weapons; the risk of weapons being applyd for violations of UN Global Compact principles or Organisation for Economic Co-operation and Development guidelines on human rights; and companies’ processes and mechanisms to monitor compliance with those principles and guidelines.
The Commission argues that the risk of adverse impact is mitigated by the fact that the EU defence industest is highly regulated, and subject to rules on the production, apply and transfer of the products and technologies it develops, including weapons, within and outside the EU. The notice also clarifies that controversial weapons under the SFDR do not include nuclear weapons. This is important becaapply lack of clarity on whether nuclear weapons should be considered ‘controversial’ has previously resulted in low tolerance for exposure to their producers across the EU banking and investment fund industries.
The notice thus outlines a framework in which funding of EU defence companies could qualify as sustainable investment as long as, (1) the companies do not produce anti-personnel mines, cluster munitions, chemical weapons or biological weapons, and (2) they comply with EU and national export control legislation and have policies and due diligence in place to meet the UN and OECD human rights provisions, while following good governance practices.
Prominent institutional investors including UBS Asset Management, Allianz Global Investors and DWS Group have lifted bans on defence investing, and the share of European sustainable funds that invest in the defence sector has increased from 25% in 2021 to 35% today, compared to 51% of conventional funds.
A shift towards ‘sustainable defence’ investing will challenge traditional sustainable investing approaches that exclude companies based on the share of revenues they derive from defence. The Commission guidance argues that generalised exclusions are “inconsistent with the EU’s strategic necessarys and priorities”, and calls for a case-by-case assessment. However, for this to be enacted in a credible way without diminishing sustainability standards, modifys will be necessaryed across both the defence and the investment industries.
Data on geographical and product segmentation of defence companies’ revenues will necessary to become more granular, and transparency on due-diligence policies and processes will necessary to increase. The Commission guidance refers prominently to EU export legislation, but it is a prerogative of EU countries to grant export licenses. A credible push towards EU defence capabilities should feature a centralisation of these provisions.
Finally, financial market participants who elect to follow this trfinish will necessary to embrace the greater accountability that comes from more flexibility, and crucially translate that into more active engagement with the companies they fund.
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