Understanding the conflict two years on.
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Back in the early 2000s, when war in the West seemed unlikely, corporations, investors, and consumers had a lot of time to ponder what companies should do to be good citizens. Environmental, social, and governance (ESG) policies were all the rage—and from an ESG perspective, defense manufacturing was deplorable. How times have changed.
Back in the early 2000s, when war in the West seemed unlikely, corporations, investors, and consumers had a lot of time to ponder what companies should do to be good citizens. Environmental, social, and governance (ESG) policies were all the rage—and from an ESG perspective, defense manufacturing was deplorable. How times have changed.
Today, a growing number of funds allow themselves to invest in weapons manufacturers. But ESG policies have hurt the industry—and inadvertently contributed to the delays now plaguing arms suppliers to countries such as Ukraine.
“Everyone knows the military is using weapons and technology to kill civilians. … How can it be that responsible investment funds hold shares in companies that are funding and equipping the military? That makes these funds accessories to murder,” said Mulan, a pro-democracy activist in Myanmar. According to a 2022 report by ALTSEAN-Burma and the North Carolina-based NGO Inclusive Development International and a more recent study, “companies with links to Myanmar’s junta are often included in ESG indexes.”
In the first 27 months after taking power in a February 2021 coup, the Myanmar military imported at least $1 billion worth of weapons and raw materials for weapons, a U.N. rapporteur found. The country’s rebel forces, which have recently made significant advances, make innovative use of 3D-printed guns—but arms manufacturers supply them, too, with other weaponry.
Skepticism about arms-makers long permeated Western countries, too. “In the late 2010s, 13 of 395 of the funds monitored by [the investment research firm] Morningstar in Europe directly excluded defense,” said Robert Limmergard, the secretary-general of the Swedish Security and Defense Industry Association.
“A few years later, this number began increasing fast, mostly I think because the funds didn’t want to go against the flow. Investment banks made things rather easy for themselves. Instead of looking at defense companies individually, they pointed to ESG and placed defense companies wholesale in the category of companies not commensurate with sustainability. The defense sector became ethically dubious. ESG was characterized by faceless policies, and everyone was following everyone else.” Funds that didn’t exclude defense companies offered the companies financing at higher rates than other companies received.
ESG first popped up in the 1960s under the name “responsible investing.” By the early 2000s, it had gained so much steam that it was featured in a United Nations report titled “Who Cares Wins: Connecting Financial Markets to a Changing World.” And how could anyone disagree with the argument that investments need to take companies’ environmental impact, social policies, and governance into account? The U.N. report made ESG even more mainstream. By the late 2010s and even early 2020s, it had become practically impossible for investors and companies needing investors not to include ESG. That was mostly a good thing because in the long run a more responsible capitalism will benefit all.
But ESG didn’t square with the defense industry. Indeed, arms-makers seemed to represent the opposite of ESG. “The defense industry does not immediately come to mind when thinking about ESG issues. From an environmental perspective, weapons production has a high carbon footprint. Conservative estimates place national defense at more than 50 percent of governments’ carbon emissions. From a social perspective, defense spending has historically been viewed as contrary to social good and welfare,” three lawyers wrote on the Harvard Law School Forum on Corporate Governance’s blog in June 2022.
Matthias Wachter, in charge of defense and space at the Federation of German Industries, told me that “governments were issuing more guidelines, and asset managers went further than government guidelines. All over the private sector, companies were focusing more on ESG, which meant that it became less attractive for fund managers to invest in defense companies even if they had wanted to.” Defense stocks were viewed a bit like stocks associated with tobacco or blood diamonds.
That meant even though defense manufacturers were trying to increase production to meet Western governments’ growing orders, they were struggling to get financing. In January 2022, Rheinmetall CEO Armin Papperger told news media that his company had been denied credit by the German banks LBBW and BayernLB because the banks had ESG concerns.
Then, in February 2022, Russia invaded Ukraine. Western countries needed to seriously step up their defense, which meant ordering more weapons. Weapons-makers were arguing that their sector represented the true spirit of ESG. “I call on the [European Union] to recognize the defense industry as a positive contribution to ‘social sustainability’ within the ESG taxonomy,” Hans Christoph Atzpodien, the CEO of the German Security and Defense Industry Association, told news media soon after the invasion.
Asset managers began to view defense manufacturers with sudden interest. By last November, 1,238 funds describing themselves as ESG-focused held stocks in defense and aerospace companies—25 percent more than in March 2022, according to a Bloomberg analysis. “The invasion of Ukraine has cemented to me the ESG case for defense-related investment,” Alexander Stafford, who chairs the U.K. All-Party Parliamentary Group on ESG, told Bloomberg.
The change, though, may be happening too slowly, especially if the West’s objective is to keep Europe secure. To meet the fast-growing demand for military equipment to be used now and decades from now, defense companies have to expand, but government purchases are only executed years after increased defense spending has been decided on. “We’re seeing a change in mindset, but we’re not seeing much of an effect,” Limmergard said.
“Fund managers tell us that investments in defense companies involve a lot more paperwork than other investments, including submitting a massive questionnaire. And ESG policies still mean it’s more expensive for defense companies than for others to expand, even though it’s clear that they need to expand to keep our countries safe.”
Despite Russia’s war in Ukraine and the German government’s dramatic shift on defense policy, known as the Zeitenwende, “defense companies have worse financing conditions than nondefense companies, and some fund managers still don’t invest in defense companies at all,” Wachter said.
The situation is particularly pronounced in Europe, where governments and the EU have long focused more on ESG than the U.S. government has.
Indeed, governments’ increased defense spending means nothing if financiers aren’t sold on defense. To be sure, the behemoths of the industry—the Lockheed Martins and Rafales—can expand without outside financing, but the defense sector comprises not just the primes that sell directly to governments but also a plethora of companies of all sizes.
Have you heard of DESMI, Binz, Diehl Defence, Storz, Kappa, Hüllert Maskin, or FLIR? And if small and medium-sized enterprises can’t grow as fast as the primes, production—and the development of new defense equipment—will suffer. “At the moment, companies lack resources to invest and grow, they have less resources to invest in new technologies, and the higher costs of capital mean their products are more expensive than they would need to be,” Wachter said.
Last October, Renk—a highly profitable German company with some 3,400 employees that makes transmission parts for tanks—canceled its planned initial public offering after failing to secure financing. Its CEO, Susanne Wiegand, blamed ESG policies that haven’t been updated since the invasion of Ukraine.
The focus on ESG remains an impressive part of modern market economies, especially European ones. A prospective return to pure capitalism that considers neither the environment nor social concerns is so frightening that few would endorse it. But financiers may need to realize that global security is deteriorating so rapidly that they, too, should contribute to keeping Western countries safe.
The defense of Western countries and values requires financiers to adjust both their borrowing rates and their mindsets. As Limmergard noted: “If we want to increase defense production faster, fund managers are crucial, and they have to believe in defense.”
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