Can Defense Companies Arm an ESG Portfolio?
Do defense companies have a place in an ESG portfolio?
What factors should investors weigh when considering an allocation to the defense sector?
Approaching the one-year mark of the attacks on Israel that set off further unrest across the region, tensions continue to escalate. And while it is more than two years after Russia’s invasion of Ukraine, the conflict there also persists. With geopolitical uncertainty higher than it has been in years, increased spending on defense and security are making the controversial defense sector an attractive investment opportunity. But how do these companies align with the principles of ESG in sustainability-focused portfolios?
Operation Greenlight: The ESG Defense Debate
Just as ESG investing was on the rise, stock performance of the defense and military sector had stagnated as defense budgets were seeing cuts in what was a relatively conflict-free period. ESG frameworks treated defense companies similarly to tobacco and gambling, which meant to exclude them from portfolios.
However, Russia’s unprovoked invasion of Ukraine prompted a reassessment by some investors on the defense sector. Of course, expanding defense budgets do not inherently justify the inclusion of defense stocks, but unlike other sectors excluded from ESG portfolios - like tobacco or gambling, which lack broader societal benefit - defense activities can be viewed as serving a legitimate purpose. Proponents of defense spending argue that a well-equipped military can serve as a deterrent against aggression. Security is recognized as a fundamental human right and self-defence is generally not considered contrary to ESG principles.
Criteria for Responsible Investment
For Future Positive investors considering opportunities in the defense sector, we believe certain exclusions remain necessary. Any weapons classified as “controversial”, such as biological, chemical incendiary and nuclear weapons should not be included in ESG portfolios. These weapons often cause indiscriminate harm to civilians and violate human rights. Though there is some debate on the exact definition of a controversial weapon, adhering to the definitions in international treaties (Convention on Cluster Munitions, Ottawa Convention on the Prohibition of Anti-Personal Mines, Treaty on the Non-Proliferation of Nuclear Weapons, Chemicals Weapon Convention, and the Biological Weapons Convention) is a good foundation for responsible investing.
Another factor for investors to consider within the defense sector is governance. The interconnectedness between government and defense contractors, exemplified by former government officials working for the top defense contractors to effectively lobby their past employers raises ethical concerns. It has led to consolidation of the defense sector in the U.S., with only a handful of defense contractors dominating the market, increasing risks of price manipulation and unreliable promises on weapons performance (e.g. Lockheed Martin’s F-35 saga). Investors would be better off considering companies with a more diversified clientele, which reduces the potential impact from drastic government policy changes.
Finally, investors can focus on companies with strong performance in energy management, hazardous waste handling, and business ethics, as identified by the Sustainability Accounting Standards Board (SASB).
FINAL THOUGHTS
The decision to include defense stocks in ESG portfolios remains complex. The current geopolitical context is prompting new consideration of the defense sector. Future Positive investors considering an allocation to defense stocks should pay particular attention to companies’ exposure to controversial weapons and their governance which pose the greatest ethical concerns.
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