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Rise of ESG adds to pressure on European defence companies

Defence executives are used to being targeted by antiwar demonstrators, who regularly try to gatecrash shareholder meetings and trade fairs. But now, the industry faces a different kind of adversary: socially conscious investors.

They are stepping up demands on companies to cut the carbon footprints of fuel-hungry fighter jets and battle tanks. At the same time, they are urging greater transparency over the manufacture and sale of weapons following a surge in environmental, social and governance, ESG, investing in the aftermath of the pandemic.

Some executives, particularly in Europe, fear the growing scrutiny, a lack of precise investment definitions and new sustainable finance proposals could ultimately lead to their sector being shunned completely, making them pariahs of the investment world.

These fears have prompted the European trade federation, ASD, to write to the EU commission, warning that proposals on socially sustainable finance threaten to undermine their ability to invest, with banks and fund managers increasingly turning away from the sector.

The federation points out what it says are contradictions between the EU’s desire to strengthen its capability in defence and draft proposals on criteria to define sectors that are socially positive or socially harmful.

Already banks and investors are cutting ties with the industry, said Alessandro Profumo, ASD president and chief executive of Italy’s defence group Leonardo.

“It is important that initiatives on sustainable finance do not contradict other EU policies,” he said. EU measures should “recognise the importance of the industry . . . Defence is part of sustainability and must be recognised as such. Without security we cannot have sustainability.”

Separately, other European executives warn that a valuation gap is opening up with the US, where defence groups are more widely accepted for their role as government contractors despite being excluded from ESG-focused funds.

Some executives are now fighting back. Several of Europe’s largest defence companies, including France’s Thales and Britain’s BAE Systems, have stepped up their efforts to explain what they do and stress their contributions to economies and national security. Both BAE and Thales last month held ESG-focused seminars.

“If for whatever reason sectors are blackballed, then it constrains where you can put money to work and ultimately loses the opportunity for good returns,” said Sir Roger Carr, chair of Britain’s largest defence contractor, BAE Systems, in response to an analyst question at the company’s event last month.

“We are there to help ourselves but also to help the industry to make sure this sector is not on a naughty step and is understood for the value it creates and the ethics and principles that it adopts in the way it delivers its product.”

Bertrand Delcaire, head of investor relations at Thales, said: “As the designer of many innovative solutions for a greener, safer and more inclusive world, we do not understand how cyber security, in which we are a tier-one player, can be seen as a positive ESG activity while other elements of our product portfolio such as radars, sonars and military communication systems that contribute to physical security are seen as a negative ESG activity.”

A particular worry for European executives is the absence of precisely defined ESG investment criteria, which they fear is holding back the sector.

Charles Woodburn, chief executive of BAE Systems, told the Financial Times the industry was “suffering from a lack of consensus in defining ESG compliance, which is causing some investment funds to exclude all defence stocks, rather than taking a more considered approach to assess individual company strategies and portfolios”. 

“European defence stocks are trading at reduced multiples compared to US peers as a result of investors adopting more stringent ESG criteria,” he added.

Another big concern, according to some, is that the whole sector could fall foul of blanket exclusions.

“Blanket ESG exclusions have no middle ground. It does not make sense to simply exclude from an ESG fund all companies that have more than 5 or 10 per cent of sales in defence without looking carefully at the products they actually make,” said one European executive.

Robert Stallard, analyst at Vertical Research Partners, said: “ESG remains a big headwind for European defence companies, though it has yet to cross the Atlantic. The sector as a whole has been ‘blacklisted’ by many European investors, and even if defence companies replanted the Amazon they would still be on the blacklist.”

In Europe, Norwegian pension group KLP is among those tightening its approach. The fund recently announced it had sold holdings totalling $147m in companies including America’s Raytheon and Britain’s Rolls-Royce and Babcock International due to what it said were their links to certain types of weapons such as nuclear armaments.

The fund is taking a “more stringent line” in particular towards “borderline cases”, Kiran Aziz, KLP’s head of responsible investments, told the Financial Times, while stressing that the fund was “not against defence”. 

“We support that every country has to be invested in defence, Norway is in Nato,” Aziz added.

Rolls-Royce said in response to KLP’s divestment that the company’s “involvement in nuclear systems for the UK Royal Navy involves the design, manufacture and servicing of the nuclear power plant and propulsion system for its nuclear-powered submarines, not the production of any weapons”.

There is nothing new about investors’ qualms over defence groups. Investment in controversial weapons such as cluster bombs and landmines as defined in international treaties is banned and is well-established in the asset management industry.

Many mainstream funds adhere to universal indices set by the likes of MSCI. These can range from universal indices with the “smallest amount of exclusions such as landmines and cluster munitions” towards those that apply higher ESG rates, said Meggin Thwing Eastman, research editorial director for MSCI ESG Research.

For ESG investors, weapons manufacturers are often lumped together with tobacco and coal companies and are excluded from funds. Some, such as BlackRock’s screened ESG exchange traded funds, hold no companies that make controversial weapons or civilian firearms. Vanguard’s ESG global corporate bond ETF excludes debt from weapons makers.

“As ESG funds increasingly dominate asset flows, negative screening has risen . . . characterised by increasingly stringent internal metrics (societal value) and administrative reporting burdens,” said Charlotte Keyworth, analyst at Barclays in a recent note.

From about a 30 per cent premium in late 2019, EU defence now trades in line with tobacco, said Keyworth, attributing the change “in part to the rise of ESG investor concerns in Europe”. UK defence stocks, which have been bolstered by a spate of recent takeover activity, are trading at a premium to the wider UK market.

Nuclear is a further area of concern. Executives are increasingly fielding questions about their work on countries’ nuclear defence programmes.

Babcock International, Britain’s second biggest contractor, included an investor FAQ [frequently asked question] on nuclear weapons for the first time in its annual report this year.

Thales similarly used its ESG event to explain that it is one of more than 140 direct suppliers on the French nuclear missile programme but that its involvement was not specific to the nuclear nature of the missile and represented less than 0.1 per cent of total group sales.

BAE also used its event to commit to its exit in the near future from white phosphorous — the controversial chemical component used in incendiary weapons.

The company said that less than 0.1 per cent of its sales still relate to products containing white phosphorous and that it was in talks with the UK Ministry of Defence to phase in a replacement solution.

Making the case for defence, however, is only likely to get harder.

“The risk of continued ESG headwinds doesn’t just undermine the defensive characteristics of defence stocks, it potentially risks them becoming an uninvestable asset class for European fund managers,” warned Stallard.

Additional reporting by Patrick Temple-West in New York

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