Are some causes worth bending ESG rules?

Excluding defence companies has long been common practice for responsible investors. At a minimum, most negatively screened ‘ethical’ funds exclude the controversial weapons banned under international law: for example, chemical weapons and cluster bombs.

However, most funds take it a step further and exclude all companies (typically screened on the basis of revenue) involved in weapons manufacture, in line with the preferences of many underlying investors.

The invasion of Ukraine has shocked the world and spurred many countries to increase their spending on defence. Germany announced a €100 billion (AU$153 billion) spending package and a commitment to reach 2% of GDP spent on defence. Poland will raise its defence spending to 3% of GDP starting next year, and Lithuania, Romania, Sweden and Denmark have all announced dramatic spending increases. Even in Australia, Prime Minister Scott Morrison announced a plan to increase the size of the Australian Defence Force by 30% over the next 18 years.

Whilst the reaction of these countries is not unexpected, it has been fascinating to follow the conversations from within the investment industry about whether armaments could, or should, now be considered appropriate ESG, or even ‘impact’ investments. We have seen calls for the EU to recognise the defence industry as a positive contribution to ‘social sustainability’ under the EU Taxonomy, which has been convened by the European Union to define the ESG investment rules.

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According to the UN Global Compact, social sustainability is about identifying and managing business impacts, both positive and negative, on people. Within social sustainability, human rights is the main component that would be relevant to questions of defence.

Protecting and promoting human rights would be seen as a positive contribution to social sustainability.

A recent report from Citi seems to indicate that they see no challenge in applying this definition: “Defence is likely to be increasingly seen as a necessity that facilitates ESG as an enterprise as well as maintaining peace, stability and other social goods.” Similar conclusions have been reached in the financial press: if something is obviously vital to maintaining peace how can it also cause social harm?

At Pengana, we find this approach astonishing. The defence function of governments is an important one and they rely on the private sector for components and equipment. But the social sustainability of their use will be entirely dependent on how a government manages its defence function. We don’t need to look too far into history to find examples of actions taken in the name of defence which have resulted in significant social harm.

Taking the view that weapons contribute to positive impacts that outweigh the harm is a challenging conclusion to reach in our view. Not only does it require analysis of the customer base, it also requires normative judgements of who are the good and bad actors, and which conflicts are justified.

We prefer to consider the issue from the perspective of risk of negative impact, rather than taking a normative view. With this lens it is very difficult to reach a conclusion of net positive impact from these activities given the inherently high risk of human harm, particularly given that the companies can’t influence their product’s end use.

CREATING POSITIVE IMPACT

Investors have two main ways of creating positive impact: influencing the cost of capital; and engagement. These have evidence of success in climate and diversity. In the defence industry they risk being significantly less effective: Defence expenditure and budgets are set by governments and those spending decisions are likely to outweigh any impact on the cost of capital from investor decisions.

Secondly, private enterprise doesn’t influence defence strategy, it merely acts as part of the governmental supply chain. It is difficult to see how investors could have any influence over the use of these products to ensure they only achieve social good. More importantly, it’s questionable whether we would actually want either capital markets or the companies themselves to have influence over defence decisions.

The debate has made clear that there is still a lack of clarity on the difference between impact and ESG investing. The latter is about risk mitigation and the sustainability of internal operations. Investors who choose to invest in the defence sector should certainly consider material ESG risks in their decision-making and engage on those matters. Impact is about furthering social sustainability, and this is where it is hard to make the case for the defence sector.

This conflict is different. Its potential scale and the nuclear threat are unlike anything that we have seen in recent years. Who it’s affecting and our ability to identify with the victims of this crisis may also have played a role in the sudden emergence of the ‘defence is ESG’ claim.

But the need for defence is not new. Larger budgets may improve the growth opportunity and for some that will make defence a more attractive investment. However, it doesn’t change the underlying principles of ESG and impact investing, and it doesn’t justify the conclusion that defence contributes to social good more so now than it did before this conflict.

OTHER ESG IMPLICATIONS

There are many knock-on effects related to the invasion, including ongoing supply chain disruptions. But the effect on oil and natural gas prices will have broader implications for companies and the global economy.

Combined, Russia is the largest net exporter of oil and gas in the world, earning $241 billion in 2021. Europe is its biggest customer, buying nearly half of Russia’s oil and three quarters of its natural gas exports last year. Historically, fossil fuels have accounted for as much as 63% of Russia’s exports and a third of its federal budget. This cash has helped fund the military force that is currently destroying Ukraine.

Aware that Russia’s economy is propped up by its fossil fuel exports, America has already banned imports of Russian oil and gas. But, given the implications to its own economy and citizens, Europe has been unable to do the same – at least, not yet. Germany is particularly reliant on Russian energy imports – thinktank IMK has argued that halting Russian energy imports would cause a deep recession in Germany.

Nonetheless, European citizens are still paying a high price for its reliance on imported fossil fuels. 35% higher, to be precise, as the invasion of Ukraine adds fuel to the fire of an already deepening energy crisis. Clean and sustainable energy has always been an environmental priority for the EU. Now it is a political one as well.

In March, the European Commission unveiled RePower EU, a policy initiative which aims to achieve independence from Russian energy by 2030. However, Europe’s slow approval process may make this target unattainable. The permitting process in the EU is slow and over-complicated. In fact, it is the number one constraining factor on European wind development. As the CEO of Vestas Wind Systems complained to WHEB last month – “It’s not lack of capital, we just need to get permitting going”. 

If Europe can fix this issue, it may finally be able to deliver on its pledge to install 451GW of wind capacity by 2030.

Meanwhile, in the US, President Joe Biden has announced several initiatives aimed at “achieving real American energy independence”. These include a further $3 billion in funding for household efficiency and electrification upgrades and smart standards focused on more efficient home appliances and equipment.

The Biden administration tried and failed to pass big Cleaner Energy policies last year. Their mistake was to appeal to ideals of environmental justice and climate resilience that are simply not strong enough in America, the world’s largest oil producer. So they are changing the narrative. American Cleaner Energy policy is now being framed as a battle between democracy and autocracy, in which America must compete to win.

Europe has always had big ambitions for environmental policy. The EU has so far failed to build capacity at a fast enough rate to meet its commitments, however. That looks set to change as Europe’s reliance on Russian power weakens its ability to respond to acts of atrocity and leaves its own energy security hanging in the balance. Europe can no longer afford to drag its feet.

Russia’s huge military and its invasion of Ukraine is largely funded by its fossil fuel exports. While investing in armaments to help Ukraine seems a bridge too far regarding ESG, ending the West’s reliance on Russia through investments in clean and efficient energy is a much better bet, with undeniable ESG benefits, while potentially constraining an autocratic regime for years to come.  

Victoria MacLean is associate fund manager and Claire Jervis is senior analyst for the Pengana WHEB Sustainable Impact fund.