Quo vadis sustainable finance: Why defensive weapons should never be classified as an ESG investment

ABSTRACT

The Russian invasion of Ukraine has influenced how investors categorize sustainable investments. More precisely, an invasion has been used as an excuse to label investments in companies supplying weapons used in self-defense to fight against Russian aggression as socially sustainable since they are a tool helping democracy to repel the invasion of the non-democratic counterpart. Suddenly, the weapons industry started becoming an entirely acceptable sustainable investment asset. This demonstrated that weapons are not the cause but only the result of flawed sustainable investing thinking, which can sometimes be based on ideas that vary widely in terms of consistency and accuracy. This paper discusses some of the reasons underlining systematic problems in the sustainable finance realm and lists why defensive weapons can never be classified as an acceptable asset to invest in.

KEYWORDS:

• Conflict
• sin stocks
• sustainable finance
• SDGs
• climate change

Introduction

In the early morning of 24 February 2022, Russia invaded Ukraine. Hostilities had been slowly accumulating between the two countries since the brief Russo-Ukrainian War in 2014 (Kirby 2022). Lithuania, Poland, Romania, Moldova, and Hungary received most of the more than 6 million people who have fled the country since mid-May 2022 (UNHCR 2022). The European Union (EU) and the United States (US) provided Ukraine with billions of euros and dollars in humanitarian, financial, and military aid (Kiel Institute 2020). Simultaneously, with over 5,000 different targeted sanctions, Russia became the world’s most-sanctioned country – surpassing Iran, Syria, and North Korea (Vuksic 2022).

The Russian invasion of Ukraine has brought large-scale urban destruction, increased human suffering, and political debates linked to the relevance of the enlargement of the EU and the North Atlantic Treaty Organization. It has also profoundly impacted the realm of sustainable finance.

More precisely, the invasion has raised important questions regarding how investors perceive Environmental, Social, and Governance (ESG) principles and what that means in practical application when it comes to sustainable investing.

As the Ukrainian government repeatedly asked the EU and the US for ‘weapons, weapons, and weapons’, Western governments decided to respond to this request because they saw arming Ukraine as the best solution to counter the large-scale Russian invasion (Reed and Henry 2022). For the first time in history, the EU pledged to provide €500 million in weapons to Ukraine (Bilquin 2022). Additionally, the US provided around $3.8 billion in military assistance (United States Department of State 2022).

The financial markets were not immune to this geopolitical event and the injection of government funding into the defense industry. The German defense industry lobby group (BDSV) took the position that defensive weapons are guardians of democracy, using the Ukrainian case to back up their statement (Ainger and Arons 2022). BDSV argued that defense weapons should be included in the EU Taxonomy registry alongside natural gas and nuclear energy, recently added to the EU’s list of ‘accepted environmentally sustainable economic activities’ (Dwyer 2022).

Meanwhile, one of the biggest banks in the Nordics, Swedish SEB, decided to reverse its sustainability policy and permit some of its funds to invest in defense companies (Skandinaviska Enskilda Banken AB 2022). The price of stocks of major weapons producers in the West has seen a sharp increase since the beginning of the invasion of Ukraine (Adetunji 2022).

Does this mean that weapons will slowly evolve from ‘sin stock’ to acceptable ESG investments?

Why weapons should not be classified as an ESG investment

The United Nations (UN)-supported international network of investors, the UN Principles for Responsible Investment (UNPRI), defines responsible investing as a strategy and practice to incorporate ESG elements in investment decisions and active ownership (Douma 2020). ESG-labeled investment should have a wide-scale range of benefits that could equally and simultaneously benefit society and the environment.

ESG investing should be long-term and multifaceted, meaning the investments are more than just profit drivers. Moreover, investments are seen as working toward the betterment of society because they are based on principles and values. More precisely, investors should be ready to sacrifice returns for value-aligned investment choices.

Beyond UNPRI, the Sustainable Development Goal (SDG) 16 promotes peaceful and inclusive societies for sustainable development and advocates for reducing all forms of violence and related death rates globally. The arms industry (i.e. weapons) prevents countries and the world as a whole from meeting the SDG 16 targets. Weapons are designed for destruction, threatening societies’ desire to build equitable and universal access to impartial justice and vital services through promoting violence.

Weapons and war also pollute the environment and fighting generates greenhouse gas emissions. Already, the Ukraine war has contributed to a global rush to secure fossil fuel supplies. Russian invasion caused soaring energy prices, significantly increased investment in oil and gas projects across the globe (Climate Action Tracker 2022). Additionally, military arsenal (e.g. airplanes, tanks, and ships) used in the war are machines that consume large amounts of diesel. Emissions are also coming from the war efforts themselves: burning housing infrastructure, broken gas lines, ammunition storages going up in smoke, from individuals switching to diesel generators because they lack access to electricity (Simon 2022).

When we think about weapons, scanning them through the ESG principles lens, there are several strong reasons why these assets do not satisfy ESG criteria. First, it is tough to determine whether the weapons will be used according to the ESG principles. Weapons could be classified as defensive and offensive. Still, the weapons’ character depends on the user's preferences (i.e. the army) or how the user will utilize the weapons’ power at their disposal.

Arguably, delivering certain weapons to Ukraine would genuinely serve the purpose of ESG investing by protecting human rights since militarily superior Russia attacked the country, which did not pose any serious threat to its security. Conversely, certain weapons used in Ukraine to help the country defend itself are also used to arm the Saudi Arabian Armed Forces, which since 2015 have been conducting a series of military incursions in Yemen using Western-made weapons, resulting in serious crimes again humanity (Hartung and Draper 2020; Burki 2021).

Second, compared to other ESG-classified industries (e.g. renewable energy), the arms industry has never had a problem attracting capital. In 2020, sales of arms and military services by the100 largest companies in that sector totaled $531 billion, growing by 1.3% amid the COVID-19 pandemic (SIPRI 2021).

As numerous researchers have demonstrated, on average, more typical ESG investments have a much harder time attracting the funding they need (Wiek and Weber 2014; Whelan and Fink 2016; Maiti 2020; PricewaterhouseCoopers 2022). Most arms industry contracts are long-term deals with governments that encompass secure funding arrangements (Lineberger and Hussain 2018; Hartung 2021). Solar, wind, and hydropower renewable energy investments need government subsidies that they have a hard time retaining (Baietti, la Rocca, and Causevic 2015).

Third, the arms industry is characterized by practices of non-transparency and corruption. A recent analysis of 134 of the world’s leading arms companies showed that 100 examined companies demonstrated little to no commitment to tackling corruption (Transparency International 2020). Furthermore, the industry is poorly regulated. For example, the global trade in bananas is more tightly regulated than the global trade in arms (Yale Global Justice Program 2021).

The veil of national security-imposed secrecy has allowed politicians, military leaders, corporate executives, and dubious intermediaries to conduct non-transparent transactions replete with corrupt actions. This is evident in the fact that 61 companies in the abovementioned study show no clear evidence of policies or processes to assess and manage risk in their markets (Transparency International 2020). Only 13 companies actively disclose full details of the countries where they conduct business.

Fourth, an increasing body of scientific literature demonstrates that using weapons has a strong negative impact on the environment (Handley-Sidhu et al. 2010; Certini, Scalenghe, and Woods 2013; Manduca et al. 2019; Skalny et al. 2021). Besides the loss of human life and destruction of infrastructure, weapons can devastate a landscape and have long-lasting environmental consequences. Different chemical substances that are part of the weapons themselves (e.g. depleted uranium in bombs) or substances used to manufacture the equipment can decimate ecosystems and emit toxic substances in soil, air, and water that endanger humans, animals, and plants in the long-term.

Fifth, the arms industry manufacturing processes are resource- and emissions-intensive practices. The global defense industry currently contributes 2% to global carbon dioxide emissions, but if its growth continues alongside current projections, this share could rise to 25% by 2050 (Dimitrova et al. 2021). Also, pollution from dumped or abandoned weapons manufacturing waste contributes directly to the weapons industry's carbon footprint.

But sometimes, the emissions are not direct and instead are part of the arms industry’s modus operandi. For instance, the Al Yamamah Arms Deals between the United Kingdom and Saudi Arabia occurred between 1985 and 2008. The United Kingdom agreed to accept 600,000 barrels of crude oil per day as payment from its Saudi counterparts (de Vries 2021). Moreover, manufacturing weapons requires significant quantities of many different materials: more precisely, 39 types of raw materials, including gold, magnesium, and titanium, are necessary to produce different weapons in the EU. Of these, 19 are imported from abroad, increasing their carbon footprint and exporting their mining impacts abroad (Pavel and Tzimas 2016).

Lastly, the UN Universal Declaration of Human Rights implies that all humans are born free and equal in their dignity and rights. Humans are endowed with reason and conscience and should act towards one another in a spirit of brotherhood and sisterhood. Human rights are universal and applicable to all human beings. Weapons cause violations of human rights and societal fragmentation.

And when it comes to the SDGs and ESG principles, weapons do not guarantee social inclusion and protection of health and well-being through healthcare, access to essential services, and minimum income. Weapons instead cause harm to overall physical and mental health. And weapons destroy gender equality, one of the leading social pillars of ESG principles.

Conflicts adversely affect the socioeconomic empowerment of women and girls living in war-torn and otherwise violent zones. Women and girls are more susceptible to radiation from weapons than men (Borrie et al. 2016). Water scarcity frequently occurs in conflict and affects health and sanitation, including the dignity of menstruating girls. The toxicity of soil further enables food insecurity, which also triggers infection, disease, wasting, and stunting in children (Semet 2020).

Conflicts erode social cohesion, and the neoliberal approach to allow weapons to become a positive investment instead puts profits over people and increases social inequities.

Certain systemic problems of the ESG universe

The idea of labeling defense weapons as ESG-approved investments points to a systemic problem the ESG field is experiencing. That is because some ESG data can sometimes be prone to inaccuracies.

In 2020, for example, the global clothing giant H&M earned a 70/100 score for sustainability on the Dow Jones Sustainability Index (H&M Group 2020). At the same time, the company faced issues that should have decreased that score, such as its responsibility for environmental pollution where its clothing is made and for paying workers low wages in developing countries (Beslik 2020). Another example is the tech giant Facebook. Before the Cambridge Analytica scandal, in which Facebook allowed a British company to harvest data of millions of users without their consent, the tech giant had a solid ESG score for years (Mooney 2018).

Deep in their design, not all ESG funds are sustainability-oriented. A recent report by CIBC Capital Markets discovered that ESG funds owned twice as much Russian oil and gas as Canadian oil and gas at the end of 2021. Russian energy companies NK Lukoil, Novatek, Gazprom, and NK Rosneft, accounted for around 0.2% of worldwide ESG holdings (CIBC Capital Markets 2022).

In the first month following the onset of the war in Ukraine, a $2.1 billion BlackRock emerging-markets bond fund that tracks a JPMorgan ESG index decreased by 4.74% (Wriz 2022). The ESG fund underperformed because it had relatively large allocations to Russian government bonds, which are heavily backed by the fact that the country is one of the major global fossil fuels producers.

This is not surprising because the ESG field is still in its early stages of development and the definition of sustainability is fluid across geographies and cultures. However, this can sometimes present a risk because of the potential of greenwashing a product (i.e. defensive weapons) and can potentially lead to greenwashing certain aspects of the ESG field (Fancy 2021).

In mid-May 2022, at the Financial Times Moral Money conference, HSBC’s Global Head of Responsible Investments, Stuart Kirk, firmly stated that climate change is not a financial risk and that investors need to worry about a different set of debates across the world (Financial Times 2022). Kirk received a lot of criticism and he was immediately suspended from HSBC. However, his presentation sparked discussions around the sustainable finance market. Inconsistent definitions of what qualifies as a good ESG investment can produce a lot of discrepancies (Ricketts 2022). Therefore, it is understandable why certain financial actors would like to label defensive weapons as a pro-ESG investment.

Conclusion

Integrating ESG principles into the modus operandi of the global economy and financial system is an ongoing and constantly evolving process (Beslik and Sayyad 2021). The system needs to be continuously updated and monitored, especially if humanity wants to combat climate change more efficiently by redirecting and greening mainstream financial flows (Rezende de Carvalho Ferreira, Vinicius Amorim Sobreiro, and de Moraes Barboza 2016).

Some banks and investors did not show significant commitment to investing in companies and sectors that truly promote ESG principles. In 2020, the value of sustainability-themed investment products amounted to $3.2 trillion, which shows that the trend is increasing. However, this type of finance is still minuscule compared to investments in traditional finance (UNCTAD 2021).

ESG data and reporting standards are crucial because these mechanisms measure the side effects that humanity needs to manage better. Nevertheless, the structure of the data will need to improve. Besides account filings, financial reports, and market data from which a company’s financial health or activity can be assessed, other data such as satellite imagery, product reviews, and social media content should be evaluated to have a more in-depth ESG analysis.

Having alternative data will give investors a broader picture of the ESG compliance of a prospective investment. Raw data on company performance can provide a certain level of analysis. Still, this data should be complemented with alternative data to fill the missing gaps, ensuring transparency and accuracy of ESG screening for specific companies. Doing so would make it easier to enhance the protection against greenwashing and ideas that weapons can be labeled as investments containing ESG principles.

Some banks claim that by investing in weapons, they are directly contributing to protecting democracy, freedom, stability, and human rights while at the same time strengthening their ESG performance; however, other already available financial mechanisms can more credibly justify their ESG purpose. For example, by investing in sustainability or green-focused sovereign bonds (i.e. Lithuania, Poland, France, and South Korea), investors can invest in democratic countries to build better societies (OECD 2021). Hence, there is no need to invest in weapons and claim that investing in these assets will strengthen their ESG value – this is simply not the case.

ESGs should positively impact investments by promoting SDGs. However, the result is the opposite when investing in weapons under a false sustainability pretext. By supporting investment in weapons, ESG is generating setbacks in healthcare, individual health, and gender equality that violate the achievement of SDGs 1, 3, 5, and 16.

The idea of ESG principles for investment is benevolent at its core. However, for the investment to obtain its full potential and become a true force for change, it needs to be based on principles that consider E, S, and G alongside SDGs first and profit second. Defensive or any other weapons simply do not fit in this concept.

Declaration of interest statement

The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Correction Statement

This article has been corrected with minor changes. These changes do not impact the academic content of the article.

Additional information

Funding

Stockholm Sustainable Finance Centre partially funded this work.