European rearmament and responsible investment
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Article Type
Insights
Topic
Responsible Investing
Published
April 03, 2025
Read time
5 mins
Author
Aegon AM Responsible Investment Specialists
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As Europe reassesses its security arrangements and seeks to rearm itself, a lively debate on the role of the investment industry – particularly capital markets – in supporting Europe’s domestic weapons industry has developed. Responsible Investment (RI) sceptics have sensed an opportunity, claiming RI practices hinder the defence industry’s ability to finance growth.  We see several problems with this line of reasoning.

Responsible investment is driven by client preferences

 

Investors in RI solutions have a broad, diverse range of social and environmental objectives, ranging from simply wishing to avoid certain economic activities to demanding measurable environmental or social impact alongside a financial return[1].  It is incorrect to assume all RI products exclude all defence sector companies, even when looking at the subset of RI products applying an exclusionary approach.  A popular approach, applied by our own parent company Aegon Ltd in its RI policy[2], is to exclude companies involved in manufacturing controversial weapons.  These are defined by the European Securities and Markets Authority (ESMA) in its latest guidelines on fund names as “anti-personnel mines, cluster munitions, chemical and biological weapons”. A quick scan of defence sector companies for involvement in such weapons reveals no European companies. 

 

Another approach commonly applied is to consider defence companies’ involvement in provision of weapons to countries with poor human rights records, or countries involved in active conflicts.  These investors wish to go beyond the legal restrictions – arms embargoes – to avoid being involved in weapons provision to countries like Saudi Arabia and Israel.  Here again, however, we see limited European company involvement.  Among the European defence companies in broad market indices, perhaps 20-30% have faced allegations of involvement in Yemen and Gaza.  

 

Most importantly, we would argue best practice is to ensure each investor gets a choice in the matter.  Funds should clearly disclose their exclusionary approach in a way investors can easily understand.  Regulation in Europe has recently imposed client questioning on sustainability preferences, and this should work to ensure investors are aware of the choices available to them.  Conversations on client preferences with regards to investment in defence should already be taking place, and may be already having an impact on portfolio construction and product exclusion policies, as we see reports of increasing RI product exposure to the sector.

 

Financing defence sector growth

 

The role of capital market players in financing defence sector expansion is likely limited.  Defence companies will probably seek financing for capital expenditures to increase production capabilities when they receive strong, possibly contractual, signals from public sector procurers.  With public sector contracts, firms can obtain cheaper financing through debt – possibly even cheaper though private, bank-led financing – than through equity or bond markets.  Most of the big European banks maintain policies that only restrict lending to companies involved in controversial weapons, so here again we fail to see a strong link between RI practices and the sector’s ability to finance growth.

 

Furthermore, even if growth is to be financed through capital markets, we’ve previously written about the potential impact of exclusionary approaches on the cost of capital companies experience.  The proportion of investors excluding defence companies indiscriminately would have to be very large to have any perceptible impact on their cost of capital, and that impact may be limited to equity – academic evidence on the impact of exclusions on bond pricing is even more limited.  Yet estimates of the relative size of sustainable investment assets in Europe range from 19 to 38%[3], typically applying broad definitions that encompass multiple different approaches, not all of them excluding the defence sector.

 

Don’t forget your fiduciary duty

 

Sector exclusion is a blunt instrument to avoid the sector’s ESG risks, but investors in the sector do still need to take into account the industry’s significant problems, which European companies are not immune to.  For those companies also involved in aviation, there are usually product safety controversies and pending lawsuits to price in financial analysis.  Export-focused companies usually face serious corruption issues in developing countries, while labor issues, particularly health & safety, are common albeit not as severe in Europe as in other regions.  Defence sector investors must always be mindful of these risks and may choose to divest or exclude certain companies purely due to ESG risks they see as financially material in the short to medium term.  To force investors to do otherwise may cause them to be in breach of their fiduciary duty.

 

Solutions for more targeted defence financing

 

Financing defence companies, or the sell-side, may be fraught with reputational and ESG risks, product usage issues and controversies unavoidable when using general financing instruments like equity and traditional bonds.  However, it is not the only way to mobilize capital markets to support defence sector growth.

 

The buy-side, in the form of sovereign bonds, remains an attractive option to better target capital to European countries activities supporting security, human rights and European values.  Polish government bonds, for example, are increasingly financing contracts with defence companies as the government seeks to spend around 5% of GDP on defence.  We may see new issuance of rearmament bonds, akin to the war bonds of the past, becoming an attractive option for certain countries and for investors keen to support these activities specifically.

 

Similarly, we could see issuance of labelled bonds by European defence companies themselves, restricting their use of proceeds to capital expenditures for weapons contracted by European governments.  These would of course be less targeted, since new facilities may always be used to produce weapons for unsavoury regimes, but still present superior capital traceability for investors concerned about such risks.

 

In summary, it is far from clear that RI practices in Europe are hindering the growth of European defence companies.  Rather than genuine concern, the recent spate of news coverage on the topic is more likely driven by a misguided desire to stimulate further stock price growth and with it, executive compensation.

 

[1] Aegon Asset Management categorizes RI solutions or products into five distinct categories: exclusion and ethical, best-in-class ESG, climate, sustainable and impact, further described in our Responsible Investment Framework.

[2] The Aegon Ltd Responsible Investment Policy is applicable to general account assets of its business units, which are primarily managed by Aegon Asset Management.

[3] According to the Association of the Luxembourg Fund Industry, sustainable funds account for 19% of the European investment fund market as of end 2023.  The Global Sustainable Investment Alliance estimated sustainable investment assets to represent 38% of total managed assets as of end 2022.  Please note the definitions used in calculating these proportions vary significantly.

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