Few industries provoke as much debate among ESG investors as defence.
As the conflict in Ukraine continues, so does the debate about defence stocks and ESG. The shifting geopolitical landscape has sparked renewed discussion about the role of defence companies in investment portfolios. However, at Parmenion, we remain committed to excluding weapons companies from our ESG solutions, recognising the ethical and transparency challenges they present.
Russia’s invasion of Ukraine and the US Trump administration pulling back from defence spending in Europe has led to a growing appreciation of the importance of national security. Public opinion on the defence industry is shifting, with some investors seeing it as essential for national security while others remain wary of its ESG risks. This ongoing debate makes it a particularly challenging area for ESG investors to navigate.
Growing threats
The sad truth is that the number of global conflicts is on the rise, the last three years were the most violent in the last three decades. The Institute for Economics and Peace estimates the cost of global conflict at $14 trillion a year. That’s equivalent to $5 a day for every person on the planet. The human cost in terms of fatalities and forced displacements is immeasurable and remains a moral dilemma, not just for ESG investors.
War is an expensive business, as Neville Chamberlain said, “there are no winners”. But as geopolitical risks and national security threats increase, the defence sector has undoubtedly thrived.
Global defence spending soared to a new high of $2.46 trillion in 2024 in response to rising threats. Work towards a hoped-for end to the Ukraine war has raised the prospect of a further military spending surge in Europe, which had already jumped by nearly 12% last year. The region’s leading defence stocks – including BAE Systems, Rolls Royce, Safran and Thales – have boomed.
Indeed, a basket of the seven leading European defence shares has eclipsed the performance of the large-cap US tech stocks since Russia’s invasion of Ukraine early in 2022. The reduction in US military support appears likely to only add to this impetus.
Red lines
Alongside alcohol, gambling, tobacco and pornography, armaments have long been seen by ESG investors as one of the key ‘sin’ sectors.
The ESG risks related to the defence sector are well known: the impacts on human rights; the increased risk of political instability and corruption; pollution and contamination. Defence companies also significantly impact the environment. Through equipment production and dependence on fossil fuels, the world’s armed forces and the industries supplying them are reckoned to cause more than 5% of global carbon dioxide emissions.
In our view, these remain compelling arguments why ESG portfolios should exclude defence companies. In addition, a significant and intractable problem is that investors cannot control where the weapons sold by defence companies end up. This lack of transparency is perhaps our biggest red line.
The need for national defence is clear but cannot be disentangled from the international arms trade, which is a murkier place. Quite simply, who decides which are the ‘good guys’ and how can investors be sure that arms won’t find their way into the ‘wrong hands’?
Some argue that limiting investments to defence companies based in NATO countries could mitigate geopolitical risks. However, while that may appease some ESG investors with a focus on Ukraine, NATO-domiciled companies have supplied 100% of arms to Israel which, according to the UN Human Rights Council, has displayed “clear evidence” of war crimes in Gaza.
This is just one example of how the ESG landscape is being reassessed and reshaped as the Ukraine war and other conflicts rage on. But for us, it highlights why the defence industry remains a no-go for our active ethical and passive ESG solutions.
Our approach to government bonds in ESG portfolios
While we exclude weapons companies from our ESG portfolios, government bond exposure presents a more nuanced challenge. Defence spending is a key component of national budgets, and our approach varies depending on the ESG mandate of each solution.
Our active and passive ESG solutions include some exposure to government bonds, to provide diversification and downside risk mitigation particularly within lower risk grades. This naturally introduces an element of exposure to defence spending by governments, which is projected to rise, particularly for the UK and European countries. However, we take a selective approach:
- Parmenion solutions: These invest broadly across global government bonds (fixed interest and inflation-linked), typically including exposure to all major countries issuing investment-grade government debt.
- Active Ethical Profiles A, B, C and Passive ESG solutions: These also include government bonds but focus primarily on the UK, US and European countries. We deliberately avoid investing in countries with significant human rights concerns, like China, Israel or Saudi Arabia. While these exclusions represent a relatively small part of the investment universe, we believe they align better with the ESG mandate of these solutions. As a result, these portfolios have a slightly different government bonds mix compared to our other solutions, and a slightly longer duration as a result.
- Active Ethical Profile D: Designed for the strictest ethical investors, this profile has historically avoided all government bonds to avoid any indirect exposure to defence spending. However, we recently added an allocation to sovereign green bonds - a relatively new asset class that maintains the defensive investment characteristics of mainstream government bonds, but involves investing only in bonds backing particular environmental projects (such as renewable energy, green transport, building efficiency) making sure there's no defence-related exposure.
Balancing ESG principles with investment strategy is never simple, but our commitment remains clear: to provide sustainable solutions that align with ethical values while delivering strong portfolios.
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This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.
