Is it responsible to invest in the Defence industry?

Kari Vatanen

8.11.2022, Blog

Corporate responsibility is nowadays an integral part of core activities of an institutional investor. The traditional method of implementing responsibility into the investment process has been negative screening, for example the exclusion of the non-responsible companies. How has the war in Ukraine changed our attitude towards blacklists as a tool of responsible investing?

Corporate responsibility refers both to the integrity and governance of the investment organization, but also to the manner how the investment portfolio is managed and what kind of principles are considered in the investment management process. Responsible investing is typically associated with the letter combination ESG, which refers to the three principal factors of responsible investing: environment, social responsibility and governance. The objectives of responsible investing are to mitigate and prevent risks and to identify potential investments that can benefit from the ESG activities.

Since the late 1990s, one of the main methods of responsible investing has been negative screening, such as the exclusion of non-responsible investments from the potential investment universe. The objective is to exclude individual companies if there has been reported violations of international norms or if the entire industry has been defined as irresponsible. Typical excluded industries have been tobacco, gambling and controversial weapons, but blacklists can easily expand to include companies such as energy producers, alcohol and the defence industry as a whole.

Negative screening is based on the idea that some industries or companies are irresponsible in their core essence and that condition does not change over time. In fact, investors have hardly ever reported that some company was removed from the blacklist. Even if exclusion is often motivated by scientifically valid research and argumentation, classification ultimately relies on some ethical norms within a particular cultural context and investors value those norms from their subjective perception. Nevertheless, ethical norms accepted within a culture can change radically over time when either new scientific knowledge or new cultural aspects are found.

For instance, a couple of decades ago nuclear power was thought to be the most environmentally harmful form of energy production, but in recent years it has been treated as an environmentally friendly transition energy on the way to a non-fossil-fuel economy. Similarly, it is quite likely that producers of fast food or sugary food will be placed on blacklists in next ten years, not to mention wine or other alcohol producers. Furthermore, the cultural context plays a role in determining blacklists. In some cultures, alcohol can be seen as a significantly more irresponsible thing than tobacco.

Nowadays, advanced institutional investors have integrated ESG factors in their investment process as part of the investment analysis and investment decisions. Instead of blacklists and exclusions, different ESG factors are evaluated at the portfolio level. The objective is to transform the investment portfolio to be more responsible over time based on the commonly agreed ESG measures. Investors seek to engage with the companies, for example by communicating directly to the company’s management at investor meetings and general meetings to promote the development of corporate responsibility within the companies. Exclusion is only the last option if the desired development of responsibility cannot be observed. Usually, the best investment opportunities lie in the companies which are not best in class but are changing either themselves or society to be more responsible.

From a holistic perspective, there are companies in the Defence industry that could meet the criteria for responsible investing. The defence industry is rarely especially environmentally friendly, but the social impact can be clearly a more significant factor embedded to it during these days. Manufacturing of Defence equipment is required for promoting the democracy, sovereignty and social welfare of nations in the event of possible invasion. Investing in the Defence sector does not need to mean a Machiavellian ethics where the outcome justifies the means. We can still require good corporate governance and exclude the companies that produce weapons or parts of weapons which are designed to breach fundamental humanitarian principles. When these criteria are fulfilled, companies in the Defence sector can be both responsible and profitable investments for an institutional investor.

The article has been published in the Q3 edition of EQDerivatives Magazine in September 2022.

Kari Vatanen

  • Chief Investment Officer