Responsible Investment Newsletter

Can ESG include armaments?

The current invasion of the Ukraine has sparked considerable debate as to whether ESG investors have been mistaken or even naïve in excluding armaments from their investment policies. I want to take this opportunity to broaden the debate and elaborate on our own thinking and processes.

ESG is different to Responsible

Central to our philosophy is the belief that a Responsible Investor is cognisant of how their profits are created, and has a direct connect with the activities of that company. We offer investors the ability to invest in companies that they are happy to profit from, and avoid activities that they are unhappy to profit from. That is different to ESG in so far as ESG analysis is increasingly used as a financial risk management tool rather than a tool for implementing a set of personal values. On an ESG basis there may be little reason to firmly exclude arms manufacturer. On Responsibility grounds we believe the answer is much more nuanced.

The changing face of war

Those of us a certain vintage will remember the sense of relief that accompanied the collapse of the Soviet Union and the subsequent reduction of the threat of global annihilation from the Soviets. There have of course been a constant stream of wars around the world since then, many of which have involved the United Kingdom directly. Many of these conflicts however have little direct relationship to the safety of our homeland or our allies. We would suggest that there is merit in differentiating between the differing activities and involvements of companies.

Where are the problems?

Of particular note to UK investors is the current involvement of Saudi Arabia (by far the UK’s largest arms customer) in the war in Yemen. Other issues such as the aftermath of conflict and the lasting impact of discarded munitions, cluster bombs, mines and guns have received considerable publicity over the last couple of decades. Consequently, investors have rightly evolved their thinking about the probity of investing in armaments.

Defense or offense?

Each individual investor’s motivation for excluding armaments will differ. The most stringent might be pacifist or faith-based attitudes where total exclusion is required. Another way in which investors have framed the decision to exclude, or not, has been to differentiate between the defense of the realm versus manufacture for export, believing that this differentiation reflects the realpolitik of the world, whilst desisting from profiting from the misfortune of other peoples’ conflicts. On the face of it this is a rational and simple compromise. But is that simplicity investable?

What’s in and what’s out?

These days, manufacturers are often supplying to international joint ventures. For example fighter jet design such as the American F35 or the Eurofighter. These are major international joint ventures or projects in which a UK company may be supplying specialist components. In such instances the ultimate end user is not under their immediate control, even if the intended market is NATO based. We also find that companies with significant involvement with the UK defense sector might also have significant contracts with other countries that have human rights issues. As such it is not always easy to differentiate companies purely on home market vs export criteria, even though the major market is defense oriented. So we need to apply a different framework.

How do we differentiate?

To help investors select, we detail the following separate criteria, trying to distinguish the most contentious issues from the least. We also try to differentiate between the actual or likely end use, and user:

·         Involvement with controversial weapons

·         Production of weapons and weapons systems

·         Supply of armaments directly or indirectly to Oppressive regimes

·         Major involvement in components or services that have only military use

·         Minor involvement in components or services that have only military use

·         Major involvement in components or services that have both military and civilian use

·         Minor involvement in components or services that have both military and civilian use

There is usually sufficient information to make an informed decision on the grounds above. Investors have the opportunity to rule out the most controversial issues (such as land mines) and accept the least contentious (such as facilities management) or various points in between.

Will my portfolio suffer?

The United Kingdom does not have a huge military industrial complex and there are few major military equipment manufacturers, so it isn’t difficult to avoid this area of investment. From a portfolio management perspective, there is no real need to be involved. At times there can be some opportunity cost but there are other things to invest in.

Chris Redman, Chartered FCSI
Investment Director and Head of Responsible Investments